Daily Archives: August 20, 2009

Pumping Liquidity to Fight Deflation

By L. Randall Wray [via CFEPS]

In recent years there have been numerous calls on the central banks to “pump” liquidity into the system to fight deflationary pressures, first in Japan and more recently in the US. (Bernanke 2003) Years ago, Friedman (1969) had joked about helicopters dropping bags of money as a way to increase the money supply. If this practice were adopted, it probably would be an effective means of reversing deflationary pressures—if a sufficient number of bags were dropped. There are two problems with suc h a policy recommendation, however. First, of course, no central bank would even consider such a policy. Second, and more importantly, this would not really be a monetary policy operation, but rather a fiscal policy operation akin to welfare spending. In practice, central banks are more-or- less limited to providing reserves at the discount window or in open market operations. In both cases, the central bank increases its liabilities (reserves)and gains an asset (mostly sovereign debt or private bank liabilities, although the central bank could also buy gold, foreign currencies, and other private assets). Helicopter money drops are quite different because they increase private sector wealth; in contrast central bank operations do not (except to the extent that adoption of a lower interest rate target increases prices of financial assets).

From the previous section, it should be clear that the central bank cannot choose to increase reserves beyond the level desired/required by the banking system if it wishes to maintain positive overnight rates. If private banks have all the reserves they need/want,then they will not borrow more from the central bank. Open market purchases would simply result in excess reserve holdings; banks with excessive reserves would offer them in the overnight market, causing the interbank interest rate to decline. Once the overnight rate reached the bottom of the central bank’s target range, an open market sale would be triggered to drain excess reserves. This would return the overnight rate to the target, and the central bank would find that it had drained an amount of reserves more-or-less equivalent to the reserves it had “pumped” into the system to fight deflation. Fortunately,no central bank with a positive overnight interest rate target would be so foolish as to follow the advice that they ought to “pump liquidity” to fight deflation.

Japan presents a somewhat different case, because it operates with a zero overnight rate target. This is maintained by keeping some excess reserves in the banking system. The Bank of Japan can always add more excess reserves to the system since it is satisfied with a zero rate. However, from the perspective of banks, all that “pumping liquidity” into the system means is that they hold more non-earning reserves and fewer low-earning sovereign bills and bonds. There is no reason to believe that this helps to fight deflation, and Japan’s long experience with zero overnight rates even in the presence of deflation provides empirical evidence that even where “pumping liquidity” is possible, it has no discernible positive impact. (The US had a similar experience with discount rates at 1% during the Great Depression.) And, to repeat, “pumping liquidity” is not even a policy option for any nation that operates with positive overnight rates.

Can the central bank do anything about deflation? As the overnight interest rate is a policy variable, the central bank is free to adjust the target to fight deflation. However, both theory and empirical evidence provide ambiguous advice, at best. It is commonly believed that a lower interest rate target will stimulate private borrowing and spending—although many years of zero rates in Japan with chronic deflation provide counter evidence. There is little empirical evidence in support of the common belief that low rates stimulate investment. This could be for a variety of reasons: the central bank can lower the overnight rate, but the relevant longer-term rates are more difficult to reduce; most evidence suggests that investment is interest- inelastic; and in a downturn, the expected returns to investment fall farther and faster than market interest rates can be brought down.

Evidence is more conclusive regarding effects of low rates on housing and consumer durables; indeed, recent lower mortgage rates in the US have undoubtedly spurred a refinancing boom that fueled spending on home remodeling and consumer purchases.

Still, this effect must run its course once all the potentially refinanceable mortgages are turned-over. Further, it must be remembered that for every payment of interest there is an interest receipt. Lower rates reduce interest income. It is generally assumed that debtors have higher spending propensities than creditors, hence, the net effect is presumed to be positive. As populations age, it is probable that a greater proportion of the “rentier” class is retired and at least somewhat dependent upon interest income. This could reverse those marginal propensities.

More importantly, if national government debt is a large proportion of outstanding debt, and if the government debt to GDP ratio is sufficiently high, the net effect of interest rate reductions could well be deflationary. This is because the reduction of interest income provided by government could reduce private spending more than lower rates stimulated private sector borrowing. In sum, the central bank can lower overnight rate targets to fight deflation, but it is not clear that this will have a significant effect.

Read the full article here.

Let’s Create a Real Job Czar for the Jobless

By L. Randal Wray [via CFEPS]

For an example of what can be done, we can look to the recent experience of Argentina. As everyone knows, Argentina had been the darling of the Washington Consensus and of the IMF structural adjustment approach. It opened its economy, freed its markets, privatized government operations, downsized government, adopted fiscal and monetary austerity, and—importantly—adopted a currency board based on the dollar. It did everything “right”, but the IMF/Washington Consensus approach was fundamentally flawed and put Argentina into an inherently unsustainable situation. When world financial markets began to doubt the nation’s ability to maintain the currency board arrangement, there was a run on the domestic currency. The IMF/Washington Consensus recommended more austerity—which caused unemployment and poverty to explode. Social unrest eventually led to rioting in the streets. Argentina wisely abandoned the dollar, floated the currency, defaulted on some of the debt, and rejected the IMF/Washington Consensus.

The rioting stopped when the government implemented a job creation program designed to provide a social safety net for poor households with children. The program evolved through several stages, with the final phase beginning in April 2002 with the implementation of the Jefes de Hogar (Heads of Household) program that provides a payment of 150 pesos per month to a head of household for a minimum of 4 hours of work daily. Participants work in community services and small construction or maintenance activities, or are directed to training programs (including finishing basic education). The household must contain children under age 18, persons with handicaps, or a pregnant woman. Households are generally limited to one participant in the Jefes program.

The program’s total spending is currently equal to about 1% of GDP, with nearly 2 million participants (about 1.7 million in Jefes and 300,000 in PEL). This is out of a population of only 37 million, or more than 5% of the population. However, it should be noted that the US spends 1% of GDP on social assistance, while France and the UK spend 3-4% of GDP on such programs. Given a national poverty rate above 50%, and with 9.6 million indigents and a child poverty rate approaching 75%, Argentina’s spending is small relative to needs.

According to the World Bank’s reviews, the program has been highly successful in achieving a number of goals. First, program spending is well-targeted to the intended population—poor households with children. Second, the program has provided needed services and small infrastructure projects in poor communities, with most projects successfully completed and operating. Third, the program has increased income of poor households. While there have been some problems associated with implementation and supervision of the program cases involving mismanagement or corruption appear to have been relatively rare. Still, there are reports of favoritism, and home country researchers have made serious critiques of program design. However, surveys show that program participants are overwhelmingly happy with the program.

On November 3, 2003, the Mayor of Istanbul, Turkey, announced his intention to create a similar program to fight the growing unemployment problem in that city. Unemployment imposes severe costs on society—both economic costs in terms of foregone output, but also intolerable social costs in terms of rising crime and disintegrating families and communities. The Mayor recognized that no other social program brings so many benefits as those that accompany a job creation program. It will be interesting to follow the developments in Turkey as a “heads of household” job creation program is implemented.

Any sovereign nation that issues its own floating rate currency can “afford” full employment. (Indeed, one might rightly question whether nations can truly “afford” unemployment.) This is because such a government spends by crediting bank accounts, and taxes by debiting them. There can be no question about the solvency of such a nation—even if a deficit results. Japan’s sovereign deficit reaches 8% of GDP; Turkey’s sovereign deficit exceeds 25% of GDP. But so long as these nations maintain floating exchange rates, they can always spend and “service” debt by crediting bank accounts. Hence, if there are unemployed resources, including labor, the sovereign government can put them to work.

The big fear, of course, is that full employment will necessarily generate inflation. If full employment is achieved by “pump priming”, that is, by trying to raise aggregate demand through tax cuts or general government spending, it can in some circumstances generate inflation. However, if full employment is generated through a job creation program designed like Argentina’s Jefes program, it cannot be inflationary. This is because such a program sets a fixed basic wage and then hires all who are ready and willing to work at that wage. This operates like a commodities buffer stock program that sets a floor price—it prevents prices from falling through the floor, but does not push up prices. If the private sector expands, workers are hired out of the labor “buffer stock”; when the private sector down-sizes, workers flow into the “buffer stock”. Hence, the Jefes-type program also provides a strong counter-cyclical stabilizing force. It should be noted that government spending on the program will also be strongly counter-cyclical.

A real Job Czar would be put in charge of a job creation program that would achieve full employment without generating inflationary pressures. Once full employment is achieved, then the pressures to use protectionist measures to fight imports will be diminished. Further, the wage-and-price stabilizing features of a buffer stock approach would reduce reliance on fiscal and monetary austerity to fight inflation.