Tag Archives: inflation

BIS Report Warns That Main Problems Have Not Been Solved

by Eric Tymoigne

The Bank for International Settlements (BIS) in its 79th Report makes several interesting points that are consistent with what has been argued on this blog. Echoing an argument made by William Black, the BIS notes that we must thoroughly analyze banks’ balance sheets in order to rebuild the financial system: “A major cause for concern is the limited progress in addressing the underlying problems in the financial sector . . . a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuid its capital base. These conditions are not being met. . . The banks must . . . adjust by becoming smaller, simpler and safer.”

The report also notes rightly that worries about “exit strategies” for current central banks’ policies are misplaced, because “even if central banks are not able to shrink their balance sheets, they can withdraw liquidity through repurchase operations or the issuance of central bank bills or by making it more attractive for banks to hold reserves.” As noted in previous posts by Scott Fullwiler and L. Randall Wray, there are straightforward means for a central bank to always meet its interest rate targets, and these strategies are not intrinsically inflationary.

The report also recognizes that “there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.” The Report, however, does not go far enough in recognizing that some products should be banned even if used by “sophisticated” financial institutions. Not all financial innovations are a desirable sign of progress. This is especially so if they promote Ponzi finance, which should be a central criterion to judge the safety of a financial product and an institutional organization.

A final interesting point is the acknowledgement that price stability and economic growth are not guaranteed by fine-tuning policies, and that there is a need to manage financial stability. Indeed, the crisis has shown that price stability does not guarantee financial stability and that, contrary to what most economists believed until very recently (and some still believe), the fine-tuning of inflation by interest rates is of limited effectiveness. “The crisis has confirmed that the monetary and fiscal policy framework that delivered the Great Moderation cannot be relied upon to stabilize prices and real growth forever . . . policymakers must be given an explicit financial stability mandate and that they will need additional tools to carry it out.”

However, the way financial stability should be promoted is highly contentious. Most economists argue that the causes of financial instability are imperfections of markets (asymmetry of information, mispricing, etc.) or of individuals (lack of financial education, irrationality, etc.). Hyman Minsky provided a very different explanation of financial instability that did not rely on imperfections and bubbles but on the intrinsic mechanisms of market economies over a long period of economic growth. According to Minsky, over periods of long-term expansion, economic growth and the maintenance of competitiveness require the growing use of Ponzi finance. As a consequence, not only illegal and fraudulent activities, but also legal economic activities become financially fragile. He advocated policies that strongly discourage the use of Ponzi practices (e.g., tax incentives) and/or an outright elimination of legal and illegal Ponzi processes, no matter how necessary they may seem to be for the (short-term) improvement of standards of living and competitiveness. This, rather than improvements of risk-management techniques or improvements in the management of asset prices (detection and pricking of bubbles), would help to prevent financial instability. That would require a much more flexible regulatory system that includes all financial institutions and products, without any exception, and that constantly monitors innovations (i.e. new ways of using existing products or new products) to prevent the emergence of Ponzi processes.

Don’t Fear the Rise in the Fed’s Reserve Balances

By Scott Fullwiler

Many in the financial press have noted the rise since September 2008 in the Fed’s reserve balances from about $20 billion to more than $800 billion today. A number of well-known economists have expressed concern that this will be inflationary.

However, fears that these are inflationary are misplaced, even inapplicable, as they apply only to a monetary system operating under a gold standard, currency board, or similar arrangement, not the flexible exchange rate system of the U. S.

Under a gold standard, for instance, banks must be careful when creating loans that they have sufficient gold or central bank reserves to meet depositor outflows or legal reserve requirements. This is the fractional banking, money multiplier system standard in the economics textbooks. If there is an inflow of gold, then bank deposit creation can increase and prices can rise. The same can occur if the central bank raises the quantity of reserves circulating relative to its own gold reserves.

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Will the Run-Up in Government Debt Doom Us All?

By Stephanie Kelton

Arthur Laffer has taken aim at Chairman Bernanke and President Obama, warning that somewhere down the road their policies will exact a huge price on the American economy. With respect to the Chairman’s handling of monetary policy, Mr. Laffer predicts “rapidly rising prices and much, much higher interest rates.” I am not going to critique Laffer on this point, because Paul Krugman and Mark Thoma have already done so in fine form.

Instead, I want to address Mr. Laffer’s fiscal concerns. He said:

“Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. . . With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.”

I believe that he is wrong on each of the above points, and here is why:

1. Increases in the federal deficit tend to decrease, rather than increase, interest rates. This is because deficit spending leads to a net injection of reserves into the banking system. (And big deficits imply big injections of reserves.) When the banking system is flush with reserves, the price of those reserves – in the U.S. the federal funds rate – is driven to zero (yes, zero!). Unless a zero-bid is consistent with Fed policy, the central bank will begin selling bonds in order to drain excess reserves. The bond sales continue until the fed funds rate falls within the Fed’s target band. The Federal Reserve sets the key interest rate in the U.S., and it can always hit any nominal interest rate it chooses, regardless of the size of the budget deficit (or debt). And this isn’t just true of the Fed. Just look at the Japanese experience:

Thus, despite a debt-to-GDP ratio in excess of 200%, the Bank of Japan never lost the ability to set the key overnight interest rate, which has remained below 1% for about a decade. And, the debt didn’t drive long-term rates higher either. The chart below shows that rates on 10-yr government bonds trended sharply downward as Japan’s public sector debt exploded:

Laffer’s prediction about what will happen to U.S. interest rates as a consequence of the Obama stimulus package are based on a faulty understanding of the relationship between deficit spending, bank reserves and interest rates. The Japanese experience serves as prime example of his flawed logic. (My fellow bloggers, Scott Fullwiler, Randy Wray and I have all published numerous articles that lay out the technical details surrounding the coordination of Treasury Fed operations and the management of U.S. interest rates.)

2. Increases in the federal deficit (and the subsequent run-up in outstanding debt) do not mandate higher taxes in the future. Taxes do not “pay for” the deficits we ran in the past. Taxes drain reserves (an important function) and constrain aggregate demand. Tax revenue obviously moves endogenously, with the business cycle, but revenues can also change as a matter of policy. What Mr. Laffer is apparently arguing is that today’s deficits will require “tomorrow’s” leaders to raise marginal tax rates (or impose new taxes). But this isn’t the U.S. experience.

Corporate taxes, as well as taxes on the wealthiest Americans, have trended downward for decades, even as the U.S. debt quadrupled in size.

And, while payroll taxes have risen steadily over the past 40 years, tax revenues, as a percentage of GDP have hardly budged in more than 50 years.

Thus, Laffer’s assertion that the current run-up in government debt will require “massive tax increases” isn’t borne out by our experience. And, it wasn’t the case in Japan either:

Despite an explosive increase in the government debt in both the U.S. (throughout the 1980s and again under George W. Bush) and Japan (especially in the late 1990s and early 2000s), taxes in both countries are among the lowest in the developed world.

3. Laffer contends that a “partial default on government promises” is an inevitable consequence of the Obama administration’s “ill-conceived” fiscal policies. A statement like this is at best misleading and at worst intellectually dishonest.

As any serious macro economist knows, a government like the United States – i.e. one that controls its own currency – can meet any and all outstanding financial obligations, provided the debts are denominated in the national currency. This is a point that Alan Greenspan made several years ago, when he wrote that “the U.S. government, by virtue of its ability to create money, can never become insolvent with respect to obligations in its own currency.”

Monetary Policy and the Crisis

Historical Perspectives on the Crisis