Green quantitative easing and the creation of money: Quackery or sanity?
On Saturday the redoubtable Green New Deal group issued another call for green infrastructure spending, as they have been doing since the earliest days off the financial crisis. (See e.g. their first report on the new economics foundation website.) This time they promote the idea of ‘Green Infrastructure Quantitative Easing’. Rather than conventional QE, the group argue that the Bank of England should create money to spend on green initiatives.
Five years ago the idea of Green QE would have been met by disbelief or ridicule, but things have changed. Given the Bank of England has already created £375 billion which has been injected into the economy through purchases of government debt, the idea of money creation cannot be avoided.
As if to re-enforce the point, the Bank of England (BoE) has also issued two articles in their Quarterly Bulletin explaining to the interested public the nature of money and the processes of credit creation (see their 2014 Q1 Quarterly Bulletin and / or an associated discussion by Prime Economics) . Other respected figures have also come in with their own variations on a theme; most notably Adair Turner, Martin Wolf and Simon Jenkins want to create money for households to spend (aka helicopter money). Yet in Liam Byrne’s doom-laden (and recently reinvigorated) words the notion that ‘there is no money left’ dominates political discourse.
This blog therefore reviews the standard objections to the GND proposals, which I have done under headings of four ‘I’s – indebtedness, ignorance, inflation (and imports) and ideology.
The overriding consideration for the authorities appears to be preventing financial markets from turning their backs on UK government debt, which would presumably be manifest in serious rises in the interest rates the government pays on its borrowing. Austerity is meant to calm any such fears by demonstrating that the extent of public debt is under control.
In 2009-10 the public sector deficit was 11 per cent of GDP, the highest borrowing since the end of the Second World War. The government planned to reduce quickly the deficit and hence also bring the debt under control. (Note that debt is the stock and deficit is the flow; in cash terms debt continues to rise when the public sector is in deficit, even as the size of the deficit is reduced; so it takes time to turn round the debt.) Crudely the government originally envisaged reducing the current budget deficit from £110 billion to zero over a five year period, through austerity amounting to £110 divided by 5, so just over £20 billion a year. The idea was that debt as a share of GDP would be falling by 2014-15 (i.e. now). Insofar as these things can be judged, markets at the time were satisfied with these plans.
Two different charges were raised against this approach. One that the schedule of cuts proceeded too quickly, and the (for these commentators) necessary pain would be unnecessarily severe and risky to the economy as a whole. The second charge was that the simplistic arithmetic of the cuts neglected deeper interconnectedness between macroeconomic outcomes, erroneously assuming that government budgeting and spending was just like that of a household, when everything the government does affects everything else.
As all spending (both private and public) is somebody’s income, cutting spending reduces the aggregate income of an economy, and reduced income means reduced tax revenues. So spending cuts aimed at improving the public sector finances end up causing harm.
While policymakers do actually recognise these relations, they tend to regard the impact as relatively small. A way of thinking about the ‘multiplier’ is as a measure of the strength of these so-called second-round effects. The fact that deficit reduction has come in way short of plans (see), suggests that the multiplier may have been greatly under-estimated by the authorities.
Reversing the argument that cuts may lead to deteriorating public sector finances, spending increases may therefore improve matters, as higher spending increases income and tax revenues. The IMF have recently accepted this logic, with fewer than the usual caveats.
Imagining for one moment that this logic prevailed, and the government wanted to increase expenditure, there is still the fear that any such increase in spending will feed through to the deficit and debt in the short term, even if gains are ultimately beneficial.
So various financing arrangements are devised: cutting spending elsewhere, increasing taxes (or capturing avoided taxes), or simply taking the rise in debt on the chin and hope than bond markets grin and bear it. Now, at present, it seems likely that bond markets would take this in their stride, given they have watched the government’s plans fall apart without batting an eyelid. (In the November Inflation Report (p. 11), the Bank of England report that government bond yield have declined sharply across advanced economies since the start of the year, falling by 1 ½ per cent in the UK, and indicating that debt is more not less attractive). The alternative is to use credit creation to bridge any gap between spending and income.
It is now widely recognised that there are grave shortcomings in the mainstream account of money, finance and debt. As a result, the economics profession failed to see the financial crisis coming, and, when it came, failed to recognise its severity. The same methodological shortcomings stand in the way of a full discussion of fiscal policy options. For a proper understanding of monetary theory leads to the conclusion that it is not possible to run out of money. You cannot run out of money is a similar way to not being able to run out of centimetres. Today the vast majority of money is in the form of deposits at banks and with the financial sector more generally. As the Bank confirmed, the financial system is able to create these deposits at will. While regulatory requirements can restrict such actions, they exist as a result of the basic fact of credit creation. Affirming the failure of mainstream, economics the BoE emphasise that the processes of credit creation are at odds with the standard textbook description (“the reverse of the sequence typically described in textbooks”).
The BoE discuss in some detail how central banks create deposits and the associated transmission to private banks and the real economy through QE, but they do not address any implications for fiscal policy. Through QE the central bank purchases government debt, albeit not directly from government but from banks and financial institutions that have bought government debt themselves. (In fact the CB owns a sizeable portion of the government debt issued since the start of the financial crisis.) There is no technical reason that the processes should be aimed more explicitly and deliberately at supporting fiscal policy.
The GND group are deliberately vague about the precise mechanisms through which this support would work, and there are many options.
The Bank could be instructed to create deposits into the government’s bank account (these used to be called ‘ways and means advances’); it could simply buy up an increased issue of government bonds; it could buy bonds issued by a third party, for example by the green investment bank; or it could even instead instruct private banks to create the credit for government (in the Second World War this mechanism operated through an instrument called a Treasury Deposit Receipt). The extent of any such operation might depend on both the scale of government spending to be financed and the amount the private bond market wanted to take up.
Under a Keynes view, this would only be an interim process, financing the transition between the initial spending and the revenues coming in (just as a private credit to a business finances expansion until increased sales revenues come in). The QE would pay for itself, through newly created economic activity. There would seem to be advantages over existing processes where QE has mainly stayed on the balance sheets of financial institutions, arguably fostering asset price inflations (e.g. stock exchange booms) rather than productivity activity.
3. Inflation (and imports)
Even if all of the above were conceded by policymakers, the conventional barrier could still be inflation. The standard approach to this is through the so-called output gap, which sets the level of activity against an interpretation of the capacity of the economy. Both the BoE and the Office for Budgetary Responsibility have the output gap very narrow, which implies that further expansionary policies will lead to inflation. On the one hand this can be contested, and a number of institutions have the gap much larger. On the other hand, if expansionary policies lead to higher capacity, capacity could expand alongside higher activity. It seems highly doubtful that there is no room to expand the economy given not only the employment situation (2 million unemployed, 3 million underemployed), but in parallel the collapse in real earnings.
A variant on the theme would be the danger of simply sucking in imports. But this must be a far greater danger under existing policies that are aimed at consumption not production. The charge would also be fairly raised at helicopter money schemes. Instead infrastructure spending policies should be part of a wider strategy, including not least industrial policies to support a wider expansion of the UK industrial base and protect the UK economy from both inflation and imports.
When Liam Byrne left office in 2010, the government had not run out of money. There was a large public sector deficit. Only on a very specific interpretation of the structural deficit / output gap had the government run out of money. The government runs out of money when work runs out; if there is work to be done, it will be paid and taxes will be paid. For my own part, I do not believe that here was no work to be done when the coalition took office. Credit can be used to bridge the gap between spending and work.
But the idea of the structural deficit and a wider ignorance of associated monetary considerations is also potent in the political or ideological sense. The mainstream economic narrative is entirely consistent with the goal of a smaller state, and an increased role for the private sector provision of public services.
Susan Howson, a distinguished economic historian, points out that in the 1940s when TDRs were devised the Labour Party recognised them as a revolution in public finances. Hugh Dalton, the first Chancellor to Attlee’s government observed:
Compulsory short-term loans from the banks to the Treasury. These were not popular with the banks and have now been replaced, as before the war, by Treasury Bills. ‘T.D.R.s’ could be revived either by agreement or under my Bank of England Act of 1946. (Principles of Public Finance, 1954)
The idea that credit creation might be put at the disposal of the state to permit public expenditures is deeply inimical to long-standing and still prevailing orthodoxy.
But this orthodoxy has economic as well as political consequences. An attempt has been made to shrink the state when public spending was imperative to support the economy. As a result incomes have suffered a severe fall, and tax revenues and the public sector finances suffered accordingly. The Green New Deal proposals rise above a political debate that is characterised by timidity and toxicity. And the TUC agree that investing in infrastructure and moving to a low carbon economy should be top priorities for the next government. Considering using QE to invest directly in jobs and growth makes sense, just as any rational government should always be prepared to borrow to fund productive investment particularly in an economy running well below its potential, with two million unemployed and three million underemployed.