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Debt, Money, and Mephistopheles: How Do We Get Out of This Mess?

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Group of Thirty, Washington, DC

Adair Turner

About the Author

Adair Turner has combined careers in business, public policy and academia. In April 2013, he became Senior Fellow of the Institute for New Economic Thinking (INET).

From September 2008 to March 2013, Lord Turner was Chairman of the UK Financial Services Authority, and from January 2008 until spring 2012, Chair of the Climate

Change Committee.

He became a cross-bench member of the House of Lords in 2005, and was Chair of the UK Pensions Commission from 2003 to 2006, and of the Low Pay Commission from 2002 to

2006. He is the author of Just Capital – The Liberal Economy (Macmillan 2001), and Economics after the Crisis – Objectives and Means (MIT Press 2012).

He is a Visiting Professor at the London School of Economics and at Cass Business School, City University; a Visiting Fellow at Nuffield College Oxford; and a Trustee and Chair of

the Audit Committee at the British Museum.

Prior to 2008, Lord Turner was a non-executive Director at Standard Chartered Bank, United British Media, and Siemens UK; from 2000 to 2006 he was Vice-Chairman of

Merrill Lynch Europe, and from 1995 to 1999, Director General of the Confederation of British Industry. He was with McKinsey & Co. from 1982 to 1995, building McKinsey’s

practice in Eastern Europe and Russia between 1992 and 1995. He was Chair of the Overseas Development Institute from 2007 to 2010.

Lord Turner studied History and Economics at Caius College, Cambridge, from 1974 to 1978, and was college supervisor in economics from 1979 to 1981.

ISBN 1-56708-161-4Copies of this paper are available for US$30.00 from:

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Published by

Group of Thirty©

Washington, D.C.

May 2013

Debt, Money, and Mephistopheles: How Do We Get Out of This Mess?

Adair Turner

Occasional PaperNo. 87

This Occasional Paper was adapted from a speech given by Adair Turner on February 6, 2013, at the

Cass Business School in London.

Contents

List of Exhibits iv

Abbreviations v

Introduction 1

1. Policy Levers and Aggregate Demand: Price and Output Effects 6

2. Milton Friedman, Money-Financed Deficits, and Narrow Banking 11

3. Leverage and Financial Stability: Deleveraging and Deflation 15

4. Targets: Should We Move Away from Current Inflation Rate Targets? 19

5. Achieving the Chosen Target: Monetary and Macroprudential Levers 24

6. Fiscal Policy Stimulus 28

7. Overt Money Finance: Advantages, Dangers, and Required Constraints 31

8. Possible Implications by Country: Some Initial Thoughts 43

9. Conclusions 48

Exhibits 51

Bibliography 69

Group of Thirty Members 2013 73

Group of Thirty Publications 77

iv

List of Exhibits

Exhibit 1: From fractional reserve to 100% reserve banking 51

Exhibit 2: Leverage in the real and financial sectors 52

Exhibit 3: Private nonfinancial corporate deposits and loans: UK 1964–2009 52

Exhibit 4: Household deposits and loans: UK 1964–2009 53

Exhibit 5: Private-credit-to-GDP ratio and growth 53

Exhibit 6: Lending to UK business 54

Exhibit 7: Lending to individuals 54

Exhibit 8: Japan policy rate vs. credit growth per year 55

Exhibit 9: Sectoral Financial surpluses/deficits as % of GDP: Japan 1990–2012 55

Exhibit 10: Japanese government and corporate debt: 1990–2010 56

Exhibit 11: Shifting leverage: Private and public debt to GDP 57

Exhibit 12: UK inflation: Bank of England forecasts and actual 58

Exhibit 13: Public debt to GDP: US and UK 58

Exhibit 14: GDP growth rates 1950–1970 59

Exhibit 15: UK public debt deleveraging: 1945–1970 60

Exhibit 16: Central Bank policy rates 61

Exhibit 17. Central Bank balance sheets as % GDP 61

Exhibit 18: Japan 10-year nominal yield 62

Exhibit 19: UK trends in lending: % 12-month growth rates 62

Exhibit 20: Gross lending to and repayments by UK nonfinancial businesses 63

Exhibit 21: Post-facto money finance: US 1940–1951 63

Exhibit 22: Japanese government debt as % of GDP 64

Exhibit 23: Varying actual and appropriate policies: McCulley and Pozsar’s framework 64

Exhibit 24: Private and public leverage cycles 65

Exhibit 25: Varying actual and appropriate policies: McCulley and Pozsar’s framework 65

Exhibit 26: Fiscal adjustment required for long-term debt sustainability 66

Exhibit 27: Nominal GDP in four major economic areas: 2007–2011 66

Exhibit 28: GDP growth of developed economies 67

Exhibit 29: Breakdown of nominal GDP growth from trough: 2009–2012 67

v

Abbreviations

CCB countercyclical buffer

ECB European Central Bank

GDP gross domestic product

IMF International Monetary Fund

NGDP nominal gross domestic product

OMF overt money finance

OPMF overt permanent money finance

QE quantitative easing

1

Introduction

It has been five-and-a-half years since the financial crisis began in summer 2007 and four-and-a-half years since its dramatic intensification in autumn 2008. It was clear from autumn 2008 that the economic impact would be large. But only slowly have we realized just how large. All official forecasts in spring 2009 suggested a far faster economic recovery than was actually achieved in the four major developed economies—the United States, Japan, the eurozone, and the United Kingdom. UK gross domestic product (GDP) is now around 12 percent below where it would have been if it had continued the pre-2007 trend growth rate, and latest forecasts suggest that the UK will not return to 2007 levels of GDP per capita until 2016 or 2017. In terms of the growth of prosperity, this is truly a lost decade.

This huge harm reflects the scale of precrisis financial folly—above all, the growth of excessive leverage—and the severe difficulties created by postcrisis deleveraging. And failure to foresee either the crisis or the length of the subsequent recession reflects an intellectual failure within mainstream economics—an inadequate focus on the links between financial stability and macroeconomic stability, and on the crucial role that leverage levels and cycles play in macroeconomic developments. We are still crawling only very slowly out of a very bad mess, and still only slowly gaining better understanding of the factors that got us there and that constrain our recovery.

We must think fundamentally about what went wrong and be adequately radical in the redesign of financial regulation and of macroprudential policy to ensure that it does not happen again. But we must also think creatively about the combination of macroeconomic (monetary and fiscal) and macroprudential policies needed to navigate against the deflationary headwinds created by postcrisis deleveraging.

In the field of macroeconomic management—the management of aggregate demand to support, as well as possible, low inflationary real growth—two issues are central: appropriate targets and appropriate tools. In respect to both, precrisis certainty has been replaced by wide-ranging debate.

2

Targets. In the precrisis period, a dominant consensus reigned; most central banks focused on the attainment of low but positive inflation rates, often expressed in formal symmetric targets. Now debate rages. Olivier Blanchard, Chief Economist of the International Monetary Fund (IMF), floated in 2010 the possibility of temporarily higher inflation rate targets (Blanchard, Dell’Ariccia, and Mauro 2010). The Federal Reserve has adopted a policy stance explicitly contingent on the rates of unemployment and inflation. Mark Carney, Governor of the Bank of Canada, has suggested that the issue of nominal GDP targets should at least be encompassed within the debate (Carney 2012). And Michael Woodford, a prominent theoretician of precrisis monetary policy orthodoxy (Woodford 2003), argued at Jackson Hole, Wyoming, in August 2012, for an explicit target to return to the level of nominal GDP that would have resulted from the continuation of precrisis trends (Woodford 2012). The issue of appropriate targets clearly will be and should now be a subject of intense debate.

Tools. But important as the issue of appropriate targets is, the more fundamental issue is what policy tools are needed to achieve, in an optimal fashion, whatever the chosen objectives or targets should be. More fundamentally, even if we did decide to set a new target—such as one related to nominal GDP—we might not be able to meet it except through the use of policy tools that produce damaging side effects on future financial and thus macroeconomic stability.

The question is, by what means can we and should we seek to stimulate or constrain aggregate nominal demand. Before the crisis, the consensus was that conventional monetary policy, operating through movements in the policy rate and thus affecting the price of credit/money, should be the dominant tool with little or no role for discretionary fiscal policy and no need for measures focused directly on credit or money quantities. Postcrisis, a wide spectrum of policy tools is already in use or under debate, such as:

• Interest rates have been reduced close to zero bounds. But central banks can and have implemented quantitative easing (QE) operations.

• QE can be extended to a still wider range of assets than government bonds, and central banks can get into the business of directly subsidizing commercial bank lending as, for instance, through the Bank of England’s Funding for Lending Scheme.

• And the case that fiscal policy can be an effective tool of demand management in circumstances when interest rates are at the zero bound has been forcefully restated by Brad DeLong and Larry Summers (2012).

At the extreme end of this spectrum of possible tools lies the overt money finance (OMF) of fiscal deficits—“helicopter money”—permanent monetization of government debt. This extreme option should not be excluded from consideration for three reasons:

• Because analysis of the full range of options (including OMF) can help clarify basic theory and identify the potential disadvantages and risks of other less extreme and currently deployed policy tools;

• Because there can be extreme circumstances in which it is an appropriate policy; and

3

• Because if we do not debate in advance how we might deploy OMF in extreme circumstances, while maintaining the tight disciplines of rules and independent authorities that are required to guard against inflationary risks, we will increase the danger that we eventually use this option in an undisciplined and dangerously inflationary fashion.

Even to mention the possibility of overt monetary finance is, however, close to breaking a taboo. When some comments of mine in autumn 2012 were interpreted as suggesting that OMF should be considered, some press articles argued that this would inevitably lead to hyperinflation. And in the eurozone, the need utterly to eschew monetary finance of public debt is the absolute core of inherited Bundesbank philosophy.

To print money to finance deficits indeed has the status of a mortal sin—the work of the devil—as much as a technical error. In a speech in September 2012, Jens Weidmann, President of the Bundesbank, cited the story of Part II of Goethe’s Faust, in which Mephistopheles, agent of the devil, tempts the Emperor to distribute paper money, increasing spending power, writing off state debts, and fueling an upswing which, however, “degenerates into inflation, destroying the monetary system” (Weidmann 2012).

And there are certainly good reasons for being very fearful of the potential to create paper or (in modern terms) electronic money. In a post-gold-standard world, money is what is accepted as money: it is simply the “fiat,” the creation of the public authority. It can therefore be created in limitless nominal amounts.1 But if created in excessive amounts, it creates harmful inflation. And it was John Maynard Keynes who rightly argued that “there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency” (Keynes 1919, 236).

The ability of governments to create money is a potential poison, and we rightly seek to limit it within tight disciplines, with independent central banks, self-denying ordinances, and clear inflation rate targets. Where these devices are not in place or are not effective, the temptation that Mephistopheles presents can indeed lead to hyperinflation—the experience of Germany in 1923 or Zimbabwe in recent years.

But before deciding from that that we should always exclude the use of money-financed deficits, consider the following paradox from the history of economic thought. Milton Friedman is rightly seen as a central figure in the development of free market economics and in the definition of policies required to guard against the dangers of inflation. But Friedman argued in an article in 1948 not only that government deficits should sometimes be financed with fiat money, but that they should always be financed in that fashion with, he argued, no useful role for debt finance. Under his proposal, “government expenditures would be financed entirely by tax revenues or the creation of money, that is, the

1 Clearly, the real value of the money created is limited by the endogenous changes in prices that might be induced by changes in nominal amounts.

The chief function of the monetary authority [would be] the

creation of money to meet government deficits or the retirement of

money when the government has a surplus. (p. 247)

Under the proposal, government expenditures would be financed

entirely by tax revenues or the creation of money, that is, the issue

of non-interest-bearing securities. (p. 250)

— Milton FriedMan, 1948

4

issue of non-interest-bearing securities” (Friedman 1948, 250). And he believed that such a system of money-financed deficits could provide a surer foundation for a low-inflation regime than the complex procedures of debt finance and central bank open market operations that had by that time developed.

Friedman was not alone. Henry Simons, one of the founding fathers of the Chicago School of free market economics, argued in

his seminal article, “Rules versus Authorities in Monetary Policy,” that the price level should be controlled by “expanding and contracting issues of actual money” (Simons 1936, 22), and that therefore “the monetary rules should be implemented entirely by and in turn should largely determine fiscal policy” (Simons 1936, 30). Irving Fisher argued exactly the same (Fisher 1933). And the idea that pure money finance is the ultimate answer to extreme deflationary dangers is a convergence point of economic thought at which there is total agreement between Friedman and Keynes. Friedman (1969) described the potential role of “helicopter money” picked up gratis from the ground; Keynes, surprisingly, since he was not usually a puritan, wanted people to at least have to dig up the “old bottles [filled] with bank notes” (Keynes 1936, 129). But the prescription was the same. And Ben Bernanke, current Chairman of the Federal Reserve, argued quite explicitly in 2003 that Japan should consider “a tax cut … in effect financed by money creation” (Bernanke 2003).

When economists of the ca l iber of Simons, F i sher, Friedman, Keynes, and Bernanke have all explicitly argued for a potential role for overt-money-financed deficits, and done so while believing that the effective control of inflation is central to a well-run market economy, we would be unwise to dismiss this policy option out of hand.

Rather, we should consider whether there are spec i f ic circumstances in which it could play a role and/or needs to play a role, and even if not, whether exploration of the theory of

The powers of the government to inject purchasing power through

expenditure and to withdraw it through taxation—i.e., the powers

of expanding and contracting issues of actual currency and other

obligations more or less serviceable as money—are surely adequate

to price-level control. (p. 22)

… in other words, the monetary rules should be implemented

entirely by, and in turn should largely determine, fiscal policy.

(p. 30)

— Henry SiMonS, 1936

Let us suppose now that one day a helicopter flies over this

community and drops an additional $1,000 in bills from the sky,

which is, of course, hastily collected by members of the community.

— Milton FriedMan, 1969, 4

If the Treasury were to fill old bottles with bank notes, bury them

at suitable depths in disused coalmines … and leave it to private

enterprise on well-tried principles of laissez-faire to dig the notes

up again … there need be no more unemployment and … the real

income of the community … would probably become a good deal

greater than it actually is.

— JoHn Maynard KeyneS, 1936, 129

5

money and of debt helps us better understand the problems we face, problems that may be addressed by other policy tools.

I will therefore address both appropriate targets and appropriate tools, and will consider the full range of possible tools. But I will also stress the need for us to integrate issues of financial stability and of macroeconomic policy far more effectively than mainstream economics did ahead of the crisis.

This paper is organized as follows.

• First, I present a framework for thinking about the relationship between the objectives of price stability and real output growth, and the levers of macro demand management—fiscal, monetary, and macroprudential.

• Second, Friedman’s 1948 proposals, and the crucial link between macroeconomic policy and issues relating to financial structure and stability are discussed.

• Third, I explore the crucial impact on financial and economic stability of the level of leverage, and the processes of leveraging and deleveraging, balance sheet effects that were dangerously ignored before the crisis in the dominant schools of economic theory and policy.

• Fourth, the question of targets is discussed: should we move away from inflation rate targets, and if so to what?

• Fifth, I discuss why purely monetary policy levers such as interest rates or QE, or macroprudential levers, may be inadequate to achieve desirable objectives and/or may have harmful, adverse consequences.

• Sixth, I explore why purely fiscal policy levers may also either be ineffective or have harmful adverse consequences.

• Seventh, I address the questions of why overt money finance may be appropriate and necessary in extreme circumstances and how its use could be placed within the discipline of rules and independent authorities, which would be essential to prevent its potentially disastrous misuse.

• Eighth, I discuss possible implications of my conclusions for policy in Japan, the United States, the eurozone, and the UK, although I want to stress that my purpose is primarily to consider general principles and to arrive at general conclusions, not to suggest specific short-term policy actions.

• I then summarize my conclusions and end with a reflection on Mephistopheles, money, and debt.

6

1. Policy Levers and Aggregate Demand: Price and Output Effects

Diagram 1 sets out a framework for thinking about the relationship between macro-policy levers, aggregate nominal demand, prices, and output.

LEVERS EFFECTS

PRICES

REAL OUTPUT

CENTRAL BANK PRIVATE CREDIT SUPPORT• US “credit easing”• UK Funding for

Lending Scheme

MONETARY POLICY• Interest rates• Quantitative easing• Forward guidance

FISCAL POLICY• Deficits or surpluses

MACROPRUDENTIAL POLICY• Bank capital

and liquidity

AGGREGATENOMINALDEMAND

NOMINALGDP =

diagraM 1: relationSHip between Macro-policy leverS,

aggregate noMinal deMand, priceS, and output

7

On the left-hand side we have policy levers that might (or might not) be effective in changing the level of aggregate nominal demand and thus the rate of growth of nominal GDP. These include:

• Fiscal policy—running fiscal deficits or surpluses.

• Monetary policy in both its conventional (interest rate) and unconventional (quantitative easing) forms. Here, too, we locate forward guidance that might influence expectations as to future interest rates.

• Central bank support for private credit creation, whether in the form of the Federal Reserve’s “credit easing” or the Bank of England’s Funding for Lending Scheme.

• And macroprudential policy, for instance, the operation of countercyclical bank capital or liquidity regulations.

This fourfold division is not definitive. In particular, we could categorize differently the range of policies that lie in the monetary policy, private credit support, and macroprudential boxes; and there are important interrelationships among these sets of policy. In Section 5, I will therefore deal jointly with those three boxes. But together these four categories cover the available spectrum, if we make one addition—overt permanent money finance of fiscal deficits (Diagram 2)—which, as described in Section 7, is effectively a combination of fiscal and monetary policy.

diagraM 2: Macro-policy leverS and opMF

OVERT PERMANENT MONEY FINANCE

PRICES

REAL OUTPUT

CENTRAL BANK PRIVATE CREDIT SUPPORT• US “credit easing”• UK Funding for

Lending Scheme

MONETARY POLICY• Interest rates• Quantitative easing• Forward guidance

FISCAL POLICY• Deficits or surpluses

MACROPRUDENTIAL POLICY• Bank capital

and liquidity

AGGREGATENOMINALDEMAND

LEVERS EFFECTS

8

All of these levers, to different degrees and in different circumstances, might affect the rate of growth of nominal GDP, which in turn may result in either increases in the price level and thus in the rate of inflation, or increases in real output and thus in the rate of real growth.

That division is shown on the right-hand side of Diagram 2.The framework suggests two questions:

• How effective will each of the levers on the left-hand side be, in different specific conditions, at stimulating aggregate nominal demand?

• And, for any given level of nominal demand (or increase in that level), what will be the division of impact between price and output effects?

In assessing these questions, it is important to decide whether we believe that the choices of the left-hand-side lever and the right-hand-side division of impact are independent. I will initially assume independence but consider subsequently whether there are specific conditions (involving the use of specific levers) that might require us to relax that independence assumption.

By “independence” I mean the following (Diagrams 3 and 4):

• That the division of any given change in the level of aggregate nominal demand between change in prices and change in real output, is determined by real economy factors such as (a) the degree of spare capacity in either labor markets or physical capital, and (b) the degree of flexibility in price-setting processes in labor or product markets.

• And that this division is independent of which policy lever was pulled in order to achieve the given increase in aggregate nominal demand.

diagraM 3: diviSion oF iMpact due to cHangeS in aggregate noMinal deMand

PRICES

REAL OUTPUT

AGGREGATENOMINALDEMAND

DIVISION DETERMINED BY:• Spare capacity in labor or physical capital• Flexibility of price-setting processes in

labor or product markets

9

Of course, it is possible that this independence assumption does not apply, and I will return later (particularly in Section 8’s observations on the UK) to the implications if it does not. As shown in Diagram 5:

• It is possible that different policy levers on the left-hand side could have different impacts on expectations of future policy, and that this (for example, by de-anchoring inflationary expectations) might bias the right-hand-side division toward a price effect. This may, for political economy rather than technical reasons, be an important risk to be considered in relation to overt money finance.

• And it is possible that we might be clever enough to devise left-hand-side policy levers (perhaps in the fiscal or direct credit support space) that do not merely stimulate aggregate demand, but that also tend to increase supply capacity, potentially biasing the right-hand division toward the real output element.

But while exceptions to the independence hypothesis are possible, we will only think straight if we proceed by first assuming independence and then considering quite explicitly whether exceptions exist. Much of the debate on macro-policy is bedeviled by a failure to be explicit about those two steps of the logic. As a result, the same commentators will sometimes (a) assert that we need “more credit to get the economy going”—making the assumption that this will achieve a predominantly real output rather than price effect; but (b) warn that stimulating GDP via other means (whether fiscal or monetary) will “drive up inflation,” that is, will have a price rather than output effect, all without specifying why the different balance

diagraM 4: tHe “independence” aSSuMption

OVERT PERMANENT MONEY FINANCE

PRICES

REAL OUTPUT

CENTRAL BANKPRIVATE CREDIT SUPPORT

MONETARY POLICY

FISCAL POLICY

MACROPRUDENTIAL POLICY

AGGREGATENOMINALDEMAND

Division of the e�ect between prices and real outputis independent of the tools used to stimulate nominal demand

LEVERS EFFECTS

10

between a price or output effect will result from the different levers that effect aggregate nominal demand.

In Sections 5 to 7, I will therefore assume independence. This will enable us to focus on the question: If more nominal demand is needed, which policy levers will most effectively deliver it, and with what offsetting side effects, disadvantages, and risks?

We must also, of course, be open to the possibility that more demand is not needed at all—that growth in a particular economy is supply (that is, capacity) rather than demand constrained. But if that is true, that would be an argument against any action that might stimulate nominal demand, and not just against the use of one particular lever.

diagraM 5: poSSible contraventionS oF “independence”

Expectation channel?

Supply enhancement?

Supply enhancement?

OVERT PERMANENT MONEY FINANCE (OPMF)

PRICES

REAL OUTPUT

CENTRAL BANKPRIVATE CREDIT SUPPORT

MONETARY POLICY

FISCAL POLICY

MACROPRUDENTIAL POLICY

AGGREGATENOMINALDEMAND

Unconventional monetary policy or OPMF

create expectations of future price e�ects?

Fiscal expenditure or credit support targeted

to achieve supply increase as well as demand?

LEVERS EFFECTS

11

2. Milton Friedman, Money-Financed Deficits, and Narrow Banking

In 1948, Milton Friedman wrote an article entitled “A Monetary and Fiscal Framework for Economic Stability” (Friedman 1948). As the title implies, one of his concerns was which fiscal and monetary arrangements were most likely to produce macroeconomic stability—meaning a low and predictable rate of inflation, and as steady as possible growth in real GDP. He was also concerned with financial stability, which he perceived as important per se and because of its effects on wider economic stability.

His conclusion was that the government should allow automatic fiscal stabilizers to operate so as to use “automatic adaptations to the current income stream to offset, at least in part, changes in other segments of aggregate demand” (Friedman 1948, 250), and that it should finance any resulting government deficits entirely with pure fiat money, conversely withdrawing such money from circulation when fiscal surpluses were required to constrain overbuoyant demand.

Thus, he argued that, “the chief function of the monetary authority [would be] the creation of money to meet government deficits or the retirement of money when the government has a surplus” (Friedman 1948, 247). Friedman argued that such an arrangement—that is, public deficits 100 percent financed by money whenever they arose—would be a better basis for stability than arrangements that combined the issuance of interest-bearing debt by governments to fund fiscal deficits and open-market operations by central banks to influence the price of money.

Diagram 6 provides a simple mathematical illustration of what Friedman was in essence proposing.

• Suppose nominal GDP is 100 and the money supply 50. And suppose that it is sensible to aim to grow nominal GDP at 4 percent per year allowing for, say, 2 percent inflation and 2 percent real growth.

12

• Then the equilibrium growth in money supply (assuming a roughly stable velocity of money circulation) might be 4 percent, or around 2 units in the first year.

• This growth could be achieved by running a fiscal deficit of 2 percent GDP, and financing it entirely with central-bank- or treasury-created fiat money.

This illustration, of course, makes the following two simplifying assumptions, the second of which highlights a central element of Friedman’s proposal:

• First, that there is a stable relationship between money supply and money GDP—so that if money velocity (GDP / Money Supply) is 2, and if we want nominal GDP to grow at 4 percent, then we know that we have to run a money-financed deficit of 2 percent of GDP. Of course, that is not necessarily the case—the velocity of circulation of money can vary and has varied.2 But relaxing this assumption does not radically change the appropriateness of Friedman’s proposal. It could still make a nominal GDP target sensible—and it could still be sensible to fund all government deficits with money. It would simply mean that the scale of money-financed deficits would have to be judged and adjusted through time in the light of empirical observation of the evolving marginal velocity of money (that is, the relationship between the change in money supply and the change in nominal GDP).

• Second, however, what both my illustration and Friedman’s proposal assume is that all money is base money, that is, that there is no private money creation, or in Gurley and Shaw’s terms, no “inside money” (Gurley and Shaw 1960). This, in turn, is because in Friedman’s proposal, there are no fractional reserve banks (Exhibit 1). In Friedman’s proposal, indeed, the absence of fractional reserve banks is not simply an assumption, but an essential element, with Friedman arguing for “a reform of the monetary and banking system to eliminate both the private creation or destruction of money and discretionary control of the quantity of money by the central bank” (Friedman 1948, 247).

2 It is, of course, possible that in Friedman’s imagined world in which the only money is high-powered money, the velocity of money circulation would be more stable than in a world with fractional reserve banks. Much of the variation in the velocity of money circulation actually observed (and, in particular, the large gradual decline in that velocity from the 1950s on) is precisely explained by the growth of private bank credit and money relative to GDP, which the existence of fractional reserve banks makes possible. See Richard Werner (2005) for a detailed analysis of this effect.

diagraM 6: FriedMan’S 1948 propoSal: a SiMple illuStration

SuppoSe

� Nominal GDP = 100 and money supply = 50

� Sensible aim is to grow nominal GDP at 4% per year,

allowing for 2% real growth and 2% inflation

Then

� Equilibrium money supply growth might be around 4%

� Appropriate increase in money supply is achieved by

running fiscal deficit of 2% of GDP, financed entirely by

money

� Money supply grows by 2 (= 4% for 50)

13

Friedman thus saw in 1948 an essential link between the optimal approach to macroeconomic policy (fiscal and monetary) and issues of financial structure and financial stability. In doing so, he was drawing on the work of economists such as Henry Simons and Irving Fisher who, writing in the mid-1930s, had reflected on the causes of the 1929 financial crash and subsequent Great Depression, and concluded that the central problem lay in the excessive growth of private credit in the run-up to 1929 and its collapse thereafter.

This excessive growth of credit, they noted, was made possible by the ability of fractional reserve banks to create private credit and private money simultaneously. And their conclusion was that fractional reserve banking was inherently unstable. As Simons put it, “In the very nature of the system, banks will flood the economy with money substitutes during booms and precipitate futile efforts at general liquidation afterwards” (1936, 9–10). He therefore argued that “private initiative has been allowed too much freedom in determining the character of our financial structure and in directing changes in the quantity of money and money-substitutes” (Simons 1936, 3).

As a result, Simons reached a conclusion that gives us a second paradox from the history of economic thought—that the rigorously free-market Henry Simons, one of the father figures of the Chicago School, believed that financial markets, in general, and fractional reserve banks, in particular, were such special cases that fractional reserve banking should not only be tightly regulated but effectively abolished.

S o we r e S i mon s , a nd Friedman (in 1948) right? Should fractional reserve banking be abolished, removing the ability of private banks to create and destroy private credit and money? My answer is no. I think their stance too radical, failing to recognize the economically and socially valuable functions that private debt and fractional reserve banking perform.

Simons argued not only for the abolition of fractional reserve banks, but ideally for severe restrictions on the use of any short-term debt instruments. He argued correctly that debt contracts introduce rigidities and potential vulnerabilities into economic relations, and that an economy in which all contracts were equity would adjust more smoothly to exogenous shocks. But he failed to recognize the extent to which debt contracts (as, indeed, fixed wage rather than profit share labor contracts) have naturally arisen to meet fundamental human desires for greater certainty of future income.3

And while fractional reserve banks undoubtedly create risks, there is a good argument that they also perform a value creative function. Fractional reserve banks perform maturity transformation that enables households and businesses to hold shorter-term financial assets

3 A point well made by his Italian contemporary Luigi Einaudi in an elegant essay entitled simply “Debts” (Einaudi 2006).

… private initiative has been allowed too much freedom in

determining the character of our financial structure and in

directing changes in the quantity of money and money-

substitutes. (p. 3)

… in the very nature of the system, banks will flood the economy

with money-substitutes during booms and precipitate futile effects

at general liquidation afterward. (pp. 9–10)

— Henry SiMonS, 1936

14

than liabilities: this maturity transformation may help support greater long-term investment than would otherwise occur. As Walter Bagehot4 argued, the development of joint stock fractional reserve banks may well have played an important role in the development of the mid-19th century British economy, giving it a capital mobilization advantage over other economies where maturity transforming banking systems were less developed (Bagehot 1873).5

But even if we reject the radical policy prescriptions of Simons, Fisher, and early Friedman, their reflections on the causes of the Great Depression should prompt us to consider whether our own analysis of the 2008 financial crisis and subsequent Great Recession has been sufficiently fundamental and our policy redesign sufficiently radical. Three implications, in particular, may follow.

First, while there is a good case, in principle, for the existence of fractional reserve banks, social optimality does not require the fraction (whether expressed in capital or reserve ratio terms) to be anything like as small, and thus leverage anything like as high, as we allowed in the precrisis period, and still allow today.6 As David Miles and Martin Hellwig, among others, have shown, there are strong theoretical and empirical arguments for believing that if we were able to set capital ratios for a greenfield economy (abstracting from the problems of transition), the optimal ratios would likely be significantly higher even than those we are establishing through the Basel III standard (Admati et al. 2010; Miles, Yang, and Marcheggiano 2011).

Second, issues of optimal macroeconomic policy and of optimal financial structure and regulation are closely and necessarily linked, a fact obvious to Simons, Fisher, and Friedman, but largely ignored by the precrisis economic orthodoxy. As Mervyn King, Governor of the Bank of England, put it in a recent lecture, the dominant new Keynesian model of monetary economics “lacks an account of financial intermediation, so money, credit and banking play no meaningful role” (King 2012a, 5). Or, as Olivier Blanchard has put it, “we had assumed that we could ignore much of the details of the financial system” (Blanchard 2012). That was a fatal mistake.

Third, in our design of both future financial regulation and macroeconomic policy, it is vital that we understand the fundamental importance of leverage to financial stability risks, and of deleveraging to postcrisis macrodynamics.

4 Walter Bagehot (1826–1877) was a British businessman, essayist, and journalist who wrote extensively about economic affairs, among other issues.

5 In Chapter 1 of Lombard Street, Bagehot argues that the development of the British banking system, by creating bank deposit money, made those resources “borrowable” and thus investible, in a way that was less true of the cash held outside banks in France and Germany.

6 Note that the ability of fractional reserve banks to create private credit and money can be limited by either (a) constraints on the ratio of deposit liabilities to required reserve holdings (Simons and Fisher thought in these terms, but central banks in developed countries gradually discarded this tool in the half-century after World War II), or (b) through capital ratio requirements.

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3. leverage and Financial Stability: deleveraging and deflation

The fundamental cause of the financial crisis of 2007–08 was the build-up of excessive leverage in both the financial system (banks and shadow banks) and in the real economy. Increased leverage creates rigidities and financial stability risks. The detailed argument for that proposition has been made extensively elsewhere.7 Here I will simply outline the essential points.

debt contracts and rigiditiesDebt contracts play a valuable role in advanced economies, providing businesses and individuals with greater certainty over future income streams than would be delivered in a world where all contracts took an equity form. But the presence of debt contracts inevitably creates financial stability risks. These derive from three inherent features of debt versus equity.

First is the tendency of investors/lenders to suffer from “local thinking,” or myopia, entering into contracts, which, as Gennaioli, Shleifer, and Vishny put it, “owe their very existence to neglected risk” (Gennaioli, Shleifer, and Vishny 2010, 39).

Second are the rigidities and potential disruption of default and bankruptcy processes, which, as Ben Bernanke has pointed out, “in a complete-markets world … would never be observed,” (Bernanke 2004, 53), but which in the real world create fire sale and disruption risks.

Third is the need for short- and medium-term debt contracts to be continually rolled over, making the stability of new credit flows a key macroeconomic variable.

banks and private credit creationThese risks are inherent in debt contracts and would exist even if there were no banks, that is, even if all debt contracts directly linked end investors with end borrowers. But fractional

7 See, for example, Bernanke (2004); Gennaioli, Shleifer, and Vishny (2010); Schularick and Taylor (2009); and Taylor (2012). Turner (2012a) and Turner (2012b) provide a more detailed account of these arguments than provided here.

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reserve banks, simultaneously creating private credit and private money, can greatly swell the scale of debt contracts in an economy and introduce maturity transformation. And there is no naturally arising mechanism to ensure that the scale of such majority transformation is optimal.8

As a result, banks can greatly increase the scale of financial and economic stability risks. They can also play an important autonomous role in the creation and destruction of spending power, that is, of nominal demand, and as a result can generate booms and busts in overall economic activity.

Secured lending, credit, and asset price cyclesThe danger of excessive and volatile bank credit creation is still further exacerbated when credit is extended to finance the purchase of assets—particularly real estate—whose value is itself dependent on the level of debt-financed demand. Unsustainable bank credit extension can therefore lead to credit and asset price cycles of the sort that Hyman Minsky described.9 So too, however, as we learned before the crisis, can uncontrolled credit extension by chains of shadow-banking entities that in the aggregate perform credit intermediation with leverage and maturity transformation (the defining characteristic of banks but outside the scope of bank regulation).10

Together, these inherent characteristics of debt contracts, banks, and credit/asset price cycles make the level of leverage in both the financial system and the real economy, and the rate of change of leverage, key drivers of financial instability risks. And over the last 50 years, as in the decade running up to the 1929 crisis, levels of leverage in both the real economy and in the financial system hugely increased (Exhibit 2). Exhibits 2–4 provide some indicators of that increase in private leverage for the UK and the United States.

Ahead of the crisis, the predominant assumption of much economic theory and of macroeconomic policy was that such increasing leverage—arising from private sector contracts between rational agents—could be either ignored or positively welcomed—ignored because financial system developments were considered as neutral (or simply absent) in models of money demand, inflation, and real output, or welcomed because financial deepening was axiomatically beneficial, since it reflected market completion.

In retrospect, those assumptions were part of a widespread intellectual delusion that left us ill-equipped to spot emerging financial stability risks. They are now being roundly challenged. An important recent Bank of International Settlements’ paper by Steve Cecchetti and Enisse Kharroubi (2012), for instance, aims to reassess the impact of financial deepening on growth, and reaches the tentative conclusion that private-credit-to-GDP ratios may be related to economic growth in an inverse U function, with a level beyond which further financial deepening has a negative impact (Exhibit 5). Similar conclusions have been reached in recent papers by Moritz Schularick and Alan Taylor (2009; 2012).

8 As Jeremy Stein has illustrated, given inherent market failures, “unregulated private money creation can lead to an externality in which intermediaries issue too much short-term debt and leave the system extremely vulnerable to costly financial crisis” (Stein 2012, 57).

9 The links between Minsky’s beliefs and those of some of the Chicago School economists are rarely noted but significant. See Whalen (1988).

10 See Turner (2012a) and Financial Stability Board (2012).

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This implies that financial stability authorities in future should monitor and respond to the absolute level of leverage in economies, the aggregate balance between debt and equity contracts. That may require a still wider role for macroprudential levers than currently anticipated, focusing not solely on growth rates of credit relative to trend, but seeking also to constrain absolute levels of leverage that is, debt to GDP.11, 12

But it also implies that we need to think about the relationship between macro demand management (the classic domain of monetary policy) and quantity effects relevant to financial stability. Central banks pursue policies aimed at achieving aggregate demand growth, which will ensure price stability while being at least compatible with real growth, and until the crisis they appeared largely successful in this objective. But adequate nominal demand growth in the precrisis years was accompanied with increasing aggregate leverage, as nominal private debt grew faster than nominal GDP in many countries. And this increase in debt appeared to be essential to ensure that nominal demand grew at an adequate rate. But if that is indeed the case—if we have an economy in which adequate demand growth requires increasing leverage levels, then we have an unstable system and need to redesign it—if necessary with new policy tools—to make it more stable and sustainable.

The inherent links between macroeconomic and financial stability, largely ignored before the crisis, may therefore carry implications for optimal policy mix in “normal times” or in upswings of the credit cycle. But they do so even more clearly in the deflationary periods that tend to follow financial crisis.

deleveraging and deflationThe financial crisis of 2007–08 occurred because we failed to contain the financial system’s creation of private credit and money; we failed to prevent excessive leverage. The fundamental macroeconomic challenge today arises from the deflationary effect of private sector deleveraging.

In the wake of the crisis, private credit creation collapsed. Exhibits 6 and 7 illustrate that collapse in the UK, in both the corporate and household sectors.

That collapse in credit reflects in part necessary deleveraging in the financial system—the reduction in bank leverage from excessively high and risky levels. Such financial sector deleveraging potentially depresses the supply of credit. But it also reflects a fall in demand for credit, as corporates and households seek to increase balance sheet strength in the face of both lower asset prices and reduced expectations of future income.13

11 This implies that the Basel III guideline for the application of the countercyclical buffer (CCB), if applied too mechanistically, could be inappropriate. This guideline proposes that there should be a presumption in favor of an increase in the CCB when credit growth is running above past trend. This implies, however, that a continually rising level of credit as a percent of GDP would be acceptable as long as the growth rate was steady, that is, in line with trend even if continually above nominal GDP growth.

12 In some sense, this may appear to support the Bundesbank’s long-held belief, reflected in the monetary pillar of the European Central Bank policy framework, that central banks should not focus solely on the current and medium-term prospective rate of inflation, but on “money” aggregates. While, however, the size and growth rates of bank balance sheets clearly matters, it is arguably more fruitful to focus on credit creation as the motive force, and to see money creation as the dependent result, agreeing with Benjamin Friedman that “in retrospect, the economics profession’s focus on money—meaning various subsets of instruments on the liability side of the banking system’s balance sheet in contrast to bank assets … turns out to have been a half century long diversion that did not serve our profession well” (Friedman 2012, 302). (See also Turner 2011b.)

13 The inherent difficulty of distinguishing supply and demand factors in the determination of credit growth is discussed in the Bank of England’s “Financial Stability Review” (June 2012, box 3).

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Collapsed credit growth in turn depresses both asset prices and nominal private demand, threatening economic activity and income, and making it more difficult for firms and individuals to achieve desired deleveraging.

Such an attempted deleveraging was, as Irving Fisher (1933) argued, fundamental to the process by which the financial crisis of 1929 turned into the Great Depression. And as Richard Koo has argued, it is core to understanding the drivers of Japan’s low real growth and gradual price deflation over the last two decades (Koo 2009).

In Koo’s persuasive account, Japan from 1990 suffered a “balance sheet recession” in which the dominant driver of depressed demand and activity was private sector (and specifically corporate sector) attempts to repair balance sheets left overleveraged by the credit boom of the 1980s. In such “balance sheet recessions,” Koo argues, the reduction of interest rates to the zero bound (achieved in Japan by around 1996) (Exhibit 8) has very limited ability to stimulate credit demand since firms’ financing decisions are driven by balance sheet considerations. As a result, Koo argues, economies in a deleveraging cycle will face deep recessions unless governments are willing to run large fiscal deficits, deficits that in any case tend naturally to arise as depressed demand and economic activity reduces tax revenue and increases some categories of government expenditure.

Large Japanese government deficits in the 1990s were, therefore, in Koo’s analysis, the necessary and useful offset to a corporate sector determined to delever whatever the interest rate on new loans (Exhibit 9). And Koo argues persuasively that Japan’s economic performance would have been still worse, with the economy facing a real 1930s-style Great Depression, if these deficits had not been accepted.

But the inevitable consequence of such large fiscal deficits is that aggregate economywide leverage does not actually reduce, but simply shifts from the private to the public sector, a pattern observed in Japan from 1990 to today (Exhibit 10) and in Spain, the UK, the United States, and many other countries in the wake of the 2007–08 crisis (Exhibit 11). Beyond some level, however, rising public debt levels may themselves become unsustainable, necessitating fiscal consolidation.

Postcrisis deleveraging, while essential for long-term financial stability, thus creates an immensely challenging macroeconomic environment. Key features of this environment are:

• Monetary policy acting through short- or long-term interest rates loses stimulative power.

• Fiscal policy offsets may be constrained by long-term debt sustainability concerns.

• Slow growth in nominal GDP makes it more difficult to achieve attempted deleveraging in the private sector, or to limit the growth of public debt as a percent of GDP.

The danger in this environment is that other countries could suffer not just a few years of slow growth, but the sustained decades of slow growth and rising public debt burdens that Japan has suffered. It is in this environment that we must consider the two questions posed earlier:

• What are the appropriate targets of macroeconomic policy?

• What policy tools should we use to achieve them?

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4. Targets: Should We Move Away from Current Inflation Rate Targets?

The increasingly dominant assumption of the last thirty years has been that central banks should have independent mandates to pursue inflation rate targets. The specifics vary by country, but orthodoxy and practice have tended to set price stability as the objective and to define price stability as low but positive inflation, for instance, around 2 percent. Central banks typically pursue that objective looking forward over medium-term time frames, for example, over two to three years.

That orthodoxy is now extensively challenged, and a plethora of alternative possible rules have either already been applied or are now proposed (Diagram 7). Blanchard, Dell’Ariccia, and Mauro question whether a period of somewhat higher inflation might be required to cope with the challenges of high debt levels and attempted deleveraging (Blanchard, Dell’Ariccia, and Mauro 2010). The Federal Reserve has adopted a policy of state contingent future commitment, with a clearly stated intent to keep interest rates close to the zero bound and to continue quantitative easing until and unless employment falls below 6.5 percent or inflation goes above 2.5 percent. Mark Carney has suggested that a range of possible options, including a focus on nominal GDP, should at least be considered (Carney 2012). And Michael Woodford, author of a canonical statement of precrisis monetary theory (Woodford 2003), has proposed that central banks should conduct policy so as to deliver a return to the trend level of nominal GDP, which would have resulted from the continuation of precrisis nominal gross domestic product (NGDP) growth (Woodford 2012).

This questioning of precrisis orthodoxy reflects the challenges created by excessive debt levels and attempted postcrisis deleveraging. Those challenges may make it appropriate to diverge from medium-term inflation rate targeting. But, any such diversion needs to maintain the anchor of commitment to long-term price stability.

One possible change, illustrated by UK experience, would not be fundamental—amounting simply to greater flexibility in the interpretation of the inflation rate mandate to reflect the impact of exceptional or transient impacts on current inflation. Over the last three years,

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the UK inflation rate has run continually and significantly above the Bank of England’s 2 percent consumer price index target (Exhibit 12). This has in part reflected effects that could be interpreted as exceptional or one-off, in the sense that they produce an unavoidable (and indeed necessary) fall in real incomes, but without resulting in any de-anchoring of inflationary expectations or any increase in, for instance, the rate of increase in average earnings. These effects include the depreciation of sterling in 2008 to 2009, large increases in energy costs, value-added tax increases, and increases in student fees.

If such increases truly are one-off and transient in effect, it is reasonable even for an inflation-targeting central bank to look through them to the medium-term trend. That is indeed what the Bank of England post facto has done, maintaining the Bank Rate at 0.5 percent despite inflation significantly above target. Arguably, therefore, no adjustment to the UK inflation target is required to ensure appropriate policy, but simply what we have actually seen—an intelligent and flexible interpretation of mandate by the Monetary Policy Committee.

But it is also notable that this Monetary Policy Committee flexibility has been exercised only in an environment where Bank of England forecasts of inflation failed to anticipate the above target levels that de facto occurred. An interesting question, therefore, is whether the Monetary Policy Committee would have maintained a 0.5 percent Bank Rate if the forecasts produced in 2009 or 2010 had accurately anticipated subsequent inflation. The answer may be yes, but if it is no, and if we believe (as I do) that maintaining the 0.5 percent Bank Rate in the face of above trend inflation was the post facto appropriate policy, then we face the ironic and unsettling fact that we have only had appropriate interest rate policy because of unavoidable imperfections in forecasting. This might argue for a redefinition of the inflation target explicitly to exclude some exceptional one-off items.

The appropriate treatment of one-off or exceptional inflation rate effects is not, however, fundamental. The crucial issue is whether we should move from the objective of a medium-term (say two to three years) inflation rate of around 2 percent, to some variant that either (a) seeks to target real growth as well as price stability effects, and/or (b) accepts the possibility of a period of higher inflation either as an acceptable by-product of a focus on real growth or as an end desirable in itself.

The variants could include a higher inflation rate target, a focus on price levels rather than inflation rates, or a focus on either nominal GDP (NGDP) growth rates or levels.

Three arguments for such variants could be put forward, the third of which provides the strongest case for a change in formal target.

diagraM 7: alternative poSSible targetS

excluSively price focuSed price and real ouTpuT/employmenT focuSed

� Alternative inflation rate measures (e.g., excluding “one-off”

tax or commodity price effects

� Higher inflation rate (permanently or for a period of time)

(see Blanchard, dell’Ariccia, and Mauro 2010)

� Guidance implying loose policy even after inflation rate is

back on target (see Carney 2012)

� Price level trend

� Guidance contingent on future developments

(loose policy until unemployment below x%)

(see Carney 2012; Federal Reserve Policy 2012)

� Money GDP growth rate (as permanent rule or

temporarily)

� Money GDP level trend (see Carney 2012;

Woodford 2012)

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First, high potential for noninflationary real growth. Increases in nominal GDP can result in or reflect either price or real output increases. Real output effects are likely to dominate if economies are operating with significant spare capacity and if firms and individuals have low expectations of future inflation. If both conditions apply, there may be a wide range of potential growth rates of nominal GDP across which the impact on the inflation rate up or down is very small. It may therefore be possible for a central bank, motivated by a nominal GDP target, to stimulate aggregate nominal demand with high confidence that this will produce a primarily real output rather than price effect. Strictly, however, such a central bank response does not require setting an NGDP target, but simply an objective function of the form, “promote growth and employment subject to the constraint of a clear inflation target.” The Federal Reserve’s statutory objective is already close to this, and most central banks are de facto interested in noninflationary growth even if their mandate does not formally commit them to it. The fact that in several countries there may exist significant potential for nominal demand stimulation that has a predominantly real output effect cannot, therefore, be a sufficient basis for a change in the definition of the formal target.

Second, erosion of excess debt levels (public or private) via higher inflation. As Section 3 argued, the most fundamental challenge we face is accumulated levels of debt (initially private and now public) above optimal levels. Reducing these leverage levels without reasonable growth rates of nominal GDP will be extremely difficult. Countries such as the UK and the United States, which achieved public sector deleveraging after World War II, were only able to do so with growth rates of nominal GDP far above current rates (Exhibits 13 to 15). Both rapid real growth rates and inflation rates in excess of interest rates (achieved via effective “financial repression”) were essential to the deleveraging process.

These observations could be used to support a temporary increase in inflation rate targets (see, for example, Blanchard, Dell’Ariccia, and Mauro 2010). But the potential disadvantages of such an approach need to be clearly faced. A higher rate of inflation can only erode the real value of long-term fixed rate debt, not short-term variable debt (see Bootle and Jessop 2011). And temporary higher inflation targets would clearly entail the risk that expectations of higher inflation would become permanently embedded.

The risks involved in any move to a temporarily higher inflation target—and the potential limits to its effectiveness in eroding past debt burdens—would therefore require very careful assessment. But what the historic experience of past deleveraging clearly implies is that it is essential at least to set and achieve a positive inflation target (such as 2 percent), and that when countries fail to do this (for example, Japan over the last twenty years), aggregate deleveraging (as opposed to a mere shift of leverage from the private to public sectors) becomes close to impossible.

Third, forward commitment to future accommodative policy. As Michael Woodford (2012), in particular, has pointed out, the impact of movements in central bank policy rates on nominal demand may depend only to a small extent on immediate changes in market interest rates, and to a large extent on expectations of future nominal and real interest rates looking forward over several years.14 Individuals or firms entering into debt contracts today do so in the light

14 Goodhart et al. (2013) have, however, pointed out that in economies where there are debt contracts explicitly linked to the policy rate (for example, in the UK, Bank Rate linked mortgages), the direct importance of changes to the policy rate should not be entirely discounted.

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of expectations as to the real interest burden arising from these contracts over time, and of the nominal and real income flows likely to be available to support debt servicing.

But the ability of central banks to generate appropriate expectations of medium-term real interest rates may be seriously undermined in conditions where interest rates are already close to the zero bound and when deleveraging creates deflationary headwinds. Negative real interest rates may be required over a number of years to ensure a path of real growth consistent with medium-term inflation at a low but positive level, but expectations of future real interest rates may be driven up if firms or individuals anticipate that the central bank—pursuing a forward-looking inflation rate target at any point in time—will respond to any pickup in inflation by immediately raising interest rates.

One response to this difficulty is to provide forward guidance that interest rates will remain low for a sustained period of time. But as Woodford has pointed out, if agents interpret such guidance as indicating central bank pessimism about future prospects, it could potentially have a contractionary rather than a stimulative effect (Woodford 2012).

Alternative targets may, therefore, be required, at least for a period of time, to achieve escape from deflationary traps. As Mark Carney has put it, “a central bank may need to commit credibly to maintain highly accommodative policy even after the economy and, potentially, inflation picks up,” and to make that commitment credible, it may need to “tie its hands” (Carney 2012, 8). This might then justify a range of precommitment devices ranging from (a) precise numerical thresholds for inflation and unemployment; (b) commitments to achieve a particular level of prices; and (c) commitments to either particular growth rates of NGDP or to a particular level of NGDP, even if the inflation rate for a period of time goes above target.

Together, the three arguments above establish a strong case for serious consideration of alternative central bank targets. But there are also strong arguments for making any such shift temporary and for focusing strongly on how to achieve exit from a temporary regime, reverting to an inflation rate target when appropriate.

• In particular, while the case for permanent nominal GDP targeting has some theoretical attractions, it could also suffer from major disadvantages. As Charles Goodhart has pointed out, defining the appropriate percent rate of increase would require a point of view on the sustainable medium-term growth rate of the economy, about which there is considerable uncertainty. And under some circumstances, pursuing an NGDP target could result in greater volatility of inflation, making it more difficult to ensure reasonably stable inflationary expectations (Goodhart et al. 2013).

• And while a period of above-target inflation might be required to ensure strong recovery and be compatible with steady medium-term inflationary expectations, the longer the period over which inflation remains above target the greater the danger that expectations of high future inflation are generated. Woodford’s proposal of a commitment to achieve in future a level of GDP in line with the continuation of the precrisis trend might, therefore, if the stimulus turned out to produce a predominantly price rather than real output effect, result in sustained inflation at too high a level.

Given the severity of the challenge created by postcrisis deleveraging, all the alternative options should now be carefully considered. But the considerations above suggest that the most attractive are likely to be:

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• Precommitments to maintain stimulus until and unless numerical thresholds for unemployment or inflation are met (that is, the Federal Reserve’s current approach).

• Commitments to achieve some defined level of increase in NGDP over a number of years, but without the open-ended commitment to return to the precrisis trend in NGDP level, which Woodford has proposed.

While this debate is important, however, I will argue here that it is less important than the issue of the tools by which we should seek to achieve whatever is the chosen objective. The mere setting of a more accommodative target will not ensure that it is met. And some of the tools we could use to achieve the objective might be ineffective or have seriously adverse side effects.

The next three sections consider those tools, looking first at pure monetary instruments, then at pure fiscal instruments, and then at the combination—overt money finance of fiscal deficits.

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5. Achieving the Chosen Target: Monetary and Macroprudential Levers

Suppose that, whatever the formal target we wish to pursue, we want nominal demand to grow faster than it otherwise would. Can we achieve that with levers that fall within the monetary policy, credit stimulus, or macroprudential boxes on the left-hand side of the framework diagram (Diagram 1)? And if we could, would there be harmful side effects?

The classic instrument of monetary policy is the interest rate. The US Federal Reserve, the Bank of England, the Bank of Japan, and the European Central Bank reduced policy rates close to the zero bound in 2009 (Exhibit 16). In some cases further small reductions could be made, but their direct impact on market interest rates for savings and lending products, and thus their likely stimulative effect, would clearly be small.

Even when the zero bound is reached, however, central banks have multiple policy levers available, especially if they are also macroprudential authorities. These tools include:

• Forward guidance that policy interest rates will stay at low levels into the future, potentially underpinned by the precommitment devices (state contingent, price level, or nominal GDP related) considered in Section 4.

• Quantitative easing in its standard form, that is, central bank purchases of government debt. This will affect nominal demand through at least three closely related transmission channels (Joyce, Tong, and Woods 2011):

○ A reduction in long-term risk-free interest rates, which will induce holders of government bonds (or sellers who now hold cash) to seek new opportunities to deploy cash into higher-yield instruments.

○ An increase in the value of government bonds and of the other assets into which investors move, which, by increasing wealth, may generate additional consumption or investment expenditures.

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○ A decline in the exchange rate.

• QE focused on purchases of assets other than government bonds. Such assets could include, as Ben Bernanke (2000) describes, credit securities, equities, property assets and foreign exchange. Transmission mechanisms would include increased asset price/wealth effects, a decline in the exchange rate, or a reduction in credit risk premia, reinforcing the impact on market interest rates of the reductions in the risk-free rate induced by standard QE.

• Liquidity support to commercial banks at favorable rates such as provided through the European Central Bank’s Long-Term Refinancing Operation.

• Direct subsidy/support for commercial bank credit supply, such as provided by the Bank of England’s Funding for Lending Scheme.

• Macroprudential policies, for example, relaxing either capital or liquidity requirements, either on a stand-alone basis or, as agreed by the UK Financial Policy Committee in summer 2012, as part of a package of measures that also included the Funding for Lending Scheme and enhanced central bank liquidity support.

Clearly, therefore, central banks do not “run out of ammunition” when the interest rate zero bound is reached, and all four major central banks have dramatically increased the scale of their balance sheets relative to GDP since the start of the crisis (Exhibit 17). Analysis suggests moreover, that such policies can be effective in raising nominal GDP. For instance, the Bank of England’s best estimates of the impact of QE up until summer 2011 suggest that it might have resulted in both a .75 to 1.5 percent increase in the price level, and a 1.5 to 2 percent increase in the real output level, relative to the non-QE counterfactual (Joyce, Tong, and Woods 2011).

That favorable assessment of initial effect could, however, be compatible with two concerns: (a) that there may be important limits to the effectiveness of monetary, credit support, and macroprudential levers; and (b) that they may have adverse side effects.

limits to effectiveness?All of the policy levers considered in this section—if deployed on their own—work through interest rate, credit, and asset price channels. In different ways they induce agents to change behavior—by substituting money for bonds, by reducing medium- and long-term interest rates and stimulating a search for yield, by directly or indirectly reducing the cost of credit supply, or by enabling banks to supply a higher quantity of credit as a result of lower capital or liquidity ratios.

But the effectiveness of each of these transmission channels may be constrained if postcrisis deleveraging produces the “balance sheet recession” behaviors described by Richard Koo (2009) in Japan, as follows:

• Real economy borrowers seeking to restore balance sheets may be highly inelastic in their response to any conceivable fall in interest rates. Forward guidance, QE-induced effects on long-term interest rates, and direct central bank credit subsidy may all therefore end up “pushing on a string.”

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• And the closer long-term and short-term yields fall toward zero levels (Exhibit 18), the more that risk-free bonds and money become perfect substitutes, the economy entering a liquidity trap in which replacing investor holdings of bonds with central bank money has minimal effects on behavior.

Whether and to what extent such limit conditions have been reached is an empirical issue. Koo’s analysis and the extremely low level of yields on long-term Japanese Government Bonds, suggest that they may apply in Japan. In Britain, a crucial question is whether slow credit growth in the household sector and negative in the business sector reflects supply constraints or a deficiency of demand (at almost any price), driven by the desire to reduce leverage levels and by depressed expectations of future activity and income levels. Interpretation of past evidence is ambivalent; the impact of the Funding for Lending Scheme will be a key test. So far, the evidence seems to suggest a limited impact on mortgage volumes, but little or no impact on business borrowing behavior (Exhibits 19 and 20).

potential adverse Side effectsThe second concern is that monetary, credit support, or macroprudential policy levers, whether or not effective in stimulating nominal demand, may have adverse side effects. In particular, as economists such as William White (2012) have warned:

• Low interest rates sustained over many years (and perhaps, in the experience of Japan, decades), could have harmful long-term effects.

○ Incentives will be created for complex carry trade and asset speculation activities, creating financial stability risks that macroprudential authorities have only imperfect capacity to spot. And low interest credit may flow into such activities far more readily than it flows into real economy investment projects, as household and corporates attempt deleveraging to restore balance sheet strength.

○ And sustained low interest rates, accompanied by extensive loan forbearance, may enable inherently unsustainable companies to (just) survive in a low-productivity, low-growth state, stymying the processes of capital allocation required to drive long-term improvements in supply capacity.

• The success of monetary policy, credit subsidy, and macroprudential policies depends in large part on the stimulus to private credit and money creation, persuading households to increase mortgage debt or businesses to borrow more money. In some circumstances, such stimulus might be compatible with required long-term deleveraging, since the nominal GDP stimulus outweighs the growth in nominal debt. But it is also possible that monetary, credit subsidy, and macroprudential levers will only work by stimulating increases in leverage, which reinforce our vulnerability to financial and economic instability. We got into this mess because of excessive creation of private credit and money; we should be concerned if our only escape route implies building up future excess.

• That concern should be particularly strong when we use macroprudential levers to facilitate greater bank credit supply, given that such levers work via the relaxation of leverage constraints. Excessive leverage and maturity transformation in the banking system was central to the 2007–08 crisis. And as argued in Section 2, there are strong arguments that

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optimal bank capital ratios would be well above even the new Basel III Standards. Any weakening of capital or liquidity standards in order to support increased lending capacity, however justifiable as a necessary stimulus to short-term nominal demand, inevitably involves an increase in financial stability risks.

• Finally, if the transmission mechanism of QE works via the exchange rate, national QE policies can have important and potentially harmful spill-over effects, with other countries (whether developed or emerging) having to cope with the consequences of rising exchange rates, potentially reinforced by speculative and volatile capital inflows.

An exclusive reliance on monetary, credit subsidy, and macroprudential policy levers to stimulate nominal demand thus carries significant long-term risks—a danger that, in seeking to escape from the deleveraging trap created by past excesses, we may build up future vulnerabilities.

That does not mean I disagree with recent policy measures in the UK. If I had been on the UK Monetary Policy Committee, I would have voted for the Bank Rate to be reduced to and then maintained at 0.5 percent, and for QE at the current level. And on the Financial Policy Committee, I strongly supported the macroprudential relaxations that we introduced last summer, and agreed with the support we expressed for the Bank’s introduction of the Funding for Lending Scheme. These policies are all better than no action. But we should, I believe, recognize both that their effectiveness may have limits, and that they carry long-term risks.

We therefore need to ask whether there are other policies that could more effectively stimulate aggregate nominal demand with fewer harmful side effects.

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6. Fiscal policy Stimulus

Monetary, credit support, and macroprudential policy levers stimulate demand via the indirect transmission mechanisms of private credit creation, portfolio rebalance, and asset price/wealth effects. The argument for fiscal stimulus is that it operates in a more direct fashion, cutting taxes or increasing public expenditure, putting spending power directly into the hands of individuals or businesses. In Friedman’s terms, the money directly enters “the income stream.” But in “normal times” (and, in particular, when interest rates are not close to the zero bound), the direct effects on nominal demand of a funded fiscal stimulus can be partially or fully offset by three factors15:

• An increase in interest rates that generates a “crowding out” effect, reducing private consumption or investment and thus offsetting the direct impact of the fiscal stimulus. This effect will be most likely, indeed it will be hardwired into the policy framework, if the central bank has a mandate to contain inflation, and if that central bank has already set interest rates at the level it considers compatible with low inflation growth.16

• A “Ricardian equivalence” effect, with individuals and businesses saving rather than spending the money they receive, since they are aware that they will in future have to meet (through increased taxes or reduced public expenditure receipts) the cost of servicing the increased public debt.

• And a variant of that effect, in which the potential increase in future public debt level is so high that it generates concerns about debt sustainability, and thus increases the interest rate the government has to pay on public debt, further increasing future debt servicing burdens.

15 Note that we assume here, as in Section 5, that an increase in nominal demand is desirable, with some of that increase likely to result in a real output, rather than solely a price effect. If the economy is at full capacity, of course, fiscal policy stimulus would be inappropriate even if it could stimulate nominal demand, since only a price inflation effect would result. But in those circumstances, any monetary policy stimulus would also be inappropriate.

16 See Sargent and Wallace (1981).

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Given these factors, the dominant conventional wisdom of the last thirty years has been that fiscal policy is not an effective lever for macro demand management (let alone an effective lever for increasing long-term real growth rates, as some policy makers in the 1950s and 1960s erroneously believed).

However, Brad DeLong and Larry Summers (2012) have argued that these normally compelling arguments do not apply in the current circumstances. They accept that “in normal times central banks offset the effects of fiscal policy,” and that “this keeps the policy-relevant multiplier near zero” (DeLong and Summers 2012, 1). This, in turn, “leaves no scope for expansionary fiscal policy as a stabilization policy tool” (DeLong and Summers 2012, 1). But they argue that in current conditions:

• There will be no offsetting increase in interest rates, and therefore no “crowding out” effect. Policy rates are close to the zero bound (and already higher in real terms than policy makers would ideally seek); the Federal Reserve is committed to keeping the policy rate low into the foreseeable future, and it is committed to substantial (and now potentially limitless) quantitative easing, buying government bonds in whatever quantity is required to keep long-term interest rates low.17 In these circumstances, a funded fiscal stimulus will be effective in stimulating nominal demand.

• There is sufficient potential slack in the economy that a significant proportion of such stimulus will have a real output rather than a purely price effect, and not only in the short but also in the long term, since the avoidance of hysteresis18 effects will enhance long-term supply capacity above the counterfactual level.

Allowing for these considerations, DeLong and Summers argue that policy-relevant fiscal multipliers are far higher today than in “normal times,” and that, as a result, under “plausible assumptions, temporary expansionary fiscal policies may well reduce long-run debt financing burdens” (DeLong and Summers 2012, 1).

DeLong and Summers establish a strong case for believing that a conventional funded fiscal stimulus could be appropriate in some circumstances and that those circumstances may exist in the United States today. In addition, it could be argued (though this is not part of the DeLong and Summers argument), that there may be circumstances in which Ricardian equivalence effects are unlikely to be important. In general, the power of Ricardian equivalence effects must surely be circumstance dependent, reflecting factors that include (a) the degree of public awareness of future debt burdens; (b) the existing level of public debt relative to GDP, and thus the rationality of any concerns about future debt sustainability; and (c) the income level of the beneficiaries of fiscal stimulus, and thus their capacity to save even if they were worried

17 At the time of publication of DeLong and Summers’ article, the Federal Reserve was providing time-specific forward guidance, underpinned with predefined amounts of QE. Since then, it has moved to a circumstance-contingent framework, underpinned by QE with no predefined limit. The power of DeLong and Summers’ argument has, therefore, increased further since publication.

18 Hysterisis refers to the tendency of periods of high unemployment to reduce long-term capacity and to increase the level of unemployment below which inflation tends to accelerate.

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about future debt levels.19 It seems unlikely, for instance, that a desperate U.S. worker in the midst of the Great Depression would have responded to a fiscally induced increase in real income by deciding “I better not spend this, because of the future taxes I am bound to face,” particularly given that U.S. federal debt to GDP was around only 20 percent at the onset of the Great Depression.

Richard Koo’s argument that conditions existed in which Roosevelt’s fiscal expenditures could be effective in stimulating demand is therefore convincing.20

But it also seems highly likely that there are other circumstances in which Ricardian equivalence effects will be powerful. If public debt has already reached (as in Japan) 200 percent of GDP, and if there is extensive public discussion about the need for future taxes to reduce fiscal deficits and debt levels (as is also the case in Japan, which plans to introduce a significant sales tax), then, in these circumstances the stimulative effect of fiscal deficits may well be offset.

Thus, while Koo (2009) argues persuasively that Japan would have grown even more slowly than it did but for the very large fiscal deficits run over the last twenty years, he has no persuasive explanation of how Japan will ever contain or reduce the growth of its public debt burden relative to GDP. In Section 8 I will suggest that it never will, except via monetization or debt restructuring or repudiation. And Koo fails to address the depressive effect on consumer and business confidence, and thus on demand, which rising public debt burdens beyond some level must induce.

Thus, while funded fiscal policy as described by DeLong and Summers may be effective in some circumstances, which may pertain to the United States today, there are others when it might not work, or work only temporarily by storing up intractable problems for the future.

If that is the case, and if pure monetary policies face the limits to effectiveness and/or create the adverse side effects considered in Section 5, we need to consider whether any other tools of demand stimulation are available.

The potentially available tool is overt money finance of fiscal deficits.

19 This raises a more general issue as to the accurate specification of the role of expectations in determining the impact of current policy measures (or, indeed, of guidance intended to influence such expectations). The rational expectations model assumes that economic agents are both fully informed and rational in their processing of information. In reality, expectations are influenced by factors such as the extent to which issues (for example, future debt sustainability) are discussed in the media, and expectations are developed by processes part rational and part not. This issue is relevant also to the formation of expectations relating to the future possible reversal of current policies, whether QE or OMF, which is discussed in Section 7.A.

20 Koo also addresses the contested issue of whether Roosevelt’s fiscal policy was simulative or not. He argues persuasively that the significant increases in government expenditure should be seen as amounting to significant fiscal stimulus, even if the resulting increase in fiscal deficits was reduced by the tax revenue increases which recovery delivered. What is certainly true, however, is that Roosevelt’s fiscally stimulative policy in office was in contrast to his fiscally conservative rhetoric in the 1932 election.

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7. overt Money Finance: advantages, dangers, and required constraints

I will argue in this section that the option of overt money finance (OMF) of fiscal deficits should not be a taboo subject, and that:

• OMF could in some circumstances be essential and in some others be less harmful than alternative policy tools.

• It is possible and essential to design institutional constraints and rules that would guard against the misuse of this powerful medicine which, taken in large quantities, would undoubtedly become a poison.

This argument is set out in subsections A through E, below.

a. oMF and its relationship to QeBen Bernanke’s 2003 speech, “Some Thoughts on Monetary Policy in Japan,” set out a clear description of how OMF would work and why it would stimulate nominal demand. He:

• Proposed “a tax cut for households and businesses that is explicitly coupled with incremental BoJ [Bank of Japan] purchases of government debt, so that the tax cut is in effect financed by money creation”

• Suggested that it should be made clear “that much or all of the increase in the money stock is viewed as permanent”

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• Argued that consumers and businesses would likely be willing to spend their tax cut receipts since “no current or future debt service burden has been created to imply future taxes” (that is, that there would be no rational Ricardian equivalence affects)21,22

• Argued that the policy would likely produce a fall in the Japanese government debt-to-GDP ratio, since the nominal debt burden would remain unchanged while “nominal GDP would rise owing to increased nominal spending”

• And, while his main illustrative proposal was for a tax cut, he noted that the same principle of a money-financed fiscal stimulus “could also support spending programs, to facilitate industrial restructuring, for instance” (Bernanke 2003).

Bernanke’s description of a money-financed deficit thus makes clear its potential advantages over either pure monetary policy or pure funded fiscal deficits as a means of stimulating nominal demand. Compared with the monetary policy options considered in Section 5, it is more direct and certain in its first-order effect. Monetary, credit support, and macroprudential policy levers work through the indirect mechanism of stimulating changes in private sector borrower and investor behaviors, and may therefore be ineffective if behavior is driven by deleveraging during a “balance sheet recession.” OMF, because it finances an increased fiscal deficit, results in a direct input to what Friedman labeled “the income stream.”

As Bernanke (2003) notes, this means “that the health of the banking sector is irrelevant to this means of transmitting the expansionary effects,” making concerns about “broken channels of monetary transmission” irrelevant. But unlike the funded fiscal policy stimulus considered in Section 6, the stimulative effect of a money-financed increase in fiscal deficit will not be offset by crowding out or Ricardian equivalence effects, since no new interest-bearing debt needs to be publicly issued, and no increased debt burden has to be serviced in future.

As a result, OMF is bound to be at least or more stimulative than an increase in funded fiscal deficits. As Friedman put it in 1948, “another reason sometimes given for issuing interest bearing securities [that is, for running a funded fiscal deficit] is that in a period of unemployment it is less deflationary to issue securities than to levy taxes. This is true. But it is still less deflationary to issue money” (Friedman 1948, 250–51).

21 Bernanke assumes here, as do most accounts of central bank money creation and resulting seignorage, that base money is noninterest bearing whether or not it takes the form of notes and coins or of central bank reserves. In fact, in the UK, the current practice is that commercial bank reserves at the Bank of England are remunerated at Bank Rate. As a result, if the Bank of England financed an increased deficit with created reserves, and if it continued to remunerate all of those reserves, there would be a “debt service” cost for the combined government/central bank equal to the rate of interest on reserves, which would increase when and if the Bank Rate rose. The practice of paying Bank Rate on all reserves at the Bank of England can, however, be changed, and such a change would be a natural complement to an OMF operation.

22 Note that the seignorage benefit of the ability to create pure fiat money can arise in (at least) two specific accounting forms. Thus either (a) the government can issue interest-bearing debt, and the central bank can buy and hold this in perpetuity (rolling over into new government debt if the existing debt on its balance sheet reaches maturity). In this case, the government will face a debt interest servicing cost, but the central bank will make an exactly matching profit from the difference between the interest rate it receives on its debt and the zero cost of its money liabilities, and the central bank would then return this profit to the government; or (b) it would be possible to structure a permanent money finance operation, while still making the central bank’s balance sheet balance in accounting terms, by having the central bank “buy” a government security that was explicitly noninterest bearing and never redeemable. In terms of the fundamentals of money creation and government finance, the choice of these two routes makes no difference. It might, however, have signaling or political economy implications.

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Essentially, therefore, OMF is a combination of fiscal and monetary policy levers (Diagram 2)23; and the fiscal aspect of its character seems to make it quite distinct from QE, which is unaccompanied by increased fiscal deficits and is intended to be reversed at some future date.

The distinction between standard QE and OMF is, however, less absolute than first appears, and resides only in the expectations that exist as to future policy. Thus:

QE may turn out post facto to be permanent (though perhaps not overt) money finance. Conventional QE involves the purchase of government bonds by the central bank, which pays with central bank reserves, that is, with base money. The stated intent of such operations is that at some future time, the QE will be reversed, the central bank will sell back bonds and withdraw reserves.24 In fact, however, it is neither necessary nor certain that that will occur:

• There is no necessity of “exit,” since the central bank balance sheet might stay permanently bigger in nominal terms. And the central bank should decide whether or not to exit in future, not on the basis of some nonexistent necessity, but on the basis of whether exit (that is, sale of bonds and withdrawal of reserves) is required at each future date to achieve the central bank’s inflation rate (or other) targets.25

• As a result, there is no certainty that exit will actually occur, and a possibility that QE will turn out post facto to have amounted to permanent money finance of a part of fiscal deficits. From the early 1940s to 1951, the U.S. Federal Reserve conducted open market operations designed to ensure that the long-term interest rate remained at 2.5 percent whatever the size of the fiscal deficit. As a result, the monetary base increased (Exhibit 21). Following the 1951 Federal Reserve-Treasury Accord,26 this policy ceased. But there was no “exit,” no reversal; the monetary base ceased rising in nominal terms but it did not reduce, and such stabilization rather than reduction proved compatible with a return to low inflation. Post facto, a significant proportion of U.S. fiscal deficits from the early 1940s to 1951 was money financed; formally at the time, they were financed with interest-bearing debt, which the Federal Reserve bought in what we would now call QE operations.

All QE operations, therefore, carry within them the contingent possibility that they will turn out post facto to have been (in part or whole) permanent monetization, and that this may be an appropriate policy. The gross debts of the Government of Japan, after netting out holdings by the Japanese government, amount to 200 percent of GDP. Of this 200 percent,

23 In a speech in October 2012, Mervyn King commented that “the advocates of helicopter money and related ideas are really talking about a relaxation of fiscal policy. It would be better to be open about that” (King 2012b, 6). He was quite right to insist that OMF is a variant of fiscal policy stimulus. But it is importantly different in its likely effects, and in particular in its possible implications for long-term public debt sustainability, from funded fiscal stimulus.

24 Note that even when QE operations are reversed, they may result in a (relatively small but still material) element of permanent money finance of the fiscal deficit, since seignorage profits may be earned during the period in which government bonds are held , and will be subsequently remitted to the government. The recent transfer from the Bank of England to the UK Treasury of cash balances accrued in the course of the Bank’s QE operations may turn out to be an example of this effect.

25 If the bonds held by the central bank reach maturity during the course of a QE operation, the central bank of course needs to reinvest the money received from the government in the purchase of other government bonds to maintain an unchanged policy stance.

26 The 1951 Accord was an agreement between the executive branch of the US government, namely the US Treasury, and the Federal Reserve system. The Accord created a lasting separation between monetary policy and the Treasury’s control over debt management. The Accord also led to the establishment of an independent central bank focused on price stability.

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around a sixth (that is, 31 percent of GDP) is held by the Bank of Japan (Exhibit 22). Whether this debt exists in any meaningful economic sense, or whether an element of Japan’s past fiscal deficits has been de facto money financed, is a moot point (see Section 8 for further discussion of this issue).

Conversely, apparently permanent OMF could, if necessary, be reversed or offset by other means. Indeed, Friedman (and Simons) explicitly envisaged that at times it would be, with fiscal surpluses resulting in the withdrawal of base money, just as fiscal deficits result in its issuance (Friedman 1948; Simons 1936). And while this would be the only way to offset too rapid growth of nominal demand in the 100 percent reserve banking world that Friedman and Simons envisaged, in a world of fractional reserve banks, the potentially inflationary effect of too much OMF could be offset with new (or rather old ) macroprudential policy tools.

In such a world, there are risks that the initial direct impetus to nominal demand induced by a tax cut of the sort Ben Bernanke described, might be multiplied in future if banks with increased holdings of central bank reserves subsequently created additional private debt and money.27 But this can be offset by equipping central bank/macroprudential authorities with the ability to impose quantitative minimum reserve requirements. Indeed, the imposition of minimum reserve requirements,28 and the remuneration of the relevant minimum reserves at a zero interest rate, would be a logical and necessary complement to overt money finance.29 More generally indeed, as Carmen Reinhart and Kenneth Rogoff (2013) have argued in a recent paper, and as Jeremy Stein (2012) has also proposed, effective macro demand policies may well require us to revive tools focused directly on the quantity of private debt and money creation, which were rejected in the precrisis orthodoxy.

Thus, it is possible that QE described as temporary will turn out to be permanent, and that OMF described as permanent can be made temporary or offset by other policy tools.

The differences between QE and OMF are not, therefore, as absolute as first appears, but reside in two factors:

• OMF is accompanied with an overt increase in the fiscal deficit, while QE is not.

• OMF is accompanied with a statement of current intent that it should be permanent, and QE with a statement of intent that it should be temporary. Given the role that expectations of future policy action may play, such statements of current intent are likely important even if neither can absolutely bind future policy actions.

27 This, of course, means that the empirical estimation of the nominal demand impact of any OMF is much more complex in a world with fractional reserve banks than in the illustration of Friedman’s proposal presented in Section 2.

28 As discussed in footnote 6, variations in capital requirements can also be used to constrain bank creation of private debt and money. The precise impact of these will depend on the extent to which banks are able to raise or earn new equity capital to offset increased required ratios. There could, therefore, be strong arguments for also considering the use of quantitative reserve requirements, which more directly control the quantity of potential private debt and money creation.

29 Zero remuneration of the relevant slice of reserves is essential to ensure that the monetary base initially created does not impose on the central bank (and thus on the consolidated central bank/government combined) a positive and potentially rising future interest expense burden: if reserves were instead remunerated at a variable and potentially rising rate—such as the policy rate—the stimulus provided by the initial OMF might be partially offset by Ricardian equivalence concerns about this future interest expense burden.

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B. OMF’s Noninflationary Potential: The Undoubted Technical PossibilityOMF is the most certain means by which to stimulate nominal demand. As Willem Buiter puts it, “irredeemable fiat base money, the proper combination of monetary and fiscal policies, can almost always … boost aggregate demand” (Buiter 2003, 10).30

It might also, in some circumstances, be the only policy capable of stimulating aggregate nominal demand, since there could exist circumstances in which both purely monetary and purely fiscal policy options are made powerless by liquidity trap and balance sheet recession effects. This would most likely be the case in the face of deleveraging after a build-up of excessive private debt levels, and if funded fiscal stimuli were made powerless by Ricardian equivalence effects. This would most likely arise when government debt levels are already high relative to GDP.

There is, moreover, no inherent technical reason (as opposed to political economy reason) to believe that OMF will be more inflationary than any other policy stimulus, or that it will produce hyperinflation, because:

• It is no more inflationary than other policy levers provided the “independence” hypothesis holds (Diagrams 3 and 4). If spare capacity exists and if price and wage formation processes are flexible, the impetus to nominal demand induced by OMF will have a real output and price effect, and in the same proportion as if nominal demand were stimulated by other policy levers. Conversely, if these conditions do not apply, the additional nominal stimulus will produce solely a price effect whether it is stimulated by OMF or by any other policy lever.

• The impact on nominal demand, and thus potentially on inflation, will depend on the scale of the operation. A “helicopter drop” of £1 billion would have a trivial effect on nominal GDP: a drop of £100 billion would have a very significant effect, and as a result create greater danger of inflation.

• If the stimulative effect of OMF subsequently proved greater than anticipated or desired, it could be offset by future policy tightening, whether in the extreme form of Friedman’s “money withdrawing fiscal surpluses” or through the tightening of bank capital or reserve requirements.

The idea that OMF is inherently any more inflationary than the other policy levers by which we might attempt to stimulate demand is therefore without any technical foundation.

C. OMF, Fiat Money, and Political Economy RisksBut while the use of OMF is clearly technically compatible with sustained low inflation, there are strong political economy reasons for treating OMF as a potential poison. As Friedman recognized in his 1948 article: “The proposal has of course its dangers. Explicit control of the quantity of money by government and explicit creation of money to meet actual government deficits may establish a climate favorable to irresponsible government action and to inflation” (Friedman 1948, 264).

30 The circumstance that requires the addition of the condition “almost” is the possibility of “perverse future policies (future reversals of current expansionary monetary policies)” (Buiter 2003, 10).

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Thus, while OMF can be valuable and beneficial when used in contained quantities, there is a danger that once politicians and electorates understand that it is possible, they will want to use it in excessive amounts and in the many circumstances when it is not justified, as well as in the specific circumstances where it is.

Governments respond to popular demands and seek to win elections. If they feel free to run money-financed fiscal deficits and face inflationary consequences later, the temptation to do so will be huge. The history of fiat money is replete with examples of that temptation leading to hyperinflation—from John Law’s money printing in early eighteenth century France, to the hyperinflation of Weimar Germany following World War I, and to Zimbabwe in recent years.

It is for fear of such consequences that the prohibition of money-financed deficits has gained within our political economy the status of a taboo, a policy characterized not merely as in many circumstances and on balance undesirable, but as something we should not even think about let alone propose.

This taboo is buttressed by assertions that OMF is in some sense “impossible” and undesirable, and by a coy unwillingness to mention OMF overtly, even when economists are de facto proposing a variant of it.

Thus, arguments are sometimes advanced that OMF operations are impossible, since they would result in a threat to central bank solvency. In fact, such threats are more likely to come from reversible and reversed QE operations than from overtly permanent money finance.31

But, more fundamentally, such arguments fail to recognize that central banks, as Bernanke said, “cannot go bankrupt in the sense that a private bank can” and that “the usual reasons that a commercial bank holds capital … do not directly apply to the BoJ [Bank of Japan]” (or any other central bank) (Bernanke 2003). As Willem Buiter has pointed out, it would be technically possible for a central bank to run quite effectively with negative accounting equity (Buiter and Rahbari 2012b). Central banks’ solvency constraints are not absolute technical limits, but political economy “commitment devices” designed to place the creation of fiat money within tight limits. That does not make them any less important; while a central bank could in fact run on permanently negative equity, it is very useful for us to pretend that it cannot. But we need to recognize this constraint for what it is.

Perhaps as a result of the strength of the taboo, policy proposals that are de facto close to or fully equivalent to OMF often avoid making that clear. And policy proposals that are de facto close to or fully equivalent to OMF often avoid making that clear. Thus, DeLong and Summers (2012) argue that fiscal multipliers are now high because we can assume that the Federal Reserve will maintain close to zero interest rates and QE purchases in the face of whatever deficit the government runs. This is very close to an argument for money finance of a fiscal deficit. But the possibility that it will amount to OMF post facto (the Federal Reserve balance sheet staying permanently higher) is never explicitly recognized in their paper.

And while Woodford’s 2012 paper ends with something very close to an argument for OMF, the language stops just short of explicitness. Woodford is concerned by the potential ineffectiveness of the sort of monetary or macroprudential levers described in Section 4, which work indirectly through, for instance, portfolio rebalancing (“preferred habitat”) effects. He therefore argues for “policy actions that should stimulate spending immediately without relying

31 When a central bank conducts and then reverses a QE operation, it may suffer an accounting loss due to movements in the price of the bonds held between the purchase and sale. If an OMF operation is structured in the fashion described by option (b) in footnote 22, no such capital loss can result.

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too much on expectational channels.” He asserts that “the most obvious source of a boost to aggregate demand that would not depend solely on expectational channels is fiscal stimulus,” and he discusses the need to be clear that some part of “the increase in base money is intended to be permanent” (Woodford 2012, 86). But he never quite says that he is essentially repeating Bernanke’s call for an overt money-financed increase in the fiscal deficit.

Even when it is effectively proposed, overt money finance is the policy that dare not speak its name.

OMF, therefore, maintains its taboo status, and there are good political economy reasons for why that is so. But if it is also the case that there exists some circumstances in which OMF is the only effective way to stimulate nominal demand, and other circumstances in which it might stimulate nominal demand with less adverse side effects than alternative available policies (purely monetary or purely fiscal), then it could be harmful to make the taboo too absolute.

The challenge is, therefore, to take the possibility of OMF out of the taboo box, to consider whether and under what circumstances it can play an appropriate role, but to ensure that we have in place the rules and institutional authorities that would constrain its misuse. In a paper prepared for the Norges Bank centenary project, Stefano Ugolini argued that “monetization should not necessarily be seen as an evil, but rather than as an option to be subject to benefit cost analysis” (Ugolini 2011, 3). It must also be subject to clearly defined disciplines to guard against political economy risks.

d. constraining oMF through rules and central bank independence Central bank independence is perceived to be under threat. Stephen King, Chief Economist of HSBC, wrote recently in the Financial Times that “the era of central bank independence is coming to an end” (King 2013). And in Japan, the new government of Shinzo Abe has not only imposed on the Bank of Japan an explicit inflation target (which in itself would still be fully compatible with central bank operational independence), but demanded Bank of Japan commitment to specific actions in pursuit of that target, which comes very close to monetization of government debt.

Central bank independence, and the commitment device constraints (such as positive accounting solvency) that limit central bank action, are often perceived as absolutes fixed permanently over time. But as Paul McCulley and Zoltan Pozsar (2013) point out in a recent paper, the extent of central bank independence and the tools that they routinely use have changed over time. In particular, they argue compellingly that both the appropriate role of central banks and the role that they will inevitably play changes between leveraging and deleveraging periods (Exhibit 23).32

32 An interesting account of a changed approach within the career of one central banker is provided in a paper by Thorvald Moe (2013), which considers the themes and policy actions of Marriner Eccles, Federal Reserve Board Chairman for 1934–48. Eccles is sometimes seen as inconsistent in being a believer in fiscal/monetary coordination, and in encouraging the fiscal deficits and the easy monetary policy that amounted to de facto monetization in the 1930s and the early stages of World War II, but having subsequently been a key mover in the arguments for Federal Reserve independence that led to the Accord of March 1951. But as Moe persuasively argues, Eccles was not inconsistent at all, but appropriately reflecting different circumstances, including, in particular, the emergence post-1945 of rapid private credit growth. Like Simons, Fisher, and Friedman, Eccles believed that an understanding of the dynamics of banks’ abilities to create credit (rather than simply to intermediate existing money into loans) was fundamental to an understanding of macroeconomics and to the appropriate policy response, and that “’laissez-faire in banking and the attainment of business stability are incompatible’” (Moe 2013, 16).

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From 1919 to 1929, private leverage levels in the United States soared. This was followed by a 15-year period of falling leverage, and then followed, in turn, by a long upswing in private sector leverage from the late 1940s to 2008, with an acceleration in the final few decades before the crisis. We are now in an era of attempted private deleveraging (Exhibit 24).

During the long upswing of leverage, potential private credit demand creates circumstances in which that demand is, at least to a degree, elastic in response to changes in the interest rate. The “pull” of interest rate rises could, therefore, be used, at least to a degree, to contain demand and the release of that pull tended to increase it.

In this environment, the relationship between central banks and governments evolved to a particular pattern of institutional independence, target definition, and policy tools used.

Gradually, over time, it became clear that control over inflation required monetary discipline, and that a determined and independent monetary authority could in turn indirectly impose discipline on fiscal policy, since otherwise increased deficits would simply translate into increased real interest rates. Key steps in this process in the United States were the 1951 Federal Reserve-Treasury Accord, and former Federal Reserve Chairman Paul Volcker’s willingness in the early 1980s to take interest rates to whatever level was required to contain inflation.

Increasingly, over time, central banks were given formal mandates to achieve “price stability,” and in many cases to pursue defined low, positive, and symmetric inflation targets.

Also increasingly, central banks relied exclusively on the use of short-term policy interest rates to manage nominal demand, eschewing the use of quantity-focused levers (for example, reserve requirements or direct credit controls), which had been common in previous years.

This combination of roles, targets, and tools appeared to work well. But in fact, in one crucial sense it did not; that is, it failed to recognize that leverage was itself a key financial and macro stability variable. It allowed the steady build-up of real economy and financial sector leverage, which culminated in the crisis of 2007–08. This lack of any macroprudential focus was a fatal flaw.

But at least, in respect to the relationship between fiscal and monetary authorities, the arrangements fitted the context well, and underpinned the achievement, after the stagflation years of the 1970s, of sustained low and stable inflation compatible with reasonable steady growth.

But as McCulley and Pozsar suggest, the circumstances created by balance sheet recessions and deleveraging—in the 1930s, in Japan in the 1990s, and in much of the developed world today—create a quite different context. Reductions in short-term policy rates to the zero bound are ineffective in stimulating demand of credit; they become attempts to “push on a string.” QE operations combined with commitments to future reversal may also be subject to declining marginal impact. In these circumstances, McCulley and Pozsar argue, appropriate policy will need to migrate toward the quadrant of their map marked “helicopter money,” that is, overt permanent money finance (Exhibit 25). And they argue that not only will central banks do so but that they should do so, since without such a stimulus, depression will result (McCulley and Pozar 2013).

As a statement of what has occurred historically and will occur, this is convincing. And, arguably, it is a compelling statement of what should occur. Appropriate policies and institutional roles should be contingent on the circumstances, and the circumstances of a long deleveraging phase are quite different from those of the leveraging upswing. Monetization is not inherently evil, but a potentially necessary tool in these circumstances.

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As Ben Bernanke said in 2003,

“It is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say ‘no’ to the government. [In a liquidity trap], however, excessive money creation is unlikely to be the problem, and a more cooperative stand on the part of the central bank may be called for. Under [some circumstances] greater cooperation for a time between the central bank and the fiscal authorities is in no way inconsistent with the independence of the central bank” (Bernanke 2003).

But that still leaves the questions: How exactly should this coordination work? What rules should constrain central banks and governments in this new environment? If we accept that fiscal and monetary policy coordination is required, and that the absolute taboo against overt permanent monetization should be set aside, how do we ensure discipline against too much money creation?

Past examples of de facto monetization—such as the United States in the 1940s—were undisciplined. The government ran whatever deficit was required to pay for war expenditure, and the Federal Reserve was required to buy whatever volume of bonds was required to keep interest rates at a continually low level. Acceptable as wartime necessity, such indiscipline cannot be the basis for a peacetime policy regime.

Any use of the extreme option of OMF should therefore be placed within the same constraints of central bank independence and clear rules that constrain the use of existing monetary tools. As Mervyn King has said, “It is important to distinguish between ‘good’ and ‘bad’ money creation ... ‘good’ money creation is where an independent central bank creates enough money in the economy to achieve price stability. ‘Bad’ money creation is where the government chooses the amount of money that is created in order to finance its expenditure” (King 2012b, 5).

This principle, applicable to the decisions about temporary monetization—that is, QE—can also be applied to overt and permanent money finance. Thus, it would be possible and desirable to give to an independent central bank the sole ultimate authority to determine what level of OMF (that is, of increased fiscal deficit financed by money) it considered compatible with the pursuit of whatever target (inflation or, temporarily, NGDP) it was mandated to achieve. It would also be possible, as Samuel Brittan has suggested, to buttress this with a rule that the amount should not exceed that element of the fiscal deficit that is cyclical, as determined by a wholly independent body (such as, in Britain, the Office of Budget Responsibility) (Brittan 2011).

An alternative approach would be to limit the allowable use of OMF to operations that of their nature are clearly one-off and that are focused not on immediate nominal demand stimulus, but on the creation of a sounder and significantly less leveraged banking system. Such an approach could entail a requirement by the macroprudential authority that capital ratios must be significantly increased. This would be combined with a fiscal backstop of government recapitalization in the event that private equity was not forthcoming, but with that specific slice of fiscal expenditure financed not by newly issued interest-bearing debt, but

40

by permanent central bank money. Such a plan would bear some similarities to the Chicago plan presented by Simons and others to Roosevelt in 1934.33

My aim, however, is not to propose any one specific scheme for the use of OMF, but to stress the importance of debating the options. For the danger if we do not debate how to place the use of overt money finance within defined rules and authorities, is that we may end up deploying it in response to short-term political pressures, and not subject to the rules and independent authorities that will constrain its excessive use.

We need to debate how to use this potentially powerful medicine and how to discipline and constrain its use, to make it less likely that it will end up being used in poisonous quantities.

e. oMF as a policy option for debateOMF, as Buiter (2003) has said, is the tool that will almost always stimulate nominal demand. Governments and central banks together never run out of ammunition to stimulate nominal demand. And in some extreme circumstances—those in which there is a simultaneous and significant fall in both the price level and real output—it is unambiguously clear that OMF would be the best policy, and in some circumstances may be the only policy available to prevent continual deflation.

For example, if Herbert Hoover had known in 1931 that OMF was possible, the U.S. Great Depression would have been less severe. If Germany’s Chancellor Brüning had known then that it was possible, the history of Germany and of Europe in the 1930s might have been less awful. Hitler’s electoral breakthrough from 2.6 percent of the vote in the election of May 1928 to 37.4 percent in the election of July 1932 was achieved against a backdrop of rapid price falls—not inflation. And while Japan’s deflationary experience of the last twenty years has been far less severe than that of the 1930s, (as a result, Koo argues, of fiscal deficits that were effective despite being funded), there is a very strong case that Ben Bernanke was right and that if Japan had deployed OMF 10 or 15 years ago, it would be in a much better position today, with a higher price level, a higher level of real GDP, and a lower government debt burden as a percent of GDP, but with inflation still at low though positive levels. And it is possible that there are no other policy levers that could have achieved this.

In other circumstances, the case for deploying OMF is less clear, and the other policy options may be sufficient to escape deflationary traps. Pure funded fiscal policy may be effective, particularly if the government debt-to-GDP level is initially low. Monetary policy, credit support, and macroprudential levers of the sort described in Section 5 may be effective, particularly if long-term interest rates have not yet reached the extremely low levels reached in Japan, and if the economy does not face absolute price deflation.

In such circumstances, an argument could be made for excluding OMF options from consideration, given the political economy risks that the use of OMF entails. OMF might be technically attractive but too politically risky to use if not essential.

Even in circumstances where non-OMF tools might be sufficient to drive eventual recovery from recession, however, excluding the option of OMF may carry serious disadvantages, given

33 The Chicago Plan aimed indeed at a one-off transition to the 100 percent reserve model that Simons and others preferred. In an August 2012 IMF Working Paper entitled “The Chicago Plan Revisited,” Jaromir Benes and Michael Kumhof argued that a transition to a 100 percent money banking system is both desirable and possible, and that it could and should be accompanied by a dramatic write-down of existing household debts, removing in one fell swoop the vulnerability to financial and macroeconomic instability created by high levels of household leverage (Benes and Kumhof 2012).

41

the potential long-term adverse side effects of alternative approaches. There is, therefore, a good case for debating explicitly the pros and cons of all alternative policies.

Consider, for instance, the two alternative policy options illustrated in Diagram 8.

The first option involves large volumes of quantitative easing, let us say in the many hundreds of billion pounds, together with a Funding for Lending Scheme and a relaxation of bank liquidity and capital standards. It aims to work through the indirect channels of stimulated credit growth (operating on both supply and demand levers) and through portfolio rebalancing and wealth effects, which depend on asset price increases. It probably commits us to many years of very low interest rates. It carries within it the contingent possibility that some of the QE will never be reversed, but the sheer scale of the QE makes it likely that a significant part will have to be reversed (or mopped up by other mechanisms such as increased reserve requirements) to prevent future excess inflation.34 The stated intention is full reversal.

The second option is OMF. It seeks to stimulate demand directly by putting money into individuals’ or firms’ pockets, whether by tax cuts or by increased public expenditure. In quantity it would be far smaller—perhaps several tens of billion pounds rather than hundreds of billions. But the clearly stated intent would be that this increase in the monetary base would be permanent and never reversed. Mopping up would be possible, however, through the use of bank reserve requirements, if such a permanent stimulus proved too great. If successful, it might well have a more immediate effect than option 1, and might speed the return to more normal interest rates. But if it generated the fear that OMF once deployed would be repeated

34 Michael Woodford discusses the problem that can be created by QE operations of this size. He suggests that a commitment permanently to increase the monetary base may be essential to communicate future central bank intent, “but the kinds of large increases in the monetary base associated with “quantitative easing” in Japan or with the Fed’s recent programs do not suggest particular expectations about future policy in the same way: the expansions have been too large for any plausible suggestion that they are intended to be permanent, nor is the size of the expansion tied in any obvious way to any aspect of the central banks’ future targets that one might be trying to signal” (Woodford 2012, 85).

Several hundreds of billion pounds of quantitative easingwith commitment to future reversal

Funding for lending

Relaxation of bank capitaland liquidity standards

+

+

Several tens of billion pounds of overt money financeof increased fiscal deficit

(tax cuts or public spending increasing)… with commitment that this

will be permanent

OPTION 1 OPTION 2

WHICH WILL

Be most e�ective in stimulating nominal demand?

Have least adverse side e�ects?

diagraM 8: two policy optionS

42

and increased, it might generate expectations of high inflation, which would bias the impact of nominal demand increase toward an inflationary effect.

Which of these two policies would be most likely to stimulate demand without either excessive medium-term inflation or adverse long-term side effects on financial stability? The answer should be based on detailed analysis using the best available models to estimate first- and second-order effects. I do not know what the answer would be, and it would depend on specific circumstances, which vary among countries and across time. But we should at least ask the question.

43

8. Possible Implications by Country: Some Initial Thoughts

My main purpose is not to propose policies relevant to today’s circumstances in specific countries, but to explore theoretical points relevant to policy in an era of deleveraging and potentially depressed private demand. But let me very briefly suggest some possible implications or some considerations that need to be taken into account.

a. Japan: bernanke was right.Bernanke was right. Japan should have done some OMF over the last twenty years, and if it had done so, it would now have a higher nominal GDP, some combination of a higher price level and a higher real output level, and a lower debt-to-GDP ratio.

This would have placed Japan in a much better position than it now finds itself. Koo (2009) may be right that, absent such a policy, Japan’s large funded fiscal deficits were essential to avoid still greater deflation and outright depression. But these deficits have led to a level of government debt as a percent of GDP that is unsustainable.

Japan’s real growth rates will inevitably be slow—because of demographics and because it is already at the technological frontier. Given this slow growth, and given continuing fiscal deficits, debt of 200 percent of GDP is not repayable. The IMF “Fiscal Monitor” of October 2012 presented scenarios for the fiscal consolidation required in different countries to meet, by 2030, benchmarks of fiscal sustainability. For Japan, it set a lower benchmark (80 percent debt to GDP) compared to 60 percent for other countries, and it focused on net debt, not gross (Exhibit 26). Even with these less stretching assumptions, the scenario is simply not credible—it would require Japan to move from an 8 percent primary deficit today to a 13 percent primary surplus by 2020. This will not occur, and if attempted would drive the Japanese economy back into deep recession. Japan’s government debt will eventually be either monetized or restructured, it will not be repaid in the normal sense of the word.

44

One possible optimistic counter to this argument is to recognize that in some senses the debt may already have been monetized. Japanese debt to GDP after government and social security holdings is 200 percent (Exhibit 22). But of that, around a sixth (31 percent) is owned by the Bank of Japan, which in turn is owned by the government. And a further 46 percent is owned by the Post Bank, which is also owned by the government. In some senses, this part of the debt has been de facto financed by the noninterest-bearing money accounts that Japanese customers hold at the Post Bank (Diagram 9). Japan, therefore, has the potential to perform accounting exercises that simply recognize the already existing reality that some of its fiscal deficits have been monetized, without changing the cash asset Japanese individuals hold.

But even after allowing for these effects, Japan’s non-money-financed debt burden is also relentlessly rising, and will continue to do so unless the government achieves its 2 percent inflation target and a faster rate of nominal GDP growth. To achieve that may require overt money finance. But the danger is that the level of OMF now required to reduce debt-to-GDP ratios may be so high that it would result in unacceptably high inflation.

Japan, therefore, illustrates three points:

• There exists some circumstances in which OMF is essential to adequately stimulate nominal demand.

• The issue of new tools is as important as new targets. If fifteen years ago Japan had simply set a positive and symmetric inflation target, and used all available tools to achieve it, it would be in a better position. No shift to a less conventional target, such as nominal GDP, was required.

• And if there are conditions in which OMF will eventually be required, it would be better to deploy it early and in small amounts than to allow fiscal debt as a percent of GDP to accumulate to unsustainable levels.

Close to money financing of deficits

Closer still if government owns banks

Which it does in case of Japan Post

Money claims ofJapanese householdsand corporations

Current anddepositaccounts atzero interest

Governmentbonds atclose to zerointerest

COMMERCIAL BANKS

GOVERNMENT

diagraM 9: Money Financing via JapaneSe banKing SySteM?

45

b. the united States: the current policy mix is reasonably successful and may post facto amount to oMF, but admitting so openly may simply make the politics more difficult.The United States has been the most successful of the four major economies over the last four years. It has the highest rate of nominal GDP growth (Exhibit 27), and it has had by far the strongest recovery in real GDP (Exhibit 28).

Its policy mix has entailed (at least until now) a combination of large fiscal deficits combined with a monetary policy stance which, as per DeLong and Summers’ analysis, offsets any dangers of crowding out effects and which thus increases the policy-relevant multiplier.

And it may turn out post facto that the QE monetization is permanent, with the Federal Reserve balance sheet (as after 1951) falling as a percent of GDP but simply stabilizing (rather than falling) in nominal terms. If that does occur, some or all of QE will turn out post facto to have entailed money finance of fiscal deficits.

But while to point that out might add intellectual clarity, it might also complicate already fraught political debates, in which case, continuing with a policy that dare not speak its name may be the most sensible approach.

c. eurozone: optimal policy blocked by incomplete currency union; fiscal and monetary policy coordination requires some fiscal federalism.The eurozone has performed much less well than the United States since the 2009 trough. It has had a much lower real growth rate and significantly lower nominal GDP growth. With nominal GDP growing at only around 2 percent per year, there is a prima facie case that more rapid growth in aggregate nominal demand could be beneficial, even if long-term structural supply-side impediments to growth are also important in some countries.

But the ability to conduct even classical QE (let alone to consider overt money finance) is hugely complicated by the eurozone’s peculiar character—a single currency zone in which almost all fiscal decisions and all fiscal debt resides at what Charles Goodhart has labeled the “subsidiary sovereign” (that is, national) level (Goodhart 2011). As a result:

• Any QE operation by the European Central Bank (ECB) raises distributional and incentive issues not present in a unitary fiscal/monetary system. ECB purchases of Italian and Spanish government debt, for instance, would be equivalent to Federal Reserve purchases of, say, California or Illinois debt.

• And while it would be possible to find ways around this challenge, (for example, the purchase by ECB of the debts of all eurozone members in line with some agreed proportion system), decisions about the appropriate proportion (for example, relative to size of GDP or to debt outstanding) would be difficult to depoliticize.

In addition, the ECB is constrained by particularly tight legal restrictions on its ability to conduct monetary finance, whether temporary or permanent.

In practice, there is flexibility around these constraints. The distinction between a central bank buying bonds directly from governments (primary market finance) and buying existing bonds in secondary markets is not fundamental in economic terms. And the sterilization

46

actions the ECB insists it takes if and when it conducts bond purchases, may well have fewer implications than first appears. As Paul McCulley has pointed out,

“To be sure, the ECB stresses that it is sterilizing its creation of reserves, quickly pulling those new reserves out of the system in exchange for term deposits on itself. Thus, technically, the monetary base is left unchanged. But as a practical matter, reserves and term deposits are both newly created ECB liabilities that are very close substitutes” (McCulley 2010).

But even if that is true, the ECB’s political freedom or willingness to use its full capabilities is constrained by concerns about the political economy consequences. In a complex multistate polity, and with divergent economic interest among the different subsidiary sovereign states, the difficulty of ensuring that OMF is placed within the necessary tight disciplines discussed in Section 7.D would be extreme. Within the eurozone political construct, the case for keeping OMF in the taboo box remains strong.

The danger remains, however, that the constraints created by the existing structure will induce a severe deflationary bias to policy, with attempted public deleveraging in high-deficit/high-debt states depressing nominal GDP to an extent that makes deleveraging in effect impossible. DeLong and Summers’ (2012) argument that policy-relevant fiscal multipliers are high in an environment where the central bank policy is an exogenous given, applies still more forcefully in the context of subsidiary sovereign states that cannot set their own monetary policy.

The attainment of optimal policy is, therefore, severely constrained by structural deficiencies within the eurozone project. The required first steps in resolving these deficiencies, difficult enough in themselves, entail the achievement not only of a banking union, but of some degree of limited fiscal federalism, with some small but still significant revenues and expenditures at the federal level and the creation of some variant of eurobonds.

d. the united Kingdom: oMF, but also other demand-stimulative policies, may be least applicable in this economy, given apparent supply restraints.Finally, the UK. Here I suggest two reasons for considerable caution about using unconventional measures to stimulate nominal demand.

The first is that since the UK is both the smallest of these four economies, and therefore, inevitably, the most open (that is, the highest level of exports and imports as a percent of GDP), it is both the one where extreme policy levers ought to be least necessary given that it has the greatest potential to adjust via external exchange rate movements, and the one where there is the greatest danger that an expectational channel (see Diagram 5) would bias the division of change in NGDP toward a price rather than real output effect. If OMF today were perceived as unleashing a political risk of excessive OMF in future, an exchange rate/inflation cycle might be created.

The second is that the UK is the economy where it is least certain that the fundamental problem is one of demand (deficient nominal GDP growth) rather than supply. Diagram 10 shows for the United States, the eurozone, and the UK the division of nominal GDP growth since the depth of the 2009 recession, between the price effect (the GDP deflator) and real GDP. Exhibit 29 then illustrates the share of change in NDGP accounted for by the price effect and by the

47

real output effect in the three zones. The UK division is the least favorable—with more of the impetus of increased nominal GDP turning simply into higher prices rather than real output.

It may still be a reasonable judgment that the UK suffers from deficient nominal demand. But Exhibit 29 suggests the need to focus on supply factors, as well. So, too, does the only small beneficial impact that the sterling depreciation of 2009 appears to have had on the UK’s net export performance.

The explanation for this phenomenon may be that the sectoral imbalances induced by the UK’s overreliance on financial sector growth has left nonfinancial traded sectors (in particular manufacturing) so weak that the economy cannot now respond strongly to nominal demand stimulus. That could suggest that in choosing policy levers that stimulate nominal demand, we should also focus on their potential impact on supply capacity (Diagram 5). Achieving success in such focus is, however, notoriously difficult.

CHANGE IN PRICES(GDP DEFLATOR)

CHANGE IN REAL OUTPUT

UK: +8.1% US: +5.2% Eurozone: +3.8%

UK: +2.2% US: +6.5% Eurozone: +3.1%

UK: +10.4% US: +12.0% Eurozone: +7.1%

CHANGE INNOMINAL GDP

diagraM 10: breaKdown oF noMinal gdp growtH FroM trougH (2009) to peaK

48

9. Conclusions

Section 8 set out several tentative thoughts on the implications of my analysis for policy in specific countries. But as I stated earlier, my key concern is not to comment on specific current policy issues, but to arrive at general conclusions about the required relationship between financial stability and macro-demand-oriented policies, and in particular about the implications for appropriate macro-demand policies arising from the deleveraging that follows a financial crisis.

I suggest nine key conclusions.

1. Leverage and the credit cycle matter a lot. The level of leverage in both the real economy and the financial system are crucial variables that we dangerously ignored precrisis. Future macroprudential policy should reflect a judgment on maximum desirable levels of cross-economy leverage, and on desirable growth rates of credit. A wide range of policy levers may be required to contain leverage.

2. Banks are different. The arguments for free markets—strong in other sectors of the economy—do not apply. Private credit and money creation are fundamental drivers of both financial and macroeconomic instability and need to be tightly regulated.

3. Financial crises that result from excess leverage are followed by long periods of deleveraging that depress nominal demand and that change fundamentally the context within which appropriate macro-demand policy must be designed and implemented.

4. In that context, there is a good case for a temporary shift away from a pure inflation rate target. State contingent policy rules such as currently applied by the Federal Reserve, or a policy target that for a period of time takes account of nominal GDP growth rates or levels have attractions. But simply changing the targets without also changing policy tools, may in some circumstances be insufficient to ensure optimal policy.

5. In a deleveraging cycle, monetary policy levers alone—whether conventional or unconventional—may be insufficiently powerful and/or have adverse long-term side

49

effects for financial stability. If we got into this mess through excess private leverage, we should be wary of escape strategies that depend on creating more private debt.

6. Fiscal multipliers are likely to be higher when interest rates are at the zero bound, and when monetary authorities are precommitted to accommodative policy in future. But long-term debt sustainability must be recognized as a significant constraint.

7. Governments and central banks together never run out of ammunition to create nominal demand. Overt permanent money finance (OPMF) can always achieve that and is the only policy lever certain to do so. And in some circumstances, OPMF may have fewer adverse side effects than the use of pure monetary policy levers (conventional or unconventional). In technical terms, OPMF carries no more inflationary risks than other policy levers.

8. But the political economy risks of OPMF are great. Strong disciplines and rules are therefore essential to ensure that excessive use does not turn OPMF from a useful medicine to a dangerous poison. But such disciplines and rules, based on independent central bank judgment and clear inflation or other targets, can be designed.

9. We should, therefore, cease treating overt money finance as a taboo subject. And if we continue to do so, we increase the danger that overt money finance may be deployed too late to be effective or safe, or deployed in an undisciplined fashion, increasing the long-term risks to financial and macro stability.

Mephistopheles, Money, and debtFinally, then, what should we conclude about Mephistopheles, money, and debt? For Jens Weidmann, the implication of Faust Part II is clear. After a pleasing but passing upswing of rising consumer demand and falling state debt, “all this activity degenerates into inflation, destroying the monetary system because the money rapidly loses its value” (Weidmann 2012).

But Weidmann’s stress on the negative consequence of Mephistopheles’s monetary experiment has been challenged, and by someone who speaks with considerable authority. Professor Harold James of Princeton University is one of the world’s preeminent economic historians and a leading expert on interwar German economic history (James 1987). He is also a man steeped in knowledge of German history and literature. And in a short article entitled “Germany should re-read Goethe’s Faust Part II,” his take on the consequences is a bit more positive.

“Everything in the empire improves as a consequence of the introduction of paper money. The generals are pleased because the soldiers are paid once more, the treasurer finds that he can pay off all the debts, tailors are busily making new clothes, ladies become more willing to embark on well-paid romantic adventures” (James 2012).

So that while there are undoubtedly subsequent consequences, which, in the wake of our own crisis, we would recognize as warning signs—“the property market booms and simpletons can buy big houses” (James 2012)—the potential benefits of paper money creation should not be ignored.

So who is right, Weidmann or James? In reality, the differences in their interpretation are slighter than first appear. Both refer to the beneficial effects of modest money creation, and both to the dangers of inflation when money is created in excess, leading us clearly to

50

James’s conclusion that “a well-managed paper currency could offer greater price stability than gold- or silver-based currencies,” (James 2012) while also better serving the needs of a potentially expanding economy. Money—in its pure fiat irredeemable base money form—is a powerful economic medic ine i f used within tight constraints, and a potential poison if used to excess.

As for debt contracts between private sector agents, and, in particular, bank loans that create matching quantities of bank credit and bank money, they are not mentioned in Goethe’s Faust. But as great economists of the 1930s such as Irving Fisher and Henry Simons correctly pointed out, uncontrolled creation of bank credit and money can be a major driver of financial instability and subsequent economic harm, even when the creation of irredeemable fiat money is tightly controlled, with fiscal deficits small or nonexistent and inflation low.

This suggests two conclusions.First, in the deflationary, deleveraging downswing of the economic cycle, we may need

to be a little bit more relaxed about the creation, within disciplined limits, of additional irredeemable fiat base money.

But, second, in the upswing of the cycle, we should have been massively more worried than we were precrisis about the excessive creation of private debt and private money, and we should be wary of relying on a resurgence of private debt and leverage as our means of escape from the mess into which excessive debt creation landed us.

Mephistopheles leaps to a single conclusion, that there has been too

much deflation and austerity and what was lacking was money.

There is, he says, plenty of gold and silver beneath the earth, and

the Emperor simply needs to issue pieces of paper in the form of

claims against the underground metallic treasure. The Emperor is

suspicious of this clever advice.

But everything in the empire improves as a consequence of the

introduction of paper money. The generals are pleased because the

soldiers are paid once more, the treasurer finds that he can pay off

all the debts, tailors are busily making new clothes, ladies become

more willing to embark on well-paid romantic adventures, the

property market booms.

— Harold JaMeS, 2012

51

exHibit 1: FroM Fractional reServe to 100% reServe banKing

100% RESERVE BANKING

Central Bank

ANotes &Coins

Reserves

L

CommercialBanks

Reserves Depositsc

a. Deposit money equals multiple of reserves at central bank. b. Total money supply equals multiple of base money.

FRACTIONAL RESERVE BANKING

Central Bank CommercialBanks

Money supplyb

Notes &

coins&

bankdeposits

Money supplyd

Notes &

coins&

bankdeposits

A

Reserves

Loans

L

Depositsa

A L

Reserves

Notes &Coins

c. Deposit money equals reserves at central bank.d. Total money supply equals base money.

Exhibits

52

Source: Bank of England.

Securitizations and loan transfers Deposits Loans

1964

1967

1970

1973

1976

1979

1982

1985

1988 1991

1994

1997

2000

2003

2006

2009

PER

CEN

T O

F G

DP

40

35

30

25

20

15

10

5

0

ExhiBiT 2: LEvERagE iN ThE REaL aNd FiNaNCiaL sECTORs

ExhiBiT 3: PRivaTE NONFiNaNCiaL CORPORaTE dEPOsiTs aNd LOaNs: UK 1964–2009

Sources: Datastream; US Federal Reserve Flow of Funds.

UK debt as a % GDP by borrower type (1987–2007), Debt Liabilities on B/S

Household

Corporate

Financial

USA debt as a % GDP by borrower type (1929–2007)

Household

Corporate

Financial

1987

1929

1987

1989 1991

1993

1995

1997

1999

2001

2003

2005

2007

1935

1941

1947

1953

1959

1965

1971

1977

1983

1990

1996

2002

2007

300

250

200

150

100

50

10

PER

CEN

TPE

RCE

NT

600

500

400

300

200

100

0

53

Source: Bank of England.

Securitizations and loan transfers Deposits Loans19

64

1967

1970

1973

1976

1979

1982

1985

1988 1991

1994

1997

2000

2003

2006

2009

PER

CEN

T O

F G

DP

100

90

80

70

60

50

40

30

20

10

0

exHibit 4: HouSeHold depoSitS and loanS: uK 1964–2009

exHibit 5: private-credit-to-gdp ratio and growtH

Source: Cecchetti and Kharroubi 2012.

0.10

0.05

0.00

-0.05

-0.10-0.50 -0.25 0.00

Five-year average private-credit-to-GDP(Deviation from country mean)

Five

-yea

r ave

rage

GD

P-pe

r-w

orke

r gro

wth

(Dev

iatio

n fr

om c

ount

ry m

ean)

0.25 0.50 0.75 1.00

54

Source: Bank of England 2013.

All currency loans

1964

1970

1976

1982

1988

1994

2000

2006

2012

PER

CEN

T

50

40

30

20

10

0

-10

-20

Secured

Unsecured

Individuals

Source: Bankstats 2012.

1994

1996

1998

2000

2002

2006

2004

2008

2010

2012

PER

CEN

T

20

15

10

5

0

-5

exHibit 6: lending to uK buSineSS

percentage changes over a year earlier

exHibit 7: lending to individualS

percentage changes over a year earlier

55

Source: Datastream.

Private credit growth (% per year)

Bank of Japanpolicy rate

Dec-

1985

Dec-

1987

Dec-

1989

Dec-

1991

Dec-

1993

Dec-

1997

Dec-

1995

Dec-

1999

Dec-

2001

Dec-

2003

Dec-

2005

Dec-

2007

Dec-

2009

Dec-

2011

PER

CEN

T

16

12

8

4

0

-4

-8

exHibit 8: Japan policy rate vS. credit growtH per year

1990

1992

1994

1996

1998

2002

2000

2004

2006

2008

2010

2012

PER

CEN

T O

F G

DP

10

5

0

-5

-10

-15

Sources: Bank of Japan Flow of Funds Accounts; IMF.

Private nonfinancial corporations (PNFCs)

Government

exHibit 9: Sectoral Financial SurpluSeS/deFicitS aS % oF gdp: Japan 1990–2012

56

1990

1992

1994

1996

1998

2002

2000

2004

2006

2008

2010

PER

CEN

T O

F G

DP

250

200

150

100

50

0

General government debt

Banking lending to nonfinacial corporations

Sources: Bank of Japan Flow of Funds Accounts; Financial Services Authority calculations; IMF World Economic Outlook database.

exHibit 10: JapaneSe governMent and corporate debt: 1990–2010

57

Q1-200

2

Q1-200

3

Q1-200

4

Q1-200

5

Q1-200

6

Q1-200

8

Q1-200

7

Q1-200

9

Q1-201

0

Q1-201

1

PER

CEN

T O

F G

DP

PER

CEN

T O

F G

DP

PER

CEN

T O

F G

DP

250

200

150

100

50

0

Household

Public

PNFCs

Q1-200

2

Q1-200

3

Q1-200

4

Q1-200

5

Q1-200

6

Q1-200

8

Q1-200

7

Q1-200

9

Q1-201

0

Q1-201

1

120

100

80

60

40

20

0

Household

PublicPNFCs

Q1-200

2

Q1-200

3

Q1-200

4

Q1-200

5

Q1-200

6

Q1-200

8

Q1-200

7

Q1-200

9

Q1-201

0

Q1-201

1

160

140

120

100

80

60

40

20

0

Household

Public

PNFCs

Q = quarter

a. Public includes central and local governments. b. Public includes federal, state, and local government.

Sources: Bureau of Economic Analysis; European Central Bank; O�ce of National Statistics (UK).

UKa

USb

Spaina

ExhiBiT 11: shiFTiNg LEvERagE: PRivaTE aNd PUBLiC dEBT TO gdP

58

Q3-20

09Q4-

2009

Q1-201

0Q2-

2010

Q3-20

10

Q1-201

1

Q4-20

10

Q2-20

11Q3-

2011

Q4-20

11Q1-2

012

Q2-20

12Q3-

2012

Q4-20

12Q1-2

013

Q2-20

13

PER

CEN

T

6

5

4

3

2

1

0August 2009 Projection

August 2010

August 2011

Actual CPIInflation target

Q = quarter CPI = consumer price index

Source: Bank of England.

1930

1935

1940

1945

1950

1960

1955

1965

1970

1975

1980

PER

CEN

T O

F G

DP

300

250

200

150

100

50

0

Sources: UK Debt Management O�ce; UK O�ce of National Statistics.

US

UK

exHibit 12: uK inFlation: banK oF england ForecaStS and actual

exHibit 13: public debt to gdp: uS and uK

national debt as % of gdp

59

Real annual average GDP growth

US

UK

Germany

France

Japan

PERCENT PERCENT

US

UK

Germany

France

Japan

Nominal annual average GDP growth

Sources: Bureau of Labor Statistics; Federal Statistical Oce; Financial Services Authority calculations; Japan Cabinet Oce; Maddison 2004; Oce of National Statistics.

0 2 4 6 8 10 12 14 16 0 2 4 6 8 10 12 14 16

exHibit 14: gdp growtH rateS 1950–1970

60

1945

1950

1955

1960

1965

1970

PER

CEN

T O

F G

DP

£ B

ILLI

ON

PER

CEN

T

300

250

200

150

100

50

0

1945

1950

1955

1960

1965

1970

60

50

40

30

20

10

0

1945

1950

1955

1960

1965

1970

10987654321

0

Public debt: GDP

Nominal value of UK public debt and GDP

UK inflation and nominal interest rates

Consumer price index

UK GDP

UK public debt

3-month treasury bill rate

Note: CPI is derived from retail prices index after 1947 and the national accounts deflator until then.Sources: UK Debt Management O­ce; UK O­ce of National Statistics.

exHibit 15: uK public debt deleveraging: 1945–1970

61

Apr-0

8

Jan-

08

Oct-0

8

Jul-0

8

Apr-0

9

Jan-

09

Oct-0

9

Jul-0

9

Apr-1

0

Jan-

10

Apr-1

1

Oct-10

Oct-11

Apr-1

2

Oct-12

Jan-

13

Jan-

11

Jul-1

0

Jul-1

1

Jan-

12

Jul-1

2

6

5

4

3

2

1

0

Sources: European Central Bank; Bank of England; Bank of Japan; United States Federal Reserve.

European Central Bank

Bank of England

Bank of Japan

US Federal Reserve

PER

CEN

T O

F G

DP

exHibit 16: central banK policy rateSSe

p-97

Sep-

99

Sep-

01Se

p-03

Sep-

05

Sep-

07

Sep-

98

Sep-

00Se

p-02

Sep-

04

Sep-

06

Sep-

08

Sep-

10Se

p-12

Sep-

09Se

p-11

35

30

25

20

15

10

5

0

Q1-200

7

Q1-200

8

Q1-200

9

Q1-201

0

Q1-201

1

Q1-201

2

Q3-20

07

Q3-20

08

Q3-20

09

Q3-20

10

Q3-20

11

Q3-20

12

30

25

20

15

10

5

0

Q1-200

7

Q1-200

8

Q1-200

9

Q1-201

0

Q1-201

1

Q1-201

2

Q3-20

07

Q3-20

08

Q3-20

09

Q3-20

10

Q3-20

11

Q3-20

12

35

30

25

20

15

10

5

0

Q1-200

7

Q1-200

8

Q1-200

9

Q1-201

0

Q1-201

1

Q1-201

2

Q3-20

07

Q3-20

08

Q3-20

09

Q3-20

10

Q3-20

11

Q3-20

12

25

20

15

10

5

0

Japan United Kingdom

United States European Union

Sources: Bank of England; Bank of Japan; European Central Bank; United States Federal Reserve.

exHibit 17. central banK balance SHeetS aS % gdp

62

Jan-

91

Jan-

90

Jan-

93

Jan-

92

Jan-

95

Jan-

94

Jan-

97

Jan-

96

Jan-

99

Jan-

98

Jan-

03

Jan-

01

Jan-

07

Jan-

11

Jan-

13

Jan-

02

Jan-

00

Jan-

04Ja

n-05

Jan-

09

Jan-

06

Jan-

10

Jan-

12

Jan-

08

9

8

7

6

5

4

3

2

1

0

Source: Bloomberg.

PER

CEN

T

2008

2007

2010

2009

Q1-201

2

2011

Q3-20

12

Q2-20

12

Q4-20

12

20

15

10

5

0

-5

-10

Lending to UK businesses

Secured lending to individualsConsumer credit

Q = quarter

Source: Bank of England 2013.

PER

CEN

TexHibit 18: Japan 10-year noMinal yield

exHibit 19: uK trendS in lending: % 12-MontH growtH rateS

63

Large wartime budget deficits “funded” by government debt issues

Federal Reserve commitment to keep interest rates at 2.5%—buying bonds to achieve target

Source: Friedman and Schwartz 1963.

Post-facto permanent money finance

No subsequent reversal / “exit”

High-powered base money

1941

1940

1944

1947

1950

1953

1954

1955

1943

1946

1949

1952

1942

1945

1948 1951

60

50

40

30

20

10

0

$ B

ILLI

ON

Q3-20

11

Q2-20

11

Q4-20

11

Q1-201

2

Q2-20

12

Q4-20

12

60

50

40

30

20

10

0

Q = quarter LB = large business SME = small and medium enterprise

Source: Bank of England 2013.

SME repayments

LB repayments

SME gross lending

LB gross lending

£ B

ILLI

ON

exHibit 20: groSS lending to and repayMentS

by uK nonFinancial buSineSSeS (£ billion)

exHibit 21: poSt-Facto Money Finance: uS 1940–1951

64

2003

2002

2006

2009

2012

2005

2008 2011

2004

2007

2010

250

200

150

100

50

0

Sources: Bank of Japan; Japan Post Holdings.

Minus Bank of Japan

Minus Japan Post

Minus domestic commercial banks

46% of GDP

Gross debt Minus government + social security holdings

30.6% of GDP

33.7% of GDP PER

CEN

T

PRIVATE SECTORMinsky moment

y

x

FISC

AL

POLI

CYBa

lanc

ed b

udge

t

Zero balanceMONETARY POLICY

LeveragingDeficits

“Fat Inflation Tails”Crowding Out

Inflation Risks“Crowding In”

Deflation RisksNo Crowding Out

“Fat Deflation Tails”Economic Depression

ConventionalRates

DeleveragingSurpluses

UnorthodoxQuantitative easing

Aus

terit

ySu

rplu

ses

Stim

ulus

Defi

cits

PRIV

ATE

DEB

T PRIVATE D

EBT

Source: McCulley and Pozsar 2013.

exHibit 22: JapaneSe governMent debt aS % oF gdp

exHibit 23: varying actual and appropriate policieS:

Mcculley and pozSar’S FraMeworK

65

Source: McCulley and Pozsar 2013.

0

50

100

150

200

25019

15

1925

1935

1945

1955

1965

1975

1985

1995

2005

Public

Private

WW

II en

ds Financial Repression

Hou

sing

bur

sts

PER

CEN

T O

F G

DP

PRIVATE SECTORMinsky moment

y

x

FISC

AL

POLI

CYBa

lanc

ed b

udge

t

Zero balance

LeveragingDeficits

Plai

n A

sset

Pur

chas

es

Reve

rse

Vol

cker

Mom

ent

Hel

icop

ter M

oney

ConventionalRates

DeleveragingSurpluses

Quantitative easing

Aus

terit

ySu

rplu

ses

Stim

ulus

Defi

cits

Source: McCulley and Pozsar 2013.

MONETARY INDEPENDENCE FMC~

Unconv. Radical Nuclear

exHibit 24: private and public leverage cycleS

debt as a % of nominal gross domestic product

exHibit 25: varying actual and appropriate policieS:

Mcculley and pozSar’S FraMeworK

66

ACTUAL TODAY REQUIRED FOR DEBT SUSTAINABILITY

Debt as % of GDP 2011

Cyclical adjusted primary balance

2011

Cyclical adjustedprimary surplus 2020

Required adjustment

Spain 69

UK 82

US 103

Italy 120

Japan 126

Gro

ss D

ebt

Net

Deb

t

-5.1

-3.7

-5.3

2.0

-7.7

5.5

5.7

7.5

12.6

7.6

+ 10.6

+ 9.4

+ 12.8

+ 20.3

+ 5.6

To get to 60%

debtto G

DP by 20

30

To get to 80%debt to GDP

exHibit 26: FiScal adJuStMent reQuired For long-terM debt SuStainability

exHibit 27: noMinal gdp in Four MaJor econoMic areaS: 2007–2011

Q2Q1

Q3 Q1Q1

Q3 Q1

Q3 Q1

Q3

Q4 Q2Q2

Q4 Q2

Q4 Q2

Q4

115

110

105

100

95

90

85

2007 2008 2009 2010 2011

Index, Q1 2007 = 100

Q = quarter

Sources: Bureau of Economic Analysis; Eurostat; Japan Cabinet O�ce; UK O�ce of National Statistics.

UK US Eurozone Japan

IND

EX

67

exHibit 28: gdp growtH oF developed econoMieS

exHibit 29: breaKdown oF noMinal gdp growtH FroM trougH: 2009–2012

2008

2007

2012

2011

2009

2010

105

100

95

90

UK

Japan

US

Euro area

Source: McCulley and Pozsar 2013.

GDP = gross domestic productNGDP = nominal gross domestic product

UK

US

Eurozone

0 20 40 60 80 100

Share of NGDP change due to pricesShare of GDP change

due to real output

PERCENT

69

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73

Group of Thirty Members 2013*

paul a. volckerChairman Emeritus, Group of ThirtyFormer Chairman, President Barack Obama’s Economic Recovery Advisory BoardFormer Chairman, Board of Governors of the Federal Reserve System

Jacob a. FrenkelChairman of the Board of Trustees, Group of ThirtyChairman, JPMorgan Chase InternationalFormer Governor, Bank of IsraelFormer Professor of Economics, University of ChicagoFormer Counselor, Director of Research, International Monetary Fund

Jean-claude trichetChairman, Group of ThirtyHonorary Governor, Banque de FranceFormer President, European Central BankFormer Governor, Banque de France

geoffrey l. bellExecutive Secretary, Group of ThirtyPresident, Geoffrey Bell & Company, Inc.

leszek balcerowiczProfessor, Warsaw School of EconomicsChairman of the Board, BruegelFormer President, National Bank of PolandFormer Deputy Prime Minister and Minister of Finance, Poland

Mark carneyGovernor, Bank of CanadaChairman, Financial Stability BoardMember, Board of Directors, Bank for International Settlements

Jaime caruanaGeneral Manager, Bank for International SettlementsFormer Financial Counsellor, International Monetary FundFormer Governor, Banco de EspañaFormer Chairman, Basel Committee on Banking Supervision

domingo cavalloChairman and CEO, DFC Associates, LLCFormer Minister of Economy, Argentina

e. gerald corriganManaging Director, Goldman Sachs Group, Inc.Former President, Federal Reserve Bank of New York

guillermo de la dehesa romeroDirector and Member of the Executive Committee, Grupo Santander Chairman, Aviva Grupo Corporativo Chairman, Centre for Economic Policy Research Former Deputy Managing Director, Banco de EspañaFormer Secretary of State, Ministry of Economy and Finance, Spain

Mario draghiPresident, European Central BankMember, Board of Directors, Bank for International Settlements Former Governor, Banca d’ItaliaFormer Chairman, Financial Stability BoardFormer Vice Chairman and Managing Director, Goldman Sachs International

* As of April 1, 2013.

74

william dudleyPresident, Federal Reserve Bank of New YorkMember, Board of Directors, Bank for International SettlementsFormer Partner and Managing Director, Goldman Sachs and Company

Martin FeldsteinProfessor of Economics, Harvard UniversityPresident Emeritus, National Bureau of Economic ResearchFormer Chairman, Council of Economic Advisers

roger w. Ferguson, Jr.President and CEO, TIAA-CREFFormer Chairman, Swiss Re America Holding CorporationFormer Vice Chairman, Board of Governors of the Federal Reserve System

Stanley FischerGovernor, Bank of IsraelFormer First Managing Director, International Monetary Fund

arminio Fraga netoFounding Partner, Gávea InvestimentosChairman of the Board, BM&F-BovespaFormer Governor, Banco Central do Brasil

gerd HäuslerChief Executive Officer, Bayerische LandesbankMember of the Board of Directors and Senior Advisor, RHJ InternationalFormer Managing Director and Member of the Advisory Board, Lazard & Co.Former Counselor and Director, International Monetary FundFormer Managing Director, Dresdner Bank

philipp HildebrandVice Chairman, BlackRockFormer Senior Visiting Fellow at the Blavatnik School of Government, Oxford UniversityFormer Chairman of the Governing Board, Swiss National BankFormer Partner, Moore Capital Management

Mervyn KingGovernor, Bank of EnglandMember, Board of Directors, Bank for International SettlementsMember of the General Council, European Central BankFormer Professor of Economics, London School of Economics

paul KrugmanProfessor of Economics, Woodrow Wilson School, Princeton UniversityFormer Member, Council of Economic Advisors

guillermo ortiz President and Chairman, Grupo Finaciero BanorteFormer Governor, Banco de MéxicoFormer Chairman of the Board, Bank for International SettlementsFormer Secretary of Finance and Public Credit, Mexico

raghuram g. rajanChief Economic Advisor, Ministry of Finance, IndiaProfessor of Economics, Chicago Booth School of BusinessEconomic Advisor to Prime Minister of India

Kenneth rogoffThomas D. Cabot Professor of Public Policy and Economics, Harvard UniversityFormer Chief Economist and Director of Research, IMF

tharman ShanmugaratnamDeputy Prime Minister & Minister for Finance & Manpower, SingaporeChairman, Monetary Authority of SingaporeChairman of International Monetary & Financial Committee, IMFFormer Managing Director, Monetary Authority of Singapore

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Masaaki ShirakawaFormer Governor, Bank of JapanVice-Chairman, Board of Directors, Bank for International SettlementsFormer Professor, Kyoto University School of Government

lawrence H. SummersCharles W. Eliot University Professor at Harvard UniversityFormer Director, National Economics Council for President Barack ObamaFormer President, Harvard UniversityFormer Secretary of the Treasury

adair turnerSenior Fellow, Institute for New Economic ThinkingFormer Chairman, Financial Services AuthorityMember of the House of Lords, United Kingdom

david walkerChairman, Barclays PLCSenior Advisor, Morgan Stanley International, Inc.Former Chairman, Morgan Stanley International, Inc.Former Chairman, Securities and Investments Board, U.K.

axel a. weberChairman, UBSFormer Visiting Professor of Economics, Chicago Booth School of BusinessFormer President, Deutsche Bundesbank

yutaka yamaguchiFormer Deputy Governor, Bank of JapanFormer Chairman, Euro Currency Standing Commission

ernesto zedilloDirector, Yale Center for the Study of Globalization, Yale UniversityFormer President of Mexico

zhou xiaochuanGovernor, People’s Bank of ChinaMember, Board of Directors, Bank for International SettlementsFormer President, China Construction BankFormer Assistant Minister of Foreign Trade

senior MeMbers

abdlatif al-HamadChairman, Arab Fund for Economic and Social DevelopmentFormer Minister of Finance and Minister of Planning, Kuwait

eMeritus MeMbers

Jacques de larosièrePresident, EurofiConseiller, BNP ParibasFormer President, European Bank for Reconstruction and DevelopmentFormer Managing Director, International Monetary FundFormer Governor, Banque de France

richard a. debsAdvisory Director, Morgan StanleyFormer President, Morgan Stanley InternationalFormer COO, Federal Reserve Bank of New York

gerhard FelsFormer Director, Institut der deutschen Wirtschaft

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toyoo gyohtenPresident, Institute for International Monetary AffairsFormer Chairman, Bank of Tokyo

John g. HeimannSenior Advisor, Financial Stability InstituteFormer U.S. Comptroller of the Currency

erik HoffmeyerChairman, Politiken-FondenFormer Chairman, Danmarks Nationalbank

william McdonoughFormer Vice Chairman, Bank of America/ Merrill LynchFormer Chairman, Public Company Accounting Oversight BoardFormer President, Federal Reserve Bank of New York

Shijuro ogataDeputy Chairman, Pacific Asia Region, the Trilateral CommissionFormer Deputy Governor, Bank of JapanFormer Deputy Governor, Japan Development Bank

Sylvia ostryDistinguished Research Fellow, Munk Centre for International Studies, TorontoFormer Ambassador for Trade Negotiations, CanadaFormer Head, OECD Economics and Statistics Department

william r. rhodesPresident and CEO, William R. Rhodes Global AdvisorsSenior Advisor, CitigroupFormer Senior Vice Chairman, Citigroup

ernest SternPartner and Senior Advisor, The Rohatyn GroupFormer Managing Director, JPMorgan ChaseFormer Managing Director, World Bank

Marina v n. whitmanProfessor of Business Administration & Public Policy, University of MichiganFormer Member, Council of Economic Advisors

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Group of Thirty Publications

SPECIAL REPORTS SINCE 1990

Long-term Finance and Economic growthLong-term Finance Working Group. 2013

Toward Effective governance of Financial institutions Corporate Governance Working Group. 2012

Enhancing Financial stability and Resilience: Macroprudential Policy, Tools, and systems for the FutureMacroprudential Policy Working Group. 2010

The Reform of the international Monetary FundIMF Reform Working Group. 2009

Financial Reform: a Framework for Financial stabilityFinancial Reform Working Group. 2009

The structure of Financial supervision: approaches and Challenges in a global MarketplaceFinancial Regulatory Systems Working Group. 2008

global Clearing and settlement: Final Monitoring ReportGlobal Monitoring Committee. 2006

Reinsurance and international Financial MarketsReinsurance Study Group. 2006

Enhancing Public Confidence in Financial ReportingSteering & Working Committees on Accounting. 2004

global Clearing and settlement: a Plan of actionSteering & Working Committees of Global Clearing & Settlements Study. 2003

derivatives: Practices and Principles: Follow-up surveys of industry PracticeGlobal Derivatives Study Group. 1994

derivatives: Practices and Principles, appendix iii: survey of industry PracticeGlobal Derivatives Study Group. 1994

derivatives: Practices and Principles, appendix ii: Legal Enforceability: survey of Nine JurisdictionsGlobal Derivatives Study Group. 1993

derivatives: Practices and Principles, appendix i: Working PapersGlobal Derivatives Study Group. 1993

derivatives: Practices and PrinciplesGlobal Derivatives Study Group. 1993

Clearance and settlement systems: status Reports, autumn 1992Various Authors. 1992

Clearance and settlement systems: status Reports, Year-End 1990Various Authors. 1991

Conference on Clearance and settlement systems.London, March 1990: SpeechesVarious Authors. 1990

Clearance and settlement systems: status Reports, spring 1990Various Authors. 1990

REPORTS SINCE 1990

sharing the gains from Trade: Reviving the dohaStudy Group Report. 2004

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Key issues in Sovereign debt restructuringStudy Group Report. 2002

reducing the risks of international insolvencyA Compendium of Work in Progress. 2000

collapse: the venezuelan banking crisis of ‘94Ruth de Krivoy. 2000

the evolving corporation: global imperatives and national responsesStudy Group Report. 1999

international insolvencies in the Financial SectorStudy Group Report. 1998

global institutions, national Supervision and Systemic riskStudy Group on Supervision and Regulation. 1997

latin american capital Flows: living with volatilityLatin American Capital Flows Study Group. 1994

defining the roles of accountants, bankers and regulators in the united StatesStudy Group on Accountants, Bankers and Regulators. 1994

eMu after MaastrichtPeter B. Kenen. 1992

Sea changes in latin americaPedro Aspe, Andres Bianchi, and Domingo Cavallo,with discussion by S.T. Beza and William Rhodes. 1992

the Summit process and collective Security: Future responsibility SharingThe Summit Reform Study Group. 1991

Financing eastern europeRichard A. Debs, Harvey Shapiro, and Charles Taylor. 1991

the risks Facing the world economyThe Risks Facing the World Economy Study Group. 1991

tHe WiLLiAM tAYLor MeMoriAL LeCtures

three years later: unfinished business in Financial reformPaul A. Volcker. 2011

it’s not over ’til it’s over: leadership and Financial regulationThomas M. Hoenig. 2010

the credit crisis: the Quest for Stability and reformE. Gerald Corrigan. 2008

lessons learned from the 2008 Financial crisisEugene A. Ludwig. 2008

two cheers for Financial StabilityHoward Davies. 2006

implications of basel ii for emerging Market countriesStanley Fischer. 2003

issues in corporate governanceWilliam J. McDonough. 2003

post crisis asia: the way ForwardLee Hsien Loong. 2001

licensing banks: Still necessary?Tommaso Padoa-Schioppa. 2000

banking Supervision and Financial StabilityAndrew Crockett. 1998

79

global risk ManagementUlrich Cartellieri and Alan Greenspan. 1996

the Financial disruptions of the 1980s: a central banker looks backE. Gerald Corrigan. 1993

oCCAsionAL PAPers sinCe 2000

86. a Self-inflicted crisis?: design and Management Failures leading to the eurozone crisisGuillermo de la Dehesa. 2012

85. policies for Stabilization and growth in Small very open economiesDeLisle Worrell. 2012

84. the long-term outlook for the european project and the Single currencyJacques de Larosière. 2012

83. Macroprudential policy: addressing the things we don’t KnowAlastair Clark and Andrew Large. 2011

82. the 2008 Financial crisis and its aftermath: addressing the next debt challengeThomas A. Russo and Aaron J. Katzel. 2011

81. regulatory reforms and remaining challengesMark Carney, Paul Tucker, Philipp Hildebrand, Jacques de Larosière,William Dudley, Adair Turner, and Roger W. Ferguson, Jr. 2011

80. 12 Market and government Failures leading to the 2008–09 Financial crisis Guillermo de la Dehesa. 2010

79. lessons learned from previous banking crises: Sweden, Japan, Spain, and MexicoStefan Ingves, Goran Lind, Masaaki Shirakawa, Jaime Caruana,and Guillermo Ortiz Martinez. 2009

78. the g30 at thirtyPeter Kenen. 2008

77. distorting the Micro to embellish the Macro: the case of argentinaDomingo Cavallo and Joaquin Cottani. 2008

76. credit crunch: where do we Stand?Thomas A. Russo. 2008

75. banking, Financial, and regulatory reformLiu Mingkang, Roger Ferguson, and Guillermo Ortiz Martinez. 2007

74. the achievements and challenges of european union Financial integration and its implications for the united StatesJacques de Larosière. 2007

73. nine common Misconceptions about competitiveness and globalizationGuillermo de la Dehesa. 2007

72. international currencies and national Monetary policiesBarry Eichengreen. 2006

71. the international role of the dollar and trade balance adjustmentLinda Goldberg and Cédric Tille. 2006

70. the critical Mission of the european Stability and growth pactJacques de Larosière. 2005

69. is it possible to preserve the european Social Model?Guillermo de la Dehesa. 2005

68. external transparency in trade policySylvia Ostry. 2004

67. american capitalism and global convergenceMarina V.N. Whitman. 2003

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66. enron et al.: Market Forces in disarrayJaime Caruana, Andrew Crockett, Douglas Flint, Trevor Harris, and Tom Jones. 2002

65. venture capital in the united States and europeGuillermo de la Dehesa. 2002

64. explaining the euro to a washington audienceTommaso Padoa-Schioppa. 2001

63. exchange rate regimes: Some lessons from postwar europeCharles Wyplosz. 2000

62. decisionmaking for european economic and Monetary unionErik Hoffmeyer. 2000

Group of ThirTy

1726 M Street, N.W., Suite 200Washington, DC 20036ISBN 1-56708-161-4

Group of T

hirty D

ebt, Money, and M

ephistopheles: A

dair Turner

H

ow D

o We G

et Out of T

his Mess?