Even devolving balanced-budget tax and spend powers is tricky

Phew.  Or, wait?  What economic form is devolution going to take?  I blogged before that there was an argument that devolving borrowing powers out to component states would weaken the speed and force with which discretionary fiscal policy could be used to stabilise the macroeconomy, an especially important tool when we are at the zero bound to nominal interest rates.  A natural question arises:  well, what about devolving balanced budget tax and spend powers, then?  Isn’t that ok?  If the Federal government needs to do discretionary borrowing and taxing later on top of these local taxes, won’t that  work?  This would allow great differences in the size of the state in Scotland versus England, for example.  Scotland could set much higher taxes, and spend more on education and health.

I’m not sure this can work either:  even balanced budget tax and spend powers would have to be proscribed.  To take an extreme example.  Imagine Scotland sets taxes right up to its Laffer limit, the point at which any further increase in taxes levied there would raise no more money, and would just shrink the tax base.  (I’m not accusing the Scots of wanting to do this.  It’s just an example).  In that case, although the Federal government could in principle borrow and spend to stimulate the economy at the zero lower bound, it would find that its borrowing costs were higher on account of the Laffer-maximising balanced budget policy in Scotland, since markets would know that there was no scope for paying the debt back out of that part of the UK’s tax base.  And, when it came to pay the debt back, that would wind up being paid out of taxes raised in the rest of the UK, which (just for argument’s sake) I’m assuming has a smaller state, with a tax base ripe for raising funds.  This would not be fair, since it places the burden of fighting recessions on a part of the Union only.  And it would limit the fiscal room that parts of the union with the smaller welfare states would have to do the recession fighting, leading to a choppier business cycle, and a greater chance of hitting and becoming trapped at the zero bound for all.

Devolving balanced budget tax and spend powers also limits risk sharing.  Following through the extreme example above, a boom in a Scotland which spends the increase in taxes and stays at the Laffer limit prevents redistributed flows away from Scotland to pay for a recession in England.  I see this as a terrible cost of fiscal localism.  But some local nationalists seem to celebrate it.

 

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Salmond’s QE grab

I read on Faisal Islam’s twitter feed that Alex Salmond had suggested on Sky to Adam Boulton that the SNP should get its rightful share of the gilts bought under the QE program by the Bank of England.  This prompted an exchange between finance gurus Frances Coppola, Dan Davies and Eric Lonnergan.

A QE grab would be nice for a newly independent Scotland.  Take a share of the gilts, and when they mature, the Treasury pays them out of RoUK taxes!  Lovely-jubbly, as one TV character used to say.   I’m sure the RoUK government would not accept that.  As things stand, when the gilts mature, the Treasury pays out money to the Bank (in fact it does so all the time on account of the gilts’ coupons).  But, remembering that the Bank is part of the public sector, this is really just one part of the public sector paying itself.  Salmond’s proposal, taken on its own, would lead to the UK government paying out not to itself, but to another government.

How could this be dealt with fairly?  One way would simply be to unwind QE before Scotland sets up its own currency.  Another would be to financially engineer a clean split of the BoE’s balance sheet.  When it sets up its own currency, Scotland takes away 1/10th of the debt stock, but the Scottish Central Bank takes 1/10th of the gilts on the BoE’s balance sheet.  The gilt contracts would have to be rewritten so that when maturing, the SCB gets a payment from the Scottish Treasury.  (Nothing would be rewritten presumably, but new liabilities would be set up to make this happen).

It’s easy to get blinded by thinking about reserves and cash and confusing things like that, when trying to fathom the fairest division of the ‘spoils’.  The only really significant thing about QE is debt management.  Exactly the same effect could have been achieved when embarking on QE by the DMO issuing lots of very short-term Treasuries and swapping them for longer term gilts in the market, tilting the private sector portfolio away from longer term gilts.  (In fact, this could still be done, by the consolidated public sector ‘swapping’ the reserves that were created for short-term debt.)  Then, Alex Salmond would simply be saying:  ‘can we inherit 1/10 of the share of the new, slightly shorter term portfolio of government debt liabilities please?’  Oh, well, I guess he would not be shouting about that!  It’s the artifice of the Bank holding the gilts, and them being a result of electronic reserve creation that fuels the sense that there could be a fair profit to make.

[The Bank itself might not agree with this, at least if their early communication about the importance of expanding the money supply, or their educational material about pumping or injecting money into the economy are to be taken at face value.  But this part of QE is hot air in my view.]

Salmond’s financial sophistry is akin to the SNP’s consistent message that, in exchange for taking their share of the debt, they should get a ‘share of Sterling’, as though it were an asset, and not a club with a set of rules the SNP want to free themselves from.

That said, to be fair, the UK Government has engaged in its own naughtiness over QE, appropriating the coupon payments from QE to make its own public finances look healthier than they really are.  The presumption is that those flows will be reversed, so that the Bank of England can ultimately reverse QE itself and restore its balance sheet to (something like) its former state.  But the fact that the funds were taken in the first place for no reason than massaging the accounts did not bode well for that.  The latest protracted undershoot of the inflation target, while very unwelcome and worrying in itself, has the fortunate side-effect that it works against suspicions that dangerous mixing of monetary and fiscal matters could be the harbinger of debt monetisation and inflation stealth.

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Project Fear, or Project Stop Them Having Their Cake and Eating It?

The effort to get supermarkets to explain that they will probably raise prices in an independent Scotland, and to get Banks to make plain their plans to redomicile into the Rest of the UK, has been dubbed, seemingly successfully, ‘Project Fear’.  The same idea has been used to describe the effort to describe the economic realities of independence.

But I see it differently.

It would be pretty strange if the banks stayed silent in the run up to the referendum, refusing to comment on Better Together speculation that they would redomicile, fuelling the Yes campaign’s scorn of their forecasts, and then to redomicile anyway after a Yes vote.  If that’s what had played out, the Yes would have been won on false pretenses.

Likewise, wouldn’t it have been almost dishonest if the supermarkets had kept their own post independence pricing strategies to themselves, until it was too late and votes were cast?

In fact, if you think about it, these organisations’ silence about their intentions for so much of the campaign, leaving it so late, is odd.  I would call that silence Project Have Your Cake and Eat It.  Here the cake is ‘appearing cool, exploiting a bit of Scottish localism to boost the brand, feigning neutrality about the whole thing, especially when it seemed like there was no chance of a Yes win’.  And this cake was being had, and eaten, in the sense that all the while there were clear strategic plans in the event of independence, based on the bottom line only, with not a thought for the welfare of the Scots, or English, or anyone, in fact, unsurprisingly, simply for the benefit of their shareholders.

Hence, if the Government and HMT were involved in ‘Project Fear’, I’d think it was better named ‘Project Stopping Them Having Their Cake And Eating It’.

 

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Devolved borrowing would create the same mess as giving Indy Scotland a currency union

This hurried post, that I would have liked to think about much more carefully, is prompted by the all-party promise for more devolved powers for Scotland, in the event of a ‘No’ vote, and also the provocative paper put out by the National Institute for Economic and Social Research by Angus Armstrong and Monique Ebell.

I don’t think that we should be offering Scotland devolved powers to borrow independently, incurring deficits and running up debt.  Doing so risks creating the same eurozone style mess that would result if the Rest of UK offered a newly independent Scotland a currency union without fiscal union.

First, such a system would create what is known as the ‘tragedy of the commons’.  The name refers to the situation where individual farmers have an incentive to overgraze common grass land with their cattle, collectively ruining the land.  It’s not in the interests of any one farmer to behave better, because doing so won’t encourage the others, and they will simply get less grass themselves.  Fiscally, overgrazing means overborrowing, taking advantage of the protection of the Federal authorities and the central bank that they sponsor.   This might not be a big deal, because of the much greater size of England relative to others (as Armstrong and Ebell point out), but it would still be unfair on the English.  And, who knows, perhaps it would be an existential problem.  The eurozone was hobbled by three tiny states (Greece, Ireland and Portugal), and the contagion it fed to larger ones.  Whatever problems are caused in this way could be eliminated by establishing credible central institutions that promise not to bail out one of the individual countries in the event that they get into difficulty.  But trying to set up such institutions from scratch is not easy.

Second, the crisis has taught us that the old way of doing macroeconomic stabilisation – having fiscal policy on autopilot, letting monetary policy do the work – isn’t adequate.  As Simon Wren Lewis and others have argued, nimble, discretionary fiscal policy IS needed, and urgently so, in the event that the economy encounters the zero lower bound to interest rates, where conventional monetary policy tools can do no more.  Devolving the power to borrow will weaken the fiscal room and coordination power retained by the centre to enact a powerful fiscal stimulus.  We won’t be able to rely on the individual fiscal units to borrow and spend separately, because it may not be in all their interests.  Witness the sorry tale unfolding in the eurozone, with those governments that don’t need a fiscal stimulus for their own economies (eg Germany) naturally reluctant to implement one for the benefit of the euro area as a whole.  Unconventional ‘monetary policy’ tools used by central banks don’t offer a way out of this problem because they involve the central bank taking large fiscal risks that have to be underwritten by the central government.  (This is why German ECB board member Weidman is against the ECB’s planned purchases of private securities).  Such underwriting requires that adequate fiscal ‘room’ to bail out the central bank if needs be is maintained.  And for me that rules out devolved borrowing.

Third, devolving the power to borrow inhibits risk-sharing, as Adam Posen argued powerfully in his article imploring the Scots to vote ‘No’.  ‘Risk-sharing’ sounds like a technical detail, a piece of financial arcana.  But it’s not.  It goes to the heart of what the public sector is for:  rule for dishing out resources to the unfortunate, funded by the fortunate.  Huge, slow to materialise risks like longevity uncertainty combined with defined benefit pensions;  quick to materialise risks like natural disasters or financial crises, or conflicts:  devolved borrowing weakens mechanisms to channel funds from the lucky to the unlucky people in the UK, and at a time when there seems to be a lot of risk about.

UK political parties have (rightly) ruled out offering a currency union to an independent Scotland, calculating (I think correctly) that the Scots would not accept, or be able to follow through on the fiscal promises required to make that viable.  For the same reasons, I hope that the devolution promises made today don’t entail much in the way of powers to borrow (we can’t tell yet).  Because if they do, they would risk creating the same mess that the curency union they won’t offer would entail.  Whatever the heartbreak, separation would be better than setting up an ineffectual fiscal federation.

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Saving the euro with second order Ricardian non-equivalence

This post picks up on Draghis’ comments that buying riskier assets can be better for the stabilising properties of the ECB’s forthcoming credit easing.  The title looks like it’s calculated to put readers off.  But 1) it’s Friday, 2) I’m tired after spending the afternoon re-learning how to derive the Kalman Filter for students and 3) it’s factually correct.

What you might call first order Ricardian equivalence is the claim that giving consumers a tax cut won’t increase spending, because they correctly foresee that in the future, taxes will have to rise again to repay the debt that was incurred financing the tax cut in the first place.  It fails for many reasons, not least that consumers don’t forecast as well or behave as optimally as we macroeconomists take them to in our models.  And also that the timing of taxes matters.  If I am pressed up against my borrowing constraint and struggling to feed my family on a measly academic salary (purely hypothetical, you’ll understand) I will be glad of extra disposable income now, and knowing that in a few years time taxes will be a bit higher, and the income will be clawed back, won’t negate the benefit.  The fallacious Ricardian Equivalence argument is not just academic, as it got a run around in the debates about the usefulness of the fiscal stimulus in the early part of the crisis.

Hard-line second order Ricardian Equivalence people would say that whether the ECB takes risky assets onto its balance sheet or not shouldn’t affect spending in the private sector in the eurozone.  Banks get relieved of the risk, which is great.  But the risk is now borne by the ECB, and ultimately by the ECB’s owners – eurozone governments – and that risk means more variance in (or larger second moments of) taxes and spending to make up for it.  So the private sector’s risk doesn’t change, though the routes through which the risk impacts its income does.  You could call this second order Ricardian Equivalence, because it’s about how the variance (second moment) of returns of the private sector’s cash-flows is not changed by undertaking asset purchases (or whatever).

Which brings us to why purchasing more risky assets from the private sector will be more stimulative.  Although at some point in the future, taxes and spending will have to be adjusted by governments to recapitalise the ECB if things go badly with the assets purchased, the future is some time down the road, when consumers and firms and banks will be all lifted further from their borrowing constraints (Panglossian view for simplicity here) and happy to fork out.  Right now, with deflation a real prospect, bad debts, high cost of finance, the private sector appetite for risk in the eurozone is low, and the ECB taking it off them will be welcome.

Hence the title.  Second order Ricardian non Equivalence refers to the fact that even though the variance of after-tax cashflows at some imaginary end point once purchases have been unwound does not change, the private sector feels better off, because riskiness in the near term, under stress, is more costly to it.

One caveat.  All this works fine for a monetary union where there is no possibility whatsoever of dissolution.  But where there is – eg in the eurozone – there will be some uncertainty about who will make good, or benefit, when the private sector assets come to be sold.  And that will depend on who exits and who is left standing backing the ECB, and on the outcome of any subsequent negotiations with the new ‘outs’ to compensate the ‘ins’.  It seems at least possible that that uncertainty could, in extreme circumstances, weigh as heavily as the risk-relief of the asset purchases themselves.  That might be an argument for these purchases being done directly by the eurozone fiscal agents, with liabilities spelled out up front.   But good luck getting them to agree on anything.

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Short term separation risk: a confidence run at the zero bound with fiscal policy incapacitated

A long-time risk of simply the possibility of a Yes vote for Scottish independence, let alone the actuality, is that investment would dry up in Scotland, and perhaps in the rest of the UK;  deposits and wholesale funding for Scottish banks and other non bank financials would also get re-routed, most likely to the South, but perhaps out of the country altogether.  This conraction in funding liquidity would cause lending to fall, certainly in Scotland, but possibly in the South too, and that would compound the confidence-induced fall in demand.  As polls narrowed, different versions of this story have popped up in financial research notes, and economic commentary.  And the tremors of a confidence shock have started to be felt.  A fall in Sterling and the market capitalisation of firms exposed to Scotland, commercial property deals falling through or being made contingent on a No vote, and so on.

If these trends worsen, we are in trouble.  Monetary policy is, to a first approximation, now powerless to stimulate further.  Rates are stuck at the zero bound, where they have been since 2009.  Long rates don’t leave much room for loosening via forward guidance.  For reasons best known to itself, the Bank of England’s Monetary Policy Committee decided against further asset purchases:  plausibly, the MPC is doubtful as to whether further QE is desirable.  (Some of us never thought it did much good anyway.)

What about fiscal policy?  Surely that could come to the rescue?  Well, this is problematic, for two reasons.

First, with the Coalition’s staying, if not halting of the deficit-reduction plan, the scope for further fiscal expansion on top of what is already being injected, is somewhat limited.

Second, the unravelling of the union makes it much harder to pull off a loosening of discretionary fiscal spending.  How would the soon-to-be-unravelled polity agree to any such program?  Where would money be spent and on what?  Who would be voting on it?   Who would own what the money was spent on, if it went towards infrastructure or some other durable?  How would the crumbling UK governmental infrastructure, with so much to resolve about its own future, and the division of spoils, spare any high quality decision-making time for a fiscal stimulus package?  Would the debt incurred by a stimus package after a Yes vote be treated differently from debt incurred before?  Would there be differently stamped debt to finance spending in Scotland?  Could the stimulus in different regions therefore be different on that account?

A contraction in liquidity and credit, causing, or accompanying a reduction in spending because of shaken confidence about the institutional framework for the UK, would be a great misfortune in normal times.  Trapped at the zero bound with no obvious means of injecting stimulus, it would be a disaster now.  And it seems to me that the very impotence of monetary and fiscal policy would be something that would make such a confidence drop more likely to happen.  Imagine Japan convulsing over how to split in two right now.  Or, er, the Eurozone….

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Why ECB purchases could be more stimulative, euro for euro, than UK or US QE.

A short post substantiating my tweet yesterday asserting this, which was picked up by the Guardian, but, all on its own, to those not swimming in this stuff, might look rather odd.

We could think of an ECB purchase of a package of bank loans (an ABS) in two steps. First, it agrees to buy a government security from the bank. Then, in step 2, it agrees to swap this for an ABS issued/held by the bank. In reality, of course, the purchase involves a single step, a straight swap of electronic reserves for the ABS.

However, thinking of the purchases in two synthetic steps highlights why these purchases might be more stimulative than the Fed/BoE asset purchases, which involved straight swaps of reserves for gilts. [Leave aside the earlier Fed purchases of agency debt, and the tiny amounts of corporate paper the BoE bought]. Unless you think the swap stage would have no stimulating effect on the bank, or a negative effect, the ABS purchase must be more stimulative. If one supposes that the value of the government securities is effectively underpinned by Draghi’s earlier promise to invoke ‘Outright Monetary Transactions’ (OMTs), then we presume that the private bank and its funders feel its balance sheet to be less risky if it dispenses with an ABS than a government security. (In the past I blogged that I thought that OMTs were an almighty bluff and was puzzled that markets had not called it. They don’t look like calling it any time soon, so this presumption seems fine.) Wholesale debt funding can now be sourced more cheaply, its equity price will rise, and it will feel able to extend new loans at lower cost, stimulating spending by households and companies dependent on that funding.

Actions like this were urged on the Bank in the early days of the crisis, both publicly, by former MPC member Adam Posen, for example, but also privately, by myself and others on the staff, precisely on the grounds that one would presume them to have a larger bank for buck using this logic. In that case there was less of a question surrounding the credit-worthiness of gilts either, so the conclusion that private asset purchases would be more stimulative was on firmer ground.

This said, as I tweeted, though more stimulative euro for euro, one would presume that the purchases will be on a significantly smaller scale than US/UK QE.  [At least, assuming that there is no subsequent round of straight purchases of government securities].

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