Peston’s Mr Markets, Krugman and Wren-Lewis’ Dr Pangloss

Robert Peston has been basking in the unusual distinction – for a journalist – of getting a pasting from Paul Krugman, and the somewhat less unusual distinction of criticism from Simon Wren Lewis.  Simon has coined a phrase to describe the sub-discipline of macro practiced by journalists:  ‘mediamacro’.  Part of this caricature is the idea that deficit stimulus is a bad thing, to be curtailed always, and always risks incurring the wrath of markets [aka the gendered ‘Mr Market’].

Both Krugman and Wren Lewis maintain that a country with its own independent central bank, pursuing its own monetary policy, does not need to worry about the effect of markets running from its bond markets, or demanding large risk premia in order not to.  Peston responds by saying that there are economists who believe such worries to be founded.

I am one of them.

I agree with Simon and PK that ‘mediamacro’ has recently, in the UK, missed an opportunity to correct an illiterate focus on deficit reduction that prevails in the debate between Labour and Conservative politicians.  For reasons best known to themselves, despite a few attempts by SWL, PK and myself and others to explain other ways of thinking, TV commentators have not bothered to put to politicians the notion that deficit spending is positively needed, right now, with the scope for monetary policy loosening severely constrained by the zero lower bound to interest rates, and the uncertain efficacy of further QE.  Is this argument too complicated to explain to viewers?  Are TV economic journalists ideological deficit hawks?

But, I don’t agree that one can take this as far as to suggest that monetarily independent countries are immune from problems of sovereign default.  Recent economic history serves up several examples.  None of them suggest that outright default is particularly likely for the UK.  But the risk is tangible enough to mean that there has to be some weighing of it against the desire for a persistent fiscal stimulus.

The point of conceptual dispute seems to be the proposition that because you can print your own currency, you will never be short of what you need to satisfy the claims of sovereign bond holders.  Ergo, you need never default.  Ergo, there need never be default risk premia in your bonds.  Ergo you can borrow as much as you like for as long as it takes to stimulate the economy back to full employment.

I don’t dispute that you can money-finance.  What I contend is that you would not want to.  And for that reason, it isn’t credible to promise it.  And so default risk premia will emerge if tax and spending plans are not arranged with sufficient clarity and discipline.  Why would you not want to pay your bondholders from the printing press?  Surely you are giving them what you agreed to when you signed the loan contract, right?  Because seigniorage finance is extremely inefficient, and it would require massive, and colossally damaging inflation to execute.  If it came to it, it would be far better, and far more popular to default on a few either rich or remote, institutional bondholders, than devastate the typically less well inflation-indexed poor.

So, in short, at some point, bondholders will demand a default-risk premium, because they know that, if borrowing gets completely out of hand, you will do the right thing for society and default on them.  At what point do such things become material?  Who knows.  Japan seems to be doing fine [in terms of default risk premia at least] at the moment, with gross debt more than twice its GDP.  So on that basis, the UK need not stress about deficit reduction over the lifetime of the next Parliament at least.  And ‘mediamacro’ ought instead to skewer the politicians on what they are going to do to assist the Bank of England in lifting the economy off the zero bound.  [And, while you are at it, ask them why they are not contemplating raising the Bank of England’s inflation target by at least 2 percentage points to reduce the risk of us becoming trapped there again].


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13 Responses to Peston’s Mr Markets, Krugman and Wren-Lewis’ Dr Pangloss

  1. Roy Lonergan says:

    You, SWL and PK seem to be mostly agreeing furiously that borrowing is fine at the moment but that you would rain it in once we have a genuinely established recovery. And so that it would be very hard to create inflation now via that route.
    In which case, as you say, the real sin of commission is the lack of anyone on the TV suggesting fiscal measures now. Is that fair?

  2. Emmanuel says:

    Roy has it just right. Talk of a ‘persistent’ fiscal stimulus doesn’t help. What is needed is enough of a stimulus to escape the ZLB and give the bank some playroom. After all, Keynesians are all for the idea that there’s a time for tight money, they just think that’s the time of the boom.

  3. Nick Edmonds says:

    Isn’t the possibility that the government will decide to go the money printing / massive inflation route also not a risk for bondholders that might require a risk premium?

  4. Simon Reynolds says:

    Thank you for an enlightening blog. You, along with Chris Dillow, Simon Wren-Lewis, the Pieria crowd, flipchart Rick and co are all very helpful to a non-economist trying to understand macroeconomics.

    You say: “…seigniorage finance is extremely inefficient, and it would require massive, and colossally damaging inflation to execute.”

    Scott Fullwiler says: “whether a deficit is accompanied by bond sales is irrelevant for understanding the potential inflationary effects of the deficit.”

    What is a non-economist supposed to make of this difference in views. One professor of economics says printing money requires (causes?) massive, colossally damaging inflation — another professor of economics says printing money is no different from bond financing in its effect on inflation.

    • Tony Yates says:

      Thanks for such a good question. I’m sorry that you can read conflciting accounts of important theoretical and practical issues. But that’s the state economics is in. Many things do have conflicting theoretical answers, and are the subject of empirical controversies too. It’s hard to give a very general answer to the point you raise. But, suppose we are away from the zero bound, and cruising at positive interest rates. Bond finance with a credible promise to repay need not imply any change in the price level relative to some previously desired or targeted level. Money finance will. For the simple reason that more money means higher prices away from the zero bound. The simple law that fails conservative radicals when they foretell doom at the zero bound with quantitative easing serves us well in more normal times. At least, this is the answer in theory. Empirically, it’s pretty robustly verifiable too.

      • Nick Edmonds says:

        I don’t think Fullwiler is talking specifically about the situation at the zero lower bound. But, critically, he is assuming a situation where the Fed is paying interest on reserves and using that as a way to achieve the target rate. His analysis is that, in this situation, any additional reserve balances created by money financed expenditure would be excess to those needed for regulatory requirements or interbank settlement. As such their function on bank balance sheets would simply be as part of the general high quality liquid asset holdings and they would therefore be close substitutes for treasuries. In this situation, there is no mechanism for differences in the mix of treasuries and reserves to have any great effect. (It is useful to note that in his framework, the mix between reserves and treasuries in the future is not particularly dependent on the current mix.)

      • Tony Yates says:

        Well, the question about helicopter drops vs OMOs is not about the mix, is it? H drops increase gross liabilities. OMOs don’t, but, just change the mix.

      • This is an excellent back and forth. The upshot is that there are three things: two theories and one empirical reality and they are not-compatible with one another. You’ll say, “Actually, there is disagreement about the empirical situation. It could be compatible with one of the theories.”

        Ok. But either way: is there any amount of confusion that would trigger the question, “Maybe the problem is endemic to all publishable economics? Maybe these conflicts reveal a methodological dead end?”

        That point should theoretically exist, right?

      • Nick Edmonds says:

        I’m not sure these views are so incompatible. Sometimes apparent differences are just due to different assumptions.

        The zero lower bound is at zero because that’s the effective nominal interest rate on cash. It prevents rates falling below that level, no matter how much extra base money is created. Where interest is paid on reserves, that interest rate creates a floor in pretty much the same way, again no matter how much extra base money is created. It creates a lower bound, but at the IOR rate rather than zero. So the analysis that applies at the ZLB should also apply at this non-zero lower bound.

        That is what I read into what Fullwiler is saying and I don’t actually think that is inconsistent with what Tony is saying (but maybe Tony would disagree).

  5. Simon Reynolds says:

    @ Nick Edmonds

    I think that Scott Fullwiler is clear in his article (ZLB or not) that:

    “the absence of a bond sale does not somehow mean there is a greater amount of liquid financial assets, income or ‘funds available’ for borrowing or spending…With or without bond sales, it is the non-government sector’s decision to spend or save that matters in regard to the potential inflationary impact of a given government deficit.”

    I can’t read this as anything other than a statement that: regarding inflation it doesn’t matter if a government finances a deficit by selling bonds or by printing money. Maybe I’ve read it wrong? This seems to be inconsistent with Tony Yates’ view.

    Two questions:

    Q1) Should I believe Fullwiler? Or Yates?

    Q2) If I should not believe Fullwiler, where does does his argument go wrong? It doesn’t seem to be an article about a theory but rather about the operational realities of financing a (US) deficit.

    • Nick Edmonds says:

      I think you have to understand the context. Fullwiler is not saying it never matters, just that it doesn’t matter given the framework he is assuming. He explicitly states that his analysis would have been different in the pre-2008 regime.

      So he is specifically talking about a situation where the rate on reserves provides a floor to interest rates (like the ZLB does) and money is not in short supply. This implies that excess money is held simply as a substitute for government debt.

      However, models where an increase in money balances leads to inflation generally associate the increased money with a fall in interest rates (except of course at the ZLB). This is what I think Tony has in mind (but maybe I’m completely wrong), but it is a different situation to the one which Fullwiler is talking about.

      I’m not sure what the analysis would be that concluded that money-financed expenditure would be more inflationary than bond financed, specifically in an IOR regime where the rate was held fixed. I would certainly be interested in looking at any papers that looked at this specifically, if Tony (or anyone else) could point me in the right direction.

    • Thanks for the engaging discussion of my piece from several years ago–if I may add a clarification because it seems my main point is being missed:

      The point is that in the real world “printing money” results in the monetary base and tbills necessarily being perfect substitutes. This is just supply and demand–you can’t “print money” without either accepting that the interbank rate is zero (which is defined in the post here as a liquidity trap) or keeping the interbank rate above zero via IOR set at the CBs target rate, in which case, there’s no economically meaningful difference between holding reserves at IOR or a tbill that arbitrages with the CBs target rate.

      In other words, if you want a CB target above zero, the choice is between deficits via tbills or via the monetary base earning IOR set equal to the target rate, not “bonds vs. ‘money.'” Again, just supply and demand + basics of central bank operations.

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