There is a magic money tree

Well, not really:  that was click-bait.   But bear with me.

The unprecedented increase in the size of central bank balance sheets since before the great financial crisis is unlikely to be entirely reversed.  And that means a one-off bit of magic money tree-growth.

Equilibrium real interest rates look like being much lower for the foreseeable future.  That means that the resting point for central bank interest rates consistent with hitting the inflation target will be much lower.  [Think of that resting point as the inflation target plus the real rate, roughly].  Perhaps around 3 per cent, rather than say 6% before the crisis.  That will raise the demand for non-interest bearing paper money.  And as a consequence central banks will hold larger balances of government securities to ‘back’ it.

Added to that, the UK/US/Eurozone central banks are paying interest on reserves.  This increases the demand for those reserves, swelling long run central bank balance sheets, and perpetual holdings of government securities, even further.  Another bit of magic money from the tree.

One hypothesis about low real interest rates is that it is about weak demand, and expectations of that persisting long into the future.  If that were true, and central banks and governments coordinated successfully to combat it, the magic money growth for public finances, such as it was, would go into reverse.  Indeed, the fiscal masters of the central bank ought not to be rubbing their hands at their good fortune, but hoping the magic reverses.  Otherwise central bank rates will be hovering perilously close to the zero bound, unable to do much about the next recession that comes our way.

Needless to say, all this is very different from embracing the idea that monetary policy should be subordinated to fiscal goals.  The ebb and flow of this minor magic money growth has taken place entirely as a consequence of central bank policy being focused on monetary policy goals.

Even when one contemplates helicopter money as a device to escape the zero bound to interest rates and demand-side secular stagnation, the goal is to subordinate this fiscal magic to monetary policy goals, not vice versa, and proponents like Simon Wren Lewis have, as I read him, been careful to stipulate that this should be the case.

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5 Responses to There is a magic money tree

  1. Max says:

    “Perhaps around 3 per cent, rather than say 6% before the crisis. That will raise the demand for non-interest bearing paper money. And as a consequence central banks will hold larger balances of government securities to ‘back’ it.”

    For the central bank to come out ahead, the cash money supply would have to more than double. And that’s ignoring costs.

    Interest on reverses is also not a money tree, because even a tiny bit less than the market rate causes reserves to go to almost zero.

    • Tony Yates says:

      Assume there are no spreads anywhere. The rise in demand for reserves and paper money increases real balances for as long as it persists, which allows the government to finance a one off expenditure equal to that amount forever.

      • Max says:

        If there are no spreads then the central bank is a money sink. It has expenses but it’s not bringing in any money.

        Given a permanently lower interest rate, the value of the CB could increase despite a fall in profit. But the significance is questionable because the CB isn’t for sale. Better to have the profit, I think.

      • Tony Yates says:

        You are missing the point; the balance sheet expansion is equivalent to a helicopter drop. The CBC expenses are no different and financed how all the other money sinks are financed.

  2. I agree with Eric Lonergan who suggested recently that there is no such thing as the equilibrium rate of interest. The rate that is compatible with full employment depends on how large the national debt is compared to the size of the stock of ultra safe assets that the private sector wants to hold.
    E.g. given a large debt (e.g. because of recent government profligacy), that will result in debt holders trying to spend away their debt holdings, which in turn raises demand. All else equal, the central bank would need to impose a relatively high rate of interest to counter that.

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