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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Social care funding and inheritance tax

The General Election has focused attention on how to fund ‘social care’.  This is money spent looking after people at the end of their lives when they are not able to look after themselves.

The Conservative Party manifesto included the proposal to charge social care costs against the value of the estate that the old person’s heirs would otherwise inherit, down to a limit of £100k.  At the time of writing, there seems to be talk of there being a review of whether the amount that would be charged in this way is capped.

One reaction to the original proposal was ‘why should the state fund the social care of the rich [ie those who would otherwise die with a large estate]?’

During the period when we are able enough to work and plan for ourselves, we all face, looking ahead, uncertainty about how much we need to put aside for our own care and pleasure at the end of life.  That uncertainty comprises not knowing how long we are going to live – in particular how long we will be alive when we are not able or inclined to work – and how much money it will cost to sustain us during that period.

From the perspective of this end of life lottery, the lucky ones are those who die suddenly at the onset of retirement.  The unlucky live long into old age with considerable care needs.  This is why popular discourse dubbed the Conservative proposal a ‘dementia tax’.  One of the losers in the end of life lottery is someone who takes a long time to die, but loses their mental faculties and has to pay others to look after them.  One of the winners, as Chris Giles noted, is the person who dies of a heart attack promptly, after finishing work, caused by a hedonistic life of excessive pizza eating.

Seen this way, the risk of ill health in old age magnifies the impact of the risk posed by longevity uncertainty [a point emphasied by Dan Davies today on Twitter], from the perspective of the young worker-investor-planner.

Just as with plain vanilla longevity uncertainty, one way to mitigate it is to marry.  You commit to leaving your riches to your partner in the event that you are lucky enough to die first.  And if you are unlucky and live long, and/or need caring for, you exact the terms of the promise made under ’til death do us part’ to get you through your daily needs.

Even better, you pool your resources with a larger group in a market economy and buy an insurance product.

The case for state intervention at this point rests, as always, on a few arguments.

First, market failure.  You know more about your lifestyle, life expectancy, and genetic predispositions to suffer dementia or similar than the insurer [asymmetric information];  and the insurer suspects that once you have signed up for the longevity/social care insurance, you will live solely on quinoa [moral hazard]. This drives up the price or even destroys the market altogether.

Second, we may be predisposed to under-insure against risks that seem remote;  and under-save for the future anyway.

Third, an additional risk arises because of aggregate cohort risk.  The dramatic rise in life expectancy in western countries made many defined benefit pensions worth a lot more than was predicted when they were first offered.  The only way to insure against this risk is for the state to step in and smooth the costs over generations.  Social care costs are, I suspect, probably subject to the same kind of aggregate cohort risks.   When we all live longer than we thought, because we gave up cigarettes, but contract dementia instead, there is not enough money from the estates of the lucky dead ones to sustain us.

Looked at like this, paying for the social care of the elderly rich is not an injustice, it’s the state paying out on a just and efficient scheme for insuring against the costs of old age.  Note the use of the word efficient there.  We can get to this conclusion without any politics about what the old do and do not deserve.

Shouldn’t inheritance tax be adjusted accordingly, then, if the Conservatives were to back-track on the proposal to charge social care costs against estates, either wholly or partially?  More generally, shouldn’t inheritance tax be how this insurance is financed?

No, inheritance tax is there to mitigate against a different problem:  weighing up the competing considerations of how inherited wealth distorts the allocation of talent and incentives in the next generation and opposing political considerations relating to equality and liberty.

There is no more reason to finance social care out of inheritance tax than any other tax.  If inheritance tax is at the right level, having balanced the factors mentioned above, then it should bear no more of the burden of this increase in state provision than other taxes.  If it is too low, then it should be increased [and other taxes adjusted accordingly] regardless of what will be charged for social care against estates.

Another response to the policy on social care was ‘three cheers:  this is progressive!’.

The progressivity of the overall tax system is another matter that has to weigh political ideas about redistribution [how much equality do we like?], liberty [how much should the state be allowed to determine how much I have] and efficiency [what effect does pursuing the other two objectives have on the size of the pie and therefore the tax base?].

If the tax system was not sufficiently progressive for you before hand, then you should not cheer something that puts all the burden of making it more so on impairing the state’s intervention in longevity and social care risk, but instead call for tax changes across the board.

[One reader, Tony Holmes, answered the question posed earlier ‘Why should the state fund the social care of the rich?’ more succinctly than did this post, by posing another question:  ‘why should the state fund the healthcare of the rich?’  And we could substitute in any state policy that is directed at risk:  fire fighting, flood defence, etc.]

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Does it ‘cost’ anything to nationalise a company?

Labour’s manifesto reveals that they intend to re-nationalise water companies if they are elected.  How much would this ‘cost’? was many people’s response.  For example, the BBC’s Laura Kuenssberg noted that a ‘costing’ of this policy was omitted from the manifesto.

The nationalisation would happen by the government selling debt to the market, and using the money raised to buy shares [presumably at least a majority, perhaps all] in the company.   There are questions about which internationally acredited accounting conventions this borrowing would be included under, and which it would not.  But this issue is not very interesting [to me, anyway].

The interesting thing is to think through the economic consequences and ‘costs’ of the policy.

Supposing that the fair price for the assets were knowable, and that the cost of doing the transaction was small, in principle the company could be sold again at some point in the future, leaving public finances back to square one.  The extra liability of the government is matched for a while by an asset;  then the transaction is reversed.  The ‘ifs’ there are significant.

The next question is what happens to the revenues that ownership of the firm would, under private management, generate.  If the company is managed in a commercial way, with appropriate amounts of revenues ploughed back into the company, there need be no ‘cost’ from this source.  Once again that is a substantial ‘if’.

Taking ownership may inject risk into public finances, if the public sector does not already implicitly stand entirely behind the water companies.  At some times, when market dysfunction means that risk is not priced properly, taking on risk like this may be a good thing;  it’s similar to the Bank of England buying private sector assets with QE.  At other times, the drain of uncertainty on the public finances will be one that comes without a compensating social benefit.

A stark example of how to maximise the ‘cost’ of nationalisation is the oil industry of Venezuela, where its output was sold at subsidised or sometimes zero cost, and many jobs treated as posts of patronage, experts let go, and capital expenditure cut.  This is not a serious comparison, but it does make a point.  There will be political pressure on government owners NOT to manage the assets in a commercial way and to use it as a means of redistribution.  As Mike Bird of the WSJ pointed out on Twitter, one has to ask: why nationalise?  It’s possible, but unlikely, that the reason is to run it on the same commercial terms as before.

It’s worth pointing out that interfering in commerce like this could make things better, not worse.  If ownership proves simpler than regulation, and rent extraction is reduced, there might be benefits in terms of lower costs that generate offsetting revenues in other parts of the tax base (that use water as an input).

Buying a company like this does not ‘cost’ in the same way that it costs me to borrow to buy a house.  There, I am borrowing to consume the housing services that the house affords me.  A better analogy is borrowing to buy a house to let it out.  This would consume a lot of my personal fiscal space.  But only because the credit risk associated with the capital value of the house, and my rental management skills are large relative to the other income streams that I have available to me to make good the interest on the loan and repay the principle.  For the same reason, the government would find it tricky to raise the money to buy Microsoft.

Continuing the analogy, the credit history of the government is pretty good, bar a period after WW2 when there was a hefty amount of inflation and what economists came to term ‘financial repression’ [taking our savings and charging less than market rates for it].  But the record of managing public companies is somewhat less compelling;  markets may therefore conclude that public ownership is a drain on public funds if that history was to repeat itself.

Some on Twitter commented that public ownership might make it easier to realise environmental benefits.  If that can be done without affecting the revenue streams, then this also does not need to be seen as a ‘cost’.  However, if this means placing further restrictions or duties on the water companies that impairs revenue, then the environmental benefits that ensue have to be seen as something that the taxpayer pays for out of future taxes, and today’s fiscal ‘space’.  That is, unless those benefits somehow undo a market failure [flooding?  long-term land productivity?] whose resolution commands a price.  It may be money well spent, in these terms, but it would be money spent.

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Imagining that how to spend the BoE missing stimulus was the GE2017 centrepiece

Myself and many others have suggested that in order to help out monetary policy when interest rates reach their effective lower bound [around 0], there should be a discretionary fiscal stimulus.

My version of this is that the BoE would quantify how much was missing given what was possible not just with rates, but also QE.  And the Treasury would decide whether to accept this advice, and, if so, how to implement it.

Imagine if this system was already in place for the 2017 General Election.

The question for all parties would then be:  do you agree with the BoE’s current estimate of the missing stimulus?  If not, what do you think it is, and why does your analysis differ?  If you do agree, how are you going to implement and unwind it?  What other – for example distributional – objectives are guiding those choices?  If there has been missing stimulus applied in the past, has it worked and had the intended effect?  If not, what is to be done differently next time?  If the BoE, in the face of one of the many downside risks that might materialise, were to sharply increase its missing stimulus quantification, what would your contingency be?  How are the answers to all these to be made consistent with long term fiscal sustainability?

This would be a much better world, in my opinion, than the clash of brands and scare stories that colours the current discussion of fiscal policy on the airwaves, which – Labour’s draft manifesto aside – never mentions the constraints on monetary policy.

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What use Eurozone integration?

Martin Sandbu posed an interesting question in his Free Lunch column this week:  What can a common treasury achieve that existing institutions and national authorities can not?

The question was by way of warding off French President-elect Emmanuel Macron from demanding too much by way of fiscal union when political capital could be spent more wisely.

The answer in the abstract is:  the benefits that flow from commitment, enforceability, and internalising externalities.

Martin’s question could be asked of any collective.  What can a national Treasury achieve that could not be replicated by tens of millions of people agreeing to contribute or accept payments from a pool of resources, depending on how their luck fared?

We have national Treasuries to implement agreed plans for contributions and withdrawals;  or, more realistically, implement plans devised by people we collectively agree to give the authority to devise them.  Without this central body, there would be every risk that if we were lucky, we would decide not to part with our agreed contributions toward the plight of the unlucky.

The ‘banking union’ could be replicated by a list of promises to supervise and promises to pay out/bail out/resolve wherever financial trouble emerges.  But, once that happens, the similarity of interests dissolve.

The Eurozone collectively signed up to the Stability and Growth Pact at its inception.  But subsequently – leaving aside the merits of it – proved unable to enforce it.

Bound up with enforceability, of course, is that there can be majority rule.   Like all public contracts, a Eurozone finance ministry is a desire to implement a median fiscal policy that some won’t approve of even ex ante, let alone ex post.

On top of this, is the idea that centralised institutions can internalise externalities.  An example here is the tragedy of the commons.  The phrases refers to the archaic problem of preventing individual farmers overgrazing and degrading common land.  Here we might think of the incentive for a single government in the EZ to over-borrow, or under-supervise its banks and free-ride on the better behaviour and tax base of the others.  Central budgets and supervisors can stop that.

Formal integration institutions are not cast iron guarantees themselves, of course.  States face time-consistency problems;  and get taken over by those who come of the age when they can decide, having not previously had any say.  But they raise the cost of changing direction.

Macron’s ambitions on fiscal union may not be feasible, but, within a currency union, they are logical.  One might even argue that without further steps, such as a centralised Treasury, existing common institutions [like the small fund backing the banking union] won’t be robust enough to prevent a recurrence of the last financial crisis.




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Labour’s leaked manifesto and fiscal rules

If the document being described as a leak of a draft of the Labour manifesto really is that, the section on fiscal policy, tweeted by Robert Peston, is interesting.

It contains the encouraging suggestion that HMT rules would be suspended at the point where interest rates hit their effective lower bound.  It is unfortunately silent about what happens next.

My preference is that the Bank of England’s Monetary Policy Committee be asked to quantify the missing stimulus in terms of the trajectory for its constrained instrument.  The Treasury or Office for Budget Responsibility [OBR] would then devise a set of paths for spending and tax instruments that reproduced this stimulus – which would be a thing that varies over time – and which included a plan for unwinding.

Regardless of who devised the plan, the OBR would report on its consistency with long-term fiscal sustainability.

This procedure would have to be regularly updated as news about the economy unfolded, and the missing stimulus grew or shrank.  To be practical, the updating could coincide with the Inflation Report forecast updates.

Without specifying what happens at the zero bound, the suspension of all fiscal plans at this point leaves policy entirely unconstrained and prey to the politics of the moment.

This is of particular importance right now, since it could be that rates are not ready for lift off for two years or more, perhaps even longer if one or more of the many downside risks [China credit, Eurozone banks, no Brexit deal] were to crystallize.  So there would be a non-negligible chance that the rules as written amount to ‘do whatever we feel like for the foreseeable future’.

If the MPC are not asked to quantify the stimulus, it begs the question why they are trusted to quantify and implement the stimulus when their instruments allow them to.  Put differently, why would the finance ministry be trusted with the job of macro stabilisation at the zero bound, but not trusted away from it?

The leaked Labour plan – if that is what it is – includes a provision committing to reductions in the ratio of government debt to trend GDP.  Such a plan is a little odd.  In the long-term, I don’t see the motivation for continually reducing this ratio.  In the shorter term, with monetary policy constrained at the zero bound now, and the cost of public finance so low, it is not a sensible thing to emphasise.

Regardless, using the ‘trend’ in the ratio creates difficulties.  At the least, what ‘trend’ GDP was at any point in time would have to be decided independently by the OBR.  Right now, establishing what trend GDP is, with the path of productivity so extraordinarily low after the financial crisis, and the peculiar developments in the labour market reducing the apparent natural rate of unemployment, trend GDP is hazardous.  And this is without getting into the analytical controversies about the many, many models of trend that could plausibly be taken to the data.

It is tricky to draw general lessons from the academic literature on government debt.  But if forced to, I’d say that one should try to estimate a maximum desirable debt/GDP that could be sustained without risking a run on our UK government bonds;  and estimate a likely frequency/magnitude of recessions, and their implications for the trajectory of deficits and debt as governments deal with them.  Out of this would emerge a rough idea of the average level of debt/GDP that would be desirable.

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FTAlphaville and optimal currency areas.

There are a lot of talking points in this fun post on FTAlphaville by Matthew Klein.

The piece is a spirited defence of the idea of returning to the gold standard, based on logic that Martin Sandbu uses as a defence of the multi-country-currency euro.  If you don’t like it, he wants us to believe, then for the same reasons, you should not like the euro.

What this misses out is the notion of an optimal currency area, which goes back at least as far as Mundell.

The larger the geographical area, the more likely that area is to embrace regions with asynchronous economic conditions.  (Unless there is literally no variation by region in the type of economic activity).  So long as fiscal policies are imperfect substitutes for having a different monetary policy, and there are costs of adjusting prices, wages or of moving, the case against mounts as the geographical area grows.

Also, the larger the area, the less strong are the financial and trade linkages that motivate eliminating financial currency transactions and price denomination differences.  So the case for a common currency weakens.

So it’s perfectly possible to argue for the euro, but against a global currency.  Equally, it’s possible to argue for national or multinational currencies, but against individual bank, firm or person fiat monies.  Although there are asymmetries in economic conditions across small economic units like banks, firms or people, and government policies or private markets don’t do a perfect job of sharing the risk that results, the costs of asset management, transactions and figuring out prices under individual currencies would far outweigh the benefits.

As to the question of whether a global should be the gold standard.  Klein notes the problem caused by the physical path of gold supply, determined by [until we develop alchemy] the amount in the ground and resources devoted to extraction.  Assuming there is no new great discovery, this means a falling path for prices, since the growth of gold will be exceeded by the growth of the real economy.   If you believe in downward nominal rigidity, that isn’t great, as it means some relative prices won’t be at their optimum.  With rising prices, its less likely that any sector requiring real/relative wage cuts would need a nominal wage cut.

A gold standard also means no monetary policy tool to deal with aggregate economic fluctuations.  Klein makes the argument that this might not be any more inconvenient than the peripherals found the common Eurozone monetary policy.  But the difference here is that for aggregate fluctuations, all countries would feel the pain and conclude, rightly, that they would be better off with fiat currency.  That’s with the proviso that its printing could be managed as well as the best nation states do it.

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