The fiscal-monetary mix

In my previous post, I pointed out that, given the inflation target, a less tight fiscal policy implies higher official interest rates. This means that the choice between the two main parties isn't just about fiscal policy, but about the fiscal-monetary mix: Labour offers looser fiscal and tighter* money than the Tories. Which poses the question: what should be the right mix?

Simon is, of course, right:

It is stupid to commit to further significant fiscal contraction (‘austerity’) when interest rates are still at or close to their lower bound. It means we become more vulnerable to adverse shocks to demand.

Let's suppose, however, that the OBR's forecasts are right and that the economy can grow decently and that inflation will rise even with a tight fiscal policy: this is, of course, a strong assumption as economies are inherently unforecastable. If this is the case, we might well be pulling away from the zero bound midway through the next parliament; markets are pricing in a 1.5% Bank rate by 2017.

Which poses the question: what should be the policy mix then? If we could achieve the same growth and inflation with different fiscal-monetary mixes, which mix should we prefer?

The argument for fiscal tightness is straightforward. We need to stabilize or reduce the debt-GDP ratio sometime. Intergenerational equity counts for something, and there's a risk that global real interest rates will trend up, adding to debt service costs. There's also a case for raising real interest rates: a long period of low rates risks creating a social norm against saving.

There are, though, three issues here.

1. Inequality. For a given level of unemployment, loose money and tight fiscal policy might generate more inequality. This is because loose money raises the prices of assets, which are - by definition - held by the rich. Also, the burden of fiscal austerity is likely to fall upon welfare claimants. (Yes, many of the poor are in debt - but the interest rates they pay aren't related to Bank rate.)

This, though, isn't a knockdown argument. If a loose money/tight fiscal mix does have adverse effects on equality, the solution lies in changing taxes and benefits - not necessarily in altering the policy mix.

2. Secular stagnation. If low interest rates stimulate productive capital spending, they are to be welcomed. However, if there's a dearth of monetizable investment opportunities, low rates might instead fuel bubbles and malinvestments. In such a world, looser fiscal policy might be preferred precisely because it would crowd out the private sector.

Again, though, it's not clear how relevant this is. On the one hand, the housing market seems to be cooling and the stock market isn't in a bubble: if it were, I'd have retired by now. But on the other hand, the fact that business investment fell in Q3 suggests that real investment opportunities might still be limited.

3. Practicality. One argument against a sharp tightening is that it implies cuts in public spending which are too big to be credible. A slower pace of cuts would have the virtue of giving the government time to research ways of improving efficiency; make the organizational changes which could deliver services more cheaply; and create more of a political consensus on which functions the state should relinquish.

Now, I don't have especially strong views here. Which is my point. The best fiscal/monetary mix depends upon the context. As Edmund Burke said:

Circumstances (which with some gentlemen pass for nothing) give in reality to every political principle its distinguishing colour and discriminating effect.

I can easily imagine circumstances in which I would be on the side of some sort of fiscal austerity; my opposition to austerity so far has been because the circumstances aren't right for it.

I fear, though, that my view is a minority one and that many others' positions (on both sides) are more fixed. But then, that's the thing about us Marxists - we are so much less dogmatic than others.  

* By tighter money, I mean a higher real Bank rate. I find arguments about the definition of "tight" money tiresome.

Comments

[Ralph Musgrave]

“We need to stabilize or reduce the debt-GDP ratio”. Why? Because it’s higher than it used to be? That’s not a good argument: Japan has a debt-GDP ratio three times ours, and the sky hasn’t fallen in there.

The fundamental question is: “what’s the OPTIMUM debt-GDP ratio?”. Well first there is an argument for having government borrow to fund public investments. In that capacity, government is acting as a contractor, sort of, which builds and runs roads etc. But I can’t get my head round whether public investments should be funded via borrowing or tax.

Apart from that, I see no reason for ANY BORROWING. Certainly when it comes to “borrow and spend” with a view to imparting stimulus, it’s strange to do something that has a DEFLATIONARY effect (borrowing) when the object of the exercise is the opposite: stimulus.

You might as well throw dirt over your car before washing it.

[Matt Moore]

If it turned out that tight money and loose spending resulted in less inequality, but also less growth in the absolute standard of living for the poorest, would you still support it?

I'm not saying that's necessarily the case, I'm just wondering about priorities.

[SK]

The housing market is not cooling at all.
Prices are ridiculous.
And we never had any serious correction in 2007.
Wait now for the SDLT reform to manifest and the April pension reforms to take place, and the market will sadly increase again.

Hope BoE have the guts to do something about this even now.

@Matt,
Ofcourse it makes sense to support something that offers less inequality. Currently both fiscal/monetary policy (QE/FLS/HTB/SDLT/ZIRP) support asset-holders to such an extent that the 35-40% of UK population who are tenants are getting poorer and poorer.

@Ralph,
Nobody believes that Japan will pay its debt.
Public investment should be paid by taxes and that is why we need LVT.

[PM]

Excellent post overall. It would be great, however, if someone could add some more insight to the logic underlying point 1 on inequality.

Specifically, what I am getting hung up on is the following -- I agree that loose money increases the price of assets, and I agree that these assets are mostly held by the upper class, but these two facts make it tough to then assert that inequality increases. As I see it, asset prices do not simply increase when money is looser: they increase because demand for them increases (which is a by-product of loose money). If this asset market is, to a first approximation, for the rich, then for every rich man who sells an asset at an inflated price, there must also be a rich man who buys the asset at the inflated price. In other words, every rich man who sells an asset is now better off due to loose money, but every rich man who buys an asset is equally worse off - there is a transfer of funds among the rich rather than a flow of funds from the poor to the rich.

Note that I'm not convinced of the argument I make above, but it is a point that I think needs to be fleshed out more.

[Luis Enrique]

PM,

it's possible that 90% of assets are held without changing hands, and prices are set by the 10% that are bought and sold.

[Ralph Musgrave]

SK,

If no one believed the Japanese government was going to pay its debt, the latter’s value would collapse. There’s no sign of a collapse far as I know.

PM,

One reason why loose money raises inequality is that if govt issues excessive amounts of base money (and the amount currently in circulation is at unprecedented levels) govt may then have to induce those money holders not to spend the money by issuing bonds, i.e. paying interest on some of that money. But to get the desired deflationary (i.e. demand reducing) effect, govt will probably fund the interest on those bonds by robbing the average taxpayer (rather than by printing more money). And the recipient of that interest are the relatively well-off: those bond holders. So… average taxpayers worse off and well-off bond holders better off.

[Nick Rowe]

Chris: "1. Inequality. For a given level of unemployment, loose money and tight fiscal policy might generate more inequality. This is because loose money raises the prices of assets, which are - by definition - held by the rich."

I think I remember 30 years ago the left making the exact opposite argument. High interest rates were good for the rich, because lenders are by definition rich.

[Metatone]

@Nick Rowe - guess what, the system people like you have created isn't designed to be detrimental for the rich in either direction.

Well done.

I hope you enjoy our coming slide into banana republic levels of inequality.

[Blissex]

«If low interest rates stimulate productive capital spending, they are to be welcomed. However, if there's a dearth of monetizable investment opportunities, low rates might instead fuel bubbles and malinvestments.x

But no "real" investment can beat the 50-100% net return per year of investing in property. My usual quote:

http://www.bbc.co.uk/news/business-19288208
«In 2001, the average price of a house was £121,769 and the average salary was £16,557, according to the National Housing Federation. A decade on, the typical price of a property is 94% higher at £236,518, while average wages are up 29% to £21,330»

Look at the total gross return at the end of the 10 years. It is around £110-120k of capital appreciation, plus a gross yield of around 5% a year for rent, so another £80-90,000.

The total gross nominal return in 10 years is around £200,000, or £20,000 per year. Assuming that the house was bought for 10% deposit, of around £12,000, that's a gross nominal return of 160% per year for 10 years, or 33% compound for 10 years, and most of it tax-free.

Do people here realize how transformative these huge returns have been of the lifestyles of landlords who bought some years ago?

That's the stuff of legends, it has been the fun recipe for wealth and happiness.

Why bother investing in anything else as low productivity and low yielding as business or other forms of work?

Boris Johnson agrees:

http://www.telegraph.co.uk/finance/personalfinance/pensions/10717846/Budget-2014-the-Lamborghini-ride-that-says-power-to-the-people.html
«I think the vast majority will want to put their pots into the market with the greatest yield over the past 40 years – and that is property»

Plus property speculation not only has the enormous advantage of being purely redistributive, and thus generating no value, thus punishing low productivity workers and businessmen and rewarding highly productive landlords, but also of being in effect fully government guaranteed.

[Blissex]

«For a given level of unemployment, loose money and tight fiscal policy might generate more inequality.»

In a democratic system this might be a strongly expressed preference of many if not most voters, because they might well think that more inequality favours them, especially if it is asset-price based inequality and they happen to be long assets but (relatively) short productive work, for example middle aged or retired people.

[Blissex]

«I think I remember 30 years ago the left making the exact opposite argument. High interest rates were good for the rich, because lenders are by definition rich.»

* A tight monetary policy is not necessarily the same as «High interest rates»: what also matters is availability of credit, and that can matter more than its price. Currently because of regulatory issues essentially unlimited credit is available, but only for "good" collateral (like residential property), thus generating a collateral-debt spiral that soars ever more.

* There are rich people who are long assets, and rich people who are long cash. Low interest rates favour those long assets, high interest rates those long cash. Both categories are still rich people. The united front of the rich has internal tensions too.

[Blissex]

«it's possible that 90% of assets are held without changing hands, and prices are set by the 10% that are bought and sold»

Good point... It has interesting consequences.

Other than selling public property at huge discounts to tory voters in the South East, the Thatcher (and Blair) governments other "Critical Success Factor" was to make it easy to remortgage those properties.

Widespread remortgaging has been a core target of economic policy for decades, because it means that when the small number of properties that get traded every year results in higher valuations, these can be applied to the vast majority, justifying booming debt levels.

Crucially, *without putting those properties on the market for sale*, and thus boosting valuations even higher than otherwise, by creating a thinner market.

If a street in some South East suburb has 20 houses and just one of them is sold for £230,000 10 years after being bought for £110,000 this generates (notional!) £120,000 capital gains for each of the other 19 too.

This means potentially not just new *net* debt of £120,000 for the mortgage of the property that has been sold, but an extra £2,280,000 of remortgages on the other 19 properties, crucially again without them actually having to be put on the market.

Totally safe lending of course :-), as it is at that point an easily verifiable fact that the valuation of properties in that street as collateral is indeed £230,000 as it is a matter of record.

So not only remortgages can balloon in volume, but this is also entirely safe!
And government-guaranteed! :-)

Such are the wonders of the debt-collateral spiral.

The Germans who have wasted the past few decades stupidly investing in low-productivity export oriented industries and even services must soon realize how silly they have been and follow Boris Johnson's advice and invest only in high-productivity South East UK property. :-)

[Blissex]

«I hope you enjoy our coming slide into banana republic levels of inequality.»

A very popular prospect, as the smug middle aged and retired landladies of the South East dream of a Tory future in which a Johnson government boosts even more the valuation of their mini-manors, and their resulting lifestyle as gentlefolk.

A quote from "The Macmillan Diaries, Vol II" is topical:

«As a kind of tranquiliser I am taking a course of Henry James! What a world – how quiet and peaceful and happy it was for the “upper and upper-middle classes”. Now it’s a nightmare. Happily, it’s a much better world for the masses, as has been brought home to me most forcibly in writing the history of the inter-war years.»

That «quiet and peaceful and happy it was for the “upper and upper-middle classes» dream is the tory dream of the South East middle classes: to soar "upstairs" into the upper-middle or upper classes thanks to millionaire property valuations, and to be served deferentially by the "downstairs" help from the North and Bulgaria and Romania or even better Burma or Guinea.

Cheap hired help will become easy to find again!

Note: some of the middle and upper classes detest the EU because of its immigration policy: it prevents the UK from opening immigration from really poor countries for really cheap hired help without any rights, instead of forcing the UK to hire only help from relatively expensive Bulgaria and Romania who also have to be given rights.

The model for them is the immigration and residence policies of places like Qatar or Saudi Arabia, with none of those EU-mandate coddling rules.

[Nick Rowe]

Metatone and Blissex: let me see if I have got this straight:

"If she floats she must be a rich witch; if she sinks she must be a rich witch!"

Is that the official lefty position?

You guys are funny!

[Bob]

What about helicopter money? You could spend money directly into the economy and make the pound weaker, balancing towards exports. There have been times with expansionary fiscal and monetary policy and those with neither.

[CurmRincewind]

There's an issue here which I've never really understood.

If the main point, which Chris argues elsewhere as being "obvious", is that "the government is not in control of the public finances" then why should we concern ourselves with any of these questions?

Sure, on a micro level, specific government policies affect the lives of some individuals, but if the government isn't really in control of the public finances I guess it follows that it doesn't much matter what they do on a macro basis.

[gastro george]

Isn't the point that the government is not in control of the public finances to the extent that any policy supposed to directly affect those finances (viz austerity) doesn't work in such a direct manner. So it would be foolish for policy to target the public finances directly.

However there are other targets (unemployment, growth, demand) that government can target directly.

[Ralph Musgrave]

Gastro George,

I quite agree. Having a target for the deficit or debt is nonsense because no one knows what will happen to exports, private sector domestic demand and so on in two or three years’ time. E.g. if the latter two contact, government will have to expand the deficit if it wants to maintain full employment.

In contrast, numbers employed is a target that makes sense (as I just suggested). Indeed Keynes said as much when he said “Look after unemployment and the budget will look after itself”. Plus avoiding paying too much interest on the debt is a target that makes sense. Milton Friedman argued for a zero rate on the debt, which effectively means no debt at all: i.e. the only liability issued by government should be base money. Can’t say I strongly disagree with Friedman.

[Blissex]

«if I have got this straight:
"If she floats she must be a rich witch; if she sinks she must be a rich witch!"»

That's arguing like silly.

If she has 2 million pounds in gilts earning 0.5% interest of £10,000 she is rich and invested long liquidity and short risk; if she has a 2 million pound property earning £200,000 a year of tax free capital gains she is rich and invested short liquidity and long risk (except that the government tries hard to eliminate that risk).

Too bad that rich people long liquidity and short risk want high interest rates, and rich people short liquidity and long risk want low interest rates, and the government has a hard time giving both types of rich people whatever they want, even by squeezing the high-living luxury-loving poor until the pips squeak.

While there are relatively small welfare handouts to rich people long liquidity and short risk like "tory voter bonds":

«You’ve planned your retirement, you’ve planned a level of income based on savings and on interest and then suddenly interest rates are at a completely historically unprecedented level. And there’s nothing you can do about it.
“That is why the government has stepped in.”
The pensioner bonds, first announced in the Budget in March, will be available to buy in January and will operate as one-year and three-year fixed term investments. Some 11 million savers over the age of 65 will be eligible to invest up to £10,000 in both the one and three year bonds.
But the Treasury has capped the total savings pot at £10 billion. Once this level of investments has been reached, no further bonds will be sold.»

The government is clearly far keener to create the conditions to redistribute income and wealth away from the parasitic and lazy poor and working poor to the productive and hard-working property owners than to the productive and hard-working bond owners.

This government thus not only has taken sides between the exploitative poor and the deserving rich, but also between the rich who are long or short liquidity in their choice of wealth strategy.

[Blissex]

«What about helicopter money? You could spend money directly into the economy and make the pound weaker, balancing towards exports.»

That's fiscal policy, and fiscal policy is described as "inflationary" and "class war", because it results in more and better paid jobs.

"Inflation" has been redefined a few times, but currently mostly to mean "wage rises" (not even "unit cost increases"). "Wage rises" are "inflation", but generalized asset price increases are "the just reward to the hard work of property owners".

Wage rises are also "class war" because they can reduce "the just reward to the hard work of property owners" expressed as after tax profits,

The above are long running attitudes; in centuries past there was the "Iron Law of Wages" which stated that the only wages that workers deserve are subsistence ones, because labour does not produce any value. Ayn Rand later expressed this again by saying that only property owners produce value.

[Blissex]

««What about helicopter money?»

That's fiscal policy, and fiscal policy is described as "inflationary" and
"class war"»

The extra interest to be paid on "tory voter bonds" is a good recent example of "helicopter money" because the extra 3.5% of interest on the £10 billion total, £350m a year, is a pure handout, and unusually it is direct from the government. This is different from the usual "helicopter money" which is a handout from the central bank to financial speculators in the form of hundreds of billions of zero-interest never-never loans, or the purchase at par of insolvent securities, or colossal bailouts to protect the jobs and bonuses of failed City or wall Street bankers.

But these massive handouts are "clearly" not (directly) "inflationary" or "class war" like wage rises because they are carefully targeted at deserving property owners. In the case of "tory voter bonds" they are restricted to owners of significant amounts of liquid savings who are pensioners rather than workers, and the immense handouts to financial speculators and failed bankers are restricted to the best friends of friends of the central bank.

[Blissex]

«This government thus not only has taken sides between the exploitative poor and the deserving rich, but also between the rich who are long or short liquidity in their choice of wealth strategy.»

And in a massive, declared, shouted way, here is Cameron for once speaking truth to power as well as ably prevaricating:

http://blogs.reuters.com/felix-salmon/2013/03/13/britains-fiscal-failure/

"It is hard to overstate the fundamental importance of low interest rates for an economy as indebted as ours… …and the unthinkable damage that a sharp rise in interest rates would do.

When you’ve got a mountain of private sector debt, built up during the boom… …low interest rates mean indebted businesses and families don’t have to spend every spare pound just paying their interest bills.

In this way, low interest rates mean more money to spare to invest for the future.

A sharp rise in interest rates – as has happened in other countries which lost the world’s confidence – would put all this at risk… …with more businesses going bust and more families losing their homes."

Thus spoke the beneficiary of a few dozen properties in London, according to some reports.