Anchors Away

A cautionary tale on cutting the cord of traditional macroeconomic policy

With the Canadian government announcing that they will be weighing the proverbial fiscal anchor and setting sail across the sea of never-ending deficits, it is not far-fetched to think that some Canadians feel economically adrift. In light of the COVID-19 pandemic, which undoubtedly presents one of the greatest and most unprecedented economic challenges to our society, the question now becomes: will the established economic tools that are available to the government be enough to steer the Canadian economy on a course towards full employment, price stability, and growth? Although the current government may not be comprised of the sharpest tools in the economic shed, they should be cautioned against throwing away old methods in order to pick up the shiniest new ones.

Current Macroeconomic Policy

During the global financial crisis, central banks cut interest rates to near zero levels to incentivize people to spend. Across the world, bankers hypothesized that lowering interest rates would encourage banks to issue more loans. More loans meant the multiplying effect on new money issued would “create new money”, more money would be spent, and economic output would rebound.

Unfortunately, these policies did not have the impact that bankers had expected. This was largely due to the fact that people and businesses were too scarred from the crisis to borrow and pick up on the attractive rates being offered. As is so often the case, when the economic rubber hit the road, the irrational nature of human beings muddied the waters of otherwise clear-cut economic policy.

In response, the central banks invented a new tool to address the economic collapse: Quantitative Easing (QE). This strategy meant that the central bank would purchase government and corporate bonds along with other securities from the market with cash, having two primary effects:

1)      Excess liquidity from the sale of assets could then be used to lend and spend, kickstarting an economic rebound; and

2)      The cost of borrowing would fall given the considerable amount of liquidity floating around in the markets.

These purchases took two forms: secondary purchases that entailed buying assets from investors in the secondary market, and primary purchases that involved the purchase of assets directly from the institution issuing them (i.e. government bonds).

In theory, primary QE requires the central bank to print money to lend to the government and finance their spending on output-expanding capital projects that drive economic recovery. For those of you familiar with the more progressive views on monetary policy, this might sound eerily familiar to you. Indeed, large primary purchase programs are a good step along the road to Modern Monetary Theory (MMT). The question becomes, how do they differ, and which should be used?

MMT vs QE

As I’m sure you’ve deduced, MMT and QE both involve a significant number of purchases by the central bank of government bonds. The difference is that under QE, the expectation is that central banks will sell the bonds to private investors before they mature, so the government will need to raise money to pay its private debtors. This is inherently a temporary policy of money creation to address short-run economic shocks.

Under MMT, in contrast, there is no expectation that the government will pay the central bank back. When the bonds come due, the central bank would just roll them over. As such, this is a continuous policy allowing the government to fund itself with money printed by the central bank. With a policy that theoretically provides unlimited free money for seemingly never-ending government-supplied services, what could possibly be the controversy? As is so often the case living in a world encumbered by reality, the problem is that it is too good to be true.

MMT – A Victim of Harsh Reality

Economic arguments against MMT largely revolve around the fact that the unlimited printing of money will cause a run up in inflation. However, MMT proponents often argue that inflation fears are simply unfounded, as the massive widespread adoption of QE since 2008 – which can be viewed as a trial run for MMT – has resulted in few, if any, inflationary repercussions. Proponents of MMT also suggest that even if there were to be rampant inflation, the government could control the increase in prices by raising taxes significantly to force money out of the hands of consumers. This would severely reduce the money in circulation and effectively choke off the money supply.

What these arguments and counterarguments boil down to at the most fundamental level are two questions. Will MMT cause an unacceptable level of inflation, and if so, will MMT policies – such as excess taxation – effectively mitigate against it?

The answer to the first question is that MMT will indeed cause an unacceptable level of inflation. Although modern QE (the quasi-proof of concept for MMT) has not significantly contributed to inflation in the last 12 years, that test period was hardly normal. In fact, it could be argued that the economy was already in a deflationary state when QE began. Consumers, scarred by the beginning of the global financial crisis, hoarded money and expected prices to fall. This triggered a deflationary cycle as the expectations of sinking prices encouraged people to hoard more money, which further perpetuated the cycle. In effect, the inflationary effects of QE were absorbed by the record low levels of consumer sentiment, and when they began to recover, QE was halted (Exhibit A).

This phenomenon may explain why inflation was a non-factor until 2014 (while consumer sentiment remained below the 20-year average), but not why it stayed so low once consumer sentiment returned to normal levels.

The second contributor to low inflation, despite upwards pressure from QE, is a function of the increased reserves of commercial banks. In the aftermath of the global financial crisis, financial institutions kept the liquidity resulting from QE to shore up their balance sheets. To see this phenomenon in action, look no further than the sharp increase in tier 1 capital requirements – which is the amount of money the bank stores to keep it functioning through the risky transactions it performs – from 5% at the end of 2008 to more than 10% by 2012.  As commercial banks absorbed the money being issued by central banks (by keeping it in reserve rather than loaning it out), the economy did not see the multiplying effect as it would have under normal circumstances (Exhibit B).

Given that this absorbing effect on the money supply has lasted since the end of QE, it follows that inflation has been dampened, at least to a degree, over the last 12 years. Some may argue that this strategy can be used in perpetuity, to allow commercial banks to continue to absorb the multiplying effect of new money. Indeed, central banks do use commercial banks to regulate money supply through overnight lending rates, reserve requirements and other monetary levers. The issue is, to depend on these commercial banks to control the money supply entirely is to defeat the purpose and benefits of a central bank as well as severely limit the efficacy of a unified monetary policy.

Given this, it can be deduced that MMT is likely to cause inflation. So, is MMT able to effectively mitigate against this inflationary pressure? The answer to this is a resounding no. Given that taxes are set in a highly politicized arena, the politicization of inflation control will result in inflation becoming less predictable and more erratic due to competing pressures from conflicting political agendas. A central bank that is at least more independent would be able to target the issue of inflation much more effectively than fiscal authorities focused not on the economic or business cycle, but only on the next election cycle.

New Role of the Central Bank

So, what should the new role of the central bank and government look like? It should look very similar to the old role. The central bank should focus on the areas in which they have expertise, and where their tools are most effective at realizing real economic recovery.

The central banks should continue very cautiously with their programs of QE, specifically, a greater ratio of primary to secondary purchases. QE provides much needed liquidity and security in an uncertain time, but the effects of secondary asset purchases should not be taken lightly. According to the New York Times, US total disposable personal income has actually increased by $1.03 trillion from March to November 2020. Compared with a decrease of $535 billion in total household outlays over the same period, that leaves a significant amount of money to be saved and invested by consumers. With demand in the equity markets already being spurred by record low yields in the debt markets and increased household savings, the central banks need not prop up equity valuations any further.

With an increasing divergence between Bay Street and Main Street, the central bank should be looking at using these primary purchases to enable the government to recover the real economy without triggering another sell-off in the financial economy; a task that is certainly easier said than done.

On their part, the government should soak up this financial support with effervescent zeal, but should not expect the central bank to become their magical money tree. Indeed, the government should resist developing a taste for the forbidden fruit of Modern Monetary Theory, lest they be banished from the paradise of stable controllable inflation.

Undoubtedly, the central bank and government must work in tandem within specified fiscal anchors to achieve real economic recovery rather than jump ship to a seemingly more attractive policy. As British economist Sir Charles Bean said recently in a lecture at the London School of Economics, “when it comes to MMT, there is much that is right, and much that is new, but what is right is not new, and what is new is not right.”