Tuesday, 13 December 2011

A thought experiment: why the ECB should print money...

...and why the Bank of England and Fed are right to have done so already.

I'm not talking about whether the European Central Bank should directly buy eurozone government bonds. This causes a moral hazard problem - it might encourage governments to be profligate and reduce incentives for structural reform. It's, at the very least, debatable. I'm talking about a more general question: why should central banks print money in a recession?

This post won't have much new to say to macroeconomists, but it attempts to address a concern of many non-economists - won't printing money just cause more inflation?

First, let's run a thought experiment. Imagine that your national government has decided that profligate use of fossil fuels is a problem. Probably because of the risk of climate change. Instead of using a carbon tax, the government decides to restrict the supply of oil coming into the country. It could allow more oil in if necessary - in fact it has a large reserve stored up for emergencies - but it chooses to limit how much oil its citizens use, by keeping the supply at the level which corresponds to a sustainable quantity of carbon emissions. Aside from this intervention, it lets the market set prices and doesn't regulate who uses the oil or what for.

Over time, people come to know what the supply of oil is going to be each day, and they know how much they use, so prices adjust to the level that balances supply and demand. Most people have a certain "stock" of oil - petrol in their car, oil in their heating tanks, or - for electricity generators - a reserve of oil to run their power stations for a certain number of days.

Suddenly there is a disruption to oil supply. Maybe terrorists start attacking oil pipelines and people start to get very worried about whether they will still be able to get petrol. Perhaps a couple of refineries break down and there's a global shortage of refining capacity. Maybe a couple of petrol tankers explode, and 80% of tankers are taken off the roads for a few months until they can be fitted with new safety equipment. What happens now?

The first thing is, people's demand to hold spare oil reserves will go up. They are aware of the supply risks, and the disruptions to the oil distribution system makes them worry that they won't be able to get petrol when they want it. So people start to hoard oil and petrol. Maybe there are knock-on effects - petrol stations can't get the petrol they need to sell, and some of them might become bankrupt. Probably, the price of petrol would soar. Electricity companies will, if they can, increase prices or reduce the amount of power generated so that they in turn can build up their inventories. Note that all this may happen even if the supply problem is more feared than real.

People try to buy extra petrol to build up a reserve, while still maintaining their normal lifestyle - but they can't, because there's only so much petrol to go around. So there are shortages at the pump - which of course receive national news coverage. The next day, everyone else shows up to fill their tanks - the gas stations run out within a few hours - and the problem gets worse and worse.

Everyone is trying to hoard petrol just in case the next person gets in and hoards it first. Of course oil prices might eventually stimulate new distribution channels or new sources of production, but it will take a while. In the meantime, the economy is seriously disrupted because everyone is forced to use less oil and petrol than they are used to, and the country will probably quickly enter a recession, with high unemployment, reduced GDP - and government deficits following automatically.

What should policymakers do (if anything)?

Even though the government still regards climate change as a serious risk (and let's say voters agree with this concern), there's a paradox: demand is up but petrol usage is down. All the extra demand is for reserves, not petrol usage.

I say the government should gradually release its reserves into the market. This will let people build up their stocks of oil and petrol to whatever level they are comfortable with, and usage will go back to normal. Once this happens, the government can stop releasing the reserves and a new equilibrium will be reached. Petrol stations will get back to roughly the level of sales they had before, electricity companies will get the reserves they need and start generating power at normal levels again.

The story is: a demand has arisen for people to hold more petrol stocks, but not to burn more petrol. The government is the regulator of petrol supply, and has a reserve, so it can open the taps and let people have the stocks they want, without causing any more carbon emissions. Then, if people's worries about supply reduce over time, they will run down the spare petrol stocks, and the government can restrict national supply a little more to balance this out and build up its reserves again.

To get the timing and the supply just right, the government will have to keep a close eye on petrol prices, but that isn't too difficult to do - the market signals are all available. Opening the reserves seems an obvious solution with no real downside.

Now you may have figured out where I'm going with this. In this story, replace "oil" and "petrol" with "money", "national oil reserve" with "central bank printing press" and "carbon emissions" with "inflation". Now we have the story of the financial crisis and the recession.

The government (via the central bank) in normal times deliberately restricts the supply of money to keep inflation under control (interest rates are just another way of doing this). They have a reserve - they can in fact print as much money as they want - but they choose not to use it, because that's their way of managing inflation and maintaining the value of their currency.

When the credit crunch happened in 2007-08 - a couple of banks went bust, so people naturally became concerned that the supply of money and loans was going to shrink. Everyone wanted to hang onto more money, just in case. Banks stopped lending to each other in order to keep more of their money in reserve - and because they were worried that the other banks couldn't repay them. People cut back on spending not because they didn't want as much stuff any more, but in order to keep some spare cash just in case they lost their jobs. And of course, these actions feed off each other - when the whole population cuts spending, people do lose their jobs. When all banks stop lending to each other, they don't end up with more money - they end up with less.

We have a situation where there is high demand for money - not because people want to spend more, but because they want to save more. To stop this from causing a recession, the central bank has to "open the taps" - by printing more money. Normally this would be the equivalent of cutting interest rates - but when interest rates get to zero, it needs to be done in other was.

This will not cause inflation if they only release just enough new money to let people increase their reserves to their new "safety level". And later, when people are reassured and don't need to hold as much spare cash any more, the central bank can reduce the money supply again and/or increase interest rates to soak up the money back into the reserve.

Just as with the oil reserve, there are different ways of doing this. The government could give out petrol directly to individual households. Or it could sell it to the oil companies (at market prices) and let them sell it on - this would probably result in it going more accurately to where it's needed, but the oil companies would make a profit too, so it might not be politically popular. No doubt you can see the parallel again - some people would like the central bank to just give money directly to citizens, but instead they normally do this by "selling" money to banks (by buying government bonds from the banks) and let the banks lend it out, again making a profit. This is a more economically sound way of getting the money to where it's needed, but the banks will make a profit on it - because distributing money is, after all, their business.

If the political situation calls for it, perhaps the government will impose a windfall tax on the oil companies/banks to compensate for the extra profits they are deemed to have made while helping to solve the problem.

It turns out the Federal Reserve, Bank of England and Bank of Japan have been doing just this throughout the last few years. While it hasn't resulted in those economies returning to full health, it has probably helped stop them going back into recession. Many economists think they just haven't released enough reserves, and should do a bit more; though there is also an argument that some of the economic slowdown would have happened anyway, while the economy rebalances away from housing and finance, towards other industries.

The one major central bank that has not done it is the European Central Bank. They have cut interest rates - though probably not enough - and loaned a bit of extra money to some of the banks to tide them over (imagine giving the petrol companies enough extra reserves to help them stock up their spare petrol tankers, but not enough to satisfy the demands of the population itself).

And now there's a new twist: imagine that eurozone governments themselves use a lot of oil (money), and now they can't get enough petrol (money) to fuel their own operations. With petrol (money) prices soaring, some of them have used up their internal reserves and may have to shut down some of their operations. This in turn would cause more problems for the economy, making things even worse for the citizens who are short of both oil (money) and the government support they partly rely on.

The ECB's job now is to open the reserves. An infusion of money into the Eurozone would help cure the capital problem that the private banks are suffering from, restoring economic growth and automatically improving the financial position of Eurozone governments. It would help prevent or soften the recession that is currently expected in Europe, making it more likely that Italy, Spain and Greece will be able to finance or refinance their debts, which in turn will let them borrow at more reasonable rates.

The ECB does not need to buy the bonds of those countries directly, if it is concerned about setting a bad precedent - just as the oil reserve would not need to be issued on credit to unstable petrol companies. Just increasing the supply to the good companies (good banks, creditworthy eurozone countries) will have a knock-on effect on the others.

Because the problem has been allowed to get this bad, there is now a risk that the money (petrol) will not get to where it is most needed. To help fix this, other steps might be needed. In the petrol scenario, the government might part-nationalise some of the weaker petrol companies, or subsidise investment in new pipelines to make sure the petrol gets to all parts of the country. In the Eurozone, some big capital investment programmes in southern Europe might be a better way to distribute money than simply giving it directly to the Italian, Portuguese or Greek governments. But these are less important than the emergency response.

It's time to open the taps - or as Doug Saunders put it the other day: Mr Draghi: TURN ON THAT PRINTING PRESS!


Rob H said...

Nice analogy though I think it breaks down a bit when you consider that people need to use a fairly capped amount of oil to cover heat and transport. But most people have an almost limitless capacity to spend money.

Ralph Musgrave said...

The idea that money supply increases do not necessarily cause inflation was set out by David Hume in his essay “Of Money” in 1752. See: See para starting “It is also evident…” here: http://socserv.mcmaster.ca/~econ/ugcm/3ll3/hume/money.txt

It would be nice if humanity’s understanding of economics had improved since then. Arguably it hasn’t.

Re the need to supply households with the money they feel comfortable with, that idea is pure Modern Monetary Theory (MMT). Leading advocates of MMT include:

Warren Mosler: http://moslereconomics.com/
Bill Mitchell: http://bilbo.economicoutlook.net/blog/
Rodger Mitchell: http://rodgermmitchell.wordpress.com/
Department of Economics, University of Missouri-Kansas City: http://neweconomicperspectives.blogspot.com/

I don’t agree with the following passage: “some people would like the central bank to just give money directly to citizens, but instead they normally do this by "selling" money to banks (by buying government bonds from the banks) and let the banks lend it out, again making a profit. This is a more economically sound way of getting the money to where it's needed….”

We have had a recession caused by excessive and irresponsible borrowing, and the authorities try to solve the problem by cutting interest rates and implementing QE so as to encourage more borrowing!!!!!!! They’re stark raving bonkers, aren’t they?

The solution advocated by MMT is not to “give” money to households, but to SPEND extra money into the economy (e.g. extra spending on health, education, etc) – and/or cut taxes.

Re the idea that Europe wide stimulus will solve Europe’s problems, the big problem there is that the level of stimulus that would get the periphery back to full employment would cause rampant inflation in the core. And Germans just won’t wear inflation: I don’t blame them.

Leigh Caldwell said...

Thanks for the comments.

Rob: yes, the analogy is imperfect. However, people's capacity to spend money is limited by their ability (and willingness) to earn it with their labour - just as with oil, which they buy with cash instead of time. But yes, this does make money a bit harder to manage macroeconomically than oil.

Ralph - good find of the Hume stuff. I am reading up on MMT and plan to write something on it at a later date. No doubt there is something to it, though I think some of its advocates harm its cause with the condescending attitude that if only "humanity's understanding of economics" would catch up with yours, then everyone would know the truth. It would be better to acknowledge that MMT is one theory, which could be an improvement on mainstream theory or which may not be right, and is not yet accepted by most economists.

I suspect that the validity of MMT depends on how meaningfully independent the government is from the central bank (by which I mean: how uncorrelated is fiscal policy with monetary policy). In the very long run, that independence is probably vestigial, but in the short run the independence is clear. And the short run is what recessions are all about.

You say: "We have had a recession caused by excessive and irresponsible borrowing, and the authorities try to solve the problem by cutting interest rates and implementing QE so as to encourage more borrowing". I'd argue that the recession was caused not directly by borrowing itself, but by a sudden collapse in borrowing to which the economy couldn't immediately adjust. Thus QE is indeed intended to increase borrowing - or at least to cushion its decline - so that the economy has time to adjust.

MichaelB said...

Your analogy shows a far better appreciation of the situation at hand than I've found elsewhere. In 40 year's of amateur observation of central banker's seeming penchant for manipulation of governments and economies, I have gone from disdain to appreciation for the function of a good central banking system. Primarily for the more rapid advancement allowed by the disciplined use of credit. The present situation is due to un-checked promotion of UN-disiplined use of credit. As an employer, I have learned that good behavior is best promulgated by frequent accolades, and poor behavior is best handled with gentle, tactful reminders of the benefits of good behavior. The challenge is to provide a mechanism for this on a societal level. Personally, even good schooling did not adequately correct poor examples of financial management at home. . . . Your mission, Mr. Phelps, should you choose . . .