Macroeconomic Policy in Europe, USA and Japan: A New Paradigm

Facts revealed in recent months, including in these columns, suggest that a substantial change in macroeconomic policy settings is required to save many economies from further man-made disasters:

  • The IMF analysis (Blanchard and Leigh, 2013) showing multipliers have been underestimated.
  • The De Grauwe and Ji analysis (2013) showing high levels of austerity increase public debt and cause slower growth/recession/depression.
  • The latest analysis questioning the conventional interpretation of the Rogoff and Reinhart causality, and suggesting that slower growth/recessions/depression could increase public debt rather than the reverse.
  • The increased widespread questioning of the further quantitative easing undertaken in the United States and, in particular, in Japan.

Fiscal austerity in Europe, and quantitative easing, are on an unprecedented scale.  There will be substantial adverse consequences of these actions for the global economy.

Fiscal Austerity

The emerging facts are telling.  The German austerity philosophy, imposed on already weakened periphery economies, is totally misplaced on the basis of the latest facts.  Continued austerity will further damage the periphery economies and the United Kingdom.  It is not a matter of ‘toning down’ austerity.  With policy interest rates near zero bounds, there is an urgent need to provide fiscal stimulus to reflate these economies.

Lance Roberts (‘It’s A Bit Early To Declare A Winner In The Economic Debate’, EconoMonitor, April 25) argues that deficit spending is highly destructive to economic growth.  He and many others assume that running budget deficits necessarily means that public debt increases.  This represents a misunderstanding of policy possibilities.  Whether or not public debt increases depends on how the budget deficit is financed.  If the budget deficit is financed by issuing new government bonds then, yes, obviously, public debt rises.  But budget deficits could be financed by new money creation, in which case public debt need not increase at all.

Further Quantitative Easing

In a 1999 article (‘Japanese Monetary Policy: A Case of Self-Induced Paralysis’) Ben Bernanke argues that money issuance must ultimately raise the price level if, for example, the monetary authority could ‘acquire infinite quantities of goods and assets’.

However, later in the same article Bernanke argues that nonstandard open-market operations (read as ‘quantitative easing’) would raise asset prices.  No mention here of goods prices.

Consequently, we now have the United States and Japan hell bent on raising asset prices.  At the same time, new money creation (a precious resource) is occurring on an unprecedented scale.  Commercial bank reserves, asset prices, commodity prices, stock market prices, house prices, bond prices and the exchange rates of foreign countries will now rise on an unprecedented scale if this policy is continued.  The winners will be the banks, the investors, the speculators, the traders and the hedge funds, all with a low marginal propensity to consume goods and services.

The prices of goods in the real economy will be hardly affected, or be affected very indirectly.  Inflation, as measured by consumer price indexes, will hardly be impacted.  No wonder measured consumer price inflation in the United States is falling after years of quantitative easing.  What a waste of such a precious resource?  What a way to conduct monetary policy?  What, in heaven’s name, is the value in dishing-out even more new money to investors, banks, hedge funds, speculators and traders?  Why distort the yield curve even more?  Why distort risk allocation throughout the economy in the process?  Why deprive retirees, insurance companies and superannuation funds the interest income from holding safe assets? Why require investors to take on riskier assets? Why support unviable business with a distorted interest rate structure? Why would the Japanese authorities pursue a monetary expansion policy on an unprecedented scale, one that is unlikely to significantly increase goods and services price inflation?  And, with central bank balance sheets distorted, and with investments, production and savings misallocated, how will it all be unwound in a controlled manner?

The Way Forward

If the facts and the economic logic are correct in identifying austerity and further quantitative easing as unsound policies, what are the monetary and fiscal policies that are relevant to today’s crisis?

In many affected counties there are two fundamental macroeconomic problems: deficient aggregate demand and excessive public debt.  The objective of macroeconomic policy should be to raise aggregate demand without increasing public debt or creating excessive inflation.  This can be achieved if the new money creation is not used (as at present) to finance banks, speculators and investors, but is instead directed to provide increased financial resources to public infrastructure, households and to the unemployed and disadvantaged so that they can increase domestic demand.  This is the policy that Bernanke recommended to Japan in 2002 (Remarks before The National Economists Club).  That policy is even more relevant today (see R. Wood, How to Solve the European Economic Crisis: Challenging Orthodoxy and Creating New Policy Paradigms, Amazon Books, published 19 December 2012) given the high levels of public debt which are set to go higher as a consequence of the forecast higher-than-expected budget deficits.

Rather than monetary and fiscal policy being determined in separate silos, the coordinated monetary/fiscal policy combination of new monetary creation to finance public spending is certain to raise consumer spending without increasing public debt.  This policy combination is the most powerful fiscal and monetary policy combination that is available to address current excessive debt and inadequate demand difficulties.

If liquidity becomes excessive under this policy at some future point in time when resources ultimately become fully utilised then the increased money supply can be sterilised.  The sole purpose of the new money creation is to create the first round of stimulus: beyond that point the multiplier/accelerator process can be relied upon spread the recovery process throughout the economy provided there is sufficient liquidity.

The above policy recommendation is valid whether countries stay within the Eurozone or not.  If the Eurozone is disbanded these policies will still remain necessary to create a safe economic recovery.

Richard has published papers on wages policy, the taxation of financial arrangements and macroeconomic issues in Pacific Island countries. Views expressed in these articles are his own and may not be shared by his employing agency.

3 Responses to "Macroeconomic Policy in Europe, USA and Japan: A New Paradigm"

  1. Dr. Hergen Heinemann   April 27, 2013 at 4:28 am

    Sounds logical and convincing. But do some examples exist that sterilizing in case of a start of inflation in a democracy with parties scrambling for reelection does really happen? Who should be in command to make this really happen? I guess, not hte government and not the parliament?

    • richard wood   April 28, 2013 at 5:04 pm

      Sir, Thanks. Whether central banks are independent or not, authority to use monetary policy to keep inflation low could be yielded to the central bank. My concern about total independence is that there is not sufficient coordination between monetary and fiscal policy. The effectiveness of overall macroeconomic policy can be increased by more closely coordinating and integrating the two arms of policy to a common purpose. Currently central banks focus exclusively on achieving the lowest possible interest rates by buying bonds and other assets with new money, while government's determine the size of the deficit and then issue more new bonds to finance the deficit. New bonds mean higher public debt. The authorities should instead coordinate and issue the new money to finance the deficit directly: there would be no need to increase public debt. Currently new money is directed to banks, investors and speculators – they benefit: it doesn't get into the real economy -, but that new money could better be more productively directed to the poor people, the unemployed and to public infrasructure. My article is a private contribution to the debate, and views expressed may not be shared by my employer.