From the Economist – good video on government bonds and debt through the ages with some great graphics.
It asks the question is government debt a concern today? They state that as long as a country’s GDP is growing faster than the country’s debt accumulating in interest then it grow its way out of debt with no fiscal cost. It also questions why interest rates today are low? Central banks such as the RBNZ and the US Federal Reserve set the interest rates and will keep them low until the economy starts some sort of recovery. They are able to do this as there is little to no inflationary pressure in the economy – remember most central banks have an inflationary target. This does mean that savers lose out as the return they get is very low. Furthermore implementing a programme of quantitative easing floods the market with cash which in turn leads to a lower cost of borrowing.
Part of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College in London. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted. Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.
Central banks have found that inflation has been the pest it has been in the past – most countries inflation rates have been short of its target rate. After the GFC the level of unemployment rose and inflation was quite subdues. However, with the post GFC recovery unemployment began to fall whilst the inflation rate was still showing no signs of accelerating which went against the original Phillips Curve. A further problem was that imported goods and services in one country have little relevance on the wages in another and the low levels of unemployment tempted people back into the labour force who hadn’t been counted as unemployed. This is particularly the case in Japan.
When there is an increase in job numbers, with a boom period, inflation may also be slow to rise. Although firms tend to be reluctant to lower wages when the economic climate slows as it is harmful to staff morale. The same could be said in good times as wages tend not to rise that quickly.
For many businesses changing the price of their goods or services can be costly especially for a small increase in price. Therefore the change in the business cycle tends not to be reflected in price changes as there needs to be major swings before prices will move at all. Central bank policy tends to manipulate interest rates to maintain a stable inflation causing unemployment to move up or down – unemployment is what changes not inflation.
The problem that central banks face today is that to keep the phillips curve flat they need to be able to cut interest rates to stimulate growth when inflation threatens to become deflation. However there is little room for further easing with rates so low. Central banks will need to work with the government’s fiscal policy to stimulate growth and spend the money that the central bank’s create.
Physicists and mathematicians have puzzled over the three-body problem – the question of how three objects orbit one another according to Newton’s laws. No single equation can predict how three bodies will move in relation to one another and whether their orbits will repeat or devolve into chaos.
John Mauldin of Mauldin Economics wrote about the eight-body problem in economics in which we cannot predict how the economy will react when eight variables change. He lists the following:
What is certain is that as government fiscal intervention starts to lose its effectiveness it will be inevitable that monetary policy will continue to remain very accommodating with bond buybacks and record low interest rates. COVID-19 has turned conventional economic thinking upside down.
I have blogged on this area before but thought it useful with the current discussion around macroeconomic policy. How does Modern Monetary Theory differ from more mainstream monetary policy – see table below.
The Economist ‘Briefing’ recently looked at what now for macroeconomic policy in the global economy. The GFC of 2008 and outbreak of COVID-19 has got policymakers scratching their head as what can be done to stimulate aggregate demand.
Keynes’ ideas of government involvement in managing the economy in the business cycle – spend in recessions and pay of debt in booms – was flavour of the month in the post-war period. However by the1970’s this policy was in trouble which the spectre of stagflation – high inflation accompanied by high unemployment. According to Keynes the two variables should move in opposite directions. In 1976 the UK Prime Minister James Callaghan in his speech at the Labour Party Conference said:
We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment.
The 1980’s saw monetarist ideas enter the scene with a focus on the control of inflation though constraining the money supply. University of Chicago economist Milton Friedman and US Federal Reserve Chairman Paul Volcker knew that in order the get inflation down that the economy would have to go through a recession and very higher unemployment in the short-run. However once inflation started to drop the Central Bank could relax monetary policy (interest rates) and then encourage more economic activity in the economy and thereby reducing unemployment. Previously policy had focused on equality of incomes which had a large impact of economic efficiency. Price stability was now the primary focus of a central bank and it was in New Zealand with the 1989 Reserve Bank Act that the first central bank became independent from government. Gone were the days where the Minister of Finance could get on the phone to the Reserve Bank Governor to change interest rates. Central banks had inflationary targets whilst fiscal policy was to keep government debts low and to redistribute income as the government saw fit.
This policy came unstuck after the GFC as central banks dropped interest rates to record levels and implemented a series of quantitative easing (QE) measures to no avail. Growth was stagnant for a long time but eventually demand for labour picked up. This would have normally been accompanied by higher inflation but it wasn’t the case. Just like in the 1970’s inflation and unemployment were not behaving according to the theory but at this time both were favourable – low inflation and low unemployment. However inequality was now gripping the attention of economists and there was concern about the monopoly position of some firms. The rich have a higher tendency to save rather than spend, so if their share of income rises then overall saving goes up and lower interest rates and QE were driving up inequality by increasing house and equity prices.
Once COVID-19 hit it was government’s fiscal policy which has been used to try and stabilise the economy and boost growth. Fiscal stimulus – government spending with running up large deficits might be required for a long period of time in order to support the economy. This is more acceptable amongst economists as low interest rates enable the government to service much larger debts and with such low inflation it is unlikely that rates will increase anytime soon. This resembles Modern Monetary Theory (MMT) – the situation where the government can create its own money therefore:
Cannot default on debt denominated in its own currency;
Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
Does not need to compete with the private sector for scarce savings by issuing bonds. Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.
Negative interest rates
Some governments have gone the way of negative interest rates (see graphic) to try and stimulate more aggregate demand. This would discourage saving and see a potential withdrawal of cash from the banking system leaving less money to lend out. Avoiding this scenario might involve abolishing high-denomination bank notes and making the holding of large amount of cash expensive and unfeasible. However in order to keep money in the banks might renege on interest rate cuts as customers might move their money to rival banks therefore high negative interest rates would severely dent banks’ profits.
The current economic environment may make negative interest more plausible as:
Cash is in decline.
Banks are becoming less important to finance.
Central bankers are looking at creating their own digital currencies
Greater government intervention is what the majority of economists want but it does carry with it risks of significant debt and high inflation. There is an opportunity to rethink the economics discipline and as stated in The Economist:
A level-headed reassessment of public debt could lead to the green public investment necessary to fight climate change. And governments could unleash a new era of finance, involving more innovation, cheaper financial intermediation and, perhaps, a monetary policy that is not constrained by the presence of physical cash. What is clear is that the old economic paradigm is looking tired. One way or another, change is coming
Sources: The Economist – A new era of economics – July 25th 2020 http://www.britishpoliticalspeech.org/speech-archive.htm?speech=174
Another very good video from Tom Chitty at CNBC. He explains how negative interest rates in theory are supposed to work but also looks at some of the problems that might eventuate. Very good for macro policy Unit 5 CIE and NCEA Level 2 and 3.
I have blogged before about Modern Monetary Theory. Basically it says that you can print your own currency by having your own central bank, run large deficits, have full employment, have no inflationary pressure and do this year after year. However while large deficits and monetary stimulus make some sense during a short deflationary economic contraction, sustaining those policies for years, will lead to inflation and economic stagnation – stagflation. The video below is from BBC Reel where Stephanie Kelton, author of The Deficit Myth, argues that we need to rethink our attitudes towards government spending. Worth a look – great graphics.
Central bankers around the world have been toying with the idea of going into negative territory with interest rates. The economic indicators influencing their decision tend to focus on the inflation rate and the amount of spare capacity – output gaps. Some research has suggested that interest rates needed to go as low as -6.5% (UK in 2013) and -3% ( USA in 2014) to stimulate growth.
Negative interest rates does encourage people to take money out of their bank accounts and store in safe deposit boxes or under the mattress, the latter being vulnerable to theft. This makes the process of buying goods/services difficult – do you carry a lot of cash as electronic transfer is no longer used? Additionally online transactions would disappear with people holding cash. According to The Economist central bankers face three important questions.
The technical feasibility – rates could be pushed lower by getting rid of high-denomination banknotes and impose fees on large transfers might raise the cost of hoarding cash by enough to allow rates to be cut further.
Hurting growth – negative interest rates can weaken demand rather than boosting it. As commercial banks have to keep reserves at the central bank negative interest rates means that they are losing money. However the commercial banks may not want to pass these costs onto customers so their profits are squeezed. This is especially a concern for less profitable banks that may limit their lending and ultimately investment and growth.
Is it worth it? Is the easing of interest rates into negative territory enough to make the difference between a strong recovery or a weak one. Also will people still borrow when rates are negative. Even with the low rates today borrowing levels are not significant and even if rates went negative would it make any difference? Consumers are worried about taking on debt with job security a concern therefore borrowing is not a top priority.
In order to kick start the economy there needs to be more fiscal expansion. Giving people money with a wage subsidy or just crediting their bank accounts would be more effective in achieving more economic activity.
Source: The Economist – Should the Fed cut rates below zero? 23rd May 2020
Just covering macro policies / conflicts with my A2 Economics class and produced this mind map in OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4.
My question would be what policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives?
Below is a useful graph from the ANZ Quarterly Economic Outlook – full publication here. It covers Aggregate Demand in the New Zealand economy and the relative importance of each of the four components AD = C+I+G+(X-M).
C = Private Consumption I = Business Investment G = Government Consumption (X-M) = Net Exports
Notice how consumption and investment become negative during the Covid-19 pandemic – over 15% of GDP in the first quarter of 2021. However it could be expected that net exports will start to bring in much needed growth in the economy – New Zealand is lucky to be a producer of food an inelastic product meaning the demand remains quite stable. With weak domestic demand there is no such need for imported capital goods as business investment starts to dry up. With net exports, Government spending also will be a significant part of a recovery and to offset the deficit in consumption (C) and investment (I).
Income from the tourism industry will be limited in New Zealand as the country closes its borders although domestic demand could offset some of this loss. But with a loss of income and job insecurity this spending might not be forthcoming.
The recovery will require a massive stimulus – monetary and stimulus. For the RBNZ negative interest rates might be considered as a policy option especially with a depressed labour market and the threat of deflation. As the ANZ point out in their publication there are plenty of long-term challenges ahead. But New Zealand is resilient, and has come into this crisis with a lot of advantages:
We have been in a position to respond to the outbreak quickly;
We produce a lot of essential goods domestically and our exports are still in demand;
We have a well-functioning health system and government;
We have plenty of fiscal firepower to respond;
The financial system is resilient; and
The exchange rate and monetary policy can provide a buffer.