On quantitative easing, fiscal policy, and Abenomics

I was just re-reading Richard Werner’s initial quantitative easing scheme for Japan from 1995. What he says is relevant to today’s situation in Europe and the United States as well as for today’s Japan. I want to highlight a few lines within his brief note and expand on these where they don’t make sense.

You may know that Werner, a German economist who was working in Asia as the head of economics at Jardine Fleming Securities in the 1990s is the man who invented the term quantitative easing. His idea was that the central bank and the government would borrow money directly from Japanese commercial banks and that it could purchase private sector assets in order to boost total purchasing power in the economy. His contention is that supply side government intervention would be most effective if it was not just limited to interest rate policy but was much more aggressive. Only by taking these aggressive measure, he argued, could Japan escape its debt deflation.

Werner is an economist at the University of Southampton in the UK now and his ideas on banking, money and credit have developed considerably since the 1990s as evidenced by a 2012 paper that he wrote (pdf link here). Nonetheless, I want to concentrate on the 1995 piece because I believe there are some major flaws in the thinking about the economy in it which go to the heart of the flaws with monetarist-style solutions like quantitative easing.

Here’s what Werner wrote:

“It would take a very long time for the private sector on its own to escape from this downward deflationary spiral, and therefore government intervention is indispensable. But whether the policies adopted by the government are beneficial or not depends on whether they increase the purchasing power in the entire economy. This most crucial point must be made clear, otherwise government policies aimed at boosting the economy will not prove helpful, and Keynesian fiscal policies will achieve nothing.

Pure fiscal policy withdraws money from the private sector, as it is funded either through bond issuance or via increased taxes. Pure fiscal policy does not increase overall purchasing power, but merely transfers existing purchasing power from one part of the economy to another. This is the reason why the large fiscal stimulation packages over the past two years have failed to stimulate the economy significantly. the same reason, the BoJ’s policies, which have focused on interest rates, have not produced sufficient results.

Due to deflation, real interest rates will rise. Simply reducing nominal interest rates will be ineffective. Even serial reductions in the official discount rate will not be able to stimulate the economy.

In such a situation the single most vital policy is for the government to act and focus on increasing total purchasing power in the economy. Put simply, the central bank can print money and purchase assets in the markets from participants beyond the banking system. It can intervene in the foreign exchange markets, without sterilising the monetary expansion. In these ways the central bank can inject new purchasing power in the economy. If this were done, then the overall amount of purchasing power in the economy would increase and commercial transactions throughout business would be revived. If such policies were taken, within 6 months we could see a marked improvement in business conditions.

[…]

The BoJ’s past tight monetary policies have become the target of criticism, but it can also be said that its policies have started a historic structural transformation. At this stage, where Japan’s structural reform has reached a cross-roads, it is precisely by now changing to a policy focused on quantitative easing that the Bank of Japan can redeem its prior tight monetary policy stance.” [emphasis in original]

The most important problem with this framing is right at the beginning where Werner says in bold that without quantitative easing “Keynesian fiscal policies will achieve nothing” because “pure fiscal policy withdraws money from the private sector, as it is funded either through bond issuance or via increased taxes. Pure fiscal policy does not increase overall purchasing power.”

Absolute rubbish – this is simply not true.

As I have explained in the past, the main distinction between fiscal policy and monetary policy is that fiscal policy – no matter how it is ‘funded’ – results in additions and subtractions from private sector net financial assets but monetary policy does not.

Monetary policy either adjusts interest rates or promotes asset swaps of central bank reserves for privately held assets. In monetary policy, there is no addition of net financial assets to the private sector – ever. Monetary policy is usually about adjusting interest rates. Before this crisis and the zero rates it engendered, the policy interest rate was a central bank’s primary policy tool. But even if the central bank buys any asset in the private sector, it must pay with reserves it created. The central bank is not confiscating assets or conducting pure helicopter drops of money. If it could do so, that would be fscal policy because it would be adding net financial assets to the private sector. But that is not what it does.

Fiscal policy is inherently about adding to or subtracting from financial assets on net in the private sector because when the government spends money in the private sector it creates a transfer of assets to the private sector. For example, if the government contracts a company to repair a highway, when it pays the contractor, the private sector’s net financial assets increase by the amount of the payment. If the government taxes that same contractor, the private sector’s net financial assets decrease by the amount of the tax. So pure fiscal policy either adds to or subtracts from money in the private sector.

Moreover, it is clear that Werner is implying that there is a long-run government solvency constraint which mandates it to meet all spending with an offsetting tax. And even under this scenario, government spending is long-term net asset neutral for the private sector. It isn’t withdrawing money from the private sector. But the concept that fiscal policy must be funded through bond issuance or via increased taxes is inherently bogus in a fiat currency regime. Governments fund themselves by simply making credits to bank accounts. The US government issues bonds because it has legally mandated itself to do so as a curb in order to prevent it from over-spending. The bond issuance and the tax payments are separate activities from the spending as clearly evidenced by the deficits that governments have been running. Bond issuance isn’t ‘funding’ spending because the government is paying in money it creates.

So the whole setup here is wrong right from the outset.

Furthermore, what Werner proposes is “the central bank can print money and purchase assets in the markets from participants beyond the banking system. It can intervene in the foreign exchange markets, without sterilising the monetary expansion”. How does that increase purchasing power? If the central bank buys assets from me at a fair market rate and gives me money (that it has just printed) how has purchasing power increased at all? It hasn’t unless the central bank has bought the assets from me at an inflated price as the Fed did during its first round of quantitative easing. The only way that the private sector can gain from this exercise is if the Fed buys assets at inflated prices in lieu of Treasury bonds and the differential in income to the Fed accrues positively to the private sector. But this is just a socialization of losses.

At heart, Werner’s QE proposal only works if the goal of the central bank is to purchase assets at inflated prices and socialize the losses by earning less interest income on its balance sheet.

In reality, QE needs a fiscal and structural component to work as we see with Abenomics. The problem is private debt – and not just the servicing capacity of the debt but the actual levels of debt relative to the size of the economy. When interest rates fall to their lowest levels, an economy’s private sector debt level can only go so high before that debt is unserviceable out of the income private assets throw off. At that point, mass defaults are a certainty. To solve this problem, you need to either write down the debt, increase the income of the debtors specifically or increase the nominal rate of growth of the economy as a whole.  

While the economy gets over the hump until private debt levels are brought down, deficit spending will increase and socialize some of the losses from the debt, credit will be written down and the private sector will undergo a major industrial reorganization, and the central bank will print money to maintain interest rates at low levels to minimize debt service costs. That’s what QE, so-called Keynesian fiscal policies and Abenomics should be about. If you leave out any of those components, you have a problem and the private debt level remains unsustainable.

At heart, this is a private debt problem. The debt levels cannot be supported by the income that the private assets supporting the debt throw off. Private debtors need to reduce those levels by hook or by crook. And to the degree government can help, it is only by helping to reduce that debt and to increase private income and wages in a sustainable way. QE alone is insufficient.