Sunday, November 20, 2011

Post Apocalyptic Nominalism

Karl Smith takes issue with my argument that the monetary authority should solely focus on keeping nominal expenditure on target, and should not serve as "lender of last resort" to the government or the banks. Smith believes that the consequence of this approach will be "Post-Apocalyptic Nominalism." Apparently, a few will become vastly wealthy because they will be able to borrow at negative nominal interest rates.

I don't consider this likely. (I hope it is a joke.)

Smith accepts a scenario where a policy aimed at 4 percent nominal GDP growth creates expectations such that all European governments can "self-finance," and the euro-zone economy rapidly recovers.

It seems that the key element of this favorable scenario is that none of the PIGS default. The apocalyptic scenarios both include actual defaults. In one scenario, nominal expenditure is expected to grow on target, but default occurs anyway. The other occurs when nominal expenditure is not expected to grow on target, and default occurs.

Why does government default lead to such a disaster? In my view, the effect is that those governments that lose confidence of creditors default, reduce government spending to current tax revenues, make minimal payments on interest and principal, and presumably reduce the provision of government services. Not exactly pleasant, but hardly apocalyptic.

So why the disaster? Smith assumes the banking system "collapses." Why? Presumably, it is because all the banks in Europe hold the debt of the PIGS. If any of the governments default, then the banks become insolvent. The ECB, then, is supposed to commit to lending to the PIGS so that they will be able to repay banks. And that means that the banks remain solvent. Otherwise, the banks collapse and then it is the apocalypse.

I suppose in Smith's world, when the banks are insolvent they are closed and liquidated, and the depositors receive some partial payment. And then there is a world without banks. Presumably, everyone uses hand-to-hand currency to make all payments. And the ECB creates money solely by purchasing bonds from people they consider solvent. There being so few such people, in order to get them to issue and sell enough bonds, the nominal interest rate is negative.

My view is that permanently closing and liquidating all banks is a very bad idea. If there are many small banks and a few of them are insolvent, closing and liquidating those banks is a reasonable approach. However, when a substantial portion of the banking system is insolvent, reorganizing and reopening those banks is important. If all banks are insolvent, rapid reorganization and reopening is essential.

The simplest approach is that the banks close on Friday, and Monday morning they open again and all of the depositors have substantially lower deposits and shares of stock in the reorganized bank. The banks open and then carry on operations as usual.

If the governments of France or Germany instead want to bail out their banks, then they can purchase the bonds of the governments that default. If, on the other hand, they want to only bail out the depositors in their banks, they can do the same, but reorganize the banks--sell stock to new owners. If they want to solely avoid runs, and bail out all the short term depositors, then they can again do the same, reorganize the banks, and impose haircuts on long term creditors too.

But who exactly is bailed out and how should be the determination of the fiscally sound governments. The ECB should focus on expanding the quantity of money, currency if necessary, enough to meet the demand to hold currency with nominal GDP growing on target. It should not be the responsibility of the monetary authority to lend money to governments so that they can pay off their debts to banks. Nor should it be the responsibility of the monetary authority to lend money to insolvent banks so that they can pay off their depositors.


  1. Bill, excellent comment. I completely agree that the job of the ECB is not to be "lender-of-last-resort" for governments. The job of the central bank should be to ensure that NGDP hits a given target. In general many have a hard time differentiating between bailing out certain governments, banks and institutions through "easy money" and then monetary easing that is needed to bring back NGDP to the pre-crisis target level.

    With a rigid NGDP level target both governments and banks can easily be allowed to fail and contagion effects are likely to be quite limited. Unfortunately we didn't system out with a NGDP targeting ECB so it might be politically complicated to come the the "right" set-up from the present situation.

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