Sunday, December 30, 2012

Fiscal Policy 2

In my view, monetary policy should be aimed solely at stabilizing spending on output--a slow, steady growth path for nominal GDP.

Generally, a take a "Virginia School" approach to public finance.  I think that "fiscal policy" should be aimed at the appropriate provision of public goods.   Voters should have a good idea of the taxes they must pay, signaling the private goods that must be sacrificed to produce the public goods.   Each voter can then consider the benefit of the public goods to be produced versus the private good that must be sacrificed.

However, "fiscal policy" could be used to manipulate interest rates.

To see this, consider an alternative monetary regime.  It has no hand-to-hand currency, with all payments made by checkable deposit.   Base money is also solely made up of deposit accounts,  which banks use to clear checks.  

Banking is competitive, so those holding money earn interest on their deposit accounts.   The monetary authority also pays interest on the deposits that serve as reserve balances. 

Monetary policy occurs through open market operations with Treasury bills.   The monetary authority pays an interest rate on reserve balances less than it earns on the Treasury bills it holds as earning assets.   The monetary authority's target is a growth path for nominal GDP.

After households and firms reflect a bit on the old saying, "neither a borrower or lender be," a massive deleveraging occurs.   Not only do firms refrain from selling new debt to finance capital goods, they use current revenues to pay down debt rather than buy capital goods.   At the same time, households refrain from obtaining new consumer loans and use current income to pay down existing consumer debt.

The decrease in spending on capital goods by firms and decrease in spending on consumer goods by households would tend to push nominal GDP below target.   Another way to describe the situation is that investment demand decreases and saving supply increases.    The natural interest rate is lower.   If market interest rates adjust with the natural interest rate, the quantity of saving supplied and quantity of investment demanded will adjust enough to prevent or reverse the decease in spending on output, so that nominal GDP would either remain on target or  promptly return to target.

How might interest rates adjust?

As households and firms pay down debt and refrain from obtaining new loans, a single bank would have excess funds to lend.   This would be reinforced because as a bank's deposit customers receive net repayment of loans, they would be depositing more funds.

Any individual bank can accumulate reserve balances with the monetary authority.  But since the interest rate paid on those balances is lower than what can be earned on T-bills, purchasing T-bills would be a more profitable use of funds..   Meanwhile, any households or firm receiving net loan repayments could simply hold money--balances in a checkable deposit--but purchasing T-bills is likely to be a better option for them as well.   And so, consideration of the impact of the deleveraging suggests that Treasury bill yields would be driven down.  

Now, if  we assume for a moment  that the monetary authority keeps the interest rate it pays on reserve balances unchanged, then these lower T-bill yields reduces the opportunity cost of holding reserve balances, so that the demand for reserve balances rise.   Banks would be motivated to accumulate "excess" reserves.  (This monetary regime has no reserve requirements.)

Similarly, if we assume for a moment that banks keep the interest rates paid on checkable deposits unchanged, then the lower T-bill yields reduces the opportunity cost of holding money.  This would result in an increase in the demand to hold money. 

 If all banks seek to accumulate reserves, the actual impact is a decrease in the quantity of checkable deposits--the quantity of money under this regime.   And if people choose to hold more funds in checkable deposits, this is an increase in the demand to hold money.   The resulting shortage of money would cause a decrease in spending on output, pushing nominal GDP below target.

However, with this regime, the monetary authority drops the interest rate it pays on reserve balances in proportion to the decrease in T-bill yields.   Assuming banks hold T-bills, the lower interest received on their earning assets would cause them to lower the interest rates they are willing to pay on checkable deposits as well.   Considering the scenario more broadly, the reduced credit demand faced by banks would lead them to lower all of the interest rates they charge for loans, and the resulting industry-wide decrease in the interest rates received on earning assets would lead competitive banks to lower the interest rates they pay on checkable deposits as well.

By simply removing the assumption that the monetary authority keeps the interest rate paid on reserve balances fixed (perhaps at zero) and the interest rates banks pay on deposits is fixed as well, the impact of the deleveraging has no obvious effect on either the quantity of money or the demand to hold money.   From a monetary disequilibrium perspective, there is no tendency for spending on output to fall.  Nominal GDP should remain on target.

From a Wicksellian framing, the lower interest rates, including the ones that banks charge and pay, decrease the quantity of saving supplied and increase the quantity of investment demanded.    This is an increase in spending on consumer good and an increase in spending on capital goods, so that total spending on output remains unchanged and nominal GDP remains on target.  

It is certainly possible that interest rates on checkable deposits, Treasury bills, and assorted bank loans would remain above zero.    However, it is also possible that some or all of these nominal interest rates would fall below zero.

Consider the following scenario:   checkable deposits have a negative interest rate--people holding money must pay to hold those balances.   The interest rate the monetary authority pays on reserve balances is also below zero.  Banks pay to hold funds in reserve balances.   The interest rate on T-bills is below zero.   People holding T-bills pay to lend to the government.   The government borrows at a negative interest rate.   However, the interest rates banks charge for loans remain slightly above zero.    

The negative interest rate on checkable deposits deters those receiving net repayment of loans from simply holding increased money balances.   They receive a signal and are given incentive to reduce their saving, or dissave out of accumulated wealth, spending on consumer goods.  Presumably, purchases of consumer durables would be sensible.   Similarly, firms that are earning profits would be deterred from accumulating revenues (and profit) in the form of checkable deposits and instead spend on capital goods.

Returning to the scenario of deleveraging, it is true that some of those who wanted to pay down debt may reverse, or at least postpone, their efforts.   And some of those who were refraining from borrowing might respond to the lower interest rates by borrowing more.   In aggregate, the deleveraging might stop, or at least be dampened and slow down.

Suppose that retirees had saved during their working years planning to spend their asset income and gradually dissave to fund consumption later in life.   While they may have accumulated stocks and long term bonds during their working years, when they retired, they sold those off and instead purchased T-bills and various types of bank deposits.  They wanted to avoid risk of capital loss when they dissave by selling off securities.  Now that they are retired, they spend all of the income they earn on their T-bills and bank deposits.  As the T-bills and bank deposits mature, they only reinvest part of the funds and consume the rest.

The massive deleveraging reduces their interest income to below zero and requires that these retirees dissave more than planned.   The most likely scenario is that their consumption falls now and is expected fall by more in the future.    The least bad solution of an individual would be to purchase longer term bonds to obtain more yield.   Of course, with the plan to gradually dissave, this results in risk of capital loss.   A market solution would be to purchase an annuity.  The insurance company can then bear the interest rate risk directly.

But there is an alternative.   Fiscal policy!

The government can cut taxes and instead fund government expenditure by the sale of T-bills.  Or, it could introduce new spending programs and fund them by the sale of T-bills.   Or, it could do both.  

The retirees are earning "too little" on their T-bills, so the solution is for the government to sell more, increasing the yield.   The retirees are earning "too little" on their short term borrowing, so the solution is for the government to borrow more.  

Framing this in terms of saving supply and investment demand, when the government runs a budget deficit, this is a decrease in national saving, which raises the natural interest rate.   An increase in the natural interest rate increases interest income for creditors.  If the level of interest rates needed to coordinate saving and investment is considered "too low" for any reason, the government can intervene by running deficits and reducing national saving.  

My own view is that the proper level of interest rates is the one that coordinates saving and investment, and so, I would oppose using "fiscal policy" to manipulate interest rates.   Still, consider a monetary authority that frames its activity in terms of manipulating interest rates.    Would such a central bank be inclined to insist that it needs the aid of fiscal policy to keep spending on target when really what it needs is fiscal policy to change the interest rate where saving equals investment to what it considers an acceptable level?


  1. Nice blogging.

    In general, I concur that monetary policy is the right tool for stimulating or keeping economic growth on path.

    Government outlays should the the smallest possible, for those things we know government should do, roads, police etc.

    That said, and pondering the Europe situation, I have concluded there is another role for fiscal policy---mini, intranational regional stabilization.

    Okay, what does that mean? Let's look at Europe, and its "one size fits all monetary policy." It doesn't work. Greece needs to print money to the moon. But it can't. (Yes, Greece needs to balance its budget too).

    If you like Europe, how about a global monetary authority? But we know what would happen: It would be too tight for some regions and too loose for others.

    Back to the USA. Some regions are booming---North Dakota---and do not need stimulus. Others are dying on the vine. We have a "one size fits all" monetary policy, though.

    Okay, so we can use the federal budget to spend in depressed areas to make a proper monetary policy more bearable for those depressed areas.

    Of course, this would never work in real life. Oddly enough, what the federal budget does every year is heavily subsidize rural areas, one of the secrets of the budget. States like North Dakota are probably getting north of $6k per capita in excess federal spending over receipts.

    But, in theory, using fiscal outlays to make a national "one size fits all" monetary policy work more humanely is a nice idea.

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