resilience, not stability

The Greenspan Fed’s Biggest Mistake: The LTCM Rate Cuts

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The debate as to whether the Greenspan Fed’s easy money policies are to blame for the 2008 financial crisis tends to focus on the Fed’s actions after the bursting of the dot-com bubble in 2001. Some (like Stanley Druckenmiller) argue that the Fed should have allowed a recession and a “cleanup” while others such as Paul Krugman argue that it is ludicrous to tighten monetary policy in the face of high unemployment and low inflation.

The simplistic criticism of Greenspan-era monetary policy is that we should have simply allowed recessions such as the 2001 recession to play themselves out. In other words “let it burn”. But the more nuanced criticism of the ‘Greenspan Put’ school of monetary policy is not that it supports the economy, but that it does so via a monomaniacal obsession with supporting asset prices and hoping that the resulting wealth effect trickles down to the masses. I have made this point many times in the past as have many others (e.g. Cullen Roche).

There are many ways to support the economy and only our current system focuses entirely on bailing out banks and shoring up asset prices in exclusion to all other policy options. Why can’t we allow the banks and the market to fail and send helicopter money to individuals instead? Why can’t we start money-financed deficits and increase interest rates at the same time? By narrowing our options to a choice between ‘save everybody!’ or ‘let it burn!’, we choose an economic system that favours the 1% at all times. The Fed Kremlinologist extracts rents from the Greenspan Put during the times of stability and the sharks come out during the collapse1.

Krugman is correct in arguing that a recession is no time to stop the firefighting so that an asset market bubble may be prevented. But the original sin of the Greenspan era was not in triggering bubbles during a recession. It was in using monetary policy to support asset markets and the financial sector even when the real economy was in no need of monetary stimulus. The most egregious example of such an intervention were the rate cuts during the LTCM collapse which were implemented with the sole purpose of “saving” financial markets at a time when the real economy showed no signs of stress. Between September and November 1998, the Fed cut rates by 75 basis points solely for the purpose of supporting asset prices and avoiding even a small failure within the financial sector. Even a cursory glance at market events would have told you that the wider economy was in no need of monetary stimulus. Predictably, the rate cuts also provided the fuel for the final exponential ascent of the dot-com bubble2. This “success” also put Greenspan, Robert Rubin and Larry Summers on the cover of TIME magazine, which goes to show just how biased political incentives are in favour of stabilisation and against resilience.

The problem with the ‘Greenspan Put’ doctrine is not that it fails to prevent bubbles when a recession is on. The problem is that it creates conditions such that eventually there are only two states possible for the economic system – a bubble or a collapse. Market participants could assume that any fall in asset prices would be countered with monetary stimulus and took on more macroeconomic asset-price risk. They then substituted for the market risk they had been relieved of by the Fed with increased leverage. Rates of return across asset classes settle down to permanently low “bubble-like” levels except during times of collapse which are increasingly catastrophic due to the increased system-wide leverage. The stark choice faced by Greenspan in 2001, either an asset bubble or a recession, was a result of his many misguided interventions from 1987 till 2001. Of all these interventions, the LTCM affair was his biggest mistake.

  1. As Constantino Bresciani-Turroni notes in his book on the Weimar hyperinflation ‘The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany’, “even in the past times of economic regressions, of social dissolution, and of profound political disturbances have often been characterised by a concentration of property. In those periods the strong recovered their primitive habits as beasts of prey.” ↩
  2. For example, the last rate cut by the Fed came three days after set a record for the largest first-day gain of any IPO on Nov 13, 1998. ↩
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Written by Ashwin Parameswaran

March 4th, 2013 at 1:44 pm

Helicopter Money Is Not Dangerous, All Macroeconomic Policy Is Dangerous

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In my previous post I argued that introducing helicopter money does not imply that the inflation target must change. Another misguided criticism of helicopter money is that it is somehow more dangerous than other forms of monetary policy. The reality is very different – all forms of macroeconomic stimulus (fiscal or monetary) are equally “dangerous” in the sense that irresponsible implementation can lead to macroeconomic chaos.

Fiscal Deficits Are Dangerous

Whether they are monetised or not, excessive fiscal deficits are inflationary. The best example is the historical experience of Turkey where inflation remained out of control from the 1980s till 2001 despite there being no monetisation of deficits by the central bank. Innovations such as repos enabled the private sector to monetise government deficits as effectively as the central bank would have (For details, see section titled ‘Bond-financed or Money-financed deficits’ in my post ‘Monetary and Fiscal Economics for a Near-Credit Economy’).

Negative Real Rates Are Dangerous

During most significant hyperinflations throughout history, the catastrophic phase where money loses all value has been triggered by the central bank’s enforcement of highly negative real interest rates which encourages the rich and the well-connected to borrow at negative real rates and invest in real assets. The most famous example was the Weimar hyperinflation in Germany in the 1920s during which the central bank allowed banks and industrialists to borrow from it at as low an interest rate of 5% when inflation was well above 100%. The same phenomenon repeated itself during the hyperinflation in Zimbabwe during the last decade (For details on both, see my post ‘Hyperinflation, Deficits and Real Interest Rates’).

This also highlights the danger in simply enforcing a higher inflation target without taking the level of real interest rates into account. For example, if the Bank of England decided to target an inflation rate of 6% with the bank rates remaining at 0.50%, the risk of an inflationary spiral will increase dramatically as more and more private actors are tempted to borrow at a negative real rate and invest in real assets. Large negative real rates rarely incentivise those with access to cheap borrowing to invest in businesses. After all, why bother with building a business when borrowing and buying a house can make you rich? Moreover, just as was the case during the Weimar hyperinflation, it is only the rich and the well-connected crony capitalists and banks who benefit during such an episode. If the “danger” from macroeconomic policy is defined as the possibility of a rapid and spiralling loss of value in money, then negative real rates are far more dangerous than helicopter money.

Helicopter Money + Rate Hike Is Not Dangerous

If helicopter drops are implemented without any concern for how negative real interest rates may get, they are dangerous. But, as I mentioned in my previous post, “helicopter drops can be implemented without any change in inflation so long as interest rates are hiked to counteract the inflationary impact of helicopter money”.

“Permanent” helicopter money is no more dangerous than “temporary” QE. In a world where the central bank pays interest on reserves, money itself is just a form of government debt. Even prior to the crisis, the ability of the private sector to repo government bonds for cash meant that government bonds function as money-equivalents. Once the deficit has been incurred, the nature of financing (bond or money) is irrelevant. All that matters are the level of fiscal deficits and the level of real interest rates.

As always, the conventional wisdom simply mirrors the interests of the 1%. It is considered “normal” to dole out favours to well-connected crony capitalists. It is considered “safe” for the central bank to drive down real rates, buy financial assets and prop up asset prices. But it is considered “dangerous” to direct stimulus to the asset-poor masses.

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Written by Ashwin Parameswaran

February 18th, 2013 at 11:11 am

Posted in Monetary Policy

Helicopter Drops Do Not Imply Higher Inflation

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I am a strong advocate of helicopter drops as the primary and first-choice tool of macroeconomic stabilisation. There is increasing debate about helicopter drops but almost everyone assumes that helicopter money is just another way to generate higher inflation. Those who fear inflation see helicopter drops as irresponsible and those who seek more inflation see helicopter drops as irrelevant and equivalent to asset purchases by the central bank. Both these views are wrong – helicopter drops can be implemented without any change in inflation so long as interest rates are hiked to counteract the inflationary impact of helicopter money. Let me take a simple example to illustrate how – if the UK government were to send a sum of £500 to each British resident and financed this transfer via monetary financing from the Bank of England, the Bank of England in turn could simply hike the base rate till the inflationary impact of the helicopter drop was negated.

Even if helicopter drops did lead to higher inflation, the inflation target does not matter in a world of interest-bearing money. Holders of money and holders of bonds only care about real interest rates. If helicopter drops result in inflation going up from 3% to 5% and interest rates going from 0.50% to 2.50%, then money-holders are no better or worse off.

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Written by Ashwin Parameswaran

February 14th, 2013 at 6:06 pm

Posted in Monetary Policy

The Ever-Increasing Cost of Propping Up A Fragile And Dysfunctional System

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Monetary Medication And The Economy

Mervyn King:

We’re now in a position where you can see it’s harder and harder for monetary policy to push spending back up to the old path . . . It’s as if you’re running up an ever steeper hill.

Psychotropic Medication And The Brain

Robert Whitaker quoted in an earlier essay:

Over time….the dopaminergic pathways tended to become permanently dysfunctional. They became irreversibly stuck in a hyperactive state….Doctors would then need to prescribe higher doses of antipsychotics.

Fire Suppression And The Forest

From an earlier essay:

The initial low cost of suppression is short-lived and the cumulative effect of the fragilisation of the system has led to rapidly increasing costs of wildfire suppression and levels of area burned in the last three decades.

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Written by Ashwin Parameswaran

February 13th, 2013 at 1:08 pm

Unifying The Fiscal And Monetary Functions: A Policy Proposal

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With the emergence of interest-bearing money, the concept of ‘money supply’ is now meaningless. The obsolescence of interest-free money is not just a consequence of payment of interest on reserves by the Fed (as Steve Waldman argues). If short-tenor government bonds are liquid enough, then no one needs to hold non interest-bearing deposits for any meaningful length of time. For example, let us assume that rates are at 6%, the Fed has sold off all its QE holdings and is no longer paying interest on reserves. Therefore, bank deposits yield no interest. In such a scenario, most individuals can put most of their risk-free investments into an ETF or index fund invested in T-bills that pays say 5.80% (with 20 bps fees). In a world of such liquid risk-free investments, there is simply no need to hold cash except immediately before the need to make a payment arises.

The near-moneyness of governmentt bonds is not a new phenomenon. Preston Miller argued that this was already the case in 1983:

In the financial sector….higher interest rates make profitable the development of new financial instruments that make government bonds more like money. These instruments allow people to hold interest-bearing assets that are as risk-free and as useful in transactions as money is. In this way, the private sector effectively monetizes government debt that the Federal Reserve doesn’t, so the inflationary effects of higher deficit policies increase…..
In recent years in the United States there have developed, at money market mutual funds, demand deposit accounts that are backed by Treasury securities and, at banks, deep-discount insured certificates of deposit that are backed by Treasury securities, issued in denominations of as little as $250, and assured of purchase by a broker. In Brazil, which has run high deficits for years, Treasury bills have become very liquid: their average turnover is now less than two days.”

An institutional player doesn’t even have to sell his government bond holdings to access liquidity. He can simply repo his holdings instead. In fact the emergence of the government bond repo market in many emerging markets was driven by the private sector’s need to monetise its government bond holdings. Akçay et al illustrate how fiscal deficits led to inflation in Turkey despite the absence of monetisation because ”innovations in the form of new financial instruments are encouraged through high interest rates, and repos are typical examples of such innovations in chronic and high inflation countries. People are thus able to hold interest-bearing assets that are almost as liquid as money, and monetization is effectively done by the private financial sector instead of the government”.

Nevertheless, government bonds are only near-money and although financial institutions have easy low-cost access to them, the rest of us do not. In the remainder of this post, I will lay out how and why we can transform short-term government debt into not just near-money but money for the man on the street. This has significant benefits for every section of society and the government itself. The significant loser in this transition would be the incumbent oligopolistic players within our financial system, most notably the banks. This however is not a bug of the proposal, it is a feature.


Public Deposit and Payments Option

I have already described the essence of the public deposit option in an earlier post as “a system similar to the postal savings system where all deposits are necessarily backed by short-term treasury bills. If the current stock of T-bills is not sufficient to back the demand for such deposits, the Treasury should shift the maturity profile of its debt until the demand is met.”. The public deposit account should also include the ability to make payments (just like a normal bank account would).

Low-Cost Retail Access to Government Bonds

Government bonds must be as liquid and low-cost for retail investors to buy and sell as they are for financial institutions. The present options for retail investors to buy government bonds are not good enough. For example, TreasuryDirect requires you to transfer your bonds if you need to sell them. In the UK, the transaction costs (between 0.35% and 0.7%) are too high.


Reduced Funding Costs for the Government and Lower Public Debt

A large chunk of the present demand for long-term borrowing comes from the government(see this post for data). Unlike the private sector for whom the avoidance of refinancing risk is worth issuing long-term debt and paying up the liquidity premium, the government has no such need to indulge in long-term borrowing. The government can and should capture the safety premium that people are willing to pay for holding short-term risk-free deposits by shifting its financing to a shorter tenor. The United Kingdom is the best example of just how much governments can save by adopting this strategy. With the Bank of England owning as much as £375 bn of the national debt, the Treasury is in effect paying only 0.5% on this stock of debt. Many view this as an unwarranted monetisation of the public debt and argue that the profits being repatriated by the BoE to the Treasury will soon reverse themselves. But the Treasury could easily achieve the same economics as today by simply shifting its debt profile towards shorter-term funding. If it simply funded its entire debt by issuing bonds of less than 3-year tenor, it would fund at even less than the current BoE rate of 0.5%. There is no doubt that the appetite and demand to allow such a shift exists – the deposit base of the UK banking sector is far greater than £375 bn.

Safe Short-Term Deposits Without Deposit Insurance

In the system outlined above, there would be no deposit insurance i.e. all investments/deposits except for the “public option” will be explicitly risky and unprotected. The public benefits from a safe deposit, investment and payments option without the taxpayer being put on the hook for the costs of deposit insurance.

Improved Retail Investment Options

There is a significant retail demand for government bonds that is not being met at the moment. For example, Belgians lent €520 per resident to its own government when the Belgian government sold €5.7 bn of 5-year bonds at a rate significantly below the market rate in 2011. The reason was not patriotism but simply the fact that even this below-market risk-free rate represented a significant premium over the rates that ordinary Belgians could access through a risky bank savings account.

Firewall Between The Deposit/Payments System and Risky Banking

Rather than shackling incumbent risky banks, my proposal simply separates them from the risk-free depository and payments system.The public deposit option will also eliminate the rents currently being earned by the banks and shadow banking entities such as money-market mutual funds. The liquidity premium that is currently being captured by TBTF oligopolies will be captured by the state itself.

The obvious objection to this plan is: but what about maturity transformation? As I have shown in previous posts, the data is clear that modern economies no longer need maturity transformation. Household long-term savings (which includes pensions and life insurance) are more than sufficient to meet the long-term borrowing needs of the corporate and the household sector in both the United States and Europe.

My proposal does not nationalise our financial system. It simply extends the privileges enjoyed by financial institutions and corporates to the rest of us. Financial institutions and corporations have long enjoyed the benefits of interest-bearing money and the use of government debt as money. The first known instance may be the East India Company who could repo their government bond holdings for cash with the Bank of England (see footnote 20 in this paper). Unfortunately not much has changed between then and now. As is typical of the neo-liberal era, the classes demand an increased supply of interest-bearing safe assets for themselves while restricting the masses to putting their money in interest-free bank deposits.


Note: Parts of the above post have been rehashed from earlier posts and comments on Steve Waldman’s post linked above.

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Written by Ashwin Parameswaran

January 15th, 2013 at 5:26 pm

Posted in Monetary Policy

On The Folly of Inflation Targeting In A World Of Interest Bearing Money

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One of the little known facts of the history of monetary policy is that until 1994, the Fed did not actually announce interest rate decisions. Market participants had to infer rate changes from the Fed’s open market operations. This is just one example of how so many things we take to be natural and obvious are, in reality, relatively recent phenomena. In less than twenty years, the Fed has transitioned from near-opacity to an almost obsessive transparency. Another example of a relatively recent monetary policy doctrine that is now unquestioned is the doctrine of inflation targeting. The essential idea of inflation targeting is that people and firms should not have to think about the level and volatility of inflation when they make economic decisions. Inflation must therefore be kept at low and stable levels so that the long-run costs of unpredictable and uncertain inflation are minimised. As Mervyn King notes, inflation targeting has always been about improving the “credibility and predictability of monetary policy”.

However, in a world where money earns interest, minimising the uncertainty of macroeconomic policy does not equate to minimising the volatility of inflation. When all money bears interest, all that matters for those who hold money or bonds is the real interest rate earned on money and bonds. Given the fiscal stance and state of private credit growth, central banks should manage the real rate of interest such that rentiers do not capture a free lunch (i.e. real rates should not be too high) and there is no risk of a hot-potato/credit-bubble cycle (i.e. real rates should not be too low).

Money does not bear interest today because central banks pay interest on reserves. The primary reason why we live in a world of interest-bearing money is the gradual deregulation and innovation in financial markets over the last thirty years that triggered a shift from money to near-money assets. Apart from minimal liquidity reserves, there is simply no need to hold significant amounts of money in one’s zero-interest current account. Individuals can hold money in money market funds or treasury ETFs. Firms and high net-worth individuals can simply hold treasury bills that are as risk-free and liquid as money is. Even treasury bonds consist of a risk-free component that can be separated from the duration-risk component and monetised via the repo market. The equivalence of money and bonds is not just a temporary “liquidity trap” phenomenon. The evolution of financial markets means that the role of interest-free money is obsolete, now and forever.

In such an environment, the uncertainty and the volatility that individuals and firms care about is the volatility of the real interest rate. Let me take a simple example to illustrate this point. Let us assume that you hold a significant proportion of your assets in a short-term T-bill ETF that currently yields 0% in an environment when inflation is 2%. Therefore, the real interest rate is -2% but you swallow this loss as a “safety premium” fearful that investing in risky assets inflated by monetary stimulus may result in much greater losses. Now suppose the Fed decides to adopt an inflation target of 5% instead, which it achieves by buying up private sector assets such as equities1 while still holding the Fed Funds rate at 0%. This move to 5% inflation obviously hurts your investment in T-bills but the real reason is not that inflation has gone up. The real reason is that real rates have turned even more negative from -2% to -5%.

Many economists will complain that there is no other option. But when government bonds effectively function as money, there are a multitude of other options. The 5% inflation target could be hit by instituting a significant increase in fiscal stimulus (preferably via helicopter drops) and simultaneously hiking rates to 3%. From the perspective of most firms and individuals, this option which minimises the volatility of real interest rates is by far the more predictable and less uncertain policy. Those who borrow or invest at fixed rates for longer tenors will obviously suffer more volatility but such activities are explicitly risk-taking by nature. There is no conceivable reason why the central bank or the government should subsidise such risk-taking.

Proponents of inflation-targeting sometimes point to the poor economic performance of many developing countries with high and variable inflation. But what is really at fault in many of these instances is the tendency of the fiscal and monetary authorities to inject unexpected bursts of inflation that are uncompensated for by the interest rate regime enforced by the central bank. It is the persistent erosion of purchasing power due to negative real interest rates2 that is the real source of the poor macroeconomic performance in most high-inflation regimes.

The obvious object to my argument is that there is no reason why real interest rates must be held constant – I agree. My argument is not that real rates should be held constant but simply that excessive volatility in real rates must be avoided even if it is at the expense of a more volatile inflation rate. If the economy is hit by an inflationary supply shock, then it must be met by an increase in the inflation rate and an increase in the nominal interest rate (thus keeping real rates stable) rather than a rate hike to maintain a constant inflation rate (which would simply be an unwarranted transfer of wealth to lenders). There are also limits to how negative real rates can be driven to before an inflationary spiral is triggered. As of now, we are clearly well within these limits but it is foolish to assume that the inflation target can be increased to any level while central bank rates still remain at zero. Sooner or later, increasingly negative real rates will set off a inflationary spiral and a stampede to buy up real assets instead of nominal bonds.

I am not opposed to central banks driving down real rates to counter the increased demand for safety during a liquidity crisis. But in an environment like today when junk bond prices are at all-time highs, there is no justification for maintaining artificially low real rates. To restore economic prosperity in today’s crony capitalist and stagnant economy, we need to provide direct transfers to individuals via money-financed stimulus while simultaneously hiking rates to stop the permanent bailout of incumbent banks and firms.

  1. See my earlier post ‘The Case Against Monetary Stimulus Via Asset Purchases’ for why I oppose such a policy.  ↩

  2. Negative rates may also be enforced by restrictions on the interest rate payable on deposits and similar financial market regulations.  ↩

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Written by Ashwin Parameswaran

January 7th, 2013 at 3:21 pm

Posted in Monetary Policy

New Essay

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I have written a new essay in the economics section of my new project reconciling the possibility of technological unemployment during a time of innovative stagnation titled Technological Unemployment Amidst Stagnation. Most of it is just a rehash of arguments that I have made on this blog especially in the posts Innovation, Stagnation and Unemployment and Advances in Technology and Artificial Intelligence: Implications for Education and Employment but about 25-30% of the essay is new material and the overall essay itself is written in a much simpler manner than many of my posts here.

Do let me know what you think. Thanks for reading.

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Written by Ashwin Parameswaran

January 4th, 2013 at 12:00 am

Posted in Uncategorized

An Experiment

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Most of my posts on this blog tackle different topics from essentially the same perspective, which is a biological/ecological systems-influenced take on the concept of system resilience. But the basic concepts of this underlying framework are spread out among a bunch of overlapping posts. In an attempt to make each post stand on its own, I find myself spending more and more time repeating past arguments in new posts in order to set the stage for new ideas. I find this repetition incredibly boring and at the same time, this half-hearted repetition probably doesn’t do much to help a new reader either.

To try and resolve this problem, I’m going to write most of my interdisciplinary resilience material in a more hierarchical format. The format I’m going to adopt here is to distil the essential framework into short summary essay and organise the rest of my writing by domain – economics, biology, ecology, technology etc. The idea is that you should be able to read the summary essays and then dive into whichever domain takes your fancy. Conversely the core ideas explored in each domain should mostly be summarised in the summary essays. These essays will be relatively simple but the material within the domain sections will be much more detailed and often messy.

This format also allows me to reconcile my desire to draw generalised parallels across domains while at the same time exploring each domain in detail. So to kick off this experiment, I’ve posted the initial summary essay titled “All Systems Need A Little Disorder” at The basic idea in this essay – that systems that need to be robust and generate novelty need some chaos (not a lot of chaos, just a little bit) – underlies pretty much all of the posts I have written on this blog. In the next few months, I will apply and elaborate upon the basic concepts in this essay across a wider array of domains than I have explored so far.

By adopting this format, I can hopefully increase the output of material that I post online and explore new topics more easily without having to rehash old posts. At the same time new readers will hopefully have a more coherent way of navigating through my ideas. I will post links to any new material on this blog as well for those of you who subscribe to the RSS feed here. I will continue to write here but the material will probably be more limited to macroeconomics and finance than it has previously been.

As always any feedback is much appreciated. Thanks for reading.

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Written by Ashwin Parameswaran

December 11th, 2012 at 3:55 pm

Posted in Uncategorized

Monetary and Fiscal Economics for a Near-Credit Economy

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In an earlier post, I argued that our current monetary system is close to being to a Wicksellian ‘pure credit economy’. In Hans Trautwein’s words, this is “a state of affairs in which all money is held in interest- bearing bank deposits and in which all payments are effected by means of book-keeping transfers in the banking system”. One significant way in which our current system is not quite a pure credit economy is that economic agents still retain the option to hold currency notes. This option is not very important in positive-rate environments but it denies the central bank the ability to enforce negative interest rates (which can be avoided by simply hoarding zero-interest physical notes). The dominance of interest-bearing money combined with the inability to enforce negative interest rates implies that the quantity of base money in the system is irrelevant, not just now in a ‘liquidity trap’, but at all points in the future.

The Irrelevance of The Quantity of Base Money and The Absence of The Monetarist Hot Potato

It is trivially obvious that interest-bearing money cannot be a hot potato in the monetarist sense. There is no reason to get rid of interest-bearing money balances and interest-bearing money holdings only need to be minimised if the interest rate is insufficient relative to the ‘natural’ real rates and safety premium implied in holding money. To put it simply, if interest rates are 5% and inflation is 15% then interest-bearing money will act as a hot potato and fuel inflation. But in the current environment of possibly negative natural real rates and a high demand for safety, prolonged negative real rate regimes are perfectly sustainable without triggering any ‘hot potato’ inflation. The above holds not only at the zero-bound but at all positive interest rates. If the central bank wants to sustain positive bank rates, it must either pay interest on reserves or mop up all excess reserves. In either scenario, we have no hot potato.

Interest-Bearing Money: Debt as Money

The history of interest-bearing money is essentially the history of debt as money. The modern history of transferable debt as money is exemplified by the use of bills of exchange in post-Renaissance Europe. As Philip Coggan explains:

trading systems were an early form of our modern economy, with its layers of debt and reliance on paper money. A merchant might extend credit to his customers; in turn, he would need such credit from his own suppliers, who might only have bought the goods with money borrowed from someone else. The default of one party would ripple through the system. This system was formalized in the form of bills of exchange, promissory notes offered as payment from one trader to another. The recipient might then use the bill as collateral to raise cash from a bank or other lender. The bill would be accepted at a discount, depending on a number of factors, most crucially the creditworthiness of the merchant concerned. This was, in effect, a paper money system outside the government’s control.

It is instructive to examine the evolution of this private credit economy in order to fully understand where we stand now. The rest of this section is primarily drawn from Carl Wennerlind’s excellent book ‘Casualties of Credit’. The private credit economy was an essential component of the English economy due to the perennial shortage of metallic currency. As Wennerlind notes, it wasn’t just merchants but the bulk of the English population who were participants in the credit economy. In the early days in the seventeenth century , the supply of private credit alone was nowhere near enough to make up for the scarcity of metallic currency. One reason was the limited transferability of private debt, a problem that was solved by the passage of the Promissory Notes Act of 1704 which made all debt instruments negotiable. Nevertheless, the limited elasticity of the private credit system in responding to demand from commerce remained a problem. A related and equally severe problem was fragility induced by the possibility of default. This was the Achilles heel of the private credit economy in the 17th century and it remains the case in the 21st century. Just as in the 21st century, the real systemic risk is the threat of a wave of cascading defaults brought upon by the tightly interconnected nature of private credit agreements.

The solution to this problem that we are all aware of and that has been well-documented is the growth of modern banking ultimately backstopped by central banks (usually via lender-of-last-resort actions). This architecture was initially limited by the restrictions placed upon the central bank by the metallic/gold standard, Bretton Woods etc which were finally thrown away in 1971 to construct the “perfectly elastic” monetary system that we have today. This is the logical conclusion of the process of abstracting away from the prior personal nature of “money as debt” to a decentralised impersonal system.

Less documented but equally important are the attempts to improve the supply and safety of the credit economy via collateral. The idea is simple – assets can be used as security to back the credit, thus improving the supply as well as the safety of credit. There were many recommendations as to what constitutes eligible collateral in the 17th and 18th century but by far the most popular suggestion was land. It is worth quoting Wennerlind on this subject (who in turn quotes William Potter):

Potter also offered a proposal for a land bank, which was remarkably similar to that of Culpeper. Since “Credit grounded upon the best security is the same thing with Money,” the key was to establish a bank that used a different asset than precious metals as security backing the credit money. Since land was considered the most concrete and stable commodity at the time, there could be no better security than land to induce people to part with their commodities in exchange. By mortgaging land, which “would serve as well and better for such a pawn,” the land bank created a credit currency that would have “as true intrinsick value, as Gold and Silver”

Others, such as Hugh Chamberlen advocated a general storehouse of goods that would serve as collateral. Nevertheless, none of these ideas were adopted in 17th/18th century England for good reasons – none of these choices for collateral were liquid enough or permanent enough for the purpose. To a modern investor, government bonds are the obvious answer to this dilemma. But in 17th century Europe, government debt was neither liquid nor safe. However, a series of institutional changes after the ‘Glorious Revolution’ in 1688 changed all this (see North and Weingast 1989 for details). With the setting up of the Bank of England, British government bonds began to resemble the “risk-free” counterparts of the modern world by the mid-18th century. It is obvious how the ability of the new more representative English Parliament to credibly commit to repay its debts enabled England to fund itself at a much lower cost. What is less appreciated is the fillip that the institution of a liquid, comparatively safe government bond market gave to the private credit economy. As Baskin and Miranti note, these government obligations could be used to collateralise private borrowing in a manner that is uncannily similar to the modern-day term repo contract.

The Hot Potato Constraint in a Credit Economy

What does all this have to do with the modern monetary system? In the modern pure fiat-currency economy (i.e. not the Eurozone), interest-bearing deposits, interest-bearing central bank reserves and interest-bearing government debt are all equivalent in that they are all nominally safe state obligations unencumbered by restraints such as a gold standard. Any shift in liabilities between central bank reserves, deposits and debt engineered by the central bank is only relevant for its interest-rate impact. There is nothing in this process that can be even remotely termed as  “money printing”. The inflation tax and any “hot potato” effect are dependent not on the absolute levels of inflation but the real interest rate offered on each tenor of these government obligations.

To the extent that any activity of the state approaches money printing, it is the act of deficit spending. Even this does not necessarily entail inflation – the central bank can force a contraction in the private credit economy by a sufficient rate-hike to counter any fiscal stance. Again there is no inflation tax and no possibility of hyperinflation as long as interest rates across the government obligation curve compensate sufficiently for inflation. Each fiscal stance has a separate sustainable level of inflation and interest rates that constitutes a short-term equilibrium. When a loose fiscal stance breaks out into excessive inflation and the risk of hyperinflation, it is usually the result of this rate hike being inadequate for fear of a collapse in the private economy.

Rather than talk in the abstract, it is easier to elaborate on the above framework with a few relevant and timely examples.

Permanence of QE is irrelevant

Gavyn Davies gives us the conventional argument as to why the perceived temporary nature of QE matters in preventing out-of-control inflation:

Fiscal policy, in theory at least, is set separately by the government, and the budget deficit is covered by selling bonds. The central bank then comes along and buys some of these bonds, in order to reduce long-term interest rates. It views this, purely and simply, as an unconventional arm of monetary policy. The bonds are explicitly intended to be parked only temporarily at the central bank, and they will be sold back into the private sector when monetary policy needs to be tightened. Therefore, in the long term, the amount of government debt held by the public is not reduced by QE, and all of the restraining effects of the bond sales in the long run will still occur. The government’s long-run fiscal arithmetic is not impacted.

As I have illustrated above, QE in a world of interest-bearing money is simply an adjustment in the maturity profile of government debt. But that is not all. In a credit economy where government bonds are a repoable safe asset, the bond-holder can simply repo his bonds for cash if he so chooses. Just as the East India Company could access cash on the back of their government bond holdings in the 18th century, any pension fund, insurer or bank can do the same today. This illustrates why the reversal of QE, if and when it happens, will have no impact on economy-wide access to cash/purchasing power.

Bond-financed or Money-financed deficits

Gavyn Davies again gives us the conventional argument:

When it runs a budget deficit, the government injects demand into the economy. By selling bonds to cover the deficit, it absorbs private savings, leaving less to be used to finance private investment. Another way of looking at this is that it raises interest rates by selling the bonds. Furthermore the private sector recognises that the bonds will one day need to be redeemed, so the expected burden of taxation in the future rises. This reduces private expenditure today. Let us call this combination of factors the “restraining effect” of bond sales.
All of this is changed if the government does not sell bonds to finance the budget deficit, but asks the central bank to print money instead. In that case, there is no absorption of private savings, no tendency for interest rates to rise, and no expected burden of future taxation. The restraining effect does not apply. Obviously, for any given budget deficit, this is likely to be much more expansionary (and potentially inflationary) than bond finance.

The ability of the private sector to repo its government bonds to access purchasing power today gives us a profound result. Whether the central bank monetises government debt or not is almost irrelevant (except from a signalling perspective) because the private sector can monetise government debt just as effectively. And when the government debt does not represent a ‘hot potato’, the private sector often does exactly that. This is not a theoretical argument. For example, Akçay et al illustrate how fiscal deficits led to inflation in Turkey despite the absence of monetisation because ” innovations in the form of new financial instruments are encouraged through high interest rates, and repos are typical examples of such innovations in chronic and high inflation countries. People are thus able to hold interest-bearing assets that are almost as liquid as money, and monetization is effectively done by the private financial sector instead of the government”. As Çavuşoğlu summarises, “The money creation process under high budget deficits can as well be characterised as an endogenous credit-money expansion rather than a monetary expansion to maximize seignorage revenue”.

Lest you assume that this only applies to developing market economies, the same argument has been made almost three decades ago by Preston Miller:

In the financial sector….higher interest rates make profitable the development of new financial instruments that make government bonds more like money. These instruments allow people to hold interest-bearing assets that are as risk-free and as useful in transactions as money is. In this way, the private sector effectively monetizes government debt that the Federal Reserve doesn’t, so the inflationary effects of higher deficit policies increase.

Even in the early 80s, Miller saw the gradual demise of non-interest bearing money:

In recent years in the United States there have developed, at money market mutual funds, demand deposit accounts that are backed by Treasury securities and, at banks, deep-discount insured certificates of deposit that are backed by Treasury securities, issued in denominations of as little as $250, and assured of purchase by a broker. In Brazil, which has run high deficits for years, Treasury bills have become very liquid: their average turnover is now less than two days.

As in the case of Turkey and as argued by Preston Miller, the private sector can monetize the deficit as effectively as the central bank can. And so long as government obligations are deemed safe, it almost certainly will. In an interest-bearing economy, the safety of these obligations have nothing to do with the absolute level of inflation and everything to do with the real rate of return on the bonds. When central banks and governments attempt to enforce an excessively negative rate of return, they play with fire and risk hyperinflation.

The Near-Permanence of (Non Hot-Potato) Government Debt

P.G.M. Dickson characterised the rise of the government bond market in London during the 18th century as the era of “debts that were permanent for the state, liquid for the individual”. In a credit economy, government debt issued in the past is simply money that has already been printed. Erasing this debt would not imply a monetary collapse but it would unleash strong deflationary forces.

Most of the developed world (ex the Eurozone) could easily maintain their current levels of government debt ad infinitum so long as the real interest rates paid on them are sufficient. And in fact it makes sense for them to do exactly that. Even without the monetisability of long-term government debt, there is a significant demand for them from many private sector holders – the pension fund and insurance industry which needs long-tenor bonds to match its liabilities to retirees, investors who need long-tenor bonds to hedge their risky assets and provide tail-risk protection. Even without taking into account the “natural” real rate of interest, there is a strong argument to be made that the average real rate of return on long-tenor government bonds should be negative. Therefore, it does not even make economic sense for governments to pay back their debt, as long as it can be serviced at a sustainable real rate.

The appropriate question to ask is not ‘What is the maximum level of government debt is that can be plausibly paid back?’. It is ‘What is the maximum level of government debt that can be plausibly serviced on a permanent basis?’. If there are any Ponzi schemes in government debt, they exist only if and when there are real limits to economic growth – working-age population growth, energy limits etc.

What Matters: Future Deficits and Real Rates

A policy option such as a cancellation of past debt or an announcement of helicopter drops would be relevant to the extent that it effects future deficits. Higher deficits would typically warrant a more hawkish monetary stance and it is the combination of this fiscal stance and the monetary response that determines whether the deficit regime constitutes an inflation tax on the private sector. For example, the state could institute a helicopter drop and raise interest rates at the same time to maintain real rates at acceptable levels – again the level of real rates is much more important than the absolute level of inflation. Even this hike in rates may not be required if the private sector is undergoing an endogenous delevering at the time.

Modern Repo and the Asset Price Approach to Monetary Policy

If the collateral underpinning the private credit economy was limited to government bonds, the lender-of-last-resort role of the central bank in the repo market would be trivial. However, the current scope of the repo market and similar financing arrangements (notably ABCP) extends to far riskier assets. Although the risk management in today’s repo market is far superior from an individual counterparty’s perspective ( the predominance of the overnight repo, more sophisticated margining etc ) the systemic risk of cascading defaults triggering a credit collapse has in fact spread to all asset markets.

In order to meet their stabilisation mandate, central banks have implicitly taken on a mandate to backstop and stabilise the entire spectrum of liquid asset markets. If the central banks influence anything that could be termed as money supply in the modern credit economy, they do so via their influence on asset price levels (influenced in turn through the central bank’s actions on present interest rates, future interest rate path and liquidity). In a collateral-dependent credit economy, the Greenspan Put is the logical end-point of the stabilisation processes, the modern motto of which could be summarised as: ‘Focus on collateral values and the money supply will take care of itself’. Successive stabilisation leaves the economy in a condition where all economic actors have moved away from the idiosyncratic, illiquid economic risks that are the essence of an innovative, entrepreneurial economy towards the homogeneous liquid risks of a stagnant economy (detailed argument here).

In an earlier post, I noted that “The long-arc of stabilised cycles is itself a disequilibrium process (a sort of disequilibrium super-cycle) where performance in each cycle deteriorates compared to the last one – an increasing amount of stabilisation needs to be applied in each short-run cycle to achieve poorer results compared to the previous cycle.” This sentiment applies even when we look at the long-arc of stabilisation in England since the 17th century. In the 17th century, it only took a change in the laws (making debts negotiable) to prevent a collapse in the credit economy whereas now we need to prop up the entire spectrum of asset markets.

1. The section on monetary hot potatoes and high-powered money is almost completely taken from commenter ‘K’ – example here

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Written by Ashwin Parameswaran

October 17th, 2012 at 1:54 pm

Hyperinflation, Deficits and Real Interest Rates

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Hyperinflation is often viewed as a phenomenon where a currency is repudiated by its holders who refuse to hold the currency in any nominal form i.e. a collapse in demand for the currency. This is a reasonable but nevertheless incomplete explanation of how hyperinflation plays out in reality in modern capitalist economies.

In a world of interest-bearing money, high and monetised fiscal deficits by themselves are not reason enough for deposit-holders to repudiate a currency. If the central bank maintains a nominal interest rate at the short-end that compensates money-holders for the fiscally-created inflation, then there is no shortage of willing holders for the currency (in an interest-bearing form such as deposits). By the same token, the central bank must adjust lending rates at the short end (the equivalent of the ECB repo rate) to avoid an explosion in private credit growth fuelled by negative real rates. For each chosen fiscal regime, there is a monetary stance that can avert hyperinflation. However as fiscal deficits increase beyond a point, the equilibrating monetary stance consists of a nominal lending rate that must necessarily crowd out the private economy.

Understandably, most central banks are reluctant to raise rates in such a dramatic fashion. Instead they raise rates but only to the extent that real rates remain negative but not negative enough to motivate a wholesale repudiation of the currency. So long as real rates are maintained at a small negative rate, deposit-holders usually treat it as a “safe asset” premium that they are willing to pay. An environment that enables hyperinflation as a possibility is triggered when these real rates turn significantly negative. Significant negative real rates encourage holders of the currency even in its interest-bearing deposit form to shed their holdings of the currency when faced with constant and high real losses, losses that cannot be justified simply on account of the safety premium of the nominal asset.

But this repudiation of money is not the core driver of hyperinflation as we know it in the modern world. What almost always accompanies this repudiation is a sustained barrage of borrowing at the artificially low nominal and real rate enforced by the central bank or government (directly or indirectly via banks). Until late in the Weimar inflation, the Reichsbank kept discount rates as low as 5% (see table here) , a free lunch that was taken full advantage of by bankers and industrialists to lever up and invest in any real assets they could find. As Adam Fergusson notes, “new borrowings from the Reichsbank…from whom commercial enterprises could obtain credit at very low discount rates even at the height of the crisis in 1923, were automatically written off” due to the ludicrously negative levels of real interest rates that were enabled by the Reichsbank. The same was true in Zimbabwe where the central bank not only maintained one-year treasury bill rates at a level well below the inflation rate (enabling monetisation of deficits at a subsidised rate) but did the same with prime and bank lending rates which led to the predictable explosion in private sector credit expansion (see data here for a sample month).

Once real rates become sufficiently negative, credit growth explodes and the positive feedback loop of ever higher inflation fuelled not just by currency repudiation but by active exploitation of the banking and central bank discount window to access essentially free loans is set in motion. In other words, hyperinflation in modern capitalist economies is characterised not just by a collapse in the demand for deposits but an explosion in demand for loans at the “free lunch” level of nominal interest rates enforced by the central bank. Many commentators have recently asserted that Iran is in the midst of hyperinflation. Whether this is actually the case is still unclear – the current bout of higher inflation and prices may yet turn out to be temporary. But what makes hyperinflation possible is clear. Both lending rates and deposit rates have been set at levels well below the inflation rate for years now, a situation that threatens to descend into farce with inflation at above 50% per month and bank rates at only 21% per annum.

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Written by Ashwin Parameswaran

October 12th, 2012 at 3:32 pm

Posted in Monetary Policy