Opinion: 7th March 2013: The turning point.

You will have woken this morning to news that Vince Cable has launched a Plan C or Plan Cable featuring a ‘Keynesian’ stimulus centred around borrowing (at the current low rates that the Government can borrow) to fund infrastructure projects.  But as usual the media is doing the country a grave disservice.

It is an historic day filled with possibility, but to understand the full pregnancy of the position you will need to go beyond the crude headlines of crude Keynsianism and read Cable’s full article When the Facts Change, Should I Change My Mind.

But you will also need to read what the Chancellor has announced today in the Financial Times on both the day of Cable’s statements (coincidental) and the day that the Monetary Policy Committee meets (surely no coincidence). Both statements have been signed off by their Coalition partners. Yes, George signed off on Vince and ‘we’ signed off George’s. Provided the two sides don’t fall out about caravans and pasties in the days leading up to the Budget, the instructions to the Bank of England will change this Spring.

The MPC meets once a month and has the ability to counter the effects it perceives of any changes in fiscal policy.  So, if you do want to introduce any fiscal easing, the Quad must first change its instructions to the Bank of England and it can do so conveniently every spring (as I pointed out last year).

Members of the MPC have been saying publicly that until they are told otherwise by the Chancellor, their target must remain the same. The next Governor of the Bank of England has been saying that the debate on those instructions must be settled before he takes office in July. And, privately, the Quad has been debating the pros and cons since before Christmas.

So, the bigger of the two stories is the Chancellor’s. But with a new target in place the argument will shift to ask, ‘will that be enough?’

Cable’s superb paper sets out the full extent of the problems:

A variety of approaches is relevant. Worryingly, few economists beyond Hyman Minsky and Charles Kindleberger have really addressed the phenomenon of financial mania and banking collapses (although Ben Bernanke, the chairman of the Federal Reserve, produced important work on how the banking crisis worsened the Great Depression in the US). Another defining feature of the present crisis has been the accumulation of a large volume of household debt, mostly linked to mortgages, which, as Irving Fisher argued a century ago, leads to “debt deflation”, with a downward spiral of depressed demand, unserviceable debt and weak confidence. Then Milton Friedman understood the importance of money supply in the interwar slump, which has played out in the current crisis in activist, unorthodox monetary policy. And largely ignored in our parochial policy squabbles has been the impact of the rapidly shifting centre of gravity of the world economy towards emerging markets and the impact of this change on capital flows and demand, shifting the terms of trade – mainly through oil – against commodity importers. None of these issues makes Keynes irrelevant, but they suggest the need for a more complex and eclectic framework for analysis.

We need, and can expect, action on all these fronts. But it looks as if the first big step has been taken by facilitating looser monetary policy.

And the recent story from Japan, where in mid-November the then leader of the opposition declared that when elected (and it was a certainty) he would force the Bank of Japan to change its target to a growth in NGDP of 3% with the threat that if it did not do so voluntarily, the new Prime Minister would remove its independence.  The Nikkei 225 has risen close on 50% since then.

Eastleigh was a great victory, but our electoral fortunes remain bound up with the performance of the UK economy. An understanding of the central role of monetary stimulus, now acknowledged by Osborne thanks to the influence of the Liberal Democrats and Cable’s office in particular, and the license given to the incoming Governor of the Bank of England and the MPC (meeting today) is a turning point of immense significance.

We are set to remove the foot of the Bank of England from the throat of the UK economy.

* Bill le Breton is a former Chair and President of ALDC and a member of the 1997 and 2001 General Election teams

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26 Comments

  • Richard Dean 7th Mar '13 - 1:39pm

    This doesn’t look “historic” or “pregnant” to me, just a little bump that could be anything.

    Here is what the FT says about Cable: “The chancellor is resisting suggestions by Vince Cable”

    Here is what the FT says about the BoE: “Options include …” That’s not any kind of promise of immediate change.

  • Paul in Twickenham 7th Mar '13 - 2:57pm

    Interesting that Vince Cable has chosen to mention Irving Fisher. Fisher’s debt-deflation theory is at the centre of much anti-austerity argument today.

    Of course Fisher made that notorious comment about the stock market being at “a permanently high plateau” just a couple of months before the Wall Street Crash and given the current all-time highs (driven by cheap QE money flooding the markets, with no relation to economic reality) it’s a timely reminder of the fallibility of economists.

    How refreshing to hear Liberal Democrats talk like Liberal Democrats.

  • Good round up of the arguments by the BBC economics correspondent Stephnie Flanders here Vince Cable’s plan B: a “matter of judgment”.

    Vince Cable’s essay, while politically nuanced, is clear enough. We cannot expect monetary policy alone to bring about a sustained recovery in the UK economy. Monetary policy and the Bank of Englands mandate must be designed to support capital and structural investments in the real economy – infrastructure, housing and skills together with direct interventions and lending support to bypass the damaged transmission mechanisms in the banking system.

    Whether the Bank of England’s mandate is amended to more flexible inflation targeting, a dual inflation and employment target or nominal spending – this will not address the fundamental weaknesses in the financial and monetary transmission systems resulting from a financial sector crisis, as was clearly explained by Hyman Minsky’s financial instability hypothesis .

    Vince cable rightly characterises the policy debate as a question of judgement on the balance of risks. I believe Lord Oakshott is correct when he says that the great majority of Libdems would favour a more active infrastructure and housing invetment program as well as targeted support for SME lending as part of a longer term industrial strategy.

  • Bill le Breton 7th Mar '13 - 4:06pm

    It is most important to read and react to the full piece http://www.newstatesman.com/economics/economics/2013/03/when-facts-change-should-i-change-my-mind

    The continuing low rates and subdued changes in nominal income are indications that monetary policy has been and remains too tight. The MPC say that they will continue to react to the existing target (now set at 2% CPI three years hence). Three, including the Governor of the Bank of England, last month thought that it required further loosening. But they want the Chancellor to release them from the constraints of the present target.The next Governor would like not to have to fight that battle on day 1, himself, and that would be right – this should be the parting ‘gift’ of the outgoing Governor.

    The concentration on investment spending and fiscal easing by the New Statesmen’s short feature and a number of journalists and politicians puts in jeopardy the necessary agreement among the Coalition Leadership for such a change to monetary policy – which has now been derelict for 10 years – five into the crisis and five since..

    Today, the UK stands at the cross roads. In the direction proposed by Cable is further monetary loosening and a deepening and widening of bond purchases. Japan suggests this is the right way forward for a currency issuing country. The status quo will see a continuance of stagnation, rising deficits and pressure on welfare (defined to include unemployment and underemployment).

    This is a big test for the political class, the media and the economics profession.

    Everyone should get behind Cable.

  • Eddie Sammon 7th Mar '13 - 4:11pm

    I agree with Vince. And I’m a staunch Liberal Reformer. It can’t be hard to generate a rate of return that is greater than our low interest rates. We just need to avoid building for building sake.

  • Every time I falter Vince picks me up :)

  • Eddie Sammon 7th Mar '13 - 4:34pm

    The argument that Nick makes, which says borrowing more could put up our interest rates, can be countered by saying the bond markets might even see it as a good thing; as long as we don’t over do it. I certainly don’t think they are going to panic with a little bit of fiscal/monetary stimulus.

    Tax revenues have collapsed, John Maynard Keynes was not an idiot.

  • While I agree we should be accepting the need for good quality, well costed, highly targeted infrastructure investment paid for directly by the state, we should be under no illusions that it will be easy for the UK economy on its own to achieve “escape velocity” under the current circumstances:

    1) Eurozone meltdown killing any prospects of growth in 40% of our export market;
    2) Collapsing oil and gas production;
    3) High oil, food and other commodity prices;
    4) Households still repairing their balance sheets after a massive credit binge.

    We should also accept that any expansionary measures will inevitably lead our balance of payments deficit to widen as at least some of this demand leaks out into the wider international economy.

    Just as deficit reduction isn’t the main reason why the UK isn’t growing, nor will infrastructure investment result in immediate miraculous recovery. There are too many other (negative) things going on at the moment to make it possible.

  • Bill,

    I would disagree with your contention that the Chancellors FT article is the more important of today’s news stories.

    Vince Cable’s intervention comes on the day before David Cameron has announced that changing course on the economy would plunge the UK “back into the abyss”, and that “there is no alternative” to “sticking to the plan” on the economy.

    Vince in his article has explained that it is the broken transmission mechanisms from cheap BofE money and ample liquidity in the banking sector to the SME sector that is the source of tight money conditions in the real economy and how QE created money is flowing from the banks into safer low yield gilts rather than private sector investment.

    “Today’s problem is more complex. Negative official real rates coexist with high lending rates charged by the banks, especially to SMEs. Indeed, the low level of risk-free rates, including our very low gilt yields, actually indicate how monetary conditions have been tight for the greater part of the economy.

    Money growth has been low and nominal spending growth in the economy weaker in the past five years than in any other years of our history. Low gilt yields indicate how risk-free government paper becomes an attractive investment in these circumstances, as an alternative rather than a boost to privatesector investment.”

    While advocating a more interventionist monetary policy, in acquiring corporate loans and infrastructure bonds – on changes to the Bank of Englands manadate he is somewhat more circumspect saying “there are voices asking whether there is scope to be more flexible. On the other hand, inflation targeting helped produce a decade of relative stability for the UK economy and is well understood by the public, so the bar for any change must be high.”

  • Bill le Breton 8th Mar '13 - 6:46am

    Joe, Although inflation targeting worked well for most of the Great Moderation, it clearly failed in the run up to the crisis of 2008 – allowing monetary policy to be too loose. But it also failed in the five years since – evidence the continuing low rates (the search as you say for scarce ‘safe’ assets’) and the ‘way below’ trend rise in nominal GDP. 2.5% since 2008 and 2% since the Coalition. Leaving the dreadful ‘lost’ opportunities and life chances portrayed by this graph http://uneconomical.files.wordpress.com/2013/02/uk-pn2-ngdp-trend-2012q4.png

    So, reading the FT article, it looks like by July 2013 we shall have a new regime and a New Governor, which will take our approach much closer to that of the FED and, who knows, more in line with Japan’s new direction.

    Cable’s inclination (in his article) is that deepened and widened QE could/should include the purchase of bonds, some of which would be issued to fund infrastructure projects. This does not YET have the support of either the Conservatives or the rest of the Liberal Democrat leadership.

    Thus, barring a big surprise, the FT article says will have some kind of target that includes growth. Job done? Only half – witness the PM’s speech. But what we need to do now is to get the Leadership to understand that generating confidence and expected growth in nominal income (or NGDP) may be best achieved by a more unconventional approach to buying bonds/creating safe assets., some of which are directed in partnership with the private sector to necessary infrastructure projects.

  • Bill le Breton 8th Mar '13 - 6:08pm

    Geoff, as ever I benefit from your thoughts. The irony of Cameron’s Magic Money Trees is that as you say (less dramatically than this but … ) in a system of fiat currency there really are magic money trees! Or as you write, “It truly is virtual and not real. ”

    My memory of the long article is that Vince (at first) is not arguing that, ‘it must be borrowed. it must be paid back.’ It is only when he writes that he has been told we can’t do that lawfully anymore that he advocates looking at the second option.

    Since the spectre of deflation raised its head in 2008 I have been trying to point people to this simple equation. Change in Money Supply = PSBR + change in bank lending to non-bank private sector – change in non-bank private sector lending to the public sector (+ overseas impact on the money supply).

    If you do not engage in non-bank private sector lending to the public sector, an increase in the PSBR will compensate for a reduction in bank lending to non-bank private sector (in a time of deleveraging/non bank private sector appetite for risk/unwillingness or inability of banks to lend to non-bank private sector)

    This has two results. a) the money supply increases, and b) aggregate demand increases at the very least by the increase in the PSBR. i.e. there is a fiscal and a monetary stimulus.

    The resulting increase in aggregate demand inspires entrepreneurs to accept risk and reassures the commercial banks that it is prudent to lend to them. And we are off and onwards.

    Central Bankers hate this idea. They spent most of the ’80s and ever since hoping that politicians never remembered that they had once used this technique. That is why King is so vitriolic against it now. But it is not an easy cope out for the politician if there is a rule which says that once cash measured GDP reaches x it must stop. If cash measured GDP exceeds x it will chop these trees down and increase the price of money.

    Central Bankers don’t believe that politicans will ever willing stop when once they find the magic money tree orchard. And they have created a taboo around it so powerful that the Prime Minister of a country that hasn’t seen real growth for three years, who is heading for electoral defeat and the opprobrium of history and whose chancellor holds in a big box of money tree seeds on his desk, declares that the whole thing is dangerous magic and must be avoided at all cost.

    Oh dear.

  • Eddie Sammon 8th Mar '13 - 6:42pm

    Hi Geoff,

    You say: “If we had a totally automated economy, money vouchers would be printed and scrapped each year.”, but what would the benefit of this be? You would just be playing with the currency price and therefore inflating and deflating the economy.

    This would effectively be just continuous quantitative easing and tightening. I am of the opinion that QE is just an illusion aimed at conning the public into thinking they have more money so they spend more. I believe any benefits derived from this are counteracted by the cruelty it represents to people on fixed incomes; especially long-term fixed incomes.

    People talk about devaluing the pound, but really I think they should talk about devaluing the penny because that puts it into perspective: we don’t need to devalue the penny, it’s cheap enough.

    The other very significant worry I have is the notion that we can just service the interest and we never have to actually pay the debt back. This means we would plan on forever remortgaging our debt, but what if one day no one wants to buy our debt? Interest rates would shoot up and we’d be crippled.

    You also say that debt can be written off each year, but I don’t see China writing off any of our debt any time soon.

    I like to think I’m an open-minded kind of guy but this argument seems to have many flaws.

  • Bill,

    as you know, I upport NGDP targeting as a replacement for the current regime of inflation targeting. I do think it is important though not to raise unrealistic expectations as to the economic effects of a technical change in the Bank of Englands mandate.

    You note that inflation targeting failed in the five years or so prior to the financial crisis and that monetrary policy was too loose for much of that period. That is, I believe patently true, but targeting NGDP during this period would have produced a virtually identical result Is the UK Secretly Targeting NGDP? and done nothing to prevent a house price bubble or the banking crisis.

    A change in the Banks mandate would be welcome at this juncture in preventing unneccearary monetary tightening in response to external inflation or demand shocks. Whether a Taylor-type rule or NGDP targeting is adopted, is in my opinion, of secondary and corollary importance to the longer-term structural investments and fiscal interventions that need to be undertaken to position the UK economy for a sustainable, productivity led recovery. An NGDP target is not required to allow the BofE the flexibility to use QE for the acquisition of Housing Association bonds or other riskier assets than government bonds – this can be done within the existing regime with treasury approval.

  • Eddie Sammon 8th Mar '13 - 8:48pm

    Hi Geoff,

    I now understand your money creating and destroying argument but I just don’t think it is a good way to go. This NGDP idea also frightens me because of what I fear it would do to many pensioners’ incomes.

    I think the only way to lessen the effect of the cuts is by increasing taxes where possible and to invest more.

    I also fear this borrowing to invest in infrastructure might not actually be the best way to go. Do some of it sure, but investing into small UK businesses could be better.

  • Richard Dean 8th Mar '13 - 9:26pm

    As Eddie Sammon suggests, a possible problem with Bill le Breton’s Money Tree Equation is that the equation has missed two important costs, the cost of risk and the cost of future debt repayments. Both are real costs, not virtual or imaginary at all. If there is a 10% risk of losing on any given deal, there is a certainty that you will lose 10% on average over a large enough number of deals. So, in the absence of non-bank private sector lending to the public section, the equation should read:

    Increase of Money Supply = Increase of Public Sector Borrowing PLUS Increase of bank lending to private sector LESS Increase of Government’s Risk LESS Increase in (Future) Debt Repayments

    If PSB increases without change to bank lending, there will also be an increase in debt repayments for future years, and a consequent increase in risk costs, which could manifest themselves as a reduced credit rating and increased interest rates on borrowing. It’s true that the increase economic activity might make markets perceive less risk, but somehow I doubt that. It is entirely feasible that the two effects, increase in debt repayments and increase in government risk, can completely offset the increase of PSBR, and may even dominate the problem so much that the effect of the increase of PSB may be a net reduction in the money supply.

    Worse, if the PSBR is increased to offset a reduction of bank lending, what would actually be happening too is that risk is would be transferred from the banks to the government, again increasing the government’s risk costs.

  • Eddie Sammon 8th Mar '13 - 9:51pm

    Richard, would I get your vote? :)

  • Bill le Breton 9th Mar '13 - 7:39am

    Geoff – in the equation, try increasing PSBR (by employing a nurse and building a bridge) without changing the other factors on the right hand side and you get an increase in the money supply (and of course the increased Gov Ex gets the country an nurse and a bridge). It beats the way QE operates at the moment because it doesn’t increase potential demand it increases actual demand. QE allowed banks to increase their reserves (and get paid an interest for doing so!). It was hoped that these repairs to the commercial bank balance sheets would free them up to begin lending again.

    ….

    The equation was formulated by the IMF in the ’70s and called the Domestic Credit Expansion equation. Of course in the 70s the equation justified now ‘reducing’ the PSBR would reduce the money supply and aggregate demand.

    It just seemed obvious to me in 2008 that all you had to do was reverse the process to get rid of the deflation. (I seem to recall that Joe B knew of it, but very few others.) Central Bankers built a high wall round the magic money tree orchard, locked it and hid the key. People kept on thinking that any increase in PSBR HAD to be funded by an balancing increase in non bank private sector loans to Government – gilts.

    Have a look at Friedman’s ‘A Monetary and Fiscal Foreword for Economic Stability’, American Economic Review, Vol. 38, June 1948. People forget that Friedman’s original thinking was developed in relation to defeating deflation NOT inflation.

  • Bill le Breton 9th Mar '13 - 7:57am

    Richard – there are no increases in debt repayments. Read the equation again, put through a £1 billion increase in PSBR, all else unchanged on the right hand side. The Government has not borrowed from anyone – it has just caused the Bank of England to create electronic deposits to the value of £1 billio … and received £1 billion of services or infrastructure.

    In the 1970s this was the normal way of funding the PSBR.

    Increasing the money supply in the long run will have no effect on the real economy, prices will rise to compensate. i.e. Inflation. BUT in the short term sticky prices mean that there is a short window in which the increased demand can encourage firms to expand/new firms to come into their markets – and encourage commercial banks to lend to these firms. If the increase in money/aggregate demand increases out put by a similar amount, no inflation.

    Central Bankers know that this can be done but do not advocate it because they fear that when the moment comes for the Chancellor to reverse the process, s/he will refuse to do so and bring about another Great Inflation.

    I believe that the risk is worth taking given the length of the stagnation and given the evidence of Japan that if you don’t do this, stagnation can last for decades. Japan has finally found a politician and a Party willing to take that risk. I have always thought that in this country that could/should be our leader and our Party, but the present leader prefers no to believe in magic money trees.

  • Bill le Breton 9th Mar '13 - 8:04am

    Joe, I agree that it is not sufficient just to introduce an NGDP level target without a full-on communications campaign. The whole thing works through expectations so you need to create sufficient awareness and knowledge to ensure those can operate.

    In fact if you read Carney’s review of all targets, he thought a year ago that this lack of understanding was the only reason not to adopt such a target. I don’t think this is an unsurmountable problem. People soon got the Taylor Rule.

  • Richard Dean 9th Mar '13 - 1:07pm

    Bill,
    The B in PSBR means Borrowing! The system you describe for the £1 billion seems more like a type of extended QE system, not the borrowing system at all. When government borrows money from investors and companies, it pays interest on the loan. When QE is used simply to refill bank reserves, it’s not actually spent, it’s just sitting there giving people confidence and so preventing a bank run, so it is claimed that it doesn’t cause inflation. If it was spent on infrastructure, the inflation it would cause would have the same detrimental effect on government finances as loan inteest would!

    Googling “Domestic Credit Expansion equation” finds nothing! Are you sure of your sources? The IMF publishes a lot of research reports but usually they have disclaimers saying they are not necessarily IMF policy.

  • Eddie Sammon 9th Mar '13 - 1:47pm

    It’s a big con, we should target real GDP not nominal GDP. Japan’s approach may have puffed up the stock market but it doesn’t mean it has improved standards of living.

  • Eddie Sammon 9th Mar '13 - 1:54pm

    GDP itself is flawed because it allowed New Labour to just borrow huge sums of money, pump it into the economy and claim GDP was going up. It takes no consideration of debt. There’s a good quote from Tony Blair’s book where he says “The economic growth was said to be a delusion based on debt”.

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