Pushing on a string

This week, leading right-wing economists in the US launched a campaign in the Wall Street Journal attacking the plan of the US Federal Reserve Bank under Chairman Ben Bernanke to buy $600bn in US government bonds.

This plan is the next chapter in so-called ‘quantitative easing’ (QE) by the Fed.  QE is a weapon in monetary policy.  Central banks like the Fed can lower interest rates in an economy by lowering the rate of interest that banks can borrow cash from it.  Reducing the price of borrowing should help an economy to grow faster.

But when the interest rate reaches zero, as it has done in the US, a central bank must resort to pumping more cash into the economy, so it is the quantity, not the price, of money or liquidity that is increased.  The Fed buys bonds or other assets from the banks and pays for it with cash.  The cash is found by simply printing it (or to be more exact, increasing the amount of the reserves that the commercial banks hold with the Fed).  It’s just done by fiat.  Thus we have ‘quantitative easing’.

The Fed’s plan is to get the value of government bonds up and thus interest rates paid on holding those bonds down.  Government bond interest rates usually set the floor for all interest rates in an economy.  That’s because mortgage lenders and banks borrow their funds at rates set by government bonds (the safest form of loan). So if interest rates on government bonds fall, then so will mortgage rates, the interest rates on corporate loans and on corporate debt.  If those rates fall, then households will be more willing to take out loans to buy homes or consumer goods.  And corporations will be more willing to invest in plant, offices, machinery and jobs.  Or at least that’s the theory of QE.

Bernanke also hopes that rising bond prices will feed through to rising share prices, inspiring increased ‘confidence’ that will feed through to more investment and consumer purchases and so get the economy going.   As a leading student of the Great Depression of the 1930s, Bernanke has been really worried that the US capitalism could slip back into a ‘double-dip’ recession with deflating prices, as happened in 1937-38.  Quantitative easing is his plan to avoid that.

The Austerians are those economists who reckon that the printing of money is wrong in theory and won’t work in practice (see my earlier post, Keynesians versus Austerians, 22 June 2010).  They believe that reducing debt, not increasing it, is what is necessary to get capitalism on its feet again.   So they are strongly opposed to the Fed’s move.  As they say in their open letter to Ben Bernanke in the Wall Street Journal: “ the planned asset purchases risk currency debasement and inflation and we do not think they will achieve the Fed’s objective of promoting employment.”

And if the result of the previous bout of QE by the Fed back in 2008-9 is anything to go by, the Austerians are right.  Then the Fed launched a huge programme of purchasing the mortgage loans and bonds of the banks and financial institutions, along with some government bonds, to provide the likes of Goldman Sachs, Morgan Stanley and all the other banks with more cash.    As a result, the Fed increased its balance sheet from about $800bn to $2.3trn, or a tripling.

But the economy failed to make much of a recovery, and with unemployment not a dent was made.  And it is clear why.  Just look at this graphic.  It shows the rise in Fed purchases against the change in lending by the banks to companies and households.  Bank lending fell.

It shows the classic Keynesian concept of the ‘liquidity trap’.  Back in the 1930s, JM Keynes argued that, by keeping interest rates too high, people were encouraged to ‘hoard’ their cash rather than spend it or lend it on.  As long as that lasted, more money would not lead to more economic growth – the monetary authorities would be pushing on a string.

That’s why the Keynesians are also less than enthusiastic about Bernanke’s QE2 measures.  However, this time it is not high interest rates that are the problem – the Fed has its base rate down to virtually zero.   And with inflation around 2%, real interest rates are negative.  Nor is it the lack of supply of money that is the problem – the Fed has already pumped in trillions and plans even more.  There is just a lack of demand for cash to invest or spend.  People don’t want to borrow more money when they still have big mortgage debts, lower home prices, no increases in wages and the possible loss of their jobs.  And banks don’t want to lend money to risky companies and indebted householders, when they can take advantage of rising government bond prices supported by the Fed to get an easy profit.

So the Austerians and the Keynesians are right.  The Fed’s QE2 plan won’t work.  But what is their alternative?  The Austerian position is that there is nothing you can do to revive the economy ‘artificially’.  We must just wait for markets to cleanse the bad debts by ‘deleveraging’ .  At  some point when unemployment is high enough and bad debts have been written off enough, profitability for new investment will be high enough to kick it off.  Any attempt to interfere with this process will only prolong the agony.

It’s been the argument of this blog that eventually capitalism will recover once profitability is restored sufficiently.  In that sense, I agree with the Austerians.  But, given the very high levels of debt (or what Marx called fictitious capital) built up during the great credit bubble and the subsequent Great Recession, it is going to take a very long time to get the costs of capital down to levels that will revive profitability (see my post, The overhang of debt, 3 March 2010).  In the meantime, the ‘collateral damage’ to people’s  livelihoods, jobs and incomes will be huge.

For the Austerians that is the price you have to pay for capitalism’s past ‘excesses’.  The Keynesian solution is different.  Their argument is that, given the liquidity trap, the Bernanke plan won’t work.  So what is needed is massive government spending even if it runs up huge deficits and debt.  They don’t matter.  Government spending will boost ‘effective demand’ , replacing private sector weakness and thus generate new economic growth.

The problem with this approach is that if it was imposed effectively, it would seriously impinge on private sector profitability and ‘free markets’.  When Keynes first proposed government spending as a solution to the Great Depression, he too recognised that it would encroach on the ‘rights’ of the private sector to make a profit.  As a result, he thought it should be done gradually so as not to frighten the horses.  Modern Keynesians do not even consider this conflict – it is assumed that the private sector will remain intact and increased government spending will not be a problem for profits.  But is it that easy?

If governments increase spending and don’t raise taxes, they will increase the budget deficit and the government debt.  The Keynesians say this does not matter.  Indeed, cutting government spending to reduce a budget deficit would also reduce economic growth.   Paul Krugman, the doyen of the Keynesians, for example, has stated that the plans of the UK government to cut its budget deficit over the next four years will ensure that Britain slips into another Great Depression.

However, a recent study by the IMF has shown that different sorts of spending have different results (see the IMF’s World Economic Outlook, October 2010, chapter 3, http://www.imf.org/external/pubs/ft/weo/2010/02/index.htm).   And so which sort of spending you cut will produce different outcomes for the capitalist economy.   The IMF looked at 15 developed capitalist economies from 1980 that carried out reductions in government spending to see what the impact was on economic growth over the following years.  I’m afraid that the results must be taken with some pinches of salt given all the assumptions that the IMF makes.  Indeed, the results are now subject to criticism from other researchers and a debate is under way.  But I think there are some reasonably firm conclusions to draw from the IMF study and the others.

look at the graph in the IMF report.  First, it seems that a cut in welfare benefits would raise growth.   It does not do so by much – just one-quarter of 1% on the growth rate.  And it’s not so surprising under capitalism.  Increased welfare benefits to the unemployed, disabled and poor is a cost to capitalist profits and is not compensated by a sufficient rise in effective demand.  The poorest and weakest in our society just spend too little.  A cut in welfare costs provides a breather to private sector profits

However, cutting government consumption does damage economic growth by up to 0.3% pts off the growth rate.  That’s because spending on government services like schools, universities, medical services, transport and housing creates jobs and boosts incomes for millions of households.  Cutting the spending on these services will do the opposite.

But economic growth gets the biggest impetus from government investment, according to the IMF.  Cutting government investment by 1% of GDP takes up to three-quarters of 1% off the growth rate of an economy.   That’s because government investment into infrastructure projects to build bridges, roads, schools, hospitals or railways help industry and commerce, while providing millions of jobs that can make a significant contribution to economic growth.

There is a glaring example in Britain, where the private sector cannot manage to build more than 150,000 new homes a year.  That’s way below what is required just to replace 250,000 a year that become uninhabitable.  So there is a chronic housing shortage in the UK that has driven up home prices and rents to the highest levels in Europe.   As a result, housing benefits to subsidise rent payments for the poorest in society have rocketed.  Now the coalition government plans to slash benefits, making it impossible for hundreds of thousands of families to pay their rent and forcing them to move to cheaper areas, lose their jobs, take their kids out of schools etc.  Government investment in homes construction over the last decade could have avoided this misery and boosted employment and growth at the same time’.

Its the same argument for government investment in environmental projects that improve the quality of life , raise efficiency and help deal with climate change, while providing jobs to replace those lost in the private sector during the Great Recession.

In the second world war, both the US and British governments took over the planning of industrial investment and employment for the ‘war effort’.   It could not be left to the private sector and production for profit to do the right thing.  But, of course, that was an emergency not to be repeated in peace time, such are the assumptions of both the Keynesians and Austerians.  Instead, we shall going on pushing on a string.

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