Message to Jack Layton and the NDP: monetary policy is not out of reach of Parliament

If the leader of the NDP wants to improve the way monetary policy is conducted in Canada without breaching the doctrine of central bank independence, I would suggest that he and his party use their influence in the upcoming Parliament to require that the government and the Bank of Canada modify their agreed-upon inflation-control target. The timing seems right given that the operational target that the Bank uses to control the level of inflation is due to be renewed at the end of the year.

There is considerable evidence that the current target of 2 percent is too low to ensure an acceptable level of employment and adequate exchange rate (for instance, to support the economy's export market). Speaking in relation to the US, Paul Krugman has recently explained that a target of 4 percent would go a long way to help the economy get closer to full employment. Mr. Krugman's arguments could easily be applied to Canada, as well. The question of whether low inflation targets are desirable was also recently raised by senior IMF economist, Olivier Blanchard, within the context of an IMF-sponsored conference aimed at identifying ways of improving macroeconomic policymaking.

From a political standpoint, I can assure Mr. Layton that many parliamentarians would appreciate having a debate on the merits of low-inflation at all costs. Finally, while he's at it, Mr. Layton should also ask officials at the Bank what they intend to do about the recent increase in unemployment in the face of what appears to be, at most, mild inflation.

Study: Indebtedness and family type

Statistics Canada has just released an interesting study dealing with indebtedness according to family characteristics. While I disagree with the study's premise that indebtedness levels were caused by low interest rates and factors such as "the rise of consumerism" (see here), I thought the sections dealing with the debt profiles of lone-parent families and couple families with children were particularly insightful. According to the study, although the average debt to income ratio in Canada currently stands at 148 percent, the ratios for couple families with children and lone-parent families are as high as 170 percent and 227 percent, respectively. Such statistics are rarely mentioned in most discussions on the issue of indebtedness.

Although the study focuses only on Canadian debt metrics, I can't imagine the situation in other countries with similar demographics (i.e. UK, US or Australia) being any different.

St. Louis Fed knows about...the Fed's policy of paying interest on reserves

In a previous post, I criticized the research staff of the St. Louis Fed for failing to explain in an article on the expansion in the US monetary base that the Fed now has the ability to simultaneously defend against inflation and maintain large amounts of excess reserves (contrary to what most macro textbooks claim).

Well, it turns out that someone at the St. Louis Fed is actually aware of the Fed's new policy of paying interest on reserves (see p.2). As mentioned in my commentary, the payment of interest on reserves nullifies a central monetarist tenet which holds that all increases in the monetary base are inflationary by nature. Perhaps someone at the regional Fed realized that their position on this matter was inconsistent and needed to be clarified. Still, it seems pretty clear that the piece by Wen was aimed at (incorrectly) inciting fear about the potential for inflation caused by the expansion in the US monetary base since 2008.

Also, just to clarify my view on this issue, the reason why I wish to highlight the fact that the Fed now has the ability to both control inflation (via the setting of interest rates) and maintain a large monetary base (via the remuneration rate on reserves) is not to support QE as a policy objective. As I've made clear previously, I have serious doubts about the effectiveness of QE as a means to get the US economy back on track. Rather, my goal is to show that, in the event that the US government decides to pursue additional stimulus via fiscal policy (which I believe is needed), the Fed would have all the tools at its disposal to stabilize the benchmark rate, control inflationary pressures and accommodate for the excess bank reserves created as a result of the additional deficit spending by the US Treasury.

h/t: Cullen Roche

S&P cuts the US ratings outlook to negative

So the rating agency is cutting the US's fiscal outlook to negative? It appears that the reason behind S&P's decision is that the US failed to follow the likes of Canada, the UK and France, among others, in concocting a "credible" plan to achieve a balanced budget within a completely arbitrary and meaningless time period.

If you're interested in learning why the US cannot face insolvency (or "go bankrupt", as Davos and D.C. types like to claim), I recommend you read "True Sovereigns will not default" by Steve Major of HSBC Global Research (January 2010, p. 3). Essentially, the article explains why the notion of default risk is a non-starter for countries such as the US, Japan and the UK where governments have full sovereignty over their own currency. In the case of these "true sovereigns", the risk to investors stems from interest rates and inflation.

Also, I strongly recommend the comments made here by Ed Rombach on Reuters Insider, who describes S&P's decision as a "non-event". According to Mr. Rombach, the US cannot default on its debt given that it issues its own currency. Also, Mr. Rombach discusses the remote possibility that the US could choose to default for political reasons rather than for financial ones as a result of Congress not raising its debt ceiling. Bottom line for Mr. Rombach: sell 5-year credit default swaps on US government debt.*

* The last paragraph was added on April 19, 2011.

The modern "financial flows" view of deficit spending

In this presentation, post-Keynesian economist Mario Seccareccia of the University of Ottawa applies the sectoral flows approach to macroeconomics to discuss the importance of fiscal policy. Some of the issues covered in the presentation were discussed in two of my earlier posts (here and here). The presentation was given last week in Bretton Woods, NH, at a conference organized by the Institute for New Economic Thinking. It's well worth the 15 minutes.

The paper submitted by Prof. Seccareccia can be found on the conference website here.

As mentioned in my earlier posts, the sectoral flows view of the economy facilitates macroeconomic analysis by showing how the receipts and outlays of each sector of the economy create a corresponding rise or fall in the sectors' net acquisition of financial assets. In the presentation, Prof. Seccareccia uses the example of the Canadian economy to show how the government surpluses of the late 1990s and early 2000s corresponded with a decrease in savings by the household sector.

h/t: Cullen Roche

Thoughts on the expansion of the US monetary base

In the cover article of the latest edition of Monetary Trends, economist Yi Wen of the St. Louis Fed is cautioning US policymakers on the risks associated with having a large monetary base (i.e. bank reserves plus currency). In the article, Wen argues that the increase in the monetary base resulting from the Fed’s liquidity facilities (e.g. quantitative easing) since 2008 has the potential to lead to a rise in inflation and, in the longer term, an increase in unemployment.

To support his argument, Wen provides a summary of recent economic research concluding that increases in the rate of growth in base money generally have an opposite effect on the economy’s rate of growth. Also, he points to research suggesting that increases in the rate of growth in the monetary base have a negative impact on both inflation and unemployment.

While there is nothing out of the ordinary in Wen’s argument (it's essentially textbook monetarism...typical for the St. Louis Fed), it is surprising that the article does not mention the fact that the Fed now has the ability, as a result of recent changes in the Fed’s basic operational framework, to both maintain a large monetary base and defend the economy against inflation.

Recall that in October 2008 the Fed started paying interest on bank reserves at a prescribed remuneration rate. In several respects, this new mechanism represented a fundamental shift in the way monetary policy is implemented in the US because it enables the Fed to control both short-term interest rates and the size of the monetary base. The decision was at the time considered as so significant that economists of the NY Fed felt compelled to explain the implications of the new approach toward implementing monetary policy in a staff report in July 2009:

Paying interest on reserves breaks the link between the quantity of reserves and banks’ willingness to lend. By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves. (p. 9) (my emphasis)

In contrast, under the Fed's previous operational framework, it was generally understood that the central bank influenced interest rates and the level of economic activity by making changes to the quantity of reserves. This meant that to control inflation the central bank would have to raise rates by reducing the amount of excess reserves and the size of the monetary base as a whole. Under the Fed’s traditional framework, large quantities of excess reserves were usually regarded as an indication of future inflation.

Getting back to Wen’s article, it is clear that the author is still thinking of monetary policy in terms of the operational realities of the Fed’s previous framework. By solely focusing on the size of the monetary base and its potential negative impact on future inflation and by citing economic research relying on data that predates the Fed’s decision to pay interest on bank reserves, Wen appears to be suggesting that the potential risks to the economy should simply be mitigated by resorting to a reduction in the amount of base money. In my view, this would explain why the article avoids the more useful (and interesting) discussion about how best to use the Fed’s new operational framework to stabilize future inflation (via its influence over market interest rates) while also maintaining a large monetary base (via its authority to set the remuneration rate on reserves) in the event that it becomes necessary for the Fed to support its liquidity facilities for a period longer than anticipated.

To conclude, if the purpose of the article was truly to assist policymakers, as the final paragraph seems to suggest, the author should not have simply cited research on the possible impact of permanent increases in base money and concluded that "caution must be exercised such that long-term inflation does not increase". Rather, it would have been more helpful for the author to mention the ways in which the negative effects of a large monetary base can now be more effectively addressed than in the past as a result of the improved operational framework in place at the Fed since October 2008.

For more on the payment of interest on bank reserves, I recommend the following articles. If you're interested in reading about the implications of the new policy from a post-Keynesian perspective, see the excellent articles by Scott Fullwiler and Marc Lavoie:

Borio, C and P. Disyatat (2009): “Unconventional monetary policies: an appraisal” Bank for International Settlements Working Papers, No. 292.

Fullwiler, S. 2005. “Paying interest on reserve balances: It’s more significant than you think.” Journal of Economic Issues 39(2): 543–550.

Keister, T and J. McAndrews (2009): “Why are banks holding so many excess reserves?” Federal Reserve Bank of New York Staff Reports, No. 380.

Lavoie, M (2010) "Changes in Central Bank Procedures during the subprime Crisis and theit Repercussions on Monetary Theory", Levy Institute Working Paper, No. 606.

The Governor of the People's Bank of China discusses Chinese savings and the global trade imbalance

The Banque de France recently published an interesting article by the Governor of the People's Bank of China, Dr. Zhou Xiaochuan, in its Revue de la stabilité financière. The article discusses the causes of high Chinese savings, as well as provides some interesting insight on how to address the current global trade imbalances. It also presents an interesting view of US-China trade dynamics.

The point I found most interesting in the article was Dr Xiaochuan's refutation of the common claim which holds that the increase in US consumer credit was fueled by the high level of Chinese savings. According to the Governor, Chinese savings could not have caused US consumption to increase given that the high consumption in the US commenced in the mid-1990s whereas "the savings ratio of East Asian countries only surged after the Asian financial crisis and China’s savings ratios did not begin to increase until 2002" (p. 168). Dr. Xiaochuan's take on this matter is in line with the point I made here regarding the causes of the high household debt burden in the US.

Canada's federal budget: a note on tax cuts, deficit reduction and export growth

Canada's 2011 federal budget was announced yesterday. It includes a number of measures aimed at lowering taxes for individuals and businesses. In a slack economy such as Canada's, tax cuts (especially for individuals) can be helpful from the standpoint of demand and purchasing power because they help move the economy toward a fuller utilization of existing capacity. The problem, however, is that the budget also calls for significant reductions in expenditures as a way for the government to return to a balanced budget by the year 2015. Needless to say, such expenditure cuts would only act to offset (read eliminate) any improvement in aggregate demand achieved through the proposed tax reductions.

The strategy behind the government's plan to return the budget into a balanced or surplus position is reminiscent of the strategy used by the federal government in the early 1990s as part of the deficit reduction initiative that followed the 1990-1991 recession. Take, for instance, the current strategy aimed at eliminating the deficit by reducing program expenditures: this is the famous "program review" of the 1990s all over again. In the 1990s, this strategy seemed to have worked quite successfully given that the federal deficit transformed into a surplus within only a few years. Will it work this time? I'm doubtful of it. Here are a few reasons why.

First, it is important to keep in mind that in the 1990s the US dollar strengthened after President Clinton announced on 19 April 1995 that the US "wants a strong dollar". This change in US exchange rate policy resulted in the rise in the value of the US dollar against other currencies. The ensuing depreciation of the Canadian dollar provided a huge boost to Canada's exports, and helped Canada achieve several years of consecutive current account surpluses. Today, the chance of such a scenario repeating itself is unlikely given that President Obama has publicly pledged to significantly cut the US trade deficit by 2015. To the detriment of Canadian exports, President's Obama's goal is only achievable if the value of the US dollar remains weak against other major currencies. Also, it is important to note that the current large inflow of foreign investments into Canada is contributing to further strengthen the Canadian dollar. This too is jeopardizing the country's export potential.

Second, as discussed in this post, the federal government's success in reducing its deficit and achieving budget surpluses in the late 1990s was in part made possible by the economic growth resulting from the increased indebtedness of Canada's household sector. Today, we are facing a much different situation, as Canadian households are slowly in the process of reducing debt and increasing savings.

Under these circumstances, the only way the federal government can eliminate its deficit is if there is a reversal in the financial positions of the corporate sector and household sector (see chart below). Such a situation would involve the household sector returning to its traditional role of being primary lender to the rest of the economy and the corporate sector resuming its role in fostering growth by increasing its level of investment and activity in the economy.