Tag: quantitative easing

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Deeper in debt

On 25 November, the UK government published its Spending Review 2020. This gives details of estimated government expenditure for the current financial year, 2020/21, and plans for government expenditure and the likely totals for 2021/22.

The focus of the Review is specifically on the effects of and responses to the coronavirus pandemic. It does not consider the effects of Brexit, with or without a trade deal, or plans for taxation. The Review is based on forecasts by the Office for Budget Responsibility (OBR). Because of the high degree of uncertainty over the spread of the disease and the timing and efficacy of vaccines, the OBR gives three forecast values for most variables – pessimistic, central and optimistic.

According to the central forecast, real GDP is set to decline by 11.3% in 2020, the largest one-year fall since the Great Frost of 1709. The economy is then set to ‘bounce back’ (somewhat), with GDP rising by 5.2% in 2021.

Unemployment will rise from 3.9% in 2019 to a peak of 7.5% in mid-2021, after the furlough scheme and other support for employers is withdrawn.

This blog focuses at the impact on government borrowing and debt and the implications for the future – both the funding of the debt and ways of reducing it.

Soaring government deficits and debt


Government expenditure during the pandemic has risen sharply through measures such as the furlough scheme, the Self-Employment Income Support Scheme and various business loans. This, combined with falling tax revenue, as incomes and consumer expenditure have declined, has led to a rise in public-sector net borrowing (PSNB) from 2.5% of GDP in 2019/20 to a central forecast of 19% for 2020/21 – the largest since World War II. By 2025/26 it is still forecast to be 3.9% of GDP. The figure has also been pushed up by a fall in nominal GDP for 2020/21 (the denominator) by nearly 7%. (Click here for a PowerPoint of the above chart.)

The high levels of PSNB are pushing up public-sector net debt (PSNB). This is forecast to rise from 85.5% of GDP in 2019/20 to 105.2% in 2020/21, peaking at 109.4% in 2023/24.

The exceptionally high deficit and debt levels will mean that the government misses by a very large margin its three borrowing and debt targets set out in the latest (Autumn 2016) ‘Charter for Budget Responsibility‘. These are:

  • to reduce cyclically-adjusted public-sector net borrowing to below 2% of GDP by 2020/21;
  • for public-sector net debt as a percentage of GDP to be falling in 2020/21;
  • for overall borrowing to be zero or in surplus by 2025/26.

But, as the Chancellor said in presenting the Review:

Our health emergency is not yet over. And our economic emergency has only just begun. So our immediate priority is to protect people’s lives and livelihoods.

Putting the public finances on a sustainable footing

Running a large budget deficit in an emergency is an essential policy for dealing with the massive decline in aggregate demand and for supporting those who have, or otherwise would have, lost their jobs. But what of the longer-term implications? What are the options for dealing with the high levels of debt?

1. Raising taxes. This tends to be the preferred approach of those on the left, who want to protect or improve public services. For them, the use of higher progressive taxes, such as income tax, or corporation tax or capital gains tax, are a means of funding such services and of providing support for those on lower incomes. There has been much discussion of the possibility of finding a way of taxing large tech companies, which are able to avoid taxes by declaring very low profits by diverting them to tax havens.

2. Cutting government expenditure. This is the traditional preference of those on the right, who prefer to cut the overall size of the state and thus allow for lower taxes. However, this is difficult to do without cutting vital services. Indeed, there is pressure to have higher government expenditure over the longer term to finance infrastructure investment – something supported by the Conservative government.

A downside of either of the above is that they squeeze aggregate demand and hence may slow the recovery. There was much discussion after the financial crisis over whether ‘austerity policies’ hindered the recovery and whether they created negative supply-side effects by dampening investment.

3. Accepting higher levels of debt into the longer term. This is a possible response as long as interest rates remain at record low levels. With depressed demand, loose monetary policy may be sustainable over a number of years. Quantitative easing depresses bond yields and makes it cheaper for governments to finance borrowing. Servicing high levels of debt may be quite affordable.

The problem is if inflation begins to rise. Even with lower aggregate demand, if aggregate supply has fallen faster because of bankruptcies and lack of investment, there may be upward pressure on prices. The Bank of England may have to raise interest rates, making it more expensive for the government to service its debts.

Another problem with not reducing the debt is that if another emergency occurs in the future, there will be less scope for further borrowing to support the economy.

4. Higher growth ‘deals’ with the deficit and reduces debt. In this scenario, austerity would be unnecessary. This is the ‘golden’ scenario – for the country to grow its way out of the problem. Higher output and incomes leads to higher tax revenues, and lower unemployment leads to lower expenditure on unemployment benefits. The crucial question is the relationship between aggregate demand and supply. For growth to be sustainable and shrink the debt/GDP ratio, aggregate demand must expand steadily in line with the growth in aggregate supply. The faster aggregate supply can grow, the faster can aggregate demand. In other words, the faster the growth in potential GDP, the faster can be the sustainable rate of growth of actual GDP and the faster can the debt/GDP ratio shrink.

One of the key issues is the degree of economic ‘scarring’ from the pandemic and the associated restrictions on economic activity. The bigger the decline in potential output from the closure of firms and the greater the deskilling of workers who have been laid off, the harder it will be for the economy to recover and the longer high deficits are likely to persist.

Another issue is the lack of labour productivity growth in the UK in recent years. If labour productivity does not increase, this will severely restrict the growth in potential output. Focusing on training and examining incentives, work practices and pay structures are necessary if productivity is to rise significantly. So too is finding ways to encourage firms to increase investment in new technologies.

Podcast and videos

Articles

OBR Data

Questions

  1. What is the significance of the relationship between the rate of economic growth and the rate of interest for financing public-sector debt over the longer term?
  2. What can the government do to encourage investment in the economy?
  3. Using OBR data, find out what has happened to the output gap over the past few years and what is forecast to happen to it over the next five years. Explain the significance of the figures.
  4. Distinguish between demand-side and supply-side policies. How would you characterise the policies to tackle public-sector net debt in terms of this distinction? Do the policies have a mixture of demand- and supply-side effects?
  5. Choose two other developed countries. Examine how their their public finances have been affected by the coronavirus pandemic and the policies they are adopting to tackle the economic effects of the pandemic.
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Lockdown 2.0: fiscal and monetary responses

With the imposition of a new lockdown in England from 5 November to 2 December and in Wales from 3 October to 9 November, and with strong restrictions in Scotland and Northern Ireland, the UK economy is set to return to negative growth – a W-shaped GDP growth curve.

With the closure of leisure facilities and non-essential shops in England and Wales, spending is likely to fall. Without support, many businesses would fail and potential output would fall. In terms of aggregate demand and supply, both would decline, as the diagram below illustrates. (Click here for a PowerPoint.)

The aggregate demand curve shifts from AD1 to AD2 as consumption and investment fall. Exports also fall as demand is hit by the pandemic in other countries. The fall in aggregate supply is represented partly by a movement along the short-run aggregate supply curve (SRAS) as demand falls for businesses which remain open (such as transport services). Largely it is represented by a leftward shift in the curve from SRAS1 to SRAS2 as businesses such as non-essential shops and those in the hospitality and leisure sector are forced to close. What happens to the long-run supply curve depends on the extent to which businesses reopen when the lockdown and any other subsequent restrictions preventing their reopening are over. It also depends on the extent to which other firms spring up or existing firms grow to replace the business of those that have closed. The continuing rise in online retailing is an example.

With the prospect of falling GDP and rising unemployment, the UK government and the Bank of England have responded by giving a fiscal and monetary boost. We examine each in turn.

Fiscal policy

In March, the Chancellor introduced the furlough scheme, whereby employees temporarily laid off would receive 80% of their wages through a government grant to their employers. This scheme was due to end on 31 October, to be replaced by the less generous Job Support Scheme (see the blog, The new UK Job Support Scheme: how much will it slow the rise in unemployment?). However, the Chancellor first announced that the original furlough scheme would be extended until 2 December for England and then, on 5 November, to the end of March 2021 for the whole of the UK. He also announced that the self-employed income support grant would increase from 55% to 80% of average profits up to £7500.

In addition, the government announced cash grants of up to £3000 per month for businesses which are closed (worth more than £1 billion per month), extra money to local authorities to support businesses and an extension of existing loan schemes for business. Furthermore, the government is extending the scheme whereby people can claim a repayment ‘holiday’ for up to 6 months for mortgages, personal loans and car finance.

The government hopes that the boost to aggregate demand will help to slow, or even reverse, the predicted decline in GDP. What is more, by people being put on furlough rather than being laid off, it hopes to slow the rise in unemployment.

Monetary policy

At the meeting of the Bank of England’s Monetary Policy Committee on 4 November, further expansionary monetary policy was announced. Rather than lowering Bank Rate from its current historically low rate of 0.1%, perhaps to a negative figure, it was decided to engage in further quantitative easing.

An additional £150 billion of government bonds will be purchased under the asset purchase facility (APF). This will bring the total vale of bonds purchased since the start of the pandemic to £450 billion (including £20 billion of corporate bonds) and to £895 billion since 2009 when QE was first introduced in response to the recession following the financial crisis of 2007–8.

The existing programme of asset purchases should be complete by the end of December this year. The Bank of England expects the additional £150 billion of purchases to begin in January 2021 and be completed within a year.

UK quantitative easing since the first round in March 2009 is shown in the chart above. The reserve liabilities represent the newly created money for the purchase of assets under the APF programme. (There are approximately £30 billion of other reserve liabilities outside the APF programme.) The grey area shows projected reserve liabilities to the end of the newly announced programme of purchases, by which time, as stated above, the total will be £895 billion. This, of course, assumes that the Bank does not announce any further QE, which it could well do if the recovery falters.

Justifying the decision, the MPC meeting’s minutes state that:

There are signs that consumer spending has softened across a range of high-frequency indicators, while investment intentions have remained weak. …The fall in activity over 2020 has reflected a decline in both demand and supply. Overall, there is judged to be a material amount of spare capacity in the economy.

Conclusions

How effective these fiscal and monetary policy measures will be in mitigating the effects of the Covid restrictions remains to be seen. A lot will depend on how successful the lockdown and other restrictions are in slowing the virus, how quickly a vaccine is developed and deployed, whether a Brexit deal is secured, and the confidence of both consumers, businesses and financial markets that the economy will bounce back in 2021. As the MPC’s minutes state:

The outlook for the economy remains unusually uncertain. It depends on the evolution of the pandemic and measures taken to protect public health, as well as the nature of, and transition to, the new trading arrangements between the European Union and the United Kingdom. It also depends on the responses of households, businesses and financial markets to these developments.

Articles

Official documents

Questions

  1. Illustrate the effects of expansionary fiscal and monetary policy on (a) a short-run aggregate supply and demand diagram; (b) a long-run aggregate supply and demand diagram.
  2. In the context of the fiscal and monetary policy measures examined in this blog, what will determine the amount that the curves shift?
  3. Illustrate on a Keynesian 45° line diagram the effects of (a) the lockdown and (b) the fiscal and monetary policy measures adopted by the government and Bank of England.
  4. If people move from full-time to part-time working, how is this reflected in the unemployment statistics? What is this type of unemployment called?
  5. How does quantitative easing through asset purchases work through the economy to affect output and employment? In other words, what is the transmission mechanism of the policy?
  6. What determines the effectiveness of quantitative easing?
  7. Under what circumstances will increasing the money supply affect (a) real output and (b) prices alone?
  8. Why might quantitative easing benefit the rich more than the poor?
  9. How could the government use quantitative easing to finance its budget deficit?
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Fed adopts new monetary targets

In the current environment of low inflation and rising unemployment, the Federal Reserve Bank, the USA’s central bank, has amended its monetary targets. The new measures were announced by the Fed chair, Jay Powell, in a speech for the annual Jackson Hole central bankers’ symposium (this year conducted online on August 27 and 28). The symposium was an opportunity for central bankers to reflect on their responses to the coronavirus pandemic and to consider what changes might need to be made to their monetary policy targets and instruments.

The Fed’s previous targets

Previously, like most other central banks, the Fed had a long-run inflation target of 2%. It did, however, also seek to ‘maximise employment’. In practice, this meant seeking to achieve a ‘normal’ rate of unemployment, which the Fed regards as ranging from 3.5 to 4.7% with a median value of 4.1%. The description of its objectives stated that:

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

The new targets

Under the new system, the Fed has softened its inflation target. It will still be 2% over the longer term, but it will be regarded as an average, rather than a firm target. The Fed will be willing to see inflation above 2% for longer than previously before raising interest rates if this is felt necessary for the economy to recover and to achieve its long-run potential economic growth rate. Fed chair, Jay Powell, in a speech on 27 August said:

Following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time.

Additionally, the Fed has increased its emphasis on employment. Instead of focusing on deviations from normal employment, the Fed will now focus on the shortfall of employment from its normal level and not be concerned if employment temporarily exceeds its normal level. As Powell said:

Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals

The Fed will also take account of the distribution of employment and pay more attention to achieving a strong labour market in low-income and disadvantaged communities. However, apart from the benefits to such communities from a generally strong labour market, it is not clear how the Fed could focus on disadvantaged communities through the instruments it has at its disposal – interest rate changes and quantitative easing.

Assessment

Modern monetary theorists (see blog MMT – a Magic Money Tree or Modern Monetary Theory?) will welcome the changes, arguing that they will allow more aggressive expansion and higher government borrowing at ultra-low interest rates.

The problem for the Fed is that it is attempting to achieve more aggressive goals without having any more than the two monetary instruments it currently has – lowering interest rates and increasing money supply through asset purchases (quantitative easing). Interest rates are already near rock bottom and further quantitative easing may continue to inflate asset prices (such as share and property prices) without sufficiently stimulating aggregate demand. Changing targets without changing the means of achieving them is likely to be unsuccessful.

It remains to be seen whether the Fed will move to funding government borrowing directly, which could allow for a huge stimulus through infrastructure spending, or whether it will merely stick to using asset purchases as a way for introducing new money into the system.

Articles

Speeches

Questions

  1. Find out how much asset purchases by the Fed, the Bank of England and the ECB have increased in the current rounds of quantitative easing.
  2. How do asset purchases affect narrow money, broad money and aggregate demand? Is there a fixed money multiplier effect between the narrow money increases and aggregate demand? Explain.
  3. Why did the dollar exchange rate fall following the announcement of the new measures by Jay Powell?
  4. The Governor of the Bank of England, Andrew Bailey, also gave a speech at the Jackson Hole symposium. How does the approach to money policy outlined by Bailey differ from that outlined by Jay Powell?
  5. What practical steps, if any, could a central bank take to improve the relative employment prospects of disadvantaged groups?
  6. Outline the arguments for and against central banks directly funding government expenditure through money creation.
  7. What longer-term problems are likely to arise from central banks pursuing ultra-low interest rates for an extended period of time?
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Stock markets rise despite the recession. Why?

Share prices are determined by demand and supply. The same applies to stock market indices, such as the FTSE 100 and FTSE 250 in the UK and the Dow Jones Industrial Average and the S&P 500 in the USA. After all, the indices are the weighted average prices of the shares included in the index. Generally, when economies are performing well, or are expected to do so, share prices will rise. They are likely to fall in a recession or if a recession is anticipated. A main reason for this is that the dividends paid on shares will reflect the profitability of firms, which tends to rise in times of a buoyant economy.

When it first became clear that Covid-19 would become a pandemic and as countries began locking down, so stock markets plummeted. People anticipated that many businesses would fail and that the likely recession would cause profits of many other surviving firms to decline rapidly. People sold shares.

The first chart shows how the FTSE 100 fell from 7466 in early February 2020 to 5190 in late March, a fall of 30.5%. The Dow Jones fell by 34% over the same period. In both cases the fall was driven not only by the decline in the respective economy over the period, but by speculation that further declines were to come (click here for a PowerPoint of the chart).

But then stock markets started rising again, especially the Dow Jones, despite the fact that the recessions in the UK, the USA and other countries were gathering pace. In the second quarter of 2020, the Dow Jones rose by 23% and yet the US economy declined by 33% – the biggest quarterly decline on record. How could this be explained by supply and demand?

Quantitative easing

In order to boost aggregate demand and reduce the size of the recession, central banks around the world engaged in large-scale quantitative easing. This involves central banks buying government bonds and possibly corporate bonds too with newly created money. The extra money is then used to purchase other assets, such as stocks and shares and property, or physical capital or goods and services. The second chart shows that quantitative easing by the Bank of England increased the Bank’s asset holding from April to July 2020 by 50%, from £469bn to £705bn (click here for a PowerPoint of the chart).

But given the general pessimism about the state of the global economy, employment and personal finances, there was little feed-through into consumption and investment. Instead, most of the extra money was used to buy assets. This gave a huge boost to stock markets. Stock market movements were thus out of line with movements in GDP.

Confidence

Stock market prices do not just reflect the current economic and financial situation, but also what people anticipate the situation to be in the future. As infection and death rates from Covid-19 waned around Europe and in many other countries, so consumer and business confidence rose. This is illustrated in the third chart, which shows industrial, consumer and construction confidence indicators in the EU. As you can see, after falling sharply as the pandemic took hold in early 2020 and countries were locked down, confidence then rose (click here for a PowerPoint of the chart).

But, as infection rates have risen somewhat in many countries and continue to soar in the USA, Brazil, India and some other countries, this confidence may well start to fall again and this could impact on stock markets.

Speculation

A final, but related, cause of recent stock market movements is speculation. If people see share prices falling and believe that they are likely to fall further, then they will sell shares and hold cash or safer assets instead. This will amplify the fall and encourage further speculation. If, however, they see share prices rising and believe that they will continue to do so, they are likely to want to buy shares, hoping to make a gain by buying them relatively cheaply. This will amplify the rise and, again, encourage further speculation.

If there is a second wave of the pandemic, then stock markets could well fall again, as they could if speculators think that share prices have overshot the levels that reflect the economic and financial situation. But then there may be even further quantitative easing.

There are many uncertainties, both with the pandemic and with governments’ policy responses. These make forecasting stock market movements very difficult. Large gains or large losses could await people speculating on what will happen to share prices.

Articles

Questions

  1. Illustrate the recent movements of stock markets using demand and supply diagrams. Explain your diagrams.
  2. What determines the price elasticity of demand for shares?
  3. Distinguish between stabilising and destabilising speculation. How are the concepts relevant to the recent history of stock market movements?
  4. Explain how quantitative easing works to increase (a) asset prices; (b) aggregate demand.
  5. What is the difference between quantitative easing as currently conducted by central banks and ‘helicopter money‘?
  6. Give some examples of companies whose share prices have risen strongly since March 2020. Explain why these particular shares have done so well.
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MMT – a Magic Money Tree or Modern Monetary Theory?

Is there a ‘magic money tree’? Is it desirable for central banks to create money to finance government deficits?

The standard thinking of conservative governments around the world is that creating money to finance deficits will be inflationary. Rather, governments should attempt to reduce deficits. This will reduce the problem of government expenditure crowding out private expenditure and reduce the burden placed on future generations of having to finance higher government debt.

If deficits rise because of government response to an emergency, such as supporting people and businesses during the Covid-19 pandemic, then, as soon as the problem begins to wane, governments should attempt to reduce the higher deficits by raising taxes or cutting government expenditure. This was the approach of many governments, including the Coalition and Conservative governments in the UK from 2010, as econommies began to recover from the 2007/8 financial crisis.

‘Modern Monetary Theory‘ challenges these arguments. Advocates of the theory support the use of higher deficits financed by monetary expansion if the money is spent on things that increase potential output as well as actual output. Examples include spending on R&D, education, infrastructure, health and housing.

Modern monetary theorists still accept that excess demand will lead to inflation. Governments should therefore avoid excessive deficits and central banks should avoid creating excessive amounts of money. But, they argue that inflation caused by excess demand has not been a problem for many years in most countries. Instead, we have a problem of too little investment and too little spending generally. There is plenty of scope, they maintain, for expanding demand. This, if carefully directed, can lead to productivity growth and an expansion of aggregate supply to match the rise in aggregate demand.

Government deficits, they argue, are not intrinsically bad. Government debt is someone else’s assets, whether in the form of government bonds, savings certificates, Treasury bills or other instruments. Provided the debt can be serviced at low interest rates, there is no problem for the government and the spending it generates can be managed to allow economies to function at near full capacity.

The following videos and articles look at modern monetary theory and assess its relevance. Not surprisingly, they differ in their support of the theory!

Videos

Articles

Questions

  1. Compare traditional Keynesian economics and modern monetary theory.
  2. Using the equation of exchange, MV = PY, what would a modern monetary theorist say about the effect of an expansion of M on the other variables?
  3. What is the role of fiscal policy in modern monetary theory?
  4. What evidence might suggest that money supply has been unduly restricted?
  5. When, according to modern monetary theory, is a rising government deficit (a) not a problem; (b) a problem?
  6. Is there any truth in the saying, ‘There’s no such thing as a magic money tree’?
  7. Provide a critique of modern monetary theory.