Tag: government debt

Caged Economy

Money seems to be everywhere except where we need it most

Miscreants are often locked up to keep them out of trouble. The same seems to be true of money. Not only do we stash it away for safe keeping but also act to stop too much money getting out into the economy where an excess of funds could create havoc. As such, those able to print money have, over the centuries, found ways of tying their own hands to limit how much cash they could generate. Yet such measures can backfire if the amount of funds free to move around the economy is not enough. While there seems to be plenty of cash around these days, money doesn’t seem to be able to get where it is needed.

The optimal amount of money never required much thought until it was actually something that was printed (on paper) instead of being dug up (as with gold or silver). Initially, the premise for printing money was that the paper notes were in lieu of a precious metal that was safely under lock and key. Not only was it more secure but large transactions were easier without having to lug around a bag of coins. The issuers of notes had to prove themselves trustworthy and not likely to succumb to the temptation of creating more notes that was actually backed by precious metals in the vaults.

It was banks that first issued notes but printing money later became the concern of governments who managed their own currency back by gold under a system which was known as the gold standard. The gold bullion in the vaults acted as a limit to how much cash would circulate within an economy. Growing prosperity with a relatively fixed amount of gold meant that there was likely to be a point at which enough money could not be printed.

Increased wealth also meant more trade between countries and large amounts of gold would cross borders if there was an imbalance between trade coming in and going out. If imports were larger than exports for any country, gold would flow out, thus restricting the amount of money in countries with higher imports. With less money to go around, the economy would suffer, but as a result, imports would also fall so that gold would flow back again and balance would be restored.

The gold standard thus had its own way of reigning in an economy that was overheating. But this process could be quite painful with a steep plunge in economic activity required to achieve even a small fall in imports. And this economic turmoil came at a time when there was no social welfare to help out anyone that would fall into hardship. This was at a time when only a few people had the right to vote and so the widespread suffering that would ensue had little political ramifications.

Eventually, the lack of flexibility in the money supply proved too much, especially when the government needed to spend lots, typically when at war. As such, countries in Europe suspended the gold standard during the world wars and had trouble getting it back in place. A pseudo form of the gold standard was reestablished in the postwar era when the value of the US dollar was fixed against gold while other currencies were pegged to the US dollar. This too was abandoned in the 1970s after a prolonged period of heavy spending by the US government during the Vietnam war.

The new regime involved different currencies changing in value relative to each other depending on the economic circumstances in each country. The money supply fell under the control of central banks who used inflation as a gauge as to the health of the economy. To stamp out inflation in the early 1980s, central banks raised interest rates to punishingly high levels that in many ways was similar to the harsh measures adopted under the gold standard. Yet, inflation has been relatively subdued since then and the economic conditions relatively benign with the notable exception of the global financial crisis (where it was mostly banks who were at fault).

The new monetary regime saw the end of the fluctuations between rapid growth and sharp downturn that had plagued the economy in the past. Policymakers of old did not have the understanding or the data to know what was going on in the economy and thus had to rely on the crude mechanism of the gold standard to manage policy. Nowadays we know a lot more about what is going on and have also learnt lessons from the past, allowing a better response to recent crises as compared with the measures taken which led to the Great Depression.

Yet, it may be the case that we have swapped an economy that would run hot and cold for economic growth that is lukewarm. While the management of the economy is far superior to what we had in the past, it is as if having more scope to direct the economy has increased the fears of doing something wrong. The economy could grow faster except for central banks being wary of getting too close to circumstances whereby inflation might set in. Yet, without any substantial price rises being seen in richer countries for over three decades, it is not certain that inflation would be close at hand.

A sub-optimal economy would not be an issue if there were not concerns that require a response. Potential problems such as growing inequality and climate change would be best if dealt with sooner rather than later, but a lack of funds is often cited as an excuse for not acting. Other areas that deserve more attention such as health and education are left to languish despite the potential to improve the livelihoods of many people. There has been a shift in policy toward doing more to boost the lacklustre economy but the current range of options for policymakers don’t seem up to the job.

What seems to be the issue is not a lack of money but an inability to direct funds towards solving the problems at hand. The main means to deal with such issues in the past was through government, but this path has been hampered by a general aversion to taxation as well as the rise of global business. Rather than being able to invest in the long-term health of an economy, governments tend to rack up debt during economic downturns and then focus on paying back the money when the worst is over. While being able to deal with the immediate crises at hand, the more intransient and structural problems get neglected.

Signs of change are afoot as governments have been more willing to spend, but it still seems as if public debt will act as the bars of the cage that the economy seems to hit up against. Without more resources being directed through government towards dealing with long-term issues, a growing sense of injustice from unresolved problems could fuel a political backlash. One option that has attracted growing attention has been using cash from central banks to provide funds for government to spend or repay debt. The thinking behind such a proposal is that fiscal and monetary policy seems to have reached their limits, but a combination of the two could offer up more potency.

Putting money to work in this way is obviously controversial in terms of requiring a dramatic shift in the way we think about government debt. Abandoning the gold standard also demanded a change in thinking but it was necessary to escape from limits that are self-imposed and hamper further development of the economy. Otherwise, the economy will be stuck in a cycle between inevitable crises which prompt a sharp rise in government borrowing followed by years of growth hampered by debt repayments. And, as under the gold standard, the economy will remain trapped in a cage of our own making.

Debt looms over Covid recovery

After the Covid crisis comes the overwhelming mountain of government debt

With the worst of the Covid pandemic seemingly behind us, attention is shifting to the next threat looming over the economy – paying for the cost of lockdown. With public finances suffering with every new crisis, getting the government budget back into a healthy state is tricky when the underlying economy is already under pressure. Austerity measures have fallen out of favour and monetary policy does not seem to be able to do enough. If the economy continues to flag in years to come, more unconventional policies to help with the aftermath of economic downturns might be on the cards.

When something goes wrong with the economy, it tends to fall on the government to step in and provide support. This action by governments is like a type of insurance but one where the costs are borne afterward rather than funded in advance. So instead of building up a rainy-day fund (which seems to be something beyond most politicians), debt is used to get through any crises. Governments thus do what needs to be done to ride out any economic storm and then figure out later how to pay the bill.

This approach is becoming more difficult as even in good times the economy is already struggling to deal with the impact of globalization and automation. The economic difficulties are manifested through chronically low levels of inflation suggesting that demand for goods and services is relatively weak. The problem is worst in Japan where the central bank has been actively trying to push up prices in an attempt to end years of deflation. While not yet going this far, central banks in other developed economies have softened their stance towards rising prices and have been actively supporting the economy.

The likelihood of large debt repayments by governments in the years to come would go against these efforts. Austerity measures in the past have taken their toll on the economy and there seems to be an aversion to going down this road again. Yet, public debt that has piled up over the lockdown of the economy would have to be dealt with at some point. Central banks have already purchased large volumes of bonds from the government and are in no hurry to demand repayment. So, the debts could just be rolled over year after year (or more purchased if needs be) which would ease some pressure.

Rather than letting the overhanging debt stay in place, central banks could take a further step and right off some of the debt. The ability to print money means that it would be within the power of central banks to do so. Putting aside the rights and wrongs of such an action, the other major concern would be the impact on the money supply. The cash used to buy the government debt would remain in the economy and would have the potential to cause of spurt of inflation.

An increase in the money supply would normally stoke up demand as people rushed to the shops with the extra cash and supply would struggle to keep up. Along with the resulting higher prices, the value of the currency would also drop off, thus making imported goods more expensive and further exacerbating the problem. Countries such as Argentina and Turkey have often suffered such a fate, but countries with more sound economic management have increasingly gotten away with policies that could potentially spur on higher prices.

The use of unconventional policies, such as quantitative easing, has opened up a gap between what would be expected in the theory and what happens in practice. The economies in some of the richer countries seem to be able to absorb influxes of cash without inflation kicking in. The role of central banks and their firm stance against inflation is one aspect that has changed how the economy might respond to more money. Greater levels of wealth also mean that extra funds might go into financial assets rather than consumer spending. Other developments such as international supply chains also act to limit shortages brought on by a spurt of demand that would otherwise see prices rise.

While the economy might allow for such a measure by central bank, it is the politics that is likely to be the main sticking point. Overcoming the notion that debt could potentially be forgiven is likely to be a substantial hurdle. Not repaying back money that is owed seems wrong in an almost moral sense and only acceptable in terms of those for whom the debt burden is overwhelming. Yet, the cancelling of loans has a long history and has been used when the debts themselves are not sustainable.

A further complication would be the extent to which the role of the government would change. If debt was less of a limiting factor, money could be spent without having to worry too much about paying the bill afterwards. It would also take much of the meaning out of raising taxes and creates uncertainties over how the economy should be managed. But these are matters that could be dealt with as a new regime is implemented in small steps to gauge the impact. And it is central banks that would be in charge of how much relief should be offered up.

Any new measures such as this is typically not taken at a time when most optimal but when the needs arise. To override the aversion to debt forgiveness would take a prolonged slump where other options would have been exhausted. The time for implementation would come not during a crisis but in the years afterwards when attempts to repay the debts would weigh on the economy. Other demands on the government, such as the cost of pensions or healthcare, would add to the burden and potentially threaten to drag down the whole economy.

Monetary policy has been used to try and fill the gap but experience has taught us that central banks by themselves can only achieve so much. It is increasingly seen that a combination of monetary with fiscal policy is a more effective option. Using central bank cash to pay off government debt thus seems like the obvious progression in economic management. If the politics can be overcome, the hard-earned trust in central banks’ ability to manage inflation could then be put to use in cutting the mountain of government debt down to size.