Wednesday, 10 October 2012

Soak the Rich (In Liquidity): Monetary Policy, Left-wingers and Debt Deleveraging

Lately I've been seeing an increasingly large number of attacks on monetary stimulus, like this one, coming from the left of all places, even though there’s evidence that tight money massively increases inequality. Partly this is because denying that monetary policy is effective makes the argument for fiscal expansion much stronger, which is a good thing if you want to see a larger state and more redistribution. But even so it is baffling when QE is condemned as ‘giving money to fatcat bankers.’ There’s a perception that it inflates asset values, benefiting the rich, while not helping the working class or impoverished pensioners.

Krugman and others have modelled the Great Recession as a debt deleveraging story, with heterogenous agents – people with different preferences and constraints. What they show is that when, say, a big credit crunch leaves the poor unable to borrow, the rich (who are not liquidity-constrained) have no reason to raise their spending. This leads to an overall decline in nominal spending, plummeting output, rising unemployment and so on. The poor are busy paying off their debts, so if the government appears sublimely uninterested in fixing the housing market, there’s not much short of helicopter drops that you can do to increase their spending, especially once interest rates hit zero.

Under these circumstances, the state could step in to boost spending, confiscating the idle savings of the rich (perhaps through debt, which is essentially a promise to tax people in future periods) and putting that money to work in the economy. There are, however, good reasons why you wouldn't want to do this. It could have damaging incentive effects, and – in Europe, if not in America – we’re probably close enough to the optimum government share of the economy that we don’t want to permanently increase the size and reach of the state in response to one teensy little demand shortfall (which is arguably how the Great Depression got fixed). And there’s always the Sumner Critique to contend with. So ideally, unless you’re Ben Bernanke, you want monetary policy to shoulder the burden of boosting aggregate demand.

Unfortunately, there isn’t a whole lot you can do to get the poor spending, and so the shortfall in nominal spending has to be made up by the rich. But how do you get the rich to spend more, when really they’d rather hold cash? You make it possible for them to hold cash and spend at the same time, by buying their assets with newly-minted electronic money. The problem, of course, is that if you give the rich extra cash, most of it isn’t going to get spent, because their marginal propensity to save is a lot higher than that of the poor. But the beauty of monetary policy is that, unlike with fiscal intervention, you don’t have to worry about getting ‘bang for your buck', because the only major cost to printing money is the risk of overheating the economy. Provided you stand ready to take the punch bowl away, the actual dollar value of your stimulus package is pretty irrelevant. That means it’s fairly easy to overcome the propensity of the rich to save by giving them lots of money, so that what they do spend is enough to kickstart the economy again. Yes, this is a crude way to look at it, and it somewhat simplifies out the (vital) role of expectations, but it’s essentially what’s going on.

So is this a big transfer to the greedy plutocrats? Implicit in the monetary stimulus is that the injection of money is mostly temporary. If the central bankers are targeting inflation, they make it clear that the excess liquidity will be sucked out of the system before things get too out of hand. Under NGDP targeting, the central bank’s promise is essentially that enough of the expanded monetary base will be made permanent to get nominal GDP back to trend, but the rest is going to be removed. If we give every banker in the country a million pounds, but promise to take it all away again in five years, it might be enough to get the economy moving again, and get people back to work. It might also look like we were giving a bunch of cash to the wealthiest in our already-unequal society, even though that wasn’t what was really happening, and the poor ended up better off.

So that’s the story of QE you might tell if you were a New Keynesian. Those of a more monetarist bent, of course, don’t need to stoop to ‘telling stories’ about how a boost in the money supply affects nominal spending. Good for them.

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