fiscal policy

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Global inflation still driven by food and energy prices. Recession is the likely result.

Published by Anonymous (not verified) on Mon, 12/09/2022 - 10:25pm in

Grangemouth refinery, Firth of Forth, Scotland. Credit: byronv2/Flickr

The IMF reports that inflation globally continues to be driven by rises in the price of food and energy:

Food and energy are the main drivers of this inflation… Indeed, since the start of last year, the average contributions just from food exceed the overall average rate of inflation during 2016-2020. In other words, food inflation alone has eroded global living standards at the same rate as inflation of all consumption did in the five years immediately before the pandemic.

They show the breakdown of the contribution of both to global price rises on their “Chart of the Week”, as below:

Whilst inflation in other sectors (the IMF economists pick out service prices in the US) has picked up a little, it is overwhelmingly the impact of price rises in two essentials that is responsible for the rise in prices felt across the world. And because these two are essentials, with few options for substitution in either for most of us – everyone has to eat! – their combined impact on living standards is being keenly felt across the globe.

That squeeze on living standards, in turn, translates into falling sales of non-essential items. As prices for things we pretty well have to buy increases, those on lower incomes across the world – which is to say, almost everyone – are reducing what they spend on things they can choose to buy. If, as in Britain, your household energy bill has gone up £1,000 in the last few months, there are limits to how much you can plausibly reduce that consumption, especially with winter in the Northern Hemisphere approaching. People have been cutting back on expenditure elsewhere – for instance on going out for meals, or Netflix subscriptions. The price rise is, in other words, inducing a fall in demand and therefore pushing economies into recession. The National Institute of Economic Research reports Britain is already in a recession, and the US and other advanced economies are widely expected to follow suit.

This is not, according to the standard model of the macroeconomy, what is supposed to happen, or how inflation is supposed to operate. The standard models depend, critically, on inflation appearing as a result of changes in demand. If total demand for goods and services is pushed above what the economy can supply – if, for instance, the government borrows and spends a great deal of money – inflation will rise as firms chase that additional spending with price rises, rather than expanding output.

But what we can see now is something like the opposite of this process. Rising prices of specific goods and services, where consumption isn’t an option but a necessity, is causing falling demand for other goods and services as consumer shift their expenditure around. Inflation isn’t occurring from demand factors, but from changes to the supply of critical goods and services.

This has important consequences, the most obvious of which is that the usual mechanisms to regulate demand will no longer work, or at least be very limited in their impacts. Raising interest rates, as many central banks are now doing, is intended to dampen demand in an economy, since borrowing becomes more expensive (and saving more desirable). But if inflation is arriving as a result of supply shocks, changing demand won’t do much beyond perhaps pushing up unemployment. For the Bank of England and other central banks to be pushing up interest rates now risks creating “stagflation”: a recession, combined with high rates of inflation.

Traditional demand management no longer effective

The flip side of this is that, if policies to restrict demand have little impact on inflation so, too, do policies that stoke demand up. In the standard model, for the government to propose (as the British government did last week) to borrow around £150bn more than it planned, and to use this as a subsidy to household consumption (in this case, by keeping domestic energy prices lower than they would have been) would normally stoke up inflation a great deal. This time, the expected effect is likely to be exactly the opposite: any extra cash earned by households will simply compensate them for the loss of disposable income from rising energy prices, rather than adding to their earnings. Overall demand will be returned to where it was (almost) without the price hike. And since the spending is intended to cut domestic energy prices, inflation will automatically be reduced as a result – perhaps by around 4%.

The usual rules of “demand management”, in other words, do not apply in a world with idiosyncratic shocks to supply of the kind we’ve been seeing – and will continue to see in the future as the environmental crisis worsens. The implication is that government interventions against the operation of the market are likely to become more, not less, frequent in future. When price spikes are extreme, as we’ve seen in energy prices, they start to call into question the functioning of the market system itself – if the expected 80% rise in UK domestic energy prices had been allowed to go through entirely, the shock to demand in the rest of the economy would have been disastrous. Price controls, once utterly taboo in polite policymaking circles, are coming back into favour as a result.

The post Global inflation still driven by food and energy prices. Recession is the likely result. appeared first on The Progressive Economy Forum.

An Era of Chronic Uncertainty: Time for Basic Income

Published by Anonymous (not verified) on Mon, 05/09/2022 - 9:00pm in

By Guy Standing

We are living in an age of chronic uncertainty, in which crises pile into one another, plunging millions of people deeper into insecurity, impoverishment, stress and ill-health. There was the financial crash of 2008, a decade of austerity, a series of six pandemics culminating in Covid, with more to follow, and now the ‘cost-of-living’ crisis as inflation mounts, possibly reaching an incredible 20% by the winter.

Nassim Taleb coined the term ‘black swans’ to designate shocks that were rare, unpredictable and had devastating consequences. Now, they are not rare. But they are uncertain in terms of when, where and why they occur and who will be adversely affected. As such, you and I cannot be confident that we will not be among the victims.

There is something else too. It looks as if a large proportion of the population will be affected. It is predicted, for example, that 45 million people in Britain will be suffering from fuel-related hardship this coming winter, bringing more deaths and ill-health. Natural disasters could hit numerous communities, and being in a job is far from a guarantee of escaping poverty or economic insecurity.

Three deductions should flow from this bleak scenario. First, feasible economic growth will not overcome the threats. Second, old policies are not valid for tackling the new crises. Third, we need to build societal resilience, a new income distribution system and a new social protection system. ‘Targeting’ on a minority would be futile and inequitable.

The post-war welfare state was built on a presumption of Full Employment of men in full-time jobs earning family wages, in which there was a need for compensation for ‘contingency risks’ or ‘temporary interruptions of earnings power’. It was always sexist. But the essence was ex post compensation. This is inappropriate today where the core challenge is chronic uncertainty, for which one cannot devise a social insurance system. What is needed is an ex ante protection system, one which gives everybody guaranteed basic security.

But our politicians are failing to appreciate the nature of the challenge and are resorting to yesterday’s answers to yesterday’s problems. First, the Conservative leadership contenders and the Labour leadership are making overriding commitments to maximising economic growth. Keir Starmer says that the Labour motif for the next General Election will be ‘Growth, Growth and Growth’, and that he will only consider policy proposals from the Shadow Cabinet if they promote growth. Meanwhile, an adviser to several Tory Chancellors says the next Conservative Prime Minister will commit to an ‘absolute priority of maximising growth’.

A phrase that comes to mind is the one used by Michael Gove to characterise Liz Truss: they are taking a holiday from reality. Both the Conservatives and Labour are misdiagnosing the nature of the recurrent crises. Both are chasing the mirage of high GDP growth, wishing away the awful ecological implications. Starmer says the free market has failed. But we do not have a free market. It is rentier capitalism, in which most income flows to the owners of property – financial, physical and ‘intellectual’. Economic growth has to be unrealistically high for the precariat and other low-income groups to gain anything. This is why real wages have stagnated over the past three decades, and why earnings have lagged GDP growth, the difference made up by rising debt.

The income distribution system has broken down. Across all OECD countries, financialisation has accelerated, and is fuelling inflation for its benefit. In the UK, financial assets of financial institutions have risen to over 1,000% of GDP, with most finance used for speculative activity rather than for productive investment.

A rising share of income is going to capital, and more is going in rent, in excess profits. Within the shrinking share going to labour, more has gone to the top, again in forms of rent. The value of wealth has risen sharply relative to income, while wealth inequality is much greater than income inequality.

All the time, the precariat grows. What should exercise progressive politicians is that for a growing proportion of the population income instability and insecurity have grown by more than is revealed by trends in average real wages. A result is that millions of people are living on the edge of unsustainable debt. People lack income resilience. Desirable as that is, raising the minimum wage will not solve that, and nor will trying to be King Canute in banning flexible labour relations.

So what are our politicians proposing in this context of chronic uncertainty, a broken income distribution system and a daunting ecological crisis? What marks all of what they are offering is ad hoc window dressing that seems deliberately intended to avoid the reality that we have a transformation crisis on our hands. Tax cuts would benefit the relatively secure, price freezes would cost the public finances and distort markets, raising the minimum wage would bypass the precariat and those outside the labour market, and targeting more benefits to those receiving Universal Credit would merely bolster an unspeakably punitive and inequitable scheme.

It brings to mind what William Beveridge wrote in supporting his 1942 Report that led to the post-1945 welfare state. ‘It’s a time for revolutions, not for patching.’ So far, our mainstream politicians seem to lack the backbone. The strategy should be one of dismantling rentier capitalism and recycling rental incomes to everybody. Above all, in the foreseeable future of chronic economic, social and ecological uncertainty, the base of social protection should be the provision of ex ante security. People – all of us – must know that, whatever the shock, we will have the wherewithal on which to survive and recover.

This is when politicians should be looking at ways of introducing a basic income for every usual resident. It would not replace all existing benefits, and would have to involve supplements for those with special needs. It would have to start at a modest level, but would be paid to each man and woman, equally and individually, without means-testing or behavioural conditionality. Legal migrants would have to wait for a period, which does not mean they should not be assisted by other means. And to overcome the objection that it should not be paid to the rich, tax rates could be adjusted to make them more progressive.

Before coming to how to pay for it, I want to emphasise the reasons for wanting a basic income for all. The fundamental justification is moral or ethical.

First, it is a matter of common justice. Our income owes far more to the contributions of all our ancestors than to anything we do ourselves. Even Warren Buffet admits that. But as we cannot know whose ancestors created more or less, we should all have an equal ‘dividend’ on the public wealth. After all, if we allow the private inheritance of private wealth, there should be a public equivalent. The Pope has come round to that rationale for his support for basic income. It is also a matter of ecological justice, since the rich cause most of the pollution while the poor pay most of the costs, primarily in diminished health. A basic income would be a form of compensation.

Second, it would enhance personal freedom, including community freedom. Although paid individually, that would not make it individualistic. Experiments have shown that when everybody has basic income, that induces stronger feelings of social solidarity, altruism and tolerance.

Third, it would enhance basic security, in a way that means-tested, conditional benefits cannot possibly do. Politicians seem reluctant to offer ordinary people basic security, which they would always want for themselves and their families. Insecurity corrodes intelligence and induces stress and loss of the capacity to make rational decisions. We are experiencing a pandemic of stress and rising morbidity. None of the existing policy proposals would reduce that.

Finally, there are instrumental reasons. Experiments with basic income around the world have shown it results in improved mental health, less stress, better physical health, more work, not less, and enhanced social and economic status of women and people with disabilities.   

Basic income is not a panacea, but it should be part of a transformational strategy, complemented by putting public utilities, most notably water, back in public hands and by rent and energy price controls. There must also be fiscal reform that would help in the fight against the ecological decay while helping to overcome chronic uncertainty. Progressives should accept that taxes on income and consumption should be raised, because they are relatively low in this country and because more revenue is needed to pay for our public services, and in particular reverse the privatisation of our precious health service.

The call for Universal Basic Services is state paternalism and would not help with the nature of the crisis. People need financial resources to overcome the economic uncertainty and lack of resilience. No government can know the particular needs of particular people, and so subsidising some services would be both arbitrary and distortionary.

However, in addition to higher taxes on income to pay for services, we should think of ‘the commons’, that is, all that inherently belongs to every citizen of the UK, beginning with the land, air, water and sea, and the minerals and energy underneath. Over the centuries, they have been taken from us illegitimately, without us or our ancestors being compensated. This includes all the land that has been ‘enclosed’, the forest and public spaces that are being ‘privatised’, the seabed that is being auctioned off, and the oil and gas sold for windfall gains given away in tax cuts for the wealthy.

This line of reasoning leads to the proposal that levies should be put on elements of the commons that we have lost, with the revenue put into a Commons Capital Fund, which would be charged with making ecologically sustainable investments, from which ‘common dividends’ would be paid out equally to every resident citizen.

The initial base for paying for a basic income would be conversion of the personal income tax allowance, which benefits higher-income earners and contradicts the view that in a good society everybody should be a taxpayer. If the revenue from that were put into the Fund, it would provide enough for £48 a week for every adult. Then add a 1% wealth tax, justifiable because wealth has risen from three times GDP to seven times, wealth inequality is much greater than income inequality and over 60% of wealth is inherited, unearned. A 1% wealth tax would be sufficient to pay a modest basic income. And more revenue could be raised by rolling back on many of the 1,190 subsidies and tax breaks given mostly to wealthy people. A modest Land Value Tax, based on size and value of land, is also justifiable on common justice grounds, especially as the value of land has grown from an already high 39% of non-financial assets in 1995 to 56% in 2020.

Then add a Carbon Tax, vital if we are to reduce greenhouse gas emissions and global warming, but which will only be politically popular and feasible if all the revenue from it is recycled as part of Common Dividends. Other levies into the Fund could include a Frequent Flyer Levy and a Dirty Fuel Levy on all those cruise liners and container ships that keep their engines going all the time they are in port, poisoning the atmosphere and causing widespread throat cancer.   

Here we have the basis of an income distribution system suited to the era, with supplements for all those with extra needs. It is an approach that would open up a vista of multiple forms of work, unpaid as well as paid, putting care at its centre. It would be an era in which basic security was regarded as a fundamental right, and it would be one in personal freedom would be enhanced while precarity would be reduced, the precarity that comes from dependency on a discretionary state and undignified charity. At this moment of omni-crisis, we need to march in that direction.            


In their response to the cost-of-living crisis, the New Economics Foundation proposes ‘free basic energy’ for all households. Besides penalising those outside households, this presumes that all households’ poverty and insecurity is due to high energy prices. For many that will be so, but for some other factors may be more important.

It would also raise moral hazards. Some people may not need the full free allocation, but would be inclined to waste what they did not need, because it was free. The amount given free would have to be based on some ‘average’ household. But many are in non-average households, or are outside them more, for whom the free allocation would be too little or exceed our basic need.

Some people might prefer to cut energy use a little if given the choice of spending on food, debt reduction or extra clothing. Better to enable them to make the choice that suits their particular needs.

The NEF also propose to top-up Universal Credit and legacy benefits. But we know these do not reach many of the poor, due to sanctions, the humiliating application process and long delays. What about the millions in need who would be excluded? Much better than relying on paternalistic measures and behaviour-conditioned targeted benefits would be a basic income, with supplements for those with special needs, coupled with a modest wealth tax and land value tax. 

Guy Standing is a Professorial Research Associate, SOAS University of London and a council member of the Progressive Economy Forum. His new book is The Blue Commons: Rescuing the Economy of the Sea, published by Pelican. He is a technical adviser to the basic income pilot being conducted by the Government of Wales.  

photo credit flickr

The post An Era of Chronic Uncertainty: Time for Basic Income appeared first on The Progressive Economy Forum.

How Much Did Supply Constraints Boost U.S. Inflation?

Published by Anonymous (not verified) on Wed, 24/08/2022 - 9:00pm in

 Man with COVID mask picking one of the last of the breads in the grocery aisle

What factors are behind the recent inflation surge has been a huge topic of debate amongst academics and policymakers. We know that pandemic-related supply constraints such as labor shortages and supply chain bottlenecks have been key factors pushing inflation higher. These bottlenecks started with the pandemic (lockdowns, sick workers) and were made worse by the push arising from increased demand caused by very expansionary fiscal and monetary policy. Our analysis of the relative importance of supply-side versus demand-side factors finds 60 percent of U.S. inflation over the 2019-21 period was due to the jump in demand for goods while 40 percent owed to supply-side issues that magnified the impact of this higher demand.

The Debate

The U.S. has witnessed near historic inflation since the economy began to re-open in 2021 following the COVID-19 lockdowns, as seen in the chart below. There have been several factors put forth to explain this inflation outburst and its persistence, which have been difficult for policymakers to disentangle and have led to an active debate by leading economists. Some analysts have focused on the importance of supply chain constraints, while others point to demand as driving the jump in inflation. Meanwhile, some economists argue that a combination of supply and demand factors are necessary to generate the inflation we are currently witnessing. Our work belongs to the last camp.

Inflation has been very elevated

 percent for y axis and monthly on x axis from dec 2019 to Jun 2022Source: U.S. Bureau of Labor Statistics.
Notes: This chart plots the consumer price index (CPI) for all urban consumers (all items in U.S. city average). The monthly series represents the percentage change from a year ago and is not seasonally adjusted. 

A Model-Based Approach

Arriving at a definitive understanding of the relative importance of demand and supply drivers of inflation is difficult without providing some formal structure that can be taken to the data. In the recent work referenced above, we take a step in this direction by building on the work of others to quantify the effects of the pandemic on inflation over the period spanning both the collapse and recovery phases of the economy. This framework not only allows us to examine the cumulative impact of the pandemic from 2019:Q4 to 2021:Q4, before the Russia-Ukraine war’s “energy/food shock” on inflation, but also to decompose the contribution of demand- and supply-side factors underlying the observed inflation.

The model allows for the observed limited factor mobility. That is, since everyone was exposed to the same health-related shock at a global level, it was difficult for firms to reallocate labor between sectors and/or switch and substitute suppliers in the short run, leading to shortages in labor and in other inputs. Furthermore, besides demand effects being present at the aggregate level—due to accommodative fiscal and monetary policythe composition of demand also changed as consumers substituted from services to goods. The model incorporates these aggregate and sectoral demand effects, which can further amplify the impact of supply-side constraints on inflation due to the resulting supply-demand imbalances.

Taking the Model to the Data

We calibrate a closed-economy version of the model to match the observed U.S. inflation over the 2019-21 period, along with doing a similar exercise for the euro area. The model implies that inflation is a function of aggregate demand shocks, changes in hours worked, and productivity by sector. The changes in hours worked capture both demand and supply shocks, while changes in productivity/technology are sectoral supply shocks.

We assume that sector-level technological changes were zero over the 2019-21 period and use the observed inflation rate along with sectoral hours worked to back out the implied aggregate demand shock. The computed aggregate demand shock captures several possible demand drivers, such as changes in households’ preferences for consumption in the present vs. future as well as expansionary effects of fiscal and/or monetary policy.

Armed with the implied aggregate demand shock, the growth rates of sectoral hours worked, and the observed change in the composition of sectoral consumption (that is, an increase in consumption in the goods sector and a fall in consumption in the service sector), we then use the model structure to decompose the relative importance of supply and demand shocks in driving inflation. Crucially, the model structure allows us to explain why observed employment may have been below its “normal” level, and what sectoral dimensions of the data are crucial explaining this outcome—for example, a shortage of workers or a lack of demand given changes in preferences and/or the aggregate demand shift

U.S. Results

The first bar in the chart below presents our estimation of the U.S. CPI inflation rate over the 2019-21 period, which was calculated to be 9.18 percent from December 2019 to December 2021, annualized. The actual observed inflation during this period is 8.47 percent, so the model-calibrated rate is very close. The next three bars decompose the drivers of inflation. Notice that the sum of these bars is 10.5 percent, which is slightly higher given the nonlinear interactions between sixty-six sectors. The aggregate demand shock (“backed-out AD shock”) explains roughly 60 percent of model-based inflation. The remaining 40 percent of the model-based inflation is primarily explained by sectoral supply shocks (“sectoral supply shock”), while the change in households’ consumption patterns across sectors (“sectoral demand shock”) accounts for very little. The bottom line of this decomposition is that supply constraints magnified the impact of higher demand in inflation. Consequently, most sectors in the U.S.—fifty-eight out of sixty-six—were supply-constrained. This result is consistent with other research that shows that expansionary fiscal policy has increased the share of sectors classified as supply-constrained.

The model calibration shows the quantitative importance of both demand and supply shocks

 model based inflation; backed out AD shock; sectoral demand shock; sectoral supply shockSource: di Giovanni, Kalemli-Özcan, Silva, and Yildirim (2022).
Notes: The chart presents a U.S. closed-economy inflation decomposition for a sixty-six sector economy, 2019-21. The first bar shows model-based inflation considering all shocks (demand and supply). The second bar considers the aggregate demand shift only. The third bar uses sectoral demand shocks only. Finally, the fourth bar uses sectoral supply shocks only.


The current debate on whether the Federal Reserve can engineer a soft landing needs to disentangle the drivers of U.S. inflation. Our work shows that inflation in the U.S. would have been 6 percent instead of 9 percent at the end of 2021 without supply bottlenecks. Our quantitative results clarify why some pundits were wrong to predict a transitory surge in inflation, while others were right in predicting high inflation, but for the wrong reasons. Put differently, fiscal stimulus and other aggregate demand factors would not have driven inflation this high without the pandemic-related supply constraints. In the absence of any new energy or other shock, it is therefore possible that the ongoing easing of supply bottlenecks will cause a substantial drop in inflation in the near term.

 portrait of Julian Di Giovanni

Julian di Giovanni is the head of Climate Risk Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.  

How to cite this post:
Julian di Giovanni, “How Much Did Supply Constraints Boost U.S. Inflation?,” Federal Reserve Bank of New York Liberty Street Economics, August 24, 2022,

The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

Germany’s longing for the Ancien Régime is a Threat for Europe

Published by Anonymous (not verified) on Sat, 20/08/2022 - 1:18am in

Note: this is a rough translation of a piece published on the Italian neswpaper Domani, with a few edits and additions.

While the campaign for the election captures all the attention of the Italian establishment, we should not stop looking beyond our borders. In particular, the lack of interest in what is happening in Germany is striking and worrisome. The difficulties Europe’s largest economy is experiencing will in fact have far more significant consequences for many European countries than their domestic political struggles.

Last week, the ministry of economy and ecological transition (headed by the vice-chancellor and number two of the Green party, Robert Habeck) published a report on the reform of the stability pact, which, although we tend to forget it, will be THE topic of the coming months. The guiding principles for reform that the report outlines are basically a re-proposal of the existing rule, as if the disasters of the sovereign debt crisis and the Covid tsunami were a parenthesis to be closed as soon as possible by returning to the old world.

Under a gleaming hood, the German engine has been in crisis for years

There will be time to return to the inadequacy of this proposal (Carlo Clericetti does it well in the Italian magazine Micromega) and to the issue of European governance. What I would like to emphasise here is that the German elites, with this frenzy to return to the past, do not seem to fully grasp at least two things: First, the fact that after the experience of the last ten years it is not possible to return to an idea of economic policy for which the only beacon is fiscal discipline, neglecting public investment, industrial policy, social protection and so on. Second, and this is more surprising, they do not grasp the fact that the German growth model seems to have hit its boundaries. As a reminder, we are talking about a model aiming at export-led growth, that was based on the one hand on the compression of domestic demand (with wages that for decades grew much less than productivity); on the other hand it was based on an export sector that took advantage of both the dualism of the labour market and of value chains rooted in the countries of the former Soviet bloc. Germany could therefore import intermediate goods and low-cost components and re-export finished products, often with a high technological content, to non-European markets. This is the main reason why it remained a manufacturing power while most advanced countries had to cope with de-industrialisation and relocation.
Many, including myself have criticised this model, which during the sovereign debt crisis Germany successfully managed to generalise to the rest of the eurozone. In 2020, in concluding an essay on Europe, I pointed out how that model has come to an end. The public and private investment deficit, the result of decades of self-imposed frugality, has progressively depleted the capital stock and reduced the competitiveness of German industry. Meanwhile, while the growth of emerging countries has helped to provide outlets for German goods, it has also seen these countries develop high value-added production that competes with German exporting firms. But there is more: I also noted that the progressive distortion of the ordoliberal model, the increase in inequality and precariousness (which contributes to demographic stagnation and to the ageing of population), and the growing dependence on foreign demand, more problematic than ever in an increasingly uncertain geopolitical context, have all contributed to making Germany a giant with feet of clay.

A Giant with Feet of Clay

Feet of clay that today are cracking. The bottlenecks that appeared during and after the pandemic, due to lockdowns and to the recomposition of global supply and demand, have (not surprisingly) proved to be more persistent than many expected. Furthermore, the acceleration of investment in the ecological transition, obviously welcome and all too late, creates shortages particularly in sectors that are key for the German economy, such as the automotive. Finally, geopolitical tensions, the slowdown in emerging economies, and of course the war in Ukraine greatly reduce the outlets for the German export sector and have laid bare the short-sightedness of the past German leadership’s choice to rely on Russian oil and gas, admittedly reducing costs, but creating a dependency for which the country is now paying the price. It is important, however, to emphasise again that the events of the last two years have only come to add to the structural problems of a model of growth and organisation of production that was beginning to show its limits even before the pandemic.

The German elites at a crossroads

In 2020, I concluded my essay by stating that the crisis of the German model could have been an opportunity for Europe, as it would have forced Germany to worry about the imbalances within the eurozone, to promote public and private investment, to rethink industrial policy, to support (German and European) domestic demand; not out of altruism, but to create a stable European market in an international context that had become structurally uncertain and turbulent. The heartfelt support for Next Generation EU seemed to confirm the feeling that something had changed in Germany. The recent turn of the German debate is therefore worrisome and should be looked at closely. Habeck’s paper and the recent stances of the Minister of Finances, the liberal Lindner, point to a kind of “ostrich syndrome” of the German elites, who seem to long for a return to the past in order not to have to deal with the structural problems of Germany and of European integration. If this tendency prevails, not only the German citizens but the whole of Europe, which will slip into irrelevance, will pay the price in the coming years. On the contrary, representatives of the German government at European tables need to be called upon to contribute to the rethinking of industrial and energy policy and public investment policies, to the development of a European welfare state, to the definition of budget rules that allow for active and sustainable policies, to the development of the internal market, to the completion of the banking union, and the list could go on. In short, an ambitious and wide-ranging European discussion is needed to make the German elites look away from their navels and try to restore Europe’s centrality at a time of great geopolitical turbulence (which will certainly extend well beyond the war in Ukraine). France and Italy, because of their size and the influence they have had in Europe in the recent past, would obviously play a key role in countering the return to the past of the German elites. This is why the absence of European issues from the (pre-electoral) Italian and (post-electoral) French debate cannot but cause concern.

Monetary and fiscal policy in interwar Britain

Published by Anonymous (not verified) on Wed, 13/07/2022 - 6:00pm in

David Ronicle

Macroeconomic outcomes in Britain’s interwar years were terrible – they featured two of modern Britain’s worst recessions, unemployment twice peaked above 20% and was rarely below 10% and there were two periods of chronic deflation. Policy, meanwhile, was pulled in multiple directions by multiple objectives – employment, price and financial stability and debt sustainability. These challenges gave birth to modern macroeconomics, inspiring the work of John Maynard Keynes. In a new working paper, I apply modern empirical techniques to look at the period with fresh eyes. I find that monetary and fiscal policy played a central role in macroeconomic developments – and that outcomes could have been better had policymakers been less wedded to the traditional policy consensus, and especially the Gold Standard.

Asking what role macroeconomic policy played in interwar Britain is not a new topic, so why revisit it? First, although there have been some excellent recent attempts to answer narrow questions about the period (on tax, defence spending, uncertainty, inflation expectations, protectionism and exit from the Great Depression), the most recent comprehensive assessment of macroeconomic policy dates to 1995. Second, and more generally, many of the key results of modern empirical macroeconomics rest on one period and one country, the post-war United States, which contains a relatively limited set of events to exploit (Ramey (2016) offers a nice overview).

What do I do?

In the paper, I build an empirical model of the relationships between the economy and policy variables and specify how deviations from those relationship should be interpreted in terms of ‘fundamental’ shocks – in more technical terms, I estimate a vector auto-regression (VAR) model, structurally identified with sign restrictions, taking inspiration from Mountford and Uhlig (2009). This approach is both flexible, allowing for a wide range of ways to think about shocks (including contemporary responses, which traditional recursive approaches preclude), and can accommodate all my shocks of interest – two business cycle shocks (demand and supply) and three policy shocks (monetary policy, tax and government spending). I define the policy shocks so that each of a rise in Bank Rate, increase in taxes or cut in spending raises unemployment and reduces prices; a demand shock sees prices fall as unemployment rises, while a supply shock sees prices rise as unemployment rises. To overcome recent critiques of some aspects of Mountford and Uhlig’s methodology, I use the estimation approach suggested by Arias et al (2018), as implemented in the fabulous BEAR Matlab toolbox.

All of my data is at monthly frequency and is taken from sources available at the time. The baseline model is a VAR containing unemployment, the price level, Bank Rate, tax receipts and government spending. The data on the public finances are a particularly important innovation: I hand-collected them from the Government’s official journal, The Gazette – and to my knowledge they have not been used elsewhere at this high frequency (though a quarterly version has been used to look at tax and uncertainty).

What do I find?

Chart 1: Response of unemployment and prices to five shocks

Notes: Charts show the change in each variable in response to a 1 standard deviation shock. Shaded areas show the 68% credible set. Units are per cent for inflation and percentage points for unemployment.

Chart 1 neatly summarises my core results. It plots how prices and unemployment react to each of my shocks. For example, the first column shows that a typical negative demand shock increases unemployment by a peak 0.25 percentage points and reduces prices by more than 0.5% at its largest effect. These shocks are symmetrical by design, but for the sake of comparison are all presented here such that they lead to a rise in unemployment. Strikingly, all three of the policy shocks – monetary policy, spending and tax – affect unemployment by roughly the same amount, at least initially. But after three years (ie 36 months), while the effects of spending and tax shocks have largely faded, those of monetary policy persist. The effects on prices are somewhat more varied: monetary policy pushes down on the price level for an extended period; spending shocks push down by about as much, but the effect starts to unwind after about a year, while; tax shocks have a milder but more persistent downward effect on the price level.

To draw comparisons against the wider literature I re-estimate the baseline model with GDP in the place of unemployment. I find that the share of variation in GDP accounted for by my policy shocks is high relative to other estimates – 8.6%, 12% and 9.2% after two years, for monetary, tax and spending shocks respectively, compared to reported ranges of 0.5%–8.8%, 0.5%–4.8% and 2.9%–12.6% respectively. Similarly, my estimates of fiscal ‘multipliers’ (roughly, the change in GDP for a given change in tax or spending) are towards the upper end of the wider literature, at 4¾ for tax and 1½ for spending, compared to a reported range of 1 to 5 for tax and 0.2 to 2 for spending. These estimates are also large relative to era-specific estimates – Cloyne et al (2018) estimate a tax multiplier of 2.3 for the interwar years, while Crafts and Mills (2013) estimate a (defence) spending multiplier of 0.3 to 0.8 from the rearmament ahead of World War II. So policy – monetary and fiscal – could have powerful effects in this period.

Chart 2: Historical decomposition of prices and unemployment over five periods

Notes: Solid black lines indicate the total contribution of shocks to the deviation of the variable from the model steady state at each point in time, with the coloured areas denoting the contribution from each shock. The price level is expressed as the percentage deviation, while unemployment is the percentage point deviation.

But my results go further than just showing that policy was powerful – the outcomes in the period were also driven by the decisions policymakers made. Chart 2 is perhaps the most eloquent summary of my full results, plotting the contribution to the price level and unemployment over the period of each of my five shocks. Taking each of the five periods in turn, the postwar ‘boom’ was clearly fuelled predominantly by the continuation of wartime levels of spending. The subsequent ‘bust’ was the product of the fiscal tightening that took place from 1920, exacerbated by tighter monetary policy and the coal strike of 1921. The weak expansion of the later 1920s, called ‘The Doldrums’ by Arthur Pigou, was supported in its middle years by lower taxes and looser monetary policy, though both were unwound towards the end of the decade as part of the restoration of the Gold Standard. ‘The Slump’ (as the Great Depression has traditionally been known in the UK) was significantly worsened by the tightening of monetary and fiscal policy mounted in defence of sterling – an attempt which ultimately failed. With Britain off the Gold Standard from September 1931, monetary policy was eased to 2%. It remained there for the rest of the period – called the ‘Cheap Money’ era – and made a material contribution to the steady expansion of the 1930s. Strikingly, although government spending was stepped up in the later 1930s to support rearmament, consistent with results elsewhere, I find that this made only a modest contribution to lowering unemployment.

What are the policy implications?

My results suggest that changes in fiscal policies could have had material effects on unemployment, but that these effects dissipated relatively quickly – so while countercyclical (or just less procyclical) policy would have improved outcomes, Keynes’ proposal of a sustained fiscal loosening would probably not have solved the problem of interwar unemployment. By contrast, although the peak effect of monetary policy was similar in scale to that of fiscal policy, its effects were more persistent – suggesting looser monetary policy, especially before the ‘Cheap Money’ era, would have been a more powerful way to address unemployment.

The implication of this is that better outcomes might have been achieved with alternative polices: a slower fiscal consolidation in the 1920s, a later return to gold (perhaps at a devalued parity) and a less aggressive defence of sterling in 1931 could all have kept unemployment lower and prices higher. Similarly, monetary and fiscal policy could have been more complementary, with somewhat looser monetary policy facilitating a slower fiscal consolidation. But doing this would have required agreement on pursuing different objectives – a weaker commitment to gold and balanced budgets – something that would have been challenging, given the centrality of the Gold Standard in policymakers’ understanding of Britain’s economic stability and global role.

David Ronicle is on secondment from the Bank’s Monetary Analysis department to the UK delegation to the IMF.

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We Should Stop asking the ECB to carry the Eurozone on its Shoulders. It is time to Introduce New Tools for Debt Management

Published by Anonymous (not verified) on Tue, 28/06/2022 - 10:22pm in

In the past couple of years I have had a hard time to feed this blog with original content. I have therefore decided that I will post the English translation of pieces that I write for other outlets; sometimes (always??) the translation will be rough I will start, today, with an article published in the Italian daily Domani on the ECB own impossible trinity (growth, supply-side inflation, spreads).

The last few weeks have shown beyond any doubt how complicated the task of central banks has become. In normal times, inflationary pressures go hand-in-hand with an overheating of the economy caused by increases in spending (public or private, it matters little); therefore, restrictive policy simultaneously achieves the result of keeping price increases in check and cooling demand. But we do not live in normal times. In a world of increasing geopolitical risks and supply-side shocks (the pandemics, the disruption of supply chains, structural change related to the ecological and digital transition), the two objectives of growth and inflation become contradictory: central banks are forced into complicated balancing acts to try to reduce an inflation they have few tools to control, without causing a collapse in consumption and investment that would send the economy into recession.
Even in the United States, where at least some of inflation is due to the overheating of the economy, it is difficult to understand the logic of the recent acceleration in tightening: the risk that the Fed’s moves will cause a recession in the coming quarters is real. In the Eurozone the demand push is less pronounced; in addition, the ECB’s task is further complicated by the coexistence of a single monetary policy with the nineteen fiscal policies of member countries, and the resulting risk of financial instability and segmentation of sovereign debt markets. Thus, not only must the ECB decide how far it is willing to take the risk of sending the economy into recession to try to keep inflation in check; it must also be prepared to manage the consequences its actions have on spreads.

Certainly, the turmoil of the past few weeks is due to less than flawless communication, which has given markets the feeling of an ECB uncertain about what to do. Moreover, it is frankly astounding to discover, when markets are already in panic mood, that the ECB is thinking about an anti-spread shield; the shield should have been ready months ago, to be deployed as soon as the announcement of a turn toward a restrictive stance had created tensions in the markets, which were widely predictable. However, mistakes and delays cannot hide the fundamental problem: the ECB is now asked to perform its classical tasks of closing the inflation and the output gap while ensuring the stability of financial markets, in the face of a fiscal policy that always does too little and too late. Even with firmer leadership and greater cohesion within the governing council, the ECB could not carry the entire weight of the Eurozone on its shoulders; especially in turbulent times such as we are currently experiencing. The erratic communication, the feeling that the ECB is perpetually behind the curve, then, cannot be attributed to the clumsiness of Christine Lagarde or to conflicts between hawks and doves; the ECB is probably being asked to do the impossible.

How do we get out of this? First, in the fight against inflation, monetary policy needs to be assisted by industrial policies that remove bottlenecks and release some of the supply constraints Second, the risk of segmentation of sovereign debt markets needs to be reduced. For this, the EMU should move forward decisively with the creation of a central fiscal capacity. Replacing part of the member states’ debt with common borrowing would not only stabilize financial markets with a safe asset, but also mechanically reduce the segmentation of sovereign bond markets.
However, the complete normalization of monetary policy could only take place with a solution that unburdens the ECB of the goal of keeping spreads under control. While the stated intention of creating an anti-spread tool is commendable, it will probably keep interfering with the classical tasks of central banks. One (only seemingly radical) way out is to establish a European Debt Agency (EDA). This agency would form a diaphragm between the member countries, to which it would offer perpetual loans, and the markets, from which it seek financing issuing Eurobonds. The EDA would protect member countries from the irrationality of markets while ensuring, through appropriate modulation of interest installments on loans over time, that national governments remain fully accountable for their fiscal behaviour: less virtuous countries (e.g., that fail to comply with fiscal rules) would be called upon to pay higher interest. The debt mutualization so feared by the so-called frugal countries would therefore be avoided. This is only a seemingly radical solution because in the recent past it has become customary for European institutions (the ESM, SURE, even Next Generation EU) to borrow at preferential rates and then transfer those rates to member states, effectively acting as guarantors and intermediaries. The European Debt Agency would take this mechanism to its extreme consequences.
The establishment of the European Debt Agency would create a single European sovereign debt market, mimicking the operation of a federal system. This on the one hand would provide the markets with a safe asset and, as in the United States, reduce the risk of speculative attacks to virtually zero. On the other hand, it would free monetary policy from the task of having to keep spreads down. The ECB would be free to set interest rates and decide of the size of its balance sheets with in mind only a central bank’s own goals of keeping inflation low and supporting growth. This seems the only structural way out of the present difficulties.

What will COVID Mean for the Future of Fiscal and Social Policy?

Published by Anonymous (not verified) on Tue, 07/06/2022 - 10:16am in

It is the stated goal of the Canadian federal government to foster “a strong and inclusive labour market that provides every Canadian with opportunities for a good quality of life.” The legacy of COVID has, however, led to policy incoherence, with some significant reforms directly putting this goal into question.

The federal government has repeatedly stated, in different ways, a concern for a more fair and a more inclusive society, one in which all Canadians can become all that they can be and lead the lives they value. For example, in a statement specifically directed to economic policy the government stresses that fiscal and monetary policy should be coordinated to support “a strong and inclusive labour market that provides every Canadian with opportunities for a good quality of life.”

What will COVID, the policy response to it and the legacy it sets, mean for the movement toward this goal? I answer this question by addressing three more specific questions, and suggest that while there is both possibility and challenge in the framing of social and macro-economic policy, there is unfortunate policy incoherence on the horizon that will do more to weaken than strengthen the development of an inclusive labour market.

To invoke Edvard Munch’s famous painting “The Scream” is almost cliche, but it is nonetheless a remarkable summary of how many might feel about fiscal and social policy directed to inclusive growth.

1. Is a Basic Income in the social policy future?

The Canada Emergency Response Benefit (CERB) clearly demonstrated the power of federal income transfers to lower the poverty rate. In fact, the official poverty rate fell by almost one-half between 2019 and 2020 to reach an unprecedented low, well below the poverty reduction target the federal government set for 2030.

It is no small wonder that this experience might raise the expectations of many advocating for a Basic Income.

Even if this experience makes clear that the federal government could effectively take over, or at least complement, the income transfer space traditionally in the domain of provincial social assistance programs, it is also clear that a universal demogrant is not part of the social policy future.

That said, Canadian social policy has always been made incrementally, and there are two considerations that both constrain and offer an opportunity for a more robust income safety net at the federal level.

The first is the pervasive influence of the distinction between the deserving and the non-deserving poor.

Whether from an ingrained belief, or from an appreciation of Canadian political culture, this distinction has framed social policy since 2015. Children in some sense are deserving, and so the federal government has taken significant strides in reducing child poverty. The elderly, of course, have long been seen as deserving and there have been repeated expansions of income supports to those in retirement. We have a Basic Income for children, the Canada Child Benefit, and we have a Basic Income for the elderly, the Guaranteed Income Supplement.

But the Poverty Reduction Strategy set targets to lower the rate of poverty by one-fifth in the near term and by one-half in the longer term for the entire population. The working-age poor, particularly those living on their own, have been recognized as falling though a gap. Public policy considers them to be among those “working hard” to join the middle class, and therefore expected to rely on labour market engagement to move above the poverty line. They, in other words, are not “deserving” poor.

The oxygen for discussions of Basic Income, at least in the near term, will be taken up by another group of “deserving” poor, those of working age with disabilities.

On June 22nd Minister Qualtrough re-introduced legislation to enact a federal income transfer program to support this group. Bill C-22 is entirely void of any design details, leaving eligibility and benefit rates to be determined by regulations, but it is certainly most likely to borrow from the targeted negative income tax structure of its cousin programs. A good deal will depend upon how “disability” is defined, but when it is up and running and somehow coordinated with provincial programs, it will likely leave many working age people out of scope.

The political economy of deserving versus non-deserving, as opposed to a rights-based framing, is a constraint on the future of social policy. But there is also opportunity in how rights-based advocates have come to understand the design of a Basic Income. My own observations suggest that there has been a considerable evolution from the notion of a universal demogrant to that of a negative income tax, with an appreciation of the design trade-offs associated with targeting, with a budget constraint, and with labour market incentives.

An ongoing conversation about Basic Income could well begin with the recognition that the government in an incremental, yet significant way, has complemented provincial programs through refundable tax credits, and that the way to further this agenda is to continue to press for working-age singles to be included.

This could happen through the continued evolution of the Canada Workers Benefit, adding to it not just a more generous benefit structure but also a component that is not conditional on employment income.

It could also happen through constructive engagement with provinces that wish to comprehensively reform their social insurance programs toward a Basic Income in a way that fosters agency among those in need. Prince Edward Island has moved in this direction, the legislature’s Special Committee on Poverty releasing a consensus report recommending a Basic Income Guarantee.

2. Are enhanced business subsidies part of the COVID legacy?

The big bugaboo in this discussion, one that sits at the heart of the deserving versus non-deserving distinction, is the belief that income support can encourage people to work less.

No single group in Canadian society has made so much of the work disincentives criticism, and to such great effect, than some lobbyists claiming to speak for the small business community. Yet, subsidies to business have most likely led to over-insurance and a powerful moral hazard that will put a break on innovation and productivity if they become a part of the post-COVID future.

Certainly public finance principles rationalize government interventions when there is a market failure, while recognizing that there will be an efficiency trade-off associated with changes in behaviour—be it labour supply, labour demand, or saving and investment—that are a response to taxes and transfers.

As fiscal policy moves forward it is important to consider how COVID support programs to businesses have performed, the unintended consequences associated with them, and the lessons for the future.

The Canada Emergency Wage Subsidy (CEWS) was by far the most significant of these programs, indeed of the entire package of COVID-related federal government expenditures with the monies spent on ostensibly maintaining the attachment of workers with their employers rivaling total direct transfers to individuals.

A major lesson of the pandemic is that a program like CEWS should not be looked at as a model for business sector support, whether in times of a sharp shock or whether as a long-term structural policy.

CEWS was slow off the mark at the onset of the pandemic as the bulk of business closures had already taken place before the program started accepting applicants in June of 2020. I have detailed this experience in an article to be published by the American Enterprise Institute.

It can also be reasonably argued that CEWS over-compensated businesses in a poorly targeted way lowering business closures during 2020 significantly below previous levels, something that can be a drag on innovation and efficiency.

At the most basic level, CEWS fell well short of its stated goal of maintaining the tie between workers and employers during the successive ways of the pandemic.

Going forward there are much more efficient and effective ways of achieving this goal. Aspects of a reformed Employment Insurance program, particularly its “work sharing” provisions are better suited. And besides the Employment Insurance program is hard-wired to maintain a tie between workers and employers because employer premiums are not experience-rated.

The CEWS teaches us that it is much more effective to compensate impacted individuals directly than through their employers.

But this experience has had important political economy consequences that bode ill for efficient and equitable fiscal policy. Lobbyists claiming to speak for small businesses were emboldened in a significant way, public attention being artfully shifted from the plight of essential workers early in the pandemic to the plight of troubled firms, with significant policy consequences.

The federal government was very attentive to a whole host of concerns that can only be charitably described as poor public policy. These include repeated extensions of the CEWS, intergenerational transfers of capital gains, and most recently campaigns for extensions and forgiveness of loans taken through the Canada Emergency Business Account (CEBA).

There is an important discussion to be had about the moral hazards associated with these changes, and their consequences for a dynamic and efficient small business sector. Indeed, all of this is piled onto a corporate tax structure that is increasingly making small businesses a tax haven and putting a break on productivity growth.

But the coup de grace in this unfortunate policy evolution is the government’s acquiesce to the demand for an expanded Temporary Foreign Worker program. Employers now have the opportunity to hire up to one-fifth, and in some cases 30 percent, of their low-wage workforce through the Temporary Foreign Worker program.

This represents a major wage subsidy, even if it is not recorded as an expenditure in the government’s books. It is just the opposite of what policy directed to an inclusive labour market should be doing. Low wage workers, those who have a tenuous foothold in the labour market either because they themselves are recent immigrants, have a disability, or are young, will likely see more limited wage growth and job opportunities as a result of this policy change.

This change may also potentially shut off the possibility of upgrading employment and human resource practices in the care economy, particularly in Long-Term Care facilities and in early childhood care. The pandemic illustrated that the use of contingent and itinerant work arrangements in long-term care homes had devastating and shameful consequences. The challenge for a policy maker wishing to promote an inclusive labour market is to transform this sector into a “craft” based economy, with upskilling of workers who offer community and family based care and support.

An unfortunate legacy of COVID on public policy directed to employers is the threat of growing inefficiencies and inequities as a result of subsidies that cannot be rationalized by any sort of market failure.

3. Will the management of the macro-economy encourage an inclusive labour market?

Income inequality is the clearest, though certainly not the only, marker of an inclusive labour market. There are important long-term structural causes of growing inequality in market incomes, but the COVID crisis directs us to also focus on cyclical aspects of inequality. It calls for more timely and progressive fiscal policy in macro-economic management.

Higher inequality makes macro-economic management more difficult.

Certainly, it is important to no longer frame policy in terms of representative agent models and trickle down economics. It is not clear that this was ever a good guide for policy, but it was the framing of the 1980s and 1990s, no consideration at all being given to the distributional consequences of macro-policy.

Inclusive growth means that policy directed to growth and business cycle stabilization go hand-in-hand with concerns over income distribution.

What did COVID teach us about macro-economic policy?

Well, big shocks matter!

We knew this from the experience of the Great Recession in 2008; we knew this from the bursting of the commodity price bubble in 2014; and now we know it all the more clearly as a result of a world-wide pandemic.

Big shocks matter beyond the fact that they are big, they also matter because they can have long-lasting consequences well after they have passed. There is a threat that income inequality jumps after a big shock, but does not return to its original level in its aftermath, ratcheting up as those who are hardest hit are also permanently scarred.

The Gini coefficient based on market incomes did in fact jump significantly in 2020, reflecting the fact that many Canadians, particularly those in professional and managerial occupations, kept working throughout the pandemic while others in more public-facing occupations suffered significant disruptions in their work and family lives.

But strikingly this increase was more than completely undone by the tax-transfer system, the associated Gini falling to its lowest level in 45 years.

This is an amazing development that echoes back to the recessions in the early 1980s and early 1990s when the tax-transfer system was more responsive and progressive.

These policy-induced recessions were intended to lower inflation, and solidify the independence of the Central Bank. But they had significant consequences for income inequality, which rose but did not return to pre-recession levels, The Canadian tax-transfer program was sufficiently progressive to completely undo these developments, with the after tax transfer Gini staying constant in spite of rising market income inequality.

But this was not the case after 1995 when the government made a determined effort to eliminate the deficit, cutting important transfers and the unemployment insurance program. As a result of these cuts after tax and transfer inequality has tracked rather than moved against market income inequality … except in 2020.

The Bank for International Settlements calls this “inequality hysteresis” a successive ratcheting up of inequality, that in turn risks making the macro-economy more unstable and risks further recessions and higher inequality.

… inequality increases faster and more persistently in the aftermath of recessions. Furthermore, greater income inequality is associated with deeper recessions, and with the reduced effectiveness of monetary policy in steering aggregate demand. Taken together, these results point to the risk of an adverse feedback loop: recessions persistently worsen inequality, and greater inequality serves to deepen recessions. These results highlight the importance of taking inequality into account when designing and implementing fiscal and monetary policy.

da Silva et al, Bank for International Settlements, May 2022

Big shocks matter, but the nature, the timing, the duration of big shocks are fundamentally uncertain. How do we conduct policy if we appreciate that we live in an era of fundamental uncertainty about big risks? How do we do it if we appreciate that growth and distribution are linked, an inherent part of inclusive growth in the long term but also an inherent part of macro-management in the short term?

We do it with rules-based program design as much as with discretionary choices. This calls for stronger automatic stabilzers, and this part of the Canadian policy tool kit needs to be enhanced, even if we accept that there will always be a role for discretion.

Most urgently this calls for two reforms. First, a more progressive income tax structure, which most notably requires a broader tax base. The obvious reform, that also has important implications for horizontal and vertical equity, is to stop giving capital income a free ride in the tax system. A higher inclusion rate for capital income is called for, moving from the current 50 per cent to at least 75 per cent, a rate that in fact has a precedent in the Canadian income tax structure.

Second, a much more robust Employment Insurance program is called, offering more complete income insurance, including wage insurance, broader coverage, and a capacity to respond in a more timely way to sharp regional and national downturns.

Post COVID policy incoherence threatens an inclusive labour market

Public policy may continue to make determined and important changes in a progressive and inclusive direction, and even take steps toward a tighter social safety net that some will appreciate as a basic income.

But other choices bring the very goal of a “strong and inclusive labour market” into question and in the long term threaten the sustainability of more generous transfers to individuals. The labour market will be more inefficient and inequitable because of sustained subsidies to small business and increased reliance on temporary foreign workers.

And more polarization and inequality of jobs, wages, and market incomes will in turn make the maco-economy more unstable and more challenging to manage.

What will COVID mean for the future of fiscal and social policy? The future is unclear not because of inherent uncertainty, but rather because of explicit choice and the incoherence that it has engendered.

[ This post is based upon my comments to a panel discussion on “What will COVID Mean for the Future of Fiscal and Social Policy?” organized by Michael Smart and Trevor Tombe of Finances of the Nation, and held as part of the 56th Annual Meetings of the Canadian Economics Association at Carleton University, Ottawa Canada on June 3, 2022. You can download a copy of my presentation at this link. ]

MMT Banking Primer

Published by Anonymous (not verified) on Mon, 06/06/2022 - 1:28am in
by Jonathan Wilson

First published April 8, 2022, on the PMPE website (PDF).

Comments may be left via the form below or sent via email to GIMMS
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Modern Monetary Theory illustrates how governments control the use of currency, including the private banking system’s ability to create credit. Additionally, MMT’s framework argues that governments who want to encourage households to purchase consumer goods can focus on directly increasing those individuals’ deposit accounts at commercial banks—as manipulating reserve balances is inconsequential. In this short primer, we will explain the liabilities of the banking system and how the entities in the banking system interact as they hold and transfer liabilities between one another. Then, we will explain the implications this system has for the theory of state money and for monetary policy.


I.                   Transfers Within the Central Bank’s System

Let’s start with an elementary banking system model, which includes only the Central Bank, the Treasury, two commercial banks, and four customers (Figure 1). In the United States the Central Bank is called the Federal Reserve, but to avoid any confusion from non-American readers, we will only refer to it as the Central Bank or the CB. In this model, the commercial banks and the Treasury each have a reserve account at the CB with a balance of $500,000, and each of the customers has an account at their respective commercial bank with $100,000 on deposit. The Treasury’s account at the CB is also known as the Treasury General Account.


Elementary banking system model, which includes only the Central Bank, the Treasury, two commercial banks and four customersFigure 1


By debiting and crediting account balances, the CB accounts for transactions between the commercial banks and the Treasury, as well as between the two commercial banks. The CB manages the ledger that records the reserve balances held by the Treasury and commercial banks, and it adjusts that ledger by crediting and debiting accounts when it receives notice that one of the entities wishes to transfer reserve balances to one of the other entities. To be clear, changing the ledger is itself the transfer. Reserve balances are representative numbers; there is no physical object that either party needs to ship to the other when transferring reserves. For example, when a commercial bank pays taxes, fines, and fees to the Treasury, or when it purchases goods or services (such as stamps or electricity) from other government agencies, the CB debits the commercial bank’s reserve account balance and credits the Treasury General Account. Similarly, when the Treasury buys assets from commercial banks, the CB debits the Treasury General Account and credits the commercial bank’s reserve account. When one commercial bank buys assets (such as securities or real estate) from the other commercial bank, the CB debits the purchasing commercial bank’s account and credits the selling commercial bank’s account.

In the charts below, observe what happens when Bank 1 buys a $25,000 asset from Bank 2 (Figure 2), then makes a $75,000 payment to the Treasury (Figure 3).


Bank 1 buys $25,000 asset from Bank 2. As described in the text.Figure 2


Bank 1 pays $75,000 to TreasuryFigure 3


In the first transfer, Bank 1 notified the CB that it was transferring $25,000 of reserve balances to Bank 2. The CB then debited Bank 1’s reserve account balance by $25,000 and credited Bank 2’s reserve account balance by $25,000. In the second transfer, Bank 1 notified the CB that it was transferring $75,000 of reserve balances to the Treasury. Then the CB debited Bank 1’s account by $75,000 and credited the Treasury General Account by $75,000.


II.                Money Is a Liability

While reserve balances are simply numbers, both the Central Bank and the Treasury, as parts of the national government, are legally required to accept them in payment. Reserve balances are assets of the depositor and a liability for the bank, which, for the purpose of this primer, means a credit that the issuer or its affiliate accepts in exchange for extinguishing a tax liability or any other payment due to the issuer. In the case of reserve balances, the issuer is the CB, and the Treasury is its affiliate, so both the CB and the Treasury accept reserve balances in payment. For example, the CB deletes reserve balances from its ledger when commercial banks buy physical notes and coins from the CB or pay fines imposed by the CB. Similarly, the Treasury is legally required to accept reserve balances (which courts have described as being “functionally equivalent” to cash)[1] in exchange for forgiving fines and tax liabilities and for specified goods and services that several statutes require some government agencies to sell. For example, 39 USC 403 obligates the United States Postal Service to provide postal services and to sell stamps at “fair and reasonable rates and fees” (39 USC 403); 16 USC Chapters 12 through 12H collectively require the Secretary of the Army and the Secretary of Energy to operate hydropower facilities and sell the electricity “at the lowest possible rates” (§ 825s); and 38 U.S. Code §§ 7301 and 7302 require the Veterans Administration to deliver healthcare to Veterans who tender the required copay under 38 CFR § 17.36. The U.S. is not unique in this regard. For example, Bahamian[2] law and Chinese[3] law both require the maintenance of an electricity corporation that sells power at reasonable prices. Because commercial banks need reserve balances to pay government fines, to extinguish their tax liabilities and to make other payments to the Treasury, they are willing to sell goods and services in exchange for these necessary reserve balances when making payments within the banking system—not only to the national government but also among each other.

Similarly to how reserve account balances are assets that measure claims that commercial banks have against the national government, the units of account in individual bank accounts, which are usually called deposits, are likewise the depositor’s assets that measure the claims that account holders have against banks. If someone has a $100 bank deposit, they have a $100 asset, and the bank has a $100 liability (a redeemable credit) outstanding. A bank can directly redeem its deposits (debit the depositor’s account) by giving the customer cash that the bank purchases from the CB or by selling financial assets to the customer, such as certificates of deposit, bonds, or any other asset that it holds. A bank can also redeem deposits by transferring them to a recipient’s account at the same bank. It does this simply by debiting the account of the transferor and crediting the account of that recipient. Or, if the recipient’s account is at another bank, reserves can be transferred to the reserve account of the recipient’s bank, and the recipient’s bank will credit the recipient’s account at his bank. When depositors at commercial banks make payments to the Treasury, the Fed debits the commercial bank’s reserve account and credits the Treasury’s Fed account, while the commercial bank debits its depositor’s account.

Payments between individuals who have accounts at the same bank occur by debiting and crediting deposit accounts. Recall that customers A and B have accounts at Bank 1 and customers C and D have accounts at Bank 2. If A makes a payment to B, Bank 1 debits A’s account and credits B’s account.

Payments by customers to the Treasury and to customers of other banks are slightly more complicated. Because individuals don’t have reserve accounts and you cannot literally transfer an entry on a ledger to someplace outside the ledger, these types of payments are processed by multilateral agreements to increase and decrease liabilities. When a customer at Chase Bank makes a payment to a customer at HSBC, what literally happens is the Chase Bank customer asks Chase Bank to convince HSBC to give the HSBC customer a deposit. Then, to compensate HSBC for its increase in liabilities, Chase transfers reserves to HSBC. Then, to compensate Chase for its loss of assets, the Chase customer agrees to surrender some of their deposits to Chase. In other words, the payor is giving up their claim against their bank to induce the recipient’s bank to issue a liability to the recipient, with several intermediate steps.

If an individual makes a payment to the government, the bank debits the customer’s account and requests the CB to transfer reserves from the commercial bank’s account into the Treasury General Account. If A, a Bank 1 customer, makes a payment to C, a Bank 2 customer, Bank 1 debits A’s account, Bank 2 credits C’s account, and both banks request the CB to debit Bank 1’s reserve account and credit Bank 2’s reserve account. Bank 1 transfers reserves to Bank 2 to offset Bank 2’s new liability: C’s deposit. C now has the right to request cash or payment from Bank 2, and transferring reserve balances to Bank 2 ensures Bank 2 can comply with C’s requests. Like payments between A and B, payments between C and D settle without transferring reserves because they have deposit accounts at the same bank. In the charts below, observe what happens when A makes a $20,000 payment to B, then B makes a $50,000 payment to C.


Intital state before transfers begin. Treasury has $575,000 reserve balance, Commercial bank 1 has $400,000 reserve balance, Commercial bank 2 has $525,000 reserve balance and customers A & B (Bank 1) and C & D (Bank 2) each have balances of $100,000 in their deposit accounts.Figure 4


Customer A of Bank 1 pays $20,000 to Customer B of Bank 1. Therefore, Customer A then has a balance of $80,000 and Customer B has a balance of $120,000. All other balances reamain as in the initial state (Figure 4)Figure 5



Customer B (Bank 1) pays $50,000 to Customer C (Bank 2). Therefore, Customer B now has a deposit account balance of $70,000, Bank 1 has a reserve balance of $350,000, Bank 2 has a reserve balance of $575,000 and Customer C has a deposit balance of $150,000.Figure 6


In the first transfer, Bank 1 merely debits A’s deposit account by $20,000 and credits B’s deposit account by $20,000. In the second transfer, B tells Bank 1 that it wants to pay C. Bank 1 tells Bank 2 to increase C’s deposit account by $50,000, and to compensate Bank 2 for increasing Bank 2’s liabilities, Bank 1 tells the CB that it wants to pay Bank 2, so the CB debits Bank 1’s reserve balance account by $50,000 and credits Bank 2’s reserve balance account by $50,000. To compensate Bank 1 for the loss of its reserve balances, Customer B agrees to surrender some of its liabilities against Bank 1, so Bank 1 debits B’s deposit account by $50,000. When executing the transfer from B to C, usually the debiting and crediting of deposit accounts occurs instantly, and the debiting and crediting of Bank 1 and Bank 2’s reserve balance accounts occurs later, by some time set by the CB. Regardless of the actual time of execution, the legal requirement to complete the reserve balance transfer comes into existence the moment Bank 2 agrees to credit C’s deposit account.

It is very important for banks to manage the amount of liabilities depositors hold against them. Because banks are regulated entities, they are required to record and account for each transaction they make, including all deposits they issue. Every time a bank issues a deposit, whether it issues a loan, it pays its employees for their labor, buys some asset from one of its customers, or makes a charitable donation, this action is recorded as an expense that the bank must account for when recording its retained earnings, which has significant regulatory impact which we will discuss later. When banks extend loans, they offer deposits in exchange for a written agreement, or “note,”[4] promising to give the bank more financial assets—cash, reserves, debt relief, deposits at another bank, etc. In this sense, when banks lend, they sell deposits in exchange for notes promising payment with interest. From an accounting perspective, the difference between a bank buying the labor of its CEO with a $1 million bonus and buying a note from (making a loan to) a customer for $1 million is that the note is an asset that offsets the increased liability represented by the additional deposit. When the bank gives the CEO the $1 million bonus, it must record this transaction as a $1 million reduction in its retained earnings, but when the bank makes the $1 million loan, its retained earnings remain the same and will increase when the borrower pays interest.


III.             Regulations Affecting Banks

Now that you know what bank liabilities are and why they issue them to customers in exchange for value, the next step is learning what regulations limit banks’ ability to issue loans, accept deposits, and clear payments without penalty: capital adequacy ratio requirements and liquidity coverage ratio requirements. These regulations in their current configuration, which most countries use in some form, were developed by the Basel III Committee in 2009.


A.                Capital Adequacy Ratio Requirements

Capital adequacy ratio requirements mandate that a bank keep, based on a percentage of its assets, a certain amount of money that meets specific qualifications. Collectively called “capital,” this money consists of proceeds from sales of their equity, retained earnings from asset sales, and interest collected on loans. For clarity, “capital” in most contexts refers to the value of the obligation to pay shareholders upon a liquidity event, but in the regulatory context, it is an accounting[5] residual that refers to the funds paid in exchange for those shares, and the funds themselves can be thought of as a subset of the bank’s assets. Money that is encumbered—specifically, money that banks borrow and must repay—does not count towards a bank’s capital. The money that comprises the regulatory capital is held in the form of reserve balances, deposits at other banks, and cash. For clarity, everything of value that the bank holds is one of its assets. However, only assets that the bank obtains from certain sources count towards its capital. Borrowed funds do not count towards a bank’s regulatory capital; proceeds from sales of equity, retained earnings from sales of assets, and interest income do count towards a bank’s regulatory capital.

Capital adequacy ratio requirements exist in two forms. One compares a bank’s capital to its overall assets, and the second compares a bank’s capital to a risk-weighted subset of its assets. When calculating risk-weighted asset numbers, banks must multiply the value of each asset by a risk weight percentage assigned by regulation. For example, the regulations assign a 100% risk weight to deposits at financial institutions, corporate stock and unsecured loans; a 50% risk weight to residential mortgages; and a 20% risk weight to bonds issued by States. Most importantly, reserve balances, cash, and bonds issued by the national government have a risk weight of 0%, meaning they do not count towards the total. Note that certain funds, such as proceeds from the sale of the bank’s equity which is held at a correspondent account at another commercial bank, can count both towards a bank’s capital and towards its risk-weighted assets, meaning that a capital-deficient bank can approach satisfying the capital adequacy ratio by solely accumulating deposits at other banks but will likely need at least some cash, bonds, or reserve balances to fully satisfy the capital adequacy ratio requirement. Because cash, bonds, and reserve balances carry this zero-risk weight, banks will always have demand for them.

To illustrate, consider a bank that owns (i) $100 in corporate stock, liabilities against other financial institutions, and unsecured loans; (ii) $250 in residential mortgages; (iii) $400 in State bonds; and (iv) $1000 in cash, reserve balances, and US Treasury bonds. Such a bank would have a risk-weighted asset total of $225 (see Table 1 below). The regulations instruct banks to maintain a total capital ratio of 8%, meaning our hypothetical bank would need to have $18 in capital.


Risk Weight
Risk-weighted Value

Liabilities against other financial institutions, corporate stock, and unsecured loans

Residential mortgages

State bonds

Cash, reserve balances, US Treasury Bonds



Table 1


B.                 Liquidity Coverage Ratio

The liquidity coverage ratio requires banks to keep a certain amount of a specified type of liquid asset called a high quality liquid asset (“HQLA”) based on a percentage of their liabilities. HQLAs consist of reserve balances, assets issued or guaranteed by national governments, and qualified stocks and bonds. The regulations require banks maintain a level of HQLAs at 1:1 ratio with the sum of various percentages of the bank’s liabilities, called the Net Cashflow Amount. The actual regulation[6] that defines total net cashflow amount has too many sub-parts to discuss in this primer, but to get a general understanding of how it works, know that total net cashflow amount includes 3% of insured customer deposits, 10% of uninsured customer deposits, and 10% of the amount of money the bank has committed to originate retail mortgages in the last 30 days. For example, if a bank has $1,000 in insured deposits, $2,000 in uninsured deposits, and has originated $5,000 in retail mortgages in the last 30 days, its net cashflow amount is $730 (see Table 2 below).


Net Cashflow Amount

Insured Deposits

Uninsured Deposits

Retail Mortgages Originated in Last 30 days



Table 2


Similarly, the regulators take a complex series of steps to calculate[7] the HQLA amount, but this primer will use a simplified description. The regulations define two types of liquid asset. Level 1 includes reserve balances and securities issued by the US Treasury or other national governments; Level 2 (split into 2A and 2B) includes securities sponsored or guaranteed by government enterprises other than the US Treasury, corporate debt, Russel 1000 stock, and municipal bonds. To calculate a bank’s HQLA amount, take the amount of its Level 1 assets and add an amount of its Level 2 assets equal to at most 2/3rds of its Level 1 assets. For example, if a bank has $9 in Level 1 assets and $3 in Level 2 assets, its HQLA amount equals $12, and if a bank has $9 in Level assets and $6 in Level 2 assets, its HQLA amount equals $15. However, if a bank has $9 in Level 1 assets and $500,000 in Level 2 assets, its HQLA amount still equals $15 (because the Level 2 assets are only allowed to contribute $6 to the HQLA amount, as $6 is 2/3rds of $9), and if a bank has $0 in Level 1 assets and $500,000 in Level 2 assets, its HQLA amount equals $0. Consequently, banks must maintain at least some Level 1 assets to avoid civil penalties. See the Table 3 below, and for a spreadsheet that you can play with to simulate how different liquid asset amounts affect the HQLA amount, click here.


Level 1 Assets
Level 1 Contribution to HQLA Amount
Level 2 Assets
Level 2 Contribution to HQLA Amount (max of Level 2 Assets and ⅔ of Level 1 Assets)
HQLA Amount





Table 3


Banks must maintain an HQLA to Net Cashflow Ratio of 1:1, but please note that the regulations do not require banks to acquire HQLAs before issuing deposits, nor do they require banks to acquire capital before acquiring assets. However, they do influence banks’ activity; empirical studies of banks show that banks that approach the limits of the capital and liquidity guidelines will temporarily[8] reduce lending[9] until they can obtain additional capital or liquidity. In very extreme circumstances, they may alter their lending standards[10] to favor safer, more liquid loans.


IV.             What Happens When Banks Run Low on Liquidity?

If a commercial bank runs low on liquidity, it can still process payments by using mechanisms at the Central Bank and by borrowing from other commercial banks.


A.                Central Bank Mechanisms: The Overdraft Facility and the Discount Window

Adherence to the capital ratio requirements and liquidity coverage ratio requirements grants banks free access to two mechanisms at the Central Bank that provide them with flexibility to process more transactions—the overdraft facility and the discount window. The overdraft facility allows banks to have negative balances in their reserve accounts at the CB up to an amount called the net debit cap. The size of a bank’s net debit cap depends on how well it follows the capitalization and liquidity requirements, but the cap can be zero for struggling banks. A bank that makes a payment in excess of its net debit cap can still use the overdraft facility but must pay a penalty and risks being shut down by regulators if it continues to exceed its net debit cap. Banks which use the overdraft facility must obtain reserves to bring their balance back to zero by the end of the day. For example, If Bank A has a reserve balance of $500, but needs to make a $700 payment to the Treasury, the CB will credit the Treasury General Account by $500 and debit Bank A’s reserve account by $500, resulting in Bank A’s reserve account measuring negative $200. Bank A must then pay the CB $200.

The discount window allows commercial banks to borrow reserves directly from the CB, which serves as a lender of last resort when banks cannot borrow reserves from each other. Maintaining access to both of these processes allows banks to maintain their operations without penalty, even when running low on capital and liquidity. The CB imposes various rules that deter unlimited use of the discount window, including the requirement to pledge collateral and restrictions on how borrowed funds may be used. Additionally, the amount banks can borrow is limited by their regulatory capital.


B.                 Interbank Lending

One of the ways banks can eliminate negative balances from overdrafts is to borrow reserves from one another. Banks that lend reserves charge interest on these loans, and the number of total reserves existing among all banks determines the rate of interest. When there is an abundance of reserves in the system, banks charge a lower rate of interest to lend to one another, but they will always charge more than the passive rate of interest that the CB pays on reserves. If a bank receives 2% interest on reserves from the CB, it would never make sense to charge only 1% in interest when lending to another bank because it could simply do nothing and receive more. When reserves are plentiful, banks also compete with each other for loan customers by offering lower rates, which reduces the average overall interest rate.

Similarly, debiting reserves raises interest rates by making reserves more scarce, although banks will almost never charge more than the CB charges to use the discount window. A bank which can borrow from the CB at 1% interest would never pay 2% interest to borrow from another commercial bank. In this sense, the interest paid on reserves and the discount window form a corridor system[11] that places upper and lower bounds on the interbank lending rate. That being said, if there were a system-wide shortage causing liquidity issues and banks begin to exceed their net debit caps, rates would likely have no ceiling.


V.             Shadow banks, Eurodollar banks, and Payments

Until now, we have exclusively discussed banks which have accounts at the Central Bank. But some financial institutions, called shadow banks, provide banking services denominated in a given currency despite existing outside the direct supervision of the ordinary financial laws and regulations of the country originating that currency. For example, Eurodollar banks, defined as banks outside the United States that issue dollar-denominated liabilities, represent one type of shadow bank. Because shadow banks do not have accounts with the nation’s CB, Eurodollar banks and other shadow banks must hold deposits with an entity that does have an account at the CB in order to finalize payments to the Treasury.

Consider a hypothetical individual who does business in both the United States and Italy. She has $20,000 in a dollar-denominated account with Intesa Sanpaolo, an Italian bank, and needs to make a $5,000 payment to satisfy a fine imposed by an agency of the United States national government. To make an international payment like this one, commercial banks have correspondent accounts with banks in the country of the recipient. Suppose Intesa Sanpaolo has a $100,000 correspondent account at Wells Fargo in the United States and Wells Fargo and the Treasury each have $500,000 in their reserve balance accounts (Figure 7). First, Intesa Sanpaolo debits the business owner’s dollar account by $5,000, leaving $15,000. Next, Intesa Sanpaolo requests that Wells Fargo process a payment to the Treasury General Account. Wells Fargo then debits Intesa Sanpaolo’s account at Wells Fargo by $5,000, leaving a balance of $95,000, and finally, Wells Fargo requests that the CB debit its account at the CB by $5,000 and credit the Treasury General account by $5,000. Wells Fargo’s reserve balance account now holds $495,000; the Treasury General account now holds $505,000; and the payment settles.


Balances before international transfer. Details in text.Figure 7


Balances after international transfer. Details in text.Figure 8


Similarly, if someone wants to make a payment from an account at a shadow bank to an account at a commercial bank that is a part of the CB system, generally the shadow bank must have an account with a CB member-bank that has adequate reserves, access to the overdraft facility, or is willing to pay a penalty for an overdraft. CB member-banks can accept deposits at other banks in lieu of payment in reserves, but regulations limit such interbank liabilities unless the bank issuing the deposit is another CB member-bank that meets certain capital adequacy requirements. In other words, shadow banks can issue liabilities denominated in the national currency, but they must rely on CB member-banks to process many types of payments. Most importantly, shadow banks always ultimately rely on CB member-banks to process payments to the government.


VI.             Implications

The structural and legal aspects of the banking and shadow banking systems discussed above have important consequences for two areas of economics discussed by MMT: chartalism and monetary policy.


A.                Implications for Chartalism

The theory of chartalism claims that the government, through its agents which include the commercial banking system, can attempt to provision itself by demanding as payment an asset that only it can create (monopolized currency). Critics of chartalism assert that it must not actually be the case that governments have monopolized currencies because (1) commercial banks (particularly Eurodollar banks) can issue as many deposits denominated in the  government’s unit of account as they want, in a number that exceeds the total amount of the state’s base money (reserves, reserve bank notes, and coins) created by the government; (2) the Central Bank will always satisfy the need for reserves by allowing an automatic overdraft; and (3) the Treasury debits the TGA when it spends and is usually not allowed an overdraft.

Regarding the first criticism, to my knowledge, people who make it almost never explicitly state what immediate practical consequences they think stem from the difference in size between reserves and deposits; no one ever states exactly what the government cannot do because—and only because—of this fact. But as far as we can tell, the insinuation seems to be that if the government imposes a tax that the private sector does not want to pay, commercial banks can simply either (1) issue deposits to the Treasury and declare the tax paid, avoiding any punishment for non-payment; or (2) use the overdraft facility or the discount window to pay the Treasury without attempting to obtain reserves. Readers of this primer will recognize that the structure of the banking system and the requirements imposed by banking regulations make this criticism unconvincing. The Treasury does not accept payments from banks in the form of commercial bank deposits; to clear a payment to the Treasury, you must credit the Treasury General Account with reserve balances. Only CB member banks in good standing can do this; shadow banks and Eurodollar banks cannot.

The ability to create a bank deposit is relatively inconsequential; what matters is the ability to clear payments. In order for a shadowbank deposit to affect the value of the government’s currency in that currency’s country of origin, it must be able to redistribute real resources in that country. Because various regulations in every country essentially require citizens to have domestic bank accounts (as opposed to exclusively using offshore banks), shadow banks have very limited ability to affect the real economy without relying on correspondent accounts at CB member banks.

Regarding the second criticism (that the Central Bank will always satisfy the need for reserves by allowing an automatic overdraft), it is true that the CB always grants an automatic overdraft to prevent the payment system from breaking down, but this does not mean that commercial banks can spend as much as they want without penalty or that reserve balances are a pure residual with no impact on economic activity. Using the overdraft facility is not free; banks must post collateral to use the overdraft facility or the discount window, and Banks that use the overdraft facility must obtain reserve balances to clear the overdraft. The only way to get reserve balances to clear this overdraft is to borrow or purchase them from another entity with a reserve balance account or to sell assets directly to the CB, which only sells reserve balances for assets it deems eligible. Commercial banks cannot simply will infinite amounts of reserve balances into existence, just as bank customers cannot will money into their checking accounts, and if a bank fails to repay its discount window loans or clear its overdrafts, regulators will dissolve the bank. This means that commercial banks always need an income in base money and will always accept base money in payment, or else they will rely on correspondent accounts with a bank that does have such income.

Although there is a continuous need by banks to obtain net reserves to clear payments without penalty, banks can sometimes postpone this process. For example, in the US, commercial banks facilitating tax payments can use a Treasury Tax and Loan Account (TT&L), which is an account where tax payments are temporarily held. However, this does not eliminate the need to transfer reserve balances because the balances in TT&Ls are debited with a corresponding reserve transfer within 48 hours of being deposited. Additionally, banks who use TT&Ls must post collateral at the Fed equal to 100% of the balance of their TT&L. If crediting a TT&L were “payment” in a meaningful sense, no collateral would be required. Consequently, it is misleading and unhelpful to characterize use of a TT&L as “paying taxes in deposits then settling with reserves”. A more legally and operationally accurate description is that the taxpayer surrenders deposits to his or her commercial bank in exchange for the bank’s promise to transfer reserves on the taxpayer’s behalf to the Treasury, and the TT&L is simply an accounting of the collective payments to the Treasury that the commercial bank has committed to paying. The payments, however, are not actually complete until the reserve transfer. The only reason TT&Ls exist is for logistical convenience; it is more efficient for a commercial bank to keep a running tally of all the reserves it needs to transfer to the Treasury and make one big transfer at the end of the day than it is to make thousands of small transfers throughout the course of the day. The existence of TT&Ls does not negate the fact that banks need income in base money.

After pointing out why banks need to obtain the state’s base money, critics of MMT usually claim that this “sounds like the money multiplier theory and not the endogenous money theory”[12] (emphasis added). Careful readers will notice that this argument does not rebut any empirical claims but merely invokes a label, which it misapplies. The money multiplier is the specific claim that banks need to get reserves first before they can issue deposits and that banks will only issue as many deposits as their current supply of reserves allows. As described by the Federal Reserve[13], the money multiplier claim is that:

“the amount of money (deposits) banks ‘create’ is a fraction of the reserve requirement ratio set by the Fed. For example, if a bank subject to a 10 percent reserve requirement lent an additional $100 of funds, $1,000 (or 100 × 1/0.10) in total would ultimately be added to the money supply. In this case, reserves in the banking system would create 10 times as many deposits.”

The money multiplier is not the claim made by MMT; MMT’s claim as stated in this primer is as follows: “Banks need income in government liabilities to clear overdrafts, repay discount window loans, and meet other regulatory requirements and will always accept units of the monetary base or government bonds in payment. Because taxpayers as bank customers rely on banks to settle most payments to the government, assets which are denominated in the government’s unit of account–which banks must use–will always have value to taxpayers.”

With regards to the third criticism (that the Treasury debits the TGA when it spends and is usually not allowed an overdraft), while it is true that the Treasury must spend from the Treasury General Account, the Treasury has several means to bypass this self-imposed funding constraint[14] and credit the Treasury General Account with any number it chooses. It can mint coins, issue tax anticipation bills, credit TT&Ls, and coordinate with the CB to perform indirect monetary financing. Critics of MMT have claimed that the Treasury can only spend without taxing or borrowing if the CB cooperates, but we emphasize here that only one of the four methods that the Treasury uses to bypass self-imposed funding constraints relies on cooperation with the Central Bank. Therefore, any money that the Treasury “has” in the Treasury General Account is an administrative accounting residual, not a reflection of accumulated wealth or any meaningful limit on its ability to spend. Any time the Treasury declines to use these bypass methods, it is making a political decision, not observing a legal requirement. In contrast, commercial banks have no ability to simply bypass the need to obtain reserves to clear overdrafts and repay discount window loans.

Moreover, before commercial banks can purchase bonds from the Treasury or pay taxes and clear any associated overdrafts or discount window loans, the reserves used in those transactions must first be created by the government and transferred to the commercial banks, either (i) when the CB lends to the commercial banks; (ii) when the CB purchases assets from the commercial banks; or (iii) when the Treasury spends. Once enough reserve balances are in the system for it to run, the government, through some combination of actions by the CB and the Treasury, must continue to give reserve balances back to commercial banks. If the CB halted all open market operations and if the Treasury stopped spending (or even merely ran a surplus), commercial banks could not indefinitely continue settling tax payments. In that scenario, in which the government permanently commits to no longer add net reserve balances to the banking system but continues taxing the private sector, rates would rise, regulatory capital would fall, and every single commercial bank would eventually fail. Consequently, the system as currently designed requires the government to continue giving base money to the private sector, which is why MMT states that the government is the monopoly issuer of the asset it demands from the private sector in payment.[15]


B.                 Implications for Monetary Policy

Just as the banking system’s structure colors our understanding of chartalism, it also provides three important insights into why monetary stimulus has limited impact on spending. When the government wants to increase spending by private individuals, it needs private individuals to gain and then spend bank deposits. Some economists believe the government can encourage commercial banks to issue more bank deposits to their customers merely by having the CB issue more reserve balances by purchasing assets from commercial banks. However, commercial banks do not issue deposits free of charge even when they have additional reserve balances; they issue deposits in order to buy assets, labor, and promissory notes (to earn interest income). A shortage of bank deposits does not indicate a need for more reserve balances; it reflects a lack of creditworthy borrowers who desire to sell promissory notes and a lack of wealthy individuals who want to sell their assets to banks. For this reason, the first insight is that if the government wants to stimulate private spending, it can do so most effectively by directly increasing deposits held by individuals, rather than by merely increasing bank reserves and hoping that banks will extend deposits to individuals.

If the Treasury conducts fiscal policy by directly increasing deposit accounts and transferring corresponding reserve balances to the commercial banks, then it can stimulate individual spending. For example, in order to directly increase your deposit account at First Republic Bank, the Treasury can offer to send First Republic Bank reserve balances on the condition that First Republic Bank increases your deposits by the same amount. This is what the Treasury did by providing stimulus checks during the Covid-19 pandemic; when it sent out the final stimulus checks in March, deposits and reserve balances at commercial banks increased, and personal consumption expenditures immediately rose by 4.2%[16] that month.

The second insight is that the private sector can continue to spend, even if the government issues bonds and engages in deficit spending. Some economists believe that selling bonds “crowds out” private-sector spending by draining the reserve balances that the private sector needs to clear payments. This theory fails to note that swapping reserve balances for bonds replaces those reserve balances with a high quality liquid asset that can be used as collateral to obtain additional reserve balances—therefore, the bank’s liquidity coverage ratio and ability to clear payments remain unchanged. No private sector spending has been crowded out. Private sector spending is only crowded out when the CB deliberately raises rates, which is a political choice that most MMTers find empirically misguided.[17]

Finally, the third insight is that we should not expect monetary policy—specifically, the CB exchanging government bonds for reserve balances—to significantly affect the relative price level. Conventional economic theory states that if reserves become scarce and the interest rate rises, banks will issue fewer loans, leading to less spending. This narrative omits the fact that banks are primarily restrained not by reserves directly but by capital and liquidity requirements; they will always lend if they think borrowers can repay. Granted, the interest rate has some impact on this profitability analysis, but it is not dispositive.[18] If every agent in the economy receives more money in interest payments because rates have risen, this additional income may allow for greater spending in some circumstances: If more people spend money, investments may become more profitable, which may at least partially offset the fact that the person running the investment must pay higher interest expenses to their bank. If this offset occurs, then increasing interest rates may not deter lending. Additionally, even if raising rates deters some lending, it may not deter purchasing in a proportional amount. Businesses can finance their investments through debt, equity, or retained earnings. If the cost of debt rises, businesses may make the same purchases for their investments by financing them with less debt and more equity and retained earnings. If they are unable to rebalance their financing profile this way, they may simply pass the increased cost of financing onto customers, elevating the relative price level.


VII.             Conclusion

Banks have a great deal of freedom, but are forced to operate within the confines of a strict regulatory framework, where they rely on actions by the government’s Central Bank to maintain stability and liquidity. The government, therefore, is not an exterior appendage that latches on to a pre-existing financial system. Rather, the financial system emerges from the government’s institutional structures. Because of this relationship, the government has a duty to its constituents to ensure that the financial system works to their benefit. This goal can only be achieved through a proper understanding of how this legal structure impacts economic incentives. With luck, this primer has shed some light on how the banking system actually operates and how various policies affect it, and we hope that readers are better equipped to evaluate proposals to reform it.




[1] United States ex rel. Kraus v. Wells Fargo & Co., 943 F.3d 588, 602

[2] Electricity Act, 1956

[3] Electric Power Law of the People’s Republic of China, 1996

[4] Not to be confused with a “banknote”, a note or promissory note is usually colloquially called a loan contract. When someone buys a loan contract or a note, they are buying the right to payment from the person identified as the “issuer” of the note or the person identified as the “borrower” in the loan contract.

[5] Bragg, Steven. Equity capital definition, accessed 5/6/22 at

[6] 12 CFR § 249.32 – Outflow amounts. Accessed 5/6/22 at

[7] 12 CFR § 249.21 – High-quality liquid asset amount. Accessed 5/6/22 at

[8] Eickmeier, S., Kolb, B., and Prieto, E., Tighter bank capital requirements do not reduce lending long term. Accessed 5/6/22 at

[9] Bridges, J., Gregory, D., Nielsen, M., Pezzini, S., Radia, A. and Spaltro, M. 2014. The impact of capital requirements on bank lending. Accessed 5/6/22 at

[10] Roberts, D., Sarkar, A., and Shachar, O. 2018 (revised 2022). The Costs and Benefits of Liquidity Regulations. Accessed 5/6/22 at

[11] Levey, S., 2017. Buffer Stocks: A Simpler Diagram. Accessed 5/6/22 at

[12] Etzrodt, C., 2018. Modern Sovereign Money—Part II: A Synthesis of the Chicago Plan, Sovereign Money, and the Modern Money Theory. Open Journal of Social Sciences Vol 6 no 9 pp 116-135.

[13] Ihrig, J., Weinbach, G.C., and Wolla, S. A. 2021. Teaching the Linkage Between Banks and the Fed: R.I.P. Money Multiplier.

[14] Tymoigne, É., 2014. Modern Money Theory and Interrelations between the Treasury and the Central Bank: The Case of the United States. Levy Economics Institute of Bard College Working Paper no. 788.

[15] Even if you reject the MMT claim that the Central Bank (whose leadership is appointed by the government and is legally required to remit all of its profits to the Treasury) is a part of the government and insist that the Central Bank is somehow a private agent, the system as currently designed only works because the government’s regulations deem that the Central Bank’s reserve balances are legal tender, carrying a zero-risk weight and serving as a level-1 liquid asset.

[16] Lisa, A. 18 November 2021. The Effects of Stimulus Checks on the Economy. Accessed 5/6/22 at

[17] Wilson, J. 2022. How MMT Differs from Mainstream Macroeconomics: Steady-State Interest Rate Dynamics. Accessed 5/6/22 at

[18] Wilson, J. 2022. Can Tinkering with Interest Rates Solve All Inflation? Accessed 5/6/22 at











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Reblog – No, MMT Didn’t Wreck Sri Lanka

Published by Anonymous (not verified) on Sun, 15/05/2022 - 8:37pm in

Debunking Bloomberg with Fadhel Kaboub

Written by Stephanie Kelton

Originally published on Stephanie Kelton’s “The Lens” on 29th April 2022.

Two poor men sitting on a trolley on a street of closed shops. Petta, Colombo, Sri LankaImage by Harshabad on Pixabay

Last week, Bloomberg touted an opinion piece (written by one of its regular columnists) claiming that “Sri Lanka was the first country in the world to try MMT” and that “the experiment has brought the country to ruin.” A few days later, The Washington Post republished the article. So it garnered a fair bit of attention. Unfortunately, the essay offers little insight into what’s really gone wrong in Sri Lanka. But, hey, editors and writers have discovered that MMT drives clicks, so there’s no dearth of efforts to shoehorn MMT into almost anything.

A number of people sent me the link and asked me to respond. I sat down to do just that, but then I remembered that MMT economist Fadhel Kaboub talks about Sri Lanka in some of his presentations and that he’s been studying the country for years.

Fadhel is an Associate Professor of Economics at Denison University and President of the Global Institute for Sustainable Prosperity. He brings deeper knowledge of the Sri Lankan economy and the policy decisions that have paved the way for their current predicament. So I reached out to invite him to respond to Mihir Sharma’s main claims about the so-called MMT experiment in Sri Lanka.

Sharma’s big claim is that “two cherished heterodox theories…became official policy in Sri Lanka and, within two years, they brought the country to the brink of default and ruin.” The government has halted payments of its foreign debt and warned that it may default. Import prices are surging. It’s hard for people to buy food and fuel. There are periodic blackouts and rationing. Inflation is close to 19 per cent and the central bank has recently doubled interest rates. Sharma acknowledges that there are ’structural factors’ at play, and he concedes that the pandemic hammered the nation’s tourism sector while the Russian invasion of Ukraine made everything worse. But he argues that “the deeper problem” is that the ruling elite “turned Sri Lanka’s policymaking over to cranks.” One of the heterodox theories that is supposedly responsible for the crisis is MMT.[1] What follows is a lightly-edited transcript of my Q&A with Professor Kaboub.

KELTON: Sharma claims that “Sri Lanka is the first country in the world to reference MMT officially as a justification for money printing.” He blames former central bank governor, Weligamage Don Lakshman, for listening to monetary cranks who convinced him that “nobody needs to worry about debt sustainability” as long as you “increase the proportion of domestic debt [relative to debt denominated in foreign currency].” Is there anything in MMT that says that as long as you “increase the proportion of domestic debt” you can “print money” without worrying about debt sustainability or inflation?

KABOUB: When I first read the statement of Sri Lanka’s Central Bank governor, Mr Weligamage Don Lakshman, back in 2020, it was very clear to me that he does not understand the basic MMT insights. He was under the impression that what matters in terms of monetary sovereignty is the proportion of foreign currency debt relative to domestic currency debt and that there was no need to rethink the foundation of the economic development model that his country has used since the late 1970s. Governor Lakshman focused on the proportion of debt but never questioned what the external debt was fueling, and never articulated how a higher proportion of domestic debt was going to build economic resilience in Sri Lanka.

MMT economists have been very clear all along that a country’s fiscal spending capacity is constrained by the risk of inflation, which is determined by the level of productive capacity (availability of real resources, productivity, skills, logistics, supply chains, etc.) and the level of abusive market power enjoyed by key players in the economy (cartels, exclusive import license holders, shell companies, cross-border traffickers, speculators, corrupt government procurement systems, etc.). Therefore, increasing a country’s fiscal policy space must be done via strategic investments to boost productive capacity and regulation of abusive market power. Sri Lanka’s economic policy choices (pre-pandemic and Russia-Ukraine war) do not even come close to what MMT economists would have suggested.

As I will explain below, Sri Lanka has three structural economic weaknesses that were systematically reinforced via mainstream economic policies: 1.) lack of food sovereignty, 2.) lack of energy sovereignty, and 3.) low value-added exports. These deficiencies imply that accelerating the country’s economic engines leads to more pressure on its external balance, a weaker exchange rate, higher inflationary pressures (especially food/fuel/medicine and basic necessities), and, as a result, it leads to the classic trap of external debt.

Here is how it all started. Sri Lanka, like many countries in the Global South, began the liberalization of its economy in 1977, and adopted a classic IMF-style economic development model based on exports, foreign direct investment (FDI), tourism, and remittances. This development model remained tamed during the civil war (1983-2009), but it was fully unleashed in 2009, and that is when external debt began to skyrocket, going from $16 billion in 2008 to nearly $56 billion in 2019. The value of the Sri Lankan rupee dropped from 114 to 178 LCU/USD. Thanks to a massive increase in government subsidies and transfers reaching more than 30 per cent of government spending in recent years, Sri Lanka struggled to keep inflation below 5 per cent. Yet, economists celebrated Sri Lanka’s great achievements with an average growth rate exceeding 5 per cent in the decade after the civil war, and a real per capita GDP growth putting the country officially in the upper-middle-income economy category. Sri Lanka was following the mainstream economic development model like a good student. In the decade starting in 2009, exports grew from $9.3 to $19.1 billion, tourism quintupled from 0.5 to 2.5 million visitors annually, FDI inflows quadrupled by 2018 to a record $1.6 billion, and remittances doubled to nearly $7 billion annually. These are the four engines of Sri Lanka’s economic growth, but they are also the engines driving the country deeper into the structural traps of food and energy dependency, and specialization in low value-added exports.

Here is how these engines constitute a trap. An increase in tourism induces more food and energy imports. An increase in remittances means more brain drain. An increase in low value-added exports induces more imports of capital, intermediate goods, fuel etc.; and an increase in low value-added FDI does the same plus the repatriation of profits out of Sri Lanka. On a global scale, these neocolonial economic traps have suctioned $152 trillion from the Global South since 1960.

KELTON: Sharma argues that it was the “printing of money” that caused inflation to hit record highs. He cites the rate of growth of the Sri Lankan money supply and concludes that inflation hit record highs because the central bank expanded the money supply by 42 per cent from December 2019 to August 2021. Why isn’t this a critique of MMT, and how do you think about the current inflationary pressures?

KABOUB: Sharma is wrong on two fronts here. First, he is assuming that the central bank actually controls the money supply, when in fact the money supply is an endogenous variable determined by the private sector (consumers, business, and banks). The central bank simply accommodates the needs of the market in order to keep short-term interest rates at a stable target, otherwise it will cause all kinds of instability across financial markets. Second, Sharma is assuming that inflation is caused by an increase in the money supply, when in reality, Sri Lanka’s inflation, like many developing countries, imports its inflation via food and energy imports. The higher the pressure on the external balance, the weaker the exchange rate, the higher the inflation pressure from imported goods. Sri Lanka struggled with these pressures for a decade, and managed to muddle through by accumulating more external debt, which quickly became unbearable after the pandemic (loss of tourism, remittances, FDI, and export revenues) and the massive increase in global food and energy prices after the Russian invasion of Ukraine.

The solutions to Sri Lanka’s inflation problems are not in the hands of its central bank. Raising interest rates in Sri Lanka will not end the war in Ukraine, or end the pandemic-induced global supply chain disruptions. The most effective anti-inflation tools fall under fiscal policy. It is the parliament, and the various ministries and commissions that can design strategic investments to boost productive capacity, and have the legal authority to update and enforce antitrust laws. In fact, raising interest rates can often fuel inflation (and inequality) because it is the equivalent of an income subsidy to bond holders, and a tax on actual investors who might be discouraged from increasing productive capacity

KELTON: Sharma appears to know that he has offered a faulty representation of MMT. He anticipates some of the counterpoints that I suspect you and I would both raise. He writes, “proponents of MMT will likely say that this was not real MMT, or that Sri Lanka is not a sovereign country as long as it has any foreign debt.” You have been studying Sri Lanka for a few years now. What, if anything, have policymakers done that suggest that they have been running any kind of “MMT experiment” over the last two years?

KABOUB: Well, this is where Sharma nails it! As I explained above, Sri Lanka’s economic policies don’t even come close to anything informed by MMT insights. Sri Lanka’s government ignored its structural weaknesses, didn’t invest in food/energy and strategic domestic productive capacity, didn’t tax/regulate abusive market power, has a corrupt political system dominated by a single family, and when it was backed into a corner after the pandemic, it doubled down on bad economic decision by claiming that agricultural fertilizers are unhealthy (when they really didn’t have the foreign exchange reserves to pay for the imports), so they destroyed agricultural output, especially rice, in the middle of global food crisis. If the Sri Lankan government was serious about investing in healthy food or a healthy economy, it would have put forward an actual food sovereignty strategy centred on native seeds, it would have discouraged intensive monoculture farming, it would have invested in regenerative farming to undo decades of damage to the soil, and it would have supported farmers to increase yields with well-defined medium and long term strategies. Clearly, this “organic farming” experiment was sloppy at best, but it should not overshadow the fact that the roots of the agricultural vulnerability have been decades in the making.

KELTON: Sharma chides the government for shunning the advice of “mainstream economists” and for “refusing to even consult the IMF.” Let’s assume he’s right about the central bank and other policymakers turning away from mainstream economists and institutions like the IMF. What kind of advice has the IMF given to Sri Lanka in the past, and what kind of economic development strategies would you recommend if officials called on you to advise them?

KABOUB: Sri Lanka has been following the IMF instruction manual for decades. It has received 16 loans from the IMF since the 1960s, and it is currently negotiating another one. Since 1996, Sri Lanka has never been away from the IMF’s negotiating table for more than 3 or 4 years at a time. Despite the political rhetoric of the Sri Lankan government over the last couple of years, the current Sri Lankan administration has abided by the IMF’s terms and conditions of the $1.5 billion Extended Fund Facility (that’s the 16th loan disbursed between 2016-2020). So maybe the Sri Lankan government has come to realize that the IMF instruction manual is actually harmful. The problem is that they don’t fully understand why, and they certainly haven’t identified an alternative strategy to escape from this trap.

In terms of policy advice, Sri Lanka needs emergency assistance with immediate shipments of food, fuel, medicine, and basic necessities. Sri Lanka needs debt relief rather than debt restructuring. For example, UNDP has recently recommended negotiating debt-for-nature swaps. There are other debt swap mechanisms such as debt-for-development, debt-for-equity, and debt-buy backs. The Sri Lankan central bank should be negotiating FX swap line agreements with the central banks of its major trading partners in order to stabilize the value of its currency.

Sri Lanka should also access the IMF’s newly created $45 billion Resilience and Sustainability Trust (RTS), which, unlike other IMF facilities, is actually a program that funds strategic investments to build resilience and promote sustainability. Sri Lanka would qualify for up to $1.4 billion of concessional loans with substantial grace periods. However, to qualify for RTS funds, Sri Lanka must first have an existing agreement with the IMF. It needs to enter these negotiations with its own strategic vision in order to escape the IMF’s austerity and external debt trap.

The IMF wants countries to establish an economic policy framework that leads to external debt sustainability, but its track record has been a miserable failure. Sri Lanka needs to convince the IMF and other lenders and strategic partners, that it can only escape this external debt trap if it tackles the problem at its source — e.g. by investing strategically in food sovereignty (with an actual long-term strategy rather than half-baked organic farming wishful thinking), investing in renewable energy capacity (energy efficiency, public transportation, etc.), investing in education and vocational training in order to climb up the value chain in the manufacturing sector, and becoming more selective in its support for export industries and FDI projects. In other words, ending the race to the bottom policies, and building resilience to external shocks.

These strategic investments must be coupled with an actual democratization of the political as well as the economic system. The government needs to crack down on corruption, cartels, abusive price setters, and entities that enjoy exclusive economic power and have every incentive to object to the strategic investments listed above.

The sad part of this story is that Sri Lanka is only one of many countries in the Global South facing the same structural traps, struggling with unbearable external debt, soaring food and energy prices, shortages, and rising social and political tensions.


[1] The other has to do with a shift toward organic farming that has apparently fueled a precipitous drop in crop yields, farming incomes, and export revenues.











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How bad will it get?

Published by Anonymous (not verified) on Mon, 25/04/2022 - 8:15pm in

Woolworths went into administration on 6 January 2009 after 99 years trading. Flickr/Dominic Alves.

There’s an unpleasant calm before the storm feel to British politics at the minute. Anyone who remembers the period from the end of 2006 through to the debacle of autumn 2008, with the failure of Northern Rock as a half-way point, will be familiar with the sensation: of watching an increasing number of the proverbial warning lights start to flash.

This isn’t, however, a repeat of 2008. (In critical respects, it’s worse – a more fundamental malaise.) Back then, from around 2006 onwards, multiplying defaults in the US housing market were amplified by the complex financial products the same mortgage debts had been packaged into, and then traded between major global financial institutions. Over 2007 and right up to the 15 September 2008 bankruptcy of Lehman Bros, these highly leveraged packages of debt were exploding and bringing down larger and larger financial institutions. By autumn that year, the crisis had spread into the dead-centre of the financial system: the giant, world-spanning investment banks, headquartered in the larger developed economies on both sides of the Atlantic, which now faced bankruptcy. Lehman Bros was allowed by the US government to fail; the shockwaves from the overnight disappearance of one of the world’s largest investment banks were so great as to then mobilise panicked support from the world’s major-economy governments. Various packages were rapidly assembled and, by spring 2009, the Bank of England and the US Federal Reserve had embarked on unprecedented money-printing exercise of Quantitative Easing. (Although sometimes presented as a crisis of “Anglo-Saxon” capitalism, or some similar story about the more risk-taking and unstable US/UK version of capitalism, major European banks like Credit Suisse and Deutsche Bank, had seriously overreached themselves.)

Crucially, the mechanism of crisis here was “endogenous”- meaning it was generated primarily inside the financial system itself. It was a classic debt bubble, as described by Hyman Minsky and others, that was bursting. The years of stability over the 2000s had encouraged the taking of more and more risks by financial institutions in the belief that the bubble would never best. But, as in Minsky’s description of the mechanism for crisis, stability generated later instability: the “Minsky moment” occurred when just a few of those debts could not be repaid – in this case, it was the US “subprime” mortgages that defaulted first – and this wobble was amplified by the huge amounts of debt that the earlier period of stability had built up. That financial crisis was then pushed into the wider economy – a sharp retrenchment of lending leading to less spending which, in turn, pushed economies rapidly into recession.

IMF warnings

This time round, the mechanism is (mostly) running the other way: that succession of disruptions to the real economy might provoke a financial crisis which would act as amplifier for the disruption, but not itself operate as a trigger. In addition, the regulations and additional support for financial systems that have been put in place since 2008 have reduced the presence of “systemic risks”, or at least reduced the systemic risks of the kind that played a crucial role in 2008. The system has been subjected to one, immense shock, when covid first erupted in spring 2020, and, whilst there was a brief wobble in financial markets across the globe, nothing like 2008 recurred.

This doesn’t mean there are no financial risks, with the IMF’s latest Global Financial Stability Report highlighting rising leverage (indebtedness) in corporate and household sectors across the world, the weakly-regulated space of cryptoassets, and the unevenness of the recovery from 2020-21 between the advanced and “emerging market” economies. The latter is already producing strains. Sri Lanka, hard hit by covid, is facing shortages of “food, fuel and medicines” and is heading towards a default on its government debt. The government has approached China and the IMF for additional support, with China already offering a $1bn “swap line” of cheap credit – this arriving on top of the $3.5bn its government already owes to Chinese concerns.

One specific risk highlighted by the IMF across “emerging markets” is a version something that was already seen inside the eurozone in the aftermath of the 2008 crash: the “sovereign-bank nexus” turning rotten. With governments borrowing more, it has been banks in the global south who have loaned the money, leaving them with huge amounts of high-risk government debt on their balance sheet. Should a sovereign default, those banks themselves are at risk of failure. This could lead them to (at the very least) reign in their lending to households and businesses, provoking a recession – and then of course bringing the risk of sovereign default that much closer. Coupled with a slowdown in global trade, and the tightening of monetary policy in the advanced economies, particularly the US, which squeezes export markets for the less-developed world, and makes lending into the less developed less attractive, and the stage is set for an economic slowdown followed, in some cases, by default.

This is a relatively familiar story – one that fits easily into our existing ways of understanding economic crises. Either (as in 2008) a financial crisis causes a shock to demand, provoking recession, or a shock to demand provokes a financial crisis, worsening recession. In both cases the mechanism operates on the demand side. (This, incidentally, is what made austerity such a perverse response to the crash: a crisis driven by a collapse in spending was to be countered by… further cuts in spending.)

Supply-side crisis

Instead, the coming recession is emerging primarily as a result of supply-side factors. The rise in inflation, at least for the large, advanced economies in the OECD, is appearing because of rising import prices of essentials like oil, gas and food. It is not the product of “excess” domestic demand – retail sales are falling in the UK, but the prices paid by consumers are continuing to rise. And then there is the impact of concentration in different industries, enabling mark-ups on goods to stay high, and the hoarding of wealth, particularly of housing wealth: whilst consumers have seen their real incomes squeezed hard by rising prices, many large corporations have enjoyed a bumper few years. House prices, meanwhile, continue their upward march, assisted by the production of vast quantities of new, Quantitative Easing money since early 2020.

In all these cases, the causality runs from supply-side disruptions, led by covid-19, now joined by Russia’s invasion of Ukraine and, increasingly, by extreme weather across the world, that then feed into a grossly unequal distribution of ownership and finally turn into a squeeze on most people’s purchasing power as prices rise faster than their incomes. Throw in, on top of that, rising debt – in part as a result of attempting to maintain purchasing power, but itself turning quickly, via rising repayments, into a squeeze on spending – and the stage is set for a significant downturn in the UK and other advanced economies over the next 12 months.

This may not, as in the textbook demand-side recession, produce huge increases in unemployment, at least in the UK, where the “flexible” labour market has enabled the explosion of bogus self-employment, zero hours contracts, and other more insecure forms of work since 2008. We might well anticipate that if real wages are falling (since prices are rising faster than wages), the incentive for employers will be to maintain existing employment, or at least moderate their attempts to reduce costs by making redundancies. But seeing millions of people maintained in increasingly precarious employment, forced to cut back on their own spending as prices continue to rise, would hardly be a good thing.

The short-run solutions depend on two things, neither of which this government seem willing to achieve: rapid increases in wages and salaries, over and above the rate of inflation, and restrictions on price rises in key goods. Rapid increases in public sector pay, and the National Living Wage, both of which the government can control, would induce pay rises across the rest of the economy. Capping energy price rises in October – which, again, the government can determine – would significantly ease pressure on households. Down the line, a restructuring or simple write-off of unpayable household debt may well prove necessary, freeing up additional consumer spending. A short-run programme of rapid redistribution, from capital to labour and from creditors to debtors, would help get over the immediate hump. In the longer term, a more fundamental shift is needed – away from increasingly expensive non-renewable sources of energy and into cheap, domestically-generated renewables, matched to a programme of efficiency improvements such as providing proper loft insulation.  

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