Thursday, October 22, 2015

A Bridge Too Far?

There is much current angst on the difficult problem of how to escape a liquidity trap. Paul Krugman points out that in Japan, the ratio of debt to GDP is growing, leaving little room for a further tame fiscal expansion. He favors something more aggressive.

Tony Yates argues instead for a helicopter drop. Print money and give it to Japanese citizens. The benefit of that approach is that it does not leave the government with an increase in interest bearing debt. 
Simon Wren Lewis looks more closely at the technical aspects of this idea.

What are the differences between aggressive fiscal expansion financed by debt creation; and printing money and giving it to citizens? There are two.

First, an aggressive fiscal expansion, as envisaged by Keynesians, would be spent on infrastructure. A money financed transfer would be spent by citizens.

Second, an aggressive fiscal expansion, as envisaged by Keynesians, would be financed by issuing long term bonds. A money financed transfer would be financed by printing money.

While infrastructure expenditure is sorely needed, at least in the U.S., I see no reason to give up on sound cost benefit analysis to decide which projects are worth pursuing and which are not. That’s why I favor giving checks to citizens over building a bridge to nowhere.

Once we decide how the fiscal expansion is to be distributed, we face the second question: how should it be financed? Print money? Or issue long term debt. Standard Economic models tells us that it doesn’t matter. At the zero lower bound, money and three month T-bills are perfect substitutes. And financing expenditure by three month T-bills has the same effect as financing it by thirty-year bonds because the composition of the government’s liabilities is supposed to be irrelevant. That of course, is nonsense. The composition of government liabilities matters. And it matters a lot.

Why does the composition of debt matter? Because the asset markets are incomplete. Our children and our grandchildren cannot participate in asset markets that open before they are born. And none of us can sell our human capital or buy the human capital of others. Once you realize that the composition of the governments portfolio matters, it is a short step to recognize that it is all that matters.

Why be wary of building bridges that are financed with 30 year bonds? Because the yield on these bonds is low; but it is not yet zero. A big increase in public sector borrowing, at the long end of the yield curve, will drive up rates and crowd out some private investment. A big increase in public sector borrowing at the short end of the yield curve will not crowd out private sector investment because rates at the short end of the yield curve are currently zero.

That observation suggests a third alternative to building bridges or to a helicopter drop. Buy back long term government debt and refinance it by printing money. That strategy would, one hopes, lower yields at the long end of the yield curve and stimulate private companies to invest in new capital projects.

I prefer private sector investment over government sector investment. But there are also good arguments for more public infrastructure projects. Build a bridge if it is needed; but make sure that it goes somewhere first. More importantly; finance the project by printing money: not by issuing thirty year bonds.


  1. "More importantly; finance the project by printing money: not by issuing thirty year bonds."

    Are you suggesting the central bank print money and give it to the government instead of purchasing bonds?

    1. No. I am suggesting that IF the government chooses, either to spend money by increasing transfer payments to individuals or IF it decides to build new infrastructure that, in the current low interest rate environment, it should pay for an expenditure of that kind by printing money, not by borrowing.

    2. By government are you referring to the central bank and treasury combined or just the treasury?

  2. Lately, it strikes me that a lot of macroeconomic policy discourse has descended into unfocused proposals of solutions in search of problems, and is totally detached from any coherent discussion of broader social policy questions.

    Exactly what concrete human problems in Japan are these solutions intended to solve? This is a serious question.

    What kind of future do the Japanese want to build for themselves? And how do these considerations about inflation rates and whatnot play into the answer to that question? Is the rate of per capita income growth too low? In what ways? What kinds of income do Japanese need more of, and what kinds of income do they have enough of, or too much of? Are they falling short in the public sector creation of public goods? Or the private sector creation of consumer goods?. Are their retirements secure? Are their lives too harried? And if so will changing the rate of inflation fix that? Are they lonely? Bored? Confused about the future? Is the overall rate of employment too high or too low? Or do they have enough employment, but a poor distribution of that employment?

    1. Dan
      Thank you for that insightful comment.

      For the past thirty years, western economies have fought recessions by lowering the money interest rate. When the interest rate is permanently at zero, that policy is no longer viable. The concern is not with the current state of the Japanese economy, although its performance could be stronger, it is with how policy will react when the next recession hits.

      My own take on this issue is that recessions are caused by inefficient allocation of assets by financial markets and that the policies followed by central banks in the past can be improved upon. That improvement should take the form of active intervention in asset markets to prevent inefficient swings in asset prices that are sometimes transmitted into large inefficient increases in involuntary unemployment and the social misery that accompanies it. A side effect of a policy of the kind I advocate is that it would allow the central bank to increase the interest rate without triggering a recession and allow the Bank to use variations in the interest rate in the future to maintain price stability.

    2. You didn't really answer his question.

      Let's presume the Japanese are by and large healthy people, who are living a decent middle class life with the modern conveniences, who have access to decent health care, who have a decent educational system, who have reasonable access to clean food and water etc.

      Why do they need to change anything?

    3. Because the ability to maintain that standard of living is conditional on the ability to react the next financial crisis. Which WILL occur. It's simply a question of when.

    4. What a bunch of nonsensical babble which is what you usually get from Kervick.

      Policymakers should want a prosperous future. That's what elected politicians are always promising.

      It's seems like all of your comment are really bad.

  3. If by "printing money and giving it to citizens" you mean aggressive, *permanent* QE (i.e. print money and retire bonds), then yes. Not: Temporary QE (where the central bank buys bonds and promises to sell them later resulting in only a temporary increase in the money supply).

    This is an important distinction in my opinion. Fiscal expansion financed by debt implies future tax hikes, probably on income (i.e. work) or sales. Expected higher future income or sales taxes reduces future consumption and dampens the impact. Depending on where the taxes fall, it may dis-incentivize all the wrong economic activity.

    Money-financed debt elimination on the other hand implies tax cuts on income or sales, replaced with a uniform tax on current savings (=an unexpected boost in inflation). The inflation tax is permanent to the extent the central bank promises to keep monetizing debt as needed to hit the higher target. And: Taxing current savings is exactly what is needed to boost current consumption.

    Big difference. So far, QE has been temporary, in the sense that the central bank promises to sell back the bonds later, introducing uncertainty as to whether they are serious about a higher inflation target. Fiscal expansion is likely to be temporary, followed by tax hikes. Why would I build a factory now for only a temporary boost in consumption?

    On the other hand, a *permanent* addition to the money stock says the central bank is serious. And, insofar as tax incidence (income or sales tax vs. inflation tax), seems to me the incentives are better aligned with central bank goals.

  4. In normal times, (when the interest rate is positive) the quantity of base money is endogenous and the ability to control inflation is contingent on the central bank having room to move the interest rate either up, or down, in respomse to nascent inflation. That policy, inflation targeting, was highly effective in the US in the period, after 1983, when the Fed resumed interest rate control of the money supply. The sooner we are able to raise rates, and resume inflation targeting, the better.

    That however, is not enough. It is also important to maintain stability of real economic activity. In my view, THE main cause of business cycles is the animal spirits of participants in the financial markets. The financial cycle IS the business cycle. We need two instruments: interest rate movements to control inflation. And active asset market intervention to stabilize financial cycles.

  5. Hi Roger,

    Provocative post! A few additional points:

    1. Regardless of how infrastructure projects are financed, all of "the money" is spent, not so for money transfers to citizens some of which is saved;

    2. If your aim is to increase spending, then shouldn't the money transfers be focused on liquidity constrained low-income households?

    3. In doing cost-benefit analyses of public investment projects, are you willing to include the pecuniary externalities arising from the multiplier? E.g., if some underemployed workers are hired to build public projects, and these workers spend their wages on private goods at prices that exceed marginal costs, would you include these external benefits in your C-BA?

    4. I don't quite understand your antipathy toward public investment projects. Granted, there are a few "bridges to nowhere," but the majority of studies of the Obama stimulus package are rather positive. See


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