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There is no magic wand

Summary:
A recent essay by Yanis Varoufakis illustrates a frequent problem with media discussion of central bank policies: Central bankers once had a single policy lever: interest rates. Actually, the policy lever was open market operations; interest rates were one of the variables affected by those operations.  A tight money policy might raise interest rates if the liquidity effect dominated or it might reduce interest rates if the Fisher effect dominated.  Changing interest rates was not a monetary policy; it was the effect of a policy.  (To be clear, changing the interest rate on bank reserves (IOR) is a monetary policy; Varoufakis is discussing the previous (pre-IOR) policy regime.) Varoufakis says he favors a monetary policy of higher interest rates, but doesn’t tell

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A recent essay by Yanis Varoufakis illustrates a frequent problem with media discussion of central bank policies:

Central bankers once had a single policy lever: interest rates.

Actually, the policy lever was open market operations; interest rates were one of the variables affected by those operations.  A tight money policy might raise interest rates if the liquidity effect dominated or it might reduce interest rates if the Fisher effect dominated.  Changing interest rates was not a monetary policy; it was the effect of a policy.  (To be clear, changing the interest rate on bank reserves (IOR) is a monetary policy; Varoufakis is discussing the previous (pre-IOR) policy regime.)

Varoufakis says he favors a monetary policy of higher interest rates, but doesn’t tell us whether that is to be achieved via the liquidity effect or the Fisher effect.  One would hope that the rest of the article provided enough context to figure out his actual preference.  Unfortunately, the subsequent explanation was somewhat confusing:

Of course, central banks fear that hiking interest rates will render governments bankrupt and cause a serious recession. That’s why the increase in interest rates should be supported by two crucial policy moves.

First, because a serious restructuring of both public and private debt is unavoidable, central banks should stop trying to avoid it. Keeping interest rates below zero to extend into the future the bankruptcy of insolvent entities (like the Greek and Italian states and a large number of zombie firms), as the European Central Bank and the Fed are currently doing, is a fool’s wager. Instead, let us restructure unpayable debts and increase interest rates to prevent the creation of more unpayable debts.

Here Varoufakis is clearly focused on the long run path of interest rates.  He’s not calling for a brief spike in rates that would be followed by a deep recession and a subsequent fall in rates (such as what the ECB did in 2011), rather he advocates a new regime with persistently higher interest rates.  That can only be achieved with an expansionary monetary policy, a higher inflation rate.

Second, instead of ending QE, the money it produces should be diverted away from commercial banks and their corporate clients (which have spent most of the money on share buybacks). This money should fund a basic income and the green transition (via public investment banks like the World Bank and the European Investment Bank). And this form of QE will not prove inflationary if the basic income of the upper middle class and above is taxed more heavily, and if green investment begins to produce the green energy and goods that humanity needs.

This is confusing.  If higher interest rates are to be delivered via an expansionary monetary policy, then how is that not inflationary?  Is he claiming that an expansionary monetary policy will permanently raise real interest rates?  If so, how?

QE creates base money, which is currency plus bank reserves.  As a practical matter, bank reserves earn interest under most QE programs, at least when market interest rates are positive.  If the central bank did QE in a positive rate environment without paying IOR then you’d end up with hyperinflation, as we’ve seen in some developing countries with fiscal problems.  Because of the payment of IOR, there is no revenue bonus from QE to use to finance government spending.  Interest bearing reserves are swapped for interest bearing Treasury debt.

Yes, the creation of currency produces a modest annual flow of revenue for the Treasury (called seignorage), but that’s true whether or not they also do QE.  To actually bring in the sort of money you’d need to finance major spending programs you’d need the sort of extreme money creation that leads to hyperinflation.  That’s not going to happen and Varoufakis clearly indicates he does not favor high inflation.

Once hyperinflation is off the table, a few basic points become clear:

1. The Fed can only control nominal interest rates in the long run; real rates are determined by the market.  There is no magic wand by which the Fed controls interest rates.  It can permanently raise nominal interest rates, but only by creating inflation.

2.  Money creation (including QE) does not provide a large enough revenue source to fund major government programs.  Any basic income program or spending on major green initiatives will be funded by fiscal authorities, not a central bank.

3.  Existing QE programs (at least in the US) did not fund things like stock buybacks.

Last time I looked, the Fed earned about $80 billion/year in profits, which is turned over to the Treasury.  There would be an immediately outcry if the Fed suddenly announced it was going to spend that $80 billion on UBI or carbon abatement.  Those decisions are and should be made by elected officials.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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