A big week for money

Breakthroughs worldwide.

Last week might go down as one of the most important ever for monetary policy. No paradigms have shifted, and no great new knowledge has presented itself to the world, but elites across the globe have shown an unexpected ability to actually listen.

On Wednesday, the US Federal Reserve announced that it was adopt what is being called the "Evans Rule", after the Chicago Fed President who proposed it. The American central bank has always had a dual mandate – it is charged with looking after inflation and unemployment, in contrast to the Bank of England's "price stability" mandate – but this new rule makes that mandate far more explicit.

The reserve's open market committee describes the rule:

The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

In other words, the interest rate is guaranteed to stay at its historic low of 0-0.25 per cent until unemployment is below 6.5 per cent or inflation is above 2.5 per cent. It replaces an earlier guarantee that rates would be kept low until 2015, although the reserve maintains that it expects the guidance to be roughly similar in practice (that is, they think it likely that one of those targets will be hit in that year).

The plan behind this sort of guidance is based on the fact that growth – the very thing which the Fed ought to be trying to encourage – frequently leads to inflation. For example, as the economy recovers, young unemployed people are going to be getting jobs and moving out of their parent's homes, some into new houses, putting pressure on the market. At the same time, they may start driving into work, increasing demand for fuel. That will, all else being equal, increase prices for those goods, and so increase inflation; but in this sort of situation, that's definitely a price worth paying.

Without the Evans rule, or something similar to it, businesses would expect that growth-led spike in inflation to be followed by a tightening of monetary policy. As a result, they may be unwilling or unable to borrow at the low rates we have now, for fear that they will rise shortly after – creating a vicious cycle. Fear of tightening policy prevents the growth which would lead to that policy getting tightened.

Under the new rules, Americans can be assured that, unless inflation exceeds its target by quite some margin, the Fed will continue its pro-growth policy even while growth is actually happening.

A similar change was suggested by future Bank of England governor Mark Carney in a speech on Tuesday night. Talking about the role guidance plays in central bank governance, Carney had good things to say about nominal GDP (NGDP) targeting. This involves the bank targeting, not a flat level of inflation, but a level of nominal GDP. The effect is that in periods of low real growth, the bank is prepared to tolerate much higher inflation than it is in periods of high growth – leading to similar outcomes to those described above.

In addition, since an NGDP level, rather than growth rate, is targeted, even higher inflation is tolerated in periods following a recession, as Carney explains (via FT Alphaville):

adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP (chart 4)

Carney's speech was far less concrete than the Fed's actual adoption of unconventional policy guidance – and he also faces higher hurdles bringing such a change in. The Bank of England is statutorily required to target "price stability"; most commentators expect NGDP-targeting to therefore require at least a bill through parliament, although a minority argue that it could be an acceptable interpretation on Carney's part of that stability mandate.

And finally, just yesterday, Shinzo Abe won the Japanese election on a platform of forcing the Bank of Japan to do more monetary easing. He said before the election that his number one priority was to defeat deflation, with the *FT* reporting that:

He dismissed as “meaningless” recent moves by the BoJ, saying an October ¥11tn increase in the central bank’s asset purchasing programme was too limited to change market sentiment and that the central bank and government should agree on an inflation target of perhaps 2 or 3 per cent.

“The time has come for a general mobilisation of all policy measures to get rid of deflation,” said Mr Abe, a former prime minister who resigned in 2007 after a setback-strewn year in office.

The BoJ should embrace “unlimited easing” and also consider cutting the 0.1 per cent overnight interest paid on banks’ deposits at the BoJ to zero or a negative rate, in order to “strengthen pressure to lend”, he said in a speech in Tokyo.

Questions have been raised as to whether this is a genuine opinion of Mr Abe's about monetary policy, or merely an attempt to secure seignorage-driven income to fund higher government spending; but either way, the markets appear to trust the outcome, with the Yen plummeting and Nikkei surging

Alex Hern is a technology reporter for the Guardian. He was formerly staff writer at the New Statesman. You should follow Alex on Twitter.

Show Hide image

We're racing towards another private debt crisis - so why did no one see it coming?

The Office for Budget Responsibility failed to foresee the rise in household debt. 

This is a call for a public inquiry on the current situation regarding private debt.

For almost a decade now, since 2007, we have been living a lie. And that lie is preparing to wreak havoc on our economy. If we do not create some kind of impartial forum to discuss what is actually happening, the results might well prove disastrous. 

The lie I am referring to is the idea that the financial crisis of 2008, and subsequent “Great Recession,” were caused by profligate government spending and subsequent public debt. The exact opposite is in fact the case. The crash happened because of dangerously high levels of private debt (a mortgage crisis specifically). And - this is the part we are not supposed to talk about—there is an inverse relation between public and private debt levels.

If the public sector reduces its debt, overall private sector debt goes up. That's what happened in the years leading up to 2008. Now austerity is making it happening again. And if we don't do something about it, the results will, inevitably, be another catastrophe.

The winners and losers of debt

These graphs show the relationship between public and private debt. They are both forecasts from the Office for Budget Responsibility, produced in 2015 and 2017. 

This is what the OBR was projecting what would happen around now back in 2015:

This year the OBR completely changed its forecast. This is how it now projects things are likely to turn out:

First, notice how both diagrams are symmetrical. What happens on top (that part of the economy that is in surplus) precisely mirrors what happens in the bottom (that part of the economy that is in deficit). This is called an “accounting identity.”

As in any ledger sheet, credits and debits have to match. The easiest way to understand this is to imagine there are just two actors, government, and the private sector. If the government borrows £100, and spends it, then the government has a debt of £100. But by spending, it has injected £100 more pounds into the private economy. In other words, -£100 for the government, +£100 for everyone else in the diagram. 

Similarly, if the government taxes someone for £100 , then the government is £100 richer but there’s £100 subtracted from the private economy (+£100 for government, -£100 for everybody else on the diagram).

So what implications does this kind of bookkeeping have for the overall economy? It means that if the government goes into surplus, then everyone else has to go into debt.

We tend to think of money as if it is a bunch of poker chips already lying around, but that’s not how it really works. Money has to be created. And money is created when banks make loans. Either the government borrows money and injects it into the economy, or private citizens borrow money from banks. Those banks don’t take the money from people’s savings or anywhere else, they just make it up. Anyone can write an IOU. But only banks are allowed to issue IOUs that the government will accept in payment for taxes. (In other words, there actually is a magic money tree. But only banks are allowed to use it.)

There are other factors. The UK has a huge trade deficit (blue), and that means the government (yellow) also has to run a deficit (print money, or more accurately, get banks to do it) to inject into the economy to pay for all those Chinese trainers, American iPads, and German cars. The total amount of money can also fluctuate. But the real point here is, the less the government is in debt, the more everyone else must be. Austerity measures will necessarily lead to rising levels of private debt. And this is exactly what has happened.

Now, if this seems to have very little to do with the way politicians talk about such matters, there's a simple reason: most politicians don’t actually know any of this. A recent survey showed 90 per cent of MPs don't even understand where money comes from (they think it's issued by the Royal Mint). In reality, debt is money. If no one owed anyone anything at all there would be no money and the economy would grind to a halt.

But of course debt has to be owed to someone. These charts show who owes what to whom.

The crisis in private debt

Bearing all this in mind, let's look at those diagrams again - keeping our eye particularly on the dark blue that represents household debt. In the first, 2015 version, the OBR duly noted that there was a substantial build-up of household debt in the years leading up to the crash of 2008. This is significant because it was the first time in British history that total household debts were higher than total household savings, and therefore the household sector itself was in deficit territory. (Corporations, at the same time, were raking in enormous profits.) But it also predicted this wouldn't happen again.

True, the OBR observed, austerity and the reduction of government deficits meant private debt levels would have to go up. However, the OBR economists insisted this wouldn't be a problem because the burden would fall not on households but on corporations. Business-friendly Tory policies would, they insisted, inspire a boom in corporate expansion, which would mean frenzied corporate borrowing (that huge red bulge below the line in the first diagram, which was supposed to eventually replace government deficits entirely). Ordinary households would have little or nothing to worry about.

This was total fantasy. No such frenzied boom took place.

In the second diagram, two years later, the OBR is forced to acknowledge this. Corporations are just raking in the profits and sitting on them. The household sector, on the other hand, is a rolling catastrophe. Austerity has meant falling wages, less government spending on social services (or anything else), and higher de facto taxes. This puts the squeeze on household budgets and people are forced to borrow. As a result, not only are households in overall deficit for the second time in British history, the situation is actually worse than it was in the years leading up to 2008.

And remember: it was a mortgage crisis that set off the 2008 crash, which almost destroyed the world economy and plunged millions into penury. Not a crisis in public debt. A crisis in private debt.

An inquiry

In 2015, around the time the original OBR predictions came out, I wrote an essay in the Guardian predicting that austerity and budget-balancing would create a disastrous crisis in private debt. Now it's so clearly, unmistakably, happening that even the OBR cannot deny it.

I believe the time has come for there be a public investigation - a formal public inquiry, in fact - into how this could be allowed to happen. After the 2008 crash, at least the economists in Treasury and the Bank of England could plausibly claim they hadn't completely understood the relation between private debt and financial instability. Now they simply have no excuse.

What on earth is an institution called the “Office for Budget Responsibility” credulously imagining corporate borrowing binges in order to suggest the government will balance the budget to no ill effects? How responsible is that? Even the second chart is extremely odd. Up to 2017, the top and bottom of the diagram are exact mirrors of one another, as they ought to be. However, in the projected future after 2017, the section below the line is much smaller than the section above, apparently seriously understating the amount both of future government, and future private, debt. In other words, the numbers don't add up.

The OBR told the New Statesman ​that it was not aware of any errors in its 2015 forecast for corporate sector net lending, and that the forecast was based on the available data. It said the forecast for business investment has been revised down because of the uncertainty created by Brexit. 

Still, if the “Office of Budget Responsibility” was true to its name, it should be sounding off the alarm bells right about now. So far all we've got is one mention of private debt and a mild warning about the rise of personal debt from the Bank of England, which did not however connect the problem to austerity, and one fairly strong statement from a maverick columnist in the Daily Mail. Otherwise, silence. 

The only plausible explanation is that institutions like the Treasury, OBR, and to a degree as well the Bank of England can't, by definition, warn against the dangers of austerity, however alarming the situation, because they have been set up the way they have in order to justify austerity. It's important to emphasise that most professional economists have never supported Conservative policies in this regard. The policy was adopted because it was convenient to politicians; institutions were set up in order to support it; economists were hired in order to come up with arguments for austerity, rather than to judge whether it would be a good idea. At present, this situation has led us to the brink of disaster.

The last time there was a financial crash, the Queen famously asked: why was no one able to foresee this? We now have the tools. Perhaps the most important task for a public inquiry will be to finally ask: what is the real purpose of the institutions that are supposed to foresee such matters, to what degree have they been politicised, and what would it take to turn them back into institutions that can at least inform us if we're staring into the lights of an oncoming train?