Fiscal and monetary policy in a liquidity trap – Part 1- By Martin Wolf

Mosler:  Apr 19, 2012

With floating fx, it’s always a ‘liquidity trap’, in that adding liquidity to a system necessarily not liquidity constrained is moot.

Comment:

What is the correct approach to fiscal and monetary policy when an economy is depressed and the central bank’s rate of interest is close to zero? Does the independence of the central bank make it more difficult to reach the right decisions? These are two enormously important questions raised by current circumstances in the US, the eurozone, Japan and the UK.

Mosler: Apr 19, 2012

With floating fx, it’s always about a fiscal adjustment, directly or indirectly

Comment:

Broadly speaking, I can identify three macroeconomic viewpoints on these questions: 1. The first is the pre-1930 belief in balanced budgets and the gold standard (or some other form of a-political money).

Mosler: Apr 19, 2012

Yes, actual fixed fx policy, where the monetary system is continuously liquidity constrained by design.

Comment:

2. The second is the religion of balanced budgets and managed money, with Milton Friedman’s monetarism at the rules-governed end of the spectrum and independent inflation-targeting central banks at the discretionary end.

Mosler: Apr 19, 2012

Yes, the application of fixed fx logic to a floating fx regime.

Comment:

3. The third demands a return to Keynesian ways of thinking, with “modern monetary theory” (in which monetary policy and central banks are permanently subservient to fiscal policy) at one end of the policy spectrum, and temporary resort to active fiscal policy at the other.

Mosler: Apr 19, 2012

MMT recognizes the difference in monetary dynamics between fixed and floating fx regimes.

Comment:

In this note, I do not intend to address the first view, though I recognise that it has substantial influence, particularly in the Republican Party. I also do not intend to address Friedman’s monetarism, which has lost purchase on contemporary policy-makers, largely because of the views that the demand for money is unstable and the nature of money ill-defined. Finally, I intend to ignore “modern monetary theory” which would require a lengthy analysis of its own.

This leaves us with the respectable contemporary view that the best way to respond to contemporary conditions is via fiscal consolidation and aggressive monetary policy, and the somewhat less respectable view that aggressive fiscal policy is essential when official interest rates are close to zero.

Two new papers bring light from the second of these perspectives. One is co-authored by Paul McCulley, former managing director of Pimco and inventor of the terms “Minsky moment” and “shadow banking”, and Zoltan Pozsar, formerly at the Federal Reserve Bank of New York and now a visiting scholar at the International Monetary Fund.* The other is co-authored by J. Bradford DeLong of the university of California at Berkeley, and Lawrence Summers, former US treasury secretary and currently at Harvard university. **

Mosler: Apr 19, 2012

Unfortunately, and fully understood, is the imperative for you to select from ‘celebrity’ writers regardless of the quality of the content.

Comment:

The paper co-authored by Mr McCulley and Mr Pozsar puts the case for aggressive fiscal policy. The US, they argue, is in a “liquidity trap”: even with official interest rates near zero, the incentive for extra borrowing, lending and spending in the private sector is inadequate.

Mosler: Apr 19, 2012

An output gap is the evidence that total spending- public plus private- is inadequate. And yes, that can be remedied by an increase in private sector borrowing to spend, and/or a fiscal adjustment by the public sector towards a larger deficit via either an increase in spending and/or tax cut, depending on one’s politics.

Comment:

The explanation for this exceptional state of affairs is that during the credit boom and asset-price bubble that preceded the crisis, large swathes of the private sector became over-indebted. Once asset prices fell, erstwhile borrowers were forced to reduce their debts. Financial institutions were also unwilling to lend. They needed to strengthen their balance sheets. But they also confronted a shortage of willing and creditworthy borrowers.

Mosler: Apr 19, 2012

Yes, for any reason if private sector spending falls short of full employment levels, a fiscal adjustment can do the trick.

This raises an interesting question:

Is it ‘better’, for example, to facilitate the increase in spending through a private sector credit expansion, or through a tax cut that allows private sector spending to increase via increased income, or through a government spending increase?

The answer is entirely political. The output gap can be closed with any/some/all of those options.

Comment:

In such circumstances, negative real interest rates are necessary, but contractionary economic conditions rule that out.

Mosler: Apr 19, 2012

I see negative nominal rates as a tax that will reduce income and net financial assets of the non govt sectors, even as it may increase some private sector credit expansion. And the reduction of income and net financial assets works to reduce the credit worthiness of the non govt sectors reducing their ability to borrow to spend.

Comment:

Instead, there is a danger of what the great American economist, Irving Fisher called “debt deflation”: falling prices raise the real burden of debt, making the economic contraction worse.

Mosler: Apr 19, 2012

Yes, though he wrote in the context of fixed fx policy, where that tends to happen as well, though under somewhat different circumstances and different sets of forces.

Comment:

A less extreme (and so more general) version of the idea is “balance-sheet recession”, coined by Richard Koo of Nomura. That is what Japan had to manage in the 1990s.

Mosler: Apr 19, 2012

With floating fx they are all balance sheet recessions. There is no other type of recession.

Comment:

This is how the McCulley-Pozsar paper makes the point: “deleveraging is a beast of burden that capitalism cannot bear alone. At the macroeconomic level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction . . . by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.

Mosler: Apr 19, 2012

Correct, in the context of today’s floating fx. With fixed fx that option carries the risk of rising rates for the govt and default/devaluation.

Comment:

“Fiscal austerity does not work in a liquidity trap and makes as much sense as putting an anorexic on a diet. Yet ‘diets’ are the very prescriptions that fiscal ‘austerians’ have imposed (or plan to impose) in the US, UK and eurozone. Austerians fail to realise, however, that everyone cannot save at the same time and that, in liquidity traps, the paradox of thrift and depression are fellow travellers that are functionally intertwined.”.

Mosler: Apr 19, 2012

Agreed for floating fx. Fixed fx is another story, where forced deflation via austerity does make the maths work, though most often at an impossible social cost.

Comment:

Confronted by this line of argument, austerians (a term coined by Rob Parenteau, a research associate at the Levy Economics Institute of Bard College), make three arguments.

1. additional borrowing will add heavily to future debt and so be an unreasonable burden on future generations.

2. increased borrowing will crowd out private borrowing.

3. bond investors will stop buying and push yields up.

Mosler: Apr 19, 2012

Which does happen with fixed fx policy.

Comment:

In a liquidity trap, none of these arguments hold.

Mosler: Apr 19, 2012

With floating fx, none of these hold in any scenario.

Comment:

Experience over the last four years (not to mention Japan’s experience over the past 20 years) has demonstrated that governments operating with a (floating) currency do not suffer a constraint on their borrowing. The reason is that the private sector does not wish to borrow, but wants to cut its debt, instead. There is no crowding out.

Mosler: Apr 19, 2012

Right, because floating fx regimes are by design not liquidity constrained.

Comment:

Moreover, adjustment falls on the currency, not on the long-term rate of interest.

Mosler: Apr 19, 2012

Right, and again, unlike fixed fx.

Comment:

In the case of the US, foreigners also want to lend, partly in support of their mercantilist economic policies.

Mosler: Apr 19, 2012

Actually, they want to accumulate dollar denominated financial assets, which we call lending.

Note that both reserve balances at the Fed and securities account balances at the Fed (treasury securities) are simply dollar deposits at the Fed.

Comment:

Alas, argue Mr McCulley and Mr Pozsar, “held back by concerns borne out of these orthodoxies, . . . governments are not spending with passionate purpose. They are victims of intellectual paralysis borne out of inertia of dogma . . . As a result, their acting responsibly, relative to orthodoxy, and going forth with austerity may drag economies down the vortex of deflation and depression.”

Mosler: Apr 19, 2012

Right. Orthodoxy happens to be acting as if one was operating under a fixed fx regime even though it’s in fact a floating fx regime.

Comment:

Finally, they note, “the importance of fiscal expansion and the impotence of conventional monetary policy measures in a liquidity trap have profound implications for the conduct of central banks. This is because in a liquidity trap, the fat-tail risk of inflation is replaced by the fat-tail risk of deflation.”.

Mosler: Apr 19, 2012

The risk of excess aggregate demand is replaced by the risk of inadequate aggregate demand.

And the case can be made that lower rates reduce aggregate demand via the interest income channels, as the govt is a net payer of interest.

Comment:

In this situation, we do not need independent central banks that offset – and so punish – fiscally irresponsible governments. We need central banks that finance – and so encourage – economically responsible (though “fiscally irresponsible”) governments.

Mosler: Apr 19, 2012

Not the way I would say it but understood.

Comment:

When private sector credit growth is constrained, monetisation of public debt is not inflationary.

Mosler: Apr 19, 2012

While I understand the point, note that ‘monetisation’ is a fixed fx term not directly applicable to floating fx in this context.

Comment:

Indeed, it would be rather good if it were inflationary, since that would mean a stronger recovery, which would demand swift reversal of the unorthodox policy mix.

The conclusion of the McCulley-Pozsar paper is, in brief, that aggressive fiscal policy does work in the unusual circumstances of a liquidity trap, particularly if combined with monetisation. But conventional wisdom blocks full use of the unorthodox tool kit. Historically, political pressure has destroyed such resistance. Political pressure drove the UK off gold in 1931. But it also brought Hitler to power in Germany in 1933. The eurozone should take note.

Remarkably, in the circumstances of a liquidity trap, enlarged fiscal deficits are likely to reduce future levels of privately held public debt rather than raise them.

Mosler: Apr 19, 2012

As if that aspect matters?

Comment:

The view that fiscal deficits might provide such a free lunch is the core argument of the paper by DeLong and Summers, to which I will turn in a second post.

Mosler: Apr 19, 2012

Free lunch entirely misses the point.

Why does the size the balances in Fed securities accounts matter as suggested, with floating fx policy?


Fiscal and monetary policy in a liquidity trap – Part II- By Martin Wolf

Mosler:  Apr 20, 2012

Output is produced by work.

Work is a cost, not a benefit.

It is in that sense that there is no free lunch.

Comment:

Might fiscal expansion be a free lunch? This is the question addressed in a thought-provoking paper “Fiscal Policy in a Depressed Economy”, March 2012, by Brad DeLong and Larry Summers, the most important conclusion of which is obvious, but largely ignored: the impact of fiscal expansion depends on the context. *.

In normal times, with resources close to being fully utilised, the multiplier will end up very close to zero; in unusual times, such as the present, it could be large enough and the economic benefits of such expansion significant enough to pay for itself.

Mosler: Apr 20, 2012

‘Paying for itself’ implies there is some real benefit to a lower deficit outcome vs a higher deficit outcome. With the govt deficit equal to the net financial assets of the non govt sectors, ‘Paying for itself’ implies there is a real benefit to the non govt sectors have fewer net financial assets.

Comment:

In a liquidity trap fiscal retrenchment is penny wise, pound foolish.

Mosler: Apr 20, 2012

I would say it’s penny foolish as well, as it directly reduces net financial assets of the non govt sectors with no economic or financial benefit to either the govt sector or the non govt sectors.

Comment:

Indeed, relying on monetary policy alone is the foolish policy: if it worked, which it probably will not, it does so largely by expanding stretched private balance sheets even further.

Mosler: Apr 20, 2012

Agreed.

Comment:

As the authors note: “This paper examines the impact of fiscal policy in the context of a protracted period of high unemployment and output short of potential like that suffered by the United States and many other countries in recent years. We argue that, while the conventional wisdom rejecting discretionary fiscal policy is appropriate in normal times, discretionary fiscal policy where there is room to pursue it has a major role.”

There are three reasons for this.

1. First, the absence of supply constraints means that the multiplier is likely to be large.

Mosler: Apr 20, 2012

Why is a large multiplier beneficial?

A smaller multiplier means the fiscal adjustment can be that much larger.

That is, the tax cuts and/or spending increases (depending on political preference) can be that much larger with smaller multipliers.

Comment:

It is likely to be made even bigger by the fact that fiscal expansion may well raise expected inflation and so lower the real rate of interest, when the nominal rate is close to zero.

Mosler: Apr 20, 2012

However the ‘real rate of interest’ is defined. Most would think CPI, which means the likes of tobacco taxes move the needle quite a bit.

And with the MMT understanding that the currency itself is in fact a simple public monopoly, and that any monopolist is necessarily ‘price setter’, the ‘real rate of interest’ concept doesn’t have a lot of relevance.

Comment:

2. Second, even moderate hysteresis effects of such fiscal expansion, via increases in the likely level of future output, have big effects on the future debt burden.

Mosler: Apr 20, 2012

Back to the errant notion of a public sector debt in its currency of issue being a ‘burden’.

Comment:

3. Finally, today’s ultra-low real interest rates at both the short and long end of the curve, suggest that monetary policy is relatively ineffective, on its own.

Mosler: Apr 20, 2012

Most central bank studies show monetary policy is always relatively ineffective:

Comment:

The argument is set out in a simple example. “Imagine a demand-constrained economy where the fiscal multiplier is 1.5, and the real interest rate on long-term government debt is 1 per cent. Finally, assume that a $1 increase in GDP increased tax revenues and reduces spending by $0.33. Assume that the government is able to undertake a transitory increase in government spending, and then service the resulting debt in perpetuity, without any impact on risk-premia.

“Then the impact effect of an incremental $1.00 of spending is to raise the debt stock by $0.50. The annual debt service needed on this $0.50 to keep the real debt constant is $0.005. If reducing the size of the current downturn in production by $1.50 avoids a 1 per cent as large fall in future potential output – avoids a fall in future potential output of $0.0015 – then the incremental $1.00 of spending now augments future tax-period revenues by $0.005. And the fiscal expansion is self-financing.”

This is a very powerful result.

Mosler: Apr 20, 2012

Yes, it tells you that the ‘automatic fiscal stabilizers’ must be minded lest the expansion reduce the govt deficit and, by identity, reduce the net financial assets of the non govt sectors to the point of aborting the economic recovery. Which, in fact, is how most expansion cycles end.

For the non govt sectors, net financial assets are the equity that supports the credit structure.

So when a recovery driven by a private sector credit expansion (which is how most are driven), causes tax liabilities to increase and transfer payments to decrease (aka automatic fiscal stabilizers)- reducing the govt deficit and by identity reducing the growth of private sector net financial assets- private sector/non govt leverage increases to the point where it’s unsustainable and it all goes bad again.

Comment:

It rests on the three features of the present situation: high multipliers; low real interest rates; and the plausibility of hysteresis effects.

A table in the paper (Table 2.2) shows that at anything close to current real interest rates fiscal expansion is certain to pay for itself even with zero multiplier and hysteresis effects: it is a “no-brainer”.

Mosler: Apr 20, 2012

And, if allowed to play out as I just described, the falling govt deficit will also abort the expansion.

Comment:

Why is this? It is because the long-term real interest rate paid by the government is below even the most pessimistic view of the future growth rate of the economy. As I have argued on previous occasions, the US (and UK) bond markets are screaming: borrow.

Mosler: Apr 20, 2012

The bond markets are screaming ‘the govt. Will never get its act together and cause the conditions for the central bank to raise rates.’

Comment:

Of course, that is not an argument for infinite borrowing, since that would certainly raise the real interest rate substantially!

Mosler: Apr 20, 2012

Infinite borrowing implies infinite govt spending.

Govt spending is a political decision involving the political choice of the ‘right amount’ of real goods and services to be moved from private to public domain.

Comment:

Yet, more surprisingly, the expansion would continue to pay for itself even if the real interest rate were to rise far above the prospective growth rate, provided there were significantly positive multiplier and hysteresis effects.

Mosler: Apr 20, 2012

I’d say it this way:

Providing increasing private sector leverage and credit expansion continues to offset declines in govt deficit spending.

Comment:

Let us take an example: suppose the multiplier were one and the hysteresis effect were 0.1 – that is to say, the permanent loss of output were to be one tenth of the loss of output today. Then the real interest rate at which the government could obtain positive effects on its finances from additional stimulus would be as high as 7.4 per cent.

Thus, state the authors, “in a depressed economy with a moderate multiplier, small hysteresis effects, and interest rates in the historical range, temporary fiscal expansion does not materially affect the overall long-run budget picture.” Investors should not worry about it. Indeed, they should worry far more about the fiscal impact of prolonged recessions.

Mosler: Apr 20, 2012

They shouldn’t worry about the fiscal impact in any case. The public sector deficit/debt is nothing more than the net financial assets of the non govt sectors. And these net financial assets necessarily sit as balances in the central bank, as either clearing balances (reserves) or as balances in securities accounts (treasury securities). And ‘debt management’ is nothing more than the shifting of balances between these accounts.

(and there are no grandchildren involved!)

(and all assuming floating exchange rate policy)

Comment:

Are such numbers implausible? The answer is: not at all.

Multipliers above one are quite plausible in a depressed economy, though not in normal circumstances. This is particularly true when real interest rates are more likely to fall, than rise, as a result of expansion.

Mosler: Apr 20, 2012

The ‘multipliers’ are nothing more than the flip side of the aggregate ‘savings desires’ of the non govt sectors. And the largest determinant of these savings desires is the degree of credit expansion/leverage.

Comment:

Similarly, we know that recessions cause long-term economic costs. They lower investment dramatically: in the US, the investment rate fell by about 4 per cent of gross domestic product in the wake of the crisis. Businesses are unwilling to invest, not because of some mystical loss of confidence, but because there is no demand.

Again, we know that high unemployment has a permanent impact on workers, both young and old. The US, in particular, seems to have slipped into European levels of separation from the labour force: that is to say, the unemployment rate is quite low, given the sharp fall in the rate of employment. Workers have given up. This is a social catastrophe in a country in which work is effectively the only form of welfare for people of working age.

Mosler: Apr 20, 2012

Not to mention the lost real output which over the last decade has to be far higher than the total combined real losses from all the wars in history.

Comment:

Indeed, we can see hysteresis effects at work in the way in which forecasters, including official forecasters, mark down potential output in line with actual output: a self-fulfilling prophecy if ever there was one. This procedure has been particularly marked in the UK, where the Office for Budget Responsibility has more or less eliminated the notion that the UK is in a recession. Yet such effects are not God-given; they are man-chosen. They are the product of fundamentally misguided policies.

This is an important paper. It challenges complacent “do-nothingism” of policymakers, let alone the “austerians” who dominate policy almost everywhere. Policy-makers have allowed a huge financial crisis to impose a permanent blight on economies, with devastating social effects. It makes one wonder why the Obama administration, in which prof Summers was an influential adviser, did not do more, or at least argue for more, as many outsiders argued.

The private sector needs to deleverage.

Mosler: Apr 20, 2012

It’s no coincidence that with a relatively constant trade deficit, private sector net savings, as measured by net financial $ assets, has increased by about the amount of the US budget deficit.

In other words, the $trillion+ federal deficits have added that much to domestic income and savings, thereby reducing private sector leverage.

However, as evidenced by the gaping output gap, for today’s credit conditions, it’s been not nearly enough.

Comment:

The government can help by holding up the economy. It should do so. People who reject free lunches are fools.


Lessons from Crises, 1985-2014 - Stanley Fischer

Comment:

It is both an honor and a pleasure to receive this years SIEPR Prize. Let me list the reasons. First, the prize, awarded for lifetime contributions to economic policy, was started by George Shultz. I got my start in serious policy work in 1984-85, as a member of the advisory group on the Israeli economy to George Shultz, then Secretary of State. I learned a great deal from that experience, particularly from Secretary Shultz and from Herb Stein, the senior member of the two-person advisory group (I was the other member). Second, it is an honor to have been selected for this prize by a selection committee consisting of George Shultz, Ken Arrow, Gary Becker, Jim Poterba and John Shoven. Third, it is an honor to receive this prize after the first two prizes, for 2010 and for 2012 respectively, were awarded to Paul Volcker and Marty Feldstein. And fourth, it is a pleasure to receive the award itself.

When John Shoven first spoke to me about the prize, he must have expected that I would speak on the economic issues of the day and I would have been delighted to oblige. However, since then I have been nominated by President Obama but not so far confirmed by the Senate for the position of Vice-Chair of the Federal Reserve Board. Accordingly I shall not speak on current events, but rather on lessons from economic crises I have seen up close during the last three decades and about which I have written in the past starting with the Israeli stabilization of 1985, continuing with the financial crises of the 1990s, during which I was the number two at the IMF, and culminating (I hope) in the Great Recession, which I observed and with which I had to deal as Governor of the Bank of Israel between 2005 and 2013.

This is scheduled to be an after-dinner speech at the end of a fine dinner and after an intensive conference that started at 8 a.m. and ran through 6 p.m. Under the circumstances I shall try to be brief. I shall start with a list of ten lessons from the last twenty years, including the crises of Mexico in 1994-95, Asia in 1997-98, Russia in 1998, Brazil in 1999-2000, Argentina in 2000-2001, and the Great Recession. I will conclude with one or two-sentence pieces of advice I have received over the years from people with whom I had the honor of working on economic policy. The last piece of advice is contained in a story from 1985, from a conversation with George Shultz.

I. Ten lessons from the last two decades.

Lesson 1: Fiscal policy also matters macroeconomically. It has always been accepted that fiscal policy, in the sense of the structure of the tax system and the composition of government spending, matters for the behavior of the economy. At times in the past there has been less agreement about whether the macroeconomic aspects of fiscal policy, frequently summarized by the full employment budget deficit, have a significant impact on the level of GDP. As a result of the experience of the last two decades, it is once again accepted that cutting government spending and raising taxes in a recession to reduce the budget deficit is generally recessionary. This was clear from experience in Asia in the 1990s.[3] The same conclusion has been reached following the Great Recession.

Mosler: Mar 18, 2014

Who would have thought?….

Comment:

At the same time, it needs to be emphasized that there are circumstances in which a fiscal contraction can be expansionary particularly for a country running an unsustainable budget deficit.

Mosler: Mar 18, 2014

Unsustainable?

He doesn’t distinguish between floating and fixed fx policy. At best this applies to fixed fx policy, where fx reserves would be exhausted supporting the peg/conversion. And as a point of logic, with floating fx this can only mean an unsustainable inflation, whatever that means.

Comment:

More important, small budget deficits and smaller rather than larger national debts are preferable in normal times in part to ensure that it will be possible to run an expansionary fiscal policy should that be needed in a recession.

Mosler: Mar 18, 2014

Again, this applies only to fixed fx regimes where a nation might need fx reserves to support conversion at the peg. With floating fx nominal spending is in no case revenue constrained.

Comment:

Lesson 2: Reaching the zero interest lower bound is not the end of expansionary monetary policy. The macroeconomics I learned a long time ago, and even the macroeconomics taught in the textbooks of the 1980s and early 1990s, proclaimed that more expansionary monetary policy becomes either impossible or ineffective when the central bank interest rate reaches zero, and the economy finds itself in a liquidity trap. In that situation, it was said, fiscal policy is the only available expansionary tool of macroeconomic policy.

Now the textbooks should say that even with a zero central bank interest rate, there are at least two other available monetary policy tools. The first consists of quantitative easing operations up and down the yield curve, in particular central bank market purchases of longer term assets, with the intention of reducing the longer term interest rates that are more relevant than the shortest term interest rate to investment decisions.

Mosler: Mar 18, 2014

Both are about altering the term structure of rates. How about the lesson that the data seems to indicate the interest income channels matter to the point where the effect is the reverse of what the mainstream believes?

That is, with the govt a net payer of interest, lower rates lower the deficit, reducing income and net financial assets credited to the economy. For example, QE resulted in some $90 billion of annual Fed profits returned to the tsy that otherwise would have been credited to the economy. That, with a positive yield curve, QE functions first as a tax.

Comment:

The second consists of central bank interventions in particular markets whose operation has become significantly impaired by the crisis. Here one thinks for instance of the Feds intervening in the commercial paper market early in the crisis, through its Commercial Paper Funding Facility, to restore the functioning of that market, an important source of finance to the business sector. In these operations, the central bank operates as market maker of last resort when the operation of a particular market is severely impaired.

Mosler: Mar 18, 2014

The most questionable and subsequently overlooked ‘bailout’- the Fed buying, for example, GE commercial paper when it couldn’t fund itself otherwise, with no ‘terms and conditions’ as were applied to select liquidity provisioning to member banks, AIG, etc. And perhaps worse, it was the failure of the Fed to provide liquidity (not equity, which is another story/lesson) to its banking system on a timely basis (it took months to get it right) that was the immediate cause of the related liquidity issues.

However, and perhaps the most bizarre of what’s called unconventional monetary policy, the Fed did provide unlimited $US liquidity to foreign banking systems with its ‘swap lines’ where were, functionally, unsecured loans to foreign central banks for the further purpose of bringing down Libor settings by lowering the marginal cost of funds to foreign banks that otherwise paid higher rates.

Comment:

Lesson 3: The critical importance of having a strong and robust financial system. This is a lesson that we all thought we understood especially since the financial crises of the 1990s but whose central importance has been driven home, closer to home, by the Great Recession. The Great Recession was far worse in many of the advanced countries than it was in the leading emerging market countries. This was not what happened in the crises of the 1990s, and it was not a situation that I thought would ever happen. Reinhart and Rogoff in their important book, This Time is Different,[4] document the fact that recessions accompanied by a financial crisis tend to be deeper and longer than those in which the financial system remains operative. The reason is simple: the mechanisms that typically end a recession, among them monetary and fiscal policies, are less effective if households and corporations cannot obtain financing on terms appropriate to the state of the economy.

Mosler: Mar 18, 2014

The lesson should have been that the private sector is necessarily pro cyclical, and that a collapse in aggregate demand that reduces the collateral value of bank assets and reduces the income required to support the credit structure triggers a downward spiral that can only be reversed with counter cyclical fiscal policy.

Comment:

In the last few years, a great deal of work and effort has been devoted to understanding what went wrong and what needs to be done to maintain a strong and robust financial system. Some of the answers are to be found in the recommendations made by the Basel Committee on Bank Supervision and the Financial Stability Board (FSB). In particular, the recommendations relate to tougher and higher capital requirements for banks, a binding liquidity ratio, the use of countercyclical capital buffers, better risk management, more appropriate remuneration schemes, more effective corporate governance, and improved and usable resolution mechanisms of which more shortly. They also include recommendations for dealing with the clearing of derivative transactions, and with the shadow banking system. In the United States, many of these recommendations are included or enabled in the Dodd-Frank Act, and progress has been made on many of them.

Mosler: Mar 18, 2014

Everything except the recognition of the need for immediate and aggressive counter cyclical fiscal policy, assuming you don’t want to wait for the automatic fiscal stabilizers to eventually turn things around:

Instead, what they’ve done with all of the above is mute the credit expansion mechanism, but without muting the ‘demand leakages’/’savings desires’ that cause income to go unspent, and output to go unsold, leaving, for all practical purposes (the export channel isn’t a practical option for the heaving lifting), only increased deficit spending to sustain high levels of output and employment:

Comment:

Lesson 4: The strategy of going fast on bank restructuring and corporate debt restructuring is much better than regulatory forbearance. Some governments faced with the problem of failed financial institutions in a recession appear to believe that regulatory forbearance giving institutions time to try to restore solvency by rebuilding capital will heal their ills. Because recovery of the economy depends on having a healthy financial system, and recovery of the financial system depends on having a healthy economy, this strategy rarely works.

Mosler: Mar 18, 2014

The ‘problem’ is bank lending to offset the demand leakages when the will to use fiscal policy isn’t there.

And today, it’s hard to make the case that us lending is being constrained by lack of bank capital, with the better case being a lack of credit worthy, qualifying borrowers, and regulatory restrictions- called ‘regulatory overreach’ on some types of lending as well. But again, this largely comes back to the understanding that the private sector is necessarily pro cyclical, with the lesson being an immediate and aggressive tax cut and/or spending increase is the way go.

Comment:

This lesson was evident during the emerging market crises of the 1990s. The lesson was reinforced during the Great Recession, by the contrast between the response of the U.S. economy and that of the Eurozone economy to the low interest rate policies each implemented. One important reason that the U.S. economy recovered more rapidly than the Eurozone is that the U.S. moved very quickly, using stress tests for diagnosis and the TARP for financing, to restore bank capital levels, whereas banks in the Eurozone are still awaiting the rigorous examination of the value of their assets that needs to be the first step on the road to restoring the health of the banking system.

Mosler: Mar 18, 2014

The lesson remaining unlearned is that with a weaker banking structure the euro zone can implement larger fiscal adjustments- larger tax cuts and/or larger increases in public goods and services.

Comment:

Lesson 5: It is critical to develop now the tools needed to deal with potential future crises without injecting public funds.

Mosler: Mar 18, 2014

Yes, it seems the value of immediate and aggressive fiscal adjustments remains unlearned.

Comment:

This problem arose during both the crises of the 1990s and the Great Recession but in different forms. In the international financial crises of the 1990s, as the size of IMF packages grew, the pressure to bail in private sector lenders to countries in trouble mounted both because that would reduce the need for official financing, and because of moral hazard issues. In the 1980s and to a somewhat lesser extent in the 1990s, the bulk of international lending was by the large globally active banks. My successor as First Deputy Managing Director of the IMF, Anne Krueger, who took office in 2001, mounted a major effort to persuade the IMF that is to say, the governments of member countries of the IMF to develop and implement an SDRM (Sovereign Debt Restructuring Mechanism). The SDRM would have set out conditions under which a government could legally restructure its foreign debts, without the restructuring being regarded as a default.

Mosler: Mar 18, 2014

The lesson is that foreign currency debt is to be avoided, and that legal recourse in the case of default should be limited.

Comment:

Recent efforts to end too big to fail in the aftermath of the Great Recession are driven by similar concerns by the view that we should never again be in a situation in which the public sector has to inject public money into failing financial institutions in order to mitigate a financial crisis. In most cases in which banks have failed, shareholders lost their claims on the banks, but bond holders frequently did not. Based in part on aspects of the Dodd-Frank Act, real progress has been made in putting in place measures to deal with the too big to fail problem. Among them are: the significant increase in capital requirements, especially for SIFIs (Systemically Important Financial Institutions) and the introduction of counter-cyclical capital buffers for banks; the requirement that banks hold a cushion of bail-in-able bonds; and the sophisticated use of stress tests.

Mosler: Mar 18, 2014

The lesson is that the entire capital structure should be explicitly at full risk and priced accordingly:

Comment:

Just one more observation: whenever the IMF finds something good to say about a countrys economy, it balances the praise with the warning Complacency must be avoided. That is always true about economic policy and about life. In the case of financial sector reforms, there are two main concerns that the statement about significant progress raises: first, in designing a system to deal with crises, one can never know for sure how well the system will work when a crisis situation occurs which means that we will have to keep on subjecting the financial system to tough stress tests and to frequent re-examination of its resiliency; and second, there is the problem of generals who prepare for the last war the financial system and the economy keep evolving, and we need always to be asking ourselves not only about whether we could have done better last time, but whether we will do better next time and one thing is for sure, next time will be different.

Mosler: Mar 18, 2014

And in any case an immediate and aggressive fiscal adjustment can always sustain output and employment. There is no public purpose in letting a financial crisis spill over to the real economy.

Comment:

Lesson 6: The need for macroprudential supervision. Supervisors in different countries are well aware of the need for macroprudential supervision, where the term involves two elements: first, that the supervision relates to the financial system as a whole, and not just to the soundness of each individual institution; and second, that it involves systemic interactions. The Lehman failure touched off a massive global financial crisis, a reflection of the interconnectedness of the financial system, and a classic example of systemic interactions. Thus we are talking about regulation at a very broad level, and also the need for cooperation among regulators of different aspects of the financial system.

Mosler: Mar 18, 2014

The lesson are that whoever insures the deposits should do the regulation, and that independent fiscal adjustments can be immediately and aggressively employed to sustain output and employment in any economy.

Comment:

In practice, macroprudential policy has come to mean the deployment of non-monetary and non-traditional instruments of policy to deal with potential problems in financial institutions or a part of the financial system. For instance, in Israel, as in other countries whose financial system survived the Great Recession without serious damage, the low interest rate environment led to uncomfortably rapid rates of increase of housing prices. Rather than raise the interest rate, which would have affected the broader economy, the Bank of Israel in which bank supervision is located undertook measures whose effect was to make mortgages more expensive. These measures are called macroprudential, although their effect is mainly on the housing sector, and not directly on interactions within the financial system. But they nonetheless deserve being called macroprudential, because the real estate sector is often the source of financial crises, and deploying these measures should reduce the probability of a real estate bubble and its subsequent bursting, which would likely have macroeconomic effects.

Mosler: Mar 18, 2014

And real effects- there would have been more houses built. The political decision is the desire for real housing construction.

Comment:

The need for surveillance of the financial system as a whole has in some countries led to the establishment of a coordinating committee of regulators. In the United States, that group is the FSOC (Financial Stability Oversight Council), which is chaired by the Secretary of the Treasury. In the United Kingdom, a Financial Policy Committee, charged with the responsibility for oversight of the financial system, has been set up and placed in the Bank of England. It operates under the chairmanship of the Governor of the Bank of England, with a structure similar but not identical to the Bank of Englands Monetary Policy Committee.

Lesson 7: The best time to deal with moral hazard is in designing the system, not in the midst of a crisis.

Mosler: Mar 18, 2014

Agreed!

Nor did they need an IMF program!

Comment:

But the question then arises: Can you ever deal with moral hazard? The answer is yes, by building a system that will as far as possible enable policymakers to deal with crises in a way that does not create moral hazard in future crisis situations. That is the goal of financial sector reforms now underway to create mechanisms and institutions that will put an end to too big to fail.

Mosler: Mar 18, 2014

There was no too big to fail moral hazard issue. The US banks did fail when shareholders lost their capital. Failure means the owners lose and are financially punished, and new owners with new capital have a go at it.

Comment:

Lesson 8: Dont overestimate the benefits of waiting for the situation to clarify.

Early in my term as Governor of the Bank of Israel, when the interest rate decision was made by the Governor alone, I faced a very difficult decision on the interest rate. I told the advisory group with whom I was sitting that my decision was to keep the interest rate unchanged and wait for the next monthly decision, when the situation would have clarified. The then Deputy Governor, Dr. Meir Sokoler, commented: It is never clear next time; it is just unclear in a different way. I cannot help but think of this as the Tolstoy rule, from the first sentence of Anna Karenina, every unhappy family is unhappy in its own way.

It is not literally true that all interest rate decisions are equally difficult, but it is true that we tend to underestimate the lags in receiving information and the lags with which policy decisions affect the economy. Those lags led me to try to make decisions as early as possible, even if that meant that there was more uncertainty about the correctness of the decision than would have been appropriate had the lags been absent.

Mosler: Mar 18, 2014

The lesson is to be aggressive with fiscal adjustments when unemployment/the output gap starts to rise as the costs of waiting- massive quantities of lost output and negative externalities, particularly with regard to the lives of those punished by the government allowing aggregate demand to decline- are far higher than, worst case, a period of ‘excess demand’ that can also readily be addressed with fiscal policy.

Comment:

Lesson 9: Never forget the eternal verities lessons from the IMF. A country that manages itself well in normal times is likely to be better equipped to deal with the consequences of a crisis, and likely to emerge from it at lower cost.

Thus, we should continue to believe in the good housekeeping rules that the IMF has tirelessly promoted. In normal times countries should maintain fiscal discipline and monetary and financial stability. At all times they should take into account the need to follow sustainable growth-promoting macro- and structural policies. And they need to have a decent regard for the welfare of all segments of society.

Mosler: Mar 18, 2014

Yes, at all times they should sustain full employment policy as the real losses from anything less far exceed any other possible benefits.

Comment:

The list is easy to make. It is more difficult to fill in the details, to decide what policies to follow in practice. And it may be very difficult to implement such measures, particularly when times are good and when populist pressures are likely to be strong. But a country that does not do so is likely to pay a very high price.

Lesson 10.

In a crisis, central bankers will often find themselves deciding to implement policy actions they never thought they would have to undertake and these are frequently policy actions that they would have preferred not to have to undertake. Hence, a few final words of advice to central bankers (and to others):

Mosler: Mar 18, 2014

Lesson for all bankers: Proposals for the Banking System, Treasury, Fed, and FDIC.