Sunday, March 1, 2009

The fiscal policy will be more likely to succeed of people do not want to buy the bonds.

From Worthwhile Canadian Initiative:

Who will buy the bonds?

"The government needs to sell bonds to finance an expansionary fiscal policy. But who will buy the bonds? What happens if nobody wants to?"

What we ought be be concerned about is the exact opposite. The fiscal policy will be more likely to succeed of people do not want to buy the bonds.

Suppose, just as an example, that the proposed fiscal policy is a bond-financed tax cut, holding government expenditure constant. And suppose, again just as an example, that Ricardian Equivalence holds exactly. In this example, there's a simple answer to the question: "who will buy the bonds?". Each person receiving a $100 tax cut (or transfer) will want to save the whole of that $100, and buy an extra $100 of bonds. The extra supply of bonds creates its own demand. And yet this example is precisely the case where fiscal policy will fail to stimulate aggregate demand.

An increased demand for bonds means extra savings, and we don't want that to happen. We don't want an increased supply of government bonds to be met with an increased demand for government bonds. We want to create an excess supply of government bonds at existing levels of interest rates, prices, and incomes. We want to create a disequilibrium in the bond market, that will force interest rates, prices, and incomes to change. We want to create a disequilibrium in the bond market that will spillover into a disequilibrium in the market for newly produced goods.

Let's take what is conceptually the simplest example: the government prints bonds and gives them to people. (This is equivalent to helicopter bonds or a bond-financed tax cut). If people just hold the extra bonds, that is the end of the story. Nothing else happens. We hope that people will want to get rid of the bonds. We hope that the supply of bonds does not create its own demand.

We want people to try to get rid of the bonds, by trying to sell them, and trying to buy goods.

Bonds are not a medium of exchange, but money is. People cannot directly buy goods with bonds. If an excess supply of bonds is to translate into an excess demand for goods, it must first create an excess supply of money. There are two ways this could happen.

First, the excess supply of bonds could push down bond prices, which means push up interest rates on bonds. And the higher interest rates could cause a fall in the demand to hold money, creating an excess supply of money, and an excess demand for goods.

Secondly, the Central bank might buy the excess supply of bonds, in order to prevent the rise in interest rates. When it buys bonds it sells money. That creates the excess supply of money, and an excess demand for goods.

Now let's consider a bond-financed increase in government spending on goods. As a first step, the government needs to sell $100 bonds for $100 money; in the second step it uses the $100 money to buy $100 worth of goods. The net result is that the private sector holds the same amount of money, but $100 more bonds. If the private sector was willing, at unchanged interest rates, prices, and incomes, to hold the same amount of money and $100 more bonds, that would mean the fiscal policy would fail to stimulate demand. Because the only way the private sector could hold an extra $100 of bonds is if it saved an extra $100 of its income by reducing its consumption by $100. But if a $100 increase in government demand for goods lead to a $100 decline in consumption demand, the net effect on aggregate demand would be precisely $0.

Again, what we should be scared of is not that people won't want to buy the bonds, but that they will want to buy the bonds (at existing interest rates, prices and incomes). We want to create a disequilibrium on the bond market. We want fiscal policy to force interest rates, prices, and ultimately incomes to change.

In general, we should be more worried that people will want to buy and hold an extra supply of bonds than that they won't want to. Ideally, for fiscal policy to be most powerful, the private sector would refuse point blank to hold any more government bonds, at any rate of interest, price level, or level of income. In this case the central bank would be forced to buy all the bonds, so government expenditure would be money-financed. And if people refused point blank to hold any increased stock of money as well, we would be incredibly lucky. Because the extra $100 stock of money would create a $100 excess supply of money, which people would try to spend out of existence, again and again, and the hot potato would pass from one hand to another indefinitely, making the fiscal multiplier infinite.

But I think there is one important exception: if the fiscal authority in question does not have its own money and central bank, things are different. If we are talking about fiscal policy in a Canadian province, or a Eurozone country, we might be worried the other way. I will deal with that question in a later post.


Nick, Have you seen this blog post many people are talking about:

What is it about Buiter's position that makes it so unacceptable?

It seems to me that your position is similar. What am I missing?

"Hi Don: I have read Scott Sumner's post (and read through the other posts on his blog as well). I like it. My view of the world is similar to his. A couple of months back I wrote a post advocating price-level path targeting. And I have pushed for a more aggressive unorthodox monetary policy. Same sort of thing as Sumner. (Not sure I think that eliminating the 0.25% interest on reserves will make a big difference though, but sure, why not?)

I'm not sure what you mean about Buiter's position being unacceptable? Do you mean: "why doesn't the Fed do a helicopter increase in the money supply?"?

The key to Sumner's view, and Buiter's paper, is that it is by influencing expected future monetary policy that we can increase aggregate demand, and escape the recession. And the problem is: *how* to influence expected future monetary policy?

A public commitment to a price level path (or nominal GDP path) target would help. But will it be credible?

My own post "Bernanke should bet on inflation" (or whatever the title was) was on the same theme.

Is that what you were asking?

And yes, his talking about creating an excess supply of money (a disequilibrium) is in line with my way of thinking. It is one of the things I picked up from David Laidler, who was my supervisor. Good monetarist thinking.

It seems to me that the same ideas keep coming up in slightly different forms. I liked Buiter's idea because, if I remember right, it didn't involve issuing bonds. I liked your idea, but for the fact that it's linked to toxic assets. I just felt that we should leave them out of it. I don't like the Fed's QE, because it seems to be hedged in anticipation of future problems.

I read Bernanke's talk on ZIRP, but he seems not believe his own writings. I've also read that he's a big Fisher fan, which led to Bears, but the Lehman decision seems odd then.

So, yes. How many times am I going to read a QE idea trumpeted on blogs, and yet the idea goes nowhere? What is the Fed worrying about?

Don: that's a good question. I don't really have the answer. Here are some part answers:

It has been tried to some extent. The Fed's balance sheet is much bigger. The BoC bought mortgages, and lent against weird colateral. See my last post on "what next for the BoC".

It is difficult to know how to make a credible commitment for future monetary policy. How do you set the printing presses running, and disable the "reverse switch"? Especially when people know you might want/need to use the reverse switch if inflation gets too high.

Nobody has a clue about how big the policy would need to be. How would we know when we've overdone it? Sumner's posts have been helpful here: his answer is to look at private forecasts, or market forecasts, for nominal GDP (or CPI). But then there was that paper (by Bernanke? Blanchard? somebody beginning with B) saying you can't target a forecast without disappearing up your own orifice. (Sort of self-referential paradox).

Fear of central bank balance sheet losses. (I think they are overblown, and might actually be good for credibility, as in my "betting" post.

Fear of "instrument instability". We keep slowly moving the policy lever, more, more, more, and then suddenly it's effective, too effective, help! We're heading into hyperinflation! reverse the levers fast! Damn, too much!

Fear of the unknown. Orthodox monetary policy is an M16, but it's run out of ammo. Fiscal policy is Grandfather's musket. Unorthodox monetary policy is a nuke. Nobody knows the critical mass, or how big the bang will be.

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