Friday, 25 July 2014

Does QE 'finance' Government Spending? Of course it does. Get over it.

The Law School at the University of Sheffield as come up with an interesting paper about the legalities of QE - primarily in the context of the Eurozone.

Clearly QE is the central bank buying Treasury bonds by proxy. You can wave hands and make arguments as much as you like, but ultimately that is what is happening. The central bank's new money helps replenish Treasury's buffers and reduces the relative amount of interest that Treasury is paying into the wider economy.

That is just the central bank doing Open Market Operations by proxy - lowering the time preference reward on the longer dated paper. Once you consolidate the government accounts you get the true picture.
Consolidating Quantitative Easing does not significantly reduce the overall liabilities of government but it does reduce the number reported as government borrowing. Once intra-government transactions are eliminated, the scheme represents an exchange of gilts (liabilities of the National Loans Fund) for central bank reserves (liabilities of the Bank of England).
As MMT says, it's just an asset swap which results in relatively less interest coming out of the consolidated government sector into the rest of the economy. That then triggers a portfolio reconfiguration in the rest of the economy.

It is probably instructive to look at the mechanism of government bond buying relative to the banking system.

Government bonds need to be issued because there is insufficient taxation coming in and there is a silly rule in place saying that Treasury can't run an overdraft in central bank liabilities. What that means, on the other side of the fence, is that the non-government sector has stopped spending. Because if they spend, that generates tax which eliminates the need to issue some of the bonds in the first place.

So the starting assumption is that people have stopped spending and they haven't spent enough to offset government spending with taxation. That is what 'net saving' means.

At that point non-bank private entities only have two choices overall. Leave it in a private bank or buy government paper. If they buy the government paper, then some bank reserves disappear from banks and top up the Treasury's buffer.

If they decide to leave it in a private bank, then the private bank retains the extra reserves and they can decide whether to keep the reserves (in an account at the Central Bank), or buy Treasury paper. If they buy Treasury paper then some bank reserves disappear from the banks and top up the Treasury buffer.

So once all the private sector, including the banks, have finished doing their thing then either the Treasury buffer has been topped back up, or the Treasury buffer is short and the Central bank holds the difference as central bank reserve liabilities.

Now the Central Bank, if it is operating truly in the autocratic dictatorial mode that neo-classical economists aspire to, is caught in a quandary. Because its job is to maintain aggregate demand by persuading more people to borrow. If you're in a slump that doesn't happen. No matter how much you complain about banks they won't lend unless there are creditworthy borrowers at the front door.

If the central bank follows the silly restriction rules to the letter, then Treasury will be short on its buffer and won't be able to spend as much (assuming Treasury sensibly refuses to chase the market and calls the Central Bank's bluff. Remember we're assuming a hypothetical standoff situation here where the Central Bank will bounce the Treasury's cheques. The National Monetary Authority really, really believes in divine-right theory).

So aggregate demand will fall and people will lose their jobs. The Central Bank has nowhere to go. It can't push lending because that is pushing on string and Treasury can't spend to get the Central Bank out of a hole because of the dogmatic rule of the Central Bank. So the result would be a depression, which would then eliminate the private sector's savings because they would be forced to spend them. But the destruction would eliminate a lot of perfectly good capital as well.

All the Central Bank could do is start buying things itself, taking over the fiscal authority's job and enriching those it chooses without recourse to the democratic process.  And the days of Kings and Barons are thus restored.

As any first year law student will tell you, there is no law without enforcement. That way bad law can wither on the vine and fade away.