Fixing the economic transmission system: coordinating monetary & fiscal policy


By Ann Pettifor

"The economic [monetary] transmission system works to create the finance, which is then spent [fiscal] in productive investment in infrastructure. This sound investment in turn generates economic activity, i.e. employment.  Employment in turn generates wages, incomes and profits  – and these in turn generate tax revenues with which to reduce the deficit and pay down the government’s debt."

Thanks to the forthcoming budget, economic commentary has intensified. There is now a cacophony of advice for the Chancellor: commentary that reveals only how messed-up, as a discipline, economics has become.

Part of the reason for muddled thinking is that the profession has stratified or compartmentalised different parts of the machinery that make up the capitalist economy. Economists and policy-makers choose to discuss these parts in isolation – as if one part exists and functions independently of another working part.

So we are asked to consider and discuss monetary policy as if in isolation from fiscal policy.

The Chancellor announces that he is a "monetary activist and fiscal conservative."  As if monetary policy alone – without complementary action on the fiscal front – can get us out of this mess. As if monetary policy – without considering how money is spent – is all we should set our pretty heads to thinking about.  The Chancellor would have us believe that sole reliance on a civil servant, Mark Carney, the Bank of England’s new governor, and the limited policies available to the BoE, are all we need to ensure Britain’s economic recovery.

This is in stark contrast to the way e.g. engineers think. No mechanical engineer would dream of discussing the overall efficiency of a motor vehicle without taking into account (at the very least) the engine components and parts; the ignition, fuel supply and transmission systems.

Philip Coggan at the Economist in his recent ‘Buttonwood’ post  (15 March, 2013) provides a clear example of muddled and half-baked thinking, matched by a little targeted fear-mongering. He frets about Martin Wolf’s recent counter-blast to the Prime Minister’s assertion that “there is no money tree.” Wolf believes (as I do) that there is one, and it is called the Bank of England; an institution with the power to create money in a form usable by banks and other financial institutions; but also by government.

But because the Bank of England is a nationalised bank; one run by servants expected to be civil to political authority – it is feared by private bankers and their apologists in the economics profession. So whenever there is talk of the central bank providing finance for government investment as opposed to private bank speculation, the spectre of inflation is raised to frighten off politicians like the Chancellor and PM.

Note please that bankers and their apologists have a point. Politicians like Mugabe in Zimbabwe are quite capable of manipulating the central bank to create more money than the economy has potential.  As we know from Britain's experience of easy, 'liberalised' money in the 1970s, too much money chasing too few goods and services results in inflation.

But there is more than one inflation point to be made about central bank money creation – one often overlooked by free marketeers.

The provision of liquidity to the private banking sector since 2008 has indeed induced inflation – of assets – owned, on the whole, by wealthy speculators. Kevin Tanner in a letter to the Financial Times (18 March, 2013) identifies

   “waves of liquidity..created by central banks, known collectively as quantitative easing,  as the paramount force underlying momentum trading…Since 2010.. gains on the stock market have been very highly correlated with the Fed’s permanent open market operations (Pomo), the mechanism for implementing QE. The record is one of manufactured liquidity passing through banks instantaneously to “risk-on” assets traded primarily by speculators.”

  These “risk-on” assets have of course been inflated by central bank “manufactured liquidity”.

Apologists for the interests of the finance sector, have not, to my knowledge, complained loudly about global asset price inflation. But they raise a huge roar of disapproval when economists propose that central bank liquidity should be directed at sound investment in public infrastructure projects.

It was ever thus.

The economics profession as  a whole ignored the inflation of the global asset price bubble as it exploded during the 90s and 00s. The bubble expanded thanks to easy, de-regulated, ‘liberalised’ credit  chasing too few assets – stocks and shares, race horses, works of art, property, brands etc.. To this day few economists write of the global asset price bubble as inflationary.  Instead they keep their eyes narrowly focussed on ‘the little people’ – alert to any sign of inflation in workers’ wages, professional salaries and prices fixed by small businesses.

In line with this blinkered approach, Philip Coggan worries that the Bank of England’s ‘money tree’ would be inflationary: “grabbed by the most aggressive and agile people on the street, and not by little old ladies. The former would gain, the latter would lose.”

But this is just what is happening. QE is grabbed “by the most aggressive and agile people on the street” – bankers and speculators – and not by "little old ladies" nurturing their savings. Of course savers are losing out on low rates of interest. But that is only because speculators and financiers brought the global financial system to the brink of collapse, which in turn sunk economies. This led to bankruptcies, a rise in unemployment, and rising public debt. To address this ongoing crisis, and prevent the livelihoods of "little old ladies" (and their families’) being destroyed altogether, bankers deploy low rates of interest in an attempt to restore stability.

Coggan is deliberately raising the “inflation at the expense of little old ladies” bogey – to divert our attention. Those, like Martin Wolf, who advocate greater monetary and fiscal policy coordination do not intend QE to go “the most aggressive and agile people on the street”.  On the contrary QE would be used to fund sound investment in public infrastructure that generates income.  This investment would stimulate activity in e.g. the private construction sector; create jobs for the children and grandchildren of "little old ladies", and spur economic recovery.

Only when the economy recovers will "little old ladies" - and their families -  be secure.

Increased economic activity from such investment would have a positive impact on government revenues. More people in employment, and more economic activity leads to a rise in profits and incomes – for those employed, and for those who benefit from their consumption and expenditures. Profits and an increase in the number of those with incomes, will lead to an increase in tax revenues for the Treasury. This increase in tax revenues helps fund – wait for it – repayment of borrowing from the Bank of England.

Hey presto the economic transmission system works to create the finance, which is then spent in productive investment in infrastructure. This sound investment in turn generates economic activity, i.e. employment.  Employment in turn generates wages, incomes and profits  – and these in turn generate tax revenues with which to reduce the deficit and pay down the government’s debt.

There is one precondition: the whole circular process only works if it is whole and circular. Not if monetary policy is considered, or enacted, in isolation of how (central bank) money is spent. 

Right now there is an urgent need for the central bank to undertake such financing. The reason is well known: the private banking system is dysfunctional. According to the governor of the Bank of England “heightened uncertainty about the solvency of banks” lies behind their failure to lend and finance investment.

The private banking system has a solvency issue because it is heavily indebted – thanks to crazy de-regulated borrowing and risky speculation during the boom – borrowing and speculation effectively endorsed by most orthodox economists.

Given that the private banking system is unable to finance sound investment in productive (as opposed to speculative) activity - recourse to the public banking system is necessary

Of course such exceptional action will be exceptional – until the private banking system is returned to health.

Will Bank of England financing of government investment in infrastructure be inflationary? Will it erode the value of savings set aside by “little old ladies”?

I very much doubt it. The reason is this: financing investment in an economy which has been ‘cratered’ by a historically unprecedented financial crisis and the breakdown of the private banking transmission system, will just begin the process of recovery.

Pouring funds into the ‘crater’ of economic inactivity that now drags down the British economy will not be inflationary until that ‘crater’ is filled up. That is, until we reach full employment. It will be particularly non-inflationary if it uses Britain’s domestic resources – in particular its people – and is invested in activity that does not require imports or the diversion of resources abroad. These can easily be identified, and indeed we have done so in our report: “The Green New Deal” and in subsequent reports.

Nothing else will do. Nothing else will both spur the recovery of the private sector, and help pay down the public debt.

And that is a form of joined-up economics that many within the economics profession have not been trained to grasp - unlike their engineering peers.