Q and A with John Greenwood at Invespective

At our recent inaugural Invespective Live virtual event John Greenwood gave an update on his economic outlook for 2021.

Given the full schedule John was not able to answer all the questions raised, including topical ones on currency reform, monetary conditions and what impact the massive expansionary fiscal policies of today might have on the future path of inflation.

To find out his thoughts on these areas, plus more, please read the Q&A blog below.  

Q1. Do you see the chance of a currency reform?

A. No. There are two versions of a "currency reset" story that I sometimes hear.

The first, and older, version says that at some stage the US President is going to announce a reversion to the gold standard, or that the world is going to adopt some form of commodity standard.

Both ideas display some basic misunderstandings. Many people fondly believe that a commodity standard – i.e. making the value of the US dollar equal to a fixed weight and fineness of gold or silver – will prevent inflation and other monetary disturbances. But this is not true. For example, the Great Depression of the 1930s was essentially caused by gold hoarding by the Federal Reserve and by the Bank of France. In other words, there can be no assurance that countries will “play by the rules”. Even when the dollar was supposed to be fixed to gold in the post-war period from 1945 to 1971, the quantity of money in the system had no relation to the amount of gold held by central banks.

Since 1971 that fiction has been declared obsolete; the vast bulk of the money we use nowadays is not physical money, but credit money i.e. deposits that are matched by bank credit (or lending). We live in a world of fiat money i.e. in a credit-based economy.  Nowadays it is the responsibility of central banks to manage monetary policy and money to avoid extremes of inflation and deflation. They do this under mandates normally set by the legislature, and I see no prospect of this system being changed in any meaningful way in the foreseeable future.    

The second version of the “currency reset” story is that the US Federal Reserve System (America’s central bank) and the US Treasury are going to merge, with the US Treasury taking over the Fed’s role. This version of the “reset” story circulates among conspiracy theorists, but again it shows a complete lack of understanding of how these institutions operate.

The naïve conspiracy view – and to some degree the MMT view -- is that since the Fed has access to money (or the printing presses) and the US government needs money, the government will simply take over the Fed and solve its financing problems for ever.

The truth, however, goes something like this. The US Treasury operates as manager of the government’s revenues, expenditures and borrowing (and a lot more besides, but that is not for today). Because revenues generally fall short of expenditures, the government must often borrow in the debt markets by issuing Treasury bonds, notes and bills. These securities are sold by auction with the Federal Reserve Bank of New York acting as fiscal agent for the government, and the bonds are bought by a whole range of domestic and foreign investors. The Fed does not purchase any of these securities at auction, so the Fed does not finance the government in any direct way.

Separately, there are times when it is appropriate for the central bank to create substantial amounts of new money – for example, in a banking crisis as in 2008-09, or in a pandemic as in 2020. The Fed does this by buying securities or lending funds to borrowers (normally against collateral). However, this is a monetary operation, separate from the government borrowing operation I just described. So even though the two events – large-scale government borrowing and large-scale money creation by the central bank -- may occur simultaneously, they should be kept separate and understood as completely different operations.

This is a well-tried and smoothly operating system which is absolutely central to the successful operations of a modern financial system and there is no imminent prospect of any “reset”, no matter what conspiracy mavens may say.

Q2. Mr Greenwood, how do you explain the tight money conditions after GFC, in contrast with the current situation? Are the banks key?

Yes, banks were a big part of the story in the GFC, but they were not the only player in the drama.

At the time of the GFC many banks, investment banks and households were over-leveraged. When house prices, mortgage-backed security prices and other asset prices started to fall steeply in the autumn of 2008, those who were leveraged and had exposure to these falling asset values became forced sellers. They also urgently needed to de-leverage – that is, to repay their borrowings. The demand for loans collapsed; banks stopped making loans and indeed tried to get borrowers to repay loans.

In the case of banks, they soon came under regulatory pressure (from their national regulators and later under Basel III) to increase their capital ratios. So not only were banks not making loans, they were also trying to set aside funds as capital. Since loans “create” deposits, and deposits are money, the quantity of money in many economies began falling – just as it had done in the US between 1931 and 1933.  

So even though the central banks lowered interest rates abruptly to almost zero in 2008-09, nobody wanted to borrow. The quantity of money was declining, and money was extremely tight. This was widely – and correctly -- referred to as a “credit crunch”. Anyone that needed to borrow was obliged to pay a substantial spread over the yield on safe sovereign debt such as US Treasuries. In general, the situation was one of very low interest rates and very tight money.

A key take-away from the GFC episode, therefore, is that interest rates are an extremely unreliable guide to the tightness or ease of monetary policy.

The situation today is very different. Banks are no longer over-leveraged, nor are households. Standards for bank lending have been tightened up with regulators requiring banks and other lenders to check that borrowers are not becoming over-indebted or unable to service their debts. As a result, when the pandemic struck in March banks did not need to reduce lending or build up capital (as they had been compelled to do after 2008). On the contrary, regulators reduced banks’ capital requirements on this occasion.

So today, in contrast to the post-GFC period, we have low rates and easy money. In my view, this is a major reason why the stock market has been so strong and also why the recovery – once a vaccine for the coronavirus has been developed and widely distributed – will be much more vigorous than the weak, sub-par recovery of 2009-2014.

Q3. You expertly explained the role of monetary policy on the business cycle and inflation. The evidence for it is indeed overwhelming, but isn't the future path of inflation and economic recovery more dependent on the fiscal impulse?

No. I believe there is very widespread misunderstanding of the power of fiscal policy. In the current circumstances many people will be led to believe that without fiscal support the economy could not recover, and they will go from there to thinking that we are entering an era when fiscal policy will take over the lead from monetary policy. Larry Summers, for example, former US Treasury Secretary and professor at Harvard, is currently promoting the view that, after a decade in which it was claimed that monetary policy was the “only game in town”, we are about to experience a revolution which will put fiscal policy back in the driving seat. In my opinion, such views grossly overstate the case.

First, the role of fiscal support (in the form of grants, loans, income subsidies, credit guarantees etc) in a crisis like the present pandemic is indeed immensely important. The central bank cannot undertake many of these tasks either because it is legally prevented from doing so or because it is inappropriate for a central bank to be making the political choices involved with say, bailing out Main Street firms rather than airline companies, or employees rather than the self-employed or sole business proprietors and entrepreneurs.

But it is not so much this political choice that is important in my argument. In any case, once the crisis is past this kind of support role will no longer be necessary to anything like the same degree and the fiscal support will come to an end.

The real contribution of the government in the current situation is that it can use its unique power – its balance sheet – to borrow from the nation at large in very large quantities to make funds available temporarily to those individuals and businesses who have been hit by the unexpected – or government-mandated -- downturn in the economy. Only the government can do this because its creditworthiness is underwritten by future tax revenues.

This year, between February and October, the US federal government borrowed roughly US$3.6 trillion, using these funds to provide support in programs authorised under the CARES Act such as the Paycheck Protection Program (PPP), the $600 per week enhanced unemployment benefits and the US$1,200 stimulus checks. Similarly, in the period March to September the UK government has borrowed £210.4 billion to finance the Coronavirus Job Retention Scheme (CJRS) to pay for job furloughs, the Self-Employment Income Support Scheme (SEISS), and a series of other anti-coronavirus measures.

All these government spending programmes must be financed. But how? There are only three ways to finance a government deficit: by higher taxation (unlikely in the midst of a pandemic recession), by borrowing (as has been the case so far), or by “printing” the money. The latter is metaphorical language for borrowing from the central bank or from the banking system, but independent central banks are intended to guard against this kind of abuse.  

In longer run, how will total spending in the economy be maintained if government spending and borrowing returns to normal? The answer is, in the normal way – that is, through the private sector earning income and spending it on consumption and investment. Ensuring that this happens smoothly and steadily is the responsibility of the central bank by ensuring the appropriate amount of funds (or broad money supply, or as I like to say, “money in the hands of the public”) in the economy to generate a level of spending (nominal GDP) that is consistent with the real output capacity of the economy. In other words, monetary policy will return to centre stage as soon as the emergency is over.

In summary, although the government can and must provide short term, temporary support to the economy, in the longer run, inflation will be managed by the central bank through monetary policy. Despite what Professor Summers may say, we are not about to see a revolutionary switch from monetary dominance to fiscal dominance; the large role of fiscal policy is strictly a short-term phenomenon that will evaporate once the crisis is over.   

Q4. Will the rate of deceleration of money growth be relevant in the next few years?

Yes. In the months March to June or July 2020 there was a huge but temporary acceleration in the rate of growth of money both in the US and in the UK. In the more recent months since July the rate of growth of money has decelerated sharply – again, both in the US and in the UK.

The acceleration was important to create the money that was urgently needed as a result of the “dash-for-cash” by businesses and investors. When the pandemic struck in March, in face of huge uncertainties about how the economy would perform, firms drew down pre-arranged credit lines (or overdraft facilities) to ensure they had sufficient liquidity for an extended but unknown period. Investors de-risked their portfolios by selling risky securities and shifting to cash (i.e. deposits) and safe government securities. In the US the drawdown of credit lines was in excess of US$400 billion; in the UK it was roughly £60 billion. In addition, the governments in both countries needed to make funds available to businesses and individuals through the banking system. In response to these requirements and aided by central bank asset purchases (QE), the money supply surged on both sides of the Atlantic.

The more recent deceleration (since July) is to be expected as things gradually return to normal, even though there may be further outbreaks of the pandemic -- as we are currently seeing in the northern hemisphere. Investors are gradually becoming more willing to take risks again, and individuals have started to spend their savings accumulated during the lockdowns – though less on services and more on goods. In principle I expect money growth to decelerate towards mid-single digit growth rates – i.e. 4-8% p.a. in the US and the UK, but it may not be a smooth path, and further central bank QE operations may be necessary, as we have just seen with the Bank of England’s announcement on 5 November of an additional £150 billion of QE.

Accelerations and decelerations of money growth always matter – if they are sustained. If the present deceleration lasts long enough to bring down the average rate of broad money growth over the year from March 2020 to February 2021 to, say, 6-8%, then no significant harm will be done. But if money growth remains in double digits – as seems more likely – then we must expect two sets of consequences. First, the economic recovery in the second half of 2021 (or whenever a vaccine becomes widely available) will be much more vigorous than is generally expected, and second, there will be an increased risk of higher inflation in 2022. As yet, we cannot say how high the inflation rate will be, but we should be on our guard because higher inflation would also spell higher interest rates.    

Q5. Is it the caution you mention related to why the velocity of money has fallen so sharply?

Yes. The velocity of money (technically, Nominal GDP/Money supply) is the inverse of the amount of money people hold relative to income (Money supply/Nominal Income). [I personally think it is easier to think of it this way round!]  If people hold much more money per unit of income, then velocity has fallen sharply – as you say. And this is exactly what has happened as a result of two events: the “dash-for-cash” in March-May, and the huge provision of new money through QE by the central banks. The amount of excess cash relative to income that people are holding can be viewed as a measure of risk aversion.

In the UK, between 2019 Q4 and 2020 Q3 velocity has fallen from 22.1% (or, putting it the other way round, money per pound of income has increased by 28%). Similarly, in the United States velocity fell by 19.6% over the same period (or, putting it the other way round, money per dollar of income increased by 24%).

It will be helpful, going forward, to monitor the degree of risk aversion. One way people sought safety was to buy US Government Money Market Funds because these funds hold only safe short-term Treasuries or repos based on Treasuries. Also, the figures are available on a weekly basis. In the past five months (July-October) outflows from these funds have totalled about one quarter of the inflows between February and June, so the mood is shifting slowly and gradually. The more the cash holdings decline and the more that risk appetite revives, the closer we will come to a return to normal.