April 2013 Conjoncture 13

Debt, money and inflation Jean-Luc Proutat

Historically, public debt has been closelyassociated with inflation. A quick look back in time willsuffice to show why. In past centuries, rather than besaddled with debt, notably at the end of wars, Stateswould often simply monetise it. Debts, most of whichwere payable in gold, were reduced to almost nothing once they had been converted into paper. Paper moneycould be issued as long as others believed in it. Inflationcould exist, since for any given quantity of goods and services, there were more means of payment in circulation. The illusion would last a certain time before evaporating with the first requests for conversion, generally during periods of great turmoil. After 1720 andthe bankruptcy of the Law system, the notes issued bythe Royal Bank were nailed to the doors. In 1796, theplates for printing assignats were burnt in the towncentre. And in the Weimar Republic during the winter of 1923, marks were burnt to heat homes.

According to Keynes, “there was no subtler, no surer means of overturning the existing basis of society thanto debauch the currency” to get rid of debt. Monetisation was deemed dangerous, and little by little it was bannedin the western world after the Second World War. Under Article 104 of the Maastricht Treaty, the EuropeanCentral Bank (ECB) is explicitly banned from monetisingdebt. The US Federal Reserve (the Fed) and the Bankof England (BoE) have not resorted to it over the pastforty years, at least not until the recent crisis. It was onlythen that the central banks began bending the rules and breaking the ban.

In 2008, all the major central banks, in one manner or another, began providing increasing support to the financing of the economy, notably to state governments.The monetary base 1 swelled to unprecedented proportions. For those who adhere to the quantitative theory of money, the inflation in central bank liquiditywould sooner or later carry over to prices. But rather than seeing this as a threat, a number of officials are actually encouraging it. In an article in February 2010,Olivier Blanchard, head economist at the InternationalMonetary Fund (IMF), asked whether the time had not come to raise the inflation targets set by the monetary

authorities. Three years later, the Bank of Japan (BoJ)moved into action, raising its inflation target from 1% to 2%. In the United States and Europe, the same 2%targets seem increasingly less secure as anchors. The Fed has just added a target for the unemployment rate and the BoE could follow suit fairly soon.

Official purchases of debt instruments, which werefirst presented as only temporary measures, have nowbecome the norm. Most of the major central banks haveeither renewed these programmes or intensified them.Even the ECB, the most “Austrian” of them all, said it was prepared to make the leap in August 2012, when itunveiled its Outright Monetary Transactions programme (OMT).

By providing government bailouts, swelling themonetary base, and raising or circumventing inflation targets: could the central banks be on the verge of “overturning the existing basis of society”, to useKeynes’ words? In this article, the main conclusion is that the monetary shock treatment set up to resolve thecurrent crisis still has very low inflationary risks. As to the debate on the secondary effects of monetary hyper-stimulation, such as fuelling asset bubbles or the poor allocation of resources, it is more or less legitimatedepending on the region in which it occurs. In theEconomic and Monetary Union (EMU), notably in the south, the main risk is not the excessive swelling of money supply and credit but their contraction.

From debt to money

When mountains of debt collapse, the monetaryauthorities can provide as much liquidity as necessary and reduce the cost of money. But these measures do not always suffice. Contrary to common belief, the Fedlent heavily in the early 1930s, and at the same time cut its discount rate by a factor of four2. Even so, a banking holiday had to be declared in 1932. In 2008, the Fed launched a series of exceptional measures to boost liquidity, and well before the collapse of Lehman Brothers, it lowered its key policy rates. After

April 2013 Conjoncture 14

15 September, its main counterparts followed in itswake. By spring 2009, key rates were nearly zero in most of the main advanced economies: 0% in the UnitedStates and Japan; 0.25% in Canada; 0.50% in the UK and 1% in the eurozone.

Breaking with conventions to avoid a liquidity trap

The risks of a liquidity trap quickly emerged: sincenominal interest rates had already been lowered as much as possible, how could central banks stimulate activity (and discourage the hoarding of cash) while making sure that the deflation of asset bubbles, by putting downward pressure on prices, did not result inhigher real interest rates?

As largely admitted, the Bank of Japan failed to escape this impasse. For a long time, the main reproach was that the BoJ had waited too long. After the crisis broke out in Japan in 1990, the BoJ did not lower itsnominal interest rates to nearly zero until five years later, and real interest rates never entered negativeterritory. The general price level began to decline slowly,and twenty years later, this process is still going on. It is not surprising then that negative inflation expectationsdictate the savings behaviour of Japanese companies and households: any money put aside today is bound togain in purchasing power tomorrow, regardless whether it generates interest. Consequently, any surplus liquidity injected by the central bank tends to be saved, notablyin the form of government bonds, rather than spent. Asa result, monetary policy has become ineffective.3

Another more severe example of a liquidity trap isinevitably associated with the 1930s. The United States and a good portion of Europe were mired in a kind of economic nightmare that Irving Fisher calls “the debtdeflation theory”4. Asset depreciation and the resultingnegative wealth effect drove people to reduce debt andto prefer liquidity. Credit was rationed, the volume of business contracted and prices declined (products were sold off at bargain prices), but despite the efforts made, liabilities swelled in proportion to nominal revenues.Balance sheet restructuring accelerated to the point thatit looked like the banks were turning tail, which onlydeepened the depression.

Ben Bernanke, chairman of the Federal Reserve, is undoubtedly the man most aware of this ultimate threat.This academic is one of the leading experts on thedepressive mechanism of the 1930s. Author of numerous essays on the subject 5 , he knows that adisorderly liquidation of debt can result in chaos, and to

avoid it, the central bank must fully assume its role of lender of last resort, even if that means using somerather unconventional tools.

Almost all central banks began making securities purchases

When the market became illiquid in 2008, the Fedfirst accepted asset-backed securities as collateral andthen began purchasing them6. Various programmes and as many acronyms were invented, which helped swellthe Fed’s balance sheet. The PPAD (Planned Purchases of Agency Debt) and the TABSLF (Term Asset-Backed Loan Facility) were set up in fall 2008. They fuelled a first round of purchasing of debt securities, those issued or guaranteed by the mortgageagencies. Quantitative Easing (QE) became the newmonetary policy tool in the United States. Other programmes followed. In November 2010, the Fed announced "QE2" and extended its purchases to includeUS Treasury bonds. Later it initiated Operation Twist, which extended the maturity of its balance sheet in September 2011, and then QE3 in September 2012. Allin all, from September 2008 to March 2013, the Fed purchased about $2,200bn in assets and increased the size of its balance sheet 3.5 fold.

The Bank of England quadrupled its balance sheet. With the purchase of £375bn in Gilts, the central bankcovered three quarters of the government’s net borrowing needs since 2009. And that is not all. Takingits cue from the Fed, the BoE launched a special refinancing programme in July 2012 by exchanging collateral, which gave it a more active role in thedistribution of credit 7 . Even though it was by far the central bank holding the biggest stock of public debt (30% of debt outstanding), BoE governor Mervyn Kingargued for further securities purchases. Mark Carney,his successor, was already advocating options as radical as abandoning inflation benchmarks andtargeting nominal GDP instead 8. Without going that far,the BoE could expand its array of tools and adopt a target for the unemployment rate, a move already takenby the Fed.

Whatever option it adopts, the Old Lady has not finished overturning conventions. To counter a deflatingcredit bubble, the BoE has already done more in four years than the Bank of Japan did in two decades. Yet Japan is about to see a shakeup nicknamed “Abenomics”.Encouraged by the recently elected Prime Minister,Shinzo Abe, the BoJ finally raised its inflation target from

April 2013 Conjoncture 15

1% to 2%. Moreover, the new BoJ governor, HaruhikoKuroda, has vowed to meet this target “at any price”. Thissurely means more official securities purchases. In April 2013, the BoJ announced that it intends to more or lessdouble the size of its balance sheet. It plans to make JPY132,000bn in net securities purchases by year-end2014, the equivalent of 28 points of annual GDP. Under the Japanese programme, the central bank wouldeventually hold 30% of the stock of JGBs, and the country would no longer have any reason to envy the quantitativeeasing programmes in the US or the UK.

The ECB is an exception

What about the European Central Bank? Havinginherited its bylaws from the very orthodox Bundesbank,the ECB has long snubbed all forms of securities purchases. Set up in May 2010, the Securities MarketsProgramme (SMP) – which resulted in the resignation of the Governing Council’s two German members – hasheld to very small proportions: it accounts for barely 3% of the eurozone’s public debt stock, ten times less thanin the UK. Yet the ECB has not remained inactive. In addition to constant liquidity injections, it opted for a procedure of unlimited allocation at fixed rate that hasswollen its balance sheet. Through two specialrefinancing operations conducted in December 2011and March 2012, the duration and amount of loansoutstanding increased significantly, to 3 years and €1,018bn, respectively. Yet in keeping with tradition, these loans were directed towards credit institutions,while certain eurozone member states were finding it increasingly difficult to access market financing. Unable to disentangle banking and sovereign risks, this policy began to show its limits in summer 2012, when it failed to prevent spreads from widening and lending fromcontracting in the eurozone’s southern countries.

This is why the OMT programme was announced. In August 2012, for the first time the ECB said in explicitterms that it was prepared to purchase unlimitedamounts of sovereign debt. Granted, OMT is morerestrictive than other programmes. To be eligible for OMT, governments must first pledge at least to respect a “precautionary” programme, which always includes the transfer of a certain amount of sovereignty9. The ECB’s securities purchases will also concentrate on relativelyshort maturities (less than or equal to 3 years), whichsets it apart from other central banks, whose programmes are explicitly designed for the purchase of long-term debt.

8%

11%

14%

17%

20%

23%

26%

2007 2008 2009 2010 2011 2012 2013

Total assets

M0

Chart 1

Balance of the central banks% of GDP (Fed + ECB + BoJ + BoE)

National sources

From money to inflation

Regardless of the results of securities purchases or lending operations, the swelling of central bank balancesheets clearly corresponds to a type of monetary creation. In both cases, the credit institutions’ accounts,which are taken into account in the calculation of M0money supply and reported as liabilities for the central bank, are credited “ex nihilo” by the central bank. Thus itshould come as no surprise that the monetary base swells in keeping with official balance sheets: they aretwo sides of the same coin. The four main central banks(the Fed, ECB, BoE and BoJ) have more or less tripled their balance sheets since 2008, bringing them to nearly 20 points of GDP (Chart 1). This is already an all-timehigh, but things are not over yet. Assuming the BoJ andthe ECB (OMT) go ahead with their programmes as announced, the BoE takes its programme one step further and the Fed pursues its programme at the same pace, central bank money could account for as much as a third of the GDP of the main advanced economies at year-end 2014.

Since the expansion of M0 depends solely on thewillingness of the monetary authorities, it is theoretically unlimited. Yet things no longer occur like they used to, when governments mistook central bank funds for their own treasuries and had them print money in abundance.Today, when increasing assets in debt securities,notably in government bonds, central banks purchase them on the secondary market from certified intermediaries (i.e. primary dealers in the United States), not when issued. As a result, assistance withgovernment financing is neither direct nor free of charge, a useful precision for those who doubt whether OMT is compatible with European treaties. Even so,

April 2013 Conjoncture 16

official securities purchases are clearly designed toreduce the cost of debt, which is partly why they exist. This can be achieved in one of two ways: 1) like theFed, by lowering the long-term nominal interest rate, anobjective clearly assigned to quantitative easing programmes, which empirical studies generally consider to have been fulfilled10, or 2) like the Bank of Japan, by stimulating inflation and lowering real interest rates, a target that has not been reached yet and which bringsus back to the quantitative theory of money.

The monetary base multiplier plunges

By creating money, can central banks reviveinflation? In the Fisher equation (see box), the M0 monetary base is clearly differentiated from M moneysupply. In its scriptural form, it is an interbank currencythat cannot be used directly for payments to householdsor companies. This is why it is not taken into account in the definition of money supply aggregates (M2 in the United States and M3 in the eurozone). Even so, it stillinfluences them. Milton Friedman 11 described M0 as high-powered money, the resource from which banks

can lend to the economy and thus expand money supply aggregates. Before the crisis, the relation between money supply aggregates and M0 -- also called themoney multiplier -- held rather stable at about 10. Inother words, an extra euro (or dollar) of liquidity supplied by the central bank increased money supply by about 10euros (or dollars). The monetary authorities were able tomaintain a certain influence over the amount of creditand money irrigating the economy.

This is much less true today. Since 2008, themonetary base multiplier has collapsed (chart 2). In“central bank” speak, this means that monetary policytransmission channels are no longer operating normally. Bank liquidity may be abundant, but it is having a hard time flowing through the economy, a typical case of retention seen during major debt reduction phases.Given the ratios reached in 2008, the debt reductionphase continues, which is obviously straining demand for loans. Granted, credit demand seems to be less depressed in the United States, but it is still very feeblefor home purchases, even though mortgage loans have been contracting for more than five years and lendingconditions are very favourable again, according to Fed

Box: Quantitative theory of money

The quantitative theory of money looks at the relationship of the general level of prices (P) with the quantity of money (M)circulating in the economy. The origin of this theory is generally attributed to the French jurist and philosopher Jean Bodin (1529-1596). During the 16th century, a new phenomenon of rising prices developed in Europe, notably in Spain, giving rise tonumerous controversies. The most famous debate is the one that pitted Jean Bodin against the economist Jean de Malestroit in 1568. The later, like the majority of observers at the time, defended the Gresham law and associated the loss of purchasingpower of money to its physical alteration or debasement (in gold or silver). Bodin was the first to realise that the cause of “therising cost of all things” was due in the influx of precious metals from the New World. More payment resources for the sameamount of merchandise tended to drive up prices. The quantitative theory of money underwent several improvements thereafter (Hume, Ricardo, etc.) before it was summarised in the following equation by Irving Fisher in 1911: M.v = P.T (1) where v is the velocity of money in circulation (the number of times money is used in payments) and T is the volume of transitions, which in macroeconomics is the national revenue or real GDP. At this stage, equation (1) remains purely anaccounting identity. It becomes theory once money supply M is considered to be an exogenous or explanatory variable for the general level of prices (P), which assumes notably that the velocity of money in circulation does not interfere in the supposedcause and effect relationship. A basic quantitative hypothesis consists of considering v as a constant figure, specific for different ffpayment techniques. By differentiating (1), it becomes: � = m-y (2)�

where � designates the inflation rate, m the money supply growth rate and y the real GDP growth rate. In the weak version of the �quantitative theory of money, inflation is explained by the growth of money supply relative to GDP. The “strong” version considers that in a market at equilibrium, the change in the monetary base does not influence production levels (y=0). In this case:

� = m (3) �

The inflation rate varies in proportion to the money supply growth rate.

April 2013 Conjoncture 17

5

6

7

8

9

10

11

2007 2008 2009 2010 2011 2012 2013

Chart 2

Monetary basic multiplier(Fed + ECB + BoJ + BoE)

National sources

surveys. In the eurozone, credit demand has beenparticularly hard hit, notably in the southern countries,where financial liabilities are especially cumbersome. Banks in these countries are handicapped by a specialproblem: they are the largest holders of sovereign debt,while sovereigns are weakened by their commitments to banks. This intermingling of risks makes financing conditions virtually insensitive to monetary policy. In Italy, Spain, Portugal and Greece, the decline in creditshows no signs of slowing, and to the contrary, couldeven be intensifying. In early 2013, net lending flows to companies seem to be declining even more sharply than during the great contraction phase following the collapse of Lehman Brothers.

Money velocity declines

Lending to the private sector is an essential counterpart of money supply, but other factors also provide support,such as loans to public administrations or public’spreference for liquid investments. This has been the case in the eurozone, for example, since 2012. On thewhole, however, central banks would have been hard pressed to eliminate the erosion of money supplyaggregates. The Fed is the one that has managed bestso far. In recent months, M2 money supply growth haspicked up in the United States. In the eurozone, the UKand Japan, in contrast, there has been a net rupturesince 2008 (chart 3). Money supply growth is following a feeble slope, barely averaging 2% a year, which is only a quarter of the pace that prevailed before the crisis.

If we turn back to the quantitative relationship, monetary conditions are currently far from being inflationary. Indeed, price inflation indices should even tend to ease in keeping with money supply trends. Itcould be even weaker than theory seems to suggest,

100

120

130

110

120

140

2005 2007 2009 2011 2013

Chart 3

Money supply, indice 2005 = 100,smoothed (E.Zone M3 + UK M4 + Japan M2)

National sources

Logarithmic squale

since the velocity of money in circulation is declining. In the United States, as in the rest of the world, money velocity is near an all-time low: given the strong preference for liquidity, money is being used less for payments and more willingly saved.

Credibly promise to be irresponsible

Even if they wanted to, governments would have ahard time accelerating things. The central banks are already very active, and to force them to underwrite alldebt would simply be sabotaging our institutions. Their independent status would have to be broken, which issure to trigger a diplomatic crisis in Europe, notably withGermany. In a modern democracy, it is hard to imagineforcing commercial banks to loan, or better yet, forcing households and companies to borrow.

To revitalise activity and prices, it is best to operatewithin a realistic framework, even if that means pushing it to the limits. Paul Krugman summarises this in an ironic phrase: “a way to make monetary policy more effective is for central banks to credibly promise to be irresponsible”. The key is not to make inflation higher,which cannot be decreed, but to make people believe that it can be. The Fed, the BoE and soon the BoJ havebeen working in this direction through successive waves of asset purchases and by taking ever greater liberties with price stability targets.

The end goal is to obtain negative real interest rates so that debt loads become bearable, and to encouragespending. The United States and the UK have alreadyachieved this, but not the eurozone. In the EMU, the average yield on 5-7 year government bonds is close to2%, i.e. 0.7 points above core inflation (excluding food and energy prices). It is more or less at the inflationbreakeven point (anticipated inflation rate) as calculatedby the ECB.

April 2013 Conjoncture 18

Actually, this is not saying much. Anticipatedinflation rates in the eurozone are the average yield spreads between nominal and indexed rates in Franceand Germany. They are probably lower in the southern EMU countries, where GDP price indexes are not rising much, when they are not falling. In southern Europe,deflationary risks are very real: real interest rates are toohigh. They imply such enormous primary budget savingsover such long periods of time that any debt stabilisationefforts are virtually impossible. In addition to lending bythe European Stability Mechanism (ESM), the ECB’sOMT securities purchasing programme was designed precisely to facilitate the return to sustainable financing conditions. Yet so far they have not been triggered, notably due to the strong constraints they imply. Yet the earlier they resort to OMT the better.

�

� �

Nearly six years after the outbreak of the crisis,credit has not really picked up yet, except in the United States. In many parts of Europe, notably in the south, priority is still given to paying off debt. Money supply isnot growing much and its velocity is slow. As a result,monetary policies are not really aiming to generate inflation as much as to combat the depressive forces stillat work.

8 April 2013 jean-luc.proutat@bnpparibas.com

April 2013 Conjoncture 19

NOTES

1 Also known as “narrow money” or “central bank money”, it comprises currency in circulation (coins and banknotes or just banknotes depending on the definition) as well as commercial bank assets held at the central bank (mandatory reserves, surplus cash and deposit facilities). It is commonly referred to as M0 money supply.2 From October 1929 to June 1931, the Federal Reserve Bank of New York lowered its discount rate from 6% to 1.5%. If any 2

errors were made in terms of monetary policy, it was to raise interest rates much too quickly thereafter (as of October 1931).3 Japan’s liquidity trap has been largely discussed in economic literature over the past 15 years, notably by Paul Krugman. See Krugman, P. (1998), “It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on Economic Activity, 1998:2, 137-187. 4Fisher I. (1933), “The Debt-Deflation Theory of Great Depressions”, Econometrica.5 Reprinted together in 2000 in a reference work published by the Princeton University Press. See Bernanke B.S. (2000), “Essays5

on the Great Depression”, Princeton University Press. 6 For more information on the measures taken by specific central banks since the outbreak of the crisis and their consequences, 6

see d’Arvisenet P., De Lucia C., Estiot A., Newhouse C. (2012), “The Maverick, the Old Lady and the Converted”, Conjoncture BNP Paribas, November 2012, pp14-15.7 Ibid, p 24. The Funding For Lending Scheme (FLS).7

8 “If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting anominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation

” See Carney M., “Remarks on Guidance”, CFA Society Toronto, Toronto, Ontario, December 2012. Available on thetargeting.” Bank of International Settlements (BIS) website: www.bis.org9 For more details on the different programmes associated with OMT, see d’Arvisenet P. (2012) “The European debt crisis: the federal imperative”, Conjoncture BNP Paribas, n°10, October 2012, pp. 23-25.10 Ibid, pp 12-13. The impact of the two quantitative easing programmes on long-term rates was about 20-35bp for the first and 0

roughly 10bp for the second. 11 Friedman M. & Schwartz A.J. (1971) “A Monetary History of the United States, 1867-1960,” Princeton University Press.

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ISSN 0224-3288 – Copyright BNP Paribas