Tuesday, February 11, 2014

ECB could use VAT Credits to customize monetary policy for each member country.

I had a very interesting discussion with Frances Coppola, an editor at econ publication Her original post deals with incentives and efficiency in the public sector.  In the comment section, the discussion moved to the idea of giving central banks control over short-run fiscal deficits and surpluses.  I lay out the philosophical argument for such hybrid approach to government intervention here.  Frances Coppola enriched the conversation by pointing to the lack of democratic controls over unelected technocrats at central banks.  As I was describing how the hybrid approach could be implemented in Europe through VAT, I realized that combining fiscal and monetary tools could also enable the ECB to customize monetary policy based on the specific circumstances in each member country.  Currently euro-zone countries are subjected to one-fits-all monetary policy, which does not take into account the needs of either the debt-laden periphery or the savings-rich north.  Here is the relevant part of discussion:

The private sector can be just as inefficient as the public sector. But there is a significant difference - in the private sector bad investments have to be recognized and the associated financial claims liquidated. In the public sector losses due to wasteful use of resources are never recognized, nor are the respective financial claims ever liquidated. If the government borrows or prints $2 billion to build a bridge to nowhere, the productive capacity of the economy is not improved in any way; however, the $2 billion financial claim persists in perpetuity (unless, of course, the government ran a $2 billion surplus in order to liquidate such claim). As a result, persistent fiscal deficits tend to inflate financial claims and suppress productive capacity. Basically, bad government programs co-exist with good ones thus giving the public sector a reputation for inefficiency. Here's more on the core problems with the public sector and respective solutions

Oh right. So you would eliminate the discipline of the public vote and replace it with the discipline of unelected technocrats, leaving elected politicians with no real purpose other than to preserve the illusion of democratic government - which would no longer exist. Good grief.

H. Publius9 February 2014 03:07 I think you misunderstand me. I have no problem with the public sector as long as government programs are paid for. In addition to the discipline of the public vote, I want to add the discipline of a balanced budget. The decision whether to run fiscal deficits or surpluses is strictly a monetary one (deficits increase money supply and surpluses reduce it) and as such it should be controlled by central banks. More importantly, by controlling fiscal deficits central banks will no longer be constrained by the lower zero bound. By lowering sales taxes into negative territory and increasing investment credits, they can easily replicate conditions similar to negative interest rates.
Also, let's not forget it was elected politicians in the US that racked up $17T in debt. Have those resources been used wisely? Have we received $17T worth of value + interest? The fact of the matter is that the budgetary process is entirely political in nature. Unlike central banks, which measure their actions against objective yardsticks such as price stability and full employment, politicians respond to partisanship and pressures by vested interests and narrow constituencies. Deficit spending is the crack-cocaine of politics. When times are good, it is all too easy to lavish constituents with government spending without imposing the costs of higher taxation - think two wars, a medical prescription drug benefit and large tax cuts all charged to the nation's credit card during the go-go days of the housing bubble. When times are bad, bashing government deficits and preaching the virtues of austerity is the tried-and-true playbook for gaining political leverage - think the rise of the tea party, multiple threats of default over the debt ceiling and insufficient fiscal stimulus to power a real recovery.
On the other hand, if government programs could no longer be financed with debt, all vested interests will be brought into the budget process including those who will bear the costs. Such representation is the key to limiting political corruption and fostering a competitive and free market place.

No, I do not misunderstand you. You wish to remove government financing from democratic control, and force governments to run balanced budgets at all times irrespective of economic conditions. I do not agree with this - in fact I think we have already gone far too far with dilution of democratic control by placing monetary policy decisions under the control of unelected technocrats. But to lose democratic control of tax policy? Absolutely not. No way should unelected officials have the right to decide on the level of sales taxes - or any other sort of taxes, for that matter. They must be accountable to the electorate who will pay those taxes. Yes, taxes can be used as monetary policy instruments - indeed I have suggested that myself. But they must remain under democratic control.

H. Publius 9 February 2014 10:12

You make good points, and I do agree with you that checks and balances need to be in place. For example, the elected body can set the maximum level of taxation with the central bank only having authority to lower the tax but not increase it above the cap, which limits the amount of surplus central banks can run at any one time. On the deficit side, the debt ceiling in the US is currently an exercise in tautology - the money has already been appropriated and often-times spent by Congress. Under the proposed regime, the debt ceiling gives the elected body ultimate control over cumulative deficits and the maximum amount of money creation the Fed can engage in. Furthermore, in the US the President and Congress have control over Fed appointments, so it's not like the Fed is unaccountable.

The fundamental issue, though, remains the same. Government debt is nothing more than a tool for money creation, and as such it should be controlled by central banks.

Such regime will be even more beneficial to Europe (even though, the ECB may have to be reformed to ensure that appropriate checks-and-balances exist). One of the problems with the Euro is that it enforces one-fits-all monetary policy to a continent that is still defined by national, cultural and economic borders. However, if the ECB controlled a VAT credit, it could fine-tune policy by region. Back in the boom days when German savings were flooding the periphery, the ECB could increase [interest] rates to prevent overheating in Spain while funding a VAT credit in Germany to spur domestic consumption and absorb excess savings - in effect replicating conditions associated with lower rates for Germany only. Today, when monetary conditions in the periphery are severely constrained by a shortage of money and the lower zero bound, the VAT credit will go to Spain, Italy and Greece providing a much needed infusion of newly-printed euros.

If there was ever a hope for a joint EU fiscal authority and eurobonds, it's got to be through the technocratic mandate of the ECB.  There is way too much national mistrust right now plus Germany is dead-set against any debt monetization scheme.  However, if the fiscal authority is within the strictly-defined mandate of the ECB to manage the money supply with no spending capacity attached, I think it has a chance of gaining support.  Here is how it can work.

National governments set the VAT level at let's say 20%.  The ECB commits to funding the respective government at 17%.  In normal times, the ECB can set the VAT Credit at 3% with no impact on the money supply in the respective country.  The effective VAT is 17% and the national government receives all VAT proceeds.  However, suppose that Spain is in a recession calling for loose monetary policy; however, Germany is at full capacity calling for a tighter monetary policy.  The ECB could set rates to respond to German conditions, but increase the VAT credit from 3% to 10% in Spain to mitigate the impact of tighter policy there.  The effective VAT in Spain is now 10%, however, the ECB covers the revenue shortfall of 7% by issuing Eurobonds.  A mechanism similar to the debt ceiling could control the maximum Eurobond issuance.

The VAT credit could be even more powerful at the lower zero bound where the effectiveness of monetary policy is greatly diminished.  The ECB could increase the size of the credit such that the effective VAT is negative thus creating conditions consistent with negative interest rates.  Basically, central banks would be in a position to expand the money supply through monetary flows in the real economy rather than newly printed money balances that people can simply turn around and stuff in their mattresses or bank accounts.  I discuss at length here why negative taxes on consumption and investments credits are much more preferable at the lower zero bound than actually charging negative interest rates or even eliminating paper money as has been suggested by some. 

I strongly believe that granting short-term fiscal tools to central banks merits further consideration.  Such proposition creates all sorts of possibilities for central banks including the ability to customize monetary policy by region as in the case of the ECB as well as more broadly, providing central banks with new tools to operate at the lower zero bound.

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