Monday, November 30, 2015

Money Demand Targeting and the Eurozone

My work on time preferences revealed money as the systemic source of economic fluctuations, inflation as well as asset booms and busts.  Based on these findings, I develop several policy recommendations I refer to as Money Demand Targeting.  In this post, I will discuss the particular benefits Money Demand Targeting brings to the Eurozone.  Such proposal can restore growth to the Continent by eliminating the ZLB constraint to monetary policy.  The ECB will reap further benefit by being in position to customize monetary policy to the specific conditions in each member-state.  This proposal can also substitute for Eurozone fiscal union without being predicated on further political integration, fiscal transfers and loss-sharing between member-states.  Last but not least, it can help sever the link between the Euro and overly-indebted member-states.

From counter-cyclical policy standpoint, neither fiscal nor monetary policy in the Eurozone has capacity to stimulate growth in the short-term.  The lack of growth policies confines the Continent to continued stagnation, high unemployment and unsustainable sovereign debt.  Monetary policy is constrained by ZLB (zero lower bound on interest rates).  At ZLB, quantitative easing by the central bank has little impact on the real economy as agents with negative or zero time preferences[1] are indifferent between holding money or government bonds.  Eurozone fiscal policy is severely constrained by restrictions embedded in the monetary union and unsustainable sovereign debt in the Periphery.  Fiscal union with shock-absorption mechanism is predicated on economic convergence and new institutions for common decision-making[2].  According to the European Commission, this is a medium to long-term prospect.  However, the present lack of shock-absorption mechanism leads to economic divergence.   Furthermore, the sovereign debt crisis in the Periphery has also underscored the significant political barriers to fiscal transfers and public risk-sharing, which are two cornerstones of a fiscal union.

Money Demand Targeting is a new monetary policy regime that can achieve steady economic growth without asset bubbles or inflation.  This new regime relies on four policy pillars - duration-matching by banks, zero inflation target, velocity peg and new tools in the form of temporary consumption and investment tax credits.  Consumption tax credits work like a sales tax in reverse whereby people are paid to consume and invest.  Such tax credits have capacity to raise or lower the time preferences of private agents affording central banks direct control over money demand and by extension, the velocity of money.  The tax credits can be viewed as a form of QE for the People or the proverbial helicopter drop by central banks.  However, the credits are qualitatively better as they strike at the core issues affecting a depressed economy, namely negative time preferences and ever-rising money demand.

Such policy framework can be implemented in the Eurozone through joint committees comprised of the ECB and the National Central Banks (NCBs). Voting power in each committee is to be shared equally between the ECB and the respective NCB ensuring balanced representation of pan-European and member-state interests. The legislature in each member-state will vest the respective committee with authority to set consumption and investment tax credits within its borders. Such authority will also include the capacity to set negative tax credits - in other words, the joint committee will be vested with a limited authority to tax.  This is exactly what counter-cyclical fiscal authority is all about - running deficits in bad times and surpluses in good times. The credits will be funded with a new type of government bond to be issued by the respective member-state with an explicit guarantee by the ECB. Such bonds are to be exempted from the fiscal caps embedded in the monetary union as the proceeds will fund private activity through tax credits as opposed to government spending.  The benefits of this proposal can be described as follows:

1. Immediate boost to growth as monetary policy will no longer be constrained by ZLB

Central banks have limited capacity to respond to negative time preferences by private agents as interest rates cannot be lowered significantly below zero due to the existence of paper money. Such condition results in pro-longed stagnation despite monetary base expansion by the central bank as agents with negative or zero time preferences are indifferent between holding money or government bonds. Temporary consumption tax credits lift the utility gains of current consumption while investment credits increase the expected return on investment. Accordingly, both types of credits can raise the time preferences of private agents.  Armed with such counter-cyclical fiscal authority, central banks will have unlimited capacity to raise negative time preferences back into the positive with an immediate boost to economic activity.   A large consumption tax credit in the savings-rich North combined with investment credits in the low-productivity Periphery can re-energize the stagnant European economy. A return to sustained growth will help solve the sovereign debt crisis in the Periphery without the need for write-offs and loss transfers between member states.

2. Ability to customize monetary policy to the specific conditions in each member-state

One-fits-all monetary policy is a major structural flaw within the Eurozone. Ethnic, language and cultural barriers to labor mobility allow for persistent imbalances caused by the free movement of capital. In the run-up to the crisis, monetary policy was too tight for the stagnating North but too loose for the booming Periphery. Capital flowed to the Periphery fueling housing bubbles and unsustainable consumption. Arguably, one-fits-all monetary policy was the primary reason for the Euro crisis as it facilitated the build-up of unsustainable public and private debts in the Periphery[3]. Consumption and investment tax credits specific to each member-state will enable the ECB to customize monetary policy to local conditions.  In other words, such tax credits can raise or lower time preferences in each member-state such that they match the single interest rate policy by the ECB.

3. Ability to direct foreign capital flows toward productive investment

In the run-up to the crisis, capital flows from the Eurozone core countries such as Germany fueled consumption and housing bubbles in the Periphery[4].  Currently, policy makers do not have control over how such capital flows are being used. By crediting investment and taxing consumption (positive investment tax credit and negative consumption tax credit), the ECB working jointly with the respective National Central Bank can direct capital flows in member-states experiencing trade deficits toward new investment as opposed to unsustainable consumption or housing bubbles. This will put the ECB in position to resolve imbalances and prevent them from occurring in the first place.

4. A substitute for fiscal union not predicated on political integration, fiscal transfers and risk-sharing

Temporary consumption and investment tax credits can stimulate growth and reduce unemployment in the Eurozone. As this framework does not involve fiscal transfers or risk-sharing between member-states, it can be implemented in the short-term without being predicated on further economic convergence and political integration. The Catch 22 of Eurozone politics has been a fiscal union predicated on economic convergence and political integration. The current lack of shock-absorption mechanism fosters divergence and underscores national borders making the prospect of fiscal union remote. The proposed framework offers an alternative that allows for economic diversity of member-states but unity of aspiration toward prosperous, democratic and united Europe. Furthermore, vesting the ECB with such tax-credit authority will facilitate faster convergence by reducing unemployment and mitigating the costs of structural reform and high debt levels in the Periphery.

5. Safe, pan-European asset class severing the link between the Euro and overly-indebted sovereigns

The bedrock of fiat money is a central bank that stands ready to monetize the liabilities of a common fiscal authority thus fulfilling the promise of zero credit risk embedded in fiat money.  However, the Euro works differently as the ECB is strictly prohibited from monetizing the liabilities of member-state governments.  With no explicit procedure for sovereign default contemplated by the monetary union, financial markets correctly anticipated that member-states in financial trouble will be bailed-out.  Bail-outs can preserve the integrity of the Euro, but they come with two pernicious effects.  First, they remove discipline from capital markets allowing for large imbalances to build-up.  Second, bail-outs perpetuate unsustainable debts thus suppressing time preferences in creditor-countries due to the continued prospect of write-offs while preventing recovery in debtor-countries due to the high burden of bad debts.

The government bonds needed to fund the temporary consumption and investment tax credits represent a new asset class explicitly guaranteed by the ECB.  Such bonds can become the bedrock of the Euro and serve the same function in respect to the Euro as the role of US Treasuries in respect to the US Dollar.  Such safe, pan-European asset class along with Eurozone banking union will sever the link between the Euro and overly-indebted sovereigns. A default by a member-state will be no different than a default by one of the fifty states in the US. The prospect of an orderly sovereign default by a member-state will bring discipline back to capital markets and allow for recovery in future debt crises.

From an implementation standpoint, Money Demand Targeting is institutionally simple as it involves coordination only between the ECB and the respective member-state legislature.  It is important to note that the tax-credit authority will never be outside of political control as the member-state legislature will determine the parameters within which the ECB and the NCB can operate.  Such political control should address fears of giving even more power to unelected technocrats at central banks. 

As a final point, Money Demand Targeting holds significant appeal to creditor nations.  Vesting the ECB with tax-credit authority eliminates the risk of uncoordinated action and policy conflict between the monetary and fiscal authorities.  Furthermore, Money Demand Targeting calls for lowering the inflation target to zero, which should appeal to Germany.  Last but not least, the program is distinct for each member-state and fully self-sustained as the tax-credit authority comes with the capacity to levy a sales tax.  In other words, Money Demand Targeting can restore growth to the Continent and improve the sustainability of sovereign debts without the need for fiscal transfers or debt write-offs.

[1] Agents with zero or negative time preferences can be described as people who fear stagnant or declining incomes.

[2] “Completing Europe’s Economic and Monetary Union” Five President’s Report by Jean-Claude Juncker

[3] Fernadez-Villaverde, Garciano, Santos: “Political Credit Cycles: The Case of the Eurozone”; Journal of Economic Perspectives 2013;

[4] Baldwin, Giavazzi: “The Eurozone Crisis: A Consensus View of the Causes and a Few Possible Solutions”; VoxEU September 2015

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