MMT meets Rey’s dilemma: a balance sheet view of capital flight (coming soon to an EM country near you)

Recently, a colleague emailed with the following set of questions: ‘a balance sheet approach to defending currencies. Do you know literature that explains in detail the globally interlocking balance sheets between central banks, commercial banks and what happens when a national government has to defend its currency? What is the role of national and foreign reserves and how do they travel these balance sheets in the process of trying to defend a currency? I came back to this question when discussing the Swedish fight to defend the Dollar-pegged Krona in the early 90s and the promise of MMT? Most particularly we wondered to what extent national governments can just issue Krona and use them to buy foreign reserves or what sets the limits exactly to this attempt?’

My MMT friends do have answers to these questions (and they do spend a lot of time defending MMT from critiques that it doesnt consider balance of payment constraints to monetary sovereignty). I thought I would answer these questions a la Minsky, with balance sheets, since that’s how I teach my undegrad students about exchange rate management in emerging/developing countries. I teach by setting those questions within the broader conversations about global liquidity, global financial cycles and Rey’s dilemma – independent monetary policy is only possible if countries manage capital flows (capital controls).

  1. Start with an economy in autarchy: central bank issues reserves to banking sector for settlement purposes (banks pay each other in reserves), banks lend, create bank deposits in the process.

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2a. Commercial bank borrows abroad from parent bank/interbank market (USD/EUR/JPY)

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(this scenario played out in Eastern Europe before Lehman, when foreign-owned banks would borrow from parent/interbank markets – ending up with the Vienna Initiative)

2.b Commercial bank funding via fx swap with non-residents

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Step 1 occurs where local banks are allowed to lend retail in foreign currency. If it looks like MMT 2.0, it is not exactly that – without legal restrictions, the only constraint on banks creating foreign money (eurodollars) is their foreign currency reserves (an exogenous money story a la monetarism).

Even with restrictions on the lending in foreign currency (skipping steps 1&2), banks typically intermediate non-resident demand for local currency bonds via fx swaps (see my paper here on growing appetite for EM securities as part of shadow banking reform agenda). This is big enough that BIS has recently proposed to approach fx swaps as missing debt. Note that this is a global liquidity story:  without capital controls, non-resident demand/bank borrowing abroad reflects funding conditions in US money markets (see Bruno and Shin’s risk taking channel of monetary policy).

3. Rey’s dilemma kicks in: central bank intervenes to stem currency appreciation (for mercantilist or macroprudential reasons)

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For this commercial bank, the central bank’s policy rate is no longer a binding constraint, since it obtains local base money (reserves) by selling its fx liquidity to the central bank, rather than in the local interbank money market. When interest rate differentials are significant, this eases cost of funding (in the macro literature, this is part of the debate on the effect of financial globalisation on the effectiveness of inflation targeting central banks).  It’s global liquidity, not domestic liquidity, that determines short-term money market rates.

4. To regain monetary control, central banks issue own debt.

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This operation is known as sterilisation: that is, ‘sterilising’ the impact of fx market interventions on domestic money market rates. Central bank issues own securities (or sells government bonds, or takes deposits) in order to absorb back the reserves it created when it paid for the fx liquidity it bought from banks. Note here that this does not solve Rey’s dilemma, since banks have full discretion over how much to place in central bank securities. Rather, for banks this is an attractive carry – borrowing cheap abroad, placing it in risk-free local securities (banks can hedge fx risk).

If you think this is a theoretical exercise, think again.

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5. The limits to monetary sovereignty: global liquidity conditions tighten, capital flight ensues.

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In step 1, non-residents sell local securities – potentially triggering liquidity spirals if large, unregulated local repo market exists.  Note that by step 5, local banks with no direct links to global finance also start to suffer as interbank liquidity tightens. Cant the central bank mitigate this by reverse sterilisations, that is, by again insulating fx market interventions from domestic money market dynamics? The lessons from the 1997 Asian crisis, according to the IMF, is to segment domestic money markets, that is, to prevent local banks from lending to (non-resident) speculators:

Because a speculative attack requires the establishment of a net short position in the domestic currency, countries have employed a number of tactics to raise the costs of short positions. When sterilized intervention fails to stem capital outflows, short-term interest rates are allowed to rise, tightening conditions in financial markets and making it more costly for speculators to obtain a net short position by borrowing domestic currency. Frequently, however, an increase in short-term money market rates is transmitted quickly to the rest of the economy; it may therefore be difficult to sustain for an extended period, especially if there are weaknesses in either the financial system or the nonfinancial sector. When high short-term interest rates impose an unacceptable burden on domestic residents, countries may “split” the markets for domestic currency by requesting that domestic financial institutions not lend to speculators. Foreign exchange transactions associated with trade flows, foreign direct investment, and equity investments are usually excluded from such restrictions. In essence, a two-tier system is created that prevents speculators from getting domestic credit while allowing nonspeculative domestic credit demand to be satisfied at normal market rates. (IMF 1997)

Even if the central bank successfully protects local banks  from cross-border volatility triggered by global financial cycles, it can only defend the currency to the extent that it has foreign reserves. It will most likely not wait until it runs out. In the happy scenario, it draws on its swap lines to weather capital flight – but few central banks have that luxury (and ask yourself, how many will actually have it when Donald Trump needs to be consulted on this). The worst case scenario:  IMF/Troika/whoever will lend  – with heavy conditionality.


2015: Private Debt and the UK Housing Market

This report is taken from the EREP’s Review of the UK Economy in 2015.

In his 2015 Autumn Statement, Chancellor George Osborne gave a bravura performance. He congratulated himself on record growth and employment, falling public debt, surging business investment and a narrowing trade deficit. He announced projections of continuous growth and falling public debt over the next parliament.

While much of this was a straightforward misrepresentation of the facts – capital investment has yet to recover from the 2008 crisis and the current account deficit continues to widen – other sound bites came courtesy of the Office for Budget Responsibility. The OBR delivered the Chancellor an early Christmas present in the form of a set of revised projections showing better-than-expected public finances over the next five years.

When, previously, the OBR inconveniently delivered negative revisions, the Chancellor responded by pushing back the date he claims he will achieve a budget surplus. In response to the OBR’s gift, however, he chose instead to spend the windfall.  This is a risky strategy because any negative shock to the economy means he will miss his current fiscal targets – targets he has already missed repeatedly since coming to office.

As it turns out, these negative shocks have materialised rather quickly. Since the Chancellor made his statement a month ago, UK GDP growth has been revised down, the trade deficit has widened and estimates of borrowing for the current year have increased.


In reality, the OBR projections never looked plausible. The UK’s current account deficit – the amount borrowed each year from the rest of the world – is at an all- time high of around 5% of GDP. Every six months for the last three years, the OBR forecast that the deficit would start to close within a year; every time they were proved wrong (see figure above).  Their current assertion – that the trend will be broken in 2016 and the deficit will steadily narrow to around 2% of GDP in 2020 – must be taken with a large pinch of salt.

The current account deficit measures the combined overseas borrowing of the UK public and private sectors. In the unlikely event that George Osborne was to achieve his stated aim of a budget surplus, the whole of this foreign borrowing would be accounted for by the private sector. This is exactly what the OBR is projecting. Specifically, they predict that the household sector will run a deficit of around 2% per year for the next five years. They note that “this persistent and relatively large household deficit would be unprecedented”.

This projection has been the basis of recent stories in the press which have declared that the Chancellor has set the economy on a path to almost-certain financial meltdown within the current parliament. This is too simplistic an analysis. Financial imbalances can persist for a long time. The last UK financial crisis originated not in the UK lending markets but in UK banks’ exposure to overseas lending.

But the Chancellor’s strategy entails serious financial risks. Even though there is no real chance of achieving a surplus by 2020, further cuts to government spending will squeeze spending out of the economy, placing ever more of the burden on household consumption spending to maintain growth.

The figure below shows the annual growth in lending to households. While total credit growth remains subdued, unsecured lending has, in the words of Andy Haldane, chief economist at the Bank of England, been “picking up at a rate of knots”.


Moderate growth in the mortgage market may conceal deeper problems: household debt-to-income ratios have fallen since the crisis but, at around 140% of GDP, remain high both in historical terms and compared to other advanced nations. The majority of new mortgage lending since 2008 has been extended to buy-to-let landlords. These speculative buyers now face the prospect of rising interest rates and tax changes that will take a large chunk out of their property income. Many non-buy-to-let borrowers are badly exposed: a sixth of mortgage debt is held by those who have less than £200 a month left after spending on essentials.

The Financial Policy Committee has noted that these trends “… could pose direct risks to the resilience of the UK banking system, and indirect risks via its impact on economic stability”.

What is often left out of the more apocalyptic visions of a coming credit meltdown is that underlying all this is an unprecedented housing crisis in which an entire generation are locked out of home ownership. Instead of tackling this crisis, Osborne is using the housing market as a casino in the hope of keeping economic growth on track during another five years of austerity. It is a high-risk strategy. His luck may soon run out.

The report’s authors include:

John Weeks on fiscal policy

Ann Pettifor on monetary policy

Richard Murphy on taxation

Özlem Onaran on inequality and wage stagnation

Jeremy Smith on labour productivity

Andrew Simms on climate change and energy

Jo Michell on private debt

The full report is can be downloaded here.

Information on EREP is available here.

Corbyn and the Peoples’ Bank of England

Jeremy Corbyn’s proposal for ‘Peoples’ Quantitative Easing’ – public investment paid for using money printed by the Bank of England – has provoked criticism, including an intervention by Labour’s shadow Chancellor Chris Leslie. It seems the anti-Corbyn wing of the Labour party has finally decided to engage with Corbyn’s policy agenda after several weeks of simply dismissing him out of hand.

Critics of the plan make two main points: that the policy will be inflationary and that it dissolves the boundary between fiscal policy and monetary policy. It would therefore, they claim, fatally undermine the independence of the Bank of England.

The first point is inevitably followed by the observation that inflation and the policy response to inflation – interest rate hikes and recession – hurts the poor. As ever, the first line of attack on economic policies proposed by the left is to claim they will hurt the very people they aim to help. Leslie falls back on the old trope that the state must `live within its means’. It is well-known that this government-as-household analogy is nonsense. But what of the monetary argument?

Inflation is not caused by printing money per se. It is instead the result of a combination of factors: wage increases, supply not keeping pace with demand, and shortages of commodities, many of which are imported.

By these measures, inflationary pressure is currently low – official CPI is around zero. Since this measure tends to over-estimate true inflation, the UK is probably in deflation. There is finally evidence of rising wages – but this comes after both a sharp drop in wages due to the financial crisis and an extended period in which wages have grown at a slower rate than output. The pound is strong, reducing price pressure from imports.

More importantly, the purpose of investment is to increase productive capacity and raise labour productivity. Discussion of monetary policy usually revolves around the ‘output gap’ – the difference between the demand for goods and services and the potential supply. Putting to one side the problems with this immeasurable metric, the point is that investment spending increases potential output as well as stimulating demand, so the medium-run effect on the output gap cannot be determined a priori.

The issue of central bank independence is more subtle – certainly more subtle than the binary choice presented by Corbyn’s critics. That central banks should be free from the malign influence of democratically elected policy-makers has been an article of faith since 1997 when the Labour government granted the Bank of England operational independence. But, as Frances Coppola has argued, central bank independence is an illusion. The Bank’s mandate and inflation target are set by the government. In extremis, the government can choose to revoke ‘independence’.

More relevant to the current debate is the fact that the post-crisis period has already seen significant blurring of the distinction between monetary and fiscal policy. In using its balance sheet to purchase £375bn of securities – mostly government bonds – the Bank of England has, to all intents and purposes, funded the government deficit. The assertion that the barrier is maintained by allowing debt to be purchased only in the secondary market is sleight of hand: while the government was selling new bonds to private financial institutions the Bank was simultanously buying previously issued government bonds from much the same financial institutions.

At this point, critics will object that the Bank was operating within its mandate: QE was enacted in an attempt to hit the inflation target. This is most likely true, although during the inflation spike in 2011, there were suggestions the Bank was deliberately under-forecasting inflation in order to be able to run looser policy; as it turned out, the Banks’ forecasts over-estimated inflation.

None of this alters the fact that quantitative easing both increases the ability of the government to finance deficit spending and has distributional consequences; QE reduced the interest rate on government bonds while increasing the wealth of the already wealthy. Crucially, there won’t be a return to ‘conventional’ monetary policy any time soon. At a panel discussion at the FT’s Alphaville conference on ‘Central Banking After the Crisis’ featuring George Magnus and Claudio Borio among others, there was consensus that we have entered a new era in which the distinction between monetary and fiscal policy holds little relevance; there will be no return to the ‘haven of familiar monetary practice‘ in which steering of short-term interest rates is the primary mechanism of macroeconomic control.

The issue which has triggered this debate is the long-term decline in UK capital expenditure – both public and private. An increase in investment is desperately needed. Corbyn isn’t the first to suggest ‘QE for the people’ – a number of respectable economic commentators have recently called for such measures in letters to the Financial Times and Guardian. Martin Wolf, chief economics commentator at the FT, recently argued that ‘the case for using the state’s power to create credit and money in support of public spending is strong’. Former Chairman of the Financial Services Authority, Adair Turner, has made similar proposals.

I agree, however, with the view that it makes more sense to fund public investment the old-fashioned way – using bonds issued by the Treasury. Where I disagree with Corbyn’s critics is on the sanctity of `independent’ monetary policy; the Bank should stand ready to ensure that these bonds can be issued at an affordable rate of interest.

Why has Corbyn – supposedly a throwback to the 1980s – proposed this new-fangled monetary mechanism? Rather than some sort of populist gesture, I suspect this reflects a status quo which has elevated the status of monetary policy while downgrading fiscal policy. This, in turn, reflects the belief that the government can’t be trusted to make decisions about the direction of the economy; only the private sector has the correct incentive structures in place to guide us to an optimal equilibrium. Monetary policy is the macroeconomic tool of choice because it respects the primacy of the market.

Given that the boundary between fiscal and monetary policy has broken down at least semi-permanently, that status quo no longer holds. It is now time for a serious discussion about the correct approach to macroeconomic stabilisation, the state’s role in directing and financing investment and the distributional implications of monetary policy. It is to Corbyn’s credit that these issues are at last being debated.


Monbiot’s misguided monetary reforms

Joseph Schumpeter observed that “a sharply-defined type of social reform monomaniac sees money, its reform or abolition, as a social panacea”. These words came to mind while reading George Monbiot’s suggestion that alternative monetary arrangements hold the potential to transform Greece and release it from its current state of purgatory. Monbiot attributes ultimate responsibility for the unfolding Greek tragedy not to the Northern European states that have forced self-defeating austerity upon Greece, but to the “private banks” that have used European state institutions as their “intermediaries”.

While true that policy has been characterised by bailouts for the banks and austerity for the public it is plainly wrong to suggest that private banks are the ultimate puppet-masters driving European policy. Nonetheless, Monbiot suggests that the usurious grip of the bankers can be broken by introducing alternative monetary arrangements.

He highlights debates around the recently resurrected Chicago Plan which, in the 1930s, proposed that banks be forced to back all customer deposits with government-issued money. In so doing, banks would be deprived of their power to create money “out of thin air” and control of the money supply would be returned to its rightful owner – the state. Monbiot wrongly attributes the proposal to Martin Wolf of the Financial Times who is a recent convert to the plan following the lobbying of the campaign group Positive Money.

Monbiot goes on to claim that introduction of the plan would generate billions of pounds in government revenues. This mistakenly implies that the capability of private banks to create money somehow rules out the possibility of governments financing spending directly by paying for it with newly printed money. In fact, nothing about the current system prevents central banks from directly financing government spending. The obstacles that exist are legal barriers, erected to prevent government abuse of the power. Legal barriers are not irrevocable. Adair Turner has recently argued that such constraints should be relaxed in the UK, allowing a portion of the post-crisis quantitative easing to become permanent. What this amounts to is free money for the government produced at the printing press. Nothing about such public money printing requires that private banks be stripped of the capacity to also produce money.

Monbiot asserts that bank money creation somehow lies behind problems of environmental degradation. This is a dangerously confused point – albeit one which is made with increasing regularity. This view appears to rely on the false assertion that lending at interest by banks imposes an inescapable need for exponential growth in order to service the resulting debts.

Monbiot then presents his proposal for the salvation of Greece. Local currencies should be issued in combination with the “thrilling, transformative system that almost saved Europe from fascism … called stamp scrip”. In support of local currencies Monbiot uses the example of the Bristol Pound. His support of stamp scrip is based on the experience of towns in Austria and Germany in the aftermath of the hyperinflation of the 1920s.

Stamp scrip works by requiring currency to be stamped monthly at a price equal to a proportion of the face value of the note. This causes the value of the currency to degrade with time. Much the same effect could be engineered by imposing negative interest rates on bank deposits – or by raising inflation to a high enough level.

The point of such an approach is to prevent people from hoarding cash – to force them to spend their incomes. The problem in Greece is not that people are receiving income they do not spend. It is that their incomes have shrunk so much that they can no longer afford basic necessities. The poorest in Greece are accumulating debts, not hoarding. While there is a problem of hoarding, this excess saving is taking place in Germany, not Greece.

What about local currencies? Greece is currently locked in a showdown with the Troika which has two possible outcomes – either significant compromises are made by one or both sides or Greece leaves the euro. While the reinstated drachma might count as a new “local currency” it is not, I suspect, what Monbiot has in mind.

So what does he have in mind? The example he uses, the Bristol Pound, is trusted – and therefore stable in value – because it is 100% backed by sterling deposits. For every Bristol Pound in circulation a Bank of England pound is held on deposit at the Bristol Credit Union – a similar arrangement allows Scottish banks to issues their own notes. It is only the explicit backing of the British state which gives the Bristol Pound its value.

Such parallel currencies are feasible precisely because they do not threaten to undermine state-issued national currency: Bristol Council cannot fund itself by issuing Bristol Pounds. The same would not be true of Greece. The introduction of any parallel currency which wasn’t fully backed by euro balances with the ECB would amount to de facto suspension of the euro. This would almost certainly be a one-way ticket: if the currency was a success, why go back to the euro? If a failure, what are the chances of Greece being invited back?

This type of scrip currency arrangement is proposed by Flassbeck and Lapavitsas in their blueprint for Greek euro exit – they advocate the temporary introduction of state IOUs to augment the euros that would remain within the country if Greek exit become a reality. But such issuance would require both capital controls to prevent outflow of the remaining euros and a credible state guarantee that such IOUs would be redeemed. The proposal is intended only as a short-run stopgap while a new currency is prepared. Any attempt to impose such a system permanently without writing off debts to official creditors – it is these official creditors, rather than private banks, that the bailout aims to protect – would rapidly lead to a foreign exchange crisis as euros were used to service debts denominated in what would be essentially a foreign currency.

Monbiot is wrong about this being a showdown between the public and the banks. The current situation in Europe is a confrontation between states – and one in which there exists a massive imbalance of power between the protagonists. Whichever side prevails, the state – either the Greek state or the German state – will remain the dominant force in shaping society for the foreseeable future. No amount of monetary tinkering will change this.

[Edited: A shorter version appeared as a letter in the Guardian]

Jo Michell