3D economics – the confines of monetary & fiscal policy

This post discusses why monetary and fiscal policy require certain economic conditions to be present if they are to be successful in raising real GDP.  In this article I explain the interaction of monetary and fiscal policy inside an aggregate economy framework which can be visualised in 3 dimensions. This 3D shape morphs over time and its shape is very much influenced by 'demand-side' government and central bank policy. I will however hopefully explain how it is 'supply-side' economics which is, at this present time, more important than the demand-side.

Money and debt

First, a short explainer on money and debt since it is important to understand how the expansion of money and credit in the economy does not necessarily create demand. In this section we discuss the 'money supply' which acts as potential demand in the economy.  This is 'demand-side' economics.

Let's run through some examples of the creation of debt to see what impact each has on demand.

If my son borrows £10 from me, this does not increase the money supply but it may lead to an increase in current demand versus saving. Since no new money has been created (unfortunately it's not within my powers to create money), only a transfer of assets, the money supply remains constant. If I was going to spend the £10, it does not increase demand in the economy since my son spends the money but I need to defer my spending of that £10 until it is returned to me. If however, I had the £10 saved then this new loan increased demand. The £10 is removed from savings and used to fund current consumption.

If the government borrows £1bn this does not, of itself, increase the money supply but it may lead to an increase in current demand versus saving. For exactly the same reason as above, government spending and borrowing may, or may not, lead to increased demand in the economy.  If no new money is being created and investors would otherwise finance private projects, government borrowing is simply redirecting demand away from other projects which themselves are creating demand. In this scenario, governments should ensure their projects are more productive (or have other positive external social benefits) than those projects which it displaces.

When central banks create money on their balance sheet and use this money to buy government debt (or other securities) it is an increase in the money supply but does not of itself translate to demand in the economy. The central bank buying government debt from primary dealers is merely a transfer of cash from the central banks balance sheet to the dealers (with securities moving the other way).  Regardless of which institution held the government securities and sold via the primary dealer, the exchange of assets does not create demand in the economy.  Only if the objective of the sale to the central banks was to raise cash to spend in the economy would this facilitate demand.

When a commercial bank advances a loan to a customer to finance a purchase of goods or services, this both increases the money supply and adds to demand in the economy. It is the interaction of a 'want' by the customer to spend that money and the ability of the bank to add newly created money to its ledgers which creates new demand in the economy.

Unfortunately this does not however necessarily add to real GDP (i.e. output). This requires a further condition to be present, the willingness and ability to increase supply of goods and services to meet that demand.  This is the 'supply-side' of the economy.

 

The money supply and the value of fiat

We've seen then that the money supply (MS) is either retained in savings or spent in the economy. If the current level of activity in the economy were zero then all money would be held in savings.  If however nominal GDP in the current year was x and money changed hands on average y times during the year, the money supply required to generate such demand would be x/y.  The remaining amount would again be placed within savings.  An interesting corollary here is that a higher velocity of money, ceteris paribus, will allow a higher level of savings since less money is required to finance current economic activity.

An increase in the amount of fiat in circulation leads to a reduction in the value of that fiat against everything else which remains constant.  Under recent rounds of quantitative easing (QE), the velocity of money did not collapse as some have suggested but rather the money 'supplied' to the current output of the economy did not rise; it was placed into savings.  This is why prices (in fiat terms) have not changed by any material amount in the current economy but prices have risen markedly (in fiat terms) in the deferred or savings economy.

To understand the impact on prices, it is important therefore to appreciate where the change in the money supply is felt.

 

The 3D macro-economic framework

The following first image is a representation of the size economy; both current nominal GDP and savings.  The volume represents the money supply (MS).  If money is not spent in the current economy, it is saved; this is an axiom.  Savings do not necessarily represent future demand (and hence future economic benefits) but rather they represent the value placed on deferred demand. The price of stocks (and other savings and investment products) is an interaction of supply and demand. If savings products were fairly priced based on discounted future economic benefits, then the value of savings would represent future demand.

There is no reason to expand the money supply to support savings and future demand. Central banks should be aware of their role in increasing asset prices above fair value since once these savings are released, it may unleash a tidal wave of spending into the current economy and if there is a lack of excess capacity, this will lead to a significant increase in the price level.

In the image, the money supply required to facilitate current demand or nominal GDP is presented by the area GFAO.  The higher the velocity of money, the smaller this area can be for a given level of nominal GDP.  If there were no savings, then all the money supply would be used in the current level of GDP and there would be no depth; vector y would be zero.  If MS finds its way into financial assets, this reduces the amount available for current demand.

Additionally, the higher the price level z, the lower output will be for a given level of nominal GDP.  For a given level of MS and velocity in the current economy, lowering prices adds to output and creates employment provided the right supply-side circumstances are in existence.  This is quite logical since, lower prices allow wages to go further.  Provided that money is spent and not saved (i.e. velocity does not fall) output will increase ensuring profits are maintained.

This second image is the same but considers change over time and hence considers real GDP growth, general inflation and asset price inflation.  The relationships remain the same.

 

The consumer and supply-side economics

Whilst increasing the money supply increases the volume of the shape, it can lead to either higher financial asset prices, higher general prices or higher output. Where it leads depends on many factors.

Most governments and central banks are focused on increasing employment with stable inflation. Personally, I would argue for stable prices (zero inflation) rather than the arbitrary 2% inflation level since I do not believe inflation stimulates economic activity.

In order to increase output and employment, for a given price level, the conditions require the money supply to be spent on the current rather than the deferred economy (savings). But not only must consumers want to spend rather than save, for output and employment to increase, suppliers must want to meet that increased demand rather than raise prices.  As with all decisions, this is a question of relative costs and benefits.

For the consumer, if they have unsatisfied wants and are not constrained financially, they still must perceive current spending to be relatively more attractive than saving.  This decision is strongly influenced by expectations of future income from both employment and savings.  Better employment prospects and lower savings prospects should both lead to greater current spending and demand in the economy.  The large increase in property prices has locked billions into 'savings' which could have been used for current demand.  Successive governments are at fault here for 'buying votes' by artificially supporting house prices at the expense of creating employment.

In order for a supplier to increase output, they need to increase capital spending or raise employment. Both require the supplier to increase financial risk.  If the supplier believes increased demand to be permanent, they will be more willing to take on this risk.  However, not only does the supplier need to take on the risk, but there also must be resources available in the economy to meet this investment demand.  This will depend on the current state of the economy.

 

Monetary policy and the current economic state

In terms of the 3D framework, changes in interest rates do not necessarily change the money supply and hence the volume or size of the economy.  Only if lower interest rates stimulate demand for loans, do lower rates lead to an increase in the money supply.  We've seen above that this is influenced by the relative merits of current spending versus saving.   Lowering interest rates to increase demand for loans and demand in the economy will have greatest impact when consumers have the financial capacity and confidence to take on those loans and interest costs.

Reducing interest rates from 15% to 10% has a dramatic impact on the interest burden and hence willingness to take on new debt.  Reducing rates from 2% to 1%, less so.  Indeed in the late 70s when rates were above 15% and into the early 80s when unemployment was above 10% in the US (see below), it made sense to cut rates since there was ample excess capacity ready to be employed given the right demand conditions.

If the conditions are not favourable to consumers and businesses taking on new debt, cutting interest rates will only reduce the interest outstanding as it become easier to pay off. If new loans are not taken out, the money supply will shrink.  This is a surprising inference, cutting interest rates may lead to reduced employment if there is a lack of confidence in future employment prospects.

The current conditions of low interests rates does not allow for significant rate cuts which would impact demand.  Post Covid there are however significant labour resources which could be brought back into employment; indeed are being brought back.

The current central bank policy of more QE will add to the money supply but will not create employment since it does not act on the current economy.  In order for nominal GDP to expand, either the money supply retained in savings needs to be released or the money supply as a whole needs to expand. However, for real GDP to expand, the latter requires consumers and business to play their part. Demand without increasing supply will cause current prices to rise and supply without demand causes prices to fall, neither leads to increased employment.

 

Raising interest rates 

An increase in interest rates is feared by not just the bond market but also all other asset classes since higher yields makes all assets less attractive on a relative basis to bonds.  Raising rates at this time then seems illogical since it would reduce asset prices and lead to reduced demand; or so the argument goes.

Using the 3D model framework, an increase in rates does not immediately impact on the money supply. The impact depends on the demand for loans. Since the price of loans is rising, logic would suggest that demand falls. This would reduce the money supply to the current economy.  However, an expectation of rising rates and yields along the investment horizon would lead to an expectation of lower asset prices and potential capital losses. Investors may well sell their savings products to avoid losses if they perceive the central bank is on course to continue to raise rates. Only variable-rate cash products would maintain their value. If demand for such products was significant, prices could rise to such an extent that the yield made current consumption a more attractive option.

If the central bank were to pursue a policy of raising rates, the demand for loans would fall and the demand for short-term cash products would rise. The net impact would unlikely be a materially positive one for current demand and employment. Not only would there need to be a leak from savings to current demand but also suppliers would need to believe they would benefit from investing and increasing supply; else the result would simply be a significant rise in prices.

 

Inferences for government and central bank policy

Governments and central bankers need to work together to co-ordinate monetary and fiscal policy.  Government needs to create long-term opportunities for employment and therefore create the conditions which give consumers confidence to raise aggregate demand.  This is done through education, training and technology and not providing subsidies to the housing industry or reducing taxes.

At the same time, employers need the availability of skilled resources to employ and confidence that the government will provide a stable economy; i.e. not attempt to influence economic activity.  Only when those conditions are in place should central banks see an opportunity to use monetary policy.

If it is not possible to increase the 'supply-side' of the economy, central banks should know that increasing the money supply only creates asset price inflation and future general inflation once the demand conditions are favourable.

 

What the government and central banks should do

Firstly central banks should stop targeting 2% inflation since it reduces real incomes and wealth. Zero inflation should be the target; i.e. stable prices. Secondly, central banks should not conduct QE through the secondary market but rather buy government debt directly to avoid raising asset prices. They should only buy debt which is identified as financing education, training and investment in industries identified as offering high current or potential productive opportunities. Governments should finance social spending through current taxation.  Unelected central bankers should not be part of this value judgement.

National capital investment accounts should also be developed giving voters and workers a say in the governance of both their democracy and workplace.  I expect blockchain technology will play a part in the governance of our future.