Pieces in the puzzle

Just as the fall of the Berlin Wall in 1989 kick started the wave of globalisation, so the Russian invasion of Ukraine threatens to throw the process into reverse. Whereas its rise was initially a slow process which only seeped into the wider consciousness around the turn of the century, the reversal of globalisation is likely to take the form of a screeching U-turn as the west reassesses its security and economic needs. Whether or not the fighting in Ukraine quickly comes to an end, it is clear that Russia under its current government will remain an untrustworthy geopolitical partner which will require governments to reassess their political alliances. This in turn will have consequences for the shape of the global economy.

Assessing China’s position

The role of China will be particularly fascinating. Prior to 2008 it was hoped that China would align more closely with the west as rising prosperity convinced the government that opening up the economy would be in its best interests. That has proved a forlorn hope. An ever stronger China has continued to plough its own political and economic furrow with ambitions of usurping the US to become the dominant Asian power. It is ultimately likely to achieve that goal one way or another. At issue is the timing and the extent to which this transition occurs peacefully or otherwise.

It was therefore particularly interesting to hear suggestions that Russia has asked China for financial and logistical support for its invasion of Ukraine which further complicate the geopolitical mix. Whether China will agree to do this remains unclear. Last month, Russia and China extended the 2001 Sino-Russian Treaty of Friendship for another five years which commits China to support Russia “in its policies on the issue of defending the national unity and territorial integrity of the Russian Federation.” It also states that “when a situation arises in which one of the contracting parties deems that peace is being threatened and undermined or its security interests are involved or when it is confronted with the threat of aggression, the contracting parties shall immediately hold contacts and consultations in order to eliminate such threats.” Clearly, the ties between the two are very strong although it is questionable whether China expected Russia to launch its invasion which runs counter to its interests.

A particularly interesting article by Hu Wei, vice-chairman of the Public Policy Research Centre of the Counsellor’s Office of the State Council, suggests that China’s alignment with Russia could cause more problems than it solves. The thrust of the text is that if the conflict were to spiral, with NATO becoming involved, Russia cannot win by military means which would raise US influence on the global stage and leave China more isolated. He suggests that “China cannot be tied to Putin and needs to be cut off as soon as possible … Being in the same boat with Putin will impact China should he lose power. Unless Putin can secure victory with China’s backing, a prospect which looks bleak at the moment, China does not have the clout to back Russia.” It is important to stress that this does not reflect government policy and the fact that it was submitted to the Chinese-language edition of the US-China Perception Monitor and translated into English suggests it was designed for a western audience.

The official Chinese position views the world in zero-sum terms: What is good for the US must be bad for China (although the Trump administration was guilty of the same mindset). It does not have to be this way and rather than issuing threats about how the US would react – wielding the big stick would likely prove counterproductive, especially since China is aware of the consequences – a better approach may be to highlight the benefits of the cooperation which China claims to value. Whilst we should not expect China to publicly oppose Russia’s actions, at the UN or elsewhere, it has more potential than any other external force to act as a restraining influence.  

China is also aware that it runs significant reputational risk if it aligns itself with Russia and has more to lose than to gain if the west does decide to loosen economic ties. Moreover, Russia’s actions will cause problems for one of China’s signature economic policies – the Belt and Road Initiative. The BRI is designed to create a land route across central Asia, linking China to consumer markets in western Europe and raw material producers across Europe and Asia. War in eastern Europe will disrupt the supply of commodities to China and elsewhere, particularly in the event of a protracted conflict. It is thus in China’s economic interests that the war in Ukraine is swiftly resolved.

Big questions for Europe

From a European perspective, the western alliance has come together far more quickly and in a more unified fashion than we have seen for many years. The EU’s actions are a reminder that it has its roots in a project designed to ensure that the continent would not revisit the ravages of the first half of the twentieth century – a point that was lost on large parts of the UK electorate during the Brexit referendum. With the spectre of conflict once again at the EU’s border, the nature of the union is likely to change. The commitment to raising defence spending will mean more expansionary fiscal policies across Europe. During the Cold War, European economies routinely spent around 3% of GDP on defence. Recent figures suggest that this has slipped to around 1.5%. In order to boost outlays will mean either higher taxes or an increase in debt issuance (and this is before we discuss the costs of dealing with the refugee crisis).

In addition the rush to diversify away from Russian energy sources will impact on living standards for many years to come as the relative cost of energy remains elevated. This may also have implications for the EU’s green agenda. Whilst there are increased incentives to diversify away from hydrocarbon fuels, it will be difficult to make the sudden switch to renewables. Consequently, many EU countries may be forced to extend the lifetime of coal-fired power stations, rather than using gas as a transition fuel until such times as renewable sources come online.

Across the continent, governments are likely to be far more engaged in economic management than has been the case for many years, which they will justify on national security grounds. As this post from the Breugel think tank pointed out, the private sector may have responsibility for the generation and distribution of energy but has no responsibility for ensuring security of supply nor for ensuring that consumers have access to energy. The private sector may also be unwilling to carry the costs of replenishing supplies at current prices, for fear of huge losses in the event that oil and gas prices fall. All of this suggests that significant fiscal intervention may be required to guarantee energy supply.

Europe has perhaps been too complacent about the risks emerging from the geopolitical sphere in recent years, partly because it has had to cope with the aftershocks of the Greek debt crisis and Brexit. However, it has acted remarkably swiftly in the last three weeks as latest events highlight that the time for complacency is over. In the wake of the 2008 crash, hopes were expressed that we could return to the old world order. The pandemic and the war in Ukraine suggest that we are likely to return to a geopolitical order more reminiscent of 1985 than 2005.

The price of war

As the war in Ukraine unfolds and the harrowing scenes of death and displacement fill our TV screens on a daily basis, questions are increasingly being raised as to what is the end-game. Far from this being a Russian invasion with a swift conclusion, it could turn out to be a protracted conflict as Russia becomes bogged down in Ukraine. Without claiming to be an expert on Russian policy, there is plenty of good material out there which allows us to draw some conclusions as to how proceedings might unfold. One thing is evident: A range of different outcomes are possible and it is unwise to identify a single outcome at this stage of the proceedings.

Major military operations often take considerable time to conclude – for example, it took US forces one month to take Baghdad after launching its Iraq invasion in 2003. However, the Iraq invasion was planned as a slow and methodical affair: The Russian invasion of Ukraine appears from the outside to have miscalculated the strength of opposition. This runs the risk that ever more desperate measures will be taken to hasten the conclusion and increases the longer-term risks, both for Russia and the west.

How much pressure does Putin face at home?

Looking at the issue from Putin’s perspective, it is now an established fact that he sees Ukraine as part of a “greater Russia.” Having committed substantial resources and having put his domestic reputation on the line in order to take the country by force, the likelihood of him backing down before completing his objective is lower than a further escalation of Russia’s military effort. There have been suggestions that the sanctions against Russia will help to undermine Putin’s position as the oligarchy rises up against him. But a Twitter thread by Professor Olga Chyzh suggests this may be a naïve hope. Chyzh points out that they owe their wealth and position to Putin and if he goes, they do too. In her view, “the oligarchs are simply managers delegated with over-seeing day-to-day activities … Putin’s oligarchs have no political power whatsoever. Their domain is strictly economic.” She further notes that whilst the oligarchs may wield the economic power, it is the siloviki (strongmen) who wield the muscle capable of overthrowing Putin but since their interests are aligned with his, they have no incentive to bring him down.

However, Putin is not invulnerable. As a very informative article in Foreign Affairs, published last year, noted: “because of the compromises he has had to make to consolidate his personal control over the state, Putin’s tools for balancing the competing goals of rewarding elites who might otherwise conspire against him and appeasing the public are becoming less and less effective.” This suggests that sanctions may be effective. However, they will take a very long time to achieve their objective and are likely to do so only by making life for ordinary citizens intolerably hard.

The manpower cost of Ukrainian expansion

In the meantime, in the absence of a ceasefire – which currently looks unlikely – the war in Ukraine is set to continue. It is possible that Ukraine may be able to hold out long enough for Russia to opt for a face-saving exit strategy. That does not look to be on the cards at present, although we should never say never. Russia might instead decide to cut its losses and conquer only the territory to the east of the Dnieper River, claiming this was the goal all along. Alternatively it may double down its efforts and push through to the western border which will prove to be a long haul. Either way, having taken the territory it will prove economically and militarily ruinous to hold it.

In looking at the economics of occupation I am indebted to work by the economist John Llewellyn, conducted when he was working at Lehman’s in 2004 (available here). A study of the numerical requirements for a successful occupying force concluded that “no post-WWII occupation of a country has been successful at a force ratio of less than 20 troops per thousand head of population. And indeed some occupations … failed notwithstanding a force ratio of nearly 40.” This implies at the very least Russia would have to commit almost 900,000 personnel in order to have a chance of successfully occupying the whole of Ukraine. With an army comprised of one million active personnel and two million in reserve, this would require committing almost one-third of the available numbers to the task. Even if it were to occupy only the eastern half, Russia would still have to commit around 400,000 personnel which would be a considerable drain on resources.

Assessing the financial costs

Then there is the financial cost. The US is estimated to have spent $8 trillion in its 20-year “war on terror”, including its invasions and occupations of Afghanistan and Iraq. Even if Russia were to spend 5% of this amount, it would still require outlays of $400 billion – roughly seven years of Russian military spending – and this at a time when the economy will be under severe pressure as a result of global sanctions. Prior to the war, Russia could tap into $630bn of foreign exchange reserves. That amount has been roughly halved after western nations announced sanctions preventing access to any reserves held on their territory. Consequently reserves now amount to around 10 months of import coverage.

Despite the imposition of sanctions, however, oil and gas are exempt and European countries continue to buy Russian energy. German Chancellor Scholz stated yesterday that: “Supplying Europe with energy for heat generation, mobility, electricity supply and industry cannot be secured in any other way at the moment. It is therefore of essential importance for the provision of public services and the daily lives of our citizens.” Even though Urals crude is trading at a $25 discount to Brent, it is still around $100/bbl. On the basis that Russia exports around 4.5 million barrels per day to Europe, that amounts to $13.5bn per month in oil revenues alone. Similarly, Europe currently imports 32% of its gas from Russia (Russia met 40% of consumption needs in 2021). Last week, the think tank Bruegel calculated that at then-current market prices, the daily value of gas imports was around $755 million, or almost $22bn per month. If the world is serious about imposing sanctions, a reduction in hydrocarbon imports from Russia is essential otherwise the revenues will be used to further conduct the war.

The EU is working on a plan to cut Russian gas imports by two-thirds over the next twelve months, which is double the amount proposed by the IEA’s 10-point plan announced last week. Frans Timmermans, who leads the European Commission’s work on the European Green Deal, reckons that near-term savings could be made by cutting energy use, filling up gas storage in 2022 and finding new sources of supply, with the EU already in discussions with the likes of Egypt, Qatar, Australia and the US. If this can be realised, the flow of funds into Russia will dry up very quickly and reduce Putin’s capacity to pursue his war.

Weaning the EU off Russian energy imports will come at a significant economic cost. A paper published yesterday[1] attempted to measure the costs to Germany of ceasing to import energy from Russia. The authors conclude that “the effects are likely to be substantial but manageable. In the short run, a stop of Russian energy imports would lead to a GDP decline in a range between 0.5% and 3% (cf. the GDP decline in 2020 during the pandemic was 4.5%).” This is a big economic price to pay. But the moral price of continuing to fund Putin’s activities may be even higher.

Last word

Aside from the grief and heartache it causes, war is also an expensive economic enterprise. Even if Putin achieves his objective of conquering Ukraine, Russia will struggle to hold onto the territory unless it significantly raises its military commitment. But as the west cuts ties with Russia, leaving it increasingly economically isolated, Putin may not have to the resources to achieve this. Quite how a cornered Putin then reacts depends on whether the west allows him a face-saving way out and how his people react. It is not going to be pretty.

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[1] Bachmann, R., D. Baqaee, C. Bayer, M. Kuhn, A. Löschel, B. Moll, A. Peichl, K. Pittel and M. Schularick (2022) ‘What if? The economic effects for Germany of a stop of energy imports from Russia’, ECONtribute Policy Brief No. 028

Don't mess with the model

There are a number of hot takes on the Ukraine war and the implications of Brexit for the UK’s role in world events. Thankfully this is not one of them. Instead this post looks at the media, specifically the role of public service broadcasting and how it should be funded. I must confess to having started writing this post before last week’s events and then put it aside. But on reflection and in light of the importance of the media in broadcasting events from Kyiv and Moscow, this remains a topical issue.

Public service broadcasting (PSB) has dominated the airwaves of nearly all countries for the better part of a century. It can best be defined as broadcasting intended for public benefit rather than to serve purely commercial interests, providing universal access to high-quality content, free at the point of use. The BBC, which celebrates its centenary this year, was one of the pioneers of PSB but broadcasters in Japan (NHK, 1924), Denmark (DR, 1925), Switzerland (SRG, 1925) and Finland (Yle, 1926) run  it close. Almost every country in the world offers PSB in some form or another – even the US, which has long been a pioneer of free market broadcasting. Germany, for example, has two public broadcasters (ARD and ZDF) which are funded via a licence fee model whilst France has five different entities (only one of which is a television service).

During its long existence, the BBC has established a reputation for free and fair reporting as well as high quality output. At a time when the number of news and entertainment channels has multiplied, questions are increasingly being asked of the BBC, and indeed of other broadcasters around the world, as to whether current funding models are appropriate and whether there is still a role for state-backed media.

Brand recognition is important

In a world where it is becoming increasingly difficult to differentiate between factual reporting and fake news, the importance of having a trusted brand in the media space is more important than ever. Public media scores highly for trustworthiness in Germany whilst the BBC performs well both at home and abroad on this score. According to a report in 2020: “The 2020 Reuters Digital News Report found the BBC to be the most trusted news brand in the United States. A full 56% of U.S. respondents rated the BBC as “trustworthy” … putting BBC News No. 2 only to “local television news,” and ahead of all major US news brands.” That might surprise many people in the UK who have been critical of the BBC’s domestic news coverage in recent years, but it is a reminder that it has a lot of global credit in the bank.

In the post-Brexit environment where the government extols the virtues of a global Britain it may come as a surprise to many that it does not share this positive view of the national broadcaster. Last month, the Culture Secretary Nadine Dorries called into question the BBC’s funding model with this article citing sources who suggested that “the days of state-run TV are over” and “it’s over for the BBC as they know it.” It is unfortunate that the BBC has now become an unwilling participant in the culture war which rages across social media these days. Much of the debate is fuelled by political considerations which to some extent represent the self-interested pursuit of those who would benefit from its demise. Despite this, and the fact that the BBC is part of the national fabric with a very strong global reputation, there are serious questions about how to fund public service broadcasting in an era of multimedia options.

Assessing the funding options

One of the most common objections to public service broadcasters is that the flat charge used to fund them acts as a regressive tax. Recently, however, a number of European broadcasters have changed the funding model. In 2013, Finland shifted to a progressive ‘tax’ paid by all individuals on a means-tested sliding scale to fund its public service broadcaster. Denmark has abolished the mandatory licence fee and the state broadcaster is now funded directly from central government tax revenues. The BBC is still funded by an annual levy which is device dependent (i.e. all those who consume BBC services must pay the fee). There is no sign that this is as much of a problem as many politicians seem to think. A recent parliamentary report suggested that “support for the principles behind public service broadcasting remains strong.” Moreover, in 2018, the Swiss electorate rejected efforts to cut taxpayer funding to public broadcasters, after a campaign that stirred debate about the media’s role in fostering national unity.

In the UK, the debate is often portrayed as a choice between maintaining the licence fee or adopting a Netflix-style user subscription. But there are other choices. Germany, for example, has introduced a household fee that sits outside of the state budget and is not tied to the ownership of a specific device or the use of particular media services. As with other public services, all citizens pay, regardless of their use of public service broadcasting. This is a similar principle to the Council Tax used to fund local UK services. Those who oppose the licence fee on the grounds it is regressive will find even more to object to in this model unless some account is taken of household income. However, it does have the advantage of eliminating the free-rider problem and could, in theory, lead to higher revenues. One study[1] suggested that if such a model were applied in the UK it would, assuming zero evasion, raise more revenue than the current funding model. But an evasion rate of 3.6% would produce no significant revenue gain. For the record, the UK evasion rate is currently estimated in excess of 7%.

A subscription-based service is generally not regarded as suitable for a PSB model since it is only available to those who choose (and can afford) to subscribe, thus defeating the objective of public service broadcasting to provide content for public benefit rather than financial gain. Indeed the broadcaster would be under pressure to provide content only for its subscribers. Against that, one advantage often put forward is that it reduces the role of the state which in the UK controls the granting of a Royal Charter every ten years. However, the BBC's editorial independence is enshrined in the Charter. Changing to a subscription model runs the risk of undermining the brand.

Ultimately PSB has to be viewed as a ‘merit good’ that creates positive social externalities, generally acting as a form of national glue, and which should be provided on this basis rather than ability and willingness to pay. Watching reporters from around the world covering events in Ukraine acts as a reminder that they are providing a valuable public service. Just as during the height of the Covid pandemic, people turn to their national broadcasters during time of national emergency. We should be thankful for the job they do and we mess with the way we fund them at our peril.

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[1] Ramsey P. and C. Herzog (2018) ‘The End of the Television Licence Fee? Applying the German Household Levy Model to the United Kingdom’, European Journal of Communication, 33, pp 430–444

Redrawing the economic map

As Europe awoke to the news that Russia has launched military action against Ukraine, it is hard to avoid the conclusion that the geopolitical tectonic plates have shifted. A war on this scale in continental Europe is not something we have seen since 1945 although we should not forget that the Soviet Union did invade Hungary in 1956 and Czechoslovakia in 1968, so there is a parallel (albeit inexact). Twenty years ago it all seemed very different. Having experienced a form of shock therapy following the collapse of the Soviet Union in 1991, which saw hyperinflation and a huge collapse in output, the Russian economy stabilised in the late-1990s. Accession to the G8 in 1997 gave rise to hopes that it would become a reliable international partner whose political and economic interests would be more aligned with the west. The annexation of Crimea in 2014 changed all that.

From a geopolitical perspective, Russia has become an increasingly difficult problem for the west to manage. To quote the British parliamentary Intelligence and Security Committee, “Russia is simultaneously both very strong and very weak.” It is a significant military player with a permanent seat on the UN Security Council. Yet it has a relatively small population compared to the west and a weak economy which is heavily reliant on hydrocarbon revenues. This makes it difficult to respond effectively. Military engagement by the west in Ukraine is out of the question, although matters could escalate if former Soviet Republics which are now NATO members (Estonia, Latvia and Lithuania) face a similar threat. That is something we would rather not think about. But as a response to the Ukrainian incursion, it is clear that the west will implement economic sanctions.

Germany has already paused its certification of the Nord Stream 2 gas pipeline. Whilst this does not mean that the pipeline will never be used, it is a significant move and will have major implications. Although Chancellor Scholz wants to wean Germany off imported Russian gas, the view in Moscow is this will be impossible in the short term and may not even be possible on a 5-10 year horizon. This is indeed plausible and the 2011 decision to end nuclear energy generation now looks rather ill-judged. However, now that the Greens are part of the government coalition, their resolve to further reduce dependency on fossil fuels should not be underestimated. Either way, this is likely to have significant costs for one or both parties – we cannot predict at this point where the incidence will fall.

How effective will sanctions be?

The German case was merely the most high profile of a range of sanctions introduced in recent days (the British government’s efforts were a particularly weak response) and more will be forthcoming. Sanctions are now regarded as the first response to aggressor nations and in contrast to the old maxim of “shoot first and ask questions later”, the Peterson Institute for International Economics (PIIE) acknowledges that “advance planning for the imposition of sanctions is now the norm.” But what are they designed to achieve? There are a range of possibilities. Sometimes they are simply implemented to satisfy domestic considerations rather than influence the actions of others; they may be designed to send a signal that the actions of others are unacceptable, or they may be intended to implement regime change. Whether or not sanctions are successful depends on which of these is the intention. 

A study by PIIE suggested that sanctions tend to be effective in roughly one-third of cases. But the success rate depends very much on the objectives. “Episodes involving modest and limited goals, such as the release of a political prisoner, succeeded half the time. Cases involving attempts to change regimes (e.g., by destabilizing a particular leader or by encouraging an autocrat to democratize), to impair a foreign adversary’s military potential, or to otherwise change its policies in a major way succeeded in about 30 percent of those cases. Efforts to disrupt relatively minor military adventures succeeded in only a fifth of cases.” The invasion of Ukraine is not a “minor military adventure” so the odds that sanctions will reverse the outcome are limited. In any case, as PIIE notes, “sanctions are of limited utility in achieving foreign policy goals that depend on compelling the target country to take actions it stoutly resists.” US efforts to promote political change in Iran and Cuba are testimony to this. Furthermore, according to PIIE: “It is hard to bully a bully with economic measures” since the evidence suggests that democratic regimes are more susceptible to such pressure than autocracies.

In order to manage expectations, western governments have to make it clear at the outset that they do not expect economic sanctions to facilitate regime change in Russia or reverse the Ukrainian invasion (although Putin did suggest in his speech that Russia does not intend to occupy Ukraine). What kind of sanctions could the west impose? The first option would be to sanction the free flow of Russian capital by imposing restrictions on those with close links to the government, the rationale being that pressure placed on Putin by power brokers would destabilise his grip on power. This would include restrictions on their personal activity and also the banks that they use.

There have also been calls to cut Russian access to SWIFT, the global interbank payments system. Whilst this would severely impact on Russian banks, European creditors would also struggle to get their money out of Russia. This would be particularly problematic since BIS data indicate that European banks hold the vast majority of foreign banks' exposure to Russia (chart above). Russia also has huge FX reserves, totalling around $630 billion, which would mean that it has no immediate need for market access to foreign currency. It also has its own financial payments system (SPFS) which funds around 20% of Russian settlements. However, the Atlantic Council think tank reckons that “the Russian equivalent of SWIFT remains mostly aspirational [and] is much ado about nothing,” concluding that its importance is overblown.

One concern is that sanctions on Russia could drive it further into China’s orbit as the two countries have become closer in recent years as they seek to weaken US hegemony. But China has to balance its relationship with Russia against its need to preserve relationships with the west and it has nothing to gain from any conflict with Ukraine. However, closer Chinese ties may weaken the impact of any economic sanctions that the west might impose (for example, if China were to become a bigger importer of Russian oil and gas).

Implications for the west

Thirty years ago much of the talk in policy circles was of the peace dividend that would accrue as a result of reduced defence spending. That dividend now appears to have been used up and recent events may force governments to think about raising defence spending. Only seven of the 30 NATO members currently spend more than 2% of GDP on defence – the benchmark which all members are meant to achieve by 2024. Increased defence spending will stretch public finances more than in the period 1945-90 because ageing populations mean that health services are a bigger competitor for tax revenue. It is therefore possible that taxation will have to rise in order to pay for it.

More generally the era of peace, prosperity and openness characterised by increased globalisation is apparently in retreat (see the KOF index). Russia may not be the superpower of old but it is big enough to cause problems if it flexes its muscles. China waits in the wings, perhaps assessing the west’s response to the Ukrainian invasion as it ponders how to deal with Taiwan. For those of us old enough to remember the Cold War, none of this is new. Nor does it necessarily mean huge changes in the way we live our day-to-day lives. But governments will have to make increasingly difficult choices about resource allocation as we revert to a world of “them and us.”

The Magic Money Tree

Modern Monetary Theory (MMT) is back in the headlines following a recent piece in the New York Times (here). In truth, the article is more a profile of one its best known proponents, Professor Stephanie Kelton of Stony Brook University, than an attempt to examine MMT. Mainstream economists have nonetheless queued up to criticise it, probably because the original headline was titled “Time for a Victory Lap” (it has since been changed to “Is This What Winning Looks Like” so the subeditor has a lot to answer for). However, the article still contains the phrase “Kelton … is the star architect of a movement that is on something of a victory lap”. This has enraged the mainstream economics community because far from enjoying a victory lap, MMT remains untried, unproven and untestable.

A lot has happened since I first looked at the subject three years ago: Kelton’s book The Deficit Myth has become a best seller whilst the pandemic has focused minds on the role of government deficits. This fascinating area is thus worth revisiting. However, the quip that Modern Monetary Theory is not modern, is not about money and is not a theory still holds true. It is not modern because it has its roots in Abba Lerner’s Functional Finance Theory which first saw the light of day in 1943 and which suggests that government should finance itself to meet explicit economic goals, such as smoothing the business cycle, achieving full employment and boosting growth. It is also more a fiscal theory than a monetary one. At heart it is based on the premise that since the government is the monopoly supplier of money, there is no such thing as a budget constraint because governments can finance their deficits by creating additional liquidity at zero cost (subject to an inflation constraint). It is most definitely not a theory about how the economy works. Instead it is closer to a doctrine to which its adherents passionately adhere whilst regarding non-believers as having not yet seen the light (or worse, economic heretics).

What particularly riles the mainstream community is that there is no formal model which can be written down and therefore no testable hypothesis. In the words of blogger Noah Smith, “MMT proponents almost always refuse to specify exactly how they think the economy works. They offer a package of policy prescriptions, but these prescriptions can only be learned by consulting the MMT proponents themselves.” This is particularly irksome because it allows MMT proponents to sidestep the criticisms of the doctrine, of which there are many.

Many of these criticisms centre around the role of money, upon which the fiscal analysis is founded. For example, it treats money as being primarily created by the state (defined as the government sector plus the central bank) and has little or nothing to say about the role of banks in the process. It also treats money as a public good which should be used to maximise social welfare rather than its more prosaic use as a medium of exchange. This in turn assumes there is only one form of money in the economy, but as I have pointed out before this is not the case. Domestic actors may choose to use foreign currency, for example, or opt for digital options. Thus, although governments can create money almost without limit, there is no guarantee that demand will match supply. Increasing supply way beyond demand will only lead to currency debasement. In an excellent paper by the Banque de France[1] (here) the authors do a good job of picking holes in the theoretical underpinnings of MMT, noting that none of its supporters acknowledge “the reason modern literature on money puts  forward for what makes legal currency “acceptable” by the public, i.e. monetary policy credibility.”

Whilst MMT does rest on shaky theoretical foundations, it is not the only area in modern macroeconomics to suffer from such problems. The New Keynesian school, which is the predominant model used by central banks, assumes no role for the quantity of money. It also imposes perfect pass-through from the policy rate to all other rates in the economy, thus giving the central bank a powerful lever to affect intertemporal decisions, which is extremely questionable. Nobel Laureate Joseph Stiglitz published a paper in 2017 which argued that “the DSGE models that have come to dominate macroeconomics during the past quarter-century [apply] the wrong microfoundations, which failed to incorporate key aspects of economic behavior. Inadequate modelling of the financial sector meant they were ill-suited for predicting or responding to a financial crisis; and a reliance on representative agent models meant they were ill-suited for analysing either the role of distribution in fluctuations and crises or the consequences of fluctuations on inequality.”

It is thus perhaps a little unfair to single out MMT which has fallen victim to the fetish for quantification in economics. Current academic practice seems to believe that if something cannot be quantified it is not a valid explanation of how the economy works. It is instructive to remember that the ideas of Keynes, which came to dominate the agenda after 1945, were also subject to significant criticism following their publication in the 1930s. Nonetheless there is a lot wrong with MMT and I concur with the conclusion to the BdF paper: “Such a stark contrast with mainstream economics analysis and recommendations would be understandable if MMT economists engaged into a debate with their colleagues to explain and justify their positions, from both a theoretical and empirical point of view. However, they rather prefer to talk between themselves, repeating consistently the same ideas that others formulated in a distant past, disregarding facts and theories that do not fit into their approach, and accusing those who do not share their ideas of being incompetent.”

Yet despite all these reservations MMT has opened up a debate about the role of government both during and in the wake of the pandemic. One of the core ideas of MMT is that governments are not like households because they have an (almost) infinite life and therefore debt can be repaid over periods extending over many generations. There is thus no rush to impose significant fiscal tightening as the economy recovers from the Covid shock. This view is, of course, not unique to MMT: It is a standard element in fiscal dynamics but it is a lesson that governments should heed as the rush to take away support after the pandemic gathers momentum.

If it has opened the eyes of politicians to the uses of fiscal policy after decades in the doldrums, then maybe MMT has served a useful function. But a policy of near unlimited fiscal expansion is for the birds. It calls to mind the other acronym often applied to MMT: The Magic Money Tree.

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[1] Drumetz, F. and C. Pfister (2021) ‘The Meaning of MMT’, Banque de France Working Paper 833

Getting a grip on inflation

There is an old joke about a man who gets lost in the countryside and asks a local for directions to the nearest town. The local responds: “if it’s the town you’re going to, I wouldn’t start from here.” In many ways that perfectly sums up the position central bankers find themselves in today. Inflation has ramped up in a way that was unforeseen just six months ago and as a consequence interest rates are currently too low for prevailing inflation conditions. It is a very uncomfortable place to be because it opens up central banks to the charge that they are behind the curve on policy.

Onwards and upwards

It is very easy to make the case that central banks missed the inflation surge and have maintained a lax monetary stance for too long. On a literal interpretation this is true. There again, the consensus forecasts did not anticipate the inflation surge either so the noisy brigade perhaps ought to dial down some of the criticism about how slow central banks have been to react. We can see this very clearly in UK data using consensus forecasts for CPI inflation in Q4 2021 against the BoE’s projections (chart below). If anything, the central bank anticipated the inflation surge slightly quicker than most forecasters.

Perhaps the criticism is rooted in the fact that central banks were tardy in tightening policy as the economy normalised following the GFC of 2008-09. I have a lot more sympathy with this view. There was no justification for maintaining the lax stance adopted in 2009 once the economy started to normalise and those criticising central banks today perhaps feared a repeat of the policy mistakes of the 2010s which promoted significant inflation in financial asset prices.

At least the BoE has begun the process of raising interest rates, having increased them by a total of 40 bps over the last two months with more to come. Last month the Fed passed up the opportunity to raise rates and instead signalled a March rate hike whilst continuing its asset purchase programme for another six weeks rather than bringing it to an immediate end. As for the ECB, the depo rate has not been above zero since 2012 and has been stuck in negative territory since 2014. Negative rates may be an acceptable policy option for a limited period but eight years is way too long. At least this week’s press conference provided some indication that the ECB acknowledges “inflation is likely to remain elevated for longer than previously expected [and] risks to the inflation outlook are tilted to the upside, particularly in the near term. The situation has indeed changed." Suggestions from some analysts that this marked a “hawkish” stance from the ECB is rather to miss the point. Moving rates from negative territory to zero is not “hawkish” – it reflects the start of a long-overdue normalisation of the policy stance.

Given the nature of the supply-generated inflation shock it is clear that a rise in interest rates is not going to resolve the problem. But in one sense central banks have no choice but to react. By claiming credit for the fall in inflation during the 1990s they have created a paradigm in which they appear to have control over the inflation process. Under current institutional arrangements, in which central banks maintain responsibility for controlling inflation, their whole credibility is bound up in taking action to curb it which in turn requires tightening policy. However, there may be something of the emperor’s new clothes about this argument. A hugely simplified view of using monetary policy to control inflation is the assumption that it is (to use Milton Friedman’s phrase) “always and everywhere a monetary phenomenon.” As recent events have shown, that is not the case. How do we act then upon inflation?

Dealing with the energy shock

One of the problems facing consumers around the globe is the sharp rise in energy prices. European gas production has declined in recent years and to the extent that this was used largely to smooth out demand patterns during the winter, this has had a significant impact on the market. Last summer European countries were also unable to boost storage to levels that might prevent shortages from emerging during the coldest periods and the resultant scramble for gas has pushed up global prices.

This is making its presence felt in household fuel bills. UK domestic gas and electricity prices rose by 19% and 17% respectively in October and will rise again in April following the Ofgem announcement that the energy price cap will rise by 54% which is likely to push inflation to 7% or above in Q2. Whilst the problem of rising energy costs is not a uniquely British phenomenon, it has taken a different approach to other European countries. In the UK Chancellor Rishi Sunak announced that households would receive a discount of £200 on domestic energy costs in 2022 (around 10% of an average bill) which would be repaid over the following five years. The full impact of the price hike will therefore be borne by consumers.

Elsewhere in Europe, governments have taken a more aggressive approach. With one eye on the election, the French government has forced state-owned EDF to sell nuclear power to rivals at below the current market price, costing it €8.4bn in revenue, whilst limiting the rise in household bills to 4%. The German government plans to reduce the green energy surcharge by 46% and introduce subsidies for lower income households (one person households would receive €135 and a two person household would receive €175) whilst the Irish government has planned a €113 energy rebate to every household.

Calls for wage restraint are missing the point

BoE Governor Andrew Bailey came under fire for suggesting that this week’s 25 bps rate hike was implicitly designed to deter workers from demanding big pay rises. But as many people pointed out, nothing screams wage restraint like a big rise in basic living costs. In any event workers real wages have lagged productivity growth in the decade since the GFC (chart below). Even though there has been a narrowing of the gap since 2018, workers have not been compensated for such productivity growth as has been achieved since 2009. That said, the ratio is currently in line with its long-term average. But this implies that even in a zero productivity growth economy, workers are entitled to flat real wage growth and with inflation set to average close to 6% this year, a nominal wage rise of 6% could be justified on economic grounds.

The governor’s comments were (to be polite) somewhat insensitive. It would have been far better to suggest that the BoE is raising rates to keep down inflation in order that the pay packet can stretch a little further. The FT journalist Martin Sandbu also posed the question “why does the governor of the Bank of England encourage restraint in wage demands but not call for restraint in businesses’ attempts to protect their profit margins?” With BP set to announce a huge rise in profits at a time when energy customers are struggling to find the means to pay their bills, calls for wage restraint are not a good look.

None of this is to say that central banks should not raise interest rates further. But we have to recognise that this will do little to tackle the underlying problems and that a tightening of the monetary stance maybe should be accompanied by fiscal measures to offset some of the pain, especially since rapid inflation will also boost the government’s fiscal revenues. At a time when the government is struggling to remain credible, and when many prominent Brexiteers promised that prices would go down once the UK left the EU, they need to get a grip on the inflation problem soon or voters may be tempted to take their revenge at the ballot box.