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Playing with FireDeepened Financial Integration and Changing Vulnerabilities of the Global South$

Yilmaz Akyüz

Print publication date: 2017

Print ISBN-13: 9780198797173

Published to Oxford Scholarship Online: July 2017

DOI: 10.1093/oso/9780198797173.001.0001

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Policy Response in Advanced Economies

Policy Response in Advanced Economies

Neo-liberal Fallacies and Obsessions

Chapter:
(p.23) 1 Policy Response in Advanced Economies
Source:
Playing with Fire
Author(s):

Yilmaz Akyüz

Publisher:
Oxford University Press
DOI:10.1093/oso/9780198797173.003.0001

Abstract and Keywords

The world economy is in a bad shape, largely because of misguided policies in the United States and Europe in response to the crisis. The crisis is taking too long to resolve, leading to unnecessary losses of income and jobs. Recovery has been sluggish and unbalanced between labour and capital, and between industry and finance. This is mainly because governments have been unwilling to remove the debt overhang through timely, orderly, and comprehensive restructuring, and fiscal policy has acted to restrain recovery, resulting in excessive reliance on unconventional monetary policy. The ultra-easy monetary policy has led to speculation and asset bubbles and created a global debt trap rather than stimulating consumption and productive investment. This policy approach has not only failed to boost growth, but also aggravated global systemic problems, including financial fragility in both advanced and developing economies, and inequality, underconsumption and structural demand gap.

Keywords:   crisis, fiscal orthodoxy, ultra-easy monetary policy, speculation, debt overhang, inequality, financialization, underconsumption, stagnation

1.1 Why Is the Crisis Taking Too Long to Resolve?

In his remarks on the state of the world economy after half a decade from the onset of the subprime crisis in the US, the IMF’s chief economist at the time, Olivier Blanchard, is reported to have said, ‘It’s not yet a lost decade.…But it will surely take at least a decade from the beginning of the crisis for the world economy to get back to decent shape’ (Reuters 2012). Indeed, by spring 2016, almost a decade after the beginning of the crisis, the world economy had not got back to decent shape and the policies introduced in response to the crisis had not been normalized.

Even though the US economy was at the origin of the crisis, it has fared much better than other major advanced economies, notably the Eurozone. Since the end of the recession in September 2009, the US economy has had positive growth for 24 quarters, enjoying one of the longest post-war expansions. It has also restored employment to pre-crisis levels. However, the recovery has been unusually slow. The US economy had grown at a rate of around 3 per cent per annum from the 1970s until 2008, including several years of recessions with negative growth rates, and at a rate of 3.6 per cent during the 1991–2001 expansion. In the recovery from the subprime crisis, the average US growth has barely exceeded 2 per cent (see Table 1.1). As a result output has remained well below potential, resulting in significant income and employment losses. More importantly, the crisis has accelerated the decline in potential growth that had already started in the early 2000s (IMF WEO 2015: chap. 3). Investment has been particularly weak with capital spending declining in some key sectors. Although the unemployment rate has been halved from the peak of 10 per cent recorded during the depth of the crisis, it still remains above the lows attained on the eve of the crisis and the improvement is partly (p.24) due to a decline in labour force participation—from over 66 per cent in 2006 to 63 per cent in early 2016.

Table 1.1 Real GDP growth in selected advanced economies

(Per cent change)

2008

2009

2010

2011

2012

2013

2014

2015

United States

−0.3

−2.8

2.5

1.6

2.2

1.5

2.4

2.4

Eurozone (EZ)

0.5

−4.5

2.1

1.6

−0.9

−0.3

0.9

1.6

Germany

0.8

−5.6

3.9

3.7

0.6

0.4

1.6

1.5

Japan

−1.0

−5.5

4.7

−0.5

1.7

1.4

0.0

0.5

United Kingdom

−0.5

−4.2

1.5

2.0

1.2

2.2

2.9

2.2

Source: IMF WEO (2016).

Furthermore, the US recovery has been lopsided. Wages have remained stagnant and income and wealth inequality has increased (Dufour and Orhangazi 2016). And not all segments of the society have recovered. It is found that, as of 2015, only 214 counties out of a total of 3069 had recovered to pre-recession levels on four indicators: total employment, the unemployment rate, size of the economy, and home values (Morath 2016). After six years of recovery, three people out of five polled in May 2015 thought that the US economy was still in recession (Fox News 2015).

On average post-war US expansions ended after about five years, often with overheating and monetary tightening. Although the current expansion has been longer, there are no signs of overheating and the economy still operates below capacity. Thus, short of severe external shocks, such as a drastic slowdown and financial turbulence in China and/or renewed instability and contraction in the Eurozone, the US expansion may still continue for some time to come and prove to be the longest in recorded history. This means that the ultra-easy monetary policy introduced in response to the crisis will remain broadly unchanged and continue to add to financial fragility. This would make the eventual exit even more precarious. But growth is also so fragile that a moderate shock can push the economy into renewed instability and contraction. In such a case the policy-makers would have little ammunition in their existing arsenal, other than doing more of the same.

The Eurozone has barely recovered from the crisis that hit in 2008–09. Its recovery has been much weaker than the US largely because of tighter fiscal policy in the core countries, austerity imposed on the periphery and misguided tightening of monetary policy in 2011. Following a deep recession the region as a whole achieved positive growth in 2010–11, despite continued output and employment losses in the periphery, thanks to a strong recovery in Germany driven by exports. However, as the impact of the crisis spread in the region, the core and Germany in particular could not maintain the (p.25) momentum. The region had six consecutive quarters of negative growth until the second quarter of 2013 with about half of the countries in recession. The subsequent recovery was weak and uneven. With an average growth of less than 1 per cent since 2010, the region as a whole managed to restore its pre-crisis income only in the first quarter of 2016, five years after the US. GDP was still below the 2008 level in many countries of the region including Italy, Spain, Portugal, Greece, and Cyprus. By 2021, Greek and Italian per capita incomes are estimated to stand at about 14 per cent and 9 per cent, respectively, below their 2007 level (Reinhart 2016). Unemployment fell only moderately, from an all-time high of some 12 per cent in 2013 to 10.3 per cent at the end of 2015, and was still far above the pre-crisis level of 7.2 per cent. It was over 20 per cent in Spain and Greece—higher than the levels seen during the Great Depression.

The output gap in the Eurozone is greater than in the US and the decline in potential growth is more severe, posing the threat of persistent stagnation over the longer term. According to an estimate, potential output losses for 2015 were around 35 per cent for Greece and Ireland, 22 per cent for Spain, and over 13 per cent for Portugal. According to the same estimate the average loss for 2015 in 23 OECD countries was over 8 per cent (Ball 2014).

Although financial stress in the Eurozone has eased considerably, continued austerity and adjustment fatigue in much of the periphery and sluggish growth in the rest of the region could bring it back and even lead to a break-up. The removal of debt-overhang in countries hit by the crisis, notably Greece, is taking even longer than the resolution of the Latin American debt crisis of the 1980s, suggesting that few lessons have been drawn from past experiences. If the Brexit issue is not resolved positively, the damage on both Britain and the rest of Europe could be severe, even impairing further global growth ‘that has been too slow for too long’ (IMF WEO 2016).

There can be little doubt that recoveries from recessions brought about by financial crises are weak and protracted because it takes time to repair balance sheets—to remove debt overhang and unwind excessive and unviable investments generated during the bubbles that culminate in such crises. Recoveries from such crises also tend to be jobless and generate little investment. This was the case in the US during the early 1990s and particularly the early 2000s when it was recovering from recessions brought about by the bursting of the savings and loans and dot-com bubbles, respectively. In the current recovery, the pre-crisis income in the US had been restored by the second quarter of 2011, but employment was lower by some 6.5 million. Sluggish job and investment growth is also a common feature of recoveries of EDEs from financial crises (Akyüz 2006).

However, this recovery has been long even by the standards of past recessions associated with financial crises. For instance, it has been found that in (p.26) the 100 worst financial crises since the 1860s it took around seven years, on average, for the advanced economies to reach pre-crisis level of per capita income. In the current global crisis, of the 11 countries affected, only Germany has done better than the historical average while the US recovery has taken a little longer. Using the IMF projections for the coming years, it is estimated that for this group of 11 countries, it would take about nine years to reach the pre-crisis level of income (Reinhart 2016).

It seems that, if ever, it will take much longer than ‘a decade from the beginning of the crisis for the world economy to get back to decent shape’. But this is not just due to the nature and the depth of the crisis, but also to ineffectiveness of public interventions. In this respect, there are two major shortcomings in the policy response both in the US and the Eurozone. First, governments have been unwilling to remove the debt overhang through timely, orderly, and comprehensive restructuring and to bring about a redistribution of wealth from creditors to debtors. Instead, they have resorted to extensive creditor bail-outs, creating moral hazard and vulnerabilities in the financial system while enforcing austerity on debtors (Kuttner 2013). Second, there have been serious shortcomings in macroeconomic policy response in support of aggregate demand, growth, and employment. After an initial reflation governments turned to fiscal orthodoxy and relied excessively on monetary means to fight recession. These not only led to unnecessary output and job losses, but also created financial fragility that could compromise future stability and growth.

1.2 The Debt Overhang

The crises in the US and the Eurozone were due to rapid credit expansion and debt-driven property and consumption bubbles. Accordingly their resolution should have called for significant deleveraging and reduction of debt relative to income. Instead, the ultra-easy monetary policy resulted in a renewed debt pile-up both in the North and the South, by some additional $50 trillion since 2008, outpacing the growth of world nominal income. In the US, the ratio of private plus public debt as a proportion of GDP rose by 40 per cent while it more than doubled in the Eurozone periphery. The increase in household debt in advanced economies is moderate compared to debt accumulated in the seven years before the outset of the crisis, but corporate debt saw a significant acceleration (Dobbs et al. 2015; Birds 2015). There has also been a rapid increase in corporate debt in EDEs and an important part of this debt is in dollars (IMF GFSR 2015; McCauley et al. 2015). As of the end of 2015, total non-financial debt stood at 265 per cent of GDP in advanced economies and 185 per cent in EDEs, both up by 35 percentage points since 2007, creating (p.27) concerns that much of it may become unpayable in the next downturn (White 2016).

In advanced economies government debt has increased without a corresponding build-up of income-yielding public assets through investment in physical and human infrastructure. In the same vein, the increase in corporate debt has not been matched by greater investment. The ultra-easy monetary policy encouraged corporations to issue debt for M&A and stock buybacks, thereby artificially boosting share prices (Durden 2016). In this recovery business fixed investment has been 20 per cent below what would have been expected from pre-crisis trends across advanced economies, including the US (ERP 2016: 92). In 17 of the 20 largest advanced economies, investment growth remained lower during the post-2008 period than in the years before the crisis and five advanced economies experienced declines in investment during 2010–15 (Stiglitz and Rashid 2016). Despite exceptionally favourable financial conditions, real private non-residential gross fixed capital formation remained weak, mainly because of uncertainty about the future state of the economy and depressed profits expectations. As of end 2014, in some countries including France, Germany, and Italy, it had not recovered to its pre-recession level (Banerjee et al. 2015). Investment in EDEs also slowed significantly. In a few cases where corporate debt build-up went hand in hand with investment, the capacity created was in excess of what could possibly be utilized under normal conditions, as in China, or very little of it was in manufacturing, as in India.

In the US the government has been reluctant to bring down mortgages in line with the ability of households to pay by forcing the creditors to write down debt. In particular, the Federal Housing Finance Agency, which regulates government-controlled mortgage financiers Fannie Mae and Freddie Mac, constantly opposed principal reduction.1 Rather, priority was given to creditor bail-outs. Through the $700 billion Trouble Asset Relief Programme of 2008–09, the US Treasury injected capital into banks whose net worth was moving into the red as a result of loss of asset values. In alleviating the burden of household debt, the government relied mainly on open market operations by the US Federal Reserve through Quantitative Easing (QE), implemented in several rounds, buying US government bonds and mortgage-backed securities to boost their prices and lower long-term rates.

(p.28) Bail-out operations and the ultra-easy monetary policy prevented a banking collapse and hence contained the financial crisis. They allowed the banks first to recover their pre-crisis profitability and then reach record profits. Already by 2013, the four biggest US banks were 30 per cent larger than they had been before the crisis and the too-big-to-fail banks were even bigger (Warren 2013). They continued to post even higher profits during the subsequent years (Leong 2015; Cohan 2016).

However, policy interventions have been much less effective in reducing the household debt overhang and preventing foreclosures. Although there is a sizeable drop in household debt as a per cent of GDP since the outset of the crisis, an important part of this is due to foreclosures and hence reflects a corresponding reduction in household wealth. Because of foreclosures and mortgage delinquencies the home ownership rate fell to a 20-year low in 2015 (FRED 2016). Although the percentage of homes underwater dropped as the housing market recovered, as of mid-2015 there were more than 4 million US homeowners with mortgage debt at least 20 per cent more than their homes were worth and most underwater homeowners were among the homes with the least value (Fottrell 2015). As noted by Bernanke (2013), ‘gains in household net worth have been concentrated among wealthier households, while many households in the middle or lower parts of the distribution have experienced declines in wealth since the crisis’.

The failure to act directly on the debt overhang is even more visible in the Eurozone where the policy response was premised on a wrong diagnosis. The periphery was, in effect, facing a balance-of-payments-cum-external-debt crisis resulting from excessive domestic spending and foreign borrowing of the kind seen in several EDEs in Latin America and East Asia in the past decades. Contrary to the official diagnosis, this had little to do with fiscal profligacy except in Greece (Lapavitsas et al. 2010; De Grauwe 2010). Spain and Ireland adhered to the Maastricht Treaty much better than Germany—they were both running fiscal surpluses and their debt ratios were lower (see Table 1.2). In fact, Spanish and Irish fiscal balances were better than all other members of Eurozone except Luxembourg and Finland. Portugal had a relatively high deficit, but its debt ratio was not much higher than that of Germany.

As argued by Gros (2011), external debt is the key to the Eurozone crisis and the focus on total public debt is misleading. Belgium had a much higher public debt ratio than Portugal, Spain, and Ireland, but did not face any pressure and in fact enjoyed a relatively low-risk premium because it had a sustained current account surplus and a positive net external asset position. Again, Italy is less affected than other periphery countries because its current account deficit was much smaller and a large proportion of its public debt was held domestically.

(p.29) A common feature of the periphery countries in Table 1.2 is that they were all running larger current account deficits than all other Eurozone members in the run-up to the crisis. In Spain and Ireland, deficits were entirely due to a private savings gap. Even in Greece the current account deficit rose faster than the budget deficit because of a private spending boom. In 2007, the Greek current account deficit was over 14 per cent of GDP while the budget deficit was 6 per cent. Before the outbreak of the crisis, public debt in the periphery, except in Greece, was on a downward trend while private debt was rising. A growing part of the external debt was incurred by the private sector. In Greece only half of the external debt was sovereign and the proportion was even smaller for Portugal and Spain.

Table 1.2 Pre-crisis debt and deficits in the Eurozone

(per cent of GDP)

Fiscal Balance

(2000–07)

Public Debt

(2007)

Private Balance

(2000–07)

Current Account

(2000–07)

Greece

–5.6

107.3

–2.8

–8.4

Italy

–3.0

103.3

+2.4

–0.6

Portugal

–4.1

68.3

–5.2

–9.3

Spain

+0.4

36.3

–6.2

–5.8

Ireland

+1.4

25.0

–3.3

–1.9

Germany

–2.3

65.4

+5.5

+3.2

Source: IMF WEO (2013a) and IMF (2013a).

Two interrelated factors played an important role in rapid increases in current account deficits and external debt in the Eurozone periphery. First, after the monetary union, wage and price movements diverged sharply between the periphery and the core. During 2000–07 Germany undershot the inflation target and its real labour costs fell while the peripheral countries overshot the inflation target and their labour costs increased. Improved German competitiveness was not always due to a superior productivity growth and wage suppression played a central role. For instance, according to the Eurostat Labour Productivity Data, between 2000 and 2007 German real labour productivity per hour grew, on average, by 1.6 per cent per annum compared to 2.3 in Ireland and 2.6 in Greece. From early 2000 Germany was engaged in a process of what is called ‘competitive disinflation’ (Fitoussi 2006) or internal devaluation, keeping real wages and private consumption virtually stagnant and increasingly relying on exports for growth (Akyüz 2011c; Palley 2013). By contrast, in the periphery wages went ahead of productivity, leading to an appreciation of the real effective exchange rate and loss of competitiveness (see Figure 1.1). This created a surge in imports, mainly from other EU countries, but also from the rest of the world, notably China (Chen et al. 2012).

Policy Response in Advanced EconomiesNeo-liberal Fallacies and Obsessions

Figure 1.1 Real effective exchange rates in the Eurozone (1999=100)

Source: BIS.

(p.30) The divergence between the core and the periphery was sustained by a surge in capital flows from the former to the latter, triggered by the common currency and abundant international liquidity (Sinn 2011). They fuelled the boom in domestic demand, reduced private savings and widened the current account deficits in the periphery (Atoyan et al. 2013). They also helped Germany to increase exports and hence maintain a higher level of activity than was possible on the basis of domestic demand alone. As in Latin America in the early 1980s, this process of debt accumulation also ended with a shock from the US, this time the subprime crisis, leading to a sharp cutback in lending.

The strategy adopted by Eurozone policy-makers in dealing with the debt problem was very much like that of the failed Baker Plan pursued in response to the Latin American debt crisis in the 1980s—official lending to keep debtors current on their payments to private creditors and austerity (UNCTAD TDR 1988: chap. 4). For this purpose several facilities were introduced and used together with IMF lending. The European Central Bank (ECB) has engaged in sovereign bonds purchases in order to lower borrowing costs to troubled debtors and provided long-term loans to banks at low interest rates to enable them to buy high-yield sovereign bonds and earn large spreads.

Despite occasional references to the need to involve the creditors in the resolution of the crisis, interventions have mainly served to bail out creditor banks. As pointed out by the chairman of the European Banking Authority, Andrea Enria, too few European banks have been wound down and too many (p.31) of them have survived (Reuters 2013). Public money has been used to bail out banks, leading to increased sovereign debt. The debt-restructuring initiatives have brought limited relief to debtors. Greek workouts in 2012 failed to remove the debt overhang. Because of creditor bail-outs, a very large proportion of Greek sovereign debt came to be held by the official sector, including the ECB, IMF, national central banks, and other Eurozone governments, and the write-down of this debt has been resisted by the ECB and Germany. As of early 2016, Greece was still engaged in protracted negotiations with its official creditors for debt relief.

There were also inconsistencies in the approach to bailing in creditors. In Ireland and Spain, where the crisis originated in the banking system, creditors and depositors of troubled banks largely escaped without a haircut.2 Ireland gave a blanket guarantee to depositors and Greek workouts also spared deposit holders both at home and abroad. In most of these cases rescue operations involved large amounts of public money to prop up and recapitalize banks. By contrast, in Cyprus the bail-out package inflicted large losses on deposit holders, notably Russians.3

Public debt ratios in the periphery shot up significantly because of recession, relatively high spreads and the failure to bail in creditors, to ensure that they took losses on their claims (see Figure 1.2). Indeed, a fundamental dilemma faced in sustaining debt is that when the debt ratio is high and the real interest rate exceeds the growth rate by a large margin, the primary surplus needed to stabilize the debt ratio would be quite high, but cuts made in primary spending to achieve this would create a sizeable contraction in output, making the task even more difficult.4 Thus, debt ratios of Spain and Ireland rose to 80 per cent in 2015 from 36 per cent and 25 per cent on the eve of the crisis, respectively, and they doubled in Portugal and Greece. Of these countries, as of end 2015, only Ireland managed to reduce its debt ratio from the peak reached during 2012–13. Ireland is also the only crisis-hit country that has maintained positive growth since 2010.

Policy Response in Advanced EconomiesNeo-liberal Fallacies and Obsessions

Figure 1.2 Public debt in the Eurozone (per cent of GDP)

Source: IMF WEO Database.

A key problem faced in the Eurozone in debt resolution is destabilizing interfaces between private and public debt. In countries like Spain and Ireland governments had to act to rescue heavily indebted banks and this added (p.32) significantly to public debt, increasing its financing needs. However, the very same banks were also expected to play an important role in financing heavily indebted governments. Being unable to print national currency, governments had limited capacity to bail out banks or monetize their own debt. This problem was further aggravated by the tendency of international (intra-Eurozone) lenders to withdraw from crisis-hit countries. A solution to this dilemma could have been to decouple public from private debt by stopping bank bail-outs by national governments and by introducing a Eurozone-wide bank resolution mechanism including bailing-in private creditors, recapitalization, and liquidation.5

Not all countries hit by the bursting of the speculative bubble failed to remove the debt overhang. In this respect, Iceland’s debt resolution initiatives stand in sharp contrast to the approach pursued in the US and the Eurozone (Hart-Landsberg 2013; Gissurarson 2016). Relative to the size of its economy, Iceland faced the biggest banking failure in economic history. However, it managed to restructure the banking system by letting some of the banks fail and bailing in private creditors, sparing both taxpayers and domestic depositors (p.33) from paying the price. It imposed capital controls to stem exit and passed an important part of the burden on to international creditors including bondholders and depositors. More importantly, from the end of 2008 until 2013 Iceland’s banks wrote off debt for more than a quarter of the population, by some 13 per cent of 2012 GDP. An important part of this is on mortgage debt exceeding 110 per cent of home values. This played an important role in the rapid exit of Iceland from a deep recession in 2009–10 with an unemployment rate of 5 per cent, compared to double-digit unemployment and persistent output losses in the Eurozone periphery.

1.3 Fiscal Orthodoxy

Fiscal policy no doubt gained added importance because of continued debt overhang and the ineffectiveness of monetary policy in lifting effective demand. But both the US and Europe shifted to austerity after an initial fiscal stimulus. In the Eurozone, the core also joined in the austerity imposed on the crisis-hit periphery.

The case for fiscal austerity is premised on two propositions. First, budget deficits add more to public debt than to GDP so that they would raise the debt-to-GDP ratio. Second, high ratios of public debt to GDP are detrimental to growth. It is thus believed that fiscal austerity would not undermine growth and could even stimulate it by lowering the ratio of public debt to GDP—hence, the so-called ‘expansionary austerity’.

The first proposition implies that fiscal multipliers are small. This is derived from highly controversial theories that higher public spending would crowd out private spending by pushing up the interest rate and that private sector would start spending less and saving more in order to provide for future tax increases needed to meet higher government debt servicing. These theories make no sense when interest rates are at historical lows and incomes are falling. Still, in the early years of the crisis, the fiscal policy advice of the IMF was premised on the assumption of extremely low multipliers and was invariably pro-cyclical. Because of the underestimation of fiscal multipliers, IMF growth projections turned out to be more optimistic than growth outcomes in several periphery countries with IMF programmes (Weisbrot and Jorgensen 2013). As a result of mounting evidence on fiscal drag, the IMF finally admitted that fiscal multipliers were much greater than had been believed and that they were state-dependent, particularly large under recessions, with the implication that fiscal austerity could in fact raise the debt ratio by depressing income (IMF WEO 2012; Blanchard and Leigh 2013).

The second proposition that high debt ratios could deter growth found support in the finding of an empirical study by Reinhart and Rogoff (2010) (p.34) that economic growth slows sharply when the ratio of government debt to GDP exceeds 90 per cent. However, it is generally agreed that such an association says effectively nothing about causality—slow growth could cause high debt rather than high debt leading to slow growth. Furthermore, subsequent research by Herndon et al. (2013) found that several critical findings of the Reinhart and Rogoff (2010) study were erroneous and in fact a 90 per cent debt ratio was associated with a much higher rate of growth than was found by these authors.

It is possible for the public sector to add to debt across the cycle without running into sustainability problems provided that it is used to finance productive investment. This implies conducting countercyclical fiscal policy by making a distinction between current and capital spending and adding to public debt over the cycle not to finance current spending but to invest.6 It is generally agreed that public investment should aim at improving the overall productivity of private activities as well as expanding aggregate demand. Spending on human and physical infrastructure could serve both objectives. Such an approach implies that analysis of fiscal sustainability should not just focus on gross public debt alone, but also consider assets built on the other side of the balance sheet of the public sector that could generate future revenues. When interest rates are at historical lows and likely to remain subdued in the near future, additional revenues needed to service such debt would not be prohibitive.

With the Eurozone unable to reignite growth and growth in the US unable to break into a stride, such an approach is finding advocates even within the mainstream. The OECD (2015) argued that a coordinated expansion of public investment, combined with appropriate structural reforms, could expand output and lower the ratio of public debt to gross domestic product since fiscal multipliers for public investment are above unity, and much higher than multipliers for current spending. In a subsequent simulation OECD (2016) estimated that 0.5 per cent of GDP public investment stimulus in the US and Eurozone would raise GDP by more than 0.5 per cent in the first year and lower the ratio of public debt to GDP. There is considerable scope for increasing public investment not only in the US, UK, and the Eurozone periphery, but also in Germany where the infrastructure has been decaying at an alarming rate.

Spending more, running higher deficits, and financing them with new debt, however, can encounter a dilemma; if public spending is successful in raising economic activity, employment, and prices, it could lead to substantially (p.35) higher interest rates, which could eventually create debt servicing difficulties. For instance in early 2016, US rates for ten year treasuries were around 2 per cent and interest payments accounted for 6 per cent of all federal outlays. But projections by the Congressional Budget Office show that they could account for more than 13 per cent of all federal outlays in 2026 when interest rates are projected to rise to 4.1 per cent (Wessel 2016).

If and when such a dilemma emerges, other ways would have to be found to finance higher public spending. One way is to combine progressive taxation with increased public spending. This could give a significant boost to economic activity without creating deficits and debt or significantly crowding out private spending. Under conditions of deflation when private spending remains depressed, the so-called balanced-budget multiplier tends to be quite high, particularly if public spending is financed by additional taxes on top income classes. This is particularly true for the US and the UK where income and wealth inequality is much greater than other major OECD countries and taxation is much less progressive. It has been estimated that in such cases the top tax rate on the top 1 per cent income earners could be raised to over 80 per cent without impairing growth and that the potential tax revenue at stake is very large (Piketty et al. 2011). However, the dominant ideology shaping the crisis intervention has sidelined such socially progressive and economically beneficial solutions.

In the US the immediate fiscal response to consumer deleveraging and retrenchment through one-off transfers and tax cuts played an important role in restraining the downturn and initiating recovery. For instance it is estimated that the fiscal stimulus raised 2010 real GDP by as much as 3.4 per cent, held the unemployment rate about 1.5 percentage points lower, and added almost 2.7 million jobs to US payrolls (Blinder and Zandi, 2010). However, as soon as the economy started to show signs of life, fiscal orthodoxy returned. As pointed out by Janet Yellen (2013a: 4) when she was a Vice Chair of the Board of Governors of the Federal Reserve System, ‘discretionary fiscal policy hasn’t been much of a tailwind during this recovery. In the year following the end of the recession, discretionary fiscal policy at the federal, state, and local levels boosted growth at roughly the same pace as in past recoveries.…But instead of contributing to growth thereafter, discretionary fiscal policy this time has actually acted to restrain the recovery…and I expect that discretionary fiscal policy will continue to be a headwind for the recovery for some time, instead of the tailwind it has been in the past.’

Indeed, fiscal retrenchment continued unabated in the US despite weak recovery. According to Hutchins Center’s Fiscal Impact Measure, local, state, and federal governments were a drag on US economic growth over much of the last five years when the economy was still struggling to recover from the Great Recession and it was only after mid-2015 that the fiscal policy started (p.36) to give a boost to economic activity (Wessel 2015). On another account, however, fiscal policy in the US remained contractionary during 2014–16 (OECD 2016).

The initial fiscal policy response in the Eurozone was also reflationary. Between 2007 and 2009 the budget balance of the Eurozone moved from an average deficit of 0.7 per cent of GDP to 6.3 per cent and according to the European Commission, half of the increase in deficits was due to the conventionally measured automatic stabilizers and half to discretionary countercyclical fiscal policy actions (EC 2011: 15). In Germany fiscal reflation included one-off transfers, tax relief, and spending on transportation and education. From 2010 onwards fiscal policy in the Eurozone became more and more restrictive. Between 2011 and 2013 spending cuts and tax increases amounted to around 4 per cent of GDP and this played a central role in the return of the region to recession during 2012–13 (Rannenberg et al. 2015). Fiscal consolidation continued in subsequent years. According to the European Commission (EC 2015b) the aggregate budget deficit of the region was expected in 2015 to decline from 2.6 per cent of GDP in 2014 to 1.8 per cent in 2016. This is happening at a time when growth in the region is still below par and automatic stabilizers should be expected to widen headline deficits, giving rise to increased calls for a more expansionary fiscal policy to prevent the region from returning to recession (Truger 2015).

In the Eurozone lending to debtor countries incorporated austerity in the form of tax hikes, and cuts in public spending and wages. Much of the burden of fiscal consolidation fell on public investment, with cuts exceeding 2.5 per cent of GDP in Greece, Spain, and Ireland between 2010 and 2013. In a subsequent evaluation of the 2010 Stand-By Agreement with Greece, the IMF (GFSR 2013a) admitted that it had underestimated the damage done to the economy from fiscal austerity imposed in the bail-out programme and that it deviated from its own debt-sustainability standards and should have pushed harder and sooner for lenders to take a haircut to reduce Greece’s debt burden. Indeed, as already discussed in this chapter and as subsequently recognized by the OECD (2015), such consolidation efforts can move the economies away from medium-term debt sustainability rather than reducing the ratio of public debt to GDP.

Greece and Portugal made the most strenuous efforts to improve fiscal balances, by around 8 percentage points of GDP during 2010–15. These are also the two countries with the worst growth performance over the same period, with average rates of −4 per cent and −1 per cent respectively. Consequently, both countries saw a significant increase of the ratio of gross public debt to GDP, by around 35 percentage points (Weeks 2016).

While fiscal retrenchment in the periphery widened the deflationary gap (that is, the gap between full employment level of output and actual output) (p.37) and failed to stabilize sovereign debt, deflation in the core countries made it very difficult for them to make growth-oriented balance-of-payments adjustment based on export expansion rather than contractionary adjustment based on import retrenchment. As the periphery is locked in a currency whose nominal exchange rate is beyond their control, the only way to restore competitiveness would be through cuts in wages. This means that more austerity would be needed to overcome austerity; employment needs to be cut in order to generate external demand.7 Weak demand in Germany increased the retrenchment needed in the periphery to achieve any given turnaround in external balances.

So far the crisis countries with overvalued currencies have achieved a significant degree of internal devaluation and adjustment in real effective exchange rates through wage suppression (see Figure 1.1). Except Cyprus, all of them moved from current account deficits of 6 to 15 per cent of GDP in 2007 to a surplus in 2015. However, much of this improvement came from economic contraction, cuts in private investment, and imports (Atoyan et al. 2013). Greek imports at the end of 2015 were 40 per cent down from the pre-crisis peak while exports levelled off and fell to pre-crisis levels after a temporary surge in 2012–13. Import cuts were equally sharp in Portugal. In Spain, with more diversified industry, import cuts were less severe while exports showed greater dynamism than Greece and Portugal.8 This pattern of adjustment is largely shaped by fiscal austerity, sluggish wages, and trade surplus in Germany, which have placed the burden of adjustment disproportionately on debtor deficit countries.

1.4 The Ultra-easy Monetary Policy

The reluctance to use fiscal policy to expand aggregate demand resulted in excessive reliance on monetary policy, particularly as fiscal austerity became self-defeating by restraining growth. Policy interest rates have been cut to historical lows, not only in the US, the UK, and the Eurozone but also many other advanced economies. In several cases, including the Eurozone, Japan, Switzerland, Sweden, and Denmark, central banks have moved to negative rates as the ultra-easy monetary policy proved not as effective as expected. (p.38) They have also been engaged in large-scale bond purchases, financed by the creation of reserves in the banking system in order to reduce long-term interest rates and stimulate borrowing and spending.

In the US the targeted federal funds rate was cut to 0.25 per cent in December 2008 and stayed at that level until December 2015, when it was raised to 0.50 per cent. QE1 was started in 2008 for purchases of mortgage-backed securities; QE2 was introduced at the end of 2010 for a purchase of $600 billion of treasury securities and supplemented by the so-called Operation Twist whereby the US Federal Reserve replaced expiring short-term treasury bills with long-term notes and securities; Q3 came in September 2012 followed by an announcement by the US Federal Reserve in December that it would keep buying $85 billion a month in treasuries and asset-backed securities until unemployment fell below 6.5 per cent or inflation rose above 2.5 per cent. The US Federal Reserve started tapering its monthly bond purchases in January 2014 and ended it altogether in October 2014.

In the Eurozone initially monetary policy interventions were less intense, but extended and broadened significantly as the crisis deepened and the region remained in stagnation. The ECB cut its benchmark refinancing rate to 1 per cent in 2009. The two rounds of misguided increases, first to 1.25 per cent then to 1.50 per cent in 2011 were followed by successive cuts, eventually to a record low of zero per cent in March 2016. To expand liquidity in March 2010 the ECB eased collateral requirements in lending to banks, thus accepting low-grade sovereign bonds as well as asset-backed securities. This was followed by the Securities Market Programme in May of the same year with the ECB buying sovereign bonds in secondary markets—an initiative that created controversy regarding the no-bail-out provision of the 2007 Lisbon Treaty. The Long-Term Refinancing Operations were introduced at the end of 2011 for the ECB to provide three-year loans to banks at low interest rates, enabling them to buy high-yield sovereign bonds and earn large spreads, notably in Spain and Italy. As of early 2016, the nominal charge to banks using this facility was set at zero and in fact banks could borrow from the ECB at negative rates (up to -0.4 per cent) if their lending reaches a certain size.

In 2012, soon after its head reaffirmed the pledge to ‘do whatever it takes’ to save the single currency, the ECB announced that it would undertake outright monetary transactions in secondary sovereign bond markets without ex-ante time or size limits. This was activated in January 2015 with an ‘expanded asset purchase’ or a big QE programme of €60 billion monthly purchases of euro-area bonds. Originally the QE stimulus was planned to last until September 2016, but in December 2015 the ECB pledged to continue it until March 2017. In March 2016 monthly bond purchases were increased to €80 billion and investment-grade euro-denominated bonds issued by non-bank corporations established in the Eurozone were made eligible for regular purchases under QE.

(p.39) The channels through which QE programmes were expected to stimulate private spending are not always well understood and there is significant controversy over why they failed to give a significant boost to economic activity, particularly in the US. In QE operations central banks buy bonds from non-bank financial institutions such as pension funds and insurance companies through the banking system. Money supply expands as these institutions exchange their bond holdings with bank deposits while banks acquire reserves at the central bank by a corresponding amount. Since required reserves are a fraction of deposit liabilities of banks, much of these reserves would be excess reserves. The expansion of bank deposits and money supply is not driven by credit expansion as is usually the case in money creation in modern economies.9

It is sometimes maintained that the practice of payment of positive interest rates on excess reserves makes the banks unwilling to lend but keep the extra liquidity as reserves at the US Federal Reserve (e.g. Stiglitz and Rashid 2016). However, banks cannot use their reserves at the central bank for lending. In fact QE may even reduce the credit volume if it encourages other means of corporate finance such as bond issues as substitutes to bank credits (McLeay et al. 2014; Coppola 2016; Keen 2016a, 2016b).

Thus, QE operations cannot increase bank lending by providing more reserves to the banking system even though such an impression was created by various commentators, including central bankers. For instance in the early days of bond purchases Bernanke (2009) argued that the ‘idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans’. Rather, they could be expected to stimulate the economy through two channels (Sastry and Wessel 2015). First, they would lower longer-term interest rates. Secondly, investors who sold treasury bonds would shift to other assets, including houses and high-risk, high-yielding assets such as stocks and corporate bonds. This means that in effect QE was designed to stimulate private spending by creating asset bubbles and increasing the demand for corporate debt and reducing its cost.

Even though excess reserves created by QE programmes cannot be used for lending, they allow banks to expand credit without having to borrow from the central bank or in the interbank market. As bank credits and deposits expand, excess reserves would be translated into required reserves (Coppola 2016). However, this would not affect banks’ earning on reserves and their lending behaviour if interest is paid at the same rate on both required and excess reserves. This is what the US Federal Reserve has been doing since January (p.40) 2009 with the rate having been set equal to the targeted federal funds rate. It is argued that the main objective of paying interest on excess reserves is to gain a better control over the federal funds rate. Since rapid growth of reserves made it difficult to reach the targeted federal funds rate by varying the supply of bank reserves, the US Federal Reserve seeks to influence market rates by moving the interest paid on excess reserves (Bernanke and Kohn 2016).

Interest payments on excess reserves in effect constitute a subsidy to banks since the rates they offer to their deposit holders are virtually zero. They also allow reserves and bank profits to grow even in the absence of further QE operations.10 While the payment of interest on required reserves can be justified for compensation for their opportunity cost to banks, there is no good reason for paying interest on excess reserves at times of recession since the primary purpose of such payments is to prevent banks from lending at lower rates. Indeed, since interest rates on excess reserves establish a lower bound to the federal funds rate, adjustments to these rates are expected to play an important role in the US Federal Reserve’s exit from the ultra-easy monetary policy.11

Unlike the US Federal Reserve, the ECB and the Bank of Japan apply negative interest to excess reserves while paying positive and zero interest on required reserves, respectively (Bech and Malkhozov 2016). This implies that credit (and hence deposit) expansion could have a positive impact on banks’ income from reserves by shifting them from excess to required reserves. However, negative nominal policy interest rates are uncharted waters and there is considerable uncertainty regarding their impact on credit and private spending. As noted by a BIS report ‘experience so far suggests that modestly negative policy rates are transmitted to money market rates in very much the same way as positive rates are. However, questions remain as to whether negative policy rates are transmitted to the wider economy through lower lending rates for firms and households, especially in rates associated with bank intermediation’ (Bech and Malkhozov 2016: 4). Furthermore, even when they result in lower lending rates, they may not bring faster expansion of credit and private spending than has so far been achieved by massive cuts in policy (p.41) interest rates after the onset of the crisis. In reality negative policy rates can destabilize the banking system rather than expand credits: ‘if negative policy rates are transmitted to lending rates for firms and households, then there will be knock-on effects on bank profitability unless negative rates are also imposed on deposits, raising questions as to the stability of the retail deposit base’.12

The reasons for the failure of ultra-easy monetary policy in re-igniting bank lending to support spending on goods and services are found in the deflation generated by the crisis. The increased risk aversion made banks in both the US and Europe unwilling to lend to households and small businesses while big businesses have had little need for bank loans or appetite for new spending on labour and equipment in view of sluggish demand. In Europe, in addition, the banking system itself has been in a dire state; it is undercapitalized and impaired by €1 trillion of bad loans (Wharton Finance 2016). As noted, this is in large part because governments chose to rescue rather than force them to restructure in the early days of the crisis. These banks sought to meet capital charges by cutting credit rather than recapitalization even though they were flooded with liquidity. Even the initiative by the ECB to subsidize bank lending under the Long-Term Refinancing Operations was not expected in 2016 to lead to a rapid credit expansion (Münchau 2016; Jones 2016). As put by the Economist (2016), ‘increasingly, the markets are doubting the efficacy of overstretched monetary policy’.

The ultra-easy monetary policy has failed to stimulate private spending, but created significant opportunities for fiscal expansion by lowering long-term interest rates and rapidly increasing the central bank holding of government debt, notably in the US. On the one hand, it has resulted in a significant decline in interest payments from the budget. On the other hand, much of the interest payments on debt held by central banks have gone back to the budget as profit remittances.13 It is estimated that by the end of 2012, total benefits of governments in the US, the UK, and the Eurozone taken together from both reduced debt service costs and increased profits remitted from central banks reached $1.6 trillion (Dobbs et al. 2013). This space was not used effectively for fiscal reflation. In the US alone for 2007–12 benefits from lower interest rates and profit remittances were over $1 trillion compared to a total fiscal stimulus of some $800 billion in the same period (Amadeo 2013). Profit remittances (p.42) from the US Federal Reserve alone during 2006–15 reached $600 billion, meeting a large proportion of the deficit created by fiscal stimulus (Sharf 2015; Leubsdorf 2016).

The QE programmes have failed to lift private spending but succeeded in creating asset bubbles. They gave the money not to banks but to non-bank financial institutions which have used it to speculate globally by shifting to high-risk, high-yielding financial assets. They triggered a search for yield in the riskier part of the credit spectrum including high-yield bonds, subordinated debt, and leveraged syndicated loans (BIS 2013: 7). High-yield high-risk corporate debt issuance accelerated in both advanced economies and EDEs and there were significant increases in corporate debt in booming sectors such as energy.14 Stock markets in most major advanced economies reached historical highs, but the wealth effect of asset booms on spending has been weak because the gains are reaped mainly by the rich.15

All these led to an important build-up of fragility in financial markets in advanced economies. The BIS (2013: 1) described the strong issuance of bonds and loans in the riskier part of the spectrum, as ‘a phenomenon reminiscent of the exuberance prior to the global financial crisis’. They caused concern even at the US Federal Reserve with Bernanke (2013) issuing a warning that asset prices may get delinked from fundamentals, generating mispricing (see also IMF GFSR 2013a). Similar concerns were expressed by Janet Yellen before becoming the chairman of the US Federal Reserve (Yellen 2013b; see also Fontevecchia 2013).

As discussed in the subsequent chapter, the ultra-easy monetary policy in advanced economies created consumption and property bubbles in several emerging economies by giving rise to a surge in capital flows and booms in credit and asset markets of these economies. In a way, it was more ‘successful’ in stimulating spending in the South than in the North, but at the cost of creating financial fragility.

There is a growing agreement that it would be difficult to exit from an extended period of ultra-easy money without disrupting global financial stability and impairing growth (White 2012; Stein 2013). QE has created significant fragility in financial markets and increased vulnerability to shocks by producing a combination of macro liquidity and market illiquidity—something which Roubini (2015) calls ‘the liquidity time bomb’ (see also Lefeuvre 2015). While (p.43) large central bank purchases of safe, liquid government bonds expanded monetary base and macro liquidity, these purchases, together with regulations requiring banks and other large financial institutions to hold large amounts of safe liquid assets, reduced their supply and made them less liquid. For the same reason, the proportion of risky, high-yielding, illiquid assets in private portfolios such as infrequently traded corporate and emerging market bonds increased. A large proportion of these bonds have come to be held in open-ended funds that allow investors quick exit en masse, creating the risk of crash in the event of a shock—something that has caused concern at the IMF and the US Federal Reserve and triggered suggestions to impose exit fees on bond funds (Abramowicz 2014; Durden 2014a).

These imply that unexpected changes in policy or key economic performance indicators such as growth, employment, or oil prices can result in sudden and severe revaluation of asset prices. A hike in policy rates can certainly trigger such a revaluation and this is a reason why the US Federal Reserve is hesitant in normalizing its monetary policy even though it is adding more to financial fragility than to incomes and jobs.16 But more fundamentally, if growth slows down, the illiquidity of asset markets can burst the booms and bubbles created by QE programmes and zero interest rates, even without a significant tightening of monetary policy.

There were several instances of gyrations in asset markets since 2008 (such as the ‘taper tantrum’ of May 2013) and early months of 2016 also saw heightened instability. It all started with growth slowdown and reversal of capital flows in EDEs throughout 2015, including in China. As described by the BIS in March 2016, the uneasy calm that had reigned in the financial markets in late 2015 gave way to a turbulent start in 2016, witnessing one of the worst stock market sell-offs since the 2008 financial crisis. Equity prices tumbled worldwide, credit default swap spreads widened, currencies of EDEs fell, especially vis-à-vis the US dollar, and the oil price sank to below the levels seen during the Great Recession. ‘Underlying some of the turbulence was market participants' growing concern over the dwindling options for policy support in the face of the weakening growth outlook. With fiscal space tight and structural policies largely dormant, central bank measures were seen to be approaching their limits’ (BIS 2016).

Whether or not these stock market developments anticipate an imminent collapse and recession in the world economy, it must be evident that policy-makers lack ammunition to fight another downturn unless they abandon fiscal austerity and give the money to those who would spend it rather than (p.44) speculate with it. However, as problems mount, the ECB is simply promising more of the same thing. As for the US, the only option under the current policy approach would be to join the ECB and re-introduce QE purchases and cut policy rates to negative levels (Bernanke 2016)—but only to make the problems come back with greater force.

1.5 People’s Quantitative Easing: The Case for Helicopter Money

Since the large quantities of liquidity provided to financial markets through QE programmes and cuts in policy interest rates to historical lows have failed to expand private spending adequately, a way out could be to make the money available directly to those who are willing to spend but cannot do so because of tight budget constraints and debt overhang they face. Milton Friedman suggested, a long time ago, dropping money from helicopters to avert deflation. In a speech given in 2002 before becoming the chairman of the US Federal Reserve, Bernanke referred to helicopter money as a way of reversing deflation, noting that ‘the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost’ and that ‘a determined government can always generate higher spending and hence positive inflation’. He then went on to argue that ‘the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities’ and that ‘money-financed tax cut is essentially equivalent to Milton Friedman's famous “helicopter drop” of money’ (Bernanke 2002: 4, 6).

In the cooperation for deficit monetization between monetary and fiscal authorities, the Treasury would obtain a credit at the US Federal Reserve by selling sovereign debt and use this credit to finance tax cuts or transfers to households or direct purchases of goods and services in an investment programme. Part of the currency issued would return to the central bank as reserves through increases in bank deposits and a part would be held by the public. Either the US Federal Reserve cancels the treasury bonds or holds them indefinitely. In either case, the sovereign would incur no cost on this debt because the US Federal Reserve’s profits are remitted to the Treasury.

At first sight helicopter money looks like a combination of fiscal stimulus plus QE. There are, however, important differences. First, QE is an exchange of assets, newly printed dollars for bonds held by the public through the banking system. By contrast, here the base money and reserves increase as a result of additional spending on goods and services either directly by the government or indirectly by the private sectors through budgetary transfers and tax cuts, not because of asset substitution. Second, the US Federal Reserve’s purchase of (p.45) treasuries in QE operations do not provide the government non-debt creating, interest-free resources unless such debt is monetized indefinitely. In other words, deficit monetization requires permanent QE—an irreversible increase in the nominal stock of fiat money (Buiter 2014). It is true that as long as the bonds acquired by the US Federal Reserve stay on its balance sheet, they do not entail net cost to the government because the US Federal Reserve’s profits are remitted to the Treasury. But as soon as the expansion of the US Federal Reserve’s balance sheet is reversed and these bonds exit the US Federal Reserve’s balance sheet (that is, if they mature without being replaced or if they are liquidated), these profits would dry up. This, together with the return of interest rates to normalcy, would increase debt servicing costs significantly.

The kind of cooperation needed for deficit monetization between the monetary and fiscal authorities is in principle feasible in most advanced economies, including the US.17 However, in the Eurozone, direct financing of government deficit is explicitly prohibited by the Lisbon Treaty. Unless the relevant provisions of this treaty are reformed, deficit monetization in the Eurozone would have to go through the market—governments would have to issue debt to finance deficits and the ECB would have to buy sovereign bonds from secondary markets but with a commitment to hold them indefinitely. Purchases of sovereign bonds in the secondary markets are already made with the QE programme that started in January 2015.

Thus, permanent monetization of government debt provides an effective answer to deflation and long-term sovereign debt sustainability. The case for overt monetary financing also applies to deficits resulting from debt write-downs and bail-out operations to recapitalize insolvent banks. It would allow stabilizing the banking system without adding to government debt and hence shifting solvency concerns from banks to sovereigns, as has happened in the Eurozone periphery (Turner 2013b).

Should fiscal authorities be unwilling to engage in helicopter money, could central banks do it themselves by sending checks to citizens, dropping money in private bank accounts or in other ways? This is advocated by Wolf (2016): ‘If the fiscal authorities are unwilling to behave so sensibly…central banks…could be given the power to send money, ideally in electronic form, to every adult citizen. Would this add to demand? Absolutely. Under existing monetary arrangements, it would also generate a permanent rise in the reserves of commercial banks at the central bank. The easy way to contain any long-term monetary effects would be to raise reserve requirements.’ As for the Eurozone, there is nothing in the Lisbon Treaty prohibiting helicopter drops by the (p.46) ECB. Rather, ‘one could argue that the Treaty not only permits but demands helicopter money drops from the ECB’ in order for the ECB to pursue the objective of getting inflation closer to the 2 per cent target (Buiter 2014: 45).

A possible objection to helicopter drop is that it may not work—that is, money thus supplied may be hoarded rather than spent. However, ‘there always exists…a combined monetary and fiscal policy action that boosts private demand’ (Buiter 2014: 1). Under deflationary conditions ‘money-financed’ spending or tax cuts need be no riskier for financial stability than the ultra-easy monetary policy, since the money thus created would not find its way directly into asset markets. Nor would it endanger monetary instability. If a permanent increase in money supply resulting from deficit financing turns out to be inflationary, it can be sterilized by using bank reserve requirements rather than selling government bonds. As argued by Turner (2013a: 24) the idea that overt money finance of fiscal deficits is inherently any more inflationary than the other policy levers used to stimulate demand is without any technical foundation. Rather, the main challenge is how to ‘design institutional constraints and rules that would guard against the misuse of this powerful medicine’ (see also White 2013; Turner 2013b; Turner 2015; Wolf 2013).

As monetary policy has increasingly become impotent in dealing with the crisis, the orthodoxy has started to give way to pragmatism. The Financial Times, in an editorial entitled ‘Helicopter Money: Extreme Money-Printing Should be Openly Discussed’ (13–14 October 2012) argued: ‘Printing Money—not just temporarily for trading securities in the market, but permanently handing it over to be spent by someone—is the central banker’s heresy. Yet it would be irresponsible to rule that option out.’ Among the more progressive, helicopter drop has been referred to as People’s Quantitative Easing, which occupied a central place in the reform proposal of the new UK Labour Party Leader, Jeremy Corbyn.18 Some central banks, including the Bank of England, are reported to have given consideration to such a solution (Financial Times 2012).

Since 2008 circumstances have forced central bankers to abandon monetary orthodoxy first by dropping interest rates to zero and then by engaging in QE operations. Regarding the helicopter money, ‘all the really important issues are political, since…the technical feasibility and desirability in some circumstances of monetary finance is not in doubt’ (Turner 2015: 1). It is increasingly believed that helicopter money may be unorthodox policy number 3, particularly in the Eurozone which needs more radical measures to save the euro.19 (p.47) However, this route is unlikely to be taken before economic conditions worsen significantly. Moreover, in all likelihood, central bankers can be expected to try to retain their independence by giving the money directly to private citizens rather than to the government. For, as noted by a Member of the Executive Board of the ECB when asked if the ECB could print cheques and send them to people: ‘Yes, all central banks can do it. You can issue currency and you distribute it to people. That’s helicopter money. Helicopter money is giving to the people part of the net present value of your future seigniorage, the profit you make on the future banknotes. The question is, if and when is it opportune to make recourse to that sort of instrument which is really an extreme sort of instrument.…So when we say we haven’t reached the limit of the toolbox, I think that’s true’ (ECB Eurosystem 2016a).

1.6 Secular Stagnation

The failure of historically low interest rates to achieve a strong recovery in private spending and growth has bewildered many mainstream economists, leading to a search for a possible explanation within the conventional macroeconomic framework. Much of the debate revolved around the secular stagnation thesis, or what Palley (2016) calls the Zero Lower Bound (ZLB) economics, first evoked by Larry Summers in a speech at the IMF (Summers 2013), and picked up by many others in the same school of thought.20

According to this thesis, the subprime crisis uncovered the chronic demand gap that has existed in the US since the 1980s and the risk of secular stagnation. Because of vanishing investment opportunities, the real rate of interest that equates savings and investment at the full employment level of income (the so-called Wicksellian ‘natural’ rate of interest or the ‘equilibrium’ rate of interest) has declined significantly and even become negative. Since nominal interest rates cannot be pushed below zero and monetary authorities cannot create inflation, investment remains below the level needed for full employment and income remains below potential. The gap between actual and potential output creates hysteresis, resulting in a decline of potential output and growth; or, in the words of Summers, lack of demand creates its own lack of supply.

(p.48) According to this hypothesis, until the subprime crisis the chronic demand gap was masked by private spending driven by financial bubbles; Savings and Loans in the 1980s, dot-com in the 1990s and the subprime in the 2000s. These bubbles take place largely because low interest rates in search of faster growth boost asset values and drive investors to take greater risks.21 Unless the underlying causes of chronic deflationary gap are addressed, credit and asset bubbles would be needed to avert secular stagnation. Since these bubbles eventually burst and culminate in financial crises, this chronic demand gap creates a trade-off between financial stability and growth.

The concept of secular stagnation was elucidated by Alvin Hansen during the great depression of the 1930s who argued that while adequate investment would be needed to attain full employment, investment opportunities would vanish as population growth and technical progress slow down. Summers also refers to these, but at the same time throws in a number of other factors responsible for the decline in the equilibrium rate of interest: the legacy of excessive leverage caused reduction in demand for debt-financed investment; the decline in the relative price of capital reduced investment spending needed to attain a given rate of capacity expansion; and growing income and wealth inequality increased the supply of loanable funds and hence raised the level of investment needed to achieve full employment.22

The first line of response to secular stagnation, according to Summers, is to reduce real interest rates as much as possible by operating with a higher inflation target. But this also creates the risk of financial instability by leading to asset and credit bubbles. A more effective way would be to raise aggregate demand by increasing investment and consumption. Appropriate strategies include increased public investment, reductions in structural barriers to private investment, measures to promote business confidence and export promotion through trade agreements, and resistance to protectionism in trading partners.

The Hicksian liquidity trap hypothesis is also invoked to reach similar conclusions regarding the ineffectiveness of monetary policy in stimulating demand (Krugman 2013a, 2013b). According to this view, the deleveraging resulting from the subprime crisis reduced the overall level of demand at any given interest rate and made the natural rate negative, making it impossible for monetary policy to stabilize the economy. To avoid such an outcome, we should not have had debt-driven bubbles in the first place. But if there were no (p.49) bubbles, aggregate demand and employment would have remained depressed. Once the current deleveraging is over, demand will shift up, but without renewed bubbles income and employment levels would be subdued. There is also the possibility that the economy may be trapped in a liquidity trap permanently even after the current deleveraging is over and there may be a need for ever-growing debt to stay out of the liquidity trap.23 Sufficiently large and permanent fiscal stimulus—or permanently bigger government—would be required to avoid this trap. This should be no cause for concern since debt sustainability would be secured as long as the real rate of interest on government debt is below the rate of growth of the economy (Krugman 2015a).

Bernanke (2015a, 2015b) is sceptical that the US faces secular stagnation due to vanishing investment opportunities since at a real interest rate of −2 per cent there would be no dearth of private investment. He also takes issue with the contribution of bubbles to previous recoveries and attributes low interest rates and demand gap in the US to global savings glut. On this view, in the run-up to the crisis, excess savings from China and major oil exporters spilled over to the US through capital flows, depressing long-term rates even as the US Federal Reserve was trying to raise short-term rates, thereby helping sustain the subprime bubble. They also weakened US exports, created a large trade deficit, and reduced US growth by appreciating the dollar. The savings glut persisted after the crisis as the decline in excess savings of Asian EDEs and oil producers was offset by a significant increase in the combined current account surplus of the Eurozone, particularly Germany.24 It has the same effect as reduced domestic investment on economic activity.25 However, on this view, here the problem arises from policies pursued in surplus countries rather than structural factors emphasized by the secular stagnation hypothesis. Accordingly, the appropriate response would be to reverse policies that generate the savings glut. With the moderation of global imbalances in trade and financial flows, global real interest rates can thus be expected to rise and the US would be able to grow without bubbles.26

This debate among mainstream economists about secular stagnation has elicited strong interest among heterodox economists, particularly since it came from the very same people who had entertained considerable optimism (p.50) about the prospects of modern capitalism, under the rubric of Great Moderation associated with low inflation, reduced volatility of business cycle fluctuations, improvements in economic growth, and the belief that credit risk was a thing of the past (Wray 2013; Palley 2014). Indeed until they changed heart, secular stagnation remained a heretical idea for the mainstream (Backhouse and Boianovsky 2015). They now make no reference to history of economic thought as well as the more recent work done by heterodox economists (e.g. Foster and Magdoff 2009; Palley 2012).

While there is little dispute on the deceleration of accumulation and growth, its causes and the appropriate policy response are highly contentious. From a Marxian perspective, elucidated by Paul Baran, Paul Sweezy, Michael Kalecki, Joseph Steindl, and others, stagnation is the outcome of inherent contradictions in the accumulation process in a capitalist economy (Despain 2015). The mainstream fails to incorporate these or offer a sensible theoretical or a historical explanation of structural changes deemed responsible for the shift of the balance between savings and investment and the relation of secular stagnation ‘to the contemporary expansion of finance’ (Magdoff and Foster 2014: 2).

Furthermore, both the secular stagnation and savings glut arguments suffer from a failure to distinguish between savings and financing, and to grasp that in a modern monetary economy loans do not come from pre-existing stocks of deposits, and investment from pre-existing stocks savings. Rather, it is credits that generate deposits and investment that generates savings (Palley 2016; Wray 2013; Keen 2014, 2015; Hein 2015). Excess of savings over investment implies excess supply of goods or services. This sets off a process of adjustment through changes in the level and functional distribution of income, rather than the interest rate. Since savings adjust to investment, an ‘investment dearth would be matched by a savings dearth’ (Wray 2013: 4). Investment is governed by demand and profit expectations and made and financed independently of savings.27 In a monetary economy the interest rate is a monetary phenomenon and there is no such thing as a stable ‘natural’ rate of interest that is compatible with full employment: ‘Contrary to ZLB economics, not only does a laissez-faire monetary economy lack a mechanism for delivering the natural rate of interest, it may also lack such an interest rate.’28

Contrary to the savings glut argument, excess savings in surplus countries cannot exist prior to imports by deficit countries and finance those deficits (Wray 2013). Furthermore, the analysis of international influences over credit (p.51) and spending booms in deficit countries needs to take into account all kinds of gross financial flows not just net capital flows (current account balances). In these respects there is ‘increasing stylised evidence that appears prima facie inconsistent’ with the savings glut argument: ‘the link between current account balances and long-term interest rates looks tenuous’; ‘the depreciation of the US dollar for most of the past decade sits uncomfortably with the presumed attractiveness of US assets’; and ‘the link between the US current account deficit and global savings appears to be weak’ (Borio and Disyatat 2011: 4–5).

1.7 Inequality, Financialization, and Underconsumption

There is little doubt that both demand-side and supply-side factors have been at play in the emergence of a chronic demand gap and slowdown of accumulation and growth in advanced economies. The two key interdependent factors that figure prominently in heterodox explanations of stagnation are growing inequality and financialization. These are mainly the product of neo-liberal policies rather than exogenous influences affecting thrift, accumulation, and productivity.

Declining share of wages in GDP and increasing concentration of wealth in the hands of a very small minority lead to underconsumption and a structural demand gap that cannot be filled permanently by bubble-driven spending. Sluggish wages also reduce inflationary pressures and allow and encourage central banks to pursue expansionary monetary policy. This is all the more so because, with unrelenting fiscal orthodoxy, monetary policy has become the only instrument left for achieving the objective of full employment. In the US, for instance, over the past three cycles the US Federal Reserve pushed its policy rates sequentially lower, cutting it more and more during downturns and raising it less and less during upturns, creating a downward bias in interest rates (Palley 2016: 18). Thus, the ‘coincidence of a declining wage share and declining real interest rates is not…accidental’ (Goodhart and Erfurth 2014). Easy money generates asset price and debt bubbles, which occasionally but not always produce spending booms. Bubbles create waste and distortions on the supply side, reducing potential growth. They also redistribute to the top, widening the demand gap. When they crash, inequality is aggravated and the economy would need even bigger bubbles to recover and grow. The solution is to be found not in monetary policy and negative interest rates but in reversing the secular decline in wages and concentration of wealth, restraining financialization and assigning a greater role to the public sector in stabilizing aggregate demand.

(p.52) All major economies, whether in deficit or surplus, suffer from growing inequality and underconsumption. There is a secular downward trend in the share of wages in GDP. Figure 1.3 shows this for unadjusted labour share in the US, China, Germany, and Japan from the 1990s onwards, but the same trend is observed for the adjusted wage share and a wider range of advanced economies including the Eurozone as a whole and the UK from the 1970s onwards.29 The downward trend is more pronounced in the US and Japan than other major advanced economies. According to the International Labour Organization (ILO) estimates, between 1970 and 2014 the labour share declined by around 10 percentage points in the US and Japan and around 6–7 percentage points in Germany and the UK. This stands in sharp contrast with a long-standing belief that the share of labour in GDP stays relatively stable in the course of economic growth.

Policy Response in Advanced EconomiesNeo-liberal Fallacies and Obsessions

Figure 1.3 Wage share (as per cent of GDP)

Source: AMECO, European Commission and NBS (National Bureau of Statistics of the People’s Republic of China).

Evidence from EDEs is more nuanced, but there is a pronounced downward trend in the share of wages in Asian countries (ILO 2015). A notable example is China where the share of wages in GDP has shown a downward trend since the early 1990s with its growing integration into the global economic system. (p.53) The wage share in China is also lower than that in major advanced economies, about 50 per cent compared to 55 per cent or more in the latter. However, the downward trend in China appears to have been reversed since 2011 as a result of efforts to establish a strong domestic consumer market.

In advanced economies growth in real compensation of workers has weakened since the 1980s and stayed behind output per worker. According to ILO/OECD (2015), in ten advanced economies for which data are available, between 2000 and 2013 labour productivity rose by 17 per cent while real wage index rose by some 6 per cent. This means that the purchasing power of workers over the goods and services they produce has been declining. The decline in the share of labour in income is also accompanied by a well-documented increase in the concentration of wealth in the top 1 per cent and hence the growing inequality in the distribution of incomes earned on assets. These trends in income and wealth distribution imply that inequality is not only a social problem but has increasingly become a macroeconomic problem.

Several studies undertaken in the OECD, IMF, and the European Commission suggest that technological changes are the main reason for the decline in the share of labour in income. However, this is highly contentious since the measurement of this effect is fraught with difficulties (Goodhart and Erfurth 2014). Indeed, closer examination has revealed that many of these findings are not robust (Stockhammer 2009). Rather, globalization and financialization as well as reduced bargaining power of labour resulting from neo-liberal policies appear to have played a central role in the downward trend in the share of wages in advanced economies (Palley 2007; Stockhammer 2009, 2012; ILO 2011; Hein 2013; Dünhaupt 2013).

The literature has identified various channels through which financialization aggravates inequality. Financial markets and institutions exert a strong influence on policy-making, thereby promoting the interest of capital vis-à-vis labour. The increased share of the financial sector in the economy reduces the share of wages in aggregate income because finance is less labour intensive than the rest of the economy. Financial boom–bust cycles tend to widen income and wealth inequality. Capital account liberalization reduces the labour share particularly when it culminates in crises (Furceri and Loungani 2015). It widens the options of corporations in investment strategy and enhances their bargaining power vis-à-vis labour. As management remuneration is increasingly tied to profits, their interest coincides with that of shareholders rather than labour. Short-termism associated with financialization raises dividend payments relative to retained earnings. Accordingly the decline in the wage share is reflected mainly by increases in dividends and interest incomes rather than higher corporate investment from retained earnings.

Globalization has also shifted the balance between labour and capital. China’s and India’s integration into the global system and the collapse of (p.54) the Soviet Union have added to economically active persons in the world by almost 1.5 billion workers, doubling the global labour force. It is argued that as the new entrants brought little useful capital with them, the global capital-labour ratio has fallen by more than 50 per cent (Freeman 2010). This works against labour not only because labour productivity and pay tend to increase with the capital-labour ratio, but also because it shifts the balance of power towards capital as too many workers chase too few jobs or too little capital to employ them. The emergence of cheaper offshore locations has also raised the bargaining power of corporations, making capital a lot more mobile than labour.

It is also suggested that the glut in the labour market is aggravated by the entry of baby boomers in advanced economies into the workforce after 1970. On this view, the greying population in the advanced economies and demographic shifts in EDEs, notably China, would reverse the downward trend in labour income over the next three decades (Goodhart et al. 2015). However, the glut in the labour market depends on the pace of accumulation which continues to be depressed by underconsumption. Besides, demography is not the only factor influencing distributive trends. Unless financialization and the neo-liberal policies affecting the bargaining power of labour vis-à-vis capital are reversed, it is difficult to see how demographic changes alone could restore the balance.

While technology and globalization tend to have similar effects on countries, the extent of inequality differs significantly in different advanced economies. In terms of the Gini coefficient, the US and the UK come at the top of the list of major OECD countries. This is partly because financialization has gone much further in the Anglo-American world than in major economies in continental Europe. Another reason concerns differences in policies affecting the relative bargaining power of labour and capital. The erosion of labour markets institutions such as declines in union density has had a strong impact on inequality and there are significant differences in this respect between the US and UK on the one hand, and continental Europe, on the other. There are also important differences regarding minimum wage legislation (Jaumotte and Buitron 2015; ILO 2015). Thus, differences in policies with respect to finance and labour markets explain much of the intercountry variations in income and wealth distribution.

So far there have been two responses to underconsumption. First, create spending booms driven by debt and asset market bubbles, as in the US during the subprime expansion and in China in the aftermath of the Great Recession. Second, rely on exports to fill the demand gap; that is, export unemployment through macroeconomic, exchange rate, or incomes policies as done by China and Japan before the global crisis and Germany throughout the new millennium. Neither of these, however, provides a sustainable solution.

(p.55) Financial bubbles may provide partial and temporary solutions to underconsumption but can in fact aggravate the structural demand gap. First, they do not always raise aggregate demand sufficiently to reduce unemployment and accelerate growth except when they lead to increased consumption or investment through debt accumulation. This happened during the subprime expansion in the US but the contribution of the dot-com bubble to growth in spending was limited in large part because the bubble was in the stock market, benefiting mainly high-income classes with lower spending propensities (Wray 2013). Again, the asset bubbles created by historically low interest rates and QE have not had much impact on aggregate spending because the benefits have gone to the rich and there has been little lending to lower income classes (and to the periphery in the Eurozone) with higher propensities to spend. In effect financial bubbles are more effective when they involve lending to income classes with higher propensities to consume. But this also would heighten financial fragility, rendering much of the debt so accumulated unpayable.

Second, the boom–bust cycles create supply-side distortions, impeding productivity and slowing growth. During booms, cheap credit diverts resources to low-productivity sectors such as construction and real estate services at the expense of more productive sectors such as manufacturing. The financial sector also crowds out real economic activity and more productive sectors (Cecchetti and Kharroubi 2015). Viable companies are held down by zombie companies, sustained by artificially favourable financial conditions. Misallocations created by the booms are exposed during the ensuing crises when the economy would have to make a shift back to viable sectors and companies, but this is impeded by credit crunch and deflation. Such adverse supply-side effects of debt-driven booms are revealed by a BIS study. Examining the link between credit booms, productivity growth, labour reallocations, and financial crises Borio et al. (2015) conclude that labour misallocations that occur during a boom have a much larger effect on subsequent productivity if a crisis follows—when economic conditions become more hostile, misallocations beget misallocations. It is estimated that the cumulative hysteresis effect of lost productivity over a decade long boom-bust cycle amounts to several per cent of GDP.

Third, boom-bust cycles aggravate the underconsumption problem by increasing inequality. Booms favour asset holders, while crises tend to reinforce the long-term trend in inequality. In the US, the crisis impoverished the poor, particularly those subject to foreclosures, while policy interventions benefited the rich. In the recovery period 2009–14, the top 1 per cent captured 58 per cent of total growth as their income grew by 27 per cent against 4.3 per cent growth of the income of the bottom 99 per cent (Saez 2015). In 2010 the households in the middle had lower real incomes than they did (p.56) in 1996 and this was slowing the recovery by holding back aggregate spending (Stiglitz 2013). In every year from 2008 onwards real hourly wages stayed behind hourly labour productivity and the share of wages fell both during the contraction and subsequent recovery (Dufour and Orhangazi 2016).

Until the Great Recession, China, Germany, and Japan all relied on foreign markets to fill the demand gap, with GDP growing faster than domestic demand thanks to a strong growth in exports (see Table 1.3). During 2004–07, exports accounted for about one-third of Chinese GDP growth thanks to their phenomenal expansion.30 In Japan and Germany export growth was more moderate, but their contribution to growth was much greater than that in China because in both countries domestic demand was sluggish. In other words Chinese export push was accompanied by a much stronger growth in domestic demand than in Japan and Germany, creating an expanding market for many other countries, notably exporters of commodities and manufactured parts and components for consumer goods.

In all three countries, in the period until the global crisis, the shares of wages and private consumption in GDP declined. However, unlike the other two countries, in China the decline in the wage share was associated with a strong (p.57) growth in real wages as well as in employment. As noted on p. 29, Germany was engaged in ‘competitive disinflation’, cutting productivity-adjusted real wages and prices to improve competitiveness. In Japan, too, the gap between productivity and wage growth widened during that period as outsourcing and competition from low-cost EDEs put pressure on wages.

This picture changed drastically with the onset of the global crisis. With the collapse of its main markets in advanced economies, growth in China fell sharply. This in effect gave an opportunity to design a stimulus package so as to address underconsumption. However, rather than boosting household incomes and private consumption, China focused on a debt-driven boom in investment in infrastructure, property, and industry, pushing its investment ratio towards 50 per cent of GDP and credit growth well ahead of GDP. This created excess capacity in several sectors and has left a legacy of a large stock of debt in public enterprises and local governments. The ratio of debt to GDP reached 250 per cent of GDP in 2015.

Chinese policy response thus created an imbalance between domestic investment and consumption while rebalancing external and domestic sources of demand. However, since investment boom could not be maintained over time, China gradually turned its attention to rebalancing consumption and investment. So far the progress made is quite modest, with the share of private consumption rising from around 35 per cent of GDP in 2009 to 37 per cent in 2014, compared to 47 per cent at the turn of the century. The jury is still out on whether and how fast the rebalancing can be done and a large and vibrant domestic consumer market can be created without facing financial turmoil and/or a sharp slowdown of growth.

After the global financial crisis Germany replaced China as a major surplus country with its exports almost rising constantly relative to imports, also helped by the weakening euro. In almost every year since the crisis growth of domestic demand in Germany continued to remain below that of GDP (Table 1.3). The contribution of the public sector to aggregate demand remained below the levels seen before the crisis while stagnant real wages resulted in a decline in private consumption as a percentage of GDP. As a result the German surplus rose from some 5 per cent of GDP to more than 8 per cent after the crisis while China’s current account surplus dropped from a peak of 10 per cent to 2–3 per cent. Before the onset of the Eurozone crisis, the region’s current account with the rest of the world was in balance and an important part of German surplus was with other Eurozone countries, notably the periphery countries with large current account deficits. Since the crisis, the German surplus increased while the region as a whole moved to a surplus with the rest of the world, by 3 per cent of its combined GDP.

Table 1.3 GDP, domestic demand and current account in main surplus countries

(Annual per cent change unless otherwise indicated)

2004–07

2010

2011

2012

2013

2014

2015

Germany

GDP growth

2.2

3.9

3.7

0.6

0.4

1.6

1.5

Domestic demand

1.1

2.9

3.0

−0.9

0.9

1.3

1.4

Private consumption

0.5

0.3

1.3

0.9

0.8

1.0

1.9

CA (% of GDP)

5.9

5.6

6.1

7.0

6.8

7.3

8.5

Japan

GDP

1.9

4.7

−0.5

1.7

1.4

0.0

0.5

Domestic demand

1.1

2.9

0.4

2.6

1.7

0.0

0.0

Private consumption

1.2

2.8

0.3

2.3

1.7

−0.9

−1.3

CA (% of GDP)

4.0

4.0

2.2

1.0

0.8

0.5

3.3

China

GDP

12.1

10.6

9.5

7.7

7.7

7.3

6.9

Domestic demand

10.3*

12.1

10.3

7.5

7.8

7.2

6.5

Consumption (total)

8.8*

9.4

11.4

8.2

6.9

6.9

7.1

CA (% of GDP)

7.1

4.0

1.8

2.5

1.6

2.1

2.7

(*) 2005–07 average.

Source: South Centre estimates based on IMF WEO database; IMF Article IV Consultation Reports with the People’s Republic of China.

It is not clear if Germany can keep relying on foreign demand to fill the domestic demand gap at a time when growth in the US remains sluggish, (p.58) China and most other EDEs are slowing and the rest of the Eurozone is still trying to complete its recovery from the crisis. German surplus is unsustainable because it is a problem almost for everybody (Bernanke 2015c; Tilford 2015). It is sucking demand from the rest of the world while imposing deflationary adjustment on the Eurozone periphery. Given its size and role in Europe, the attempt by Germany to overcome underconsumption by exporting unemployment is no more sustainable than was the rapid export-led growth of China. It is incompatible with economic and political stability in the Eurozone. More generally, for large economies export surpluses cannot provide a viable solution to the systemic problem of underconsumption because they face the problem of fallacy of composition and breed conflict.

To sum up, neither financial bubbles nor export surpluses constitute sustainable solutions to underconsumption in major advanced economies and China. Nor is it possible to stimulate productive private investment to fill the demand gap through interest rate adjustments. The solution is to be found in the reversal of the secular decline in the share of labour in income so as to reignite a wage-led growth (Onaran and Stockhammer 2016; Lavoie and Stockhammer 2012). This is the only secure way to create inflation that many central banks are striving but unable to achieve in order to lower the real interest rate. How this can be best done naturally varies from country to country but should include significant increases in minimum wages as well as across-the-board increases in compensations in both public and private sectors. The spectre of yet another crisis and recession has prompted governments in some advanced economies to move in this direction in order to reflate demand (Sandbu 2016). Whether or not these initiatives will go far enough to meet the challenge remains to be seen.

What role should the public sector play in overcoming underconsumption? Since there is a structural demand gap, the additional public spending needed to fill the gap should be permanent. That means bigger government. But this does not imply that the public sector should run a higher level of debt. As noted, this could be self-defeating by causing higher interest rates and creating sustainability problems. To avoid this, higher levels of public spending should be financed by permanently higher taxes on top income groups rather than by borrowing from them. This would have the same effect on aggregate demand as redistributing income from the rich to the poor. Since the balance between labour and capital cannot be restored overnight, greater attention would need to be given to redistribution through the budget.

Notes:

(1) Two voluntary schemes were introduced to help debtors: the Home Affordable Modification Program to encourage lenders to lower monthly mortgage payments of homeowners facing the risk of foreclosure; and the Home Affordable Refinance Program to help homeowners with negative equity to refinance their mortgages. A bill was also introduced in 2012 for debt-for-equity-swaps by allowing the underwater home owners whose home values fall short of their debt to reduce their monthly payments in exchange for a portion of any future price appreciation on the home, known as shared appreciation (Griffith 2012).

(2) But holders of hybrid debt (securities with elements of both debt and equity) took haircut; see Hay and Unmack (2012).

(3) Ironically, while the operation in Cyprus was meant to penalize ‘Russian money launderers’, the forced conversion of deposits into shares has led the Russians to take control of Bank of Cyprus—Higgins (2013).

(4) The primary budget surplus needed to stabilize the debt ratio is given by: p = [(r – g)/(1 + g)]d where p is the ratio of primary surplus to GDP; r is the real interest rate; g the growth rate of GDP and d the ratio of debt to GDP (Akyüz 2007). A country with a debt ratio of 100 per cent, a negative growth rate and a real interest rate of 5 per cent would need to generate a primary surplus of at least 5 per cent of GDP in order to stabilize the debt ratio, even in the absence of any negative feedback from fiscal retrenchment to growth.

(5) For a proposal for such a unified banking framework see, Burda et al. (2012). In June 2012, an agreement was reached to create a Banking Union which is planned to be completed by mid-2017; see EC (2015a).

(6) In Japan traditionally a second budget was kept alongside the central budget which provided for financing public investment programs, and only the spending financed by bonds issued to cover the central deficits was considered as deficit financing; see UNCTAD TDR (1993: 78).

(7) This problem was encountered by Argentina in the 1990s when it had fixed the peso against the dollar with the Convertibility Plan. In commenting on its prospects, UNCTAD TDR (1995: 90) noted that ‘the main question for Argentina is how much unemployment will be needed to improve competitiveness, given that it has excluded the possibility of using what is normally the most potent instrument of policy to that end, namely the exchange rate, and whether such unemployment will be politically acceptable.’

(9) For the money creation process and the nature and effect of QE programmes, see McLeay et al. (2014).

(10) According to Stiglitz and Rashid (2016: 2) banks have been ‘earning nearly $30 billion—completely risk-free—during the last five years…and as a consequence of the Fed’s interest rate hike last month, the subsidy will increase by $13 billion this year’. As Bernanke and Kohn (2016) point out, the money comes from interest received on bonds purchased by the US Federal Reserve. However, as discussed later in this section, since the US Federal Reserve’s net income is transferred to the Treasury, these earnings effectively constitute a transfer from public budget.

(11) In explaining the exit strategy, the former US Federal Reserve Chairman pointed out that ‘[b]y increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally’ (Bernanke 2010).

(12) Bech and Malkhozov (2016: 6). See also Finger (2016) for other unintended adverse consequences of negative policy interest rates. That the initial impact in Japan, Switzerland, and Eurozone is quite opposite of what was expected, see Worthington (2016).

(13) In the US Federal Reserve profits are remitted to the Treasury. In the Eurozone, profits of the ECB are distributed to national central banks of the Eurozone according to their participation in its capital. National central banks also earn profits from other sources. These are transferred to governments. For instance in 2015 ECB profits were around €1.1 billion whereas the profits earned by Deutsche Bundesbank were €3.2 billion, transferred to the Federal Government of Germany.

(14) An important part of these, around $550 billion, were energy company debt—Idzelis and Torres (2014). In the US alone the junk bond market is estimated to be in the order of $1.5 trillion of which 15–20 per cent consist of energy company debt market; see Snyder (2016).

(15) The Dow Jones industrial average, UK FTSE 100 index and German DAX 30 index all reached historical highs in spring 2015, registering increases between 2 times (UK FTSE) and 3.4 times (DAX 30) from the lows seen in early 2009. The Japanese Nikkei index also rose by 2.7 times during that period; data from http://www.tradingeconomics.com/.

(16) On the eve of the US Federal Reserve rate rise in December 2015, global bond markets were said to have been haunted by the ‘spectre of illiquidity’ because the ‘levels of secondary market bond liquidity have sunk to perilously low levels’; see West et al. (2015).

(17) However, in 2011 Bernanke ruled out direct lending to state and local governments, saying that the US Federal Reserve had limited legal authority to help and little will to use that authority, see Wall Street Journal ‘Bernanke Rejects Bailouts’, 8 January 2011.

(18) See Kaletsky (2012a, 2012b). The Corbyn proposal involves the Bank of England purchasing bonds issued by a yet-to-be established National Investment Bank—see Öncü (2015: 11).

(19) For instance, Bridgewater’s fund manager Ray Dalio predicts that circumstances will probably drive them to usher in what he calls ‘monetary policy 3’ (Wigglesworth 2016). It is suggested that more radical measures that could be taken by the ECB may include intervention in currency markets, purchase of equities, and recapitalization of banks by the ECB as well as helicopter drop—Lynn (2016).

(20) See also Summers (2014) and a collection of subsequent articles and speeches, Summers (2016). For the state of the debate, see a collection of articles in Teulings and Baldwin (2014) and papers discussed in a session on ‘The Economics of Secular Stagnation’ of the American Economic Association’s January 2015 meeting, published in American Economic Review 105 (5), May 2015.

(21) There is, however, no mention of the role of financial deregulation in the emergence of bubbles, ‘the last two of which [Summers] played a huge role in fueling by playing the water-boy for Wall Street’s deregulation movement’ (Wray 2013: 1).

(22) In the Loanable Funds model underlying this analysis (Keen 2015), population, productivity, and capital good price changes shift the investment curve inwards while distributional changes shift the savings curve outwards.

(23) It seems that differences between Krugman and Summers narrowed as the former moved closer to the position taken by the latter; see Summers (2015b) and Krugman (2015b).

(24) Draghi also joined Bernanke in the savings glut argument—ECB Eurosystem (2016b).

(25) In terms of the underlying Loanable Funds model it signifies an outward shift in the savings curve rather than an inward shift in the investment curve (Keen 2015).

(26) Summers (2015a: 3) conceded the importance of global dimensions of the problem and agreed that during 2003–07 the savings glut abroad was an important impediment to demand in the US and that ‘the lower level of interest rates, the greater tendency towards deflation, and inferior output performance in Europe and Japan suggests that the spectre of secular stagnation is greater for them than for the United States’.

(27) These factors indeed played a greater role in the decline of investment during the global crisis than financial conditions—Banerjee et al. (2015).

(28) Palley (2016:1). See also Borio and Disyatat (2011) for a similar critique of the concept of the natural rate of interest.

(29) See Goodhart and Erfurth (2014: Figure 1) and ILO/OECD (2015). The labour share is defined as the share of net national income that is received by workers in the form of labour compensation. The adjusted labour share increases the unadjusted labour share by the ratio of self-employed.

(30) See Akyüz (2011c). In these estimates, imports are allocated between exports and domestic absorption according to their direct and indirect import contents. They thus differ from the conventional estimates of contribution of trade to growth based on net exports—see Akyüz (2011a).