Is a Love of Finance the Root of All Evil?

There is a syllogism that has gained currency just as financial markets have been devalued. And it goes something like: (i) finance is dangerous (ii) the economy is in danger (iii) finance must therefore be constrained. I regularly attend conferences and hear a panoply of dirigiste sentiment directed against the financial sector, arguing that not only that financial markets and banks been the root cause of the final crisis but that they must now be bound like Prometheus to a stone. Though such a conclusion is tempting, it may not be quite right.

The critiques are well known: financial markets underpriced risk, created excessive liquidity and leverage, unbundled exotic near-worthless debt instruments and at the limit, often via hedge funds, promised semi-permanent excess returns. All activities that rewarded participants on the upside and ended up having government support on the downside. The argument then is that faced with such a skew in returns, too many resources have been devoted to financial activity. It is said that banks and financial institutions have become too large both in absolute size because they cannot then be allowed to fail without creating systemic risk and relative to the size of the economies they service. Maybe.

Let us rehearse the arguments about why finance matters. Finance allows individuals and firms to disconnect in time and space their abilities to earn and their abilities to spend and hence concentrate on one or other at any particular moment. The advantages of specialisation are clear – everyone can benefit from the greater production of goods and services by allowing agents inter-temporal as well as geographical options to share resources. But we do know that the efficient allocation of funds from savers to borrowers is subject to severe informational constraints and also various temptations to renege: the avoidance of these problems requires significant regulation, institutional capability and investment in reputation-building. These kind of first order problems do not in general sort themselves out and it is possible even to write about the vast sweep of economic development itself in terms of the history of solutions, failed or otherwise, to these types of problems.

So we can expect that alongside the development of financial instruments we will have to re-write the book of rules and regulations every generation or so, as we moved from heavyweight capital controls in the immediate post-war era under Bretton Woods to an era of neo-liberalism running from the late 1970s to about now and hopefully beyond. And so let us not take the initial premise too far in that the problems with the global financial system are best solved by reducing the size of that system because it seems likely that at least some of the problems stem from its incompleteness rather than its dominance. Let me illustrate: it is entirely proper that capital flows from “impatient” countries to “patient” countries and at some real interest rate the deficits of the impatient must equal the surpluses of the patient. Over time the patient countries will then build up claims or assets against the debts of the impatient countries. Now let us suppose that the patient countries become wealthier, say as their productivity levels catch-up, and all this extra wealth is saved, global savings will then initially exceed investment and interest rates will have to fall to clear the global market for savings, encouraging the impatient to become more impatient and increase their overall level of indebtedness.

For impatient read the US and for patient read China. Under this equilibrium real rates are low and capital flows uphill from fast growing to mature economy. The problem here is that the extra savings are all being sent to the impatient, as there are limited vehicles for the patient to invest in their own economy. In a closed economy, the extra income would have to be channelled domestically and domestic growth would be stimulated in order to use the savings. And so by the same token, if there is an inadequate development of savings vehicles in the patient economies then these savings will tend to drive up the prices of existing assets, for example, US Treasuries which will be in short supply. This global excess demand for assets hence drives down real interest rates raising other asset prices in turn, for example housing, equity or real commodities.

It is thus the lack of financial development in emerging economies which arguably lies at the heart of the problem of this financial crisis and not, perversely, the excess of financial development. An example from the most recent IMF Article IV report from October 2006 for China suffices to illustrate the point, which reports that the foreign exchange rate market remains tightly managed, there seems to be little development of bond markets even at maturities of less than one-year and little or now availability of bonds in the 1-10 year maturity range and equity markets seem not to allow firms to access the market. Overall the IMF view was that the “limited role of capital markets in China…reflects the dominance of state banks in intermediation, but these markets are plagued with regulatory and governance problems”. Obviously a report form late 2006 may well be rather out of date but it does clearly illustrate the point about a lack of liquid assets in newly emerging economies at the high watermark period of so-called financial excesses.

So rather than shunning financial market development, global policies ought also to think more about deepening capital markets and encouraging the development of assets across the risk spectrum, particularly in parts of the world where surpluses are being generated. By helping the development of such assets, policy makers will help raise global real rates, help prevent the conditions under which asset price bubbles will develop and also help get various parts of the world onto more sustainable growth paths that are not reliant on the capacious appetites of Western-style consumption alone. And if as a consequence, we become a little more patient and they become a little more impatient, then we have all become a lot closer to each other, which is a rather pleasant thought.

Those Can't Get Enough of Them Fiscal Blues

In a recession it is easy to motivate some form of discretionary fiscal policy. Let us rehearse the arguments: aggregate demand is shocked downwards as real and financial wealth falls; under heightened uncertainty, consumption and investment plans are delayed; and the ongoing difficulties in obtaining (bank and other financial) credit seem likely to amplify the impact of these effects on the economy. Furthermore we can point to a co-ordinated international downturn, which not only is likely to increase the size of the initial shock but also limit individual country responses with no individual option available to increase external demand. Furthermore it has become clear that monetary policy has reached its limits, with the zero bound and resort to quantitative easing, which means that there is an "interest rate gap" to be mopped up by fiscal policy expansion.

So if we can agree that there is a demand gap going forward and fiscal policy is part of the answer, what form should the fiscal stimulus take? One background point first - there has been an upward shock to the level of public debt in all economies with substitution of private claims for public claims on banks and this means that all economies are nearer some notion of the threshold of public solvency than they were prior to the crisis. And implies that the overall room for manoeuvre is somewhat limited. The IMF use a number of key phrases in thinking about the fiscal response. That it should be timely (now); large (expensive); contingent (could be end up being even larger); collective (all join hands) and diversified (to deal with the uncertainty of multipliers in any one sector). What really worries me is that large is no substitute for well directed and that for any discretionary fiscal policy to work what it must put spending into the economy in exactly those areas where demand has been weakest during contraction, which implies to my mind that it is temporary in nature and well targeted rather than scattergun. For example, a scheme to help the recently unemployed maintain consumption or for idle construction projects to go ahead is preferable to one that raises the wages of public sector workers, even academics.

The temporary nature of the fiscal expansion is also key. If treated as permanent, the fiscal expansion is more likely to lead to higher nominal interest rates at term and hence crowd out private sector investment or expenditure as it will be perceived to reflect more probability of default or inflation risk. Obviously this kind of concern will limit the accommodative stance of monetary policy at zero nominal rates. Think flat LM curve with IS shocks and upward sloping LM curve with the same shocks - in the latter case with higher interest rates, output (and the multiplier) is lower. In this respect funding choices also matter - a government that raises discretionary expenditure with index-linked bonds may be treated as more credible than one that does so with nominal bonds and hence may be able to reduce the crowding out. It also likely to be the case that a more permanent increase in expenditure is one which people will save against. The Ricardian equivalence hypothesis may not work when there are liquidity constraints and when the government can borrow more cheaply than the private sector but if government behavior more clearly starts to resemble the private sector and of more equal risk, any advantage will be watered down.

So how should fiscal policy state what is does during a deep recession in order to maximise its effectiveness? It helps to start with monetary policy as an example. The solution to the zero bound problem for monetary policy involves some kind of commitment to inflate. Which is a long run commitment to do what is necessary to drive inflation up. This is possible because monetary policy ultimately controls the price level. But fiscal policy cannot promise to spend, spend and spend again to save the country it loves (passim Gaitskell) because that raises the spectre of fiscal solvency and increases the present value of the burden on tax payers, reducing their marginal propensity to consume. Ultimately we believe that income is supply side determined. In this sense fiscal policy is more like a one-off expansion of a deflated tyre - some air should go into the gap but not too much. The expansion should be just enough to offset deflation and leakages ought be minimised. And when the tyre gets back to the correct pressure all expansion must be turned off immediately.

So how can we answer the key question on fiscal policy? How vocal should fiscal authorities be about the exit strategy, by which we mean the relaxation of high levels of discretionary expenditure? The key is to ensure some belief in the government's present value budget constraint. That spending will be undertaken to the extent that it does not threaten fiscal solvency. But who should judge whether a government's spending is solvent? Certainly not the government itself or the(ir) IMF (representatives) and probably the financial markets should play a role, which they will do in the pricing of nominal and real government liabilities at term. But while QE continues it will be very hard to treat market prices as telling as much about the financial markets' views. And so under uncertainty about the preferences or ability of the government to cut back on fiscal expenditure, there needs to be some conditional plans about the path of real expenditure and revenue which are measurable. Which sounds very complicated and rather difficult to convey and so what so the danger is that we might end up with is something more of a random walk, which seems to increase uncertainty.

If we want to keep the public sector as large as it is now, there will have to be increases in expenditure and tax increases over the longer run. But some serious discussion about the appropriate size and role of the public sector is also required, which does seem somewhat bloated. So as well as plotting a course out of the current sequences of deficits, responsible government would also call for a debate on the appropriate size and government involvement in the economy, as well as the magnitude of both public and private indebtedness.

The Party's Over...

...and here’s the bill. So now we know more clearly the cost of this bust (in which GDP is now forecast to fall some 3.5% this year) and it is shocking. Public sector net debt was 36.5% of GDP in the fiscal year 2007/8 and today the Chancellor has projected public debt to rise to just a shade under 80% of GDP by 2013/14. Public debt was previously as large as 80% of GDP in 1968 when the trajectory was still gradually adjusting downwards after WWII. This government’s self-imposed Golden Rule, or threshold, for public debt of 40% of GDP has been shattered with some £790Bn of borrowing planned over years from 2008/9 to 2013/14.

Admittedly, accompanying this debt projection are some plans for taxes to rise and for the growth in government spending to fall somewhat more than earlier plans. But these new plans represent second order modifications around a potentially explosive path. The risks to the path for debt to GDP seem to lie on the upside should the economy continue to remain longer in the doldrums and, which may follow, should there be further calls on the public purse to bail out financial institutions.

The big picture is that a large quantity of debt, created during the long 1990s expansion which ended in 2008, has now been transferred from the private sector to the public sector. And the trick that the public sector is trying to pull off is to smooth the increase in taxes that need to be levied on the private sector to pay-off these debts. But the danger is that financial markets will see through this trick and start to treat the public sector as more risky, like the hapless private sector, and that is why the initial reaction has been for bond yields to rise some 8-10bp. Now where’s that aspirin?

Are we in another Great Depression?

Too early to tell. The chart below shows data from the Angus Maddison’s well known dataset on long run growth in world economies (the data can be downloaded from http://www.ggdc.net/maddison/), which compiles national data sources into a comprehensive annual dataset. The data was mostly constructed postwar by various academics and research institutes in the countries concerned, that is after the fact, and is probably subject to some huge measurement errors but I found the chart highly instructive when thinking about the scale of the recessionary problems we might face in comparison to the so-called Great Depression.

Before discussing the chart, let me point to an old debate that seems to have been re-ignited between those who judge business cycle phenomena such as a possible Depression to be the result of shifts in productive potential or whether such phenomena are always the result of demand deficiency. Peter Temin (MIT, JEL, September 2008) recently reviewed work by Tim Kehoe and Ed Prescott (Minnesota School, Response FRB Minneapolis, December 2008) on the causes of Great Depressions and severely questioned the basic hypothesis that it was possible to think of the Great Depression as resulting from the former rather than the latter. In recent work, Kehoe and Prescott point to a sharp fall in US productivity in 1929-33, which was associated with a sharp fall in labour hours which did not recover even when productivity recovered later in the 1930s. Temin argues that: “(a)ny description of sort run macro events needs to pay attention to the effects of monetary and fiscal policy”. I am very sympathetic to the Minnesota School but when I start to think about the current debate and possible causes of this downturn, in a world of immense and prolonged analysis, I have seen little or no reference to a productivity slowdown as a cause of the financial crisis. Maybe it will come.

Turning to the data. The data gives us 1990 US$ price GDP in a variety of countries and I simply normalise the GDP at 100 for 1929 and see when output returned back to its previous level for a few countries. The results surprised me. The UK seemed to have a relatively mild output recession following its exit from the Gold Standard in 1931. Following my previous blog, it is remarkable how often the exchange rate helps adjustment in the UK. The US did not return to its previous output level until 1936/7 but that masks positive growth from as early as 1933.

In some senses the US path is probably the worst we might expect given an absence of effective countercyclical monetary (Friedman and Schwartz, 1963) and fiscal policy and the adoption of protectionism, which exacerbated negative trade multipliers. The stylised fact for the Great Depression is that world trade (exports plus imports) in 1913 US$ constant prices was around US$36bn in 1929 and fell to $25bn in 1938 i.e. around 33% and world output over the same period moved from US$241bn to US$270bn, which meant that the fraction of trade to GDP fell from around 15% in 1929 to 9% by 1938 (Estevadeordal, et al, QJE, 2003).

For obvious reason, we may not want to dwell on the militaristic solutions in Japan and Germany but, at a stretch, these might be analogous to making some kind of point that with the right kind of demand management, economic growth might return quickly and rapidly. So the question then is whether extreme monetary and fiscal policy stimuli currently being developed are sufficient to drive demand in the absence of much global demand (recent market inflation expectations data suggests this might be the case)? And under what circumstances will the saving nations (e.g. China) shift their investment functions outwards – as this will probably require some reform of their financial institutions it will probably not happen anytime soon? A financial crisis is difficult as it impacts on demand, as agents’ wealth and ability to smooth consumption evaporates, and it impacts on supply, with capital and labour shedding resulting. So we know that output will fall and demand management can have, at best, a temporary impact. So in the end the authorities simply do what they can, given tremendous uncertainties, and hope that confidence returns.

Whither Sterling?

Much ink has recently been split on the causes and consequences of the sharp decline in UK exchange rate. The bare facts look to be a concern, since mid-September 2008 sterling has fallen by 14% against the Euro and some 25% against the US dollar. In combination with the confirmation of a deep recession, it seems that the world is shunning the UK. The speed and extent of the decline is remarkable and is not dissimilar to that which occurred in the days and weeks following ERM exit in September 1992. It is even argued that if Sterling is to lose its role as an international store of value then far better to consider joining a large currency zone where the external unit of value cannot be so easily buffeted around by gales blowing though the world of international finance.

So just how much of a problem is the depreciation of Sterling and does the scale of the decline provide a potential cure or kill for the UK economy? The Chart (below) shows a weighted average of the UK exchange rate versus the US$ and the Euro on a daily basis since 1985, with down signalling a depreciation in Sterling. The red-line shows the ratio of share prices in banks relative to those of the FT All-Share Index and is a measure of the news on banking profits relative to the whole economy. We can see that ERM exit was broadly a good thing for bank shares, most probably signalling that UK policy rates were more likely in future to reflect domestic growth prospects – implying that the bank profitability would benefit from such a re-direction. Furthermore, in the mid-1990s, once growth had been re-established Sterling did recover its previous level. On the other hand, we can see that the more recent fall in the exchange rate after the start of the Credit Crunch in 2007 (vertical line), seems to have been driven (at least in part) by the relative downgrading of bank profitability compared to the rest of the economy. In other words rather than being an exogenous cause of bank profitability and recovery, the widespread perception that this crisis will continue to constrain financial intermediation for some time to come may have led to a fundamental re-assessment of the Sterling’s fair value.



So where is the gain from the fall in the currency? Those involved in international trade will not be pleased, importers of goods and services will face higher bills and yet because of weak UK demand may find that it is not possible to pass on these higher costs and their profits will be directly reduced. Exporters may superficially benefit but much of UK exports are simply added value to imported raw materials or component manufacture and so the direct gain will be somewhat militated. It also seems likely that international corporations may dislike to notion of being sited in an economy where the exchange rate fluctuates widely as this will tend to disrupt profit forecasts and the lead to volatile remittances priced in foreign currencies.

But even if the exchange rate channel offers a rather weak form of direct support, it might be that every little bit helps. And so to the extent that the fall in sterling simply reflects an anticipated reduction in interest rates in the UK relative to those overseas, then exchange rate adjustment may help the economy adjust to its new equilibrium following a constellation of shocks. For the UK economy a list of these shocks might include: (i) a persistent downward shock to the value of financial intermediation; (ii) a downward shock to asset prices and hence net wealth; (iii) a realisation that the household balance sheet was becoming too heavily indebted and (iv) a global reduction in overall demand for UK goods and services.

As well as the possible impetus to net exports there are two further ways that the exchange rate depreciation may help the UK economy. First in the midst of mounting deflation pressures, a large exchange rate depreciation offers a one-off increase in the UK price level that will hold those pressures in abeyance for some time. The depreciation will increase the price of traded goods and lead to a temporary inflation as the increased costs of imported goods feeds though the economic pipeline as typically it is still the case that there is a large pass through from a nominal exchange rate change into the domestic price level. By keeping inflation temporarily higher than it would otherwise be, the economy may avoid some of the problems brought about by too rapid a disinflation. Secondly, the reduction in the foreign currency price of UK assets means that they may now offer a good prospective return in foreign currency terms and lead to some support for both the domestic housing market and equities from foreign capital, which may be looking for a place to park itself.

The danger really is that the depreciation in Sterling hinders in some way the government’s ongoing ability to deal with the financial crisis. By which I mean that we can characterise the policy response to the crisis as a transfer of risk from the private to the public sector, as we are using public debt to hoover up private debt contracts. If the decline in the exchange rate becomes widely thought of as a reflecting risk in the UK, rather than an adjustment associated with economic fundamentals, then the upper bound on the government’s ability to sell its debt will bite somewhat earlier than would otherwise be the case. And that in the end is the real risk from a Sterling sell-off – that it somehow signals looming fiscal insolvency.

Orthodox and Heterodox Monetary Policies

The financial crisis has shaken some core beliefs of central bankers as they find themselves running increasingly heterodox policies. Having spent much of the last two decades developing simple rules about the operational conduct of monetary policy, they now find that this new rule book has to be torn up. Although initially controversial, the adoption of the interest rate as the main operational instrument in pursuit of a clearly defined policy objective had become a near universal article of faith.

But with interest rates heading towards zero and having little impact on lending behaviour, because a freeze in financial intermediation, central bankers have had to think of new policy measures. Attention is moving from the price of money to ensuring that a sufficient quantity of money is held by the private sector in order to effect transactions. In this blog I outline the crossing of the central bank Rubicon.

The nice, linear story central banks liked to tell about monetary policy was illustrated in my blog: Deflation: A Real Problem and a Possible Cure and also in a recent working paper. The policy rate sets the base level for the funding costs of the banking sector and acts as the floor to financing in a given currency. Central banks ensure that the policy rate remains at or near the floor by draining the overall banking system of reserves and selling these back at the policy rate via open market operations, which have no monetary consequences. The hidden assumption in this framework is that the constellation of all other market interest rates, from interbank to long term corporate bond rates and beyond, will respond proportionately to any impetus from the central bank’s policy rate. The set of market interest rates are thus thought to be akin to a sequence of mark-ups over costs, related to the costs of monitoring credit and market risk. And so much of the transmission of monetary policy operates through its impact on other market interest rates.

When setting the policy rate, the central bank commits to supplying central bank money perfectly elastically at that interest rate to commercial banks. At lower interest rates, the demand for narrow money should increase, as the opportunity cost of its holding has fallen, and this extra demand is satisfied by central bank provision of base money. The expansion in narrow (central bank) money is multiplied through the economy by the money multiplier, which is the extent to which commercial banks increase their balance sheets by more than the amount of narrow money alone by extending bank credit to the private sector. And it is arguably this money multiplier that has collapsed in the current banking crisis.

In the stylised balance sheet of a fractional reserve commercial banking sector, commercial banks hold central bank money as liquid assets and loans as illiquid assets. Loans to the private sector will ultimately correspond to deposits by the private sector in the banks, which are liabilities. The ratio of broad to narrow (base) money is the money multiplier and so we can observe that when the market for central bank money clears at a higher quantity and if the money multiplier remains constant, then broad money will expand by the change in the central bank money times the money multiplier. To the extent that broad money is required to fund private sector transactions, a change in broad money will correspond to a given level of nominal transactions. If the banking system is unable to convert base money into a sufficient quantity of broad money activity may suffer in the short run and over the longer run a deflationary impetus will be established.

Clearly when and if interest rates arrive at zero, central banks can no longer control the policy interest rate via open market operations and so monetary policy is driven by the need to set the quantity of base money in circulation directly. Furthermore if financial intermediation is severely impaired, policy may also have to provide a direct impetus for the creation of broad money liabilities and this is our working definition of quantitative easing.

The central bank balance sheet typically comprises assets of foreign exchange reserves, loans to the government, bonds, claims on banks and on the private sector. Liabilities comprise currency, commercial banks’ reserves deposited with the central bank, central bank securities, government deposits and any capital reserves. Central bank balance sheets are typically dominated by the main liabilities of base money (notes, and in some cases coin, on issue) and foreign assets and claims on financial institutions.

When the central bank effects a purchase of government bonds, the following changes to the balance sheet occur. Central bank assets will rise and liabilities will expand by the exact amount of currency issued to pay for the bonds. The currency is remitted to the commercial bank, government or insurance company from whom the central bank has bought the asset and this will be measured as a commercial bank deposit. And so the purchase of government bonds will show up as both an expansion of the central bank balance sheet, an increase in base money and an increase in broad money.

At some point in the future, the central bank can close out its position in government bonds by selling back to the private sector the bonds it holds on the asset side of the balance sheet, soak up the currency created and deflate its balance sheet. This begs the question of what is the initial purpose of buying government bonds? The hope is that by creating more short-term deposits in the commercial bank sector, this will generate commercial bank lending, given a reasonably stable money multiplier. The problem is that when commercial banks are uncertain about both the availability of future liquidity, losses from past lending and the riskiness of new lending in a recession, the new monetary liabilities may not translate very easily into new lending.

And so central banks have already gone further. The purchase of commercial bank assets and mortgage backed securities at discount provide both succour to commercial banks’ balance sheets by providing liquidity against possibly undervalued long term assets, as well as expanding broad money, and the possibility that central banks may profit from the resale of these assets. The open questions here are then at what price are these assets bought – not so high as to endanger the sustainability of the central bank balance sheet but not so low as to question the sustainability of the commercial banks and to discourage their future lending.

With such a large expansion of the central bank balance sheet, central banks increase the relative supply of short term debt (including central bank debt) to long term debt, which should lead to a change in the relative price of short to long term debt, with the latter becoming relatively expensive. And if long term interest rates do indeed fall during a quantitative easing then the private sector will have an incentive to invest as the user costs of capital falls, household balance sheets should be ameliorated with lower interest and debt burdens and asset prices should be stabilised, underpinned by lower long term rates. The question then is when all this activity starts to take off when will inflationary pressures start to re-emerge?

Deflation - a real problem and a possible cure

I ended my previous post with the question: so what’s the problem? And I suppose it is Deflation. A persistent deflation poses particular problems for monetary policymakers because with nominal policy rates facing a lower bound of zero, central banks can, in principle, lose control of real rates that will continue to rise if inflation expectations follow inflation down. Deflation is, of course, not a new phenomenon and prior to WWII year on year deflation was over the long run as likely as inflation but as long as inflation expectations remained in line with notions of long run price stability real rates would perhaps not destabilise the economy. The real worry for policymakers as we head into a deep recession is that inflation expectations fall markedly in line with deflation. Wide-ranging monetary and fiscal policy responses will then be designed to try and prevent a significant and persistent fall in inflation expectations.

Over the past decade or so we had become used to the following story about monetary policy. Short-term policy rates are nudged, with some reluctance, in one direction or another in order to limit the deviation of short-term inflation forecasts from an explicit (or implicit target). These short-term inflation forecasts are projections of the output gap and so the basic story says that by stabilising inflation, output is kept as close to potential as possible at the same time. The parable finishes by soothing us with the observation that providing the economic shocks are not too large and monetary policy continues to have traction on the economy via its influence on financial prices, then the economy should tend towards stable outcomes.

This nice, linear story is illustrated in Chart 1 (see http://econpapers.repec.org/paper/ukcukcedp/0815.htm for more details). Here we show a Fisher equation, which relates short-term nominal rates equiproportionally to inflation (or inflation expectations). The intercept corresponds to the economy’s natural real rate, which is essentially exogenous to monetary policy and is closely related to the expected growth of per capita consumption. The inflation target determines the long-run expected level of nominal rates, which are equal to the natural real rate and the inflation target. The central bank’s policy reaction function is to respond actively to any expected deviations in inflation from target and so is drawn steeper than the Fisher equation line so as to suggest policy induced real rates that are lower or higher than the natural rate, when inflation is correspondingly lower or higher than target, which acts to boost or bear down on demand as required.

But things can change quite radically once we move out of this comfortable little space. Specifically, if inflation starts to decelerate quickly, the central bank can find itself bumping near to its zero bound on nominal rates and might, in principle, lose control of its ability to set real interest rates. At this point short-term debt instruments and money yield near-identical nominal returns, and given that bonds bear a default risk, there will be a strong preference to hold liquidity in the form of cash. This means that even though the central bank will continue to supply private agents with escalating levels of narrow money to meet this increased demand, it will not be spent and demand will not emerge to chomp up the large output gap.

Chart 2 shows the limits to the standard mode of interest rate control. Once nominal rates hit zero at Point A, if inflation continues to fall real rates will then start to rise. And so there is a possibility that the output gap will get even higher as rising real rates bear down even further on demand, leading to a loop of lower inflation, higher real rates, lower demand and even lower inflation. The classic answer to the deflation trap is that at some point money demand will be sated and the decrease in the price level will mean that money holders will feel wealthier and start to spend. But in a world of debt that may not be sufficient because if those money holders are also indebted, the fall in the price level will increase the real value of their debt and so ultimately the existence of a deflationary trap will depend on whether the increasing indebtedness of debtors outweighs the increasing wealth of money holders.

So will a deflation lead to a complete economic collapse? Not necessarily. Chart 3 shows two annual inflation distributions in the UK from 1800 to 1947 and again from 1948-2007. The first distribution seems reasonably symmetric around zero and suggests that deflationary years approximately matched inflationary years in the nineteenth century and the first half of the twentieth century. Subsequently, we have hardly any evidence of deflation to draw upon, with inflation mostly moderately positive (with occasional lapses in good behaviour). It is not at all clear that we can make a simple comparison between a financially complex economy and one that was still in the midst of industrialisation. But one clear distinction can be made as there seems to have been long-run price stability in Britain in the earlier period: which implied offsetting years of positive and negative inflation, but these did not necessarily bring about sustained economic crises. Why?

One reason might be that the maintenance of long-run price stability means that a temporary deflation, which lowers the price level, was also accompanied by expectations of an inflation, which would return the price level back to its long-run average. The advantage of a positive inflation expectation during a deflation is clear because even though current inflation falls, expected inflation rises and this means that the expected real return on stable nominal rates falls. And so the likelihood of a deflation taking hold in a persistent manner may be significantly mitigated.

Unfortunately, in the current deflation scare, in the UK inflation expectations have moved very much in line with current inflation, which is rather unfortunate and suggests that credibility, the belief in the inflation target, may be less than complete. The rise in CPI inflation from 2004 to 2008 was accompanied by an increase in both breakeven inflation and NOP inflation expectations and as CPI inflation has started to decelerate in the second half of this year we have almost immediately noticed a decline in inflation expectations. The nominal anchor seems to be being dragged around by contemporaneous developments and hence the monetary constitution may ultimately be in need of some reform.

An important part of the answer in dealing with a deflation is to conduct monetary and fiscal policy in such a manner that inflation expectations do not fall along with prices: that, in fact, as far as possible they remain at or near the inflation target. Convince agents that inflation will be higher in the future than it is now, so enabling real rates to fall as nominal rates fall to zero. And so if the risk of deflation is real, and in the most recent Inflation Report the Bank of England placed the probability at around 20%, we can expect a highly accommodative monetary and fiscal policy stance to be maintained.