Wednesday, February 23, 2011

If Mervyn King strayed into the political arena, it was because of the illogical division of responsibilities as between central bank and government.

Mervyn King expressed support for the UK government’s policy of front loading government spending cuts. Paul Krugman and Ed Balls (the U.K. Labour Party’s shadow finance minister) accuse Mervyn King of straying into political territory.

Neither Balls nor Krugman offered anything that that might be called a “reason” for their opinions.

This “political territory” problem arises from time to time because of the illogical division of responsibilities as between the Bank of England (and indeed most central banks) one the one hand, and governments on the other. That is, both institutions have a say in factors that influence aggregate demand (AD), which is a nonsense. You might as well have a car controlled by two steering wheels, each controlled by different people.

Central banks are normally responsible for interest rate adjustments, which in turn influence AD and hence employment levels. Thus it can be argued that Mervyn King was in order to pass comment on ANYTHING that influences AD or employment in the aggregate.

On the other hand it could be argued that he was not in order in that he passed comment on the “steering wheel adjustments” being made by government.

A more logical division of responsibility would involve central banks having sole discretion over ALL factors that influence AD: i.e. interest rates PLUS the budget deficit (or surplus). These are very much technical, rather than political questions.

In contrast, government (i.e. political parties) would have responsibility for the much more political questions like the MAKE UP of government spending and what proportion of GDP should be devoted to the public rather than private sector.

Modern Monetary Theory (aka Functional Finance).

The above points about division of responsibility is of particular relevance for Functional Finance (FF), and for the following reasons.

In an FF regime (at least as I see it), interest rate changes are not the main AD adjustment tool. The main tool is Abba Lerner’s so called “money pump”. That is, if more AD is needed, government just creates more money and spends it. And conversely, if inflation looms, government does the opposite, that is reins in money (via raised taxes) and “unprints” or extinguishes money.

This raises the question as to who controls the pump. And the answer is “the central bank”. Central banks are better qualified than politicians to pass judgement on whether AD needs adjusting so as to optimise the inflation / unemployment relationship. In contrast, as pointed out above, the question as to what proportion of GDP should be devoted to the public sector, and the make-up of that spending is very much a political question, and should be the responsibility of political parties.


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