Just read an interesting news article on a speech made by Singapore’s Minister of Trade and Industry on setting Singapore’s energy policies to achieve cost competitiveness, energy security, and sustainability.
Some interesting points:
- Regulatory measures need to account for the underlying economics and give certainty over the amount of carbon reduced.
- Putting a price on carbon
- Imposing efficiency standards for cars will not give certainty because of the ‘rebound effect’, where the driver uses the car more often because the car uses less gas for the same mileage.
- What is needed is to put a price on carbon, so consumer knows the marginal cost of his carbon emission and will adjust his behaviour accordingly. Policing through pricing will let everyone work out the most efficient response (i.e. use the market).
- Need to identify “market failure” situations (e.g. people who rent their homes are less likely to purchase energy efficient appliances compared to those who own their homes), and craft targeted policies to address them.
- Helping lower income groups
- Lower income groups generally consume less electricity than higher income groups. Research was done that showed that an increase in income leads to a less-than-proportionate rise in electrical consumption.
- One way is to price the first block of electricity at a lower rate than the subsequent blocks. However this will benefit all households, rich and poor, hence all households will be encouraged to consume more energy.
- A more efficient way to help lower income households is to have a single higher price for electricity or carbon, and to give them direct cash transfers to partially or fully offset the impact of the higher price, thus meeting general consumption needs (of the lower income groups) while encouraging the reduction of electricity consumption.
These are very good points that highlight the intellectual rigour that needs to go into setting key policies on major issues such as energy. It is this kind of analysis that makes Singapore one of the role models for public policy setting.
Combatting Debt Deflation (a.k.a Balance-Sheet Recession)
One interesting policy tool that Singapore uses frequently is in giving cash to targeted segments to achieve its policy objectives. For example, in the above scenario, a cash grant would be given to the low income groups. During the 2008-2009 crisis, Singapore had a Jobs Credit scheme that gave cash to employers that retained their local workers to mitigate retrenchment, a SPURS scheme that gave cash to companies that sent their workers for training, a Workfare Income Supplement (WIS) scheme that gave cash to low income workers (see here for more details).
While untargeted and loose cash giving can lead to the problems of a welfare state, I think there are definite advantages to putting cash directly in the hands of targeted persons (individuals, companies) to incentivise them to meet your objectives (e.g. spending, training, retaining, etc.).
Such targeted cash giving can work much better in addressing problems of a balance-sheet recession (or debt deflation) than your regular quantitative easing. In your regular quantitative easing, the new created money is injected into the banking system, but does not get into the hands of the individuals or companies because they are deleveraging and are not interested in borrowing money to increase their debt burden. Hence QE does not achieve its intended outcome.
What is needed is to put cash into the hands of individuals and companies in a very targeted manner, with conditions attached to incentivise them to achieve your intended objectives, ala Singapore-style. This will directly help companies and individuals to reduce debt, cut costs, increase spending, etc.
Ridiculous as it may sound, Ben Bernanke, a.k.a ‘Helicopter Ben’, and Milton Friedman had the right ideas when they suggested the U.S. Government can easily fight deflation by printing money and dropping it from helicopters. Bernanke’s “money-financed tax cut” is essentially equivalent to an indiscriminate helicopter drop. While the idea is right, Bernanke can learn from the Singapore experience in how exactly to give money.
Is Debt Deflation even a Problem?
Bernanke in 1995 highlighted that a counterargument to the existance of debt deflation problem is that individuals and companies deleveraging merely represents a redistribution of cash from the debtors to the creditors. If the propensity to spend is the same across both groups, then the spending from the creditors should make up for the lack of spending by the debtors.
The way to look at this is to really ask ourselves who the creditors are? I would presume that a large proportion of the lenders in a typical system are banks, investment funds and other financial intermediaries. So they had made loans to companies and individuals, which were gradually being paid back. What exactly are banks and investments going to use their customers’ money to spend on? Definitely not the Gucci, Prada, and Ferrari that consumers spend on. Are they able to lend of those funds again? Not really, nobody (except the Government) is borrowing. So the end result is that most of the funds, similar to funds generated by QE, sits idle in the banking system (granted some of the recouped investment funds can go into other investments, and most likely not in the same country — think Japan). It is not just simply about the propensity to spend.
QE is deflationary?
- Banks are never reserve constrained, hence the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.
- Central banks supply reserves as needed, or reserves can be borrowed from other banks. Hence reserve requirements merely affect the cost of loans, but not the amount of loans that can be given.
- However, banks can be capital constrained due to Basel II capital requirements (e.g. Tier 1 and 2 capital ratios). [my note: reserve requirements mean that banks need to have a certain amount of deposits at the Fed. This can either be achieved by depositing existing cash (assets) or borrowing reserves (increasing liability + assets). Capital requirement will mean that banks will need to increase their equity because making loans will cause them to increase their risk-weighted assets (now borrowing doesn’t work because increasing liability and assets by the same amount does not increase equity. Borrowing can still work to a limited extent with subordinated debt for Tier 2 capital).
- QE in a balance sheet recession is actually deflationary, not inflationary, because it removes interest bearing assets from the private sector and replaces them with deposits which does not stimulate borrowing.
The first two points are great points, but I do not think that QE is deflationary, and even if it is so, the impact (in terms of causing deflation) is negligible. Financial institutions are not forced to sell their interest bearing assets to the Central Bank. It is a willing buyer willing seller situation. If the financial institution thinks that the Central Bank is paying a high enough price that more than adequately compensates them for the future interests of the assets, then tranasction goes through. So QE does not “take money away” from the financial institutions to result in deflation.
A number of solutions have been proposed for a balance sheet recession:
- Debt relief
- Fiscal stimulus
Reflation is the idea that price levels should be returned to the level it was prior to deflation, and then to figure out a way to maintain those price levels unchanged. I do not think that this is workable. Recessions typically follow the burst of a bubble, which is typically caused by irrational excesses. It does not make sense to intentionally recreate something irrational (not supported by fundamentals) and distorted to bail out those caught in the mania. It is one thing to bail out companies that caused the crisis (e.g. TARP), but it is a whole new level to reflate a bubble.
Debt relief could work, but it is something that needs to be carefully worked out. One potential opportunity to work that in was in the Federal bailout package. For example, companies that held assets that had gone bad, but also held protection from AIG, would be required to partially or totally forgive the bad debt that they held. This is on the grounds that if not for the Federal aid, they would have lost much more. For troubled debts bought over by the Government, they can partially forgive debts for a well defined group of low income households. This is equivalent to giving cash to a targeted group of needy people. This will help to address the balance sheet of the consumers now that the balance sheet of companies has been cleaned up by the Government and the Fed.
Fiscal stimulus can work in increasing aggregate demand with Government spending and investment. The stimulus can also be in the form of targeted cash giving with conditions attached. More thought however needs to go into how the stimulus should be paid for (e.g. budget deficits? or cost cutting?) and the downstream implications (e.g. U.S. scenario of debt monetization in a debt deflation scenario with healthy companies and debt-ridden consumers).