Wednesday, 27 August 2014

Modigliani & Miller are right on bank capital.




I argued yesterday that the cost of raising bank capital requirements to 25% or even 100% was zero, because that’s what the Modigliani Miller (MM) theory says. I also pointed out that criticisms of MM are feeble.
After a bit of Googling and rummaging around, I now find that the criticisms are even more feeble that I thought. Details as follows.
Lev Ratnovski in a Voxeu paper entitled “How much capital should banks have” suggests just two possible weaknesses in MM. One, (para starting “There are two ways…) is that if you ASSUME the return on bank capital is 15% and the return on bank debt is 5%, then the more capital there is, the higher the cost of funding the bank. Well of course, but it’s PRECISELY the latter sort of 15%/5% assumption that MM proved to be a nonsense. Ratnovski’s point there is a bit like saying “assuming the Earth is flat we wouldn’t be able to have weather satellites”.
The second possible weakness in MM that Ratnovski cites is the taxation point I referred to yesterday, and which, as I explained yesterday, is nonsense. Plus Ratnovski cites another paper on MM (by Anil Kashyap and others). But that paper ALSO has no criticism of MM other than the latter flawed tax point (see p.4 in particular).
MM passes the test with flying colours.
The conclusion is that while the PROCESS of raising bank capital may involve temporary or transient costs, a permanent and higher capital ratio (25%, 50% or even 100%) is costless.
Or to be more exact, it brings net benefits in that bank subsidies and state support for banks is removed.


Tuesday, 26 August 2014

An answer to Martin Wolf’s question.




He wrote an article in the Financial Times some time ago entitled “Seven Ways to Clean up our Banking Cess-pit”. See here or here. He advocated a HUGE increase in bank capital ratios: up from the present 3-6% to about 25%: quite right.
However, he argued AGAINST raising that still further to 100%, which would amount to full reserve banking. And his reason was:
“I accept that leverage of 33 to one, as now officially proposed is frighteningly high. But I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.”
The answer to that is: “it all depends on the cost of attaining total and complete safety”. If the costs are zero, then total and complete safety makes sense.
And in the case of banks, the costs of total and complete safety ARE ZERO, and for reasons spelled out by Messers Modigliani and Miller. As M&M correctly pointed out, the costs of funding a given bank which engages in a given set of activities and hence takes given risks is a GIVEN. Thus the charge made by those covering the risk is a given. Thus if the charge is spread over a larger number of “risk carriers” i.e. shareholders rather than a smaller number, there’ll be no change in the TOTAL CHARGE made for covering the risk. Thus moving from 25% to 100% involves no costs.
The M&M theory HAS BEEN criticised, but I’m not impressed by the criticisms. About the most popular criticism seems to be that the tax treatment of bank capital and bank debt is different, thus, so the argument goes, M&M does not work out in the real world in the same way as it does in theory. For example that is the first criticism listed in a paper by three Bank of England authors entitled “Optimal Bank Capital” (p.9).
However, that “tax” criticism is feeble. Reason is that tax is an entirely ARTIFICIAL imposition. Thus for the purposes of gauging REAL costs and benefits, tax should be ignored.
The second criticism of M&M in the latter paper is that the charge made for deposit insurance may not reflect the risk.  Well the answer to that is much the same as the answer to the above “tax” criticism: for the purposes of gauging REAL costs and benefits, any “incorrect” or artificial charges should be ignored. That is, in such cost / benefit calculations or arguments, correct or accurate charges should be assumed, even if those are not the charges that obtain in the real world.
Game set and match to M&M.





Monday, 25 August 2014

Ann Pettifor, the loud mouthed idiot.




When someone keeps screaming the same point from the rooftops despite it having been explained to them they’re talking nonsense, then I start getting abusive. Anyway, details are as follows.
On 26th April this year Ann Pettifor published an article claiming that full reserve banking (FR) had similarities to monetarism: allegedly a flaw in FR. I pointed out why her monetarist point did not stand inspection in a comment after the article (the first comment) actually.
But rather than take heed of my criticism, she went on to have her article re-produced, using slightly different wording on two other sites: on the Open Democracy (on 1st May).the IDEA site (on 25th June), and on the IPPR site. Plus she did a tweet in the last week or two making the same nonsensical monetarist point.
Clearly Ann Pettifor is convinced she has an important message for us, so let’s examine it.
Incidentally her articles are garbage from start to finish, and I’ll deal with some of this nonsense in forthcoming posts, but for the moment I’ll just deal with the monetarist point.
Her actual REASONS for comparing FR to monetarism in the original and two subsequent articles are near non-existent. In the original article she simply claims that advocates of FR think (I’ve put her words in green):
“it is possible to manage aggregate economic activity within an economy like Britain’s if an “independent committee” can just pre-determine money growth, and then shrink or expand activity. This is very close to what monetarists tried to achieve….”. And that’s it!
And in the IDEA version of her article all she says by way of supporting the “monetarist” charge is: “…the notion to my mind is preposterous. It is an approach reminiscent of the misguided and failed monetarist policy prescriptions for controlling the money supply in the 1980s.”  And that’s it (again).
OK let’s examine this (in a lot more detail than Ann Pettifor is able to).
Monetarism at its simplest and most innocent is simply the idea that the quantity of money has an effect. Indeed even the mentally retarded have doubtless tumbled to the fact that if the state printed a billion tons of £20 notes and distributed them to all and sundry, there would be an effect (to put it mildly). Plus about 99% of economists agree with the “mentally retarded” so to speak.
As to monetarism a la Milton Friedman, that takes the above idea much further: claiming that the economy is best regulated PURELY by adjusting the money supply. That’s clearly more debatable.
Thus in claiming that FR (or indeed any other idea in economics) is similar to or amounts to monetarism, it is VITALLY IMPORTANT to explain EXACTLY where the idea lies on the above “innocent  - Friedman” scale. If the idea is at the innocent end of the scale, then the “monetarist” criticism is no criticism at all. But Ann Pettifor can’t be bothered with or doesn’t understand the above sort of details.  

The fiscal element.
The next absurd element in Pettfor’s criticism of how the allegedly “monetarist” stimulus is effected under FR is that that mode of effecting stimulus has actually been implemented big time over the last three years or so – without any “monetarist” objections from Ann Pettifor far as I know. Details are thus.
Over the last three years we’ve implemented fiscal stimulus and followed that by QE. Now the former consists of government borrowing £X, spending £X and giving £X of bonds to lenders, while QE consists of the state printing money and buying back those bonds. But that simply nets out to, or comes to the same thing as the state printing £X and spending it, which is what the allegedly “monetarist” stimulus under FR consists of! Perhaps Ann Pettifor hasn’t heard of QE.

Fiscal matters – continued.
Next, Ann Pettifor seems to be unaware of the fact that when the state prints and spends money, the stimulatory effect DOES NOT come purely from the money supply increase. That is, the simple fact of spending more money on say education and health results in more people being employed in schools and hospitals (revelation of the century, I don’t think). As to the “monetarist” effect, that’s entirely separate.
Indeed, therein lies one of the beauties of COMBINING monetary and fiscal stimulus in the above way. That is, economists are far from agreed on how effective fiscal and monetary stimulus are, thus it’s not a bad idea at all to combine the two! If in fact one is near useless, while the other is effective, then combining the two is bound to work.  

The next absurdity.
The next absurdity in Pettifor’s “monetarist” criticism is that the latter “print and spend” policy is not advocated JUST BY supporters of FR. Ann Pettifor will be devastated to learn that plenty of economists who are NOT famous for supporting FR (and may not support it at all) actually favour the print and spend policy. For example advocates of Modern Monetary Theory tend to favour simply creating and spending base money in a recession.  Plus Claude Hillinger, a German economist advocates print and spend. See paragraph starting “An aspect of..” on p.3 of his article here. Plus Simon Wren-Lewis (Oxford economics prof) advocates “print and spend” (albeit just at the zero bound).
Plus Keynes advocated the idea. As he pointed out in a letter to Roosevelt in the 1930s, stimulus can be effected by increased government spending funded EITHER BY borrowing or by “printed money” as he put it. See 5th paragraph of his letter.

Other bits of Pettifor nonsense.
Readers will have noticed that it’s taken me about a thousand words to demolish approximately ONE SENTENCE in Pettifor’s articles. That is, I’ve had to set out some basic elementary economics and in detail to explain where she’s gone wrong.
Unfortunately, the rest of her articles contain plenty more elementary errors. But in a way, that’s a good strategy: i.e. pouring out a torrent of emotionally appealing and plausible sounding nonsense is a great propaganda ploy: your opponents will have to expend a huge amount of time demolishing the nonsense.
And the word “monetarism” is a favourite “hate” word for lefties. So just trott out the “monetarist” charge and you’re on to a winner. Not that I’m suggesting that “righties” is any less na├»ve.



Saturday, 23 August 2014

What do UK politicians know about money?


Congratulations to Positive Money for their survey to find out whether UK politicians know where money comes from.





Incidentally there might seem to be a clash between my above agreement that loans create money, and item 3 in the left hand column which suggests that loans do not create money. The explanation is that loans certainly create money AT THE INSTANT that loans are made. However, when borrowers spend the money they’ve borrowed, there is a tendency for RECIPIENTS of that money to put their newly acquired pile of cash into term or deposit accounts, and so called money in such accounts is often not counted as money. To that extent, the above INITIAL money creation is nullified.
This is a complicated area, but there’s more on this point in sections 1.12 and 3.1 of the MPRA paper on the left.

Friday, 22 August 2014

Milton Friedman mocked “secular stagnation” 75 years ago.




Further to my foul mouthing of secular stagnation a week ago, I’ve just stumbled across an beautiful passage by Friedman in 1948. I say “beautiful” first because he criticises what he calls secular stagnation, a phrase he uses in much the same sense as it’s used nowadays.
Second, the same passage is very much Modern Monetary Theory compliant: indeed you could even say it summarises MMT.
The passage is just before the conclusion of his paper “A Monetary and Fiscal Framework for Economic Stability”. It reads as follows.
“I do not put much credence in the doctrine of secular stagnation or economic maturity that is now so widely held. But let us assume for the sake of argument that this doctrine is correct, that there has been such a sharp secular decline in the demand for capital that, at the minimum rate of interest technically feasible, the volume of investment at a full-employment level of income would be very much less than the volume of savings that would be forthcoming at this level of income and at the current price level. The result would simply be that the ' equilibrium position would involve a recurrent deficit sufficient to provide the hoards being demanded by savers. Of course, this would not really be a long-run equilibrium position, since the gradual increase in the quantity of money would increase the aggregate real value of the community's stock of money and thereby of assets, and this would tend to increase the fraction of any given level of real income consumed. As a result, there would tend to be a gradual rise in prices and the level of money income and a gradual reduction in the deficit.”
The second half of that quote, translated into MMT parlance would go something like: “Given inadequate demand, create and spend fiat (and/or cut taxes). That will result in the build-up of private sector net financial assets which will ultimately result in less of a deficit being required”.