Fractional reserve causes artificially low interest rates.

The argument put here for thinking that fractional reserve causes artificially low interest rates is a much expanded version of the argument I put here.


But first, let’s be clear on the various possible money regimes, of which four are thus.

1. A commodity based regime where the commodity based currency (e.g. gold coins) are the only form of money. In this regime, the gold coins are also the monetary base.

2. A commodity based regime where commercial banks build a pyramid of credit on the monetary base.

3. A fiat monetary base without commercial banks building a pyramid of credit on the base. This is the sort of regime that most present day advocates of full reserve want.

4. A fiat monetary base regime where commercial banks build a pyramid of credit on the base (which is the regime in most countries nowadays).


A fiat base regime.

Let us assume fiat base regime and that the base is large enough to ensure full employment, but not so large as to cause excessive inflation. (The full employment assumption is dropped a few paragraphs hence.)

As the economic text books explain, people and firms hold money for two motives: the precautionary and the transaction motive. Assuming everyone aims to keep these two stocks constant, then lenders can lend only by forgoing consumption. Thus the rate of interest charged by lenders will reflect the pain involved in this forgone consumption. And the advantage of that is that (at least at the margin) the benefits of any investment are equal to the cost in terms of the pain involved in forgoing the consumption needed to make the investment possible.

At any rate, let’s say that rate of interest in our hypothetical “monetary base only” economy is 5% for essentially risk free loans.


Enter commercial banks.

Now let us assume that commercial banks enter the scene. What banks do, amongst other things, is to offer loans (normally on the basis of collateral, of which property is the most common form). But no one needs to forgo consumption for a bank to lend, or so it would seem! Thus the bank will be happy to lend at a lower rate than those who forgo consumption in order to lend. A bank takes the title deeds of someone’s property, creates money out of thin air, and lends it to the person concerned.

Or as Murray Rothbard put it (and putting himself in the shoes of a banker) “I can charge a lower rate of interest than savers would. I don't have to save up the money myself, but can simply counterfeit it out of thin air.” (BTW: I don’t normally agree with Austrians!)

Let’s say banks can cover their costs by lending at 2%.


Some people are FORCED to reduce consumption.

Next, when the borrower spends what they have borrowed, the effect is inflationary (given the above full employment assumption). Hence government has to withdraw some monetary base to compensate, e.g. by raised taxes. Thus the reduced consumption that must take place to make room for the borrower to spend is FORCED onto those paying extra taxes.

So the net effect is that commercial bank created money displaces central bank money. Friedman alludes to this sort of effect when he says, “Private promises to pay the monetary commodity are as good as the monetary commodity itself – so long as they command widespread confidence that they will be fulfilled – and far cheaper to produce, since the issuers can meet possible demands for redemption by keeping on hand an amount of the monetary commodity equal to only a fraction of their outstanding promises. A pure commodity standard therefor tends to break down.” (That’s in Chapter 1 of his book “A Program for Monetary Stability”).

He goes too far in saying the “commodity standard breaks down”: the gold standard did not break down for the reason given by Friedman: it “broke down” because of a POLITICAL decision. However, and to repeat, Friedman alludes the sort of effect described here.

Anyway, commercial banks certainly will try to induce an economy to make maximum use commercial banks’ money and minimum use of the monetary base.

And this tussle between the two forms of money was played out in dramatic fashion when Abraham Lincoln issued green backs to fund his side in the American civil war. Commercial banks didn’t like it. See here, in particular the paragraph starting, “Abraham Lincoln. From this we see….”


Expansion of commercial bank loans versus a steady state.

The above way in which some consumers are FORCED to reduce consumption so as to make room for an EXPANSION in commercial bank loans must be distinguished from the scenario where commercial bank loans are NOT EXPANDING.

In the latter scenario, commercial bank loans presumably have no effect on demand because the creation of new loans is balanced by the repayment of existing loans.

But there is a permanent effect of allowing commercial bank credit or money creation, which is that interest rates are permanently reduced: they become sub-optimum.

After all, it is profitable for borrowers to borrow at 2% and invest in something that brings a 3% or 4% return. That beats all those investments that had to make a minimum of 5% return. Also a very significant proportion of borrowers take their “return” in kind: that is, when people borrow to buy a house, the return is the utility or satisfaction derived from living in a house (or owning a house rather than renting one).


Let’s assume some unemployment.

Full employment was assumed above. Let us now assume excess UNEMPLOYMENT. Here, there are two ways of raising demand. 1, expand the monetary base. 2, expand the amount of private bank lending.

The logic of the former is thus. The BASIC PURPOSE of an economy is to provide what the consumer wants. Thus given excess unemployment, the obvious and best solution is to give the consumer more that the stuff that lets the consumer have more of what they want: i.e. give the consumer more money. (Plus, public spending needs to be expanded by the same proportion as consumer spending expands if the economic expansion is to be politically neutral – that is, not biased towards the public or private sector.)

As regards expanding the amount of private bank lending, whence the assumption that resources are best allocated by such an expansion? That makes as much sense as assuming that given excess unemployment, it’s just spending on the military or education or airports that should be expanded.

Moreover, if stimulus is effected by giving the consumer more money and expanding public spending, THERE IS NOTHING TO STOP consumers or public sector entities from using the additional funds at their disposal to borrow more, where and when they see fit.


A new equilibrium.

The net effect of introducing commercial banks is that a new equilibrium arises. It is NOT an equilibrium at which at the margin the benefit derived from investments equals the pain or disutility of forgone consumption. It is an equilibrium at which at the margin the benefit derived from investments equals the costs to commercial banks of creating credit / money. (At least that’s my theory!).


The borrower’s property IS forgone consumption.

There might seem to be a flaw in the above argument, as follows. It was argued above that the private bank creates money / credit without any consumption being forgone. But it could on the face of it be argued that the borrower DID HAVE TO forgo consumption to acquire the property used as collateral to back the loan. The answer to that is that the property is not CONSUMED during the “lend and eventually pay back” process. Put another way, the lender does not forgo the results of the saving which was needed in order to purchase the property.

By the way, I’ve assumed above that all loans are backed by collateral in the form of property, as readers will have noticed. While this is the biggest single type of collateral, obviously there are other forms. And some loans are based on no collateral at all. However that does not change the argument much.


Full reserve’s big hitters.

And finally, please note that we full reservers have some big hitters on our side. William F. Hummel is one. Irving Fischer and James Tobin also favoured full reserve according to Mervyn King – see p.16 here. Plus there is Milton Friedman and Mike Shedlock.
 

Bibliography – or rather a list of other works on this subject and why I think they are flawed.


Brown, Ellen Hodgson. “The Web of Debt”. This is a full length book which argues against fractional reserve. It’s full of historical detail, but it says nothing about fractional reserve bringing artificially low interest rates, far as I can see.

Huerta De Soto, Jesus. “Money, Bank Credit and Economic Cycles”. This is a full length book which argues against fractional reserve. It is available online. It has “Austrian” written all over it.

Given the length of the book, it is short on good IDEAS. For example he devotes the FIRST THREE CHAPTERS to arguing that fractional reserve breaks legal principles. Well there is a simple answer to that. The important question relating to any activity is WHETHER ON BALANCE IT BRINGS BENEFITS. If it does, and in doing so, a legal principle is broken, then it’s the legal principle than needs amending, not the activity that should be banned.

Selgin, George. “Should We Let Banks Create Money?” Selgin is an advocate of fractional reserve, and his book is far better than Ellen Brown or Huerto de Soto’s. The book is well thought out, and sets out a detailed step by step argument.

On his p.97 Selgin DOES ADDRESS the artificially low interest point, and argues that commercial bank created money will not be inflationary if there is a DEMAND for that extra money. Agreed.

But Selgin then argues that if commercial banks lend too much, that results in creditors (i.e. those who deposit money in banks) holding more money they want, which according to Selgin means banks have to pay excessive rates of interest to persuade them keep their money there. (Exactly this phenomenon, incidentally, is spelled out by Warren Mosler in his hypothetical “parent, children and business card” economy.)

However there is a flaw in Selgin’s argument, as follows. Why should commercial banks be bothered if depositors find themselves with too much cash? The excess cash has an inflationary effect (as mentioned above), but that won’t bother banks too much. As far as commercial banks are concerned, inflation is a problem for government and central bank.

Moreover, if I can borrow at 2% rather than 5% to fund some project, I can afford to pay my suppliers a better price than someone doing a similar project and borrowing at 5%. Now if you are a supplier, and you already have your preferred stock of cash, and you spot the generous prices I’m offering for your product, you’ll just abandon those you currently supply, and take up my offer instead. Alternatively, you might opt to expand your business and supply BOTH me and your original customer. As to what you will do with the extra cash: well that’s not difficult: you’ll spend it on wine women and song – or something like that! And that will raise demand.

This is not to suggest that fractional reserve leads to instant hyper-inflation: clearly it does not. Amongst other reasons, that is because of the well known fact that if any INDIVIDUAL bank expands its lending much faster than its rivals, it is in trouble.

In fact the pace at which commercial bank money in the UK over the last few decades has grown in prominence compared to central bank money has been very leisurely.

The M0/M4 ratio declined from about 16% in 1969 to about 3.5% in 2000 (see here). Incidentally that decline in the importance of M0 is not explained to any great extent by the reduced use of physical cash. Physical cash as a proportion of M0 decline from around 10% in 1970 to roughly 2% in 1997 (see Chart 1 here – you’ll have to do your own calculations to check this).

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Former Archbishop of Canterbury backs cuts in welfare.

One of the main arguments he puts is that Britain's national debt is too high, and that cutting welfare payments would reduce the debt.

Like about 90% of those who sound off on the subject of the debt and deficit, he doesn’t get the distinction between micro and macroeconomics: a major blunder. He is clearly not being divinely inspired.

So for about the hundredth time, I’ll explain the distinction.

A micro economic entity, like a household or firm, can certainly cut any deficit it has by cutting expenditure. Unfortunately, if a government does the same, it causes a drop in demand and a rise in unemployment: an outcome presumably not favoured by his grace.

Moreover, in that a deficit is required for stimulus purposes (i.e. employment raising or employment maintaining purposes) it is daft to even aim to cut the deficit.

But that’s not to say the debt and/or deficit cannot be cut. Reason is that the debt and deficit are partially structural in nature: that is they exist thru pure simple failure by politicians to collect enough tax. And that part of the deficit / debt is easily cut. To do so, proceed thus.

1. Print money and pay off creditors – and probably the best way to do so is to cease rolling over debt.

But that alone would probably be too inflationary. So (step 2), get some of the money for debt repayment / deficit reduction via extra tax. As long as the deflationary effect of the tax equals the inflationary effect of the money printing, there is NO NET EFFECT.

But that’s not to say that cutting the debt is necessarily desirable. Britain is currently borrowing at a negative real rate of interest far as I can see. We’re ripping our creditors off. So let’s carry on – that’s what I say. At the very least, there is no great urgency to cut the debt.

The former archbishop’s views on welfare dependency may well be valid. But his views on the deficit and debt are flawed.
 Clerics – Christian, Buddhist, Jewish, Hindu, Muslim, Zoroastran, Druid, etc etc  -  please keep to your holy books, and don’t express views on subjects you haven’t studied.

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Employer of last resort on the 1970s - two articles.

The first is by Milton Friedman. It’s stronger on rhetoric than cold impartial analysis, to put it politely. And the second concerns Denmark.

I re-produced these via optical character recognition from hard copy, so expect typos.


“Humphrey-Hawkins” by Milton Friedman, Newsweek, 2nd Aug, 1976.

A centerpiece of the Democratic fall campaign is the "Humphrey¬Hawkins Full Employment and Bal¬anced Growth Act of 1976." Support of that bill has become the litmus test of the true-blue Democratic faith of every candidate from Jimmy Carter to the aspirant for dogcatcher.

The present expanded version of the Humphrey-Hawkins bill em¬braces the earlier Humphrey-Javits bill. It proposes to establish a process of long range economic planning to achieve "a full-employment goal ... consistent with a rate of unemploy¬ment not in excess of 3 per centum of the adult Americans in the, civilian labor force, to be attained within not more than four years after the enactment" of the act, as well as a long list of other goodies.


ADAM SMITH'S' CRITIQUE

The best critique of this bill that I have come across was published 200 years ago in that great book, "The Wealth of Nations" by Adam Smith-" the original Adam Smith, not the cur¬rent impostor who has had the effrontery to adopt that, pseudonym.

Wrote Smith: "The statesman, who should attempt to direct private peo¬ple in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so danger¬ous as in the hands of a man who had folly and presumption enough to fan¬cy himself fit to exercise it."

Has any contemporary political writer described Hubert Humphrey more concisely?

Not to put too fine a point on it, the Humphrey-Hawkins bill is as close to a fraud as has ever served as a cam¬paign document. It is full of pious promises but contains no measures capable of fulfilling those promises. It would not reduce unemployment but simply add to government employ¬ment and reduce private employ¬ment, in the process making us all poorer and very likely igniting a new inflationary binge.

How can such a bill do otherwise? Easy enough to say that the govern¬- ment will be the employer of last resort. But where does the govern¬ment get the money? Ultimately, from you and me, by hook or by crook. If it spends, we don't. If it employs people, we don't.

Of course, people on welfare could be re-labeled "civil servants assigned to home duty," thereby reducing re¬corded unemployment without addi¬tional spending. But to do more - and Humphrey-Hawkins promises to do far more - requires more government' spending. The extra spending could be financed by higher explicit taxes In that case, taxpayers would have less to spend and would hire fewer people. The extra spending could be financed by higher borrowing. In that case, the lenders, or the borrowers outbid by government, would have less to spend. Government employ¬ment would replace employment in building homes or factories. Finally, the government could print the mon¬ey, which would tax us indirectly via inflation. We would have more pieces of paper to spend but could buy less. For a time, that could mean more government spending without less private spending, but surely by now we have learned that that is a fool's paradise that would not last.

Is anyone so naive as to suppose that the government jobs created will be more productive than the private jobs destroyed?


VISIBLE GOOD, INVISIBLE HARM

Why do democrats believe that Humphrey-Hawkins is such potent political soothing syrup? Do they have such a low opinion of the intelli- gence of the American people? I do not think so. It is for a very different reason – one that is for me a source, of so many harmful government policies: the visible vs. the invisible effects of government measures.

People hired by government know who is their benefactor. People who lose their jobs or fail to get them because of the government program do not know that that is the source of their problem. The good effects are visible. The bad effects are invisible. The good effects generate votes. The bad effects generate discontent, which is as likely to be directed at private business as at the government.

The great political challenge is to overcome this bias, which has been taking us down the slippery slope to ever bigger government and to the destruction of a free society.



“Why Hanstholm has no jobless youngsters”. Times article by Christopher Follett, 16th Dec 1980.
 

Reduced fishing quotas have hit the Danes, the biggest North Sea fishing nation, hard. leaving chronic unemployment, particularly among young people in the age group 18-25, in their wake.

Thanks, however, to a unique local initiative, Hanstholm, Denmark's third largest North Sea fishing port (and number one for its idustrial fisheries), situated on the remote north west coast of Jutland, has almost totally eradicated youth unemployment.

The Conservative dominated local town council of Hans tholm decided simply to forbid youth joblessness in 1979 by refusing - as it can under Danish law - to put young people on unemployment benefits or social welfare and creating employment for them instead. After its first year of operation Hanstholm's iob creation scheme is still enthusi¬astically backed by local union representatives, employers, and last but not least, by the young themselves, who would otherwise earn 90 per cent or more of their wages (in some case even more) in unemployment benefits and/ or social aid if they were on the dole.

With' a population of 6,000, Hanstholm, like most of depressed north Jutland, suffered from above average youth unemployment before the council stepped in. Unemployment in Denmark is among the worst in the European Community at present with 200,000 or nearly 8 per cent idle. Of this figure, young people make up 75,000 or nearly 40 per cent and the Danish government's latest economic forecasts foresee a further dramatic increase in coming years.

Depressingly, youth unemployment has doubled in Denmark in the past year alone. In the Hanstholm project, the jobs created for the young are mainly geared to the important local fisheries industry. Instead of buying in fish boxes and crates from outside, as many other Danish ports tend to do, the youth of Hanstholm now make them themselves.

The first year's production amounted to an impressive 80,000 crates, more than were needed locally. The excess was, profitably sold to visiting foreign fishing vessels, earning useful foreign exchange for the hard pressed fishing community. Other created jobs undertaken by the youth of Hanstholm the manufacture and repair of toys for local schools, gardening, carpentry, painting, recycling projects.

In addition the local town council absorbs many of the otherwise idle youth. Paying wages of 40 kroner (£2,90) an hour, as agreed with the unions. Hanstholm Kommune (council) estimates that the scheme is costing it a maximum 3m kroner (£215,000) a year, putting an extra 2 per cent on the local rates.

According to Mr Niels Graversen, the councillor in charge of the Hanstholm youth project, over 92 percent of the first year's "intake" of around 150 young people found work afterwards.

"The scheme has obvious advantages for all involved, the employers, the unions, the young and the town as a whole", Mr Graversen says.
"Young people who have taken part in our programmes, which vary in duration, gain a sense of fulfilment and achievement and are, in our experience, eventually more attractive prospects to potential employers than unemployed youths who have never had any work experience at all."

The only criticism to be heard from Hanstholm town council is against the Danish Social Democratic government in Copenhagen, which, it feels, does not give sufficient incentive to local authorities to carry out job creation schemes, While a Danish local authority is automatically refunded one half of its outgoings on unemployment benefits by the state, funds spent on job creation schemes are not reimbursed at all, creating an anomaly with which the Danish bureaucracy has not yet caught up.

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Central banks should do some fiscal.

This paper by a professor of computer science, Russ Abbott, suggests that the Fed should have to right to alter sales taxes and payroll taxes. H/t to Scott Sumner. To download, click on the “One click download” phrase top centre. The paper is less than 1,000 words.

One advantage of this system, as the author points out (and as I pointed out here), is that implementing stimulus (or “anti-stimulus”) by monetary policies alone is distortionary: for example interest rate adjustments work only via entities that are significantly reliant on variable rate loans. (Technical problem: that link just above may take you to the end of the comments on the blog post linked to.)

In contrast, adjustments to a sales tax and/or payroll tax affects well over half of all households, and are thus less distortionary.


Politicians.

An obvious problem is that those economically illiterate politicians will balk at having some of their power removed.

However any politicians who make this objection are being illogical in that they conceded long ago that decisions on how much the economy needs speeding up or slowing down should be taken by central banks. Thus the only question is exactly how central banks should do this: monetary means alone, or monetary plus a bit of fiscal.

If politicians want to retain the right to control fiscal WITH A VIEW TO CONTROLLING STIMULUS, then they are saying the decision as to what stimulus an economy gets should be split between two bodies: central bank and a body of elected politicians. And that is PLAIN DAFT. As I pointed out here, you might as well have a car with two steering wheels one of them controlled by husband and the other by his wife in the middle of a marital breakdown.


Political neutrality.

A fault in Abbot’s proposal is that it is not politically neutral. That is, if stimulus is needed, only the private sector would be boosted under Abbot’s proposal. And that is a serious fault because it gives ammunition to the politicians who will claim their right to make political decisions is being diluted.

However, there is a very simple remedy namely to arrange for both public and private sectors to be boosted by the same percentage when stimulus is needed. To illustrate, given a need for stimulus, the central bank could cut the sales tax and/or payroll tax by enough to give an X% boost to the private sector over say the following two years. PLUS the central bank could tell politicians they can expand public sector spending by X% over the same period.

In short, the above “central banks do some fiscal” policy needn’t have ANY EFFECT WHATEVER on politicians’ control of the most basic political decisions that any country takes. These are first, what proportion of GDP is allocated to the public sector, and second, how public sector spending is split between education, the military, law enforcement, and so on.


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Government borrowing is pointless.

Note: the word government is used here in the sense “government and central bank combined”.

The main and valid reason for any entity to borrow arises where the entity spots a legitimate or profitable way of spending money but happens to be short of cash. For example if a business thinks a new machine makes sense, but it doesn’t have enough cash to buy the machine, then borrowing is clearly a legitimate option.

But governments have a near inexhaustible source of cash: the taxpayer. And that applies to governments which issue their own currencies (monetarily sovereign governments) and those which don’t (e.g. Eurozone counties).

Monetarily sovereign countries of course have an additional source of cash, namely that they can print the stuff – though clearly they have to watch inflation when doing so.


Borrowing spreads costs across generations?

One popular excuse for borrowing to fund capital projects is that it spreads to cost across the generations: the generations that will benefit from the expenditure. That argument does not stand inspection. See blog post here. (Clicking on that link may take you to the end of the comments on that blog post - sorry.)


Borrowing means the rich pay?

Another popular excuse for government borrowing is that the funds will inevitably come from the rich, thus there might seem to be a re-distributive element here. There are several flaws in this argument.

1. The rich are not made any worse off: they get government bonds in exchange for their cash. And not only that, but the rich will presumably withdraw a finite amount of lending to the less-well off to fund lending to government.

2. To the extent that the rich DO NOT withdraw loans to the less well-off, what economists call an “injection” takes place. That is aggregate demand is raised. Indeed this is just the standard Keynesian “borrow and spend” remedy for deficient demand.

So if the “borrow so as to re-distribute” policy is carried out on an “all else equal” basis, then it is not legitimate to count the above apparent injection merit as a merit in the re-distribute policy.

3. There is a limit to how long the “borrow so as to re-distribute” policy can go on for before it results in government debt as a proportion of GDP rising to ridiculous levels.


Borrowing with a view to stimulus.

If stimulus is required, then as mentioned above, governments CAN implement the classic Keynsian borrow and spend policy. But what’s the point of government borrowing something (i.e. money) which it can produce in limitless quantities any time? It’s plain daft.

Indeed as Keynes himself and Milton Friedman pointed out, having government just print money and spend money it in a recession (and/or cut taxes) is a perfectly viable alternative to borrowing.

As Keynes put it “the public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money.” See 5th paragraph.

Re Friedman, see p.250, paragraph starting “Under the proposal…”.



So why do governments borrow?

Political cowardice of course!!!! Or put another way, it’s a way of buying votes.

Taxpayers tend to notice tax increases. But they are less likely to blame governments for any interest rate rise that comes from more government borrowing. Indeed, the latter sort of interest rate increase does not even necessarily take place because lenders may make up for their increased lending to government by tightening up on lending criteria to other borrowers rather than actually raising interest rates. In fact the latter phenomenon is taking place right now: interest rates are at near record lows, but small and medium size businesses are complaining about difficulty in getting loans.


Borrowing so as damp down demand.

There is one possibly valid reason for government borrowing, as follows.

Suppose a government borrowed nothing, but it thought that demand and inflation were becoming excessive. Such a government could simply announce it was willing to borrow at above the going rate of interest. That would withdraw money from the private sector, which would be deflationary.

However, this is not “borrowing” in the normal sense of the word. Normally when any entity borrows it is so as to spend the funds borrowed. The above anti-inflation trick would very definitely not involve government spending the relevant funds.


Smoothing tax receipts.

The money received by governments during the year varies from one month to the next, which might seem like a reason to borrow during the months when receipts are low. But why borrow when governments can print money at will? Because the result would be inflationary? Nope.

Entities due to pay a large chunk of tax in X months time will be perfectly well aware that this liability is in the pipe line. Assuming they have the cash to hand, they think very carefully before spending that cash.

Thus a government which has constant spending needs thru the year and erratic tax receipts does not need to borrow in the “lean” months. It can perfectly well print and spend money in the lean months and balance that by having taxes exceed spending in other months.


No government borrowing would cause a shortage of private sector net financial assets?

A possible objection to the above argument is that zero government borrowing would leave the private sector short of net financial assets, which might cause paradox of thrift unemployment. The answer to that is the clearly government must supply the private sector with the net financial assets that the latter wants, but this can be done with cash instead of government debt. Indeed, this is exactly what Friedman advocated in the paper linked to above.

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P.S. (22nd Jan) – Controlling interest rates. If government does not borrow, it loses control of interest rates, except to the extent mentioned under the heading “Borrowing so as to damp down demand” above. In short, government would be able to RAISE interest rates, given excess demand and inflation, but it would not be able to lower them, given a recession. Does this matter? I think not and for several reasons.

1. Abba Lerner did not advocate adjusting interest rates with a view to adjusting demand. (He DID ADVOCATE adjusting interest rates, but NOT so as to control demand.) See end of p.39 – start of p.41 here.

2. There is a long list of weaknesses in interest rate adjustment as a means of controlling demand. See here and here.


3. Warren Mosler, as far as I can see, advocated a regime quite similar to the one set out above: that’s a regime where government does not adjust interest rates. See here, final four paragraphs in particular.









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Mind boggling stupidity from the IMF and The Times.

This IMF report argues that Japan needs to cut its national debt (h/t to Warren Mosler).

I’ve been thru the report, and no reasons are given for for Japan cutting its debt other than a selection of catchy and fashionable phrases like “fiscal sustainability”.

Other fashionable phrases, all of which have been debunked in Modern Monetary Theory literature abound in this report: the confidence fairy is there, as might be expected.

There is no appreciation of the fact that if Japanese citizens are happy to hold this debt at very low interest rates (and it’s very largely Japanese nationals rather than foreign nationals who hold Japanese debt), that indicates a desire by Japanese nationals to hold a relatively large quantity of net financial assets. And if those assets are not provided, you get paradox of thrift unemployment.

So if Japan heeds the IMF’s advice and unemployment rises in Japan in the next five years, we know who to blame: the IMF.

As Bill Mitchell has said time and again, the IMF is not fit for purpose and should be closed down. (Coincidentally Bill’s post today is yet another of his broadsides against the IMF.)

 
The Times.

This Times leading article is an inspiration. It claims that the solution for Britain’s economic ills is more investment.

As anyone who has got a quarter of the way thru a basic introductory economics text book knows, building a car plant capable of producing a thousand cars a week will not raise demand for cars by so much as one car per year. Though there are some apparent flaws the latter argument, which the gullible always fall for, as follows.

1. There is the fact that all investments are to some extent what economists call an “injection”, i.e. investments tend to increase aggregate demand. But raising demand is easy: just ask anyone who has got a quarter of the way thru a basic introductory economics text book.

2. There is the fact that really worthwhile investments can raise exports (cited by The Times). You knew that was coming didn’t you?

The problem there is that in this recession everyone else has had this brainwave. Obama thinks the U.S. can grow on the back of exports, and Germany is exhorting other European countries to be more like Germany and export more.

But you don’t even need to have OPENED a basic introductory economics text book to see the flaw in that one: it’s a zero sum game.

3. If the car plant is much more efficient than existing car plants, it will raise overall demand for cars, which might sound desirable. Trouble is that (apart from the above mentioned injection point) there is no reason to suppose aggregate demand rises in consequence. Thus the increased demand for cars will be at the expense of demand for other stuff. Net effect: zero.

In short, if inflation permits, why not just raise demand? Businesses invest when demand for their products warrants an investment. Businesses large and small do not need Times leader writers or bureaucrats or politicians to tell them when to invest and what to invest in.


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Government as employer of last resort.

This is a summary of the arguments for allocating ELR people to EXISTING employers rather than to specially set up schemes or “employers” as was the case with the WPA in the 1930s.


The “factors of production” quandry.

If an ELR scheme employs little permanent skilled labour, capital equipment or materials, that will keep costs down, but it will tend to result in inefficiency. (See any basic introductory economics text book on the optimum combination of different factors of production.)

On the other hand, if an ELR scheme involves more normal ratios of the above factors of production, the scheme becomes indistinguishable from a normal or regular employer: in effect, ELR people are subsidised into work with regular employers.

So ELR employees might as well be subsidised into work with EXISTING regular employers (along the lines of CETA).


At NAIRU, ordering up other factors is inflationary.

The above argument is backed by another argument, as follows. If unemployment is above NAIRU (or the “natural level” or the “inflation barrier” level, or whatever you call it) the best cure for unemployment is a straight rise in demand. Therefor the niche for ELR is in dealing with “at or below NAIRU” unemployment. But in that scenario you cannot order up the above “other factors of production” to supply an ELR scheme because the regular economy is already at capacity – the result would be inflation. Thus allocating ELR people to specially set up schemes along the lines of the WPA is in a logical check mate. It’s caught between a rock and a hard place.


Anti-fraud measures.

But if ELR people ARE allocated to existing employers, as suggested above there is a problem, namely how to dissuade employers from using the subsidised labour to displace regular labour. The answer is to call the employer’s bluff: that is, place a time limit on how long a ELR person can stay with a given employer (as was done – not very well in my opinion – under CETA).

The time limit could be a SPECIFIC time limit, but even better would be to allow public employment agencies to remove ELR labour from any given employer randomly, or when such agencies think they’ve spotted an ELR vacancy with some other employer where the ELR employee would be more productive. That way, the employer is forced to claim the ELR subsidy only in respect of the employer’s LEAST productive employees: the employees which the employer does not mind losing. (No employer wants to lose PRODUCTIVE employees).

Employers could of course claim the subsidy in respect of a PRODUCTIVE employee and then on hearing that that the employee was about to be removed, cease claiming the subsidy. But that ruse is easily dealt with: either remove the employee anyway, or allow the employer to keep the employee, but make the employer repay the previous month or two’s worth of subsidy money.

The latter system WOULD result in a relatively fast turnover of ELR people, but that’s arguably quite beneficial. The unemployed are those who cannot find a suitable job. They are people who by definition in many cases are going to have to acquire new skills and find a new work environment. Thus giving them experience of a variety of new and different work environments would help them decide which to go for. Many millionaires started their careers with a series of dead end jobs.


The macroeconomics.

Does the macroeconomics of the above system stand inspection? I think so….

As unemployment falls, the marginal product of labour falls: that is the unemployed become increasingly unsuited to vacancies – until the point is reached where too many employers, rather than take labour from the dole queue, spend increasing amounts on advertising for staff. And that in effect means poaching staff from other firms, which bids up the price of labour, which equals inflation.

Thus the inflation / unemployment trade-off is improved if employers can be persuaded to take on relatively unsuitable employees. That’s employees who are not TOTALLY UNPRODUCITVE, but employees who employers would not take on but for the ELR subsidy.


“Existing employer ELR” = free market.

Note that the above system is similar to a totally free and unregulated labour market (a scenario which in theory involves zero unemployment). A totally free labour market involves no minimum wage laws, no state sponsored unemployment insurance, etc. And in this scenario, the unemployed – to a greater extent than is currently the case – would take temporary and relatively low paid unproductive jobs pending the appearance of something better.

In short, the above system (if it works) would gain the advantages of a totally free labour market without the social costs.


Private sector ELR more inflationary than public sector?

It is commonly assumed that public sector ELR requires no increase in demand, thus it must be less inflationary than private sector ELR. Not true.

If the idea set out above under the heading “The Macroeconomics” works to perfection, the only net effect of introducing “existing employer ELR” is to induce employers (public and private) to marginally expand their workforces by taking on a few more less skilled people, while NOT INDUCING employers to order up more capital equipment, materials, etc.

In that case, neither public sector ELR nor private sector ELR has any inflationary effect.

Alternatively, it could be that employers ARE INDUCED to order up some more capital equipment and materials, and the effect would certainly be inflationary. But let’s have a fair comparison between public and private sectors here: let’s compare a public and private sector employer where the RATIOS of different factors of production employed are the same. On that assumption, there is no reason to suppose the private sector employer will order up MORE CAPITAL EQUIPMENT etc. than the public sector employer.

Thus there is no difference between the two sectors, inflation-wise.


Bureaucratic costs.

But having said all that, as Cullen Roche and John Carney have correctly suggested recently, the bureaucratic costs of any ELR system could exceed the benefits.




 
P.S. The above system probably occurs to some extent anyway in that as unemployment rises, there is an increased tendency to work on the black market while continuing to claim unemployment benefit.



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