Modern Monetary Theory beats interest rate adjustments.

The conventional wisdom is that changing interest rates is a good way of adjusting aggregate demand. This is nonsense and for a string of reasons given below.

There is a better way of adjusting demand (as advocated by Modern Monetary Theory). The MMT solution to a recession is to have government create new money and spend it. Conversely, when excess inflation looms, do the opposite: raise taxes, rein in money and “unprint” or extinguish money. That is, it is government net spending (i.e. spending net of tax) that should be adjusted.

This does NOT mean that in a recession, public spending as a proportion of GDP necessarily rises. That is, under MMT, new money can be used to boost private sector spending as easily as it can be channelled towards extra public spending.

The word “government” is used here to refer to government and central bank combined. The weakness in interest rate adjustments are as follows.

1. Using interest rates to regulate economies is distortionary. An interest rate change works mainly via households or firms which are significantly reliant on variable rate loans. (I.e. those reliant on FIXED rate loans are not affected by an interest rate change). This form of distortion makes no more sense than boosting an economy only via firms whose names begin with the letters A – G, while ignoring those whose names begin with the letters H – Z.

2. The idea that there is a close relationship between interest rates and the ACTUAL availability of credit has been shown to be TOTAL NONSENSE over the last two years or so. That is, rates are currently at record low levels, but banks are reluctant to lend.

3. Low interest rates can have a DEFLATIONARY effect (pointed out by Warren Mosler). If rates are cut, the central bank will then pay out less by way of interest. That is, less new money will be injected into the private sector.

This effect depends, of course, on the rules governing the relevant central bank, Treasury, etc. To illustrate, in some countries a rate reduction may NOT automatically reduce the above injection. That is, the reduction may be treated as a reduced budgetary expense for the Treasury, which in turn is expected to collect less tax to compensate. In this case the above deflationary effect would not operate.

4. The text book story is that low rates encourage investment.

E.g. “Principles of Economics” by R.G.Lipsey & K.A.Chrystal, 9th Edition, p 453. says “lower interest rates leads to more investment”.

But there is a problem here namely that lower rates means reducing the rewards for “saver/investors”. That means less saving/investing. The latter effect could wipe out the investment increasing effect. But all is not lost for the conventional wisdom (on the face of it). Salvation comes, so it might seem, from the actual WAY in which rates are reduced, namely that the central bank lowers rates by creating new money and buying government bonds. So the private sector now has excess cash, which it will spend in various ways, including buying up other assets or investing. Indeed, this has been an effect we have seen in the last year or so as a result of quantitative easing: that is, asset price rises.

But wait a moment. This all means that the fundamental cause of the increased investment is NOT the interest rate reduction AS SUCH. The fundamental cause is the cash injected into the private sector! That is, the fundament cause is the MMT government net spending effect, not the interest rate change!

5. An interest rate reduction is an inducement to borrow and invest in assets, which tends to cause asset price bubbles. In contrast, a straightforward change in government net spending need not have this effect. That is, if the additional net spending is directed at a cross section of the population (not just the wealthy or the cash rich or the asset rich), there will not be a significant asset bubble effect. The MMT net government spending policy beats interest rate changes yet again.

6. The optimum price for borrowed money (i.e. the optimum rate of interest) is determined by the same sort of factors that determine the optimum price for concrete, steel or any other commodity: supply and demand. To put that in economics jargon, the rate of interest is optimised when the marginal disutility of forgone consumption by savers equals the marginal utility or marginal benefit from the investments that those savers fund.

If government interferes with this market produced rate of interest, then the total amount invested will not be optimum. GDP will not be maximised.

7. As far as long term “big item” investments go, it is long term rates that matter, not short term rates. We are talking about house purchases and investments in plant, machinery, and so on.

And there is much argument as to just how much influence central banks have on long term rates. For example, there is one estimate here (3rd last para) to the effect that a 1% change in short term rates brings a change in long term rates of around 0.025: a total and utter irrelevance!

And if that is not bad enough, it seems that in as far as central banks can influence long term rates, they can only influence them slowly – over a two year period. See here. Again, that is utterly hopeless. For the purposes of regulating aggregate demand, one needs as quick an effect as possible.

As to house purchases, about half of those with mortgages are on variable rate mortgages and half are on so called fixed rate mortgages in Britain. See here (p. 277, 2nd col.).

Few people aiming to be on a variable rate mortgage are going to run out and buy a house, or buy a bigger house, just because the central bank drops interest rates for a couple of years. It is primarily the average rate of interest over the lifetime of the mortgage that the mortgagor needs to consider. And that average rate (particularly the real rate of interest) does not vary much from decade to decade.

As to those aiming for so called fixed rate mortgages, these are normally not fixed for more than five years or so in Britain. Thus so called fixed rate mortgages are really nothing of the sort. Thus much the same arguments apply to fixed rate mortgages as apply to variable rate mortgages.

While most people will not buy houses just because interest rates have dropped for a couple of years, there ARE those NINJA mortgage suckers who bought houses on the basis of zero or no interest for the first year or two. I.e. there ARE idiots out there. The answer to this point is that since those low initial payment mortgages were a significant part of the cause of the credit crunch, such mortgages should be banned. It is pity to interfere with the free market in this way, but where fraudsters and dummies are a significant problem, their activities must be reined in.

8. The idea that reduced interest rates encourage investment is rendered irrelevant by the fact that in a recession, more investment is exactly what is NOT needed. Reason is that in recessions, there is more than the usual amount of capital equipment lying idle! Of course it takes TIME to manufacture or create real investments like machinery or factories, and assuming an economy will return to trend growth shortly after a recession, employers need to make sure they are not SHORT of capital equipment after a recession. But employers do not need governments to tell them this. Nor will irrelevant little inducements like 2% changes in interest rates do much to optimise any given employer’s investment strategy.

9. Radcliffe Report on monetary policy in the U.K. published in 1960 concluded that ‘there can be no reliance on interest rate policy as a major short-term stabiliser of demand’.

10. As to the possibility that credit card spending is influenced by changes in a central bank’s interest rate, that is pretty much of a nonsense because there seems to be no link between those rates and credit card rates. See here.

11. Scott Sumner expresses doubts about the use of interest rate adjustments.

Conclusion: game set and match to Modern Monetary Theory and Abba Lerner (one of the founding fathers of MMT).

Endnote: some of the arguments above were in earlier posts for this blog (28th August and 13th Oct, 2010). I have or will delete these earlier posts.

Afterthought, 14th July 2011: Someone else with doubts about the effectiveness of interest rate adjustments. See p.10 here:

“Towards a Twenty-First Century Banking and Monetary System”, by Prof. R.A.Werner and others. Also, this work, while not mentioning Modern Monetary Theory, in fact advocates an MMT type method of regulating demand, that is simply printing money and spending it in a recession, and given looming inflation, doing the opposite, namely reining in money and “unprinting” it.

Afterthought, 23rd July 2011: Some more ideas on interest rates here.

“Beyond the Crash” by Gordon Brown.

This book by the former British premier is quality stuff for the most part. It is published by Simon & Schuster UK Ltd. The first half gives the detailed story of Brown’s involvement in the credit crunch (between its inception and 2010).

Brown starts with the incompetence of British banks: that is, the latter’s ignorance of, or refusal to recognise their problems in 2007-8. It says much for Brown’s government that it seems to have known more about these banks than the banks own CEOs did.

The book then detail’s Brown’s part in organising the two G20 2009 meetings which produced an international trillion dollar stimulus plan.

In the second half of the book, Brown sets out his ideas for particular countries or geographical areas: America, China, etc. That’s “Part 3” of the book. Part 4 is not much use. It contains the so called conclusion of the book, which is entitled “Markets Need Morals”. Indeed, the immoral behaviour of banks is a constant theme in this book.

I doubt that lecturing banks on the need for honesty will have much effect. Clear rules with stiff penalties for those who ignore the rules is what is needed, and Brown does not produce any brilliant ideas here.

Throughout the book, Brown stresses the need for worldwide agreements to deal with worldwide problems. He does not think much of bilateral agreements.

Brown has long had a schizophrenic attitude to banks, as Simon Jenkins made clear here. Brown deplores the dishonesty and incompetence of banks, while at the same I think he overestimates their importance. For example on p.109 he praises securitisation. Now wasn’t the securitisation of junk mortgages one of the main causes of the credit crunch? I prefer Warren Mosler’s “ban securitisation” policy – see para starting “1. Banks should only be allowed to lend….” here.

Brown unfortunately repeats more than once an idea that British politicians have been wittering on about for decades. This is idea that advanced countries will only survive or compete if they concentrate on high tech products and exports, since they clearly cannot compete with India, China, etc on the basis of low wages.

This is patronising. China is getting up speed very quickly in the high tech department. Moreover, wealthy countries can perfectly well profit from low tech products: Switzerland does a roaring trade in skiing holidays. If in twenty years, America and China are swapping both high and low tech products and in equal proportions, that won’t surprise me.

Brown was the British finance minister as from 1997 and was thus one of the world leaders responsible for the credit crunch. Needless to say he devotes a hundred times as much space to his role in sorting out the mess as compared to his contribution to causing it in the first place. But most autobiographies are ego trips.

Brown’s attitude to deficits is a muddle (but then 95% of the world’s population, economists included, are in a muddle on this one.) For example on p.224-5, Brown opposes big cuts in deficits just at the moment. But on p. 221 he favours fiscal consolidation.

This book is well researched. It is full of facts, figures and references to source documents. Reading it will certainly not be a waste of time for anyone studying the 2007-10 credit crunch in the future.

Ebenezer Scrooge economics.

I am tired of being told by the BBC and other news organisations that full shops at Xmas is “good thing”. It’s not: it means more consumption, more carbon dioxide emissions and so on.

Full shops are allegedly good because that implies more jobs, and with unemployment too high – well, more jobs must be good outcome surely.

There is actually a far better outcome, as follows. Unemployment is defined as wanting a job and not being able to find one. The better outcome and better way of reducing unemployment would be people choosing to work fewer hours and accepting a lower standard of living.

How often do you see statistics on the latter variable on the news?

And now I’m off to indulge in some unnecessary consumption.

Mish criticises Kucinich’s bill.

Mish’s criticisms of Congressman Dennis Kucinich’s “abolish the Fed” bill are a bit harsh in places.

This bill abolishes the Fed and gives Congress the right to create new money. The bill outlaws fractional reserve banking, an aspect of the bill that Mish agrees with. So do I.

Mish says:

“Neither sound money nor the free market comes from printing money into existence. Arguably the only thing worse than the Fed printing money out of thin air is Congress printing money out of thing for the purpose of full employment and/or any other absurd ideas Congress has.

The last thing we need, the very last thing we need is Congress lending money into existence to pay the bills or to do anything it wants for any reason. Those looking for hyperinflation can find the roots of it in that bill.”

Now what does “sound money” actually mean? Like most ultra reasonable sounding phrases, it is near meaningless.

If by “sound money” one means keeping the money supply growth at a level that aims to maximise employment without causing excess inflation, then there is nothing wrong with “printing money into existence”. In fact “printing money into existence” has been going on ever since the Greenback first appeared.

Also, this bill does not give Congress the right to create money to fund any old form of spending proposed by any old politician. It proposes setting up a “Monetary Authority” to control money creation. Now isn’t that the fundamental flaw in the bill? That is, it just replaces the Fed with a “Monetary Authority”.

Mish’s final paragraph reads:

“All things considered, and in spite of horrendous flaws, it may be a plus that someone has actually submitted a bill in Congress to end Fractional Reserve Lending. Now all we to do is throw away the entire rest of the bill and let Ron Paul draft a proper bill ending FRL as the central idea.”

Agreed.

Monetary union requires political union?

I’m tired of that cliché. Hong Kong and various mid American countries use the US dollar or have their currencies pegged to the dollar. Same went for Argentina between 1991 and 2002. To call these countries a political union is obvious nonsense.

As this article in the Financial Times suggests, giving peripheral European countries an easier escape from the Euro might be a better option than forcing them to stay in and endure years of austerity.

Are Canadians are suckers for moral hazard?

As Walter Bagehot pointed out in “Lombard Street” (published in 1873), booms and recessions are a regular cycle. That is, irrational exuberance goes too far, which leads to a crash, followed by a slow recovery. Memories are short, so after a few years of recovery, no one thinks the inevitable new bout of exuberance can possibly be irrational, so the cycle starts again.

To say that memories are short in Canada looks like being an understatement: they haven’t learned the lessons of the recession WE ARE STILL IN! The Bank of Canada seems to be buying junk mortgages like there’s no tomorrow. See Mish.

Is the natural rate of interest really zero?

There is a widely accepted phrase amongst advocates of Monetary Theory (MMT) that the “natural rate of interest is zero”, e.g. see Mitchell here and here. Or for a more concise exposition of the zero interest rate idea, see Mosler. I support MMT, but I’m not enthusiastic about this natural rate idea.

By the way, the word “government” will be used below to refer to “government and central bank combined”.

One possible sense of the phrase “natural rate of interest” is something like “the free market rate” or “the rate that would prevail assuming no attempt by government to influence the rate”. In other words this is the rate that arises just from the relationship between those who want to be net borrowers and those who want to save up, and be net lenders.

The phrase “natural rate” is used differently in MMT: the phrase is used to help explain what happens when government creates and spends money (i.e. does not borrow or tax to fund the spending). The effect is a drop in interest rates. And the rate can, according to MMTers drop to zero. In the words of Mosler (p. 539), “Our main point is, in nations that include the USA, Japan, and others where interest is not paid on central bank reserves, the “penalty” for deficit spending and not issuing securities is not (apart from various self-imposed constraints) “bounced” government checks but a zero percent interbank rate, as in Japan today.”

I beg to differ: it could be that full employment in some countries is attained (because of the additional spending) BEFORE interest rates reach zero! Of course the above zero interest point may well be valid in Japan. But the Japanese are ultra enthusiastic savers: they are willing to lend their government very large sums at zero or near zero rates of interest. Spendthrift Anglo-Saxons and PIG countries are different.

Now that all might seem to be contradicted by events since the recent credit crunch. That is, interest rates have dropped to near zero even in Anglo-Saxon and some other countries, yet those countries certainly do not have full employment: put another way, in these countries, a zero or near zero rate of interest coexists with a feeble rate of exit from the recession.

The answer to this contradiction is that governments have not JUST being net spending: they have engaged in quantitative easing (QE). And QE is a policy which aims specifically at reducing interest rates, with additional consumer spending being very much of a side show. Another aim of QE is to boost asset prices: nice for the rich and asset owners generally, but this again is not the same as directly putting purchasing power into the hands of the average consumer / citizen.

So which is the better policy: QE or extra net spending? Well the basic purpose of the economy is to produce what consumer / citizens want. Thus the better policy is net spending because this puts more purchasing power into consumer / citizens’ pockets.

Of course additional net spending can mean extra government spending AND/OR reduced taxation. And it is arguable that extra government spending does not equal putting additional purchasing power into consumer / citizens’ pockets. On the other hand, additional purchasing power IS put in their pockets in the sense that citizens vote at election time for government to act as citizens’ agent and do some spending on behalf of citizens: e.g. spend money on schools, the police and so on. So let’s just say the phrase “put purchasing power into consumer / citizens’ pockets” is being used in a broad or “dual” sense here.

To put the latter point another way, and summarise, the distinction being made here is between two policies. The first is to increase both traditional consumer spending (e.g. on cars, houses, etc) plus traditional government spending (e.g. schools, the police, etc). The second policy, that is QE, is to drop interest rates and boost asset prices.
At the time of writing, the weaknesses of putting much of the emphasis on QE have been layed bare: we have (at least in the U.S.) record low interest rates and a feeble recovery from the recession.

So my favoured policy in a recession is to have government do more net spending, and let the market determine the interest rate – or at least have “net spend” as the main anti recessionary tool, with interest rate adjustments being a minor and supplementary tool. That was more or less what Abba Lerner advocated, except that he though bureaucrates and politicians were someow good judges of the optimum the interest rate for the purposes of optimising the total amount of investment.

Keynes also advocated the above “extra net government spending” idea, but not in such a blatant or bold manner as Lerner.

Afterthought (18th Dec). To summarise, “the natural rate of interest is zero” is a bit of a non statement, for the following reasons. Given falling unemployment and no deliberate attempt by government to influence interest rates, full employment may be attained at least in some countries before interest rates reach zero. And if demand is then raised still further, inflation ensues. In this scenario the “zero interest rate” scenario is an irrelevance: it should be avoided.

So perhaps the above quote from Warren Mosler should be rephrased and toned down, and the phrases “natural rate” and “zero” should be avoided. The above quote reads “the “penalty” for deficit spending and not issuing securities is not . . . bounced government checks but a zero percent interbank rate…” . Instead, it should simply read, “the penalty of deficit spending and not issuing securities is not bounced government checks but a reduced interest rate”.

Why sack people before there’s an alternative job for them?

The British government is currently reducing the size of the public sector, which involves sacking public sector employees. The hope is that the private sector will take up the slack, employment-wise.

“Hope” is a fatuous economic policy. Here is a better alternative.

There is something ridiculous in sacking public sector employees: those employees become unemployed but STILL GET PAID BY GOVERNMENT! That is, they are paid unemployment benefit. I.e. the net effect is (roughly speaking) that the employees pay is halved, but far from doing half the amount of work, they do NO WORK AT ALL!

Now here is a better alternative. This is to let the employees stay at their jobs, but (approximately) halve their pay and hours of work. Let’s call these people “half time workers”.

Note that this is preferable to any sort of make work employment like the Job Guarantee advocated to Modern Monetary Theory enthusiasts. At least it’s preferable in that make work schemes tend to be inefficient for various reasons, e.g. they normally involve a high ratio of unskilled / temporary employees to “other factors of production” (like capital equipment, permanent skilled workers, etc etc). In contrast, this ratio would be the NORMAL ratio for our half time workers.

Since these people are after full time jobs (or at least jobs involving longer hours), they’d still have an inducement to seek alternative jobs (private sector ones, most likely). Thus aggregate labour supply is not reduced. Meanwhile more work gets done, and we all benefit.

The “aggregate labour supply is not reduced” point is important. The purpose of unemployment (to use the word purpose in a somewhat unusual sense) is to counter inflation by maintaining a decent level of aggregate labour supply. This level of labour supply is (hopefully) maintained under the half time working scheme advocated here.


The private sector.

Now if that all works in the case of PUBLIC sector sackings, would it work for PRIVATE sector sackings: i.e. could we have a system under which NO ONE quits a job till there is an alternative? Well the idea that an economy can guarantee 100% full employment 100% of the time is unrealistic, but would a private sector equivalent to the above public sector “no sacking before there is an alternative job” policy be helpful, and if so why? What would it’s modus operandum be?

Suppose a private sector employer wants to sack some employees. As an alternative, the employer could apply to government for a subsidy to keep the employees on, and working fewer hours, till they find alternative work.

But there is a problem, as follows. Such a subsidy would enable employers to obtain workers at a subsidised rate, which is an inducement to claim the subsidy for less than honest or fraudulent reasons: i.e. claiming the subsidy in respect of economically viable or PRODUCTIVE employees. The inducement for the employees to seek alternative work is still there, but the employer might be induced to pay the employees cash under the counter to induce them to stay longer than they should. On the other hand, there is ALWAYS an inducement to offer employees cash under the counter: it avoids income tax and so on. So whether the “cash under the counter” problem would be much exacerbated here would require some research.

But if this really is a significant problem, there ARE bureaucratic measues that could be taken to minimise the problem. For example, a maximum time that subsidised employees stay with a given employer could be imposed (with no return to the same employer allowed for say a year or so). That bureaucratic measure essentially calls the employer’s bluff. That is, in claiming the subsidy, the employer is saying “employees X, Y and Z” are not very productive and are only employable with the aid of a subsidy”. The above bureaucratic measure involves the state saying in return, “OK, so you won’t mind if your right to employ X, Y and Z after say three months is forbidden, will you?”

Anyway, let’s assume that problem can be solved.

The next possible problem is that the private sector half time work system involves a higher level of aggregate demand (AD) than where the relevant employees are sacked and paid unemployment benefit. That is, instead of government collecting extra tax and paying benefits, money is left out there in consumers’ pockets in the hope that those consumers demand the products made by our half time workers.

Would that additonal AD be inflationary? The answer is possibly not, and for the following reasons.

Assume an economy where the half time worker scheme is NOT operational. I.e. assume something like our current or exisiting economy. Given rising AD, employers expand numbers employed, and unemployment falls. The further this process is taken, the less suitable is each succeeding new employee for the best vacancy they can find. That is simply because the fewer people there are to chose from for a vacancy, the less suited and qualified the best available person will be for the vacancy.

In short, as unemployment falls, the output or revenue derived from each succeeding person hired will fall. And when it falls to the union wage, minimum wage or whatever, that’s it. AD cannot be raised any further. To put in NAIRU terms, “NAIRU” has been reached.

But there is a solution to this problem. (Yes, you guessed right: it’s the half time worker system!) Suppose employers can get their least wanted or least productive employees at a subsidised rate, that would enable a rise in AD without the inflation that would otherwise occur. Put another way, the half time worker system reduces NAIRU, or enables us to break through the NAIRU barrier.

Finally, note that the above system amounts very much to a totally free labour market, in that employers, if they want, can pay employees a wage well below the present legal minimum. The only difference as compared to the present regime is that in the case of these ultra low wages, the state funds some of the wage.

One possible objection to the above idea is that it is highly bureaucratic. That is true. But our economies are being bureaucratised anyway. For example, wages to a significant extent are not set by market forces, but by union agreements, minimum wage laws and so on. The latter phenomena interfere with market forces and thus raise unemployment. There are only two types of solution to this problem. The first is to dispense with the above sort of market interferences, i.e. reduce the powers of trade unions and/or abolish minimum wages laws. The second alternative is to allow the market interferences, and implement yet further bureaucratic systems to counter the employment destroying effects of the interferences. (There is a moral here for those intent on introducing well meaning market interferences: the costs are much higher than you think they are.)

Afterthought (17th Dec). In connection with the half time private sector scheme above, I posed the question above “Would the additional AD be inflationary?”, and concluded that hopefully it would not. There is actually an additional reason for thinking the effect would not be inflationary (at least no more inflationary than in the public sector).

Inflation does not arise just because of excess AD. It arises where AD is excessive RELATIVE to aggregate supply. Or put another way, it is SHORTAGES that cause inflation: primarily shortages of skilled or specific types of labour, capital equipment, materials and so on. We’ll call these “other factors of production” for the sake of brevity.

Now the above half time scheme involves a small increase in jobs for what might be called “almost superfluous employees”. And if these employees are going to work with or alongside the usual concomitant other factors of production, then there will be no difference inflation-wise as between X additional half time workers in the private sector as compared to X additional half time workers in the public sector. That is, in both cases, demand for other factors of production will rise by the same amount. (Actually the public sector makes heavier use of skilled labour than the private sector, thus for X half time workers, the inflationary effect is WORSE in the public sector!)

Thus the points about NAIRU etc under the “private sector” heading above are just as applicable to the public sector.

What did the Fed do with $9 trillion?

Fed Inspector General can’t explain what happened to $9 trillion. The first two thirds or so of this clip deals with a ONE trillion sum. Then they move on to the nine trillion.

(I got this from Brenda Rosser in the comments section here: http://economistsview.typepad.com/economistsview/2010/12/roubini-fiscal-follies.html#comments)

QE does not equal printing money.

QE is often equated with printing money. This is nonsense.

Let’s start with the QEing of government bonds near maturity. These bonds are widely regarded as, and accepted as a very near equivalent of cash in the world’s financial centres. Thus QEing these bonds is about as earth shatteringly irrelevant as swapping $10 bills for $20 bills. Giving someone two $10 bills in exchange for a $20 bill does not constitute “printing money” and nor does QEing short term government bonds.

As to QEing longer term government bonds or private sector bonds, things are a little more complicated. Let’s start by defining the word money and the phrase “print money”.

There are numerous definitions of the word money, but one definition is “a very liquid asset”: that is, an asset which is readily accepted as a means to pay for less liquid assets like cars, houses, and so on.

As to the phrase “print money”, this is normally understood to mean the creation and distribution of MORE money with no corresponding reduction in the amount of assets which are “near money”. To illustrate (and to use the above example of QEing short term government bonds) creating $X out of thin air and using the $X to buy and tear up $X worth of short term government bonds certainly NOT the same as creating $X out of thin air and distributing the $X to the population (e.g. via a tax reducution or a helidrop).

In the latter case (e.g. a tax reduction), private sector assets RISE by $X. In contrast, in the former case (QEing) the value of private sector assets remain constant, or very nearly CONSTANT. That is a BIG DIFFERENCE! And since the “QE equals money printing” brigade cannot see the difference, the conclusion is that they can’t see an awful lot.


Printing versus printing and distributing.

I said above that money printing equals the creation AND distribution of more money. It could be argued that the distribution element is not a necessary part of the definition. For example, if I print a million tonnes of £20 notes and stash them down a disused coal mine and don’t tell anyone what I’ve done, that is still “money printing” isn’t it? Perhaps it is. But the above senseless “stashing” operation will have no effect whatever on demand, inflation or anything else (apart from temporarily increasing the demand for paper and ink).


QEing private sector bonds.

QEing private sector bonds and longer term government bonds is a little different from QEing short term government bonds, which as noted above is little different to swapping $20 bills for $10 bills.

Assuming a fair price is paid for “long term / private” bonds, then no money printing takes place in the sense that the value of private sector assets remains the same. On the other hand, the liquidity of a portion of those assets certainly IS improved: in the extreme case, hard to dispose of bonds are turned into cash, which is a very definite improvement in liquidity.

The EXTENT of money creation here is hard to estimate. It is certainly nonsense to claim that QEing $Y worth of these bonds equals the printing and distribution of $Y worth of new money. But SOME money HAS been created in that extra liquidity has been created. I’ll leave it to others to quantify this!

Martin Wolf is wrong to back low interest rates.

Martin Wolf in the Financial Times attacks the idea that low interest rates are unfair to older people (who tend to be lenders / savers). This article is not up to Wolf’s usual high standards.

His first argument is that older people have benefited from “huge capital gains in their houses”. Completely irrelevant! Not everyone owns a house: some rent. And second, the gain in value of one’s house is no benefit, unless one trades down to more humble accommodation. And third, some peoples’ houses are worth far more than others, plus some people have more than one house!

Martin Wolf’s argument above is a bit like arging that men should pay a higher rate of tax than women because men tend to earn more. The way to a more equitable distribution of post tax income is INCOME TAX. The sex of individual taxpayers is irrelevant.

If there is something wrong with large capital gains on large houses or second homes, then fine: introduce a tax on those gains. Though any such tax (and thus Wolf’s point about house price increases) is rendered somewhat irrelevant by the fact that at least in the U.K., capital gains tax is payable on second homes, plus the value of everyone’s main residence is included in estate valuations for inheritance tax purposes when they die.

Wolf then argues that given excess debt, excessive leverage and weak financial sectors, low interest rates will help profligate and irresponsible lenders and borrowers rectify their mistakes. Well it’s not the job of pensioners (or anyone else) to subsidise or come to the rescue of the irresponsible.

Walter Bagehot advocated, quite rightly, that where a bank is in trouble, the central bank should provide TEMPORARY assistance based on QUALITY collateral and at PUNATIVE rates of interest. If the bank cannot produce quality collateral or pay those punative rates, then it does not just have a temporary liquidity problem: it is bust. Bankrupt. It should be closed down.

Of course politicians HATE taking the latter bull by the horns. It means disruption, which might lose them votes (but benefit the country in the long term). “Kicking the can down the road” is so much more appealing for politicians. And there is another bonus, at least in the U.S.: the irresponsible lenders who are rescued with taxpayers’ money then continue contributing to said politicians’ campaign funds.

Subsidies for the irresponsible are themselves irresponsible.

Martin Wolf then claims that “with higher rates, house prices would fall further, unemployment would rise, more loans would default and banks would fall back into difficulties.”

The idea that higher rates of interest have to lead to higher unemployment is nonsense. Of course it is perfectly true that ALL OTHER THINGS BEING EQUAL higher rates MAY lead to higher unemployment: certainly adjusting interest rates is a popular way of supposedly regulating aggregate demand.

However there are plenty of authorities who have questioned the effects of interest rates on demand and hence on employment levels. For example, the Radcliffe Report in the U.K. in 1960 concluded that interest rates were a poor way of regulating demand.

And Scott Sumner, Prof of economics at Bentley University (U.S.A.) thinks likewise.

But more important than the questionable effects of interest rates in regulating demand is the above “other things being equal” point. The flaw in Martin Wolf’s argument here is as follows.

Suppose we were to adopt what might be called the above purist Walter Bagehot approach and keep interest rates relatively high. And let’s also assume that high interest rates DO curtail demand. The result – no question about it – would be raised unemployment.

However, interest rates are not the only factor determining employment levels! That is, there are well known ways of boosting demand (and employment) other than adjusting interest rates. E.g. an unfunded deficit with the additional or new money channelled into household pockets would raise demand: pretty much what Keynes advocated, as did Milton Friedman.

To summarise, we could perfectly well go for higher interest rates, and compensate for any demand reducing effects by boosting demand by other avenues.

Would a common fiscal policy solve Europe’s problems?

Note dated 14th Jan 2011. This post has been rather superseded by a post dated 14th Jan 2011.

The current conventional wisdom is that it would. I’m not convinced.

Suppose there had been some sort of centralised European fiscal authority between say 2000 and 20008. Would those running it have nipped PIG type problems in the bud? That is, would they have spotted that anything was wrong before the credit crunch arrived and it was blindingly obvious to everyone that something was wrong? Where ARE these geniuses with better forsight than everyone else?

And even if these geniuses exist, there is another and somewhat technical problem, as follows.

A major problem with common currency areas occurs, as is now widely appreciated, where the competitiveness of constituent countries diverge. Where such countries each have their own currency, those who have lost relative competitiveness can devalue. In a common currency area they allegedly cannot do this.

Well actually they could, though doing so is complicated and messy. The way to do it, assuming an X% devaluation is required, is to cut all wages in the country concerned by X%. As is the case where a country with its own currency does an X% devaluation, the X% wage cut does cut living standards, but not by anything near X%. This is because the wage of natives of the country concerned forms a significant part, and usually the vast bulk, of the cost of goods and services consumed in the country concerned.

Now presumably what is meant by “common fiscal policy” is something resembling what is currently taking place in Ireland, but in slow motion. In other words the minimum wage, social security benefits, and a few other items are cut, allegedly well before the problems we now see materialise.

But cutting those two items plus a few more, is nowhere near the same as cutting ALL wages. Presumably the idea is that cutting the above two items will eventually result in wages drifting downwards (at least relative to wages in more competitive countries). But the “drifting down” is bound to take several years. The relevant country will have to endure a long period of deflation and unnecessary unemployment in the meantime.

A better alternative would be to cut employers’ contribution to any payroll tax (National Insurance contribution in the U.K.). That would reduce the cost of employing people, which in turn would reduce the cost of the relevant country’s exports and possibly rectify the balance of payments position.

The political right is barking mad.

As Scott Sumner says, when inflation was 4.1% and unemployment below 5% in 2007 the political right favoured stimulus. Now that inflation is 1.2% and unemployment near 10%, they think stimulus will be inflationary.

They really are totally and completely barking mad.

The multiplier is totally irrelevant.

There are a thousand articles, chapters in books, papers, etc which discuss the relative merits of different forms of economic stimulus, with particular emphasis on the multiplier effects of each. For example there is the tax cut versus increased public spending debate. An recent article by Prof Michael J.Boskin is just one example.

But the multiplier or “bang per buck” argument is also dragged into other areas, for example the relative merits of different employment subsidies.

However the entire argument over mulitpliers is TOTALLY IRRELEVANT because given a relatively low multiplier, the additional dollars needed to create a given number of jobs is not a REAL cost. That is, producing the extra dollars ex nihilo required by a relatively low multiplier form of stimulus does not cost anything in REAL TERMS. All that is required is a book keeping entry.

For example, the multiplier in the case of tax cuts over the next year or two could be unimpressive because a significant proportion of households have had their fingers burned during the credit crunch. As a result they may NOT want to buy houses, or anything else, with BORROWED money. Instead, they may want to buy stuff with SAVED money.

But where does this additional stock of money come from? There is only one source: a government deficit. But that deficit, assuming it accumulates as extra monetary base rather than extra national debt, does not COST anything in real terms to produce. To put it bluntly, printing money does not cost anything.

This point is intuitively obvious to advocates of Modern Monetary Theory. I would be nice if professors of economics, like Boskin, were similarly clued up.