I drop a clanger in the FT.

Must try to think before I speak.

I argued in this letter in the Financial Times that an interest rate cut pulls investment forward in time (a point also made by Mervyn King) and that that effect works for perhaps two years. Thus Mark Carney’s announcement that interest rates will stay low is of little relevance since the “pull forward” effect is probably no longer operative in the UK right now.

Unfortunately I forgot something else: the “hot potato” effect, which is a PERMANENT effect. That is, to cut interest rates, a central bank prints money and buys up government debt. That increases the amount of cash in private sector hands and increases the value of government bonds. The owners of said cash and bonds then have a surplus of cash and a surplus of net financial assets (or they are NEARER having such a surplus than they previously were). Thus they will tend to try to spend away that surplus, which causes a rise in demand.

But that’s not to say that monetary stimulus is better than fiscal. One big drawback of monetary stimulus is that the potato effect channels stimulus into the economy via the rich. Apart from social considerations, there is no logic in channelling stimulus into the economy exclusively via the rich any more than there is via people with blue eyes or long legs.

I am indebted to Scott Sumner who is keen on hot potatoes and who lets me think aloud and put my foot in it on his site. That has sharpened up my ideas on potatos, however I don’t think MMTers have ever been totally unaware of the potato effect, because MMTers are always on about what they call “private sector net financial assets”. And I don’t see any possible reason why increasing PSNFA could be stimulatory other than via the potato effect.

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P.S. (28th Sept): Desperate attempt to save face....  I wish to point out that Mervyn King made the same mistake as I did, I think: i.e. he omitted the potato effect. 

European governments repeat the mistakes of the Treaty of Versailles.

That’s the title of a letter in this morning’s Financial Times by twenty delusional economics professors who think they have the solution Eurozone problems.

They give us a tearjerking description of austerity in the periphery. And that’s a good gambit because 95% of the population think that when their emotions are aroused, what they are reading must be of significance.

The professors then end up by telling us that the solution is “a plan to revitalise public and private investment . . . and increase employment in the peripheral countries of the union..”.

Well that sounds great doesn’t it? Who could possibly be against a “plan to increase employment”?  Unfortunately it’s just happy talk: no doubt the average left of centre dummy will be enthralled by the phrase “revitalising public and private investment”. But the professors don’t actually explain on their site how that would work. Attention to detail and reality has never been the left’s strong point.

An introductory lesson on devaluation.

The professors also show an abysmal failure to understand how internal devaluation works in a common currency area. So and introductory lesson on the subject for professors who haven’t the faintest grasp of the subject is required. Here goes.

The professors say that “Expecting the peripheral countries of Union to solve the problem unaided means requiring them to undergo a drop in wages and prices on such a scale as to cause a still more accentuated collapse of incomes and violent debt deflation…”

Wrong.

Devaluation (whether its internal devaluation of a country in a common currency area or the devaluation of the currency of a country that issues its own currency) does not require a big drop in REAL WAGES. To illustrate, the Pound Sterling was devalued by about 25% in 2008, and the majority of the UK population didn’t know it had happened: the effect on real wages was minimal.

Likewise if wages and prices in a periphery country drop by say 25%, the effect on REAL WAGES is small because local wages are themselves a large constituent of the cost of most goods and services sold in the relevant country.

These professors have past form.

Three of the professors have a record of talking nonsense. They are Dani Rodrick, Jan Kregel and Dimitri Papadimitriou.

Conclusion.

The Eurozone’s problems are simply problems that are INHERENT to a common currency area, and there are no easy solutions. Solution No.1 is the current austerity/slow internal devaluation solution. Solution No.2 is to leave the Euro.

If I was economic dictator of the EZ I could impose a very quick and relatively painless solution. That is to organise an overnight internal devaluation for the periphery: i.e. FORCE THRU a 25% or so cut in wage and prices in the periphery. That would be administratively difficult and expensive to do, but the costs would be less than the existing costs of austerity in the periphery.

If the US abandoned interest rate adjustments, it would be less indebted to China.

I listed NINE reasons here why adjusting demand via fiscal policy is better than doing it via monetary policy.

But there is one point I missed. And that is that if government issues debt on which it pays interest – and in particular if it raises interest rates when inflation looms  - that just encourages foreigners to buy up some of the debt. And getting indebted to foreigners is not a brilliant idea, unless there is a particularly good reason for doing so. And in this case, there just aren’t any “particularly good reasons”.

Moreover, raising interest rates boosts the value of the relevant country’s currency relative to other currencies, and that is a totally uncalled for, or irrelevant side effect: it just messes up exporters and importers, and for no good reason.

Of course cutting demand via fiscal adjustments ALSO boosts  the currency because fewer imports are drawn in. But there is no good reason for the ADDITIONAL currency boosting effect that comes if demand is adjusted via interest rate changes.

Another point is that if a country issues no interest paying debt and issues just currency (as advocated by Milton Friedman and Warren Mosler) foreigners will doubt less still stock up with a supply of the currency (particularly in the case of the World’s premier currency: the US Dollar). That phenomenon is unavoidable. But there is no need to exacerbate that phenomenon by paying interest to foreigners who hold one’s currency.

Mervyn King’s strange “paradox of policy” ideas.

I respect Mervyn King, the recently departed governor of the Bank of England. I’ve quoted him with approval more than once.

Unfortunately in this speech, he goes off the rails.

The national debt.

In one passage in reference to the UK national debt, he says, “In the long run, we will need to…. repay our debts…”.  Complete nonsense!!

National debt is just a form of private sector net financial asset, as every advocate of Modern Monetary Theory knows. And the size of PSNFA needs to be whatever induces the private sector to spend at a rate that brings full employment.

Keynes expressed exactly the same idea when he said, “Look after unemployment and the budget looks after itself”.  In other words aiming for any particular speed of debt reduction is daft. If the private sector has a fit of irrational exuberance, a surplus may be in order: it may necessary to confiscated some PSNFA (i.e. raise taxes) so as to calm things down, and the debt will come down. Conversely if the private sector goes into subdued or savings mode, the deficit will need to continue.

King has fallen for the argument put by many so called economists, namely that the debt is higher now than it used to be, ergo it should be brought down. Which is as ridiculous as saying that the temperature in your house is currently five degrees higher than it was an hour ago, therefor it ought to come down.

The CRUCIAL question in relation to the debt and the temperature in your house is: what’s the OPTIMUM size of the debt or temperature. And that’s about the five hundredth time I’ve seen a member of the so called intelligentsia having a problem with the concept “optimum”.

MMTers have SPECIFIC IDEAS as to what the optimum size of the debt ought to be. Other economists seem to have no such ideas. They don’t even asking the question: “what’s the optimum?” 

The balance of payments.

Next, King claims “In the long run, we will need to rebalance our economy away from domestic spending and towards exports, to reduce our trade deficit…  So you are probably puzzled by the fact that we seem to be doing exactly the opposite of that today.”

Whaaaaat?

So the UK is running an external deficit which we can leave in place for now, but which we’ll have to deal with in the long run?

The reality is that the Bank of England nowadays does not make a big effort to intervene to support the pound on foreign exchange markets. So if the UK has an external deficit (ignoring capital flows), market forces will immediately start rectifying that imbalance by devaluing the pound. So the idea that we are running an external deficit as long as the recession lasts is nonsense.

Moreover, even if a country’s central bank DID CONSIDER supporting its currency during a recession, that would be a questionable policy. That policy would of course temporarily support living standards, but the price would be a more violent adjustment for exporters and importers in the long run.

And finally, far from countries’ balance of payments tending to be in poor shape during a recession, the opposite is actually the case. That is, when demand in a country declines, that cuts imports which IMPROVES the balance of payments.

Combining monetary and fiscal policy.

Next, King tries to attack the idea that monetary and fiscal policy should be combined. (Helicopter drops in the form of central bank creating new money with government distributing that money in the form of extra public spending or tax cuts is an example of that “combination”).

His argument against the combination is that either government has the power to create new money in which case we’re just asking for inflationary booms before elections. Or else, the central bank creates new money and takes fiscal decisions (e.g. decisions as to how to allocate money to health, education, and so on).

As he puts it, “Not only is combining monetary and fiscal policies unnecessary, it is also dangerous. Either the government controls the process – which is “bad” money creation – or the Bank controls it and enters the forbidden territory of fiscal policy.”

The reality, as pointed out by Positive Money and others, is that we could perfectly well have some sort of independent committee of economists (much like the existing Bank of England Monetary Policy Committee) which would periodically decide HOW MUCH money to create depending on what inflation looked like doing. While the decision as to how to actually allocate that money was entirely in the hands of democratically elected politicians.

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P.S. (same day). King is also confused as to how monetary policy would operate if there was no government debt. The relevant passage reads, “For the same reason, the Bank could not countenance any suggestion that we cancel our holdings of gilts. The Bank must have the ability to reverse its policy – to sell gilts and withdraw money from the economy – when that becomes necessary. Otherwise, we run the risk of losing control over monetary conditions.”
The truth of course is that even if there was no government debt, there’d be nothing to stop central bank simply announcing it was willing to borrow at above the going rate of interest.
As to the money needed to pay the interest on that borrowed money, a central bank could simply print the money. But a better option would be for the central bank to agree with the treasury that it would be better if the money came out of taxation.