OMG. Krugman still believes in secular stagnation.

I agree with Krugman 95% of the time, so I’m baffled as to why he’s fallen for, and is still paying lip service to Lawrence Summers’s secular stagnation nonsense.

In this recent New York Times article, and starting at the paragraph that begins “You may or may not have heard…”, he argues that we are short of viable investments to make, ergo investment spending is subdued, ergo aggregate demand is subdued, ergo “the result is a persistent slump” as he puts it.

Well the simple answer to that is that investment spending is not the only constituent of aggregate demand. It doesn’t even make up a big percentage of GDP for most countries. The average figure world-wide is roughly 20-25% of GDP.

So… if demand is inadequate due to subdued investment spending, why not  just channel new money into household pockets, then CONSUMPTOIN SPENDING will make up for the lost investment spending? Or if you’re on the political left, you’ll want to see more emphasis on public spending rather than household spending. Indeed, the latter cure for the problem is incorporated in post just below.

As to the instabilities that derive from twits who make daft investments, we can’t stop rich idiots behaving like rich idiots. So some instability from that source may be inevitable. But at least we can ameliorate the instabilities that derive from idiots borrowing from banks to make idiot investments which then fail and bring banks down with them.

The way to do that was set out by Milton Friedman decades ago in his book “A Program for Monetary Stability”. And a system much the same as as Friedman’s is currently being advocated by Lawrence Kotlikoff.

Essentially Friedman, Kotlikoff (and others) advocate having bank loans funded by ENTIRELY by bank shareholders or other types of loss absorbers. That means it’s impossible for banks to suddenly collapse, though the value of their shares will fall if they make silly loans. And that means they dwindle to nothing over a period of time, or they’re taken over.

As Mervyn King put it in his Bagehot to Basel speech, “we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve…”.

But unfortunately as soon as anyone suggests capital requirement improvements for banks, bankers start muttering about economic growth being hit, and politicians and regulators believe every word that comes from bankers. And I don’t blame them. You can tell how honest, sincere and trustworthy bankers are from the fact that they’ve laundered tens of billions for drug cartels, stolen billions from customers in the UK under the PPI fiasco. And then there’s the $20bn that J.P.Morgan have been fined recently. Clearly J.P.Morgan are to be trusted. Oh: I forgot to mention NINJA mortgages and dodgy CDOs.

Yep: you can trust bankers.

The optimum debt and deficit policy.

Here is simple set of rules for optimising the size of the deficit and debt. It’s more or less Modern Monetary Theory compliant, but not 100% compliant.

1. If unemployment is excessive, then expand the deficit (or reduce the surplus).

Incidental point: as Keynes made clear, a deficit can be funded either by borrowing or by simply printing money. Quite what the point of borrowing is, is a bit of a mystery. First, borrowing has a deflationary or anti-stimulatory effect (if it has any effect at all). Now what’s the point of doing something anti-stimulatory when you’re trying to impart stimulus? Darned if I know. Isn't that evidence of schizophrenia?

Second, what’s the point of borrowing money when you can print the stuff? The naughty people who have their own back street printing presses for turning out forged £20 notes don’t borrowing money: when they need money they just crack up their printing presses (so I’m told). Their understanding of economics is clearly superior to that of professional economists and finance ministers.

2. However, if a deficit IS FUNDED via borrowing, and the rate of interest demanded by creditors starts to rise too far, there is an easy solution: tell the creditors to get lost.

That is, as debt matures, instead of rolling it over, just print money and pay off the creditors. That may well be too inflationary, in which case just raise taxes and/or cut public spending so as counter the inflation.

Note that the latter increased tax / reduced public spending would not, repeat not reduce living standards (at least not to the extent that an economy is a closed economy – i.e. to the extent that it doesn’t have dealings with other countries). Reason is that the only purpose of said increased tax / reduced public spending is to cut inflation. Put another way, there is no reason to assume any big effect on REAL GDP.

Of course, to the extent that an economy is OPEN, i.e. to the extent that it borrows from abroad, obviously if foreigners can no longer get a nice rate of interest by buying the debt of a given country, then those creditors will seek yield elsewhere. And that will necessisate a devaluation of the currency of the country concerned, which in turn will lead to a cut in its standard of living.

But that’s just another reason for abstaining from borrowing, isn't it? See No.1 above. That is, when a household borrows from some external source, that temporarily raises the household’s standard of living. Then the household has to do some work, earn some money and pay back the debt: that cuts its standard of living. Same goes for countries.

Borrowing makes sense if you don’t have cash to hand and if you have spotted an investment that covers the cost of the interest. But that’s not what’s involved when a country runs a deficit funded by borrowing.

3. The above advocated “no borrowing” policy implies that interest rates are not deliberately adjusted. Does that matter? The answer is “no”: a recent Fed study showed that interest rate adjustments don’t work: at least it showed there is little relationship between interest rates and investment spending. Moreover, the optimum rate of interest is presumably the free market rate. I.e. artificial adjustments to the rate will presumably lead to a misallocation of resources.
4. The above rules are also Positive Money compliant, as I understand PM's policies.

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P.S. (same day). Rule No.5. If inflation is excessive and it looks like demand pull inflation rather than cost push inflation,  then cut the deficit / increase the surplus.

Governments don’t borrow even when they think they’re borrowing.

Let’s assume a simple economy where money comes in the form of monetary base issued by the government / central bank machine, and in just sufficient quantities to induce citizens to spend at a rate that brings full employment.  No interest is paid to holders of monetary base. We’ll also assume there are no commercial banks: i.e. citizens bank with the central bank.

The “no commercial banks” assumption might sound odd, but in fact when lending to government or paying taxes, final settlement is always done in base money, not commercial bank created money. So that assumption is not unrealistic.

Now let’s assume government wants to make a public sector investment.

Government could attract funds from citizens with a larger than normal stock of money (I’ll call them “hoarders”) and offer them interest. But unfortunately that wouldn’t work. Reason is that the investment spending would increase demand and we’ve already assumed full employment. Thus the extra spending would be inflationary.

So even if government funded the investment with borrowed money, it would still have to raise taxes so as to ameliorate inflation. (A nice illustration of a point often made by MMTers, namely that the purpose of tax is not to fund government, but to control inflation. Actually that MMT point is a bit of an exaggeration, but it’s a nice sort of “exaggeration to make point”.)

Anyway, getting back to the point that government borrowing does not reduce taxation, you could of course argue that hoarders who “lend” to government will then be short of their “rainy day” stock of money and will thus save more so as re-stock with rainy day money. And indeed, if they did save in that way, that would depress demand, which would make room for the extra demand coming from government investment spending.

However, when lending to government, lenders do not really lose access to their savings in that they can sell their government bonds anytime for cash. And assuming any individual hoarder’s need to sell bonds to meet an unexpected need for cash occurs at a random point in time (which it almost certainly does), then the need for that money by one hoarder will be balanced by another hoarder’s desire to buy government debt.

In short, the process whereby governments supposedly borrow to fund public investments is a farce: they can go through the motions of borrowing to fund investments, but the reality is that those investments are funded out of tax.

The only exception to the above argument comes to the extent that government borrowing is funded by foreigners. On the other had if we assume that citizens of country X buy a dollar of debt issued by country Y for every dollar of debt issued by country X and bought by citizens of country Y, then the above argument holds.

But even to the extent that the latter “X and Y” point does not apply, the argument in the above paragraphs, if it is correct, is an almighty dent in the whole idea that government borrowing is a good idea.

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P.S. (same day). In Britain, as in other countries, households with anything near average incomes and average net assets don’t normally buy or sell government bonds directly. But in Britain they can easily do so indirectly via “National Savings and Investments”. NSI has about £100bn of depositors money invested in government stock, and has about 20 million depositors.