My original (?) idea as to why the optimum rate of interest is zero.

I argued in two recent posts on this blog that the optimum rate of interest is zero. See here and here. The first post argued that my idea was the same as the basic idea in a paper by Warren Mosler and Matthew Forstater (published in 2004) and entitled “The Natural Rate of Interest is Zero”.

My basic argument is that the state should issue enough money into the private sector or the economy generally to induce people to spend at a rate that brings full employment, but it should not issue so much that it then has to borrow some of that money back at interest with a view to constraining demand: that results in an artificial increase in the rate of interest. At least zero should be the rate of interest to aim for: that’s not to say, given the constant shocks that hit economies that zero will always be obtained.

However in a recent exchanged of comments with “JKH” on the Worthwhile Canadian Initiative blog, JKH claims that my above argument is not the same as Mosler and Forstater’s. Incidentally I’m not sure exactly who JKH is, but I seem to remember he taught at the Manchester Business School in the UK at one point.

Anyway, if JKH is right, that means my idea might be original. On the other hand Warren Mosler tells me my idea is the same as his. So I’m in a quandry at the moment – untill I have time to go thru Mosler and Forstater’s paper in detail again. And I don’t see myself having time – ever….:-)

Incidentally, the above is not to argue that the rate charged for mortgages etc should be zero: loans between private sector entities will always involve risk, so for that and other reasons, such loans will always be at a rate which is ABOVE zero.

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P.S. (28th Nov. 2016).    Mosler sets out the idea that governments should borrow nothing because to do so distorts interest rates in the second last para of a Huffington article entitled “Proposals for the banking system.”

He says, “I would cease all issuance of Treasury securities. Instead any deficit spending would accumulate as excess reserve balances at the Fed. No public purpose is served by the issuance of Treasury securities with a non convertible currency and floating exchange rate policy. Issuing Treasury securities only serves to support the term structure of interest rates at higher levels than would be the case. And, as longer term rates are the realm of investment, higher term rates only serve to adversely distort the price structure of all goods and services.”

 
I agree that government borrowing artificially raises interest rates, but don’t see that the “term structure” is necessarily distorted. But maybe I’ve missed something.

 

Steve Keen’s strange ideas on debt.

I decided this article left considerable room for improvement, so I’ve scrubbed it and re-written it. Please see here.

Borrowing to BUILD houses is no more productive than borrowing to buy EXISTING ones.

Some monetary reformers claim that borrowing to fund the production of a real asset like a machine or house creates more jobs than borrowing to buy an existing asset, which in the case of housing for example, allegedly tends to promote house price bubbles. Ergo, so the argument goes, preference should be given to the former type of loans.

Richard Werner seems to back this idea – see Twitter exchange below.

OK, let’s consider this taking housing as an example (and housing is not a bad example given the large proportion of all loans which are for the purchase of houses).

If the existing stock of houses is just enough to meet demand, no houses will be built. But if there is a marginal increase in demand, say in the form of X immigrants arriving plus families, and those immigrants borrow to have X houses built, clearly that will create a fair amount of work for bricklayers, plumbers and so on, which is allegedly beneficial because plenty of employment is created.

In contrast, if the immigrants borrow and buy EXISTING houses, then the price of houses will rise, which in turn will mean the value of houses exceeds the cost of producing them (counting house builders’ profit as a “cost”). Builders will then be induced to start building houses. And how many will they need to build in order to get supply and demand for houses back into balance? Well the answer is pretty obviously X houses! The net effect is the same!

Of course the real world is more complicated than the above over simple scenario, but I don’t see why adding those complexities makes any difference the above conclusion.

For example, it has been alleged that in the UK house builders have set up a cartel which artificially boosts the price of houses. See this Spectator article entitled “Radical reform is the only solution….”, in particular para starting “The UK house-building market….”

Now there is always a limit to how far those who arrange a cartel can exploit the situation before one cartel member breaks ranks and grabs the profits available. So let’s suppose house builders exploit that cartel to the extent of raising house prices by Y%, then much the same argument applies. That is, where demand exactly equals supply (and that will be when houses prices are Y% above the genuine free market price) no house building takes place. Then when the immigrants arrive and buy existing houses, prices will rise. That will induce builders to erect enough houses to bring supply and demand back into balance, i.e. X houses. The end result is the same.


House price bubbles.

The above is not to say that asset price bubbles are not a problem. However, asset price bubbles can inflate even where there is no borrowing at all. To illustrate with an extreme example, it would be perfectly feasible to have an economy where everyone bought their houses for cash. In that scenario, there is nothing to stop one person demanding more for their house than might be expected, at which point the rest of the lemmings that make up the human race might decide to mark up the price of their houses as well.

Tulip mania, house price mania etc can take off anytime regardless of the circumstances.

And finally, having criticised Richard Werner, please note that I am very much a Werner fan. He has produced enough decent and original material to deserve a Nobel prize. He originated the term “quantitative easing”. And the following two works by him are master pieces: simple clear and original.

1.  Towards a Twenty-first Century Banking and Monetary System.

2. How do Banks Create Money….

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The twitter exchange: sorry about the poor quality of the images: if you click on them you should get a better view.

Pure fiscal stimulus is flawed, as is pure monetary stimulus. Cooperation between them is best.

By pure fiscal stimulus I mean “government borrows money and spends it, and/or cuts taxes”. But borrowing as such is DEFLATIONARY! Why do something deflationary when the intended effect is the opposite?

By pure monetary stimulus I mean “the state prints money and buys back government bonds so as to cut interest rates or do QE”. But that’s flawed as well. First it assumes that a recession is caused by inadequate lending, borrowing and investment spending when in fact the cause may well be a lack of some other form of spending.

Second, deliberately interfering with the rate of interest means setting interest rates at something other than their free market level, which on the face of it reduces GDP. So in what scenario is there no government interference in interest rates?

Well government borrowing will artificially raise interest rates if such borrowing is not justified. So what forms of government borrowing are justified?

First, as is generally agreed, government should not borrow so as to fund CURRENT spending. As to CAPITAL spending, the arguments for borrowing there are much weaker than is commonly supposed: Milton Friedman and Warren Mosler oppose/d all forms of government borrowing. But if the justification for government borrowing is that it funds capital spending, the state cannot then print money and buy back government bonds with a view to cutting interest rates because that amounts to an “after the event” funding of capital spending via printed money. That’s a self contradiction!

Another nonsense in having the two options “fiscal” and “monetary” is this.  Why have two different organisations charged with the same task, namely adjusting demand? That makes as much sense as a car with two steering wheels each controlled by a different person.

A possible objection to the above argument is that given excess unemployment, the state has to “interfere” in SOME WAY to rectify the situation. Well the answer to that is that having the state print extra money and spend it and/or cut taxes comes to much the same thing as the free market’s cure for excess unemployment. That is, given excess unemployment in a perfectly functioning free market, wages and prices would fall, which would raise the real value of money (base money in particular). And that would induce “money holders” (which is a very large cross section of the population and economy, public and private sectors) to spend more. That effect is known as the “Pigou effect”.

However, the Pigou effect doesn’t work too well in the real world because of the “wages are sticky downwards” effect. But boosting the real value of the total stock of money by having the state print and distribute it in some way comes to the same thing. Ergo, in a sense, the latter policy is not an artificial interference in the economy.

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P.S. (A few hours after putting the above online). Another problem with monetary stimulus is that the stimulus, at least initially, is concentrated in the "borrowing and lending" sector of the economy: i.e. the capital goods sector. All else equal, it is better to spread stimulus as widely as possible. Reason is that while the unemployed are not the most skilled section of the workforce, there is nevertheless a wide variety of skills there, thus ideally the unemployed need as wide a variety of jobs to choose from as possible.

“Debt free” money won’t solve environmental problems.

This Guardian article by Jason Hickel published yesterday starts with the claim that replacing the GDP yard stick will cut our desire for consumer goodies, and hence cut our consumption of natural resources. (Article title: "To deal with climate change...")

Whaaat? So people don’t want cars for convenient transport: they want them because car production increases GDP? Truly hilarious. And people don’t heat their homes to keep warm: they heat them because burning fossil fuels also increases GDP? If you aren’t laughing your socks off, you should be.


Debt makes economic growth necessary?

Next, the article claims that the fundamental reason why economic growth is needed is so that people can pay off their debts. As the article puts it, “Debt is the reason the economy has to grow in the first place.”

So people don’t go tens of thousands of pounds into debt so as to acquire nice, warm, well decorated houses? Rather, debt appears from nowhere, and people then sweat their guts out building and acquiring houses so as to pay off the debt. This is Alice in Wonderland stuff.


Disposing of debt based money cuts debts?

The article then trotts out the old canard that replacing so called “debt based” money with central bank (CB) issued money will cut debts (and hence cut our consumption because as explained above, we allegedly go out to work to cut debts rather than to acquire consumer goodies).

Before explaining the flaw in that argument, I’ll say something about debt based and non debt based money.

There are two basic forms of money. First there is CB issued money which consists of notes and coins plus credit balances that commercial banks have at the CB. An important characteristic of that money is that it is a NET ASSET as viewed by holders of that money, i.e. the private sector.

Second, there is money issued or created by commercial / private banks. That money is not a net asset as viewed by the private sector: reason is that for every dollar or pound of that money, there is a corresponding dollar or pound of debt owed by someone to a commercial bank. As the saying goes, privately issued money “nets to nothing”.

Thus the first form of money is arguably “debt free”. Some economists have challenged the idea that CB money is debt free, and on the grounds that such money could be said to be a debt owed by the state to the private sector. Basically I don’t agree and for reasons set out here. I.e. the claim that CB money or “base money” as it is sometimes called is debt free pretty much holds water.
 
Now money thru the centuries has taken a huge variety of different forms: almost everything has at some time or other been used as money: various metals, paper, wood, cowrie shells, cattle, you name it. And indeed, debt can be used as money.

Plus it is perfectly possible to have a system under which the use of debt as a form of money is banned. Indeed, at least four Nobel laureate economists (including Milton Friedman) have advocated that. I back the idea myself.

Unfortunately banning the use of debt as a form of money does not get rid of debts, any more than tons of gold disappeared into thin air when gold was no longer used as money in Britain and elsewhere.

Put another way, if we have a system under which only CB issued money is acceptable, there will still be people with cash to spare and others willing to borrow. And it makes sense for the former to lend to the latter. Indeed, all else equal (i.e. assuming the distribution of wealth, income inequalities and so on remain the same), the total amount of borrowing, lending and debt will remain much the same if we switch to a “central bank money” only system.

Actually there’d be a FINITE, but not large reduction in the total amount of lending, borrowing and debt under a central bank money only system. Reason is that under that system, private banks cannot just print the money the lend out: i.e. under that system, it costs more for private banks to acquire money to lend out, thus interest rates would rise a bit, thus the total amount borrowed and loaned would fall a bit.

As for any deflationary effect of that, that’s easily dealt with by having the state print and spend more money into the economy. The net result is that everyone has more money, but if you DO WANT to borrow, it’ll cost you a bit more. Certainly the UK’s “Independent Commission on Banking” considered the CB money only system, and came to the same conclusion, namely that the cost of borrowing would rise. But in the UK in the 1980s, mortgagors paid almost THREE TIMES the rate of interest that they pay nowadays, but for some strange reason the sky didn’t fall in. Thus I doubt a modest rise in interest rates would be a disaster.

Bank of England worries about the “sustainability” of national debt.

If you want to progress your career, it’s very important to use fashionable phraseology, and the word “sustainable” is very much in vogue at the moment. So congratulations to the BoE authors for that. To be more exact, they are concerned with what they call “sustainability in the long run”.

This short BoE article is concerned with the rise or fall in real (i.e. inflation adjusted) interest payments on the national debt relative to GDP. As the article rightly points out, a rise in interest payments relatively to GDP is not “sustainable”.

Well my answer to that is: “OK, but so what?” I mean an accelerating car is not a sustainable system: it cannot go on accelerating for ever! But that doesn’t prove there is anything wrong with a car accelerating for a while.

Thus the entire “sustainable” concept, fashionable as it may be, is twaddle. The important question (one that MMTers have answered) is: what’s the OPTIMUM size of the debt? Unfortunately as I’ve pointed out several times on this blog, the concept “optimum” is too difficult for most people and for most economists.

So let’s stick with fashionable twaddle like “sustainable” shall we?

Does it matter that QE increases inequality?

There were several mistakes in this article, so I’ve deleted it and re-written it.