Friday, 28 May 2010

Beware of smart new HQ buildings.

There is a nice contrast between the ECB’s new 750 million headquarters and their inability to explain clearly to anyone how the Euro monetary system works. (Or perhaps it just doesn’t work?)

There are clearly large numbers of people with a keen interest in exactly how the system works who are having difficulties unearthing relevant details.


1. Worthwhile Canadian Initiative.

2. Winterspeak. See final para of 26th May post "More on yield curve..."

3. Me.

One of Britain’s most senior bankruptcy practitioners once said that the surest sign of the collapse of an organisation was a smart new headquarters building.

In contrast there was Arnold Weinstock who built GEC into a business worth £35bn. Arnold Weinstock never allowed new carpets at GEC HQ till the old ones were badly worn, and personally went round turning off lights.

His successors squandered the £35bn in the space of a year.

Thursday, 27 May 2010

Krugman on the recession.

Yesterday I quoted Winston Churchill on the 1929 crash (see below). Today a much more succinct quote from Krugman on the present recession.

“shibboleths and conventional wisdom are blocking all routes out of this slump”.

That says it all. (I got that quote from Billyblog.)

Wednesday, 26 May 2010

Winston Churchill on the 1929 crash.

“Extraordinary optimism sustained an orgy of speculation. Books were written to prove that economic crisis was a phase which expanding business organisation and science had at last mastered. ‘We are apparently finished and done with economic cycles as we have known them,’ said the President of the New York Stock Exchange. A group of leading banks constituted a million-dollar pool to maintain and stabilise the market. All in vain. The whole wealth so swiftly gathered in the paper values of previous years vanished.

The prosperity of millions of homes had grown upon a gigantic structure of inflated credit now suddenly proved phantom.”

Plus ca change....

Thanks to Peter Mullen for that.

Tuesday, 25 May 2010

Negative feedback.

On the subject of deficits and national debts, the leading article in The Times, 25th May, trots out a piece of nonsense that has appeared regularly over the decades.

This is the idea that when government borrows and spends so as to stimulate an economy, there may be little effect because households realise that government borrowing is just tax deferred; hence households will not take part in the “stimulation”. That is, they will save so as to meet the future tax liability, hence neutering the stimulation.

This has always struck me as an example of the totally unrealistic nonsense that some academics erect so as to keep themselves employed. Is it really plausible that the average household keeps a careful eye on government borrowing and tailors household spending with a view to likely tax payments in two or three year’s time?

Where is the evidence?

Of course the CURRENT crisis could be a bit different given the recent unprecedented levels of borrowing and money creation. But as regards the last fifty years, where is the evidence?

Moreover, it is equally plausible that households have a better grasp of functional finance than economists who have been fed a fair amount of nonsense from economics text books.

That is, it is possible that households have grasped the point that government will try to keep employment at the maximum that is compatible with acceptable inflation – and stuff the deficit, the national debt, interest rates, etc. If the latter happen to rise, so be it. And if they happen to fall, so be it. Thus high government borrowing now is NOT, REPEAT NOT, a reason in itself to assume austerity to two or three years time.

Sunday, 23 May 2010

The Main Street Theory.

1. Banks lend irresponsibly. 2. A credit crunch ensues. 3. Governments pour money into banks to encourage them to . . . . yes, you guessed: lend yet more. 4. Having laughed or cried (take your pick), now for the serious analysis.

Banks are profit motivated. That is, before the crunch they engaged in lending which they thought would maximise profits. Plus, as in any business, the best or most profitable opportunities are exploited first.

Put another way, there are diminishing returns here: the more lending a bank does, the more risky is each succeeding loan.

Before the crunch, aggregate demand was not excessive. Demand for houses was too high. But aggregate demand was not: inflation was not excessive.

Now if the marginal loan is too risky, but aggregate demand is not excessive, doesn’t this tell us that too much bank lending is taking place relative to self financed business ventures or operations?

The above theory supports the “stimulate Main Street not Wall Street” theory. Or put another way, will politicians please repeat the phrase “payroll tax cut” till they are blue in the face?

P.S. Here is some evidence that the total of bank loans and debt is now excessive.

Saturday, 22 May 2010

Governments and central banks in a functional finance or MMT regime.

Most countries that issue their own currencies split economic and financial responsibilities between two organisations. First there is government, i.e. elected politicians. Second there are central banks.

Politicians have a tendency to act irresponsibility with the money printing press. So a central bank which can raise interest rates when inflation looms is good idea. This is an example of “checks and balances”.

But what set of rules would be appropriate in a functional finance scenario? I suggest the following (which are not vastly different to the current rules).

Rule No 1. Politicians must work on the assumption that they can spend slightly more than they collect each year in tax.

Rule No 2. The central bank shall be responsible for holding employment as high as is consistent with acceptable inflation. If unemployment is too high and there is room for reflation, the central banks shall inform government of what extra sums it (the central bank) will allow government to spend without any corresponding tax collection or borrowing. Conversely, if inflation is too high, the central bank may have to inform government that the latter rein in spending or collect more in tax. The central bank may even have to inform government that it must collect more in tax than it spends. This surplus money collected must be remitted to the central bank where it is effectively extinguished.

Rule No 3. However in most years there will be a small deficit, that is it will be appropriate for government to spend slightly more than it collects in tax. This is for reasons explained here – in particular see the calculations at the end.

Thursday, 20 May 2010

I have doubts about ELR and the Job Guarantee.

Given high unemployment it is easy for employers to find the skills they want. Therefore assuming high but falling unemployment, the productivity of each new person hired is OK: it covers the minimum, union wage, etc.

As unemployment falls further, it becomes progressively more difficult to find the right skills. Thus the productivity of each succeeding person hired falls. Or to put it in economics jargon the marginal net revenue product of labour falls. When it falls to the minimum wage, union wage or thereabouts, a further rise in aggregate employment is not possible.

In this scenario the advocates of having government as employer of last resort (ELR) or “job guarantee” (JG) to use an alternative expression, want to set up special employment schemes (like the WPA in the U.S. in the 1930s). Why?

While some WPA schemes were efficient, these schemes tend to involve a high ratio of temporary unskilled labour to other factors of production (like skilled labour, capital equipment, etc). Indeed the WPA in the 1930s acquired a knickname: “we piddle around”.

Indeed, the only scenario in which WPA type schemes can be efficient is where they involve normal or near normal ratios of different factors of production. But in this case, these schemes amount to virtually the same thing as a normal employer. So what’s the point of them?

The justification for ELR/JG/WPA schemes is particularly questionable given that there are higher productivity potential jobs out there staring us in the face: jobs which involve better ratios of different factors of production. These are the sub minimum wage or sub union wage jobs which don’t come into being because of minimum wages and union wages.

Solution: implement a subsidy that brings the latter jobs into being. Obviously take home pay of those concerned needs to be up to the minimum socially acceptable level. But the right subsidy would make the cost to the employer BELOW this level. Thus the jobs would come into being.

I suggest less emphasis on creating temporary subsidised WPA type jobs and more emphasis on creating temporary subsidised jobs with existing employers.

Wednesday, 19 May 2010

Fifteen love to the Bank of England.

“Inflation” surges in the U.K. This so called inflation consists of the price rises caused by the decline in the pound and by the recent Value Added Tax increase and by fuel price increases.

That’s not inflation. Inflation consists of CONTINUOUSLY rising prices. The crucial question is whether these price rises feed through to increased wage demands. If they do, you have a wage-price spiral, and that IS inflation. The Bank of England seems to have got this point - at least I saw a report saying they were keeing a careful eye on wage settlements. Quite right. In contrast numerous economics commentators have not got the above distinction between possibly non inflationary price rises and genuine inflation.

Fifteen love to the Bank of England on that one.

Tuesday, 18 May 2010

Monetary base belongs to the people.

Numerous plans have been proposed and implemented to rescue banks. Half of these plans involve governments / central banks creating money (i.e. monetary base) out of thin air and feeding this money to banks. Ostensibly such money is not given to banks, but the terms are often favourable compared those available to households or even to large profitable and solvent corporations. Thus in effect, a proportion of this money is a gift.

By what right? Why do a particular set of institutions have preferential right to this money? These are moreover institutions a proportion of which are clearly incompetent. The basic rule of free markets is to reward the competent and close down incompetent organisations. Of course the basic money transfer system cannot be allowed to collapse. This system is as important as any other utility: water or electricity supply, for example. But the other main activity carried out by banks, that is money lending, well, anyone can do that. Ordinary people, the self employed, etc are constantly forming and dissolving partnerships (formal and informal) and lending each other money. I recently lent a five figure sum to someone to do a building project. Looks like they’ll make a six figure profit and repay the capital and interest no problem. To that extent, I’m a better banker than the European banks who lent billions to no-hopers like Greece.

If a portion of the people chose to keep their share of a monetary base expansion under their matresses and ignore banks altogether, so be it. Banks should be entitled to allocate capital only to the extent that they are better at it than ordinary people or other organisations.

Let’s have two types of bank.

Banks should be split into two types (or at least people should have the choice of two types of bank account).

Type 1. These would be accounts which pay no interest and which contain money which banks are not allowed to lend to anyone else. These accounts would be state guaranteed. The availability of a totally secure bank account is a fundamental human right. The rate of interest on such accounts would effectively be negative, in that they would involve administration costs and it is fair enough to charge customers with the costs of any service provided. This is not a novelty: there are plenty of bank accounts that currently pay little or no interest but involve a monthly administration charge.

Type 2. Accounts which do pay interest and where the relevant money can be lent by the bank, but which are not state backed or guaranteed.

It is not the job of government (i.e. the taxpayer) to subsidise any commercial activity, e.g. money lending.

Objections to the above.

1. The reduced proportion of bank deposits being lent would be deflationary or hinder economic growth.

Answer: Fiat money (whether in the form of book keeping entries, cheques, credit cards or dollar bills) is not a real asset from the point of view of society as a whole. That is, fiat money is just a debt or claim by one person or entity on another person or entity.

In other words the initial effect of the above proposal might well be deflationary, but this is easily countered by expanding the monetary base.

2. Why is the above better than a Glass Steagall type split?

Answer. Glass Steagall distinguished between so called commercial and investment banking activities. The former involves loans to households, businesses, etc, whereas the latter involves a bank buying securities on its own behalf. However both activities are commercial in nature. The distinction is too fuzzy.

3. There is no need to split bank accounts into the above two types if banks are better regulated.

Answer: true in theory. The problem is the never ending, well financed, and often successful attempts by banks to water down bank regulations. In contrast, a split into two types of account, “totally non-commercial” and “commercial” might be cleaner and simpler to legislate for and administer.

4. The removal of state protection from accounts type 2 would raise the real cost of borrowing which would hinder economic growth.

Answer: borrowing costs would certainly rise. But they would rise to a level that reflected the real cost rather than a subsidised cost. Economic growth is not assisted by subsidising anything unless there is a clear case for a subsidy, e.g. obvious market failure. Put another way, far from maximising GDP, price distortions reduce GDP, unless there is a clear case for such distortions.

For a much more comprehensive list of suggestions for bank reform, see an article by Warren Mosler in the Huffington Post.

To comment or see comments, click on the word “comment” just below (in red).

Sunday, 16 May 2010

Deutsche Bank loses money in Greece?

Josef Ackermann, CEO of Germany’s Deutsche Bank says Greece may not be able to repay its debts. O.K. Herr Ackerman: if you had anything to do mit loans to Greece, warum sind sie still in your job? Sind your political connections besser als those of Goldman Sachs?

Friday, 14 May 2010

Functional finance.

I think advocates of Modern Monetary Theory (aka Functional Finance) need to get more articles into newspapers etc putting their case. I’ve penned a draft article below – 1,100 words. Comments welcome. Feel free to plagiarize and present it as your own (though I prefer credit where credit is due).


Economists and economic commentators are currently split into two camps. First there is what might be called the conservative or traditionalist camp: those who believe government deficits are undesirable if not an abhorrence. Secondly there are those who believe that without deficits, long periods of excessive unemployment will ensue.

Functional finance is a set of ideas that belong to the “pro deficit” camp. But more than that, functional finance advocates a very different view of deficits, national debts and the money supply from that set out in the economics text books. An alternative name for functional finance is “Modern Monetary Theory”.

If there is one basic point underlying functional finance, it is the inescapable reality that money for a government which issues its own currency is a very different from money as viewed by households or firms. A government that issues its own currency can print and spend money at will. Likewise, it can do the opposite, that is, raise taxes and extinguish the money collected.

For a firm or household, money inflows and outflows are a measure of earnings and expenditure and households and firms need to ensure that earnings are equal to or exceed spending, else they go bust, or become poorer. In contrast, for a government, there is no merit whatsoever in balancing the books. The sole objective of income and spending by a government should be “functional”: that is, to bring about the maximum level of employment that is consistent with acceptable inflation.

For reasons given below, normally government spending will exceed income, though occasionally the reverse will obtain.

Moreover, when it looks like spending should exceed income, there is not much point in borrowing to cover the difference: that is, governments (at least those that issue their own currencies) should simply print extra money to cover the difference. Borrowing is particularly nonsensical given that when a government borrows, it borrows “stuff” (i.e. money) which it can produce an infinite supply of at no cost. A government borrowing money is a bit like a dairy farmer buying milk at the supermarket when there is a thousand gallon tank of milk a few yards from his house.

A second nonsensical aspect of government borrowing is that when government borrows and spends, the object of the exercise is often to bring economic stimulus or “reflation”. But borrowing as such has the opposite effect: it’s deflationary. So why not just spend and forget all about the borrowing? “Borrow and spend” is a bit like throwing dirt over your car before cleaning it!

Various economists over the decades have advocated functional finance, and one of the more significant was Abba Lerner, who was much admired by Keynes. As Keynes said, “Lerner's argument is impeccable, but heaven help anyone who tries to put it across to the plain man at this stage of the evolution of our ideas." Keynes was right: functional finance can be a shock for those tutored in conventional economics.

There are three reasons why a deficit will be the norm, that is reasons why government spending will normally exceed government’s income from tax. These three reasons stem from the fact that it is generally accepted nowadays that the optimum rate of inflation is around 2% p.a.

So let’s assume 2% inflation and assume the money supply needs to remain constant in real terms. This means the Fed will have to print an additional amount of money each year equal to 2% of the money supply (or monetary base, to be more exact).

Second, assuming the economy expands in real terms by a small amount each year, (let’s say 1.5% just for illustration), then the monetary base will have to be expanded by another 1.5% p.a. That is a total of 3.5% a year, assuming the above percentages. Now that is several billion worth of deficit! But I haven’t finished.

The third point relates to the national debt. As intimated above, I think that national debts are near pointless and should be drastically reduced, but I won’t go into that. Instead, let’s just assume the national debt is to remain constant as a proportion of GDP (say 50% for the sake of argument). Much the same point applies here as applied above to the monetary base. That is, to keep the latter proportion constant, the Fed is just going to have print even more money (and borrow it back, thus creating “debt”) just to keep the national debt constant as a proportion of GDP.

Indeed, taking the above illustrative figures (2%, 1.5% and 50%), the annual unfunded deficit or amount of additional monetary base that needs to be printed each year would be about $300bn (calculations below).

There is a fourth and less common reason for deficits, which has to do with deleveraging by the private sector. Deleveraging consists of trying to pay off debts and/or accumulate a larger stock of cash. And this is exactly what the private sector has been trying to do over the last two years or so.

When one person or firm switches from spending money to trying to hoard it, that means less demand for goods and services. And that in turn means unemployment for those who would have produces these goods and services.

There is only one solution to this problem: print yet more money so as to fulfil the saving desire of the private sector. Conversely, if the private sector is trying to dissave money (the opposite of deleveraging) then to that extent the deficit will need to be reduced. Indeed, on occasions, this reduction may be so extreme as to cancel out the above mentioned first three factors which tend to bring the deficit into being. I.e. on occasion, a surplus is called for. But to repeat, given inflation of around 2%, a deficit will be the norm.

Having given four reasons that justify money printing or deficits, conservatives and those with concerns about inflation will now be seething. I admit their concerns have some justification.

Given an omniscient and omnipotent government (or even moderately intelligent government), such a government ought to be able to expand the money supply during a recession by enough to bring a quick end to the recession. And if and when this money supply looks like causing excess inflation, such a government ought to be able to rein in the additional money or take other deflationary measures so as to prevent excess inflation.

However the big problem, as Milton Friedman pointed out, is that governments are so incompetent and chaotic that the above “moderately intelligent” behaviour is unlikely. Indeed, Friedman’s conclusion was that governments are so incompetent, that it would be better if they didn’t even try to deal with recessions or inflationary booms.

Perhaps Freidman’s pessimism was justified. But I cannot just sit back while millions of lives are ruined by unemployment. I feel we’ve just got to try. We may fall off the bike twenty times before learning to ride it, but I think we’ll eventually learn.

And finally, having argued for deliberate money supply changes designed to deal with recessions and inflationary booms, I am not suggesting that economic conservatives are totally wrong to claim that economies self correct in the long run. It’s just that this self correction is too slow. Or as Keynes put it, “In the long run we are all dead”. Also, conservatives are correct to point out that the recent boom was based on artificially high house prices, which in turn distorts the entire economy, and this distortion cannot be removed instantaneously.



GDP taken as $14,000bn. Source:
Mononetary base as £2,000bn. Source:
Annual unfunded deficit under normal circumstances (i.e. absence recessions or inflationary booms) will be:
((2 + 1.5)/100) x ($14,000bn/2 + $2,000bn) = $315bn.

Monday, 3 May 2010

The Governor of the Bank of England should study economics.

The Governor recently made the absurd claim that paying off the national debt will result in such severe austerity that the party that wins the election on 6th May 2010 will be out of power for a generation. To explain the flaws in this claim, it is important to distinguish between the alleged austerity resulting from national debt repayment and other sources of austerity.

For example, the UK is a relatively small nation which is exposed to the world economy: about a quarter of what it produces is exported. This means the UK’s economic policies cannot diverge too much from those of its trading partners. To illustrate, if there is a double dip in the US and Europe due to incompetent economic management, the UK will have to endure “double dip” too, or at least it will have to endure a slower recovery from the recession than it might.

However, assuming the UK’s trading partners are more clued up than the Governor of the Bank of England (and that is doubtful) there is no reason for national debt repayment to result in austerity. For a full explanation as to why not, see here.

If I haven’t got the Governor of the Bank of England in check mate, will someone explain why not?


Update (15th May). The Governor seems to have change his mind in the last few days. In this Wall Street Journal article he seems to suggest that any deflationary effects of a deficit reduction can be countered by continuing with Q.E. Quite right!