Saturday, 11 June 2011

William Dudley of the Fed doesn’t know how to reduce the debt.

A recent speech (1) by William Dudley, president of the New York Fed is mostly quality stuff, but he seems to be unaware that reducing national debts, or at least preventing them expanding, is quite easy.

It is deficits that cause debts to rise, and (as pointed out by Keynes (2) and Milton Friedman (3)) funding a deficit with new money rather than via debt is a perfectly acceptable option. That means the deficit can continue, but the debt declines or at least ceases to grow.

The relevant passage from his speech is as follows (in green and italics).

However, the large size of the fiscal deficit and the rapid increase in the country's federal debt-to-GDP ratio means that this is not sustainable for much longer.

Standard deficit terrorist stuff. He then continues:

Ultimately, the composition of economic activity in the United States needs to be rebalanced. There are two issues here. First, the consumption share of GDP may still be too high. Second, the need for U.S. fiscal consolidation implies that there will have to be offsetting increases in investment and the U.S. trade balance as the recovery proceeds.

To illustrate this second point consider the following accounting identity:
The public sector balance + the private sector balance = the current account balance
Right now the identity holds as roughly:
-10 percent of GDP public sector balance + 7 percent of GDP private sector balance = -3 percent of GDP current account balance.5
If the public sector balance must over time move from around -10 percent to around -3 percent to stabilize the federal debt-to-GDP ratio at tolerable levels, then the private sector balance and the current account balance must move by roughly 7 percentage points of GDP to take up the slack.

The first flaw in this argument is Dudley’s suggestion that the deficit cannot continue because the debt is too large. The answer to that is that, to repeat, a deficit can perfectly well be funded by new money rather than by debt.

Put another way, debt reduction should not be an important or central economic objective. The main economic objective is keeping total numbers employed as high as is consistent with acceptable inflation.

The deficit should be whatever is needed to attain the latter objective. And then, having decided on the deficit, there is the question as to whether to fund it via debt or new money. And the arguments for funding via debt are thin on the ground (and more on this below).

The deficit might need to last another five years.

If households want to continue deleveraging or saving up dollars for the next FIVE YEARS, that does not mean as per Dudley logic that the US government has to go ever deeper into debt. The US government can simply print dollars to supply households with what they want.

Indeed, the present rate of deleveraging will have to continue for another five years or so if households want to reverse the leveraging they undertook between Jan 2005 and Jan 2008. At least that is the case if the first chart here is any guide.

Moreover, since it is money that households are after, it is eminently reasonable to fund the deficit via cash rather than debt.

Central bankers shouldn’t worry about private sector investment.

Dudley then says:

“Assuming that the consumption share of GDP still needs to fall over the medium term, the adjustment in the U.S. private balance will have to occur primarily in terms of rising residential or business fixed investment.

There does seem to be room for business investment to expand significantly when firms become more confident in the economic outlook, provided that the United States remains a competitive location for investment. But residential investment is unlikely to climb very much for some time given the chronic overhang of unsold homes.

If these two sectors cannot take up all the slack created by necessary fiscal retrenchment in the years ahead—as seems likely—then the U.S. trade balance will need to improve as well. This implies that emerging market economies (EMSs) will no longer be able to rely on expanding U.S. demand as a key driver of their own economic growth.”

In other words he is saying that if the injection by the public sector into the private sector ceases, some other injection (and investment is all he can think of) must take its place. Well the flaw in this argument is that, despite what it says in economics text books, injection can take the form of demand for consumer goods just as much as investment goods. Indeed, there is not even a sharp dividing line between the two: is something that lasts one year a consumer good or an investment good? What about two years . . three years?

Put another way, if demand by the US private sector for US private sector produced stuff expands or speeds up sufficiently, the injection from government can just cease. Period. Full stop. As to how this extra demand by the private sector breaks down as between consumer and investment goods – who cares? We don’t need central bankers worrying about that. The free market can sort that out for itself.

Thus the idea that a smallish demand for investment goods necessitates reducing the flow of dollars out of the US to EMEs does not add up. Put another way, if EMEs want to save up dollars, let them! Of course Uncle Sam will have to print dollars to supply EMEs with the dollars they want. And would require a continued but smaller deficit. But that’s not a problem.

In fact, being able to churn out bits of paper with “$100” printed on them (to put it figuratively) and exchange those bits of paper for real goods and services is great. Even better, the value of the bits of paper can be degraded by inflation. Wish I could do that! Put yet another way, anyone in the position to do some seigniorage can make good money. That’s what banks do, and if the US gets its act together, it can be the world’s banker for a few years yet before the Yuan becomes the world’s reserve currency.

Why fund a deficit via debt rather than with new money?

The first nonsensical aspect of funding via debt is that it amounts to asking to become indebted to other countries. That is, foreigners can buy one’s national debt. E.g. China holds a big chunk of U.S. debt.

Now there is nothing wrong with a microeconomic entity like a household or firm borrowing from abroad. But there is a problem when government does this, which is as follows.

Where government collects insufficient tax to cover its spending, it has to borrow instead. And the purpose of the borrowing is to provide a demand reducing effect to counteract the demand increasing (and possibly inflationary) effect that would come from just printing money to cover the tax shortfall.

But if a country borrows from abroad, it is debatable as to how much of a demand reducing effect there is. Certainly if some foreign entity brings money into the debtor country SPECIFICALLY to lend to the debtor government, there is no demand reducing effect at all! That leads to the farcical situation of the debtor country paying interest to the foreign entity, and then having to borrow as much again from domestic entities so as to get the demand reducing effect!

Of course in the real world, things aren’t that simple. For example the dollars that China allocates to US national debt are (at a guess) dollars that China would be holding anyway as a result of China’s export fetish. Nevertheless, capital moves freely across national boundaries nowadays. And you can be sure that as soon as some country announces a desire to borrow, potential lenders around the world take a look at what’s on offer.

A second daft aspect of funding a deficit via debt rather than new money is this. Regardless of whether a government borrows from domestic or foreign entities, what’s the point in a government borrowing money, and paying interest for the privilege, when it can produce such money itself for free anytime? That is as daft as a dairy farmer buying milk in a shop when there is a hundred gallon tank of milk outside the farmer’s back door.

Money printing causes inflation?

The rest of this post explains why money printing does not necessarily exacerbate inflation. So readers who know why additional money does not necessarily mean inflation can stop reading here.

The fact that governments can and do print money does not of course mean they can print it willy nilly. On the other hand the idea that money supply increases necessarily lead to increased inflation is also nonsense. For example the U.S. monetary base has TREBBELED in the last two years: totally unprecedented. But inflation, just as many of us predicted, remains at a level that is very near the post WWII average. Plus the big money is not betting on increased inflation in the near future, if the yield on various Treasuries is anything to go by.

So how much money can be printed before inflation is exacerbated (either straight away or in a few years) and how should such money be allocated? Well the answer to that question can be explained to a fifteen year old in about five minutes. The answer is thus.

New or printed money will only exacerbate inflation if and when it gets spent in serious quantities and at a serious speed. I.e. if the money just sits in deposit accounts or under mattresses, it has no effect.

Money in banks is not always loaned out.

As to the idea that a money supply increase when it is plonked in bank deposit accounts will be loaned out and thus cause a rise in demand and/or inflation, well that idea flies in the face of both the evidence and the theory.

As to the evidence, banks currently have record reserves: which they are not lending out with any great enthusiasm!!!

As to the theory (and this explains WHY banks are not lending freely) banks lend when they see viable lending opportunities: for example businesses with bulging order books. Put another way, given a healthy level of aggregate demand, banks will lend. (Incidentally, this point highlights the absurdity of rescuing Wall Street rather than Main Street, and then expecting instant recovery as a result.)

So how much money should be printed? Well how about the government / central bank machine printing money and allocating the new money between private and public sectors in the ratio that these sectors currently form as a proportion of GDP: roughly two thirds for the private sector and one third for the public sector.

So as regards the latter, government just prints money and spends it on the usual public sector items: schools, law enforcement, etc.

As the regards the private sector, the new money needs to go to the ultimate source of all demand: the consumer. A payroll tax reduction would do the job.

And wouldn’t you know it – one of the leading lights of Modern Monetary Theory, Warren Mosler (4), has been advocating a payroll tax reduction since the recession began.

Unfortunately the incompetents actually in charge have allocated new money (via QE) to the people LEAST likely to spend it: bond holders, i.e. the rich: a shambles!

As to HOW MUCH money to print and distribute, there are no sure answers to this, and for the simple reason that households’ behaviour is not all that predictable. Nor is the behaviour of businesses, politicians, or any other group. In other words the effects of a deficit funded by new money are just as uncertain as the effects of a deficit funded by borrowed money. Either policy can lead to excess demand and thus inflation, or to too little demand and thus excess unemployment.

So how about just carrying on with the current deficit, funded with new money rather than borrowed money, and see what happens? If inflation looms, that can be controlled by “unprinting” money: that is, for example raising taxes and extinguishing the money collected.


1. Dudley:

2. Keynes:
(2nd half of 5th para).

3. Friedman: (p.250)

4. Mosler:


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