Wednesday, 30 November 2011

Academia at its worst.

The words of Prof. Bryan Caplan:

"I've been in school for the last 35 years - 21 years as a student, the rest as a professor. As a result, the Real World is almost completely foreign to me. I don't know how to do much of anything. While I had a few menial jobs in my teens, my first-hand knowledge of the world of work beyond the ivory tower is roughly zero.

I'm not alone. Most professors' experience is almost as narrow as mine. If you want to succeed in academia, the Real World is a distraction. I have a dream job for life because I excelled in my coursework year after year, won admission to prestigious schools, and published a couple dozen articles for other professors to read. That's what it takes - and that's all it takes."

Words of Dean Baker (director of the Centre for Economic Policy Research):

“If we ask why economists would believe something about the world that seems to fly in the face of evidence, my answer would be that it is the easiest path for them. The vast majority of economists have no interest in upsetting the apple cart. They wanted to be economists because it is a relatively well-paying and prestigious profession. The way you move ahead in the profession is you repeat what the people who are more prominent than you are saying. This carries no risk. If they are right you can share in the glory. If they end up being wrong, then you have the “who could have known?” excuse.”

Dean Baker again:

“In elite Washington circles, ignorance is a credential.”


Tuesday, 29 November 2011

Positive Money and what proportion of the money supply is created by commercial banks.

Positive Money advocates full reserve banking. So do I. So I support Pos Mon both financially and with my time. But I disagree with them on a couple of points.

What proportion of money is created by commercial banks?

Pos Mon (and the New Economics Foundation) claim that 97% of money is created by private banks rather than the Bank of England. This figure is based on the fact that 3% of money is physical cash (£20 notes etc).

If monetary base came only in the form of the above cash, then the argument would be valid. But the reality is that a significant portion comes in the form of book keeping entries, or (as is the case nowadays) entries in computers. As far as I can see this amounts to about another 3% during normal times. In contrast, during the current recession, the monetary base in the UK and elsewhere has been significantly expanded.

For example, in the US the base as a proportion of M2 rose from about 12% at the end of 2000 to 27% in Oct 2011. For the figures, see here and here.

The “book keeping entry” portion of the monetary base is not of course strictly speaking in circulation. But nor can it be said to be private bank created.
The process by which this portion of the monetary base comes into existence (using QE for the purposes of illustration) is thus. The Bank of England (BoE) creates money and buys Gilts from X – (person or institution). The latter gets a cheque for the value of the bonds sold. The cheque is deposited at X’s commercial bank and X’s account at the commercial bank is credited. And the commercial bank presents the cheque to the BoE, who credit the commercial bank’s account in the BoE’s books.

The net result is that the money supply is expanded, NOT as a result of any private bank’s money creation activities, but as a result of the BoE’s money creation activities. And the only reason X is not a direct holder of monetary base is that the BoE does not create accounts in its books for anyone apart from very large institutions, like commercial banks. But in effect, X holds monetary base: it’s just that a commercial bank acts as agent for X at the BoE.

Are we reliant on debt for our money supply?

Another claim made by Pos Mon is that we are reliant on debt (owed to banks) for our money supply. The above 97% figure would certainly seem to support this view.

On the other hand, given a about of deleveraging, such as we have had recently, and a consequent contraction of privately created money, it is clear that central banks step in and make up for the contraction of privately created money with an expansion of central bank money (monetary base).

This phenomenon is nicely illustrated by the 2nd chart on page 2 of this Credit Suisse paper.

So are we really “reliant” on privately created money for our money supply? I suggest not. I suggest that what is going on is as follows.

The typical household with a mortgage will be in debt to the mortgage provider to the tune of very roughly £20,000 to £60,000 with only perhaps £1,000 or so in the bank. In other words the average household with a mortgage sees fit to have an amount of debt which is large compared to the amount of debt free money it chooses to hold.

Those households with £20 – 60,000 of debt will of course be balanced by other households or institutions with equally large amounts of cash to spare.
Incurring debt so as to get a roof over one’s head is largely a VOLUNTARY choice, since the alternative and debt free method of getting a roof over one’s head is to rent. Indeed, this ties up with law of reflux and the real bills doctrine which state that each private sector entity incurs the amount of debt it WANTS, or regards as appropriate, or regards as best suiting its needs.

To summarise, commercial banks provide what might be called a “debt transfer” service. Those debts are widely regarded as “good” because they are backed by respected institutions: large banks. Thus these debts are a form of money.

AS IT HAPPENS, these debts provide the economy with nearly as much money as it wants or needs. But if the population were particularly keen on incurring NO DEBT, the money supply would not shrivel up: the central bank would just step in and issue the amount of money required to keep the economy ticking over.

Do we “rent” our money supply?

Pos Mon, or at least a proportion of Pos Mon minded folk, promote the idea that because people pay interest on debt, and because that debt is a form of money, that therefor we “rent” our medium of exchange. I disagree.

The rent paid here is the rent paid by debtors to creditors. If the creditor is NOT A BANK, chances are that the debt does NOT become a form of money. Money is anything widely accepted in payment for goods and services. For example, where firm A supplies firm B with goods, a debt is than owed by B to A. And part of the agreement between the two may involve interest to be paid by B to A if B is late in paying for the goods. But this debt is not a form of money because it is not easily transferable: it is not widely accepted in payment for goods and services.

And borrowing, lending, debts, etc would continue after the introduction of full reserve, as Pos Mon admits. Put another way, if you have money in your bank account, you are, to that extent, a creditor. But you don’t pay “rent” for the privilege of possessing this money do you? Quite the reverse: other than during the very low interest rates that currently obtain as a result of the credit crunch, you probably get some interest. I.e. the bank PAYS YOU!!!!

Conclusion: debtors normally pay interest to creditors, but posessors of the money created by commercial banks do not pay rent to such banks for the privilege of being supplied with a medium of exchange.


Monday, 28 November 2011

Ron Paul, Bernanke and can money for capital investment come from the printing press?

Youtube clip of Ron Paul interviewing Bernanke.

Ron Paul asks whether money for capital investment can come from the printing press – see 1min 30 secs into the interview. Bernanke does not give a straight answer. The answer is thus.

If an economy is at capacity, and the government / central bank machine (GCBM) prints money and distributes it to commercial banks, who then lend it to firms doing capital investment, that investment expenditure will raise demand, which in turn will raise inflation. That effectively robs those who are not in receipt of GCBM largess, and those robbed are forced to forgo consumption.

Thus the REAL RESOURCES for the capital investment come from those robbed. And that is a pretty random selection of the population, and an illogical way of organising the reduction of consumption needed to fund capital investment.

If the economy is below capacity.

In contrast, if the economy is BELOW capacity, the additional demand may well not exacerbate inflation too much. But robbery still takes place. That is GCBM allocates the “right to control resources” (i.e. money) to a few chosen institutions (i.e. banks). That is money that could have been simply spent into the economy, and/or used to cut taxes (as advocated by Modern Monetary Theory and by this lot.

If GCBM can show that the amount of investment is sub-optimum, i.e. that there has been market failure, then artificial assistance for investment could be justified. But of course GCBMs have never demonstrated this: that would be too much like hard work.


Hat tip to Dr Mike Heywood. I got the link to the above Youtube clip from an email that Dr Heywood distributes about once a week. This email contains what he thinks are interesting economics articles, and a selection of economics / politics related cartoons. Contact:


Sunday, 27 November 2011

Government should not subsidise bank loans.

It’s been announced in the last 48 hours that the UK government intends underwriting a few billion of loans by banks to businesses, which to the innocent will sound a good idea.

But why should government subsidise bank loans to businesses? There are alternative sources of funding for businesses: issuing shares or obtaining loans from non-bank institutions (or in the case of small businesses, loans from family members or friends).

Siemens in Germany are very much into the “firm to firm” lending business. Are they entitled to a subsidy, and if not, why not?

Moreover, the whole bank lending business already receives an ASTRONOMIC subsidy: that’s the too big to fail subsidy plus the £85,000 per account guarantee provided by government (i.e. taxpayers). The too big to fail subsidy alone was estimated by the Independent Banking Commission as being worth well over £10bn a year (about £150 per UK resident per year). See p.130 here.

As the ICB righly say (p. 8) “The risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers.”

Government should stop tinkering with the dozens of levers that they think control the economy and concentrate on approximately one lever. As advocated by Prof Werner, Positive Money, the New Economics Foundation, government should just create new money and spend it into the economy when needed (and/or cut taxes). Modern Monetary Theory advocates the same.

Or as Simon Jenkins put it, “Governments can worry about borrowing, lending, inflation, fiscal rectitude, whatever until the cows come home – but without demand there is recession.”


Thursday, 24 November 2011

Germany fails to sell debt.

The recent failure of Deutschland to sell its debt stems does not stem the market thinking Deutschland is not credit-worthy. The very idea is absurd. The problem derives from suspicious as to whether the Euro will survive. Who wants to own bonds denominated in a currency that might cease to exist in a few months?

The solution is for the ECB to act a bit more like a normal central bank / government and create and spend money into the Euro economy. This comes to much the same thing as the Euro distribution long advocated by Warren Mosler (see para starting “The ECB would create…”).

Or have I missed something?


Wednesday, 23 November 2011

Today’s Financial Times leading article on deficits and debt is clueless.

The article starts:

It is now clear that curbing Britain’s public debt is going to be much harder than the coalition government originally predicted. While David Cameron admitted as much earlier this week, official confirmation will come next week with the publication of the Office of Budget Responsibility’s report on the state of the UK’s public finances. While disappointing, this does not undermine what still appears to be a sensible plan. The problem for the government is that weaker actual and potential growth has made the task of reining in the deficit much harder than forecast.

Now why would “weaker growth” result in “reining in the deficit” being “much harder”? Reason is that weak growth necessitates a bigger deficit, or to be more exact, weaker growth requires more stimulus, which itself requires a bigger deficit.

But what’s wrong with such a deficit? If the private sector fails to spend, the remedy is to have government spend more (and/or cut taxes so that the private sector is encouraged to spend more). So what’s wrong with such a deficit – the fact that it results in more debt?

POPPYCOCK! As both Keynes and Milton Friedman pointed out, a “stimulus deficit” can be funded EITHER by borrowed money OR printed money. If interest rates are round about zero, there is no harm in borrowing more. But if interest rates become significantly positive, then all government needs do is to go for the print option. So there is no problem there.

But the next sentence of the FT article is bizarre. It says,

Chancellor George Osborne’s hopes of eliminating the current structural deficit by 2014-5 now look impossible.

Well as made clear above, the part of the deficit that may have to expand if weak growth persists is NOT THE STRUCTURAL DEFICIT. It’s the stimulus part of the deficit.

Put another way, the structural deficit is the part of the total deficit which has no influence on growth.

Or as the Reuters definition puts it “The portion of a country's budget deficit that is not the result of changes in the economic cycle. The structural deficit will exist even when the economy is at the peak of the cycle.”

Wiki says much the same: “a structural deficit exists even when the economy is at its potential”

(There are actually a number of other and silly definitions of the phrase “structural deficit” out there. I may do a post on this, as well as contacting the authors of those definitions.)

Now if the structural deficit has no influence of growth, it follows (by definition) that removing this part of the total deficit will have no “anti-growth” effect, i.e. no “anti-stimulatory” effect!

So if it’s the structural deficit and debt that the FT is talking about, it is untrue to say that, “curbing Britain’s public debt is going to be much harder” because of poor growth figures.

As to the actual mechanics of reducing the structural deficit without harming growth, see here.


Thursday, 17 November 2011

A hopeless defence of fractional reserve banking in the Financial Times.

Ben Dyson of Positive Money authored an article in the Guardian earlier this week attacking fractional reserve banking. This blog article at the Financial Times authored by Izabella Kaminska responded. The latter’s attempt to demolish Dyson’s arguments are hopeless.

Dyson argues against the right of private banks to create money. The first five or so paragraphs of Kaminska’s article respond by pointing out that economists realised a century or more ago that private banks do this. Thus Dyson’s point, according to Kaminska is old hat.

The answer to that is that Dyson does not claim to be revealing anything that most economists are not already aware of. As Positive Money’s literature points out time and again, the object is to educate the PUBLIC. (I could cite ignorant economists who quite clearly DO NOT get Dyson’s point, but I don’t want to be cruel.)

Second, in the paragraph starting “Having staggered…” Kaminska claims that Positive Money “plans to end evil debt everywhere”. Wrong again. The advocates of full reserve banking (including Positive Money) are well aware that borrowing and lending will always take place. What advocates of full reserve object to is (amongst other things) the fact that fractional reserve exacerbates instabilities.

That is, during a boom, asset prices rise. It was primarily property prices in the run up the recent credit crunch, and in the late 1920s it was primarily share prices. This price rise makes assets better collateral to back further lending. That further lending boosts asset prices still further. And so on.

Third, and credit where credit is due, Kaminska claims that the whole full versus fractional reserve argument is complex. Agreed.

And finally, Kaminska makes the bizarre claim that “Without debt, after all, you can’t have money.” Oh yes? What about a commodity based currency, like gold coins? If I have some gold coins, exactly where is the “debt” associated with these gold coins? Answer: the debt does not exist!

And it’s not only commodity based money systems that involve debt free money. In our existing fiat money system, monetary base is effectively debt free. Of course monetary base IN THEORY has an associated debt: a debt owed by the central bank to holders of monetary base. Those £20 notes (which are part of the monetary base) have imprinted on them the phrase “I promise to pay the bearer on demand the sum of £20”. But of course that is meaningless: try going along to the Bank of England and demanding £20 of gold (or anything else) in exchange for your £20 note. You’ll be told to shove off.

In short, there is no debt associated with monetary base.


Wednesday, 16 November 2011

A flaw in Nominal GDP targeting.

There was a debate on NGDP targeting on Winterspeak’s site recently. One point missing (I think) from that debate (perhaps because it was too obvious) was as follows.

Advocates of NGDP claim that if the authorities concentrate EXCLUSIVELY on inflation, they’ll pitch aggregate demand too low when inflation has a significant cost push element.

As David Beckworth (probably the main high priest of NGDP) says,

“Inflation is the result or symptom of underlying shocks to aggregate demand (AD) and aggregate supply (AS). Monetary policy, however, can only meaningfully influence AD so that is where its focus should be. This cannot happen with strict inflation targeting because it requires the central bank to respond to any change in inflation, regardless of whether it is caused by AD or AS shocks.”

Well the answer to the latter point is that the authorities JUST DON’T concentrate exclusively on inflation: that is, the DO LOOK at the reasons behind inflation.

For example, Britain’s government and central bank think that the current excess levels of UK inflation are to a significant extent cost push and temporary. They are thus doing nothing too drastic to bring down this inflation to the 2% target within the next six months.

I don’t have any big objections to NGDP targeting: I just think it’s merits are exaggerated.


Tuesday, 15 November 2011

Saturday, 5 November 2011

Krugman confuses fractional reserve and maturity transformation.

I have plenty of respect for Krugman, but he goes off the rails in this article, in which he tries to defend fractional reserve. Near the start there are two paragraphs which read as follows (in italics):

Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Banks can largely resolve this tension, by offering deposits that can be withdrawn on demand, yet investing most of the funds thus raised in long-term, illiquid projects. What makes this possible is the fact that normally only some depositors want to withdraw funds in any given period, so it’s normally possible to meet those demands without actually having liquid assets backing every deposit. And this solution makes the economy more productive, providing more liquidity even as it allows more productive investment.

The latter process, transforming short term deposits into long term loans, is not fractional reserve: its called “maturity tansformation” (MT). Fractional reserve is the process whereby the private bank system holds a relatively small amount in the form of cash relative to its deposit lilabilities: in other words the private bank system can create and lend out money.

But since Krugman introduces MT to the argument, let’s examine it. It would certainly seem to bring benefits on the basis of the Diamond-Dybvig argument. But the first flaw in this argument is that it equates money (which is nothing more than numbers in computers) with REAL SAVINGS. Real savings are of course not just numbers in computers: real savings consist of houses, office blocks, machinery, etc.

Thus trying to make maximum use of our stock of money is senseless because numbers can be added to computers at no cost anytime. Or as Milton Friedman put it in Ch3 of his book, “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

So MT achieves nothing. That is, from the perspective of an individual bank it is profitable. But from the perspective of the country or economy as a whole, it’s a zero sum game.

Moreover, MT amounts to “borrow short and lend long”: an inherently risky strategy which brought down Northern Rock and hundreds of other banks over the centuries. Indeed, Krugman admits as much. He says:

The problem, of course, is the vulnerability of such a system to self-fulfilling panics: if people believe that a bank will fail, everyone will in fact want to withdraw funds at the same time — and because the bank’s assets are illiquid, trying to meet those demands through fire sales can in fact cause the bank to fail.

This then leads to the need for policy: deposit insurance and/or lender of last resort facilities to head off bank runs, and bank regulation to reduce the moral hazard from these explicit or implicit guarantees.

Quite. Put another way, MT is so risky that some sort of compulsory insurance is required to underwrite it. Ideally this insurance should be funded by those taking the risk (which to some extent in some countries it is). Unfortunately, insurance in most countries also comes in the form of the taxpayer funded implicit too big to fail subsidy. And that’s a blatant misallocation of resources.

Banks cannot be defined?

Krugman then claims that it is near impossible to define a bank, plus he points to the large shadow banking industry. This leads him to conclude that controlling fractional reserve is near impossible.

The first problem here is that I suspect the shadow banking industry does not engage in much fractional reserve. I suspect it’s main activity is connecting large lenders with large borrowers. That’s not fractional reserve.

In contrast, there is nothing to stop the shadow bank industry doing MT. And doubtless the latter helps explain the run on the shadow bank industry that contributed to the credit crunch.

Fractional reserve involves the CREATION OF MONEY. And money is defined as anything which is WIDELY ACCEPTED in payment for goods and services or settlement of debts. Now if I am some unheard of outfit claiming to be a bank and I want to do what large banks do, i.e. create money out of thin air and credit the account of someone applying for a loan, and that person then draws a cheque on me, the person who is given the cheque is unlikely to be happy with “payment” that consists of having their account at some “unheard of outfit” credited. The latter outfit could be me or some other shadow bank. They’re probably going to want their account at some large, respectable outfit credited.

Conclusion: it is difficult for shadow banks to do fractional reserve.

And even to the extent that shadow banks do do fractional reserve, I totally fail to see the difficulties in having government keep tabs on them. If government can keep tabs on every household with a view to extracting income tax from households, then where is the problem in keeping an eye on the smallest shadow bank which probably has a turnover fifty times that of the average household?

Government (at least in the UK) keeps tabs on, or tries to keep tabs on, one man band loan sharks who prey on poorer neighbourhoods.

And finally, the turnover of the shadow banking industry has risen sharply in recent years and is now about the same size as the official banking industry. If so called “bank regulators” are to be anything more that unproductive bureaucrats shuffling pointless bits of paper, then they are just going to have to get to grips with the shadow bank industry.


Thursday, 3 November 2011

The scourge that is unemployment.

Fractional Reserve.

Once upon a time there was an economy with a central banker called Ab Lerner. He spent money into the economy at a rate that brought full employment (and occasionally raised taxes and withdrew money when the population was gripped by irrational exuberance).

He didn’t want to operate bank accounts for households and businesses, i.e. “private sector entities” (PSEs). That function was performed by Lloyd Bankfiend, the commercial banker.

Each PSE wanted a stock of money to meet its need to make transactions, plus some extra money against a rainy day: the so called precautionary motive for holding money. Each PSE kept pretty well to its “transaction and precautionary” stock of money.

That in turn meant that no PSE could borrow unless some other PSE took the deliberate decision to forgo consumption and save money.

PSEs wanting to borrow sometimes borrowed direct from other PSEs, and sometimes they borrowed via Mr Bankfiend.

Mr Bankfiend only lent money that had been deliberately deposited with him in savings accounts rather than current or checking accounts.

The rate of interest in this economy was determined by market forces, that is, it was determined by the relationship between borrowers and lenders. That in turn optimised the amount of borrowing and lending and investment. Reason was that at the margin, the benefits of borrowing (e.g. the return on capital that businesses could obtain by making investments) was equal to the pain or disutility suffered by those abstaining from consumption so as to save.

Then one day Mr Bankfiend had an idea. “Why”, he said to himself “do I bother waiting for people to deposit money with me before crediting the accounts of those who want to borrow?”

He couldn’t think of a reason for not doing this. So next day when people came in applying for loans, and after making sure they had adequate incomes and net assets, Mr Bankfiend just clicked his computer mouse and credited the accounts of the borrowers.

The big advantage of this for Mr Bankfiend was that he collared the interest paid by the borrowers without having to pass any of it on to those who had put money in deposit accounts at his bank. Or as Murray Rothbard put it, fractional reserve bankers “can charge a lower rate of interest than savers would”.

But of course there is no such thing as a free lunch. The going rate of interest dropped, which meant that lenders (i.e. those with deposit accounts) lost income, while Mr Bankfiend gained.
Moreover, interest rates were no longer at the level at which costs and benefits at the margin were equalised. As a result GDP fell.

To make absolutely sure he retained this easy source of income, Mr Bankfiend paid the election expenses of various politicians so as to make sure they didn’t interfere with his new source of income.

P.S. 28th Jan 2012. There is a much more detailed version of the above argument here.

Tuesday, 1 November 2011


An economy consists of a labour force of twelve people and two firms. Demand is enough to employ ten people (including the two employers). So there are two unemployed.

Wages are sticky downwards, but prices are flexible. Government is too incompetent to raise aggregate demand. What do do?

One solution is to tell the two unemployed individuals that if they want to continue receiving benefits they have to turn up at an employer’s premises and work part time.

The availability of this new source of free labour would induce the employers to cut the price of their products by enough to raise output by enough to keep the two unemployed people busy. That’s Say’s Law (I think).

That’s not as good as providing full time work for the two unemployed people (assuming they want full time work). But it’s better than having them full time unemployed.

Note that even if unemployment is at NAIRU in this economy (or at the “inflation barrier” as Bill Mitchell calls it), the above system would still work – at least to some extent. Reason is that at NAIRU, employers do not take on the unemployed because of the latter’s unsuitability. So if the employment subsidy involved here makes up for this unsuitability, employment would rise.