The conventional wisdom is that aggregate demand (AD) is best regulated by adjusting interest rates - or at least that interest rates should be one of the main tools used to regulate demand.
I set out numerous criticisms of this policy here. And Prof.R.A.Werner and others set out yet more reasons and evidence here.
The crunch.
Prior to the crunch, people were betting big time on house price increases, and borrowing big time so as to fund those bets.
In a genuine free market, that increased demand for borrowed funds would have caused a significant rise in interest rates. But we don’t have a free market: interest rates are rigged because the conventional wisdom is that central banks know better than the market (ho ho).
And prior to the crunch, demand and inflation were not going thru the roof, so central banks did not raise interest rates to any significant extent.
So what was the result of this “central banks know best” policy? Well borrowing continued unabated because private banks can and will create money out of thin air and lend it out, just as long as they see what looks like good collateral (like rising property prices).
The Werner regime.
In contrast, Werner & Co advocate a regime in which private banks CANNOT create money out of thin air and lend it out, and in which the government / central bank machine DOES NOT use interest rates to control demand. Instead, demand is controlled in a much more obvious, simple and straightforward way: the government / central bank machine (in a recession) just prints new money and spends it. Conversely, if inflation looms, taxes are raised and money is “unprinted”.
Incidentally Modern Monetary Theory also advocates the latter sort of policy. Great minds think alike.
Thus under a “Werner regime”, market forces prior the crunch would have raised interest rates, which would have choked off house price increases. Incidentally the “choking off” would probably have come from a QUANTITATIVE effect as well as a PRICE effect. That is, the sheer unavailability of funds to borrow might have played as big a role as interest rate increases.
Another incidental point here is that my use of the phrase “Werner regime” should not be taken to suggest that Werner himself would agree with everything in this article – though I hope he would.
Contravening Tinbergen.
The false logic behind using interest rates to adjust demand is a beautiful illustration of failure to abide by the Tinbergen principle.
This principle (or at least my interpretation of it) is thus.
1. For each policy objective, one policy instrument, and one only is needed.
2. The policy instrument chosen for each objective should be the one that most effectively influences that objective.
To illustrate, trying to pitch demand at a level that maximises employment without exacerbating inflation too much is an “objective” which no one can object to.
In the case of adjusting demand, there are basically two sources of demand in any economy. First, the public sector (demand for personnel and equipment for the state education system, the police and armed services, etc). And the second basic source of demand is the consumer.
Thus if it looks like demand needs a boost, the logical and simplest course of action is to boost public spending and put more spending power into the hands of the consumer.
AS TO INTEREST RATES, the optimum level of interest is the level at which the marginal benefit from borrowing equals the marginal “dis-benefit” or pain derived from forgoing consumption required to make funds available for borrowing. And there is NO PRIMA FACIE REASON for thinking that the optimum interest rate varies as between a boom and a recession (though there may be minor technical reasons for a small variation). That is, there is no prima facie reason to cut interest rates in a recession.
Tinbergen, car engines and brakes.
When it comes to cars, a valid objective is making the car move. The best policy instrument there is an engine. Another valid objective is slowing the car down in a hurry. The best policy instrument is brakes.
You could of course control a car’s speed by having the engine working constantly at full power while using the brakes to control the car’s speed: not a brilliant use of policy instruments.
Put another way, using interest rates to adjust demand leads to the absurdity spelled out in blue at the top right above.
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There is a great article by the above two in yesterday’s Financial Times. It says (my summary):
1. The crisis was caused by excessive private borrowing not excessive public borrowing,
2. That we need more demand,
3. The idea that deficits are excessive is nonsense,
4. Attacks the confidence fairy,
5. Attacks structural arguments,
6. Says the anti-stimulus arguments being cited nowadays are the same ones that exacerbated the 1930s decade long depression.
In their final paragraph they say, “We therefor urge all economists and others who agree with the broad thrust of this manifesto for economic sense to register their agreement online. OK I’ve done that.
They also insert the reservation that “The best policies will differ between countries….” Quite right. For example sorting out the Eurozone is not as simple as the above five points suggest. But the “broad thrust” of the article is right.
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Summary. John Kay’s paper entitled “Narrow Banking” advocates (unsurprisingly) what he calls “narrow banking”. Like Vickers, he is concerned about the low or non-existent interest that would be earned on 100% safe accounts where the relevant money is invested in 100% safe investments. He therefor advocates investing the money in ways which are about as risky as existing bank accounts. But that gives rise to all the problems that have arisen with banking to date! So what was the point of his paper?
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This Positive Money article claimed that John Kay and Lawrence Kotlikoff’s ideas on bank reform were similar to the ideas in the joint submission to the Vickers commission made by Positive Money, Prof.R.A.Werner and the New Economics Foundation. (I’ll refer to the latter work henceforth as the “submission”).
Kotlikoffs ideas are certainly similar to those in the submission. As to Kay, his ideas might seem to be similar, given that the title of his paper is “Narrow Banking”. However, the small print reveals a different story.
Incidentally I enjoy Kay’s regular articles in the Financial Times, but he definitely had an “off-day” when writing this paper on narrow banking.
In some passages he seems to advocate full-blooded narrow banking. For example he says (p.58), “The most effective way to ensure that public subsidy to failed financial institutions is not required is to insist that retail deposits qualifying for deposit protection should be 100% supported by genuinely safe liquid assets.” Agreed.
That is much the same as a point made by Mervyn King: “…eliminating fractional reserve explicitly recognises that the pretence that risk free deposits can be supported by risky assets is alchemy.”
But Kay also says (p.50), “Narrow banks might (but need not) engage in consumer lending, lend on mortgage, and lend to businesses….” Well hang on – banks that engage in the latter activities are pretty much bog standard banks!!!!
Moreover, allowing narrow banks to engage in similar activities to standard banks just gives rise to the very problems we’ve had with standard banks, and which Kay himself eloquently describes: one of these being the complexity of the regulations needed to control such banks . Indeed, he describes Basle type regulations as “worse than useless” (p.7). And on his page 5 he describes these type of regulations as “massively inadequate”. I second that.
Unsurprisingly, Kay’s own attempts to work out how his so called narrow banks should be regulated runs into exactly the same problem: complexity. He devotes about FIVE PAGES (p.53 onwards) describing such regulation.
Well banks just love complex regulations. It’s precisely the complexity that enables them to nibble away at the regulations bit by bit.
Should narrow banks invest in government securities?
Bot Kay and Vickers think they are caught between a rock and a hard place: they want to make bank accounts (or at least some bank accounts) far safer, but they realise that if this is done by putting depositors’ money into ultra-safe investments, those investments will inevitably yield little interest.
Indeed, depositors might well pay monthly bank charges. That is, they would effectively get a NEGATIVE rate of interest.
As a way out of this dilemma, they advocate that at least depositors’ money can be put into government securities. Well unfortunately even government securities are not 100% safe. Ever heard of Greece? As to more responsible countries, even there the value of government securities rises and falls.
Biting the bullet.
The idea that those who want absolute 100% safety are not entitled to interest is a big political step to take: the peasants might revolt. Thus Vickers perhaps cannot be blamed for not taking that step: i.e. perhaps Vickers cannot be blamed for producing a whitewash report.
Perhaps members of the allegedly “independent” Vickers commission were quietly told that if they didn’t rock the boat they’d all get honours. Or perhaps they were told by City of London worthies that if they advocated getting the banking system more or less “back to business as usual” they’d get lucrative bank directorships.
But John Kay has not such excuses.
Moreover, depositors have been getting approximately nothing by way of interest over the last couple of years because of the low interest rates designed to get us out of the recession, and the peasants HAVE NOT REVOLTED. To that extent, one has to wonder why Kay and Vickers are so concerned about zero interest earning accounts.
Stricter bank regulation does not harm growth.
Another reason that Vickers wanted to channel money from 100% safe accounts into risky investments was that the Vickers commission thought that tying up too much money in non-productive accounts would reduce bank lending, which would reduce economic growth. Presumably Kay thinks the same – thought I can’t actually find a passage in Kay’s paper that says this.
Well clearly any restrictions on bank lending will be deflationary ALL ELSE EQUAL. But all else does not need to be equal. That is, government can easily expand the monetary base to compensate for any deflationary effect coming from stricter bank regulation.
Conclusion.
If we are going to have a rational banking system, we will just have to get depositors used to the idea that little or no interest is earned on 100% safe accounts. And the submission to the Vickers commission by Positive Money, Prof.Werner and the New Economics Foundation was right to advocate this “little or no interest” policy.
Of course the TEMPTATION for politicians is always to promise bread and circuses: i.e. to tell the population they can have their cake and eat it. That is, politicians like to tell voters that interest can be earned on 100% safe accounts, while keeping quiet about the fact that voters as taxpayers pay for this absurdity.
The Basle Committee on Banking Supervision and the UK’s Vickers Commission on Banking have the same aim: to make banks have enough loss absorbing buffers in the form of shareholders and bond holders to ensure that the risks involved in banking are reduced to acceptable levels.
That basic idea is flawed for the following reasons.
But first, please note that it’s the BASIC or TRADITIONAL activity performed by banks that I’ll consider here: taking deposits and lending money deposited on to borrowers. Of course banks do more than that, but the latter, to repeat is the basic activity of banks and it’s the one considered here.
Buffers.
There is always a finite possibility that EVERY LOAN made by a bank goes wrong. Thus to make a bank 100% safe, it must have loss absorbing buffers EQUAL IN VALUE to loans (or equal to deposits). But that would mean a miserable return on capital for shareholders, bond holders and depositors – or a standard return on capital for share and bond holders and zero or worse return for depositors. And that is a nonsense.
So what those designing Basle or Vickers type regulations do is to go for a compromise. That is, they aim to ensure that buffers are large enough to reduce risks to an acceptable level. But that still leaves a finite risk in place: a risk that is carried by taxpayers. In other words, if depositors are to be sure of getting their money back, then banks ABSOLUTELY MUST BE underwritten or subsidised by taxpayers.
Now what do you call an entity that claims to be commercially viable (normally headed by a self-styled swash buckling proponent of capitalism) but which in reality absolutely has to be underwritten by taxpayers? The words “farce”, “nonsense” and “hogwash” spring to mind.
And this taxpayer subsidy is ASTRONOMIC. According to this study by Andrew Haldane of the Bank of England, the value of the TBTF subsidy over recent decades has amounted to more than bank profits!!!! See 3rd paragraph under the heading “Implicit subsidies” here.
I argued above on purely theoretical grounds that the basic banking activity in its present form is fundamentally a farce. It seems from Haldane’s evidence that the numbers backs this up.
What do we get from banks in exchange for the TBTF subsidy and occasional credit crunches?
The cost of the crunch has been ASTRONOMIC: GDP of countries affected is now five to ten percent below trend. We are talking hundreds of billions or trillions.
Now if this astronomic cost is matched by some equally astronomic benefit, then OK. But it’s not.
Basically the only benefit that banks can point to is that the risk they run “improves liquidity”. Or put it another way, banks claim that if regulations are too restrictive, economic growth will be impaired.
Whichever way banks put it, half the economics profession and nine out of ten politicians are fooled. As to the word “liquidity”, that’s an important technical sounding word, so that impresses the gullible. As to threats that economic growth might be impaired, well every politician wants economic growth: it wins votes. So banks only have to mention economic growth, and politicians jump to attention, salute bank CEOs, and give banks a more or less free rein.
So do restraints on bank activity ACTUALLY impair economic growth? Well OF COURSE THEY DO ALL ELSE EQUAL!!! But all else does not have to be equal. That is, given a deflationary effect of tighter bank regulation, the government / central bank machine can easily make good with some stimulus. The result is less bank funded economic activity and more equity funded activity (in the case of industries where it is difficult to cut capital intensivity). As the rest of the economy, the result is more activity based on plain simple old consumer demand, rather than based on bank loans.
Thus the central argument put by banks against tighter regulation is HOGWASH.
As this Financial Times front page lead story pointed out, banks use any old fraudulent or dishonest argument to water down bank regulations.
Conclusion: banking in its present form is a farce.
Banks don’t need to be 100% safe?
Banks could point out that having the value of buffers equal to the value of a bank’s loans is an unnecessarily high level of safety, and involves large amounts of share and bond holder capital lying idle in exchange for a very small improvement in safety (as compared to the size of buffers and levels of safety contemplated by Basle and Vickers).
Put another way, cutting the size of buffers from say 100% of the value of loans to say 50% involves a big increase in lending in exchange for very little increased risk. And that additional lending brings a large economic boost or stimulus.
True, but banks would not be doing anything there that cannot be done at zero cost and no additional bank riskiness whatever by the government / central bank machine. That is, “economic boost” or “stimulus” can be implemented by any monetarily sovereign government anytime and at no real cost and no additional risk of banks going under.
When it comes to the question as to which is the best of the above two options, there is no contest.
An arcane point – skip if you like.
However the fact that X is a better option than Y does not mean X is the BEST POSSIBLE option. Indeed, there is still a defect in a banking system that involved buffers equal to the value of bank loans (the “X” option, so to speak). And it’s not the above point about share and bond holders’ money lying idle: money is just numbers in computers. The real defect is thus.
Depositing money in a bank knowing full well that the bank will loan that money on to businesses or for mortgages, etc is a COMMERCIAL TRANSACTION. Now if buffers are equal in value to loans, there is nothing left for depositors, as pointed out above. I.e. the latter “commercial transaction” brings a zero or worse return – which makes a mockery of the allegedly commercial nature of the transaction.
Alternatively, if buffers are much smaller, the taxpayer inevitably carries the risk. But a transaction where the taxpayer carries the risk is not a commercial transaction.
This all smells of “check mate” or “false logic”. The way out of this is set out a few paragraphs hence under the heading “A simple rule”.
Glass-Steagall.
Glass-Steagall is widely seen as a cure for banking problems. Unfortunately it is not. It DOES prevent banks making INVESTMENTS which are taxpayer backed. But it does not stop them making taxpayer backed loans that are less than 100% safe. So Glass-Steagall does not solve the basic problem dealt with here.
The complexity of Glass-Steagall, Basle, Vickers, etc.
The next flaw in regulation of the Glass-Steagall / Basle / Vickers type is its complexity.
As Martin Jacomb (Chancellor of the University of Buckingham) put it in an article about Vickers in the Financial Times, “The ring-fencing proposal involves much detailed regulation.” Or to put it more bluntly, Vickers means plenty of lucrative work for lawyers.
A second problem with complexity is that it makes it easy for banks to nibble away at the regulations a bit at a time, AND THEY SUCCEED. It is a HISTORICAL FACT that Spanish banks between around 2000 and 2005 managed to get regulations watered down. Now the disastrous results are plain for all to see.
And as distinct from “nibbling”, sometimes banks manage to have large chunks of regulation removed: Glass –Steagall.
And a THIRD result of the complexity is the authorities are quite clearly incapable of distinguishing between safe and unsafe banks. See for example here and the above article on Spanish banks. See also p.5 onwards of John Kay's paper "Narrow Banking".
IN CONTRAST, if we had relatively few and simple regulations, the merits of which everyone, especially politicians, can be made to understand, banks would have much less chance of acting as parasites on the community as a whole.
Well there is a beautifully simple rule or set of rules! Read on.
A simple rule.
Depositing money in a bank, knowing full well that the bank will loan your money on and get you a better rate of interest than if the money was not loaned on is a COMMERCIAL TRANSACTION, as mentioned above. And it is not the job of taxpayers to subsidise commerce.
Ergo, there is no justification for any taxpayer backing for the latter activity.
In contrast, there are two VERY GOOD arguments for everyone having access to a 100% safe account, if that’s what they want or need. First, it can well be argued that access to a 100% safe account is a fundamental human right. Second, there are numerous firms or other entities which would be breaking the law if they took any sort of risk with various sums of money. For example, lawyers handling clients’ money have no right to take a risk with that money, absent permission from clients.
There is thus a very simple rule that can replace Glass-Steagall, Basle, Vickers, etc., and it is this.
Depositors have to choose between, first, safe accounts, money in which IS NOT INVESTED OR LOANED ON, and which thus earn little or no interest. Second, depositors can go for what might be called “investment” accounts. Here, money IS LOANED ON, or invested. But that is a COMMERCIAL transaction, and like all commercial transactions, it offers potential rewards and potential losses. That is, the money is doing something, so a significant rate of interest is earned, but if the bank goes belly up, the taxpayer does not come to the rescue.
Laurence Kotlikoff.
The latter system is pretty much the one advocated by Laurence Kotlikoff (once described as Mervyn King’s “guru”).
Kotlikoff, in Ch 5 of his book “Jimmy Steward is Dead” suggests that all money deposited in banks should be put into mutual funds (“unit trusts” in the U.K.). Depositors would be able to choose funds of varying degrees of risk, with the least risky being what he calls “cash mutual funds”. He says “These cash mutual funds would thus represent the demand deposits (checking accounts)…”
He goes on: “In requiring that cash mutual funds hold just cash, limited purpose banking effectively provides for 100 percent reserve requirements on checking accounts.”
And the latter idea in turn amounts to much the same thing as the system advocated in the first few pages of this submission to the U.K.’s Vickers Commission.
Irving Fisher also advocated 100% reserve on checking accounts.
So there is plenty of brain power behind the idea!!!!!
I’ve been a fan of Samuel Brittan for decades, and agree with the thrust of his article in today’s Financial Times. But I don’t agree with his claim that governments should expand deficits “up to the point where the gains to output and employment are offset by the inflationary effects of a fall in the exchange rate”. That should read “up to the point where the gains to output and employment are offset by inflation.” Reasons are thus.
First, it’s a good general principle that what goes for closed economies goes for open economies, only the arguments are a bit more complicated. And in the case of a closed economy it is clearly true to say “up to the point where the gains to output and employment are offset by inflation.” Reason is that exchange rate considerations just don’t come into the picture.
Second, inflation is defined as a CONTINUOUS and excessively fast rise in prices. In contrast, the “price rise” effect of an exchange rate adjustment is not continuous: it’s a once and for all adjustment.
Third, even if we ignore point No. 2 just above and assume that exchange rate adjustments DO HAVE a genuinely inflationary effect, the only limit to the size of the deficit is inflation, period. That’s “total” inflation, or “overall” inflation. Put another way, it’s the “total amount of inflation including any inflationary effects of exchange rate adjustment” that matters. I.e. the CONTRIBUTION to inflation coming from exchange rate adjustment is a complete irrelevance: it might account of 90% of inflation or it might be 10%. Who cares? The only important consideration is TOTAL inflation.
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Martin Wolf was a member of this commission, and he claims, writing in the Financial Times, “…the Independent Commission on Banking made two principal recommendations relating to financial stability: the ringfencing of domestic retail banking from other banking activities…..”.
Er, not quite. The 2nd last paragraph of p. 11 of the ICB final report says, “…lending to large companies outside the financial sector – should be permitted (but not required) within the ring-fence.” And the left hand column of p.54 repeats the point.
“Large companies” (never mind small companies) don’t sound to me like “retail”.
Moreover, half the idea of the ICB was to try to separate high street operations from investment banking. But where do you draw the line between a loan to a business and an investment in the business? If the terms of the loan make the creditor near the last in line for reimbursement in the event of the business failing, the loan becomes very near to being a shareholding.
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The Guardian – Britain’s leading left of centre broadsheet newspaper – continues to claim that those on the Work Programme (WP) are “unpaid”. E.g. see here, here and here.
These people are not UNPAID. They are paid the same as they’d have got on benefits.
Of course that is not a desperately GENEROUS RATE OF PAY. But someone with two or more kids doing a minimum wage job is in much the same situation: take home pay is much the same as the pay they’d get on benefits. So who no outcry from the political left on the latter point? And why the blatant distortion of the facts: saying people are “unpaid” when they ARE PAID?
Presumably because the Guardian, like most newspapers, is more into propaganda rather than serious analysis or disseminating news. Plus exaggerating the plight of the downtrodden and poor (whether they really are downtrodden or not) gives Guardian journalists that halo over the head feeling when trying to make it looks as though they are riding to the rescue of the downtrodden and poor. Which in turn give me that “reach for the p*ke bucket” feeling.
Serious analysis.
The Department of Work and Pensions HAS DONE some serious analysis of the Work Programme (WP) or “Mandatory Work Activity” as they call it.
This study, at least superficially, does provide opponents of WP with some ammunition.
For example the study found that significant numbers of unemployment benefit claimants when confronted with having to do WP jobs, shifted to another form of benefit: “Employment Support Allowance”.
But that is no big surprise: professional benefit claimants can be relied on to seek another form of benefit if the type of benefit they currently claim becomes more difficult to obtain. In the 1980s and 90s hundreds of thousands if not a million or more unemployment benefit claimants switched to incapacity benefit: strange considering the improving health of the population during that period.
The latter paragraph is not supposed to suggest that a particularly high proportion of the unemployed are “professional” benefit claimants. But certainly one would expect “professionals” to make up a relatively large proportion of those who have been on unemployment benefit for some time - the sort of people likely to be confronted with WP type work.
Jonathan Portes, of the National Institute of Economic and social Research and the Guardian make much of the above “benefit switching” phenomenon. If that is the best criticism they can make of the system, it’s a pretty feeble criticism. Moreover, the benefit switching phenomenon proves nothing about WP: all it proves is that we have a somewhat chaotic benefit system.
Moreover, Jonathan Portes was just recently voicing mild approval of WP, which makes me attach less importance to his views than I otherwise would.
The indirect or macroeconomic effects.
A weakness in the above sort of Department of Work and Pensions study is that, almost inevitably, it looks at microeconomic effects, not the more important overall, or macroeconomic effects.
For example one effect of the WP is presumably to induce the unemployed to try to find jobs more quickly t – because they know they may end up on a WP placement if they don’t. That effect is very difficult to measure.
In this connection, it is important not to fall for the argument that any increase speed with which the unemployed find work is pointless because that just pushes regular employees out of work. This claim was made for example by Chris Dillow. (No disrespect to Chris Dillow, please note: he produces a large volume of interesting material every week, so I’m happy to forgive the occasional mistake.)
The reason the above “pushes regular employees out of work” argument is invalid or at least not wholly valid is thus.
If the unemployed put more effort into job searching, the effect is anti-inflationary, which in turn means government can raise demand and increase the total number of jobs. (The “pushes regular employees out of work” argument is similar to the argument that immigrants push natives out of work: both arguments are invalid for the same reason.)
Another macroeconomic route via which WP type programmes work is thus.
As unemployment falls, and full employment is approached, the marginal product of labour declines. And it continues declining till it reaches the standard wage / union wage / minimum wage, etc. At which point, employers tend to start outbidding each other for labour, rather than take labour from the ranks of the unemployed.
It follows that if the unemployed are available to employers on a subsidised basis, employers will tend to take those employees on, rather than bid up the price of existing labour (or give in more easily to wage demands). And the net effect of that is to reduce the level of unemployment at which demand pull inflation kicks in (or to reduce NAIRU, to use different phraseology).
For more on the latter point, see here.
The latter two macroeconomic effects clearly come into their own when unemployment is relatively low. But doubtless they have a finite effect at current unemployment levels.
And finally, the Guardian of course keeps rather quite about Labour’s alternative to WP. This is rumoured to involve a SIX MONTH loss of benefits for those no cooperating – shock horror.
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This article by Rogoff is riddled with mistakes. Like Niall Ferguson and Republicans, Rogoff suffers from “debtphobia”. That’s a negative psychological reaction to the overtones and innuendo of the word “debt”: bailiffs knocking at the door, etc. As for any DECENT QUALITY ANALYSIS of debt, that is thin on the ground.
He starts by referring to what he calls “the world’s most pressing macroeconomic problems” – bit of a vague category of problems don’t you think? Anyway, an example of these problems is that “Japan, meanwhile is running a 10%-of-GDP budget deficit, even as growing cohorts of new retirees turn from buying Japanese bonds to selling them.”
The suggestion here is that because a number of “retirees” are selling their government debt, the Japanese government is having problems selling its debt. Well the Japanese government JUST ISN’T having any such problems because they’re paying a negligible rate of interest on the debt. Doh!
What Keynes didn’t say.
Rogoff then goes on to say in relation to these problems (whatever they are): “One extreme is the simplistic Keynesian remedy that assumes that government deficits don’t matter when the economy is in deep recession; indeed, the bigger the better.” Nope.
Keynsians do not think that as regards the debt or deficit, it’s a case of “the bigger the better”. To quote Keynes himself, he said “Look after unemployment and the budget will look after itself”. That is, the deficit needs to be big enough to reduce unemployment as far as is compatible with avoiding too much inflation.
Deficits do not necessarily mean more debt.
Then later in the article (para starting “But who is being naïve?”) Rogoff makes the popular assumption that a deficit necessarily means increased debt.
As Keynes, Milton Friedman, MMTers and others have pointed out, a deficit can perfectly well accumulate as additional monetary base instead of extra debt. Indeed, this is exactly what has happened in several countries over the last two years or so as a result of QE.
To be pedantic, QE does not dispose of debt: it puts the debt into the hands of the central bank. But the central bank is just part of the overall government machine. So that debt might just as well be torn up, as I pointed out in the Financial Times.
Apparently studying Keynes and Friedman is not a requirement when applying for the job of professor of economics at Harvard.
Budgets balance over the cycle?
Rogoff then makes the conventional, but absurd claim that “It is quite right to argue that governments should aim only to balance their budgets over the business cycle…”
If Rogoff actually LOOKED AT the budget figures for his native U.S. or almost any other Western country since WWII, he’d find that budgets just HAVEN’T balanced over the cycle. Put another way, while there is the occasional “surplus year”, most countries run deficits in about nine years out of ten. That is, it’s basically a case of a constant and non-stop deficit. And there is a very simple reason for this, as follows.
Given the 2% inflation target that most countries go for, that inflation necessarily means the national debt and monetary base will shrink at 2% a year in real terms (or at whatever rate of inflation actually occurs). Assuming the national debt and monetary base are going to remain constant relative to real GDP (which roughly speaking is the reality over the decades) that means both have to be topped up in nominal terms on a regular basis. And that means a more or less constant deficit.
In addition, there is the fact that real GDP expands more or less year after year. And that means even more “topping up” if the national debt and monetary base are to remain constant relative to real GDP.
Private Sector Net Financial Assets.
Arguably the above point about 2% inflation leading to a PERMAENT deficit is a bit pedantic. However a more fundamental criticism of the idea that the budget should balance over the cycle is thus.
The private sector, for reasons best known to itself, may decide it wants an increased or reduced stock of what MMTers call “Private Sector Net Financial Assets” (PSNFA): that’s monetary base and government debt. This phenomenon has actually occurred over the last couple of years or so: that is, as is fairly predictable, a reaction to fingers being burned as a result of the crunch has been a desire by the private sector to save, i.e. hoard additional PSNFA.
Now where this desire to hoard arises, the government / central bank machine will just have to supply additional PSNFA, else we get paradox of thrift unemployment.
So, far from it being desirable to “balance the budget over the cycle”, the budget should be whatever supplies the private sector with the PSNFA it wants. And that could for example be be a deficit lasting two cycles, followed by a surplus lasting for another two cycles.
Paying back debt is not deflationary.
Next, he makes the appealing but nonsensical claim that we should be wary of debt financed stimulus because the debt will eventually have to be paid back. And in connection with repaying this debt he says, “The drag on growth is more likely to come from the eventual need for the government to raise taxes…”
The first weakness in that point is that in reality much of the debt gets whittled away in real terms by inflation.
Second, as long as the real or inflation adjusted rate of interest paid on debt is around zero (which it is in the U.S., U.K. and Japan for example), the debt can be left in place ad infinitum if need be: there is no need to repay it and endure any sort of “drag on growth”.
Third, there is of course the possibility (which clearly gives Rogoff and Niall Ferguson nightmares) that the private sector becomes less willing to hold government debt, with the result that interest paid on such debt rises.
Rogoff obviously thinks that the only way debt can be paid back is for government to raise taxes and pay back the debt. And indeed any such “raise taxes and pay back debt” policy would indeed be deflationary.
In fact, a national debt can be paid off with no deflationary (or stimulatory) effect at all. All the relevant government need do is to proceed as follows.
Step No.1: as Rogoff suggests, raise taxes and pay off some debt. That, as Rogoff rightly suggests is deflationary. So enter step No.2 stage left: get some of the money for the debt “pay back” from simply printing new money. The latter has a stimulatory or inflationary effect. And as long as the deflationary effect of the tax increase equals the latter deflationary effect, then the debt is reduced with no overall stimulatory or deflationary effect. QED.
A technicality relating to foreigners.
To be strictly accurate, the above point about paying back debt not being deflationary is 100% true in that the debt is held by domestic entities. In contrast, debt held by FOREIGN entities is different. If (and only if) foreigners withdraw their money from a country on being paid back money in exchange for the debt they hold, there is obviously a foreign exchange hit for the country concerned. But that “hit” will have been balanced by a foreign exchange benefit when foreigners originally bought their debt. So this “foreign” point is a bit of an irrelevance. For more on this see here.
Conclusion:
I rather sympathise with those Harvard economics students for walking out of their lectures (Rogoff and Ferguson are both Harvard academics).
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P.S. (13th June 2012). Here is something for the Rogoff / Ferguson doomsday brigade to think about. The idea that an increased debt will lead to an interest rate spike, is – how can I put it – not exactly supported by this chart, which comes to us thanks to Mike Norman. Debt has soared over the last twenty years, while interest rates have plummeted!
Of course this is all a bit misleading, for example the high nominal interest rates around 1980 were to a significant extent compensation for inflation. That is, REAL interest rates were not as high as they would seem from the chart. Plus it is undeniable that if debt rises relative to GDP, all else equal, rates WILL RISE at some point.
But it’s a nice chart all the same.
The root cause of Spanish banking problems, and indeed pretty wall all banking problems, is as follows.
When anyone deposits X money units at a bank ($,£,etc) the bank undertakes to return the same number of units (possibly plus some interest and possibly minus administration expenses).
But banks also lend the money on to a variety of borrowers who are certainly NOT GUARANTEED to return the money: they may go bust.
Thus the central promise made by banks is a complete nonsense: it’s a confidence trick. (Yes I know I’ve made this point before: I’ll carry on banging on about it till I get the point across.).
Unfortunately, the above confidence trick is one that banks have fooled governments into underwriting: politicians are easily fooled.
Does adequate capital solve the problem?
It might seem that the above risk run by banks can be dealt with by ensuring that banks have adequate capital. But just look that the shambolic history of the “adequate capital” idea. A few months prior to the collapse of Northern Rock (according to Mervyn King), the best capitalised bank in Britain was . . . . . Northern Rock. So the "experts" who set up the rules that determined and defined capital adequacy for banks prior the collapse of Northern Rock were obviously clueless.
So have British and European authorities learned anything since the collapse of Northern Rock? Nope. They learned nothing.
In 2011, the European Banking Association, plus the European Central Bank and the European Systemic Risk Board supervised stress tests on all major European banks, and what do you know? Bankia, the shambolic Spanish bank passed with flying colours.
Bankia now needs 20 billion Euros and counting if it’s to avoid going belly up. The whole capital adequacy idea is a farce. It is a nonsense.
It’s OK in theory, but the REALITY is that banks talk politicians into buying bum steers. So what we need is an ultra simple set of rules that the fraudsters and crooks who run banks cannot talk their way out of.
Here is a simple rule.
The solution is for us to call an end to the above confidence trick which is at the heart of banking.
Where anyone deposits money in a bank which in turn lends the money on to any sort of private sector or commercial entity, the bank should be forbidden to make promises about the depositor being guaranteed to get their money back.
Indeed, all communications from the bank to the depositor should contain a health warning to the effect that “you are NOT GUARANTEED to get your money back”.
Such a depositor is effectively into commerce. What they are doing is no different to investing on the stock exchange.
Everyone has right to a 100% safe account. But the only circumstance in which the state should give a guarantee that money will be returned is where the state itself looks after the money: i.e. where the money is deposited at the central bank.
That does not mean that central banks need to open accounts for everyone wanting a 100% safe account: private banks could perfectly well act as agents for central banks: i.e. collect money from those wanting 100% safe accounts and deposit the money at the central banks.
Re the above “you are not guaranteed to get your money back” stipulation, there are numerous ways of working this, and individual banks can probably be left to sort this out themselves. For example, one option would be to let the value of each currency unit deposited at a bank FLOAT in the same way as the market price of a unit trust or mutual fund units float up and down. To illustrate, the value of every thousand Euros deposited at Bankia a few years ago would by now be near worthless.
The latter proposal is very similar to the “limited purpose banking” idea put by Laurence Kotlikoff in his book “Jimmy Stewart is Dead”. Incidentally, Kotlikoff is said to be Mervyn King’s “guru”.
Beware of bankster lies.
Private banks will of course object to the above proposal, and on the wholly specious grounds that restricting bank lending will curb economic growth.
That argument is TOTAL AND COMPLETE BULLSHIT, and for the following reason.
Removing the above state guarantee for bank deposits, that is the “too big to fail subsidy” (not to mention the occasional 20 billion Euro bailout) will of course reduce lending. But the optimum amount of lending, just like the optimum amount of any commodity, will not be attained if the commodity is subsidised! I.e. the optimum amount of bank lending is almost certainly a lot less than currently takes place.
Of course removing the TBTF subsidy will have a deflatinary effect. But that effect is easily countered by a dose of stimulus.
The net result would be less bank lending based economic activity relative to other forms of activity, e.g. equity funded activity, or activity that does not require so much capital investment.
A further point that supports the idea that we need less bank lending is thus. Bank assets relative to GDP have expanded a whapping TENFOLD relative to GDP over the last 30 years, and to what benefit? Anyone know? Growth is no better than 30 years ago: indeed over the last 5 years, growth has been HOPELESS compared to 30 years ago. (See p.3 of this Bank of England publication regarding the above expansion of UK banks over the last 30 years.)
Incidentally, I’m nowhere near the first person to suggest that banks’ objections to tighter regulation are a pack of lies. This Financial Times front page report made the same point.
Endnote.
Hat tip to Frances Coppola for the above link relating to the European Central Bank, and other Euro organisations.
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The above crass idea is promoted by many in high places: for example The Economist, the U.S. Treasury, Brad DeLong and Larry Summers.
The first and obvious flaw in the above argument is that infrastructure investments last for DECADES. And there is no reason to suppose that current low interest rates will last that long. Doh!
Second, a monetarily sovereign government does not need to borrow, since it has the power to print. So never mind interest rates being LOW: such a government can obtain money at NO COST AT ALL!!!!!
So would it make sense for government in a recession to fund infrastructure investments with freshly printed money? The answer is “no”: because in order to best allocate resources as between investment goods and consumer goods, some sort of FREE MARKET rate of interest should be debited to the relevant investment – not the artificially low rates at which government can come by money.
In fact it has long been recognised by the economically literate that even when a country is NOT IN A RECESSION, government should not calculate the merits on investment projects on the basis of what it costs government to borrow. Reason is that government has an unfair advantage when it comes to borrowing: it is an ultra credit worthy borrower on account of its ability to extract money by FORCE from the population.
I dare say the Italian Mafia can borrow at relatively low interest rates and for similar reasons. That does not mean that investments made by the Italian Mafia are particularly clever or worthwhile.
In a recession, the conventional wisdom is that governments should cut interest rates. Why on Earth investment goods should suddenly become more worthwhile relative to consumer goods just because there is a recession is a mystery. In fact the whole idea is a load of codswallop. That is, there is no good reason to boost investment spending rather than consumption spending in a recession.
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Or so was told recently be someone who deals in metals. He also said the same applies to some US coins.
Anyway, UK copper coins are being replaced with a copper coloured steel alloy. Seems about half of UK “coppers” are real copper and half are now steel and you can tell the difference with a magnet.
This magnet picked up steel coppers from a distance of at least a centimetre.
As for real copper coins, the magnet didn’t want to know anything about the coin, even from a distance of 3mm or so. And as far as the copper coin was concerned, the sentiment was entirely mutual.
Principle No. 1: Access to a 100% safe bank account is a basic human right.
Principle No. 2: If an account is to be 100% safe, the relevant money cannot be invested or loaned on by the commercial bank concerned: the latter involves risk, and risk is not compatible with 100% safety. Or put another way, if the money in an allegedly 100% safe account IS LOANED ON or invested, then someone somewhere carries the risk and it’s the taxpayer: the depositor and the relevant bank profit at the expense of the taxpayer.
Principle No. 3: With the exception of the above semi-commercial 100% safe accounts, it is not the taxpayer’s job to subsidise commerce: that is commerce in general or the commercial activities of banks. Thus where money deposited in a bank IS LOANED ON or invested, the taxpayer is under no obligation to come to the rescue if it all goes wrong. In the same way, the taxpayer does not rescue those who act in a commercial manner by investing in the stock exchange.
Indeed it is a blatant absurdity that when a household invests in corporate bonds and the corporation goes bust, taxpayers do not reimburse the household, yet when the same household deposits money in a bank, which in turn lends to the same corporation, the household IS REIMBURSED if the bank also goes bust as a result.
Principle No 4: Since private sector banks are demonstrably incapable of supplying a country with a stable money supply without the taxpayer periodically coming to their rescue (during financial crashes, credit crunches, etc), a nation’s money supply is best provided only by its government and central bank. That is, full reserve is preferable to fractional reserve.
(A good 95% of money in circulation is currently provided by private banks rather than central banks.)
Principle No 5: As pointed out in a Financial Times front page lead story, commercial banks will use any old fraudulent or deceitful argument to prevent the above sort of restrictions on their activities. A common argument they cite is that restrictions on commercial bank activities impede economic growth, or will be deflationary.
The simple answer to that is that any government in combination with its central bank can provide stimulus whenever needed, and in whatever amount is needed to counteract any deflationary effect that comes from restricting commercial bank activities.
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The UK’s “Independent Commission on Banking” produced an interim report and a final report. The interim report dismissed full reserve in a few sentences, while the final report had nothing to say on the subject. Thus the interim report’s “ideas” (to put it politely) on this subject are presumably contained in the interim report.
The purpose of this post is not to argue for full or fractional reserve, but just to deal with the commission’s flawed ideas on the subject.
The first relevant section is 4.120, which reads, “Like narrow banking, a complete move from fractional to full reserve banking would drastically curtail the lending capacity of the UK banking system, reducing the amount of credit available to households and businesses and destroying intermediation synergies. To its proponents, this shrinkage of credit is a benefit, as it removes the current ability of banks to ‘create money’, a prerogative they consider should be reserved for the state.”
Well full reserve clearly would “curtail” bank lending, ALL ELSE EQUAL.
But the advocates of full reserve do not propose (surprise, surprise) leaving all else equal. They propose making good the deflationary effect of banning fractional reserve by increasing the monetary base.
By the same token, if banks make part of their profit from foisting payment protection insurance on people who don’t need it (or from bashing old ladies on the head and stealing their handbags), then the latter two undesirable activities should be banned. And very possibly that would constrain banks’ ability to lend. However it would be patently absurd to argue that foisting payment protection insurance on people or bashing old ladies on the head should therefore be permitted.
If banks currently do something undesirable, the activity should be banned. As to any deflationary effect, that can be easily dealt with by giving the economy a dose of stimulus – by increasing the monetary base or whatever.
More monetary base means less credit is needed.
Over the last couple of years the authorities in several countries have in fact increased the monetary base, though not of course because they have switched to full reserve. And they’ve channelled the extra funds to a large extent into the pockets of the wealthy, and the incompetents and fraudsters who run banks: a stroke of genius.
But assuming the extra money is effectively held by ordinary households and businesses, there’d be a reduced need for the “credit” which the commission makes much off. To illustrate, for every extra thousand you have in your bank account, that’s one thousand less that you need to borrow, should you want to borrow so as to buy a house or car.
(Incidentally, I used the phrase “effectively held by ordinary households” above for the following reasons. Strictly speaking, monetary base can only be held by banks. However, if for example a household sells Gilts, the household gets a cheque from the Bank of England, which the household deposits at its commercial bank. The net effect is that the household holds extra “commercial bank” money, while the commercial bank holds extra monetary base. However, the commercial bank is only acting as an agent or intermediary here: effectively, the household holds monetary base).
What are “intermediation synergies”?
Next, section 4.120 claims full reserve would curtail “intermediation synergies”.
As to exactly what these "synergies" are, there is no explanation, thus the word “synergies” looks like an important sounding word slipped into the text with a view to impressing all and sundry. It does not impress me.
As regards “intermediation”, there is one form of intermediation would be left untouched by the switch from fractional to full reserve: that is the fact that banks bundle up the money from a large number of small deposits and turn them into larger loans to a smaller number of borrowers (or at least a different NUMBER of borrowers).
As to intermediation in the form of maturity transformation (“borrow short and lend long”), it was precisely this that brought down Northern Rock, and has brought down hundreds of banks throughout history. Thus we needn’t shed tears about restricting or banning maturity transformation.
Or as Martin Wolf put it, “To these points must be added the vulnerability inherent in borrowing “short and safe”, in order to lend “long and risky”. If we were not so familiar with banking, we would surely treat it as fraudulent.”
Safe accounts and investment accounts.
The next relevant section of the commission’s report is No. 4.121 which reads, “Some have argued that full reserve banking should be mandated as an option for all deposits, so that depositors could choose whether or not their money was lent on. It is important to find safe deposit options and having these options might help to reduce the need for a government guarantee applicable to all deposits. However, safer deposit options than bank deposits do already exist (such as National Savings & Investments or safety deposit boxes), although these do not offer the same transactional capabilities as a current account. There is no prohibition on the establishment of a full reserve bank (or a narrow bank) which could provide such capabilities, though it would likely have to charge for them. In light of deposit insurance, mandating that all depositors have such an option appears unnecessary.”
As regards the first sentence, this implies that lending is not possible under full reserve. That is not true. Under a full blown full reserve system commercial banks can perfectly well lend: it’s just that they have to obtain ALL THE FUNDS for lending from depositors rather than create some or all the funds out of thin air.
Safe and investment accounts.
The rest of that section claims that the purpose of full reserve is to give depositors the “option” of safe accounts, and that because such ultra-safe accounts already exist, full reserve “appears unnecessary”, as they put it.
But what’s the point in putting your money into these existing safe accounts when the taxpayer underwrites riskier and more profitable forms of deposit account?
Half the problem with the existing bank set up is that banks, plus their customers can have their cake and eat it: that is, profit from risk taking when the risks pay off, but have the taxpayer foot the bill when the risk does NOT PAY OFF. And this is one of the main problems the commission was supposed to sort out: it is one of the main questions on which the commission was supposed to have some expertise!
Those who advocate 100% safe deposit accounts where the money is not loaned on at all or is loaned on in an ultra-safe manner do not just want to make this an “option”, as the commission calls it. They want to FORCE depositors to choose between safe accounts and riskier or “investment” accounts where depositors are acting in a COMMERCIAL manner, and are thus not entitled to taxpayer support if it all goes wrong. At least this is what was proposed in the joint submission to the commission authored by Prof. Richard Werner, Positive Money and the New Economics Foundation. And the above “force” (absent blatant fraud) ensures that taxpayers do not have to bail out the above “have our cake and eat it” crowd.
Under the current system, if Joe Bloggs lends directly to corporation X, Y and/or Z (e.g. by buying their bonds) and it all goes belly up, Joe Bloggs loses his money. In contrast, if Joe Bloggs deposits money in a commercial bank, and the bank lends Joe Bloggs’s money to the above corporations, and it all goes belly up, the taxpayer rescues Joe Bloggs.
That is an absurdity which the above mentioned Werner submission deals with. In contrast the Vickers commission fails to deal with the absurdity because it specifically allows banks to lend depositors’ money to corporations behind their much vaunted “ring fence”.
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