Tuesday, 30 June 2015

Germany benefits from EZ membership?

There is an ever popular economic fallacy: the old mercantilist view that exports are good and imports are bad. And a particular example of that fallacy is that a country (e.g. Germany) which gives up a strong currency (the Deutschmark) and joins a currency union which has a weaker currency will gain because membership of the weak currency union enables that country to export more.

Umair Haque is the latest of a long line of individuals to fall for that fallacy (see his No.3 here).

Let’s say a country (Germany) with an external position that is in balance (exports equal imports) forms a currency union with a country (Greece) which has an external deficit (imports exceed exports). What’s the best price for the new currency in terms of US dollars, Japanese Yen, etc? Well one not bad answer is a price that gives the new “country” an external position which is in balance (exports equal imports).

But that leaves Germany with an external surplus and Greece with an external deficit, and that can’t go on for ever. One solution is to boost demand in Germany so as to raise its inflation rate and render it less competitive. Another solution, the one favored currently in the EZ, is to depress demand in Greece so as to cut Greece’s costs and make it more competitive. Either way, everyone’s external position eventually reverts to balance, at least in theory. More particularly external balance combined with full employment is achieved (in theory).

So in the long run, Germany is no better off!

Of course the above involves a temporary period during which Germany accumulated foreign currency and then presumably spends it. But why  is that of any great benefit to Germany? Accumulating $X over say a three year period, and then spending it over the next three years comes to the same thing as not accumulating those dollars at all. It comes to the same thing as running a balanced external position for the whole of those six years.

Moreover, it can’t even be argued that during the first three years (the period during which foreign currency is accumulated) that Germany is any better off. Reason is that during that period, all Germany does is to accumulate foreign currency instead of accumulate or consume real goods and services. And it’s very debatable as to whether you are better off with $Y of cash rather than $Y of real goods.

There is more on the above mercantilist myth here and in this article entitled “Imports are a benefit, exports are a cost. Is it clear now?”

Monday, 29 June 2015

Inane drivel from the Bank of International Settlements.

Assuming the above headline from The Telegraph correctly summarises BIS thinking, then there is nothing that remotely resembles "thinking” going on at the BIS.

If interest rates are at zero that does not, contrary to the suggestions of BIS idiots, prevent further stimulus. All a country that wants more stimulus has to do is print fresh money and spend it, and/or cut taxes. The fact of spending that money, e.g. on health or eduction, creates jobs in hospitals and schools. Moreover, that spending equals extra money (base money to be exact) in the hands of the private sector. And that induces the private sector to spend more: i.e. raise demand.

The average street sweeper has worked out that when people win a lottery they spend more. Evidently some of the world’s leading economists have not worked that out.


P.S. Dean Baker also has a go at that BIS report. And a few hours later, Tim Worstall as well.

Sunday, 28 June 2015

Self pitying, deluded, victimhood seeking drivel from Tsipras.

The first para of his speech reads:

"For the past six months the Greek government has been giving battle in conditions of unprecedented economic asphyxiation, to implement your mandate, of Jan. 25. It was a mandate to negotiate with our partners to end austerity and to restore prosperity and social justice to our country."

End of austerity? Well that sounds great. Every simpleton will back the abolition of austerity. But how exactly do you do that ? In particular how does one deal with a particular country’s lack of competitiveness in a common currency area without imposing austerity for a period and with a view to cutting it’s costs and thus improving its competitiveness?

For every hundred people putting on a public display of weeping and wailing about austerity only about one has any interest in think thru workable solutions to the problem. After all, working out practical solutions involves hard work and thought (shock horror).

The reality is that in a common currency area there is no alternative, though a possible alternative is fiscal union. But that ALSO requires generosity on the part of richer or more competitive countries, and if that generosity is not there under the existing regime in the EZ, it probably won’t be there in the case of fiscal union.

Later on he says:

“These proposals clearly violate European social rules and fundamental rights to work..” 

Wow. So Tsipras knows how to guarantee everyone the “right to work”? Hilarious. The idea that any politician, especially deluded leftie politicians know how to guarantee everyone the “right to work”  is straight out of la-la land. Next:

"To this blackmail-ultimatum, for the acceptance on our part of a strict and humiliating austerity (proposal), and with no end to it in sight nor with the prospect of allowing us to ever stand on our feet economically or socially..."

Tsipras: you’re free to “stand on your own feet” any time you want, you faux cripple, in the form of getting your self your own currency, i.e. returning to the Drachma. But that involves an element of RESPONSIBILITY doesn’t it? And Greeks just HATE responsibility. E.g. Greeks are the world’s worst tax evaders. Plus they’re the world’s experts at cheating creditors, not to mention cheating their way into the Eurozone in the first place.

Irresponsibility is much preferable: that’s irresponsibility in the form of borrowing billions, burning your way through it and then crying wolf when creditors want their money back. But credit where credit is due: borrowing money and not paying it back is VERY PROFITABLE. You get top marks for chutzpah.

For banksters, wheedling billions of dollars of taxpayers’ money out of politicians is child’s play. So in a sense you can’t blame banksters for doing that. Likewise, Greeks can’t be blamed for trying to wheedle billions out of gullible North Europeans.

"Greece is, and will remain an indispensable part of Europe… "

No: Greece has about 3% of the EU’s population. No group of people making up just 3% of the population of Europe are indispensable to Europe. The cities of London and Paris have about the same population as Greece. Neither of those cities are “indispensable” to Europe.

If Islamic State let off a nuclear weapon in London or Paris, something they’d dealy love to do of course, and wiped out the population of those cities, Europe would carry on. And if the entire population of Greece emigrated to central Siberia, there’d be a huge sigh of relief in Northern Europe and Europe would carry on.

Thursday, 25 June 2015

Only dummies think government debt is a debt.

Summary.      The only good reason for government debt is to supply the private sector with paper assets and with a view to minimising Keyens’s paradox of thrift unemployment. But so called debt of that sort is not debt in any normal sense of the word debt. The reason is thus. To repay a debt normally means the debtor transfers something of real value to the creditor. But (assuming the economy is at capacity) as soon as the private sector tries to get anything of real value, i.e. goods and services, in exchange for the so called debt it holds, government will react by confiscating a chunk of that debt to make sure the private sector STOPS trying to get anything of real value in exchange for the debt it holds. The reason is to stop the inflation that would otherwise result from that "exchange". That’s exactly like robbing a bank of $X as soon as it demands you repay the $X you owe it.

That makes government debt a very strange form of debt. In fact it’s not debt at all. At least that’s certainly true of debt held by natives. In contrast, debt held by foreigners is more in the nature of genuine debt. But that form of debt can be minimised by keeping interest on the debt near zero.

Level of difficulty of this article: probably well within your grasp if you concentrate, but way beyond the comprehension of numerous Harvard professors, especially Kenneth Rogoff, Carmen Reinhard and Niall Ferguson...:-)



Base money (at least in theory) is a liability of the state or central bank. And that money normally pays no interest. It certainly pays no interest when it comes in the form of notes and coins.

I say “in theory” because while base money appears on the liability side of a central bank’s balance sheet, and while £10 notes in the UK say “I promise to pay the bearer on demand the sum of £10”, you won’t get anything from the Bank of England if you demand £10 of gold or anything else in exchange for a £10 note. So to that extent the alleged “liability” element of base money is nonsense.

In contrast to base money, there is so called government debt which sometimes pays a very low rate of interest, as in Japan. And even in some European countries in recent years, the REAL or “inflation adjusted” rate of interest has been negative. So in those cases there is no sharp distinction between base money and so called national debt. In particular, government debt near maturity, whether it pays a high or low rate of interest, is almost the same as cash.

As Martin Wolf (chief economics correspondent at the Financial Times put it), “Central-bank money can also be thought of as non-interest-bearing, irredeemable government debt. But 10-year JGBs yield less than 0.5 per cent. So the difference between the two forms of government “debt” is tiny…”

Moreover, as advocates of Modern Monetary Theory (MMT) often point out, a government which issues its own money (e.g. the US, Japan, or UK) can pay any rate of interest on its debt it likes. If it wants to reduce the rate, it just needs to print money and buy back the debt, or cease rolling over debt as it matures. And as to any excessive stimulatory or inflationary effect of that, the inflationary effect of the recent bout of QE has been near non-existent, but if there WERE an excessive inflationary effect, that’s easily dealt with by raising taxes and “unprinting” the money collected.

So that all raises the question as to what the optimum amount of debt is.

As MMTers also often point out, base money and debt are the same in that they are both what MMTers call “private sector net financial assets” (PSNFA). That is, they are assets as viewed by the private sector holders of base money and debt.

Also, as MMTers often point out, private sector spending is related (at a given rate of interest) to how much PSNFA the private sector holds. I.e. the more PSNFA the private sector holds, the more it will spend, all else equal. So one purpose of PSNFA is to keep the private sector spending at a rate that brings full employment. But since there is little difference between base money that pays a low rate of interest (aka debt) and base money which doesn’t, it’s legitimate to ask what the point of paying any interest at all on the debt is.

One apparent reason is that paying a relatively high rate induces the private sector to abstain from spending and save up so as to buy PSNFA / debt. And that leaves room for public spending.

In that case government can be said to be borrowing from the private sector.

Borrowing for current and capital spending.

Well no one supports government borrowing so as to cover CURRENT spending, though some argue that government should borrow so as to cover CAPITAL spending.

However, the fact of making a capital investment does not of itself justify borrowing: a taxi driver would not borrow to buy a new taxi if he or she had enough cash to spare.

As for the popular idea that borrowing spreads the burden of making an investment across generations, that argument does not stand inspection.

The stimulus argument.

Another popular argument for government borrowing is that it’s a way of funding stimulus. Actually it’s a completely barmy way of funding stimulus, and the reason is simple: borrowing has a DEFLATIONARY or “anti-stimulatory” effect. Now what’s the point of doing something anti-stimulatory” when the object of the exercise is stimulus?

As Keynes said, stimulus can be funded by printing or borrowing money. The print option is clearly the simpler.

So to return to the question asked a few paragraphs above: what’s the point of government borrowing? It seems there’s only one point, namely to supply the private sector with the PSNFA it wants. And that in turn begs this question: if supplying the private sector with PSNFA is the only object of the exercise, why pay any interest on the debt?

Well Milton Friedman and Warren Mosler suggested paying NO INTEREST at all: that is they argued that the state should issue only one liability, namely base money on which no interest is paid. And certainly there’s something to be said for that policy.

However, there IS AN argument for turning a portion of base money into bonds and paying a small rate of interest on it. That is that base money is volatile stuff (which is possibly why it  is sometimes called “high powered money”). That is, it’s always possible the private sector goes into a fit of irrational exuberance and tries to spend away a large chunk of that money. In contrast, it’s much more difficult to spend government bonds.

But whatever the truth of that point, the fact remains that the only logical reason for government debt is to supply the private sector with the PSNFA it wants.

So, in what sense is government debt actually a debt?

A debt is an obligation by the debtor to give or return to the creditor something of real value at some point. Normally that is money, but it’s not necessarily money. E.g. if I borrow my neighbour’s car for the day, I’m in debt to my neighbour to the tune of one car. The debt is extinguished when I return the car.

Now assuming the only point of government debt is to supply the private sector with the PSNFA or paper assets it wants, in what sense is government obliged to transfer to the private sector anything of real value? Of course when some debt reaches maturity, government has to give debt holders base money in exchange for their debt. But as pointed out above, debt at a low rate of interest is almost the same thing as base money. Plus that debt will probably just get rolled over, so government does not on balance give the private sector anything of real value there.

Another possible scenario is that the private sector uses its stock of base money to buy some of the goods and services that governments supply, it which case there would be a transfer of something of real value from the public to the private sector. Alternatively, the private sector might try to purchase more goods and services than normal from other private sector entities.

But in both of those cases, and assuming the economy is already at capacity, the result will be excess demand. And the government / central bank machine will react to that by imposing some sort of deflationary measure: for example raising the budget surplus or cutting the deficit. But that amounts to expropriating or robbing the private sector of some of PSNFA.

So to summarise, assuming the economy is at capacity and the private sector tries to get something of real value in exchange for its stock of paper assets (PSNFA), government will simply react by confiscating PSNFA so as to make sure the private sector CEASES TO get any more stuff of real value.

Now imagine you owe your bank $Y and that as soon as the bank demands repayment of that money, you’re entitled to rob the bank of $Y.

In what sense are you “in debt” to the bank? Well you aren’t IN DEBT are you?


The only good reason for government debt is to ensure that the private sector has the paper assets it wants, and with a view to making sure there is no Keynsian paradox of thrift unemployment. But that so called debt is not a debt in any normal sense of the word because as soon as the private sector tries to have government repay its debt, government will simply confiscate a chunk of that debt or base money from the private sector so as to dissuade the private sector from trying to get government to repay its so called debt.

The only exception to the above points comes with government debt held by foreigners.  Government does not have the same freedom to grab money off foreigners as it does in the case of natives. Thus for example dollars or US government debt held by non US citizens is more in the nature of a genuine debt held by those foreigners, and which will involve the US in a genuine sacrifice should those foreigners decide to cash in their investment. But that’s just another argument for keeping interest on the debt near zero: that way, foreigners are dissuaded from stocking up on too much of the currency or debt of the relevant country.

P.S. 28th June 2015.      Coincidentally Warren Mosler made the same point as me using seventeen words in a tweet two days after I published the above. He has been making the same point for years, so I'm not suggesting he copied me - more likely the other way round: me subconsciously copying him.

Wednesday, 24 June 2015

Tired of the word “neoliberal”?

Google the words “neoliberal” and “Eurozone” and you’ll find hundreds of articles by lefties all of them outraged, or pretending to be outraged, by the allegedly “neoliberal” Eurozone.

The word neoliberal is currently very much in vogue in leftie circles. In contrast “multicultural” and the phrase “cultural enrichment” seem to have gone out of fashion.

Now the idea that the Eurozone is neoliberal is a bit of a laugh and for the following reasons.

Neoliberalism is more or less synonymous with a belief in free markets. Indeed Wikipedia says “Neoliberalism is famously associated with the economic policies introduced by Margaret Thatcher in the United Kingdom and Ronald Reagan in the United States.”

But hang on: who was most in favour of the Euro and in favour of Britain joining the Euro a decade or so ago? Political left or political right? Well it’s hard to say, but certainly when Britain was trying to decide whether to join there were a number of lefties describing those opposed to joining as “little Englanders” and even xenophobes.

Moreover, the rules governing the Eurozone were clear from the start. In particular it was clear that it involved monetary union, but certainly not fiscal union: i.e. no sort of free hand-outs to less competitive countries or areas funded by more successful countries / areas of the sort we have in the UK in the form of assistance for poorer regions funded by the South East.

But now it’s all change. Apparently the Euro is now a wicked neo-Thatcherite / neoliberal project.

Hope that’s clarified the matter for you.

(h/t Tim Worstall)

Tuesday, 23 June 2015

The Guardian’s Racist Housing Proposals.

The Guardian, Britain’s “holier than thou / wouldn’t touch racism with a barge pole” newspaper, has just published an article by one of its regular columnists, Zoe Williams, proposing a blatantly racist housing policy. The policy is to “ban the ownership of housing by foreign non-residents.”

I trust you’re foaming at the mouth and jumping up and down with contrived righteous indignation.

Of course Guardianistas will doubtless argue that that policy is not racist because it does not specifically refer to race: it refers to FOREIGNERS.

Well the problem with that argument is that if you express concern about immigration in general, i.e. without regard to race, you’re guaranteed to be accused of racism, Nazism, xenophobia and worse by hoards of screaming lefties.

Moreover, the basic purpose of Zoe Williams’s plan to ban foreigners from buying property in the UK is to reduce house prices in the UK. Well that can be done very simply and without discriminating against foreigners by banning the purchase of second homes regardless of the nationality of the would be second home owner, or by placing some sort of special tax on all second homes. (Local authorities actually already have the right to charge extra council tax on empty properties).

So there’s absolutely no need for discrimination against foreigners. I’m appalled...:-)

And just to rub salt into the wound, The Guardian supports the political party which took part in the slaughter of a million Muslims in Iraq for no very good reason: the worst act of racism since the Holocaust…. while giving us sermons on racism. Meanwhile Britain’s allegedly racist “far right” parties opposed the war from day one.

Don’t  you just love it?

Friday, 19 June 2015

Fractional reserve banking is in check mate.

The powers that be, the great and the good, and so on, keep paying pay lip service to the principle that commercial banks should not be subsidised. So do they advocate that government should announce loud and clear that under no circumstances will there be any sort of taxpayer funded support or backup for banks in trouble? You bet they don’t.

Reason is that they want to have their cake and eat it: that is, the banker / politician nexus, the revolving door brigade and associated hangers on want to appear virtuous in the form of being seen to earn their keep in a genuine free market, at the same times as ensuring that their “keep” is safeguarded by taxpayer funded subsidies and backups.

But if government WERE TO ANNOUNCE loud and clear that under no circumstances would private banks get any sort of taxpayer funded assistance when banks have problems, then all of those who fund banks (including depositors and bondholders) would ipso facto become bank shareholders: at least shareholders as in “someone who at worst stands to lose everything when the relevant bank is bust”. And a bank system under which banks are funded just by shareholders is what’s called “full reserve banking”.

It COULD BE argued that we could retain depositors and bondholders in the conventional sense of the words if banks are backed up by some sort of COMMERCIALLY VIABLE insurance system (like the US FDIC system). But there’s a big problem there, as follows.

Shareholders are people who by definition insure themselves. In contrast, it’s perfectly possible to have depositors and bondholders who are insured by some third party like FDIC (as suggested just above). But assuming an FDIC type insurer gauges the insurance premium correctly and assuming shareholders also charge the right implicit insurance premium, then the total cost of funding banks will be the same in each case, except that there actually several problems with “third party” insurance, as follows.

1. There are administration costs involved in “third party” insurance.

2. There’s always a temptation under third party insurance to cheat the insurer: 10% of claims in the UK relating to house and car insurance involve an element of fraud. And both “1” and “2” involve REAL COSTS.

3. Under third party insurance, bankster / criminals will NEVER EVER give up bribing and cajoling politicians into charging a less than fully commercial premium, assisted by sob stories about the economy suffering if allegedly onerous impositions are placed on banks.

So which of the following two is better. A fractional reserve system with the latter three defects or a system where banks are funded just by shareholders, which equals full reserve banking?

No contest.

Fractional reserve is in check mate.

Wednesday, 17 June 2015

Modern monetary theory and Simon Wren-Lewis.

Summary:      In as far as government incurs debt and runs deficits to deal with lack of aggregate demand, we should never have debt or deficit reduction targets. The debt and deficit should simply be whatever maximises employment without the inflation target being exceeded by too much. Moreover, deficit adjustments (and the debt adjustments that result from that) should ideally be the ONLY tool used to adjust demand.  That is, interest rate adjustments should only be used in an emergency.


Simon Wren-Lewis is an Oxford economics prof and I’ve never been totally happy with his analysis of national debts and deficits, thought I fully back his criticisms of what he calls “macromedia. That’s the simple minded equating of government debt and deficits with the debt and deficits of microeconomic entities like a household or individual person.

That conflation is a classic example of one of the most popular mistakes in economics: applying microeconomic thinking or laws at the macroeconomic level. And the majority of politicians and perhaps roughly half of economics commentators working for newspapers make that mistake.

With a view to trying to show how modern monetary theory (MMT) is a bit better than SW-L theory here, I’ll start with the MMT take on national debts and deficits – at least what I think the MMT take is.

There is of course no central MMT authority to turn to get the “official” MMT view here, any more than there is one central authority for the official Keynsian, monetarist, or Austrian view on anything. But I suspect most MMTers will agree with my suggestions as to what the MMT take is.

Be warned however: setting out MMT thinking takes about a thousand words below before we turn to showing how that is a bit better than SW-L thinking.

Also, and to repeat, I’m not saying there is a FUNDAMENTAL difference between MMT and SW-L. I’m dealing with minor differences. But it’s of benefit to get everything 100% right in this area, as thousands of jobs depend on getting things 100% right.

Another important initial point is that the discussion below refers to a country that issues its own currency. I.e. the discussion does not apply to a country in the Eurozone, though it does apply to the EZ as a whole.

Private sector net financial assets.

MMTers often use the phrase “private sector net financial assets” (PSNFA), and PSNFA is made up of two elements: base money and national debt. The two latter have in common the fact that they are ASSETS as viewed by the private sector entities that hold them.

Moreover, those two parts of PSNFA are very little different in nature, particularly at low interest rates. That is, $X of national debt is simply a promise by government to pay the holder of the debt $X on a particular date. And assuming that’s in the near future, then there isn't much difference between $X and a promise by government to pay you $X in the near future.

Indeed, as Martin Wolf (chief economics correspondent at the Financial Times) put it, “Central-bank money can also be thought of as non-interest-bearing, irredeemable government debt. But 10-year Japanese Government Bonds yield less than 0.5 per cent. So the difference between the two forms of government “debt” is tiny…”.

Keynes’s paradox of thrift.

Next, MMTers fully endorse Keynes’s point about what he called the “paradox of thrift”. That’s the fact that if private sector entities (households and employers) save money, they are ipso facto not spending that money. And any cut in spending raises unemployment.

MMTers claim that it is therefore important for the private sector to have the PSNFA it wants. Put another way, it is important to meet what MMTers often call the private sector’s “savings desires”.

The size of PSNFA is related to interest rates.

The next important point is that the amount of PSNFA that the private sector will want to hold is related to the rate of interest offered on that debt (a very obvious point, but one which is often overlooked). I.e. if someone is offered a return of 10% for abstaining from consumption and lending $Y to government (or any other entity), they are more likely to do that than if they are offered 1%.

What’s the point of government debt?

A possible reason for government debt is to fund infrastructure. That idea is actually very debatable. That is, there are good arguments for funding public investments out of tax rather than borrowing. (There’s a paper by Kirsten Kellerman in the European Journal of Political Economy arguing the latter point).

But let’s ignore government debt used to fund infrastructure, to keep things simple. Or if you like, assume that if indeed government DOES fund infrastructure via debt, that is kept separate from other government debt. The interest on that “infrastructure debt” might be same as would be charged by those funding a private contractor for constructing a road and charging a toll to those using the road.

So…to re-phrase the above question: what’s the point of government running up debt simply because it has failed to collect enough tax to cover its current spending (as opposed to capital spending)? Indeed most people are not too bothered about government debt where it is incurred to fund productive capital investments: it’s the debt incurred simply because government has failed to collect enough tax to fund CURRENT spending that is the major concern.

Well the answer to the above question is surely that there’s absolutely no point in failing to collect enough tax to cover current spending. Thus the only merit in government debt is to supply the private sector with PSNFA.

Why pay interest on PSNFA?

But why pay any interest on national debt when the private sector positively wants it as a form of saving? That is, why not just have PSNFA made up of base money rather than base money PLUS government debt on which government pays interest. Milton Friedman and Warren Mosler argue for that zero debt arrangement. That is, government debt might as well be abolished, which would mean the only liability (aka PSNFA) issued by the state would be base money.

Alternatively, it could be argued that it’s desirable to have PSNFA partially in the form of debt which pays some interest. Reason is that base money is potentially volatile stuff (which is presumably why it is sometimes called “high powered money”): holders of that form of money can always go into a fit of irrational exuberance and try to spend away large chunks of their base money. In contrast, it is more difficult to spend away debt: try doing your weekly shopping at the supermarket with $1k of Treasuries (or in the case of the UK, £1k of Gilts).

However, answering the latter question is not actually crucial to the basic question addressed here, so let’s just assume that SOME PSNFA is in the form of debt and that it’s very nearly the same thing as base money because as in Japan, the rate of interest is near zero. (There’s certainly little point in paying anything MUCH above zero, as explained above).

The optimum amount of debt.

We can now answer the big question: what’s the optimum amount of debt (aka PSNFA)? Well the answer is simple: whatever amount brings full employment when interest on the debt is near zero.

Note incidentally that that is NOT TO suggest, as extreme monetarists do, that the quantity of money should be the only thing varied when it’s desirable to adjust aggregate demand. Reason is that THE PROCESS of adjusting PSNFA also has an effect on demand: what might be called a “fiscal” effect. For example if there is insufficient demand, the state can simply create new money and spend it (and/or cut taxes) and the fact of that spending (e.g. on health and education) will create nursing and teaching jobs. Thus there is a fiscal and monetarist effect there.

Thus a better answer to the question as to what the optimum amount of debt is thus. If the economy is not at capacity (and assuming no inflation and no growth) we should create new base money and spend it, and/or cut taxes, and continue doing so till the size of the debt / PSNFA is such that the private sector spends enough to give us full employment.

In the real world of course we have both inflation and growth. The former tends to erode the real value of PSNFA which means that assuming (to keep things simple) the private sector’s desired PSNFA/GDP ratio is constant, fresh base money will have to be CONSTANTLY created to keep that ratio constant. And much the same applies to growth: that is to keep the latter ratio constant, there will need to be a constant supply of new base money.

Indeed that constant supply of new base money is what we have actually experienced over the last century or two.

SW-L thinking.

Now for SW-L thinking. In this article SW-L considers a recent IMF paper,  the main conclusion of which (to quote SW-L) is that:

“To put it very simply, high debt does impose a burden, because the taxes required to pay the interest on that debt are ‘distortionary’ - for example income taxes prevent people from working as much as they should. But cutting debt also imposes a burden - taxes have to be raised to get debt down. Analogies between households and governments are misleading: while we as individuals do not live forever and therefore need to pay back debt eventually, the state can act as if it will go on forever. We therefore face a trade-off: is it worth paying higher taxes now in order to reduce government debt so we can pay lower taxes in the future?”

I have four objections the above passage as follows.

1. There is the phrase “high debt does impose a burden”.

There is a distinction between debt burden in the sense that there’s a small debt but a high rate of interest is being paid on it, and second, a large debt with a low rate of interest being paid on it.

For reasons give above, there is no excuse for a high rate of interest being paid on the debt, so that is indeed a “burden”. In contrast, there are not bad arguments for “doing a Japan” and having a high debt with a low rate of interest. So even if the bill for interest there is “high”, that can’t necessarily be construed as a “burden”.

2. Taxes are “distortionary”?

On the contrary: one can collect taxes in an almost distortion free way: e.g. a sales tax on everything that consumers buy.

3. “But cutting debt also imposes a burden - taxes have to be raised to get debt down.”

It’s important to make a distinction here between debt which is held domestically (as is largely the case in Japan) and debt held by internationally mobile investor / savers.

To the extent that debt is held domestically, no burden whatever is involved in cutting the debt. That’s because the only good reason to cut the debt is because the private sector seems to have too much PSNFA which is boosting demand by too much. I.e. where PSNFA is excessive, the state should raise taxes (and/or cut public spending) and confiscate some of that PSNFA. That confiscation is not, repeat not, any sort of burden: the sole objective is to cut demand to a non-inflationary level. In fact excess inflation is a real cost to the community, thus dealing with that excess ought to RAISE living standards. Thus ironically, the latter confiscation / tax far from being a burden would actually RAISE living standards. And finally, if interest on the debt is less than inflation, then then the REAL or inflation adjusted rate is negative, which means that the debtor profits at the expense of the creditor: i.e. it's the creditor who bears a "burden".

4. The final sentence of the above passage by SW-L is: “We therefore face a trade-off: is it worth paying higher taxes now in order to reduce government debt so we can pay lower taxes in the future?”

I beg to differ. I.e. there’s no trade off there. Policy should be simply to keep PSNFA at the level that maximises employment without the inflation target being exceeded by too much. That may result in a big rise in the debt this year, followed by an even bigger rise in three years’ time. Alternatively the private sector may have a fit of irrational exuberance in three years’ time, in which case PSNFA might need to be reduced. In short, debt reduction targets do not make sense.

Another SW-L article.

In his second sentence here, SW-L says “If you want to bring the government deficit and debt down, you do so when interest rates are free to counter the impact on aggregate demand.”

The first half of that sentence again implies some sort of debt reduction target. To repeat, there should be no such target.

As to the second half of the sentence, why get into the positon where PSNFA is excessive, and the resulting excess demand has to be dealt with by artificially raised interest rates? I.e. why not, at the first sign of excess demand, just confiscate PSNFA? Ideally interest rates would then not rise at all.

That is not to suggest that interest rates should NEVER be artificially raised. Interest rate adjustment is certainly a useful tool for the state to have. But the AIM should always be, when excess demand appears, to deal with that by confiscating PSNFA (aka run a budget surplus / smaller deficit).

Moreover, there is plenty of evidence that interest rate adjustments don’t work very well. Plus they are distortionary: that is, in the first instance, they influence just the behaviour of those with variable rate loans, and not those with fixed rate loans or no loans at all. That’s a bit like, in the case of helicopter drops, doing drops only on those with red or blonde hair, while everyone else waits from the trickle-down effect of red-heads and blondes going on a spending spree.

A possible objection to the above claim that demand should be adjusted just via changes in the deficit rather than interest rate adjustments is that politicians (particularly in the US) wouldn’t agree to that. (That’s on the assumption that some sort of central bank committee decides the overall size of the deficit, rather than politicians). Well my answer to that is that I’m setting out what I think is the ideal system. If politicians mess that up and put in place a second best system, well it wouldn’t be the first time has happened. (Incidentally, interest rate adjustments are criticised in that work)

As to exactly how a “deficit adjustment only” system would work with politicians retaining a say over strictly political matters while not deciding on the overall SIZE OF the deficit, see this submission to the Independent Commission on Banking. Incidentally while the authors of that work claim the work is dated (and maybe it is dated in some ways), I still think it’s the best and briefest introduction to relevant ideas.

Tinbergen and policy instruments.

Jan Tinbergen said something to the effect that just one policy instrument should be used for each policy objective.  Failure to do that partially explained the 2007/8 crisis and for the following reasons.

In the run up to the crisis it looks like households were putting a more than normal proportion of their resources into property purchases or speculation.  However, aggregate demand was not excessive, and governments to a large extent use interest rate adjustments to control demand. Thus interest rates were not raised. But they SHOULD HAVE BEEN raised given the increased demand for loans by those speculators. That increase in interest rates would have choked off the speculation, if only to a small extent.

Thus there is merit a system where demand is controlled just by varying the deficit with interest rates being left to find their own level.

Tuesday, 16 June 2015

Beware of using sectoral balances to reveal the flaw in Osborne’s budget surplus idea.

A number of people, e.g. Richard Murphy, Bill Mitchell and John Eatwell argue that sectoral balance analysis is helpful in revealing the flaw in the budget surplus idea recently advocated by the UK’s finance minister, George Osborne. This approach is dodgy.

Of course there is no denying the obvious point that a public sector surplus must be matched by a private sector deficit (assuming for the sake of simplicity we ignore the foreign sector). But that point apart, sectoral balance analysis has nothing to offer here. To see why, let’s consider Richard Murphy’s ideas, and we’ll start with a quote from his article, as follows.

“The principle is simple and is that there are just four sectors in the economy. They are:

1.Consumers = C
2. Government = G
3. Business, whose investment = I (their current trading is of course part of the flip side of C, and we must not double count).
4. The rest of the world, represented by the balance of trade = E”

Murphy continues (to quote):

“Now as a matter of fact the surpluses and deficits run by these groups must arithmetically balance in monetary terms, because double entry does work: every debit does indeed have a credit.

So if we use the same letters C, G, I and E to represent the net savings or borrowings of these groups in a period then:

C + G + I + E = 0

So, if consumers borrow someone else must lend.”

Well there’s something wrong there and as follows. If consumers borrowed ONLY FROM entities in one or more of the other sectors, then Murphy’s point would be true. But of course that’s nonsense.

The reality is that much of consumer borrowing is from OTHER CONSUMERS. That is, typically, what happens when a consumer gets a loan is as follows.  1, Consumer gets a loan from a bank, 2 the borrower spends the money, 3, the money is deposited on sundry other consumers’ bank accounts.

Now assuming the latter don’t spend the money (i.e. assuming they put it in a deposit or term account), then effectively the latter consumers have loaned money to the borrower mentioned at the outset above. The loan of course goes via a bank or banks.

It is thus quite untrue to say that if consumers borrow more, sundry entities in other sectors must LEND MORE.

In fact the latter point can be put in more general terms and for the following reasons.

Merging the consumer and business sectors.

Murphy’s sectors are unusual in that he splits the private sector into consumers and business. It’s more normal to split the domestic economy just into the private and public sectors. I.e. consumers and businesses are merged into one sector: the “private sector”.

But nothing useful is added to the analysis by splitting the private sector into consumers and businesses as Murphy does.

So returning to the point about borrowing, we can say that given an increase in borrowing by the private sector (consumers plus businesses) some of that borrowing will come from entities IN THE PRIVATE SECTOR.

In short, Murphy is completely wrong to say later on that:

“The government surplus or deficit is, in other words, the opposite of what is happening with consumer debt…”

Murphy needs to go back to the drawing board.

John Eatwell.

In his letter to the Financial Times, John Eatwell (Cambridge economist) says amongst other things that where there is a persistent surplus  “the accumulation of debt by the private sector will be a recipe for serious economic instability — an indebted private sector is very vulnerable to economic shocks.”

Well not necessarily. The reaction of the private sector to a withdrawal of central bank money (base money) may to some extent be to replace it with private bank created money, i.e. the private sector non-bank entities may borrow more from private banks. And that extra borrowing COULD BE on a totally responsible basis. Though to be realistic there is bound to be SOME IRRESPONSIBLE borrowing mixed in there. So Eatwell has a point.

Certainly the latter phenomenon, namely borrowing so as to maintain living standards seems to have been going on just prior to the 2007 crunch. On the other hand, as a general rule, private bank lending is PRO-CYCLICAL rather than anti-cyclical. It is thus debatable whether private banks, as a general rule, expand lending when there is a withdrawal of base money from the private sector.

To the extent that private banks DON’T react in the latter counter-cyclical way then effect the reaction of the private sector as a whole to a budget surplus is to accept the cut in demand, produce less, and consign a portion of the workforce to the dole queue.

In the event, the actual response of the private sector will doubtless lie somewhere between the above two extremes (1, replacing ALL the central bank money lost with privately created money with no consequent drop in demand, and 2, complete failure by the private sector to borrow more.)

Bill Mitchell.

As to Bill Mitchell’s analysis, I couldn’t see much wrong. However he goes into too much detail about sectoral balances. That is (to repeat) the only insight that sectoral balances have to offer when it comes to identifying the flaw in Osborne’s budget surplus idea is that a public sector surplus must be matched by a private sector deficit.

As to the size of the deflationary effect or “unemployment increasing effect” of that surplus, sectoral balance analysis has nothing to offer.

Monday, 15 June 2015

How the free market recovers from recessions of its own accord.

The fact is that economies DO RECOVER from recessions even when government provides no sort of artificial stimulus to assist the recovery: after all, economies recovered from recessions in the 1800s before the days of “artificial stimulus”. So how do free markets do it?

In very simple economies, Say’s law works well. To illustrate, Robinson Crusoe lands on island which has a few other inhabitants. Crusoe’s speciality is fishing. So he does that. The result is that the price of fish falls relative to other goods produced on the island. So demand for fish rises. Hey presto: full employment is achieved.

However, when economies get more complicated and money is introduced, there’s a problem. If there is excess saving (of money), that necessarily means money is being saved rather than being spent. And since spending money on goods and services employes people, the result of that saving is increased unemployment. Keynes called that phenomenon the “paradox of thrift”.

So how does the free market deal with that problem?

Well in a recession, there is a surplus of people who want to obtain money via work. Assuming a free market, the hourly wage of those people will decline. That will make it profitable for others (the asset rich) to take out loans (i.e. create money) using their assets as collateral and employ the unemployed to create more assets for the asset rich (cars, houses, etc).

Incidentally for more on the process via which loans by private banks create money, see this Bank of England publication, the first few sentences in particular.

As long as the NET ASSETS of the rich remains positive, they’re OK. And as for the poor, they get the extra money they want.

Of course the above explanation as to how free markets recover from recessions is not much use in the real world and because of another phenomenon pointed out by Keynes, namely the fact that wages are as he put it “sticky downwards”. I.e. given a recession, wages (particularly in the heavily unionised public sector) just DON’T FALL.

Nevertheless, it’s nice in economics to get all the theory properly worked out, and hopefully the above little bit of theory about how free markets recover from recessions is right. When it comes to dealing with economic problems of immediate practical importance, you’re on much firmer ground if you’ve got all the theory properly worked out than if you haven’t!

P.S. (16th June 2015).       As regards mechanisms via which the free market escapes recessions, I should have mentioned the Pigou effect: that’s the fact that given a monetary base and/or national debt and falling prices, the latter private sector paper assets will rise in value in real term which will encourage spending. In fact if base money takes a PHYSICAL FORM (e.g. gold) the effect of the Pigou effect there is similar to the above mentioned “house and car” effect: that is, in both cases the fall in the price of labour is an inducement for the rich to hire such labour and have it produce more gold/cars/houses.

As with the “house and car” effect, the Pigou effect is not  of any great help in the real world: i.e. it's just a point that is of theoretical interest.

Sunday, 14 June 2015

Barcelona’s mayor wants a law to make banks obey the law.

She said “What we need are laws that make private banks comply with the law. Because now in Spain we have a banking system that breaks the law systematically and nothing happens.”

And why not have a law that makes banks obey the new law that makes them obey the law? Oops – something wrong there.

But seriously: checking up on whether banks obey the law wouldn’t be a bad idea.

I went into my high street bank recently and deposited a sum which was enough to make it necessary for me to fill in an anti-money laundering form and to have to see the manager. And that’s not a huge sum: about £5k I think.

Anyway, after being ushered into the manager’s office, he took no interest whatever in my drug money laundering activities. Instead he just tried to sell me house insurance. Pathetic.

Saturday, 13 June 2015

Greek unemployment.

Why don’t more Greeks take advantage of the freedom of movement offered by the EU to get themselves jobs in lovely windswept Northern Europe?

Which would you prefer? Being unemployed in Greece (images below) or working in a factory in Northern Europe? Difficult choice isn't it?


Reminds me of a holiday I had in Portugal many years ago with some friends. We spent our time on the beach drinking wine. Nearby were some refugees from a former Porguguese colony (Angola I think) living in a shanty town and also sitting on the beach drinking wine.

It occurred to us that they were arguably better off than we were. After all, we had to work 50 weeks a year in Northern Europe in order to be able to sit on the beach drinking wine for two weeks, whereas they could do that 52 weeks a year.

On the other hand sitting on the beech drinking wine wouldn’t be too pleasant in Winter 9 days out of 10 in Portugal. Still, I do have a point there don’t I?

Friday, 12 June 2015

Richard Murphy puts his foot in it yet again.

It’s often claimed that base money is “debt free”. For example Positive Money often makes that point. Murphy tries to dispute the point in this recent article.

First, though, some background.

The vast bulk of money is created by private banks when they extent loans, as this Bank of England work makes clear in it’s opening sentences. That is, when obtaining a loan from such a bank, the bank sets up two debts.

First, the bank undertakes to owe the borrower £X, and it undertakes to transfer part or all of that debt or obligation to anyone else when instructed to do so by the borrower when the borrower uses his/her cheque book or debit card to issue the instruction. E.g. if I write you a cheque for £Y I’m telling my bank to reduce what it  owes to me by £Y and instead, owe the £Y to you.

Second, and at the above initial “set up” stage, the borrower undertakes to owe the bank £X in the sense that the borrower undertakes to repay the sum borrowed to the bank at some time in the future (a very long time in the future in the case of some mortgages). So, as you’ve doubtless gathered, there’s plenty of debt in the above money creation process. Put another way,  private banks cannot create £Z of money without someone going £Z into debt.

Base money.

In contrast to money issued by private banks, there is money issued by CENTRAL banks, or if you like, by the government / central bank machine. That is governments can simply print money (in physical form or book-keeping form) and spend it into the economy, as Robert Mugabe so ably demonstrated.

Now where exactly is the “debt” in that sort of money? It’s true that Bank of England £10 notes say “I promise to pay the bearer on demand the sum of £10”. But if you go the BoE and try to get £10 of gold or anything else in exchange for your £10 notes, you’ll be told to get lost. So what sort of debt is that? Contrary to Richard Murphy’s claims it just isn't a debt.

The only conceivable sense in which base money is a debt is that if the tax authorities (i.e. government) demands money from you, you can use a wad of £10 notes (or base money in any other form) to pay your debt to the tax authorities. That is arguably an instance of one debt being used to cancel an equal and opposite debt.

But that’s a very far fetched and unusual sense of the word “debt”. I.e. on any normal use or definition of the word debt, base money is indeed debt free.

The REASON why Murphy makes the mistake of thinking that base money is “debt encumbered” is that he is an accountant. And like many accountants, he sees things in terms of balance sheets and profit and loss accounts.
Indeed, in his article he sets out part of the Bank of England’s balance sheet and lo and behold, base money is shown as a LIABILITY of the BoE.

As Richard Murphy ought to know, while double entry book-keeping is a very clever and useful system, it often employs the concepts “asset” and “liability” in a very tortured way: a way that bears little resemblance to the words asset and liability as defined in dictionaries.

Deficits funded by new money – is withdrawing that money difficult?

With a view to dealing with recessions, government can fund a budget deficit either by borrowing money or printing money, as pointed out by Keynes. The “print” option is favored by several economists and groups. E.g. MMTers tend to favor that option (far as I can see). Simon Wren-Lewis (Oxford economics prof) has been toying with the idea recently, and Positive Money favors the idea.

An obvious potential problem with “print” is that the money may need to be subsequently withdrawn and that can be politically difficult: that is, raising taxes can be politically difficult.

In order to work out whether the “withdraw” problem is any worse under “print” than under “borrow”, lets first run thru the print and borrow processes.

The print option is simple enough: the government / central bank machine just prints $X and spends it and / or cuts taxes.  The result is that private sector paper assets (base money / cash to be exact) rises by $X which induces the private sector to spend more. Also the ACTUAL PROCESS of spending that money raises demand: e.g. if government spends more on road repairs, then more people are employed repairing roads.

As to “borrow”, government borrows $X, spends it, and gives $X of bonds to those it has borrowed from. The net effect is that private sector paper assets rise by $X as above, but in this case the rise in private sector paper assets takes the form of bonds instead of cash / base money.

The big problem with “print” (to repeat) is that the private sector then has more base money than before which means that when the recession is over, private sector spending may be excessive.

Obviously if the latter excess is not too much, that isn't a problem: the excess demand can be dealt with by standard deflationary measures: interest rate hikes or a budget surplus (or smaller deficit).

On the other hand if the excess spending is TOO MUCH there might be a problem. But is the problem any more under “print” than under “borrow”?

It might seem that the problem is indeed bigger under “print” and because base money is more liquid than bonds, thus when the private sector is in possession of an extra $X of money, spending will rise by more than when in possession of extra assets in the form of $X of bonds.

However, that’s not a fair comparison because to get a given amount of stimulus under the two options, fewer pounds or dollars need to be printed under “print” than the number of pounds or dollars that need to be borrowed under “borrow”. Reason is that money is more liquid than bonds, thus presumably the stimulatory effect of money (per dollar) is more than the stimulatory effect (per dollar) under “borrow”.

Also note that under “borrow”, extra cash ends up in the pockets of the less well off section of the population just as it does under “print”. That is, under “borrow”, cash is taken from the rich and spent on the population in general, so cash in the hands of the less well off will rise just as it does under “print”. And that section of the population has a higher tendency to spend extra cash it comes by than the rich. So to that extent the need to withdraw cash from the population in general might be just as much under “borrow” as under “print”.


After a bout of stimulus, there may well be a need to rein in some of that stimulus, e.g. raise taxes. But it’s not clear that the problem is any worse under the “print and spend” option than under the “borrow and spend” option.


Afterthought. (Same day). Another point which tends to reduce the political difficulty in withdrawing money after a bout of stimulus (in both the case of "print" and "borrow") is that the only point in that withdrawal is to reduce excess demand: i.e. the purpose and the effect is NOT TO cut living standards to below the level that obtains at full employment. Put another way, the effect of the extra taxes involved in withdrawal does not cut living standards, which might seem strange. Indeed, one could argue that the effect is to INCREASE living standards. Reason is that excess demand and excess inflation involve very real costs. If those costs are removed, then living standards will rise.

Thursday, 11 June 2015

Richard Murphy tries to criticise Positive Money – sigh.

Murphy gets off to a great start in this article when he says “with the exception of notes and coins all money is created by lending”. Whaaat?

He has left out bank reserves, or if you like, QE. QE consists of the central bank (CB) printing money and buying up privately held assets. That money comes NEITHER from lending by private banks, nor does it come in the form of notes and coins.

And that particular tranche of money is MASSIVE just at the moment. Admittedly in normal times bank reserves are not so large as they are right now. But they are still there and always have been.

And if you want to know why no one pointed to that glaring error in  the comments after Murphy’s article, the reason is that Richard Murphy tends not to publish comments that are critical of his articles (not that he’s the only blogger guilty of that deception). I.e. if it’s an open, free and fair debate you want, i.e. free speech, then my advice is to skip Murphy’s blog.

Are bank reserves part of the money supply?

An argument sometimes put against the latter bank reserves point is that bank reserves are not “money out there in the economy”. Thus they don’t count as money. Well that point doesn’t hold water and for the following reasons.

When the CB prints money and buys a private asset (as part of a QE operation or for any other reason), the CB sends a cheque to the seller of the asset for $X, who deposits the cheque at their commercial bank, which in turn passes the cheque to the CB, and demands that the commercial bank’s account at the CB is credited. Incidentally my assumption that a CHEQUE is used may be old fashioned, but if more up to date electronic methods of transferring money are used, it comes to the same thing.

So the net result is that the commercial bank’s reserves rise by $X which if you like is not “money out there in the economy”. But also, the asset seller’s account at the commercial bank is credited with $X, and that very definitely IS “money out there”. Net result: when the central bank prints money and buys government debt, the result is a rise in “money out there in the economy”.

The only exception to that comes where the relevant government debt is owned OUTRIGHT by commercial banks. But that’s a small proportion of government debt.

Banks as we know them cease to exist?

Murphy’s next criticism of PM (para starting “This suggestion on my part..”)  is that under PM proposals, banks as we know them cease to exist, thus PM proposals must be wrong.

Well the answer to that is that it’s stark staring obvious to everyone (apart from banksters, politicians in the pay of banksters and Richard Murphy) that there’s something very wrong with the banking system, which in turn means some pretty drastic changes might be in order. And if that means changing banks out of all recognition, then what of it?

Not to put too fine a point on it, if there’s something seriously wrong with a system, then changing the system out of all recognition is quite possibly a good idea.

Stimulus is negated by tax?

Next, there’s a paragraph starting “I admit that I have..”. Here Murphy makes the bizarre and very obvious point that if the state prints and spends new money into the economy and then withdraws that money via tax there is little or no net effect. Well that’s pretty obvious.

But PM does not advocate implementing stimulus (by printing and spending new money) and then immediately cancelling that stimulus via extra tax!! To do that would obviously be futile.

Where stimulus is needed, PM advocates creating new money and spending it. Period. Full stop. Finito.  Hope I’ve made my point.


I can’t be bothered dealing with any more of Richard Murphy’s points. He clearly has no grasp of this subject.

The fatal flaw in maturity transformation and fractional reserve banking. Part III.

Having argued in Part II that there is little difference between full and fractional reserve from what might be called a strictly accounting perspective, there is actually another reason for thinking there is little difference accountancy wise, which is thus.

The risk involved in funding a bank is determined entirely by the nature of the loans and investments a bank makes (absent FDIC type deposit insurance). For example those funding a bank which specialises in NINJA mortgages will want a higher return than those funding a bank that specialises in conventional mortgages.

Thus it doesn’t make any difference whether a bank is funded primarily by equity or by debt: the cost of funding the bank will be the same in both cases. The chance of funders losing 100% of their initial stake in the bank, is the same regardless of whether the bank is funded mainly by shares or mainly by debt.

And that’s probably just a re-statement of the Modigliani Miller theory (an over simplified re-statement I admit, but for the sake of brevity, I’m leaving it at that).

Incidentally the MM theory HAS BEEN criticised, but I examined the criticisms here (p.24) and the criticisms are pretty feeble.

Thus the conclusion so far is that from a strictly accounting perspective or “cost of funding banks perspective” there is little to choose between full and fractional reserve.

Bank vulnerability.

There is however an important difference between the two latter options: fractional reserve banks are VULNERABLE. They are organisations that are constantly skating on thin ice (and constantly falling thru). The reason for that vulnerability is as follows.

Fractional reserve banks have a liability (money) which is fixed in value (inflation apart), while they have assets (loans and investments) which can fall dramatically in value. Think Cyprus or Spanish and Irish property loans or NINJA mortgages. And that is just asking for trouble, witness the fact that banks have gone bust in large numbers and regular as clock-work ever since banks were first set up.

As Douglas Diamond and Raghuram Rajan put it in reference to banks’ liquidity creating activities, “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.” And those authors were NOT ARGUING for full reserve: quite the opposite - they argued for FRACTIONAL reserve. So in highlighting a weakness in fractional reserve, they can’t be accused of being biased towards full reserve. (That's in the abstract of their NBER paper No.7430)

The solution normally adopted to that vulnerability problem is to back up fractional reserve banks with deposit insurance and lender of last resort (LLR). Now there’s nothing wrong with those two backups if they’re implemented on a strictly COMMERCIAL BASIS, e.g. if LLR is on the basis of Walter Bagehot’s “penalty rates” and “first class collateral”). However there are four problems there, as follows.

Deposit insurance and lender of last resort.

First, the idea that those two backups ever will be implemented on a commercial basis is laughable. Banksters will always bribe and cajole politicians into implementing the backups on a bank friendly and blatantly UNCOMMERCIAL basis. Witness the THIRTEEN TRILLION DOLLARS loaned by the Fed to banks recently much of it at zero or near zero rates of interest. (That compares to the 10% Warren Buffet charged Goldman Sachs at the height of the crisis). Walter Bagehot will be turning in his grave.

Banksters will always spin sob stories to politicians about economic growth being hit if banks aren’t given favourable treatment. And politicians will believe it every time because about 99% of politicians are economic illiterates.

As for the UK, the authorities quite clearly have no intention of actually charging banks for deposit insurance (unlike FDIC in the US under which banks do actually pay an insurance premium (shock horror)). Granted the so called “Bank Levy” has recently been implemented in the UK, but it comes to a small fraction of 1% of deposits: a near irrelevance.

So a big problem with fractional reserve is that, at the very least, there is a high risk of the two backups amounting to a subsidy of private banks.

Slow versus fast bank failure.

A second problem with fractional reserve protected (allegedly) by the two backups relates to the SPEED at which bank failures take place. As to INDIVIDUAL banks under fractional reserve, failure is quick and sudden (e.g. Northern Rock). As to the banking system as a whole, failure is also quick and sudden, e.g. the sudden freezing of credit markets at the start of the recent crisis.

In contrast, under full reserve, and given poor performance, all that happens is that the bank’s share price falls. And as the former governor of the Bank of England, Mervyn King put it:

“..we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve, and when they suffer sharp falls, economic policy can respond. But when the banking system failed in September 2008, not even massive injections of both liquidity and capital by the state could prevent a devastating collapse of confidence and output around the world.”

To paraphrase Mervyn King, under the existing bank system (aka fractional reserve), bank failures can lead to chaos despite the protection allegedly offered by the two backups.

Cheating the insurer.

A third problem with the two backups is that they amount to a form of insurance for banks, and there is always a temptation to “cheat the insurer”. (10% of car and house insurance claims in the UK involve an element of fraud).

There are of course differences in the EXACT WAY that banks cheat their insurers as compared to house and car owners. In particular, in the case of banks, the cheating takes the form of running excessive risks (if possible, hidden from the insurer) in the knowledge that if it all goes wrong, the insurer will pay.

Bagehot did not approve of lender of last resort.

A fourth and final problem with LLR is that, contrary to common belief, Bagehot did not approve of LLR. In the last chapter of his book “Lombard Street” he expressed the view that LLR was wrong, but thought it was too entrenched to be worth trying to dispose of.

Wednesday, 10 June 2015

The fatal flaw in maturity transformation and fractional reserve banking. Part II.

This is the second part of a mini series of articles on maturity transformation and banking. Part I was here.

The basic point made in Part I was that maturity transformation (MT) achieves nothing because while MT does increase liquidity, the state then has to confiscate that extra liquidity in order to keep inflation under control.

A similar apparent merit seems to be part of the existing bank system (sometimes called “fractional reserve banking”). And that merit seems to give fractional reserve the edge over the alternative, namely so called “full reserve banking”.

Full reserve is a system where the only form of money is base money (which was the starting point for the hypothetical economy set out in Part I). Under full reserve private banks do everything they currently do, but they don’t actually create money. And full reserve has had numerous advocates and for a long time. For example Irving Fisher said in response to the hundreds of bank failures in the 1930s, “We could leave the banks free…. to lend money as they pleased, provided we no longer allow them to manufacture the money which they lend”.

An apparent problem with full reserve is the fact that it involves relatively large amounts of base money doing nothing which might seem to be a waste. Indeed, the UK’s Independent Commission on Banking (ICB) echoed that sentiment when it said (section 3.21): “If . . banks were not able to perform their core economic function of intermediating between deposits and loans, the economic costs would be very high.”

Money costs nothing.

The first flaw in the idea that unused base money is some sort of waste is that it costs nothing to produce such money! It’s produced simply by the central bank making a book keeping entry (done on computers nowadays). As Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”*

Thus the ICB’s claim that unused base money is some sort of waste, is beginning to look debatable.

Switching from full to fractional reserve.

But suppose a hitherto full reserve system DOES SWITCH to fractional reserve. Let’s quickly run thru the hypthetical scenario set up in Part I again which involved a country called “Hypoland” where creditors had net assets of $120k and debtors had net assets of $110k.

The fractional reserve private bank sets up in Hypoland and announces: “Deposit your money with us, and we’ll put it in instant access accounts, PLUS you get some interest”.

So instead of the private bank or banks in Hypoland being funded by shares, they are funded by deposits (aka money).

But as in Part I, where loans were initially done on a direct person to person basis and were then done via a bank and hence were turned into a form of money, the shares that fund full reserve banks in Hypoland are turned into money. I.e. those shares are “liquidised”.

As in Part I, demand then rises, so the state has to deal with inflation by confiscating that extra liquidity. As in Part I, we’re back were we started: not much is achieved by switching from full reserve to fractional reserve (or vice versa).

Indeed, George Selgin’s similar hypothetical scenario (mentioned in Part I) produced much same result, namely that private bank created money DISPLACES base money: it does not ADD to it.

And therein lies a second flaw in the above ICB claim about full reserve involving loads of unused base money. That is, if an economy switches from full to fractional reserve, it might seem that loads of unused base money can then be usefully employed as claimed by the ICB. In fact that’s not true because the introduction of fractional reserve involves DISPLACING base money with privately issued money – or put another way, to prevent the introduction of fractional reserve being inflationary, that unused money has to be confiscated.

Tuesday, 9 June 2015

The fatal flaw in maturity transformation and fractional reserve banking. Part I.

Summary.         This is the first of a mini-series of three articles. The first, or “Part I” argues that maturity transformation achieves nothing. Reason is that while it increases liquidity, and even creates a form of money, people will then try to spend away that extra liquidity / money which raises inflation. Thus government has to confiscate the extra liquidity / money via extra tax, which in turn means the net effect of maturity transformation is zero.

Part II argues that the same flaw lies at the heart of fractional reserve banking. That is, while switching from full to fractional reserve does produce extra liquidity, the state has to tax away the extra liquidity. I.e. fractional reserve achieves nothing. Thus there would seem to be little difference between full and fractional reserve.

Part III argues that while there is no difference between full and fractional reserve on what might be called a strictly accounting criterion, there is nevertheless an important difference. It’s that fractional reserve banks are very vulnerable. Witness the fact that they go bust regular as clockwork. In THEORY that deficiency can be countered (but not eliminated) if such banks are backed by deposit insurance and lender of last resort implemented on a COMMERCIAL basis. However the idea that those two backups ever will be implemented on a commercial basis is just a joke. The reality is that bankers will always bribe and cajole politicians into implementation in a manner that SUBSIDISES banks. And the scale of those subsidies is ASTRONOMIC as the recent crisis demonstrated.


Where people and firms lend DIRECTLY to each other, each creditor’s asset (the loan) is relatively illiquid. That is, a creditor probably will be able to sell the loan if need be, but it may be at a loss and may take time.

In contrast, if savers / lenders deposit their spare money at a bank, the bank can lend out the money while saver / lenders retain instant or near instant access to their money. That’s called maturity transformation (MT): the short term maturity of bank deposits is “transformed” into long term maturity loans.

Saver / lenders get what might be called a “twin benefit”: they get some of the relatively high interest that comes from making long term loans at the same time as having instant access to their money. Two things that might seem to be irreconcilable are reconciled. Everyone seems to be a winner, including the bank which of course takes a cut.

The flaw in that idea is that MT raises aggregate demand because lenders find their assets are more liquid, thus they tend to spend away that excess liquidity, which causes inflation, which in turn means the state has to confiscate that excess money or liquidity. It’s back to square one! MT has achieved nothing.

Risk sharing and money creation.

Note that when “person to person” lenders switch to lending via a bank, there are in fact TWO changes there. First, lenders pool risks. That is, if the debtor goes bust in a person to person loan, the lender may lose out big time. In contrast, lenders are highly unlikely to lose everything where lenders pool loans or risks.

The second change is thus. A person to person loan is relatively ILLIQUID. That is, creditors when making such loans lose instant access their money.  In contrast, money deposited in a bank retains its liquidity: it remains instant access unless the money is put into a term account.

Now clearly there is nothing wrong with risk pooling, so let’s forget about that. I.e. it is money / liquidity creation that is under consideration here. 

An illustration.

The above point about MT being pointless because the state has to tax away the liquidity created by MT can be illustrated more clearly with an actual example. The rest of this article sets out such an example.

Take a hypothetical economy (called “Hypoland”) where half the population are creditors and half are debtors. Assume to start with the only form of money is base money. The assets of each creditor consist of $10k of base money, $10k of loans to debtors and $100k of illiquid assets like cars and houses. As to debtors, their assets and liabilities are: $10k of base money, and $100k of cars and houses plus they have a LIABILITY in the form of $10k owed to the above creditors. Also assume that’s the PREFERRED stock of assets and liabilities of the population.

Assume that people and firms lend direct to each other, i.e. not via a bank. Also assume that that stock of base money is enough to induce the population to spend at a rate that brings full employment, but not to spend so much as to bring excess inflation.

A private bank sets up in business.

Then a hitherto unheard of organisation called a “private bank” sets up in business. Like real world private banks, it offers to accept deposits and grant loans to viable borrowers.

The bank also tells depositors (as in the real world) that they can have instant or near instant access to their money AT THE SAME TIME as reaping the rewards that come from locking up one’s money for extended periods, as mentioned above.

Incidentally, if you don’t like the idea of JUST ONE private bank setting up, then assume that SEVERAL private banks set up and replace the phrase “private bank” below with “private banks” or “private bank system”.

The macroeconomic problem.

But there is a problem.

As it explains in economics text books, most people adopt the perfectly rational policy of minimising their stock of cash. In fact the text books normally give TWO motives for holding cash. The first is the TRANSACTION motive: clearly everyone (and every employer) needs enough cash for day to day transactions.

The second motive is often called the PRECAUTIONARY motive: that’s the desire to have a stock of cash to deal with unforeseen problems. A possible third motive is the desire to save up to buy something.

And most people when they find their stock of cash is IN EXCESS of that required for the above two or three reasons, tend to spend away the excess.

Now the arrival of the private bank with its MT in Hypoland means that those loans or debts held by creditors are effectively turned into money. Or put another way, creditors then find they have excess liquidity, so they’ll try to spend that away.

But if the economy is already at capacity, that extra spending is not possible, else inflation will ensue.

Incidentally, George Selgin set up exactly the same hypothetical scenario, and his conclusions, at least as regards the above mentioned inflation were very similar to mine, (which is not to suggest he and I see eye to eye on all bank related matters.)

Anyway, government and/or central bank will have to deal with that excess demand / inflation, e.g. by raising interest rates or by running a budget surplus. And both those measures will withdraw liquidity / money from the private sector. Rather looks like we’re back where we started!

In fact, and to keep things simple, if government were to deal the excess demand SIMPLY BY grabbing money off creditors via extra tax, the amount that would have to be “grabbed” would be $10k: that’s the amount of excess liquidity or excess money in the hands of each creditor.

So the introduction of MT to Hypoland INCREASES the money supply by $10k per creditor, but government then has to tax that $10 away. Net result: zero. It’s back to square one!

Creditors’ total stock of assets.

The introduction of MT to Hypoland and the subsequent rise in tax WOULD leave creditors with less than their preferred TOTAL STOCK of assets. That is, each creditor’s total stock would then be worth $110k rather than the $120k we started with.

But that’s not a problem: creditors would then presumably work extra hours for a year or two and accumulate an extra $10k in the form of sundry assets, e.g. larger houses, a second car, or whatever.

Note that that extra work by creditors WOULD NOT be inflationary. Reason is that an attempt by a portion of the population to work extra hours equals an increase in AGGREGATE SUPPLY. And an increase in aggregate demand  is no problem if aggregate supply increases by the same amount.


* The quote is from Friedman’s book, ‘A Program for Monetary Stability.’ (1960),  New York.  Fordham University  Press, Ch 3.

Sunday, 7 June 2015

Hot air on austerity from Amartya Sen.

Harvard economist Amartya Sen recently published this article entitled “The economic consequences of austerity” in which he criticizes austerity. And there’s been much excitement on the Twittersphere about the article.

Any article which is critical of austerity is bound to get the approval of brainless lefties. Whether the article actually analyses the austerity problem correctly is irrelevant for 95% of the population, brainless lefties in particular. The important thing for the 95% is the emotional thrill that comes from reading about the evils of austerity.

So if you’re a member of the 95% I recommend Sen’s 4,000 words of hot air, flowery language and waffle. 95% of the population will always prefer listening to a well-known personality talking garbage than some unheard of individual revealing the secrets of the Universe.

In contrast, if you’re a member of the 5% who actually thinks about what the problem is, and what the best solutions might be, read on. (There’s only about 400 words to read in contrast to Sen’s 4,000).

Austerity in Europe.

Sen’s first mistake is that he attributes austerity in Europe to a failure to implement Keynsian stimulus during the recent recession. In fact the vast bulk of the most serious austerity in Europe (i.e. in periphery countries) is attributable to the inherent problems of a common currency: that’s the fact that uncompetitive countries cannot devalue, thus they have to go for INTERNAL DEVALUATION. That is they have to undergo years of deficient demand and excess unemployment so as to get their costs down. Greece is obviously the most serious case there.

However, that’s not to say that the Eurozone couldn’t have done with A BIT MORE Keynsian stimulus over the last five years or so. Given the very low inflation rates in core countries, clearly SOME additional stimulus would have been in order, and is still needed at the time of writing. At least that’s true if the inflation target is the standard 2%.

But to repeat, lack of Keynsian stimulus is not the basic cause of the worst instances of austerity in Europe (i.e. Greece).

Cutting the debt.

Sen’s second mistake is where he says “There is, in fact, plenty of evidence in the history of the world that indicates that the most effective way of cutting deficits is to resist recession and to combine deficit reduction with rapid economic growth.”

Well the big problem there (or should I say “apparent problem” which economics professors like Sen can’t solve) is that to get economic growth one has to run a bigger deficit, which in turn (allegedly) increases the debt.

Well the solution to that problem (as MMTers have been pointing out for years) is thus.

There’s a phenomenally easy way of cutting the debt which requires no growth at all (though clearly if some growth appears from nowhere, that’s nice). Indeed this amazing method of cutting the debt is known to half the population and has recently been put into effect BIG TIME. But Harvard economics professors like Sen don’t seem to be aware of it. It’s called . . . . wait for it. . . . I put it in red just for extra emphasis:

Quantitative easing.

You may have heard of it.

It consists of simply printing money and buying back the debt. And if that money printing exercise is too inflationary, no problem: just raise taxes. If taxes are raised by the right amount, that will cut demand and inflation by the right amount.

Problem solved.


Incidentally Harvard  is a hot bed of pro-austerity incompetents: e.g. Kenneth Rogoff and Carmen Reinhart. And then there’s the famous advocate of so called “expansionary fiscal austerity”: Alberto Allesina. Plus there’s the Harvard historian who thinks he knows something about economics and advocates austerity: Niall Ferguson.

And finally, there is one problem with the above advocated QE solution: people just don’t believe that solutions to economic problems can be that simple. Well sometimes they aren’t: that’s true. On the other hand, the “emperor with no clothes” phenomenon is a VERY REAL and common one. That is, THERE ARE grotesque incompetents in high places in this world.