Friday, 16 December 2016

The free market’s cure for a recession is a helicopter drop.

In a perfectly functioning free market and given a recession, wages and prices would fall in terms of dollars, pounds etc, which would increase the real value of the stock of money (base money in particular) which in turn would encourage spending.

In the REAL WORLD, the market is very far from perfectly free: in particular and to use Keynes's phrase, “wages are sticky downwards”. In other words, try cutting wages, and you’re likely to get strikes, if not riots.

That increase in the value of most people’s stock of money is known in economics as the “Pigou effect” after the economist Arthur Pigou.

Note that it’s the value of the stock of BASE MONEY (i.e. central bank issued money) which rises but not the value of the stock of COMMERCIAL BANK issued money that rises. At least in the case of commercial bank money, for each dollar of money there is a dollar of debt: reason is that commercial banks create or “print” money when they grant loans, as the opening sentences of a Bank of England article explains.  It’s often said that commercial bank money “nets to nothing”, which is true. (The BoE article is entitled “Money creation  in the modern economy”).

In other words base money is a net asset as viewed by the private sector, and by government spending departments, city authorities, etc. In contrast, commercial bank issued money is not a net asset.

In addition to the value of the stock of base money rising in a recession in a totally free market, the value of government debt also rises. Reason is that that is also a net asset as viewed by holders of that debt.

However, as MMTers (Warren Mosler in particular) pointed out some time ago, government debt is pretty much the same thing as base money. That is, the only thing government owes to holders of that debt is base money (when the debt matures). I.e. government debt can well be regarded as a deposit or term account at a bank called “government”.  Martin Wolf, chief economics commentator at the Financial Times, also made that point a year or two ago. As he 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…”. (That’s in an article entitled “Warnings from Japan for the Eurozone”).

It could perhaps be argued that if the real value of the stock of government debt rises, that might induce government to REDUCE its spending. But that would be a very irrational thing for a government to do: that would just raise unemployment. What’s the point of that?

Moreover, it is very debatable as to whether so called government debt really is a debt. Reason is that government is free to grab any amount of that “debt” (aka base money) off the private sector whenever it wants. That’s the equivalent of someone being able to walk into the bank which gave them their mortgage and grabbing wads of £10 notes so as to pay off the “debt” they owe the bank: a strange sort of debt that would be.

In short, government debt can well be regarded as an asset as viewed by holders of that debt, but not as a liability of government. As Warren Mosler put it, government debt and base money are like points in a tennis match: first they are produced from nowhere, second, they are assets as viewed by players, and third, they are not liabilities as viewed by the umpire.

Having said that the free market’s cure for a recession is a helicopter drop, that’s not quite accurate in that under a helicopter drop (pun there if you like) there is a choice as to who gets the free money. And most of us would not regard those already in possession of a pile of money as being the first priority. Nevertheless, in a helicopter drop free market style, a very WIDE RANGE of entities find themselves in possession of more spending power, (to repeat) including some central government departments, city authorities, etc.

Interest rate adjustments.

It is often assumed that the free market’s main cure for a recession is to cut interest rates. (See here for discussions as to what extent central bank interest rate adjustments are actually a REACTION to market pressures rather than the basic cause of interest rate cuts in a recession.)

No doubt interest rates do fall of their own accord in a recession, but it would not be very logical of the free market if that were the free market’s MAIN reaction to a recession: reason is that borrowing based expenditure does not account for more than a smallish proportion of total spending (in both the public and private sectors).

Tuesday, 13 December 2016

What’s the optimum or GDP maximising amount of lending and borrowing?

Note: this article also appears on the Seeking Alpha site.


Summary:  Letting private banks create money leads to an artificially low or “non GDP maximising” rate of interest and an artificially large amount of lending, borrowing and debt.

One of the basic jobs of commercial banks is to lend. So with a view to trying to determine the optimum or GDP maximising amount of lending and associated rate of interest, let’s start with the simplest possible economy, namely a barter economy, and gradually introduce the alleged improvements that result in a 2016 real world bank system.

Borrowing and lending take place in barter economies: it’s just that it’s actual goods and services that are loaned rather than money. For example, Robinson Crusoe might lend a fishing rod to Man Friday and might demand fish by way of interest.

So the first question for supporters of the existing bank system is this. Ignoring the inefficiencies of barter, is there any particular reason why the amount of borrowing in a barter economy would not be the optimum amount, and is there any reason to think the rate of interest would not be the optimum or GDP maximising rate? Well not that I can see. That is, Crusoes are free to demand any rate of interest they like. And Man Fridays are free to pay that rate, or suggest a lower rate. Some sort of genuine free market rate will emerge.

Also (and this is important for reasons which will become apparent below) note that Crusoe loses access to the rod while Man Friday is using it. Second, if Man Friday fails to return the rod, then Crusoe loses his rod. At least in barter economies I imagine that it’s difficult for lenders to get insurance for the loans they make.

A simple money based economy.

Next, assume a barter economy decides to implement a simple money based system.

Citizens agree on what the money unit will be and agree to set up a central bank or government department which issues the right amount of money: that’s an amount that induces all and sundry to spend at a rate that brings full employment, or put another way, “keeps the economy at capacity”, without excess inflation. Also, assume that banks come into existence, and accept deposits and make loans.

Assuming that (as per Crusoe and Man Friday loans) depositors who want their money loaned on by their bank lose access to that money as long as it is loaned out, we are talking about a full reserve bank system here. Also note that losing access to money while it is loaned out PROBABLY DOES NOT involve losing access for very long even where loans are on a long term basis, e.g. for mortgages. Reason is that for every person wanting their loaned out money back, there’s probably someone else who want their money loaned out.

Next question.

Next question for supporters of the existing bank system is this. Is there any reason why interest rates under the above “state money only” system would not settle down to some sort of genuine free market rate? Well not that I can see.

Enter fractional reserve, stage left.

The next stage in our increasingly sophisticated(?) hypothetical economy is that private banks are allowed to engage in the money creation trick that they indulge in in the real world. That is, when $X is deposited at a bank, the bank can lend on the $X (or most of it) while telling the depositors they still have instant access to their $X. So relevant borrowers have $X to play with, as do depositors: lo and behold, $X has been turned into about $2X.

In contrast to the above relatively simple economies, I definitely can see why, if private banks are allowed to create or “print” money, interest rates would fall to a SUB-OPTIMUM rate: i.e. an artificially LOW rate. Reasons are thus.

As George Selgin explained in an article entitled “Is Fractional-Reserve Banking Inflationary?” (published by Capitalism Magazine), if one starts from a “state money only” system, and then allows private banks to create or print money, private banks will fire ahead and do just that. (Start at the 3rd para of Selgin’s article if you like).

Incidentally, that is not to suggest that Selgin would agree with this article of mine.

As to EXACTLY HOW private banks ease their way into the money creation process, that’s not difficult: essentially they just offer loans at marginally below the going or free market rate of interest. And that’s easy for them to do because they don’t have to pay for the money they lend out: they just create it from thin air. (See para starting “Allowing banks to create new money…” in Messers Huber and Robertson’s work “Creating New Money” for more on that.)

That is, unlike Crusoe who loses access to his fishing rod while it is loaned out, and unlike lenders in the above “state money only” system who also lose access to money when they lend it, depositors in 2016 “sophisticated” real world economies can have their money loaned out AT THE SAME TIME AS retaining instant access to it. And if that isn't a sleight of hand, I don’t know what is. Indeed, as the governor of the Bank of England in the 1920s, Josiah Stamp put it, in reference to private money creation, “The process is, perhaps, the most astounding piece of sleight of hand that was ever invented.”

But that extra lending means extra SPENDING, which is inflationary assuming the economy is already at capacity. Moreover, as the saying goes, “loans create deposits”, thus people would find themselves with more deposits than they want at the going rate of interest. Thus they’ll try to spend away the excess, which will also be inflationary.

The net effect is a serious bout of inflation, as Selgin explains (though he doesn’t spell out all the details that I’ve spelled out in the latter two or three paragraphs). And as Selgin also explains, that inflation whittles away the REAL VALUE of the monetary base, plus that inflation would continue till the base had been reduced to the point where banks had only just enough of it to settle up with each other.

An alternative possibility is that government clamps down on that inflation by raising taxes, i.e. confiscating some of the private sector’s stock of base money. But the end result is the same: the stock of base money eventually declines to the point where banks have only just enough of the stuff to settle up with each other.

Incidentally another possibility is that the relevant country imposes some sort of legal minimum reserve ratio like 10%, a rule that has actually been in operation in various countries over the last century. In that case, reserves would continue to shrink in real terms till they had reached that legal minimum, instead of the above mentioned “settle up” minimum.

To summarise this section, the net effect of private banks lending money into existence is that the amount of lending and borrowing is artificially boosted, as a result of which government has to cut down on everyone’s stock of base money, which in turn causes an artificial reduction in spending which is not “lending / borrowing” based.

Put another way, a genuine free market is one where suppliers of any commodity bear the full costs of supplying the commodity. E.g. in a genuine free market for apples or steel, apple or steel suppliers have to bear the full costs of apple or steel production: not produce apples or steel by some underhand method, like popping across the border to some neighbouring country and stealing apples or steel.

Likewise, in a genuine free market for funds which owners of those funds want to lend, each supplier of funds takes a conscious decision to abstain from using a specific sum of money for some period. But in the existing real world, while depositors do take a conscious decision to put some money in term accounts and some in current or “checking” accounts, the money in checking accounts is loaned out, whether depositors like it or not.

Thus the normal process via which a market price is reached via the interaction between suppliers and buyer/consumers that operates in the market for apples or steel does not apply when it comes to the supply and demand for borrowed money.

The result is that governments, instead of pitching the quantity of money at a level that brings full employment or “capacity” as mentioned at the outset above, control demand by adjusting interest rates.

But that’s a wholly illogical way of controlling demand: there is no reason to assume, come a recession, that the cause is inadequate borrowing, lending and investment any more than there is reason to assume there’s a lack of one of the other constituents of aggregate demand, like exports or consumer spending.

In short, the whole process of letting private banks print money leads to a complete mess: it leads to a dog’s dinner.

To summarise, under the existing or fractional reserve system, money lenders, i.e. banks (unlike other corporations) can obtain some of the money they need simply by creating it out of thin air, rather than by earning it or borrowing it, which is what other corporations have to do. That is quite obviously not a level playing field. It quite clearly involves a distortion of the market: a mis-allocation of resources.

Isn't central bank money “artificial”?

It might be tempting to claim a weakness in the above arguments is that central bank issued money is just as artificial, if not more artificial, than privately issued money.

Well the first answer to that is that no form of money is possible unless there is general agreement as to what the monetary unit shall be. Or as the saying goes, “money is a social construct”. E.g. in some societies it is generally agreed that some specific weight of a rare metal like gold shall be the monetary unit. So to that extent, ALL MONEY is artificial.

Indeed, the historical evidence is that money does NOT NORMALLY arise of its own accord in a free market: rather, it has more often been the case that money is introduced by rulers trying to find a more convenient method of collecting taxes.

Moreover, having government increase the amount of state issued money in a recession is not an entirely artificial contrivance, and for the following reasons.

Given a recession and a totally free and perfectly functioning free market, wages and prices would fall. That equals a rise in the real value of money. I.e. the value of the TOTAL STOCK of money rises. (That phenomenon is sometimes called the “Pigou effect” after the economist, Arthur Pigou.)

But in the real world, it is extremely difficult to bring about a rapid fall in wages: you just get strikes, riots and the like organized by trade unions (not that non-union labour is entirely happy when wages fall either). Or as Keynes put it, “wages are sticky downwards”. So as an alternative (as I think Keynes pointed out in his General Theory) one can increase the value of the total stock of money by increasing the number of money units rather than by increasing the value of each unit. The effect is the same.

Aren’t interest rate falls “natural”?

It might also be tempting to question the basic argument in this article by pointing out that given a recession, interest rates tend to fall, so what’s wrong with the conventional method of dealing with recessions, namely interest rate cuts?

Well the answer is that, unlike in the case of wages where there is an obvious obstruction to falling “prices”, there is nothing to stop the “price” of borrowed money falling, far as I know. Banks and other lenders compete with each other. And if they have spare funds to lend, they’ll tend to cut the price charged for hiring out those funds, won’t they?

Unfortunately, as is pretty obvious, falling interest rates alone do not cure recessions. And that’s hardly surprising since falling interest rates are not the only “natural” or free market cure for recessions: there’s also the above mentioned rise in the real value of the stock of money.

Saturday, 10 December 2016

More from Scott Sumner.

A propos the last post on this blog, Sumner has a new article published by the Mercatus Centre entitled “The Four Ways of Increasing Interest Rates”.

He starts by making the popular assumption that because interest rates are currently low by historical standards, there must be something wrong with that: i.e. rates must be raised. But what if the fall in rates is entirely natural, that is, down to market forces?

After all, it is widely accepted in economics that the GDP maximising price for anything is the free market price (absent market failure). But Sumner does not consider the possibility that the fall in interest rates is entirely natural.

Moreover, he doesn’t tell us EXACTLY WHY he wants to see interest rates raised, but presumably it’s so that come another recession, central banks can cut them again.  This whole attempt to artificially raise rates so that they can then be cut again smacks of desperation.

Anyway, the first of Sumner’s four ways of raising rates is to have the central bank – er – raise interest rates. That’s under the heading “Contractionary Monetary Policy”.  Well given that we aren’t faced with excess inflation, that is somewhat pointless. Plus Sumner claims that raising rates is deflationary, which in turn tends to REDUCE rates. Well that’s certainly possible.

Then a bit later under the heading “Expansionary Fiscal Policy”, Sumner argues that expansionary fiscal policy is no use among other things because Japan has raised it’s debt to 250% of GDP and still hasn’t been able to raise interest rates.

Well that’s like arguing that because ten buckets of water don’t put out a house fire that therefor water is no use for extinguishing house fires. First, had the ten buckets not been thrown on the fire, the fire would probably have been worse. And second, if ten buckets don’t quench a fire by as much as is desired, then fifty or a hundred probably will.

Similarly in the case of fiscal stimulus, the latter involves expanding state liabilities in the hands of the private sector (those liabilities being base money or government debt).  And as Martin Wolf pointed out, money and government debt are almost the same thing, particularly in the case of Japan.

Now as MMTers keep pointing out, when the stock of state liabilities in private sector hands rises (and those liabilities are ASSETS from the private sector’s point of view) there must come a point at which households are induced to spend at a rate that brings full employment – even bringing excess inflation and the necessary rise in interest rates which Sumner wants.

When people come by a windfall, like a lottery win, their weekly spending rises. The average taxi driver has worked that out. Whether the average economist has worked it out is more doubtful.

And as for the idea that a debt: GDP ratio of 250% or above represents some sort of disaster, the UK’s debt:GDP ratio was at the level just after WWII. The sky didn’t fall in.

And as for the idea that that we can’t have a ratio of MORE THAN 250% because that’s never been tried before, well that’s like arguing that sending men to Mars should not be attempted because it’s never been done before.

Wednesday, 7 December 2016

Scott Sumner opposes infrastructure spending and fiscal stimulus generally.

(Note: this article also appears on the Seeking Alpha site.)

Scott Sumner teaches economics at Bentley University, Massachusetts. He describes the Fed’s arguments for more fiscal stimulus as “bizarre”. As he put it a few weeks ago (I’ve put his words in green italics):

“I don’t use the term ‘bizarre’ lightly, as this stuff is not just wrong, or doubly wrong, it’s quintuply wrong.  It’s not even slightly defensible.”

Strong stuff! But I suggest it’s over the top. First, it’s not just the Fed that has started to sing the praises of fiscal policy: numerous other central banks and economists are doing the same. Thus Sumner must be a disappointed man. But let’s run thru his arguments, which are as follows.

1.  The Fed claims the economy does not need any more demand stimulus.  Indeed any boost to AD from more spending would be offset by tighter money.  So what’s the point?”

The point is that (as is now obvious), monetary policy is near out of options, or at least out of conventional options. There are of course negative interest rates and having central banks buy bonds or stakes in commercial enterprises, but taking commercial risks is certainly not what central banks were set up to do (quite rightly). So why not do some fiscal stimulus? If that forces central banks to raise interest rates, that means that come a recession, central banks can do conventional monetary stimulus: which is the position central banks want to be in. What’s the big problem there?

At least that’s an argument if you’re a fan of monetary stimulus. Personally I’m not: I favour having fiscal and monetary stimulus working in cooperation (i.e. in a recession, just have the state print money and spend it, and/or cut taxes). One reason for that is that come a recession there is no obvious reason why the problem is inadequate borrowing, lending and investment rather than inadequate spending on anything else. I expanded on that point recently here.

Conclusion: if interest rate cuts are a good way of regulating the economy (and Sumner thinks they are) then a bit of fiscal stimulus plus the consequent interest rate rise isn't a bad idea.

“2.  Even if fiscal stimulus were needed, it should be done via tax cuts.  It’s not efficient to vary spending for anything other than standard cost/benefit reasons, where benefits do not include demand stimulus.  And why should the central bank be telling Congress where to spend money?”

Let’s take that one sentence at a time. First: “Even if fiscal stimulus were needed, it should be done via tax cuts”.

The answer to that is that the question as to whether to expand or contract the public sector (i.e. raise or cut taxes respectively) is a PURELY POLITICAL DECISION. That’s a decision for politicians and voters at election time: not a decision for economists like Scott Sumner.

Re “cost/benefit reasons”, certainly infrastructure investments should be decided on cost/benefit criteria, like other investments, but the same doesn’t go for other types of government spending: defence, education, health care etc. Accurate measurement of benefits there is near impossible, thus decisions there are inevitably political.

“3. The Fed might respond that fiscal stimulus would not boost demand, but it would allow the current demand to be achieved with less monetary stimulus.  But why is that desirable?”

For reasons I gave above in response to point No.1.

“4.  The Fed might argue that it would prefer a higher trend rate of nominal interest rates, so that it hit the zero bound less often in future recessions.  But fiscal stimulus is an absolutely HORRIBLE way to achieve that objective:”

Prefixing something you don’t like with the phrase “absolutely horrible” is not an intelligent argument.

Next come two points prefixed with “a” and “b”.

“a.  Fiscal stimulus can only boost nominal interest rates by raising the global real rate of interest.  Just imagine how much fiscal stimulus it would take to boost the global real rate of interest by even 100 basis points.  (Hint: far, far beyond anything Congress would ever contemplate.)  Then think about how Japan did a massive amount of fiscal stimulus in the 1990s and 2000s, and ended up with some of the lowest interest rates the world has ever seen.”

Well at least fiscal stimulus enables us to increase demand without having to resort to bizarre stuff like negative interest rates and central banks accepting commercial risks by buying bonds of private corporations. Moreover, as Milton Friedman pointed out, stimulus dollars cost nothing in real terms. To put it figuratively, if we have to print a hundred tons of $100 dollar bills and dish them out to the population or spend the money on education, health care or whatever, what’s the problem, as long as that doesn’t cause excess inflation?

Also, Sumner suggests that astronomic amounts of fiscal stimulus would be needed to raise interest rates by any significant amount. But he gives no reasons. I’m not impressed by bald statements like that. I want to see REASONS given for that sort of claim or indeed any claim.

“b.  In contrast, monetary stimulus can easily raise nominal interest rates by 100 basis points, merely by raising the inflation target from 2% to 3%.”

I’m not totally clear what the argument is here, but I assume it’s the surprisingly common argument put by so called “economists” that a central bank only has to announce an inflation target of X%, and by some magic, inflation rises to that level. Apart from the obvious point that there is no clear cause / effect mechanism (i.e. no “transmission mechanism” to use the jargon), one has to wonder why inflation has fallen well below the 2% target and for years on end in numerous countries – e.g. Japan, as mentioned by Sumner himself just above? It’s clear that simply announcing a target does not of itself have much effect – a point which the average street sweeper has probably worked out.

5.  Economists agree, or used to agree that the US and other developed countries face severe long-term fiscal changes, due to an aging population.  The consensus is, or used to be, that now is a good time to start addressing these issues. (Remember Simpson/Bowles?).

The phrase “fiscal challenge” is a bit vague, but presumably Sumner means that increased spending on the elderly may lead to a rising national debt plus a rising rate of interest on that debt. Well the solution to that is to fund that spending from tax so that the debt DOESN’T rise (revelation of the century).

Plus there’s a very basic self-contradiction in Sumner’s latter point, as follows.

Assuming demand is inadequate even when the national debt is relatively high by recent historical standards, that means the private sector is hoarding money: it is prepared to hold state liabilities at low rates of interest (witness the near zero rates that have prevailed over the last five years or so).

But if the rate of interest (and in particular the REAL or inflation adjusted rate of interest) on the debt is zero (or even negative, which is where it has been recently) where’s the problem in upping the debt? Almost no interest (at least in real terms) will need to be paid.

Moreover, the debt:GDP ratio is nowhere near where it was just after WWII (or in the case of the UK, in the mid 1800s).

As to what to do if the rate of interest demanded for holding debt rises, that’s easy: pay off the debt when it matures and tell creditors to get lost. And if that results in excess inflation, then raise taxes and “unprint” the money collected, and/or raise interest rates.

As to a rise in the so called debt WITHOUT an accompanying rise in the rate of interest that needs to be paid on that debt (i.e. assuming the real or inflation adjusted rate of interest on the debt remains near zero), what’s the problem?

Sumner continues (his point No. 5):

It would be one thing if the Fed were proposing a short-term fiscal stimulus to boost demand right now.  But they aren’t, they don’t think we need more demand right now. Instead they are proposing a long-term fiscal stimulus, which would massively worsen the already worrisome long-term fiscal trends in America.  A decade ago, sensible economists (like Krugman) criticized these sorts of proposals as reckless, and they were right.  Japan has already shown that decades of fiscal stimulus do nothing to raise NGDP growth, and merely leave you with a higher debt/GDP ratio.  Why would we want to copy Japan’s failed experiment?  All they ended up with is lots of highway projects that are little used, and destroyed some of the once beautiful Japanese countryside.

That’s about the first valid point that Sumner makes: i.e. trying to forecast what fiscal stimulus (or indeed monetary stimulus) will be needed several years in advance is silly. No one knows what the economy will be doing then.

However, there is a straw man argument there as well: fiscal stimulus does not need to consist of uneconomic forms of infrastructure. As pointed out in point No.2 above, infrastructure investment should be done along commercial lines. I.e. the criterion should be: “does this investment pay for itself”. Assuming increased government spending is the order of the day, there are dozens of other forms of government spending that can be usefully increased (e.g. education, law enforcement, health care, etc).

Moreover, the decision to increase public spending rather than effect fiscal stimulus via tax cuts is a STRICTLY POLITICAL decision since it influences that proportion of GDP allocated to public spending, which itself is of course a political decision. Thus economists like Scott Sumner (to repeat) should not express opinions on that subject.

As regards the “Simpson-Bowles” point that a rising national debt is some sort of problem, that’s nonsense. To repeat, as long as the rate of interest on the debt is near zero, or below inflation, why should we worry about the debt? And if creditors start demanding more interest, just pay them off when debt matures and tell them to go away, which in effect equals QE. QE has not proved all that inflationary, but if it did, that inflation can be countered with various deflationary measures like interest rate increases (exactly what the Fed wants) or tax increases.

And another solution to the “worrisome” fiscal problem Sumner refers to is (as Keynes pointed out nearly a century ago) to fund fiscal stimulus from new base money rather than via debt.

“6.  What does improving education have to do with fiscal stimulus?  The US already spends more on public education than most countries, and education experts seem to agree that the real problem is poorly designed schools or bad home environment, not lack of money.  Would throwing a few more billions of dollars at the LA school system boost growth?  Would it turn the LA system into the Palo Alto system?  How?”

According to this Wiki site, the US is actually near the average so far as developed country spending on education goes. On that basis there is scope for more spending on education in the US if that’s what US voters vote for. But to repeat, that’s a political decision, not a decision for economists.

Incidentally, the Fed (i.e. Yelland) is also at fault in advocating a SPECIFIC TYPE of government spending, namely education. The decision as to how much to spend on education (or on defence, law and order, etc) is a POLITICAL decision: it’s a decision for politicians. In  contrast, if Yelland had just advocated more fiscal stimulus, that would have been OK since that is pretty much a strictly an ECONOMIC point.


Sumner’s description of the Fed’s ideas as being “bizarre” and “quintuply wrong” are way out.