What proportion of economists have a grip on reality?

The Cambridge economist Ha-Joon Chang said  “Unfortunately a lot of my academic colleagues not only do not work on the real world, but are not even interested in the real world.”

Nothing illustrates that lack of interest in reality better than Ricardian Equivalence (RE). For those not acquainted with RE, it’s an idea which is about as realistic as witchcraft or astrology, and it’s as follows.

It’s the idea that if government deals with a recession by spending more and funding that extra spending via more debt, then it will have to raise taxes to repay that debt at some time, and the average individual or employer will realize that tax hike is in the pipeline, thus they’ll try to save so as to meet that tax obligation. Plus that saving will partially or wholly nullify the latter extra spending.

Incidentally I’ve dealt with the nonsense that is RE before on this blog, but a bit of repetition never goes astray when trying to get a point across. Plus the paragraphs below make a few points not made in earlier articles on this subject.

The first obviously unrealistic aspect of RE is the idea that the average individual, household or employer actually knows what the deficit is in terms of dollars, pounds, etc, and sits down  with a calculator to work out what the resulting future increased tax liability might be. I suspect the proportion of the population (individuals and employers) who know what the deficit is in terms of dollars or as a percentage of GDP is around 1%. But perhaps I’m out by a two or three hundred percent there, and the real percentage is 2% or 3%. Makes no difference: it remains true that almost NOBODY does or event tries to do the sort of calculation that RE enthusiasts claim they do.

How many of your friends spend time with their calculators working out the alleged effect of a deficit on their future tax liability? None of mine do, and I’ve never known anyone do that. Provisional conclusion: RE is an idea straight out of La-la land.

But that hasn’t stopped hundreds of economists, if not thousands, turning out papers where the validity of RE is explicitly assumed, or at least in which its partial validity is assumed.


Inflation and increased real GDP.

The second blatantly unrealistic aspect of RE is that governments basically just don’t repay their debts via increased tax. What actually happens is that a higher than normal debt relative to GDP declines over the years and decades, first because inflation eats away at the real value of the debt, and second because of increased GDP in real terms (which cuts the debt/GDP ratio assuming the debt remains constant or more or less constant in terms of dollars).

A classic example is the UK’s public debt which just after WWII was around 250% of GDP and declined to around 50% in the 1990s. But according to the chart just below, produced by Roger Farmer, economics prof in California, the whole of that debt reduction took place because of the latter two factors: inflation and increased real GDP. Put another way, according to Farmer’s chart there was a deficit every single year between WWII and the 1990s, i.e. no surplus (which would indicate repayment of debt).

Actually Farmer’s chart is not quite right: I believe there were one or two years in which THERE WAS a surplus. But never mind: the chart is BASICALLY RIGHT. That is, the vast bulk of the fall in the UK’s debt/GDP ratio came about because of the above two factors: inflation and increased real GDP and not because the debt was repaid in the conventional sense of “repay a debt”.

Conclusion: for anyone interested in reality, RE is complete nonsense. Or as the Nobel laureate economists Joseph Stiglitz put it, “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.”


A third flaw in Ricardian Equivalence.

Just by way of driving a final nail into this coffin, there is actually a third flaw in RE which is relevant where there is no inflation or real growth. Of course that “no growth or inflation” assumption is a bit unrealistic, but this is worth pursuing since the above demolition of RE was based on the assumption that THERE IS inflation and real growth. I.e. by way of closing off every possible escape route for RE supporters, it is worth explaining why RE is nonsense even where there is no real growth or inflation.

But a word of warning: this third flaw in RE is a bit complicated. Plus my explanation of this third flaw doubtless leaves much to be desired. So stop reading now if you like: arguably you won’t have missed much. Anyway, here goes.

First, as is little more than common sense, there are numerous factors that determine aggregate demand (AD ): there is for example consumer and business confidence. Thus to keep things simple, let’s assume (as per standard scientific experiment) that all variables other than the ones we’re interested in are constant.

The variables we’re interested in are AD, the deficit and the resultant stock of base money and public debt held by the average person.
(The idea that there is some sort of average person who holds a stock of base money and government debt is of course itself a simplification in that private individuals do not DIRECTLY hold a huge amount of public debt: in as far as they do hold it, they hold it (in the UK) via accounts at National Savings and Investments, unit trust holdings and via pension funds. But never mind: individuals in the UK and elsewhere are effectively owners of public debt).

Next, bear in mind that public debt is effectively more or less the same thing as money (as explained for example by Martin Wolf in the Financial Times).

Now the more money people have (both base money and public debt, which is the sense in which I’ll use the word “money” from now on) the more they’re liable to spend. Thus there must be some stock of money per average person which gives a level of AD which results in full employment.

And given a recession, governments run deficits which result in the average person’s stock of money rising, which in turn encourages more spending, which in turn brings and end to the recession. (Of course demand is also raised by the mere fact of additional public spending.)

Now why in a “no growth / no inflation” scenario does it not make sense for people to save so as to meet the tax liability that RE enthusiasts are so keen on? Well first people cannot be sure that that tax liability will ever arise: that is, if there’s been a PERMANENT increase in the amount of money people want to hold, there is no point in government withdrawing that money from people. If government does, that will simply lead to a recession.

Alternatively, suppose the increased money supply deals with a recession till the end of year X, at which point there’s an increase in consumer and business confidence, which more or less equals a reduced demand for money (aka increased desire to spend) by the private sector, so government has to withdraw some of the private sector’s stock of money.

If people save BEFORE the end of year X, that will tend to prolong the recession, in which case government will have to feed yet more money into peoples’ pockets.

Thus we are led to the absurd conclusion that if a tax increase is actually necessary at the end of year X, and people save before that time in order to meet that tax liability, that will force government to deal with the deflationary effect of that saving by running an even bigger deficit, which will presumably induce people to save even more in order meet the even bigger tax liability, which in turn exacerbates the recession even further! We appear to be going round in circles!

In short, if people do have the amazing foresight that RE supporters claim they do, people will not save in order to meet any alleged future tax liability because the mere fact of that saving means government will run an even bigger deficit, which increases the future tax liability even further.

Conclusion: this is clearly a total and complete farce.

Final conclusion: Ricardian  Equivalence is a farce.

Artificial interest rate adjustments are daft.

Summary.    The optimum or GDP maximizing price for anything, including the price of borrowed money, is the free market price. Therefor artificial adjustments to interest rates are not a GDP maximizing way of regulating demand: i.e. the best way of imparting stimulus is to simply have government and central bank create new money and spend it, and/or cut taxes.

A possible criticism of that idea is that having the state create money is equally artificial. (The word “state” is used here to refer to government and central bank as a combined or single unit.)

The answer to that criticism is that having the state create new money and spend it and/or cut taxes actually imitates the free market’s main weapon against recessions which would operate in a genuinely free market: the Pigou effect – the fact that in a genuine free market and given a recession, wages and prices would fall, which equals a rise in the real value of money, which in turn encourages spending.

_________

It is widely accepted in economics that the optimum or GDP maximizing price for anything, including the price of borrowed money, is the free market price. Thus unless there is good evidence that the free market isn't working when it comes to interest rates, there is no good reason to interfere with interest rates – i.e. fiscal stimulus is better than interest rate adjustments. That’s “fiscal stimulus” in the form of printing new money and spending it and/or cutting taxes. Or to put that another way, “print and spend” is better than artificial interest rate adjustments. (The phrase “fiscal stimulus” will be used here to refer to the latter “print and spend and/or cut taxes” policy)

And indeed, it’s hard to see why the free market does not work in the case of interest rate determination: for example, those seeking mortgages shop around for the best deal, and those looking for a home for their savings do likewise. Seems very much like a free market to me.

It might seem there’s a reason to criticize the latter claim that the free market is working: it’s that interest rates do not fall far enough to cure recessions. The flaw in that criticism is the assumption that interest rate falls are the only or the main free market cure for recessions. They are not.

Another cure is the so called “Pigou effect”: that’s the fact that in a totally free market and given a recession, wages and prices would fall (in terms of money), which equals a rise in the real value of dollars, pounds, etc. It also equals a rise in the real value of government debt, which is a private sector asset. All in all, in a genuine free market, there’d be a rise in the real value of what MMTers call “private sector net financial assets” (base money and government debt).

Moreover, as distinct from interest rate adjustments which do not seem to be obstructed in the real world, there is a very obvious obstruction in the real world to the Pigou effect: it’s Keynes’s “wages are sticky downwards” phenomenon. That is, given a recession, wages just don’t fall all that much. Indeed in some heavily unionised sectors, any attempt by employers to cut nominal wages would be met with immediate strikes: exactly what happened when Churchill tried to cut miners’ wages in the UK in the 1920s.

Incidentally, given a gold based currency, the latter fall in wages and prices would mean a rise in the real value of gold, which would encourage the production of more gold, which in turn would enhance the rise in the real value of the stock of money. But clearly that mechanism works far too slowly.

However, the “sticky downwards” inadequacy in the Pigou effect can be easily circumvented (as I think Keynes pointed out in his General Theory) by expanding the real value of the money supply by increasing the NUMBER of dollars, pounds, etc rather than increase the value of EACH dollar, pound etc. I.e. a recession can be cured by having the state create and spend more money and/or cut taxes. The fact of spending that money increases demand, plus the private sector’s increased stock of money will ITSELF raise demand. To summarise, the latter fiscal stimulus makes more sense than interest rate cuts in a recession. Reason is that that fiscal stimulus (which actually incorporates a monetary effect – increasing the money supply) rectifies the free market mechanism that goes wrong in a recession in the real world. In contrast and to repeat, it is not at all obvious that there is any deficiency in the market for savings and loans to be rectified in a real world recession. (Incidentally, as anyone who knows anything about money will know, it’s only base money which is relevance here: that is, private bank created money is irrelevant because for each £ of such money, there is a corresponding debt.)

Another point in favor of fiscal stimulus is this. The basic purpose of the economy is to produce what people want, both in terms of what they choose to purchase out of disposable income and what they vote to have the state provide for them in the form of public spending, and given that the economy in a recession is by definition not producing enough of what “people want”, the logical solution to a recession would seem to be to increase household spending (which can be done via tax cuts) and public spending. I.e. fiscal stimulus makes more sense than interest rate cuts.


Central bank and political coordination.

If tax and/or public spending are to be adjusted quickly, come a recession, there might seem to be a problem in that decisions on tax and public spending are normally taken by politicians, and they can take far too long to make decisions for the purposes of dealing quickly with recessions. In fact that shouldn’t be too much of a problem: in the UK during the recent crisis, the technocrats at the treasury twice adjusted the sales tax, VAT, without specific permission from politicians (apart from the UK finance minister, of course).

Plus, if politicians think that for example a decision by technocrats to raise taxes results in too much of GDP being allocated to public spending, then politicians are free at their leisure to reverse that and at a later date, i.e. cut both taxes and public spending. Moreover, and with a view to making technocrat’s decisions as non-political as possible, they could be instructed, when implementing fiscal stimulus, to effect it in part via increased public spending and in part via tax cuts: that way, the proportion of GDP allocated to public spending does not change when technocrats decide to implement stimulus.

That might sound complicated to those new to the idea. Actually it’s quite simple and involves no big economic or technical problems, though POLITICAL problems are possible in the form of politicians objecting to having some of their powers removed. Bernanke (1) gave his blessing to the idea in the paragraph starting “A possible arrangement..” here. And Positive Money (2) and co –authors set out the idea here.


Public borrowing.

Having argued that interest rates should be left to their own devices, i.e. left at the free market level, there is the slight problem that government borrowing, because of the sheer scale of such borrowing, has a significant effect on interest rates. Thus it is necessary to answer the question as to what the optimum amount of such borrowing is. My preferred answer to that question is the one given by Milton Friedman and Warren Mosler, i.e. that governments should borrow nothing, except perhaps in emergencies. . (At least that was the answer given by Friedman here – he later changed his mind on the “zero interest” point). Reasons for that “borrow nothing” argument are briefly as follows

1. No one with their head screwed on borrows (and thus pays interest) unless they absolutely have to, i.e. unless they’re short of cash. And given that governments can grab any amount of cash off taxpayers, plus given that governments can print money, the idea that any government is short of cash is obvious nonsense.

2. The popular “golden rule” idea that governments should borrow to fund infrastructure investments is nonsense, first because as explained above, no one pays for an investment via borrowing if they happen to have enough cash. Second, education is one huge investment, but no one ever suggests funding the entire education budget via borrowing. So there’s some muddled thinking there!

3. Fiscal stimulus in the form of “borrow and spend” is daft because borrowing has a DEFLATIONARY effect: the opposite of the intended effect. I.e. borrow and spend with a view to stimulus makes as much sense as throwing dirt over your car before washing it.


Zero borrowing and interest rate cuts.

As explained above, the undesirability of artificial interest rate adjustments is not to rule out such adjustments in an emergency (a point made by Friedman). As to how to effect those adjustments, that might seem to be a problem in a “zero government borrowing” scenario. That is, the normal way of for example cutting interest rates is to have the central bank print money and buy up government debt. But absent any government debt, the central bank can simply offer to lend to large banks at below the going inter-bank rate.

As for interest rate hikes, the central bank can just wade into the market and offer to borrow at above the going rate.

However, there is a glaring self-contradiction in the whole idea of interest rate adjustments (other than emergencies) regardless of what is regarded as the optimum or GDP maximizing amount of government debt. The self-contradiction is this.

If it is decided that the optimum amount of public debt is X% of GDP, and to deal with a recession, the central bank prints money and buys up government debt so as to reduce interest rates, then the total amount of state debt is then below the optimum or GDP maximising level! 

_________

References.

1. Bernanke. “Here's How Ben Bernanke's "Helicopter Money" Plan Might Work.” Fortune.
2. Positive Money. “Towards a Twenty-First  Century Banking and Monetary System. Submission to the Independent Commission on Banking”.
3. Friedman. “A Monetary and Fiscal Framework for Economic Stability”. American Economic Review. 1948.

Random charts - 49.

Large pink text on the charts below was added by me. Re the Persimmon chart on the cost of building houses, there's another quite similar chart for one of the other main UK house builders, so the Persimmon one may be typical for UK house builders.

Random charts - 48.

Large pink text on the charts below was added by me.

Pigou subsidies.

Bit arcane this – so don’t say you weren’t warned.

A Pigou subsidy is an idea I hadn’t come across till Nick Rowe draw the attention of all and sundry to it on Twitter. It’s the idea that a gift, particularly a gift by the rich to the poor, involves a positive externality, i.e. a net benefit for society as a whole. Ergo, the rich should be given a financial inducement to give, in rather the same way as negative externalities like pollution are DISCOURAGED by taxing the polluter.

Nick Rowe’s tweet:

EconTwitter: It is really bugging me that I can't get my head straight on this stupid exam Q: "Gifts create a positive externality (for the recipient), so a Pigou subsidy is needed to get the optimal amount of giving". Discuss.

— Nick Rowe (@MacRoweNick) December 16, 2017

 
 My answer, for what it’s worth, was thus.

Take the simple case of a country divided into two classes, rich and poor. Donations by a rich person to a poor person bring net benefits. Say the benefit is equal (in terms of dollars) to the gift. But to induce a rich person to give, they must be given a Pigou subsidy equal to the amount of the gift.

If the tax needed to fund the Pigou subsidy is raised from the rich, that all nets out to what we already do, i.e. grab tax off the rich in order to subsidise the poor. But if the tax is levied on the poor, they’re no better off.

Doubtless that argument of mine needs tidying up, but I suspect it’s basically valid: i.e. Pigou subsidies are pointless, so we might as well stick to what we already do, i.e. tax the rich and subsidise the poor.

Richard Murphy’s weak grasp of economics.

He advocates a rise in inflation to above the 2% target because that would help debtors*. As he puts it in reference to increased inflation: “….the country could do with some to assist those in debt manage the burdens they face.”

Well now there’s a teensy problem there, namely that creditors and savers are not complete idiots: that is, once they see that an increased percentage of what they save and lend will be eaten away by inflation, they’ll be reluctant to save and lend. Hey presto: interest rates are forced up, which is not exactly of “assistance” to “those in debt”. 

Indeed, that’s exactly what seems to have happened for several years after the 1970s inflationary episode: that is, it took several years of low inflation to convince savers and creditors that inflation had in fact come down PERMANENTLY. Thus debtors were faced with several years of elevated interest rates.

Next, Murphy claims (2nd half of the para in which the above “assistance” point is made) that stagnant incomes are deplorable, and a way out of that is extra demand and inflation.

Well if inflation above the 2% target really does give us extra real GDP, why did no one think of that before? Put another way, the whole point of the 2% target is that economists think that while inflation above that rate clearly gives a faster rate of growth in GDP in nominal terms (i.e. in terms of £s, $s, etc), that is one big illusion. I.e. the consensus in economics is that once inflation rises much above the 2% target, the costs of inflation exceed the benefits. Or put another way, the consensus is that GDP growth is maximised when inflation is around the 2% level.

Of course that consensus might be wrong. It could be that GDP growth is actually maximised when inflation is 4%, 6% or some other figure. But those who want to make that claim need to set out some very detailed reasons to back that claim. 

_________

 

* Article title: “On interest rates, growth and the need for the most massive rethink.”

What’s the optimum amount of national debt?

MMTers have solved this one. Others are still floundering, in particular Roger Farmer in this NIESR article on the subject, is all over the place far as I can see  (1). So I’ll run thru this vexed question for the umpteenth time.

First (a point which Farmer does not seem to appreciate) there is little difference between national debt and base money, at low rates of interest, as Martin Wolf and Warren Mosler (founder of MMT) explained. I.e. both are state liabilities, or at least ostensible state liabilities. That’s why MMTers sometimes lump the two together and refer to the pair as “private sector net financial assets” (PSNFA).
 
Thus the first problem in answering the question “What’s the optimum amount of national debt” is that the very concept “national debt” is fuzzy: it has no clear boundaries.

Second, the amount the private sector spends is related to how much PSNFA it has (or if you like, how much “cash” it has). When people win a lottery, their weekly spending rises – a point which is common sense for most people, but a source of much confusion, difficulty and perplexity for some economists.

Ergo, the optimum amount of PSNFA is simply the amount that induces the private sector to spend at a rate that brings full employment. That’s not to say government should instantaneously adjust PSNFA every time there’s a recession. But what it can do is to simply print money and spend it, and/or cut taxes, and that will tend to raise PSNFA. So under that policy, PSNFA (or “the national debt” if you like) will always tend towards its optimum level, a policy advocated by Positive Money.

 
Interest on the debt.

Interest paid on the debt itself influences the “full employment equilibrium” level of that debt: that is, the higher the rate of interest paid on the debt, the more of it the private sector will be willing to hold, all else equal, as Warren Mosler pointed out.

A country which issues its own money can pay any rate of interest it likes on its debt, as MMTers have long pointed out. E.g. if a country thinks the rate is too high, it can reduce it by printing money and buying back debt, and then dealing with any excess inflation by raising taxes and “unprinting” the money collected.

So what’s the optimum rate of interest? Well Milton Friedman and Warran Mosler said “zero”: i.e. they said “don’t pay any interest at all”. And I must say I rather agree: certainly I don’t see any point in paying anything more than the rate of inflation, i.e. I don’t see a reason to pay a positive REAL (i.e. inflation adjusted) rate of interest. That’s for the following reasons.

First, the only really good reason to borrow is if you’re short of cash, and governments are NEVER short of cash: they can print the stuff, plus they can grab near limitless amounts from taxpayers. If a taxi driver wants a new taxi, and happens to have the cash to hand, he won’t borrow in order to buy the taxi. But then taxi drivers probably have more sense than economists.

Second, the old argument that government should borrow to fund infrastructure investment does not make sense because the ENTIRE education budget is an investment, so why don’t we fund that entirely via borrowing?

Third, I set out more argument against government paying any interest on its liabilities here (2).

So, to return to the original question, i.e. what’s the optimum amount of national debt or more properly, PSNFA? The answer is “whatever brings full employment”. And that very much ties up with Keynes’s dictum: “look after unemployment, and the budget looks after itself”. As to exactly what that amount of PSNFA will be as a percentage of GDP, that will depend on how thrifty or spendthrift citizens of the country are. The Japanese are relatively thrifty, thus their optimum PSNFA:GDP ratio will be on the high side. In other countries, the ratio will be lower.

________

Title of Farmer's article: "How much debt do we need? My answer: 70% of GDP".

Title of my article: "Government borrowing is near pointless".