The massed ranks of economic illiterates is high places have been getting all worked up about the fact that the British government borrowed £600m more than expected in July. MSN describes the £600m as a “shock figure”. “Accountancy Live” says the government’s policies look “troubled”. Well all accountants can do is bean counting: they can’t do macroeconomics. Even Huffington is huffing and puffing about the figure.
The reality is that government borrowing is simply a balancing figure of no huge relevance.
As Keynes said, “Look after unemployment and the budget looks after itself”. I.e. if the private sector is saving, the government will just HAVE TO NET SPEND if demand is to be maintained. And incidentally, government does not even need to borrow: as Keynes and Milton Friedman pointed out, the deficit can perfectly well accumulate as monetary base rather than debt (which is actually what has happened to a large extent over the last two years as a result of QE).
Conversely, if the private sector is in “irrational exuberance” mode, government will just HAVE TO run a surplus if it wants to avoid inflation. There is NO MERIT WHATEVER in such a surplus. It is simply a balancing figure. It’s a figure that “comes out in the wash”, if you want a different phrase.
.
Paying off or reducing the national debt is easy. It can be reduced anytime.
The main reason the debt is seen as a problem is that there are numerous loud mouthed economic illiterates in high places who have no grasp of the distinction between macroeconomics and microeconomics: they treat national debts (which are macro) in the same way as debt owed by a microeconomic entity, like a household or firm.
Bowles and Simpson.
For example Bowles and Simpson think the only way to reduce the deficit and/or debt, is to do what a household or firm would do where the household or firm wants to reduce its deficit or debt: cut spending and/or raise income. And “income” for government of course consists of tax. So B&S think the debt and/or deficit should be cut by raising taxes or cutting government spending.
Now the problem there is that spending cuts or tax increases are deflationary: not what we need in a recession. And that problem causes much consternation and scratching of brainless heads in high places.
Well the solution to that little problem is easy: just print money and buy back the debt (or cease rolling it over). There you are: the whole “debt” problem solved in about ten words.
Of course there are a number of boringly predictable objections to the latter ultra-simple solution to the alleged problem, which I’ll now deal with.
Printing money is inflationary?
Not given a recession. That is, assuming plenty of spare resources, e.g. surplus or “unemployed” labour and capital equipment, the extra demand stemming from an increased money supply will initially just boost output and employment. Of course IF THE MONEY SUPPLY INCREASE is excessive, then inflation will ensue. But not otherwise.
In contrast to a recession, if a country wants to reduce its national debt during normal or “non-recessionary” times, all it need do is (as above) just print money and buy back debt – which of course will be inflationary. And how do we deal with the latter? Easy: raise taxes (and/or cut public spending).
And the latter tax increase / public spending cut WILL NOT have any sort of deflationary or “income reducing” effect. That’s because the sole purpose of those tax increases / spending cut is to counter the stimulatory or inflationary effect of the debt buy back. I.e.there is no net stimulatory or deflationary effect.
Adam Smith Institute.
This article by Eamonn Butler (director and co-founder of the institute) starts by claiming that “Debt imposes a large interest-payments tax on citizens..”
Whaaaat? Doesn’t he realise that the REAL or “inflation adjusted” rate of interest on the debt of monetarily sovereign countries’ debt is about zero? In fact the rate of interest on British debt for much of the last three years or so has been LESS THAN the rate of inflation. Far from the debt costing British citizens anything, Britain is MAKING A PROFIT out of supplying sundry private sector entities with the financial assets they want. Or to put that in more blunt plain English, the British are ripping their creditors off (as indeed Germans and Americans have been doing in recent years).
After the above initial blunder, the article is just a repeat of standard Bowles & Simpson nonsense: it runs through a list of possible spending cuts.
Niall Ferguson.
Niall Ferguson is one of the world’s leading and most vociferous debt-phobes.
In this Reith Lecture, he starts with a classic mistake: lumping Eurozone periphery countries together with monetarily sovereign countries. The problems affecting each type of country are so different that you can be 99% sure that anyone lumping the two together has no idea what they’re on about. (A “monetarily sovereign” country is one that issues its OWN currency, unlike, for example Eurozone counties.)
The future generation myth.
Next, Ferguson repeats the popular myth that national debts are some sort of “burden” passed on to the next generation. He says, “The heart of the matter is the way public debt allows the current generation of voters to live at the expense of those as yet too young to vote or as yet unborn.”
The REALITY is that national debt is simply a debt owed by one section of the population to another. Thus HOLDERS of this debt pass on an ASSET to their children, while those who don’t hold any debt pass on a LIABILITY. On balance, each generation passes on NOTHING to the next generation.
Indeed that is simply a reflection of the fact that time travel is not possible. To illustrate, another popular myth is that if a public sector investment is funded by national debt, that forces subsequent generations to bear part of the cost of the investment. And indeed, were time travel possible, there would be a good case for making the next generation pay because that generation reaps some of the benefit of the investment.
But the reality is that concrete and steel produced in 2030 by the blood, sweat and tears of people in 2030 cannot be used to build a bridge in 2012.
The only exception to the above “time travel” point comes, as pointed out by Nick Rowe, where the YOUTH of one generation can be made to pay for and accumulate assets, which it consumes in its old age, with the next generation of youngsters repeating the process: working its guts out and saving up.
However the latter exception is not very realistic: that is, the REALITY is that we shower gifts on youngsters in the form of free education, health care and so. And there is little prospect of our imposing any significant burden of the above sort on youngsters.
So what’s the optimum level of national debt?
Since debt can be reduced (or increased) by any amount any time, that raises the obvious question as to what the OPTIMUM level of debt is. The answer is thus.
The optimum level of “debt plus monetary base” is the level that induces the private sector to spend at a rate that brings full employment. Or as advocates of Modern Monetary Theory have pointed out ad nausiam, if the private sector has an inadequate stock of net financial assets, it will tend to save, which will bring about Keynsian “paradox of thrift” unemployment.
And that in turn raises the obvious question: how much of that stock of “debt plus base” should be base and how much should be debt. Well the answer is that it’s pretty pointless for a government to pay anyone to borrow stuff (money) which that government can produce in infinite quantities any time. In short, the debt might as well be abolished.
And what do you know? That’s exactly what Milton Friedman advocated, i.e. a “zero debt” monetary system. See paragraph starting “Under the proposal…” (p.250) here.
Foreign debt holders.
Finally, the above argument assumes a closed economy. That is, I’ve assumed no FOREIGN holders of national debt. However, introducing foreigners to the argument does not substantially alter the conclusions. For more details, see here.
Another caveat which should be added is that the basic point of the above argument is to point out that there is no TECHNICAL OR ECONOMIC difficulty in dealing with debt. In contrast, there is big potential problem, namely that handling this debt is in the hands of politicians. It is more than possible than when expanding or contracting the debt (or doing anything else) they make a total hash of the job.
So debt IS A PROBLEM in that it’s like letting a child play with a firearm.
“The Chicago Plan Revisited” is the title of an IMF paper by Jaromir Benes and Michael Kumhof which supports full reserve banking: a system advocated in the 1930s by Irving Fisher and others and later by Milton Friedman. Unfortunately there is a big mistake at the start of this paper, as follows.
The authors envisage converting from fractional to full reserve essentially by having the central bank print some truly astronomic quantities of new money, and pay off all the country’s debtors. And when I say “astronomic” I mean something like 200% of GDP: which makes QE look like extremely small damp squib.
There is a summary of the bank sector’s balance sheets before and after the transition on pages 64-6, and for the authors’ explanation of these balance sheets, see p.7.
As they say on p.7 “the principal of all bank loans to the government (20% of GDP), and of all bank loans to the private sector except investment loans (100% of GDP), is cancelled against treasury credit.” And later,“The cancellation of private debts reduces both treasury credit and government equity by 100% of GDP.” And again: “These buy-backs in turn mean that the private sector is left with a much lower debt burden, while its deposits remain unchanged.”
Well now, if you happen to be an indebted private sector entity, this is too good to be true isn’t it? Christmas will definitely have come early under this scenario for mortgagors. In fact the effect will be rampant inflation.
Mortgagors will find the tranche of their income previously devoted to paying interest on their mortgage is no longer needed for that purpose. There’ll be a HUGE increased demand for new cars, foreign holidays, and so on.
Moreover, since most mortgagors are comfortable with their mortgage and have borrowed responsibly, the effect of getting a letter saying their mortgage has been wiped out will just induce them to run out and borrow some more: most likely with a view to getting a better house. Demand for housing will sky-rocket.
Social justice?
While wiping out debts sounds like it involves oodles of social justice, this is far from the case. People with big mortgages, at least in Britain, are NOT the poorest section of the community. The poorest are just not credit worthy: they cannot get mortgages. They live in council houses or other forms of social housing.
The biggest debtors are those in the middle of the income range. As to the very rich, they certainly TEND not to need mortgages, on the other hand there is no shortage of people with incomes twenty times the national average who live in houses worth several million, with mortgages to match.
So if you think wiping out debt equals social justice, forget it.
The two account system.
The mistake in the IMF paper stems from a failure to understand a basic feature of full reserve, as follows.
Full reserve is a system under which private banks cannot create money. Only government and central bank can do that. But commercial banks CAN LEND as long as they find depositors willing to have their money lent on by commercial banks.
However, if a commercial bank were to lend on £X at the same time as allowing the money to be still available for use by the depositor, then the bank would effectively have created extra money: both the depositor and borrower would regard themselves as having £X in the bank (that’s until the borrower spent the money, in which case the borrower’s £X is someone else’s £X).
Thus a central feature of full reserve is that depositors must choose how much of their money they want to be “instant access”, and in contrast, how much they want to be loaned on or invested. Indeed, the latter choice that depositors must make is spelled out quite clearly by two contemporary advocates of full reserve: Laurence Kotlikoff and Richard Werner. (Incidentally, while the ideas advocated by these two economists are employed below, this should not be taken to imply their agreement with anything here.)
The actual balance sheet changes.
In the light of the above, let’s now consider the balance sheet changes that occur when making the change from fractional to full reserve. I’ll assume as per the IMF paper that the transition is done more or less instantaneously. (A more gradual transition might easily make more sense, but I won’t go into that here.)
Under Kotlikoff regime, depositors who want their money loaned on or invested, put their money into a mutual fund of their choosing (“unit trust” in UK parlance). That money is then no longer a liability of the bank, and (as is the case with existing mutual funds) the depositor no longer has instant access to the money.
Werner proposes a slightly different system: the bank does the lending or investing, but it is made clear to depositors who want to earn interest from having their money loaned on that they cannot have their money back immediately. Plus there is a sliding scale of interest payable to depositors depending on how long they lock their money up for and what proportion of the losses they carry when the loans or investments go wrong. But to repeat, deposits are no longer an IMMEDIATE liability of the bank.
Personally I prefer the Kotlikoff option when it comes to money that is loaned on or invested. It is simpler, which amongst other things makes explaining the balance sheet changes easier.
In contrast, I prefer the Werner option when it comes to instant access money. Under Kotlikoff, instant access money is handled by cash mutual funds. That would seem to imply that the whole business of operating cheques, plastic cards, etc is taken over by such funds. Personally I don’t see the sense in that. Banks have expertise in operating “checking accounts” as they are called in the U.S. Plus they have expertise in operating plastic card systems.
So I’ll assume a Kotlikoff system for money that is to be loaned on or invested and a Werner system for instant access money.
Balance sheet changes.
To keep things simple, let’s say banks’ balance sheet prior to the change consists of liabilities in the form of deposits equal to 100% of GDP, while assets consist just of mortgages equal to 100% of GDP. For “mortgage” read “mortgage, loans and investments” if you like.
I COULD add equity to the liability side and reserves at the central bank to the assets side, but these two items are small compared to deposits and loans, so I’ll ignore them.
During the transition, depositors have to decide how much of their money they want loaned on / invested, and how much they want to have in the “instant access” form. Let’s say depositors want 75% of their money loaned on and 25% to be instant access.
75% of banks’ liabilities and assets are then wiped out: under Kotlikoff’s proposals, depositors would withdraw the money and put it into mutual funds, while the latter would buy 75% of all mortgages off banks.
Instant access money.
Now for the 25% of deposits that are to be instant access.
As to the mortgages balancing that 25%, the central bank buys these off commercial banks with newly created CB money. And of course mortgagors then pay off their debt to the CB which destroys or “unprints” the relevant money (balancing the money it created to give commercial banks in exchange for the mortgages).
The net result.
The net result is thus. As regards money that depositors want loaned on or invested, that money is transferred to mutual funds as are the relevant loans and investments. So bank balance sheets shrink by a large amount.
As to instant access money, commercial banks owe 25% of GDP to depositors, while in turn the central bank owes central bank money to the tune of 25% of GDP to commercial banks. I.e. commercial banks have reserves equal to 25% of GDP.
Note that there has been no increase in private sector net financial assets, never mind ASTRONOMIC increase therein that occurs under the IMF paper proposals.
Of course, if the net effect of the balance sheet changes done in “Kotlikoff/Werner” style were excessively deflationary, that could easily be countered by the standard cure for excess deflation advocated by we advocates of full reserve: just have government and central bank create new money and spend it into the economy (and/or cut taxes).
1. The purpose of QE and interest rate reductions is amongst other things to encourage investment, which in turn would boost aggregate demand (AD). However, in a recession – certainly at the START OF a recession, there is a SURPLUS of capital equipment! Trying to encourage the production of capital equipment in that scenario is raving bonkers.
2. There is no reason whatever to think that because there is a recession, that the OPTIMUM ratio in which different factors of production ought be employed has changed. In particular there is no reason to think ratio “capital equipment to labour and materials” ratio will have changed. Thus there is no reason to skew demand toward investment rather than towards the employment of labour, materials, hair dressers, computer programing, or anything else.
Indeed, the latter point would seem to be a mile above the heads of the pro-QE brigade since, far as I can see, they’ve never even raised the point.
3. It is common for employers to make a 20% or even 100% profit on a capital investment, or indeed a 20% or 100% loss. Thus, interest rate changes of two or three percent are irrelevant. Same goes for the small change in the availability of funds to borrow that stems from QE.
Or as Keynes put it, “I am now somewhat skeptical of the success of a merely monetary policy directed towards influencing the rate of interest...it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital...will be too great to be offset by any practicable changes in the rate of interest." Keynes’s General Theory – near the end of Ch 12. (h/t to skeptonomist).
4. Short term government bonds and cash are near enough the same thing. That is, QE, in that it involves purchasing short term debt is about is fatuous and central bank offering $100 bills in exchange for $20 bills, or vice versa.
5. An investment is a LONG TERM commitment. Revelation of the century that, isn’t it? Thus those making investments (whether firms or families buying a house) are not greatly concerned about SHORT TERM rates. It’s LONG TERM rates that interest them.
We are five years into a recession, and the Fed seems to have only recently worked this one out in that it is only recently they’ve gone for “operation twist”: an attempt to influence long term rates.
6. You think there is a relationship between central bank rates and the rates charged by credit card operators? Sorry: there is no relationship according to this study.
Thus QE will presumably have equally little effect on credit available from card operators.
7. This attempt by the Bank of England to explain QE is a farce. It sets out several reasons as to why QE might work. But it does not say that any of them “would” or “will” work and for reasons based on empirical evidence. It simply says that the various transmission mechanisms “might” work.
8. Radcliffe commission which studied monetary policy in Britain decades ago concluded that ‘there can be no reliance on interest rate policy as a major short-term stabiliser of demand’. So presumably the same goes for QE.
9. An important (if not THE most important) cause of weak demand at the moment is private sector deleveraging: i.e. the desire by private sector entities to pay off debts and/or accumulate cash. That is, the private sector is trying to increase its stock of net financial assets. QE has virtually no effect on the private sector’s stock of net financial assets.
Conclusion.
We’d be better off with Laurel and Hardy running central banks with the Marx Brothers, Bart Simpson and Rosanne Barr in charge of governments.
___________
P.S. (9th Aug 2012) A possible justification for QE (and/or interest rate reductions) is that the lag between the decision to implement and the desired effect is shorter in the case of monetary policy than fiscal policy. Unfortunately the evidence seems to be that lags are not spectacularly short in the case of monetary policy. E.g. see this Bank of England paper.
P.S. (27th August, 2010). To add insult to injury, a recent Bank of England report on QE says that the lion’s share of the gains from QE went to the richest 5% of the population. Well surprise surprise: some of us predicted that when QE was first mooted.
P.S. (14th Sept 2012). It should be said that QE does have one small saving grace. That is that it is not 100% clear what the crowding out effects of fiscal policy are, and if the effects are significant, then QE nullifies those crowding out effects. But that’s a two edged sword: that is, the latter point is as much a criticism of QE as it is praise. As I’ve been pointing out for years, if the crowding out effects of fiscal are unclear, it’s daft to employ fiscal stimulus alone. Much better is to employ fiscal and monetary in tandem, i.e. print money and spend it into the economy when appropriate, as advocated by Modern Monetary Theory and in this work by Positive Money, Richard Werner and the New Economics foundation.
P.S. (15th Sept 2012). Reason No.10. In boosting asset prices, QE partially insulates those who have made silly investment decisions against full consequences of their silliness. The effect is to encourage asset price speculation and asset bubbles in the future. (h/t to Positive Money).
P.S. (25the Oct 2012). Also this article, which seems to be well researched, claims the UK authorities have no idea where QE money actually went.
.
The idea that government can act as employer of last resort is as old as the stars. Pericles implemented the idea 2,500 years ago in Ancient Greece.
And certainly there is nothing in theory to stop governments offering SOME FORM OF EMPLOYMENT to every single unemployed individual. Although were the idea taken that far, particularly at times of high unemployment like the present, some of the jobs created would be near fatuous: everything suffers from diminishing returns.
Numerous acronyms are used to refer to the above idea. I’ll use “JG” (short for Job Guarantee).
Two questions are addressed below. First, should JG employees be allocated to SPECIALLY SET UP projects or “employers” (as per the WPA in the US in the 1930s). Or should the employees to allocated to EXISTING EMPLOYERS (as per the UK’s “Work Programme”).
Second, should the system be confined to the public sector.
Specially set up employers.
The big problem with specially set up employers is thus.
In addition to employing those for whom JG is designed (the recently unemployed and not desperately skilled), some minimum amount of capital equipment, permanent skilled labour and materials must be employed. (I’ll refer to the latter factors of production as Other Factors of Production (OFP)).
If the amount of OFP employed is a bare minimum, then JG will be extremely inefficient compared to normal employers (public or private sector). On the other hand, the more the amount of OFP is increased, the more JG becomes indistinguishable from existing employers!
Ergo JG people might as well be allocated to existing employers.
Public versus private employers.
The big attraction of confining JG to the public sector (though JG advocates don’t seem to spell this out very often) is that no extra demand is needed to bring JG jobs into being. Thus there is no limit to the number of JG jobs that can be created – and they can be created without exacerbating inflation.
But there is a problem there as follows.
If the economy has significant spare capacity, there is no point in dealing with excess unemployment via JG: a straight rise in demand would be better. So JG really comes into its own when the economy is at capacity and unemployment is at the supposed minimum: 3-5% or whatever.
Now if unemployment is at the level at which further demand will be inflationary, then JG cannot spend any money on OFP, nor can it pay wages to JG employees that are above what they are getting anyway: benefits. Any such payments constitute an injection, or an increase in demand.
However, there is a simple solution to that problem: allocate JG people to existing employers and for free or at a heavily subsidised rate. That should induce employers to increase the amount of relatively unskilled labour they employ, while the amount of OFP they employ remains constant. At least there is an inducement there for employers to expand the amount of relatively unskilled labour they employ relative to the amount of OFP they employ.
But if JG people are allocated to PRIVATE SECTOR employers, and assuming as per the latter paragraph that employers are induced to employ just additional relatively unskilled people and no extra OFP, then we get exactly the same result: little or no extra inflation! Reason is that inflation stems from demand for OFP, not from demand for the relatively unskilled: members of the dole queue.
Other advantages of private sector JG.
First, the private sector is better at employing the relatively unskilled than the public sector: how many unskilled people can a public sector hospital, tax office or school employ? In contrast, dishing out hamburgers, stacking supermarket shelves or labouring on a building site requires less skill.
Second, the evidence is that temporary subsidised jobs in the private sector result in better subsequent employment chances and histories than temporary subsidised jobs in the public sector (see here and here).
Conclusion.
The UK’s Work Programme is on the right lines, though obviously there are plenty of criticisms that can be made of it. For example paying less than the legal minimum hourly rate is an oddity. Are we supposed to have a legal minimum hourly wage or not in Britain?
.
There are two ideas advocated by monetary radicals (for want of a better phrase) that mesh nicely. They’re as follows.
First there is full reserve banking: the idea that private banks should not create money.
Second, there is the idea advocated by Laurence Kotlikoff, Richard Werner and others, namely that those who deposit money at banks should be forced to decide how much of their money they want the bank to lodge in a 100% safe manner, and in contrast, how much they want the bank to lend on or invest.
The reason these two ideas mesh is as follows.
In a Kotlikoff-Werner (K-W) type regime, if $X is deposited at a bank, and the bank lends the money on to a borrower, money creation takes place. That is, the depositor has $X in the bank, and the borrower also has $X in the bank. M4 expands by $X.
In contrast, if $X is deposited at a bank, and the depositor wants the money to be 100% safe, the bank lodges the money in a 100% safe manner. Indeed, the latter “100% safe storage” happens more or less automatically if the bank just does nothing with the relevant money. Reason is that the above $X deposit must have come from some other bank, and that means that at the end of the relevant working day, $X is transferred from the account of the “other bank” in the books of the central bank to the account of the depositor’s bank in the books of the central bank. I.e. where a commercial bank does nothing with money deposited, that money (at least initially) is automatically lodged at the central bank.
To summarise so far, it might seem that where a bank lends on or invests depositor’s money, new money IS CREATED. Whereas if the bank does nothing with the money, the no new money is created.
However, one of the conditions attached to bank accounts under a K-W type regime is that depositors who want their money loaned on or invested do NO HAVE instant access to their money. And quite right: the money has been loaned on or invested, so it makes very good sense to say that the relevant depositors cannot have instant access. If you invest money in a house extension, you DO HAVE access to the money in that you can sell the house. But you certainly DON’T HAVE instant access. Moreover, house prices may drop between your building the extension and selling the house, so you might not get ALL the money or indeed ANY OF THE MONEY back.
Alternatively, you might double your money. In a K-W type regime, depositors who want their money loaned on or invested face similar risks and potential rewards.
Thus depositors’ money which is loaned on or invested under a K-W type regime is no longer money: it is an investment, little different from shares bought on the stock exchange.
So to summarise, under a K-W type regime, private banks CANNOT CREATE MONEY. Money deposited in a 100% safe manner does not result in money creation, and the fact of lending on or investing depositors’ money does not result in money creation either. In short, a K-W regime is INHERENTLY a full reserve banking system.
QED.
My reason for making the above point is that having read tens of thousands of words written by K & W, I don’t remember them making the above point. But it’s quite possible I’m wrong.
.