Why is Rogoff silent on QE?

I’ve just Googled “Rogoff Reinhart QE” and met a total blank. Kenneth Rogoff and Carmen Reinhart seem to have written nothing about QE. 

Of course I'm well aware that they will have written at least a paragraph or two SOMEWHERE on the subject. But it certainly isn't easy to find.

If you have a decent grasp of economics you’ll know why. But if you don’t get it, here’s the explanation.

R&R have spent the last few years trying to scare us all witless about national debts or the “debt overhang” as they like to call it. (It’s important to use emotive phraseology when you’re into propaganda rather than logic.)

But QE involves having the central bank print money and buy up the debt. Hey presto: the debt vanishes in a puff of smoke.

But that’s disastrous news if your reason for living is to scare everyone on the subject of the debt, and use that as an excuse to promote austerity. So what do you do? Well best just sweep QE under the carpet. Turn a blind eye to it. Pretend it doesn’t exist.

Secular stagnation.

I pointed out earlier this year that “secular stagnation” is B.S., e.g. here and here.

So it’s good to see Bill Mitchell putting the boot in.

Put that another way, Larry Summers, who got everyone excited about secular stagnation earlier this year, is a twit.

But the moral here is that if you produce a semi-technical sounding phrase like “secular stagnation” or “weapons of mass destruction” you’ll fool about 75% of the population, including the intelligentsia.

Maturity transformation is bunk.

Commercial banks borrow short and lend long and that is one of their basic activities, if not “the” basic activity performed by banks under the existing banking system. “Borrow short and lend long” is often referred to as “maturity transformation” (MT). And MT has plenty of adherents. The following are just some.

1. Mervyn King, recently retired governor of the Bank of England said in his "Bagehot to Basel" speech that "Maturity transformation brings economic benefits..” 

2. Paul Tucker (former BoE official).

3. Sir John Vickers: see his paper entitled “Some economics of bank reform” (section 3, p.5).

The alleged merit in MT is that it enables bank depositors to share in the relatively high interest that is earned from making long term loans or investments, while retaining liquidity. Plus those who supply wholesale money market loans to banks appear to gain in the same way: those wholesale money market loans are essentially just large deposits. I’ll refer to both those types of bank creditor as “depositors” henceforth.

In fact there are several flaws in that argument, as follows.

1. Shares offer liquidity.

If MT were banned, there would not be a total loss or absence of liquidity. Reasons are as follows.

If a bank were funded just by shares rather than deposits, those shares (like all shares) would have a degree of liquidity. Indeed my Penguin Dictionary of Economics starts its definition of the word liquidity thus. “The ease with which an asset can be exchanged for money. The liquidity of an asset is determined by the nature of the market on which it is traded. For example an ordinary share of a British company is liquid because there is a well-organised market on which shares can be bought and sold….”.

Having said that, MT does provide what might be called a more “precise” form liquidity than shares. That is, buying £A of shares does not guarantee you’ll get £A back when you sell. In contrast, when depositing £A at a bank, the bank promises to give you £A back at some stage.

2. Central banks can issue any amount of liquidity / money.

A second flaw in MT is thus. If commercial banks were barred from doing MT, i.e. if all depositors who wanted their money loaned on had to deposit their money for an extended period (or buy shares in the relevant bank), that would reduce the liquidity or money creating activities of commercial banks. And no doubt that that would reduce aggregate demand and raise unemployment. But that would be very easily countered simply by having the central bank create and spend whatever amount of money is needed to bring the economy back up to full employment. Alternatively, the state could use that extra money created to cut taxes rather than raise public spending)

Moreover, central banks can create money at zero real cost. As Milton Friedman put it, in his book “A Program for Monetary Stability” (1960), “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

3. What if central banks didn’t exist?

A third flaw in MT is thus. Even if there were no central banks, commercial banks would be able to supply any amount of liquidity / money without extending loans at the same time, i.e. without engaging in MT. Since central banks obviously do exist,  this little section is arguably arcane, so skip it if you like.
Anyway, in a "no central bank" scenario", anyone would be able to have their bank credit their account with any amount of money they like by depositing enough collateral.

Note that at the point when the collateral is deposited and the account is credited, no loan has been extended: that is the account holder has not consumed real goods or services supplied by anyone else.

In contrast, as soon as the account holder spends £X, that means they’ve been supplied with £X of goods or services: a loan has been extended.

However, if the account holder, and similar account holders around the country were simply looking for day to day transaction money (i.e. liquidity), rather than long term loans, and say everyone had £Y credited to their account (to take a simple example) then the balance on everyone’s account would rise above £Y as often as it fell below £Y. Thus essentially no long term loans would be involved.

In short, even if there were just private banks and no central banks, we could manage just fine without any MT.

So what’s the point of MT?

Well I’m darned if I know. It does give us liquidity / money, but liquidity / money can be supplied for free in whatever quantity we need by central banks. Moreover, central banks perform that function without the risk that is inevitably involved in MT.

That is, risk is absolutely inherent to MT: if you accept £B in deposits and lend on or invest the money, the claim that you can repay the depositor £B is essentially fraudulent because loans and investments can go wrong. Indeed the recent crisis was just the umpteenth example that we’d seen throughout history of MT going wrong. And it went wrong in spectacular style recently: trillions of dollars of public money was needed to rescue banks their farcical “borrow short and lend long” confidence trick.

The above point that risk is absolutely inherent to MT was eloquently made by Douglas Diamond. In his abstract and in reference to the liquidity producing characteristics of commercial banks he says, “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.”

Now perhaps I’ve missed something, but if central banks can provide us with a form of money without risks being involved, and if private banks can only provide us with a form of money by at the same time running the risk of bank runs, I don’t see the point in letting private banks do any money / liquidity creation.

Why not have taxpayers cover the risks?

Under the existing system, the risks thrown up by MT are covered to some extent by taxpayers. But that’s a subsidy of banks, and subsidies misallocate resources, i.e. reduce GDP as it explains in the introductory economics text books. Or as the Vickers commission put it, “The risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers”.

So that’s that idea smacked down.

If MT is so useless, why do banks offer it?

Assume a totally free market, in particular an economy where governments offer no sort of lender of last resort facility or bail outs to commercial banks. That’s the sort of scenario that existed prior to the 1929 crash.

Private banks in that scenario are in competition with each other, and they are induced to make depositors all sorts of tempting offers: e.g. that depositors can earn the interest that comes from long term loans and investments, while retaining liquidity. That offer is fraudulent because the long term loans can go wrong, which is plain incompatible with offering to return £X for every £X deposited. As Martin Wolf put it "If we were not so familiar with banking we would surely regard it as fraudulent".

But the fact that some fraud is involved there doesn’t bother private banks. Indeed almost every advert issued by every firm and corporation on planet Earth is fraudulent to some extent: almost all adverts over-state the merits of the product concerned.

Now if you can make some extra money by sharp practice / fraudulent / semi fraudulent activities, then why not?

Why not just raise capital requirements?

The risks involved in MT can of course be reduced by raising bank capital requirements. But strictly speaking, risks are never TOTALLY REMOVED until banks are funded JUST BY shares: i.e. the capital ratio is 100%.

As to the idea that funding banks via shares rather than deposits raises the cost of funding banks, that idea was demolished by Modigliani and Miller.

So . . . the risks that private banks run can be totally removed by funding them entirely by shares. And the costs of doing that are zero, as Modigliani and Miller showed.

As to money creation, that can be done at zero cost by central banks. And that all equals full reserve banking  - or at least one version of full reserve banking (there are actually several variations on the full reserve idea).

MT is in check mate.

Simpletons think that cutting public spending will cut the deficit.

Preliminary note: if you’re an advocate of Modern Monetary Theory you’ll probably already understand the points made in this article, and thus won’t need to read it.

______

Simple folk (and that includes many broadsheet newspaper economics commentators) see government the same way they see a microeconomic entity like a household or firm. If a micro entity has a deficit, i.e. expenditure exceeds income, then clearly cutting expenditure will reduce its deficit.

However if GOVERNMENT cuts its spending, and assuming aggregate demand (AD) is to be left untouched, then when spending is cut by £X, tax must be cut by £X as well. So, shock horror: the deficit remains unchanged. (I’ve assumed, incidentally, that when public spending is cut by £X the eventual effect on AD is equal and opposite to an £X cut in taxes. That’s not strictly true, but for the sake of simplicity I’ll stick with that over-simplification.)

So what on Earth do we do if we want to cut the deficit and/or debt while leaving AD untouched? We’re all soiling our pants over that, aren’t we?

The answer is that all announcements to the effect that the deficit/debt should be cut by some pre-ordained amount are total and complete nonsense. They’re raving lunatic. They’re a sign of mental deficiency.

The deficit is simply extra spending by government, not covered by tax, and aimed at making up for any AD deficiency. Thus if we are committed to full employment, then we’re committed to occasional deficits (well actually more or less permanent deficits for reasons I explained a few months ago on this blog).

But what if interest rates rise?

If the debt continues to rise relative to GDP, won’t creditors become increasing skeptical of a government’s willingness or ability to repay it?

Well the first answer to that is that (contrary to popular perception) deficits do not necessarily result in any rise in the debt. As Keynes pointed out nearly a century ago, a deficit can be funded by BORROWED MONEY OR PRINTED MONEY. Unfortunately half the world’s economists still haven’t grasped the latter very simple point. Certainly Kenneth Rogoff,  Harvard economics professor and former chief economist at the IMF doesn’t understand that point.

Indeed, what on Earth is the point of borrowing money when you can print the stuff? There’s no point . . . .unless you’re an academic economist or professional economics commentator looking for a way to keep yourself occupied, in which case you can write any number of articles and papers on the relative merits of borrowing versus printing. That will undoubtedly further your career and keep the salary cheques rolling in.

But assuming a government does go for the borrow option, and creditors get the jitters and raise interest rates? Well there’s a simple solution staring us all in the face: QE. That is, print money and buy back debt. (Or cease incurring debt and go for the print option).

That will have the effect of REDUCING the rate of interest paid on the debt. In fact a government that issues its own money can do just as much of the above QEing as it likes, and reduce the interest rate on its debt to any level it likes – a point which is widely accepted in Modern Monetary Theory circles.

Inflation.

Of course whenever the words “print” and “money” appear in the same sentence, hoards of Neanderthals appear from the woodwork chanting “inflation”. Now I have a message for Neanderthals, which is that the average ten year old has worked out that excessive money printing leads to excess inflation. The point is so obvious that it goes without saying.

Moving on to some slightly more subtle points (way beyond the comprehension of Neanderthals), funding a deficit with printed money will not result in excess inflation unless AD becomes excessive. Ergo . . . . roll of drums. . . . .if JUST THE RIGHT AMOUNT of money is printed and spent, then AD will rise by the right amount and employment will rise to the full employment level (or “NAIRU”, if you like acronyms).

It is of course just conceivable that inflation would rise ABSENT any rise in AD and because of inflation expectations: that is, it is possible that the average household and firm keeps an eye on the money supply figures and raises their wage demands / prices accordingly. But frankly the idea that the average household or firm keeps an eye on the money supply figures is an idea straight out of cloud cuckoo land.

But there again, expectations or “Ricardianism” is a great wheeze for keeping academic economists employed. If they could keep themselves employed counting angels on pin heads, I’m sure they’d go for that as well.

But so far as REALITY goes, I agree with Joseph Stiglitz who said “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.”

Conclusion.

Governments are FORCED TO implement deficits if they want to maintain full employment. There is nothing they can do about it. And as to the rise in the debt or expansion in the amount of base money that results from a deficit, there is NO PROBLEM there.