Laugh of the day and graph of the day.

First the laugh. The World Bank has just appointed Lehman’s Global Head of Market Risk Management as they went into bankruptcy to the position of Vice President and Treasurer. Hat tip to Billyblog. As Bill Mitchell author of Billyblog rightly asked, “Did they also interview Bernie Madoff?”



Graph of the day.

I like this, which I saw at the Schwartz Centre for Economic Policy Analysis site. It clearly shows different components of effective demand. Note the collapse in household investment (bottom line) between 2007 and 2010.

Simon Johnson, formerly of the IMF, has a brain wave.

As Bill Mitchell has pointed out numerous times, the IMF is made up of incompetents.

Simon Johnson in this article has a great idea for reducing the deficit and/or debt (DD): it’s to wait till the recovery really gets underway, and then pair down the DD in earnest. The crucial paragraph in his article is the penultimate one, which I’ve re-produced just below in purple.

The best way to bring the debt-to-G.D.P. ratio under control is to limit future spending increases and augment revenue while the economy continues to recover. In particular, health care spending needs to be credibly constrained but doing this properly would mean limiting health care costs as a percentage of G.D.P. — proposals that just push costs from government onto companies and individuals are not appealing.

There are several flaws in this argument.

First, deficits INVARIABLY decline in a recovery, and may even turn into surpluses. To that extent, Johnson is simply advocating the inevitable.

Indeed, taking an ideal scenario (a rather extreme one by today’s chaotic standards) governments would pitch their deficits at a level which resulted in almost no recessions or booms. That is, given for example a sharp decline in household spending because households are worried about the loss in value of their houses, government would ideally step in and keep demand more or less constant by running a deficit.

In this ideal scenario, DDs would decline in a recovery to an even great extent than they already do. But would there any point in cutting the DD by any MORE than was happening anyway? The answer is “NO”: because the result would be a totally unnecessary slow-down in the recovery.


Public spending cuts do NOT reduce public spending!

Next, the second sentence of Johnson’s above paragraph trots out the tired old nonsense that a way of reducing DDs is to cut government spending (he cites health care).

The flaw in this idea is that such cuts raise unemployment, which in turn increases spending on the automatic stabilisers, like unemployment benefit. In fact there is even evidence that public spending cuts actually RAISE public spending!

The above bit of nonsense is popular with those who have not grasped the difference between macroeconomics and microeconomics. A microeconomic entity (like a household or business) CAN reduce its deficit by cutting expenditure or raising income. A government which is a macroeconomic entity CANNOT.

But what a government CAN do – at least to cut the DD - is simply to reverse the process that brought the DD into being. And what brings a structural DD into being is failing to collect enough tax to cover spending. Reversing that consists of raising taxes and paying off the debt.

And of course the knee jerk reaction to the “increased taxes” idea is that living standards will suffer: there will be “austerity”. Now this is a strange claim, for the following reasons.

When a country INCURS a structural DD, no one ever claims the effect is wildly STIMULATORY (although my guess is that actually is somewhat stimulatory). That is, a structural deficit occurs simply because politicians fail to collect enough tax to cover spending (with a view to making themselves popular and winning votes).

So when the process is REVERSED, there is equally little reason to suppose the effect is deflationary or that it involves austerity.

However, it may well be (as mentioned above) that the effect of incurring and paying back a structural DD is indeed somewhat stimulatory and deflationary, respectively. But that’s not a problem. Anyone who has studied economics for a year or more knows how to give an economy a boost, or conversely, damp down economic activity. Adjusting interest rates is one possible tool (not one that I personally like, but that’s another story).

Thus Johnson’s claim that health care spending must be reined in so as to cut the DD is nonsense. And if you want empirical evidence to support this, look at Sweden: it devotes much more of its GDP to public spending that the US, yet it has a much smaller DD.

Incidentally, I am NOT, repeat NOT advocating a bigger public sector for the US or any other country. The size of a country’s public sector is a POLITICAL decision: one that has NOTHING to do with a country’s DD.


Afterthought, 18th July 2011. Simon Johnson's understanding of economics is also questioned here.

.

Let’s keep the poor in their place.

The excuses for not raising demand and reducing unemployment are a wonder to behold. Economist Michael Spence has an article in the Wall Street Journal today with a series of these excuses.

He starts his article by claiming that the root cause of current high unemployment levels are structural. So the collapse of various banks three years ago and the credit crunch had nothing to do with it? The sharp rise in unemployment just after those bank collapses was entirely coincidental? “God first makes mad those he wishes to destroy”, as the saying goes.

Spence then claims that employment in non-tradables will not rise because of “government budget woes”. Strange then, that Sweden manages to devote a much larger proportion of GDP than the US to public spending, while having a much smaller debt and deficit than the US. America’s political right just can’t work this one out because they are thick.

And before some right wing thicko accuses me of advocating an expanded public sector, I’m not. I’m concentrating on the ECONOMICS. The decision as to what size the public sector is, is a political decision, not an economic decision - a distinction with which citizens of the US seem to have much more of a problem than citizens of Europe.

Spence then points to the blindingly obvious fact that several large less developed countries are getting their act together, improving their levels of education and so on. This means they now compete more effectively with skilled Americans. And from this he concludes that the only solution is for the US to spend more on education, infrastructure and so on. The flaw in this argument is as follows.

Where a country has a comparative advantage, the relevant products will tend to be exported.

But if that comparative advantage is lost, the relevant products will no longer be exported. What of it? The UK used to have a massive comparative advantage in steel shipbuilding: it used to build HALF the world’s steel ships. Then other countries caught up.

According to Spence’s crazy logic, the UK should have busted its guts and spent billions subsidising steel production, ship-building and so on.

The policy which actually makes sense when comparative advantage is lost is simply to cease exporting the relevant products, and turn to the next best form of economic activity. And that may involve exporting, or it may not. It really doesn’t matter.

If the next best products happen not be exportable, then obviously the balance of payments suffers and the currency depreciates. But what of it? The British pound fell by 25% in 2008. Scarcely anyone in the UK has noticed. It’s been nice for exporters who have taken on more employees. Otherwise, the UK population has been completely unmoved by this massive non-event.

Spence then claims the US needs to “aim to help raise savings rates so we can finance our own investment”. What, so with interest rates at an all-time record low there is some problem funding investments? And with US corporations sitting on all time record piles of cash they can’t work out how to fund investments?

As I said, God first makes mad….

.

The big Public Sector Borrowing Requirement farce.

The Public Sector Borowing Requirement (PSBR) is one huge nonsense. This world is full of emperors with no clothes. That is, farces which are so big that no one notices them.

PSBR is a term that has rather fallen out of use in the UK. But alternative terms with the same meaning are still used. Anyway I’ll stick with “PSBR”.

The PSBR is defined by the Financial Times Lexicon as “The term used in the UK for the government's budget deficit in a particular fiscal year. It refers to the fact that the deficit (the excess of spending over revenue) is made up by government borrowing. The amount that a government has to borrow in a particular period of time to cover the difference between the money it gets from taxes and the amount it spends.”

The first reason to be suspicious of the whole PSBR concept, as defined above, is that it applies microeconomic thinking at a macroeconomic level. That is, everyone knows that if a microeconomic entity, like a business or household, has a deficit of £X for the year, then it must borrow £X (assuming it has no cash to spare). But macroeconomics is a different world.

SOMETIMES microeconomics works at the macroeconomic level, but not in this case. Reasons are as follows.

When government wants to boost the economy, a popular method is Keynsian “borrow and spend”. That is government borrows £Ybn and spends £Ybn. And that supposedly raises aggregate demand. That is, the effect of “borrow and spend” is alleged to be stimulatory.

There are actually good reasons for thinking this policy works. One is that the net effect, taking the above example, is that private sector net financial assets rise by £Ybn. That is government borrows £Ybn from the private sector and spends same (i.e. channels the £Ybn back into the private sector). Plus government gives bonds worth £Ybn to those it has borrowed from. Net result: the private sector is up by £Ybn.

Noticed the farce yet? If not, read on.

Now if government runs a deficit of £Zbn, then applying microeconomic thinking, and the above FT definition, it needs to borrow £Zbn. Put another way, if government did NOT borrow the £Zbn and simply printed £Zbn of new money to make good the tax shortfall, the results would be inflationary (assuming the economy was at capacity).

So the purpose of borrowing the £Zbn is to give a demand reducing effect that cancels out the demand increasing effect that would arise from simply printing and spending £Ybn.

But wait a moment. In the case of Keynsian borrow and spend, the effect is supposedly the OPPOSITE! That is, the effect of “borrow and spend” is supposed to be demand increasing!

Of course where borrow and spend is supposed to be demand reducing, government could let interest rate crowding out do its worst: that is, it could let interest rates rise as a result of said borrowing. But given the disagreement amounts economists as to the extent of the crowding out effect, it is hard to say what the effect would be.

Conversely, when the aim of borrow and spend it to RAISE demand, government could intervene and make sure interest rates DON’T rise, or even lower them (and no doubt governments normally do this). But in either scenario, why bother with the concept “PSBR” at all? From the above argument, it would seem that it is interest rate adjustments that do the crucial work. So why not just adjust interest rates as required and forget all about the PSBR?

Indeed, even interest rate adjustments are a farce, if the arguments I put here are correct. That is, the real work is done by having government print and spend money (or the reverse, that is, rein in money via extra taxes, and “unprint” or extinguish money).

Or as Abba Lerner said, the important point about an item of tax or spending or anything else, is the EFFECT. The actual figures – in particular the effect on the size of the deficit or surplus or the PSBR is irrelevant.

.

Trouble ahead for Sweden? It’s aiming for a balanced budget.

Looks like Sweden is aiming for a balanced budget (hat tip to Marc Robinson).

As I’ve pointed out more than once on this blog, any country which aims for inflation of around 2% will need to run a significant deficit just to prevent its monetary base and national debt declining relative to GDP at 2% a year. If it doesn’t have that deficit, private sector saving desires may not be met, which may mean paradox of thrift unemployment.

.

Fast fiscal consolidation would not hinder the recovery or involve austerity.

Note dated 26th Oct 2011. The article below is 2,700 words. I put a slightly longer and hopefully better version (3,300 words) online on about 25th Oct 2011.

______________

I’m tired of being told “we must consolidate the debt, but too fast a pace of consolidation would hinder the recovery”.

This message comes from numerous “authorities” who should know better, including the IMF, a long list of Britain’s academic elite, and William Dudley of the New York Fed. (For some directions to the relevant paragraphs in their pronouncements, see references at the end.)

The phrase “fiscal consolidation” is defined in the Financial Times online Lexicon as a reduction in the deficit but not the debt. In contrast, the OECD defines it as reducing both.

This disparity is not important for the arguments below because these arguments apply regardless of whether a country wants to reduce just its deficit, or both deficit and debt (DD).

As implied above, the argument here is that the pace of consolidation is largely independent of stimulus or attempts to adjust aggregate demand. To explain this, it is necessary to divide the DD into two parts: the structural DD and the part of the DD that results from stimulus. These two are significantly different, and I’ll start with the structural DD.


The structural deficit and debt.

The structural DD arises simply from a failure by politicians to collect enough tax to cover public spending. That is, they borrow instead of taxing.

Since there is no intention to give the economy any stimulus (or anti-stimulus) here, the deflationary effect of the borrowing ought to equal the stimulatory or “inflationary” effect of the spending (had that spending not been covered by tax or borrowing). At least, the two will be the same if those implementing the deficit know what they are doing.

Thus disposing of a structural DD is child’s play: just reverse the process that brought it into being. I.e. the debt needs be paid back. That is, taxes need to be raised and creditors paid off. Those tax increases would NOT mean “austerity”. Reason is that, as mentioned above, incurring a structural DD does not involve stimulus, thus reversing the process would not involve “anti-stimulus” or austerity. Put another way, there would be no reduction in GDP, total numbers employed, etc. At least that is certainly the case with a closed economy. Open economies are slightly different, and I’ll deal with them below.

As to where some stimulus DOES inadvertently result from incurring a structural DD (and I think this DOES happen to some extent), this is not a problem. It means that an exact mirror image of incurring the DD would involve an anti-stimulatory or demand reducing effect. But countering the latter demand reducing effect is not difficult: anyone who has studied economics for more than a year knows how to raise demand. For example, some of the money for the debt buy back could come from the printing press (as is the case with QE).

Having said that GDP, numbers employed etc remain unaltered, it is of course it is not ESSENTIAL to aim for this “everything stays the same” outcome. It would be possible to mix some stimulus with the DD reduction process. But to keep things simple, I’ll stick with the “everything remains constant” assumption.

And for any readers who are puzzled as to how taxes can be raised while all the above factors remain constant (especially take home pay), the explanation is that the effect of the debt buy-back would be to raise pre-tax incomes, while tax would nullify that increase.

So that’s the structural DD gone. Vanished. A few apparent problems associated with this cure for the DD will be dealt with below, but the stimulus DD will be considered first.


The stimulus DD.

Making a reduction in the stimulus deficit an objective is COMPLETELY BALMY.

The purpose of a deficit is to raise aggregate demand where there is a shortfall in AD (for example when indebted households rein in spending because they find the value of their houses falling dramatically compared to their debt – ring any bells?)

So long as the latter shortfall in demand persists there is NO POINT in trying to reduce the stimulus deficit.

But if such a deficit lasts a relatively long time, that might appear to involve an unacceptable expansion in the debt.

The answer to the latter non-problem is that as Milton Friedman, Keynes and others pointed out long ago, a deficit does NOT HAVE TO BE FUNDED BY DEBT. That is, a deficit can be funded EITHER by increased debt, OR it can be funded by expanding the monetary base.

There isn’t actually a huge difference between the two: that is, monetary base and government debt both appear on the liability side of a central bank’s balance sheet. Moreover, a chunk of government debt is simply a promise by government to pay the holder of such debt some money on a particular date. As to where that date is in the NEAR future, (i.e. where the debt is near maturity) there is virtually no difference between the two.

Given this rather small difference it is reasonable to ask whether it is worth turning debt in to monetary base. Well, one good reason is that the world is full of panic stricken folk who think an expanding debt means the end of the world. So keeping these folk happy is no bad idea.

Second, as I explain here, the traditional arguments for having governments run into debt do not stand inspection.



The stimulus debt.

As pointed out above, given inadequate demand, government should feed financial assets to the private sector (bonds or money). In other words, given inadequate demand, the stimulus DEFICIT should not be reduced.

However, if over recent months or years a stimulus deficit has accumulated in the form of bonds or “national debt”, there is nothing wrong with reducing or “consolidating” that debt in the sense of converting the bonds to cash. In other words the buy-back proposed here can perfectly well extend to the stimulus debt.

There is a minor problem involved in doing this, namely that simply “doing a QE” on such debt (i.e. printing money and buying it back) might be too stimulatory, and thus too inflationary. But the solution to this little problem was referred to above, namely that the funds for buying back debt can come from the printing press or alternatively from extra tax. The former is stimulatory and the latter has the opposite effect, that is it is “anti-stimulatory” or “demand reducing”.
So mix the two in the right proportions, and you get a neutral effect. That is, no effect on GDP, numbers employed, and so on.


Apparent problem No.1: distributional matters.

I’ll now consider a few apparent problems with the above DD reduction ploy.

The first apparent problem is that the ploy might benefit the asset rich (holders of government debt) at the expense of the average tax payer. Well the answer to that is that in principle, matters and policies relating to wealth and income distribution should not be mixed up with matters relating to DDs.

For example, when governments expand a deficit, the prime aim is NOT to re-distribute income or wealth (although given the less than perfect competence of governments, some inadvertent re-distribution probably does take place normally). Likewise, when the process is reversed, assuming it is reversed in a competent manner, there ought not to be any significant distributional effects. I.e. if changes to the income tax and social security system are needed to counter-balance any distributional effects of reversing a DD, then so be it. That is not a big technical or economic problem. (As to the politics, that’s a different matter!)

So let’s move on to the next problem.


Apparent problem No 2: a large monetary base expansion would be inflationary.

Laugh out loud!

The monetary base in the US just has expanded by an astronomic and unprecedented amount: it’s TREBBLED IN THE LAST TWO YEARS!!!! And where’s the hyperinflation?

To be more serious, there are some very good reasons for this lack of serious inflation. First, additions to the money supply are not inflationary till they are spent, and spent in sufficient volume and speed to cause excess demand and thus inflation. (David Hume, the Scottish philosopher pointed this out 250 years ago. It would be nice if we’d learned something about economics in the last 250 years, would’nt it?)

But wait a minute: an increase in demand IS THE SOLUTION TO THE PROBLEM! In other words it is not possible to get serious inflation without first “solving the problem” (i.e. the recession). Of course the tricky bit is to avoid overshooting the solution, to coin a phrase. But certainly in principle, it is not possible to get excess inflation without having first “solved the problem”

Second, as to the idea that this additional money might cause inflation a few years down the line, that is a feeble point, and for two reasons.

First, increases in demand and thus inflation can perfectly well occur EVEN WITH NO INCREASE IN THE MONEY SUPPLY AT ALL. For example a big increase in consumer confidence, i.e. a willingness by consumers to go into debt and a willingness by banks to lend to them would cause a rise in demand. Indeed, this was the source of a sizeable portion of many countries’ aggregate demand prior to the recession.

Perhaps the “anti money supply increase” brigade can tell us what they propose doing with the money supply given that inflation can arise ABSENT any money supply increase. Do they advocate abolishing money altogether?

Of course, expanding the monetary base raises the RISK of inflation in a few years time to a finite extent. But that should not be difficult to deal with: there are a host of anti-inflationary measures that every government has at its disposal. One of these measures is simply to reverse the above “money printing”. I.e. raise taxes, rein in money and “unprint” it, or extinguish it.

Any additional tax imposed for the latter reason would not, repeat not, mean austerity or “hindering the recovery” in any way. The sole purpose of such taxation is to remove money from the private sector, which, were it left in the private sector would cause excess inflation. And inflation REDUCES living standards rather than increases them. I.e. tax, paradoxically, can improve living standards.

Second, as to the idea that banks will lend money just because they have loads of it sitting in idle accounts, LOL yet again. Right now, as I write, banks ACTUALLY ARE sitting on larger than ever reserves, while not lending it out with any great enthusiasm. And apart from the latter evidence, there are some simple theoretical reasons that explain why banks do not automatically lend out “idle” money, as follows.

Any bank with its head screwed on, lends where it sees a PROFITABLE LENDING OPPORTUNITY, not when it happens to have money in idle accounts. Likewise car hire firms do not hire out cars at any old bargain basement price just because they have cars lying idle.

Indeed, as long as banks see profitable lending opportunities, banks will lend EVEN IF THEY HAVE INADEQUATE RESERVES!!!!! In short, the amount that banks have in idle accounts or reserves, is one big irrelevance. For more on this, see here, or Google “banks are capital constrained not reserve constrained”. Or see here.


And if by any chance it turns out that banks do lend simply because they have money in the kitty, that just proves they are incompetent. And that is a good reason for tighter bank regulation, not an argument against letting households have the amount of money they feel comfortable with, which in turn should bring full employment. Given the numerous crooks and incompetents running banks, personally I’d favour much tighter bank regulation that Basle III.

Third, one daft aspect of the idea that “money supply increases cause inflation” is that those who promote this view never tell us what the OPTIMUM amount of money per person should be. This is exactly the same as saying that ANY increase in speed for a car on a particular stretch of road will be dangerous, without saying what the OPTIMUM speed is (i.e. where the best trade-off is as between reduced journey time and danger).

In contrast, a very clear idea has been set out above (hopefully) as to what the optimum amount of money should be: whatever brings the maximum level of demand that is consistent with acceptable inflation.


Apparent problem No.3. Permanent low interest rates.

Buying back debt as advocated here is similar to QE. And the large scale and long lasting “QE” operation advocated here possibly implies low interest rates for an extended period, but this is not a problem. Far from being a problem, there are actually good arguments for the current zero or near zero interest rates to become a permanent feature. First, see two of Warren Mosler’s works: here and item No.3 under the heading “Proposals for the Federal Reserve” here.

Second, as far as stimulus is concerned, it makes no sense for a government which wants to do some Keynsian “borrow and spend” to pay any interest for the money borrowed. That is, what is the point of paying for the privilege of borrowing something (money) which you can produce yourself at no cost?

Third, one of the few valid reasons for government debt (or monetary base) is that this provides the private sector with the net financial assets it wants. Put another way, without such assets, one gets “paradox of thrift” unemployment. But in demanding such assets, private sector entities do not do society as a whole any favours. Thus there is no reason to reward such private sector entities.

Put another way, the attitude of government to private sector entities which threaten to go into saving mode and cause unemployment unless they have the savings they want should be “OK, here are the savings you want, but there is no reason taxpayers should be burdened with paying you interest, so you’re not going to be rewarded for demanding these savings”.


Should we abolish interest rate adjustments?

The above argument, of course, implies abandoning attempts to adjust aggregate demand by adjusting interest rates. That is, the implication is that it is the quantity of money that should be adjusted not its price (though of course adjustments to the quantity will inevitably impinge on the price).

This idea may be novel, but there are actually a host of weaknesses in the idea that interest rate adjustments are a good idea, which I set out here.


Apparent problem No.4: balance of payments effects.


Let’s start with the stimulus part of the deficit. QE has lead, particularly in the US, to funds quitting the country in search of better returns elsewhere. And this in turn will have depressed the dollar relative to other currencies.

Given that what is proposed in this article is QE writ large, is there a problem here?

The answer is that ANY form of stimulus depresses the value of a country’s currency. That is, the alleged “problem” here is not unique to the policy advocated here.

That is, given excess unemployment, a country will normally be better off reducing that unemployment, even if there is a slight drawback in the form of its currency losing value.

As to the structural part, QE certainly leaves debt holders with spare cash, and a proportion of those will lodge their cash abroad, which means a finite devaluation of the currency of the country concerned. And that means a standard of living hit, i.e. austerity.

On the other hand the pound Sterling was devalued by 25% or so in 2008 and any standard of living hit has been negligible compared to the standard of living reduction being experienced by European periphery countries.

Moreover, the greater the number of countries with allegedly excessive debt that implement the above policy at the same time, the less the incentive for former debt holders to shift money from one country to another, thus the less will be the changes in living standards of one country relative to another.

_______________

References.

Dudley: see para starting “As discussed earlier….”
IMF: see para starting “The policy advice to advanced economies….”

Note: The above last section “Apparent problem No 4…” was re-written on 25th Sept 2011.

Better late than never: Stephen Roach tumbles to the fact that US consumers are not spending.

Stephen Roach is a Yale University academic and non-executive chairman of Morgan Stanley Asia. He devotes a Financial Times article to the point that US consumers are not spending.

Yes, well most of us tumbled to the fact this was bound to happen when heavily indebted households saw the value of their houses plummet two or three years ago.

Roach, of course does not have a solution to the problem, other than suggesting we sit around for years on end waiting for consumers to deleverage.

In contrast, leading MMTer Warren Mosler has been trying to spell out the solution for a long time now. Namely a payroll tax reduction: that feeds stimulus direct into household pockets.

But the political and Wall Street elite would hate to see money flowing into peasants’ pockets. The former want it flowing into their own pockets. That wouldn’t matter too much if they actually spent it on something: butlers, chamber-maids, servants, yachts, you name it.

But they don’t: they use the money boost stock market prices or take the money out of the US altogether in search of better returns around the globe.

Perhaps the elite will finally be happy when the peasants are chopped up into little pieces and turned into dog food.

.