Tuesday, 13 October 2015

Osborne, Wren-Lewis and budget deficits.

Like most people, I expect lies and drivel from politicians like George Osborne, the UK’s finance minister.

In particular, his idea about balancing the budget over the cycle is nonsense. I’ve explained the reasons several times in recent years, but it seems (for reasons set out below) that I need to  explain yet again. Here goes.

Assuming we approximately hit the 2% inflation target, the REAL VALUE of the monetary base and national debt will shrink at about 2% pa. Thus assuming the debt and base are to remain about constant relative to GDP (which is what they actually do over the very long term), then both the base and the debt have to be constantly topped up. And there is only one way of topping them up: via a deficit.

Indeed, even more “topping up” is needed thanks to economic growth. That is, if the economy expands by X% and the debt and base are to remain constant relative to GDP, the clearly the debt and base have to expand by X% as well.

To illustrate that with some not unrealistic figures, if the debt and base are say 50% of GDP, real growth is 2%pa and inflation is 2%pa, then the deficit will have to be (2+2)%x0.5=2% of GDP. That’s quite a significant deficit.

And if you don’t believe that, consider the fact that we have in practice had deficits about nine years out of ten since WWII. Plus the occasional year when there has been a surplus has nowhere near cancelled out the previous nine or so years of deficit.

(Chart thanks to The Economist)

So why am I repeating all this? Well seems that Simon Wren-Lewis (Oxford economics prof) agrees with the “balancing the budget over the cycle” idea. See his 5th para (starting “In this light…”) in particular. I suggest SW-L has slipped up there.

Having said that, I agree with him about 90% of the time and regularly read his blog posts: because they are thought provoking and interesting.

Monday, 12 October 2015

Dishonesty by the political left and right.

Lefties conflate or confuse two senses of the word “austerity”: 1, inadequate aggregate demand and 2, inadequate (at least in the eyes of lefties) public spending. That’s the equivalent of, and as dishonest as the right’s conflation of deficit reduction and public spending reductions.

Put another way, the left trumpets the virtues of increasing demand as cover for lefties’ attempts to raise public spending as a proportion of GDP. While the right trumpets the virtues of deficit reduction as cover for reducing public spending.

To be more accurate, the intelligentsia on both the left and right realise that trickery is involved. Meanwhile, the majority on both sides are fooled by the above “conflations”: that is, they don’t get the distinction between for example deficit reduction and public spending cuts.

Saturday, 10 October 2015

Pro-austerity incompetents.

Simon Wren-Lewis (Oxford economics prof) said here that concerns about the size of the deficit and rapidly increasing debt at the height of the crisis (around 2010) were “understandable”.  I beg to differ.

First, it’s “understandable” that NON-ECONOMISTS should be concerned.  After all, an individual person, household or firm gets into trouble when its expenditure exceeds income for too long, and excessive debts are incurred. However, those who HAVE STUDIED economics (and not even to degree standard) ought to be aware of the difference between microeconomics and macroeconomics: in particular they ought to be aware that household deficits and debts are not comparable to GOVERNMENT deficits and debts.

SW-L cites a list of twenty people (mainly economists) who were anti deficit (i.e. pro-austerity) in 2010. Those twenty wrote a letter to the Sunday Times in 2010 advocating austerity and SW-L says their mistake was “understandable”.  Well I don’t agree: their “mistake” or rather incompetence was a disgrace to the economics profession. Those people should be removed from their jobs and given jobs to which they are better suited, like sweeping the streets. (I’ve listed them below).

But of course, an Oxford professor like SW-L can’t use language like that: professors have to be ultra-polite and couch any criticism of their peers in terms that are so anodyne that you’d hardly think criticism was involved at all.

That unfortunately results in incompetents remaining in their jobs.

The letter from the twenty so called “economists” starts thus.

“In the absence of a credible plan, there is a risk that a loss of confidence in the UK's economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery.

In order to minimise this risk and support a sustainable recovery, the next Government should set out a detailed plan to reduce the structural budget deficit more quickly than set out in the 2009 Pre-Budget Report.”

So to paraphrase, the authors claim that “loss of confidence” by the UK’s creditors might result in interest rates charged by those creditors rising, and it’s widely accepted that increased interest rates reduce demand, which of course would “undermine the recovery”.

Well the glaring flaw in that argument is that a country (like the UK) which issues its own currency has complete control of the rate of interest its government pays to borrow. That is, to reduce interest rates, the country’s central bank (CB) just prints money and buys back government debt. Indeed, and taken to the extreme, the CB can buy back the entire national debt which in a sense is what several countries have done over the last few years under the guise of QE.

To be more accurate, the US, UK and other countries have not bought back “the entire national debt”, but they HAVE BOUGHT BACK almost all the NEW DEBT issued or incurred in the last three years or so. So effectively, they haven’t borrowed at all: they’ve simply printed money and spent it (and/or cut taxes).

Thus the claim by the above twenty so called economists that a loss of confidence will cause a rise in interest rates is complete nonsense on theoretical grounds, plus it has turned out to be nonsense in practice.

Moreover, as both Keynes and Milton Friedman pointed out, having the state simply print money and spend it (and/or cut taxes) in a recession is a perfectly viable way of implementing stimulus: that is, it’s debatable as to whether it makes much sense for a government which prints its own money to borrow the stuff.

Printing money needn't cause inflation.

Of course whenever the words “print” and “money” appear in the same sentence a number of economically illiterate economists and others who have not studied economics appear from the woodwork chanting the word “inflation”.

And the answer to that point (as I and others have pointed out a thousand times) is that increasing the money supply is not inflationary unless it results in excess demand, as explained by David Hume over 200 years ago.

Foreign exchange markets.

Now let’s consider the “currency instability” to which the twenty so called economists referred.

Clearly if just ONE COUNTRY like the UK ran a relatively large deficit, then confidence in its currency might deteriorate. But the reality is that a very large “other country” was doing the same in 2010: the US. That greatly reduces any possible fall in value in the pound.

But even if the US had not been doing the same thing at the same time, why exactly would there be a reason to think the pound would fall in value? After all, the only purpose of a deficit is to maintain demand at a level that brings about full employment. EXCESS DEMAND would draw in excess imports which would hit the value of the pound, but enough demand just to bring about full employment would not draw in any more imports that full employment brought about by other means.

Credible plans are nonsense.

The latter point about the purpose of a deficit (or surplus) being to maintain full employment leads nicely to the next point which is that “credible plans” of the sort advocated by the twenty so called economists to reduce (or increase) deficits are a complete nonsense: they’re a contradiction in terms. That is, since the purpose of a deficit is to counteract any shortfall in demand, and since the extent of future shortfalls is not predictable, it’s a complete nonsense to have any sort of “credible plan” as to what the deficit will be at any point in the future.

That is, in two years time, consumer and business confidence might suddenly increase, as a result of which demand would rise. So in consequence, a smaller deficit, or even a surplus would be called for.

That is why Keynes said, quite rightly: “Look after unemployment, and the budget will look after itself”. That is, the only “credible plan” should be to attempt to use the deficit / surplus to keep the economy at full employment. In contrast, the size of the deficit / surplus is simply a number that comes out in the wash. It should be ignored.

 The final nail in the coffin.

Of course the proof of the pudding is in the eating: i.e. have continued deficits since 2010 actually brought about “currency instability” or “higher interest rates”? No they haven’t!!!

In short, those twenty so called economists (listed below) are incompetent. Their mistake was not “understandable”. They should be put onto sweeping the streets.

The twenty incompetents.

Orazio Attanasio, University College London; Tim Besley, LSE; Roger Bootle, Capital Economics; Sir Howard Davies, LSE; Lord Meghnad Desai, House of Lords; Charles Goodhart, LSE; Albert Marcet, LSE; Costas Meghir, UCL; John Muellbauer, Nuffield College, Oxford; David Newbery, Cambridge University; Hashem Pesaran, Cambridge University; Christopher Pissarides, LSE; Danny Quah, LSE; Ken Rogoff, Harvard University; Bridget Rosewell, GLA and Volterra Consulting; Thomas Sargent, New York University; Anne Sibert, Birkbeck College, University of London; Lord Andrew Turnbull, House of Lords; Sir John Vickers, Oxford University; Michael Wickens, University of York and Cardiff Business School.

Friday, 9 October 2015

Charles Goodhart finds flaws in full reserve banking?

Patrizio Laina wrote a very good summary of the history of full reserve banking (FR) here (pages 1-19). That is followed by a paper entitled “A Commentary on Patrizio LainĂ ’s ‘Proposals for Full-Reserve Banking’…” by Charles Goodhart and Meinhard Jensen (p.20 onwards).

The first weakness in that commentary is that it’s a commentary on the FR idea, not (as per the title) a commentary on Laina’s work which to is largely an impartial historical record of thinking on FR. That is, Laina does not take sides on the actual pro FR versus anti FR argument. Thus comments by Goodhart and Jensen on the historical accuracy of Laina’s points would be in order (if the objective if G&J’s paper is as per its title). In contrast, comments on the pros and cons of FR are not in order.

So that’s the first flaw in G&J’s paper. But never mind: let’s continue with the paper.

Their first criticism (p.21) alludes to the separation of lending from deposit accepting and the authors say:

One of the reasons sometimes put forward by Currency School advocates (i.e. FR advocates) for this separation, though not emphasised by LainĂ  , is the claim that money creation should be a State monopoly, so that having much of such creation done by private sector banks is, in some senses, an inappropriate transfer of seignorage from the public sector to private sector bodies. A problem with this position is that many of these same economists would probably also endorse the (invalid) Karl Menger theory of the creation of money as a private sector market response to the constraints of bartering, in which story the government only plays a subsidiary role. Holding both positions simultaneously would seem to be logically inconsistent.

Well the first point to note there is that G&J specifically say they are dealing with a point “not emphasised” by Laina. My point exactly: G&J in their paper criticise FR, not Laina’s paper.

Anyway, moving on… I’m baffled by G&J’s claim that advocates of FR are keen on the idea that money exists or arose out of a desire to do away with the inefficiencies of barter.

Of course, money certainly does do away with the inefficiencies of barter, but there is plenty of dispute (as G&J rightly suggest) over whether centuries ago money arose from that desire, or whether it arose mainly from other causes, like the desire to kings and rulers to have a more efficient method of collecting taxes.

However, having read well over a million words written by the advocates of FR, it’s news to me that they’re all that concerned about that historical dispute. Quite the contrary: advocates of FR simply take the existing money and bank systems as they are, and argue that we can do better.

Rules for determining stimulus.

Next (2nd half of p.21) G&J claim that advocates of FR are concerned (unsurprisingly) as to how stimulus should be determined.  And according to G&J there is much dispute between advocates of FR as to what rule or set of rule should be used.

Well there’s an easy answer to that: there’s plenty of dispute, including heated dispute, between advocates of the existing bank system as to how stimulus should be determined! For example there is plenty of dispute as to how effective interest rate adjustments are. Plus there is plenty of dispute at the time of writing over exactly when central banks should raise interest rates. Monetarists argue with Keynsians, who argue with market monetarists, who argue with Austrians. The list is almost endless!!!

And apparently (according to G&J) advocates of the conventional wisdom or the existing/conventional bank system “prefer discretion and flexibility” when it comes to determining stimulus.

Well one current lot of FR advocates (Positive Money, the New Economics Foundation and Prof Richard Werner) actually advocate very much the same degree of “flexibility” as advocates of the conventional wisdom in that they suggest stimulus under FR be determined by an independent committee of economists very much like the Bank of England Monetary Policy Committee which currently does that job. And that committee under the latter PM/NEF full reserve system would be entirely free (as is the BoE MPC) to use its best judgement in deciding on stimulus: if it went for a rules based system, I’d imagine PM and NEF would have no quarrel with that, and if they went for “flexibility” rather than rules, then as I understand PM and the NEF, the two latter organisations would be equally happy.

Banks will circumvent the rules.

Next, (top of p.23) G&J make a claim which has been made a dozen times before, namely that banks would try to circumvent the rules of FR.

So banks scrupulously obey the rules under the existing system? Anyone who thinks that is living in la-la land. G&J may not have noticed but banks have been fined over a hundred billion dollars in the US in the last two or three years for laundering Mexican drug money, fiddling Libor and numerous other crimes. And in the UK we’ve had the payment protection insurance scandal.

As for Dodd-Frank, the legislation in the US which is supposed to clean up banking, Prof John Cochrane in the opening sentence of a paper of his said “In recent months the realization has sunk in across the country that the 2010 Dodd-Frank financial-reform legislation is a colossal mess..”.

Or as Richard Fisher, former head of the Dallas Fed put it,“We contend that Dodd–Frank has not done enough to corral TBTF banks and that, on balance, the act has made things worse, not better. We submit that, in the short run, parts of Dodd–Frank have exacerbated weak economic growth by increasing regulatory uncertainty in key sectors of the U.S. economy. It has clearly benefited many lawyers and created new layers of bureaucracy. Despite its good intention, it has been counterproductive, working against solving the core problem it seeks to address.”

So when it comes to circumventing rules, which looks like being the worse: FR or the existing system? Well Dodd-Frank consists of a good 10,000 pages and counting (a lawyers’ paradise, as Fisher correctly observes). In contrast, the rules of FR can be written out on the back of an envelope. Those rules are basically just two in number. First, all money lenders must be funded by equity, not debt. Second, where depositors want their money to be totally safe, that money must be lodged in a genuinely safe manner or as safe a manner as possible: lodge the money at the central bank or in short term government debt.

And where rules are SIMPLE, then all else equal, they are easier to enforce. Thus the claim by G&J that banks would circumvent the rules under FR is weak in the extreme.

A small amount of circumvention doesn’t matter.

Next, it is not the aim of FR to ban all forms of private money creation. For example most advocates of FR don’t object to local currencies. Plus when it comes to small shadow banks there has to be some cut-off point or size of bank below which it is a waste of time trying to impose FR. Put another way, the important question is what the systemically important LARGE BANKS do.

Flexibility versus inflexibility (continued).

Next, G&J claim that “opponents of the Currency School” i.e. opponents of FR “believe that such rules will tend to be too inflexible, and quite often too deflationary”

Well the answer to that is that under FR (or least Positive Money and the New Economic Foundation’s version of FR) stimulus is determined in very much the same way as it is determined at present, that is (to repeat) by an independent committee of economists. If G&J want to claim that that committee gauges the amount of stimulus correctly under the existing system, but incorrectly under FR, then G&J need to explain exactly why (i.e. why the committee is likely to impose too much deflation). After all, there’s not much difference between the two systems in that under both systems, an independent committee of economists determines stimulus.

Then in support of their point, G&J quote Ann Pettifor as saying, “Linking all current and future activity to a fixed quantity of reserves (or bars of gold, or supplies of fossil fuel) limits the ability of the (public and private) banking system to generate sufficient and varied credit for society’s purposeful and hopefully expanding economic activity.”

That passage of Pettifor’s is riddled with mistakes. First, what’s all that about the quantity of reserves being fixed? Had Pettifor bothered actually reading the material published by Positive Money or other advocates of FR, she’d have discovered that reserves are FLEXIBLE, just as they are under the existing system. That is (to repeat) if the “independent committee” decides what stimulus is needed, then it creates new money (aka reserves) and government then spends that money into the private sector (and/or cuts taxes).

Second, she doesn’t distinguish (in the above passage or the surrounding text in her work) between credit granted by non-bank entities (e.g. trade credit) and the sort of credit created by and loaned out by banks, which might be described as “money-credit” or just “money”.

As to trade credit, there’d be nothing under FR to stop firms granting each other trade credit, and indeed the sums involved there are VAST. The amount owed to small and medium size firms in the UK is three times GDP (more than is loaned out by way of mortgages).

Third, it is nonsense to think, as Pettifor clearly does, that banks under the EXISTING SYSTEM can simply create credit-money willy nilly and lend it out. I set out the reasons here.

Fourth, I am not minded to attach much importance to what Pettifor thinks given that she seems to thinks we can spend limitless amounts on investments without anyone having to save or cut back on current consumption. For more on that, see here.

Fifth, returning to Pettifor’s idea that the amount available for loans by banks is rigidly fixed under FR, that idea assumes that for some strange reason the law of supply and demand doesn’t work when it comes to borrowing and loans.

That is, given a rise in demand for loans under FR, the rate of interest would clearly rise, which in turn would induce more people to put their money in accounts or entities devoted to granting loans (so called “investment accounts” under Positive Money’s system).

Now is there something wrong with the price of something rising (e.g. the cost of borrowing) when demand increases? Not that I can see. The rate of interest paid by mortgagors in the UK in the 1980s was nearly THREE TIMES the rate paid nowadays, but for some strange reason the sky didn’t fall in. Indeed, people in the 1980s actually paid off their mortgages quicker than today: caused no doubt to a greater or lesser extent by the rise in house prices in real terms in the intervening years.

Sixth, the sharp rise in demand for loans prior to the crises was not (as Pettifor seems to suggest) caused by a rise in investment in productivity increasing machinery or other innovations (her “purposeful and hopefully expanding economic activity.”) It was caused by house price bubble blowing.

Thus a rise in interest rates given increased demand for loans, as long as the rise isn't too much and too sudden, would seem to be entirely beneficial in as far as it thwarts house price bubbles.

That’s to be contrasted with the existing system under which when the private sector switches resources to bubble blowing from other forms of expenditure, central banks do NOT RAISE interest rates and on the grounds that aggregate demand and inflation do not seem to have risen – exactly what happened before the crisis.

The opponents of FR normally win.

G&J’s next criticism of FR is thus.

“Be that as it may, the Banking School may lose a few battles (as in 1844), but usually wins the war. One reason for this is that the monetary authorities like to maintain discretionary control, and do not much want to be constrained by the rules that academic economists propose. Per contra, academic economists generally prefer rules to discretion. Even Tobin flirted with narrow bank proposals. Besides the time inconsistency argument, economists can devise rules that provide ‘optimal’ welfare in the context of their own models which they naturally wish to proselytise.” (In 1844 in the UK, private banks were prohibited from issuing their own bank notes)

OK, but another and less impressive reason the “banking school . . . usually wins the war” is that it’s in the interests of banks to win it, and banks deploy HUGE RESOURCES to ensuring they win it (including wads of cash in brown envelopes sometimes euphemistically called “contributions to politicians election expenses” donated to politicians).

Indeed Laina makes that very point. As he put it, “Phillips added  that  bankers were against the Chicago  Plan  as  it  was  seen  to  reduce  their  profits.  They  resisted  any  changes  to  the status  quo,  unless it could  be  demonstrated  that  the  new  system  would  be  even more profitable.    Whittlesey was pretty much of the same opinion as he saw that the proposal was opposed because free services of banks would  no  longer  be  free  as  well  as  bank  owners  would  lose  their main source of profits.”


Well I’m only half way thru G&J’s paper and hopefully I’ve established that it is riddled with mistakes. Thus I am not minded to read the second half.

Thursday, 8 October 2015

Departing IMF chief tumbles to the merits to peoples’ QE.

Given that the IMF was advocating austerity at the height of the crisis, I’m not sure why anyone should pay much attention to IMF staff. But anyway, the outgoing chief economist at the IMF, Oliver Blanchard seems to have tumbled to the merits of peoples’ QE.

To judge from reports of his speech (I can’t find a transcript of the actual speech) and like many other advocates of PQE, he unfortunately seems to advocate spending the relevant money on infrastructure. That is, he hasn’t yet tumbled to the point that infrastructure spending is not a clever way of combating recessions, and for the blindingly obvious reason that while there are some infra projects that are shovel ready, it often takes years to get infra projects going. Plus stopping them before completion is normally pretty daft. Plus in the particular case of the UK, the requisite skills are not instantly available.

In short, “print and spend” is a perfectly viable way of dealing with recessions, as pointed out by Keynes in the early 1930s. However, the spending should be fairly widely dispersed, not concentrated on particular items like infra. Indeed Positive Money have long advocated "print and spend" with the spending being allocated to a fairly wide selection of items - at least certainly not concentrated on just one item like infra.

I’ve made the above point about in inappropriateness of infrastructure spending as a means to combat recessions about a hundred times. And doubtless I’ll have to make it another hundred times before so called “professional” economists understand the point.

Getting simple ideas into the heads of so called professional economists is often a bit like getting thru a two foot thick concrete wall with a jack hammer.

And that is not to suggest we shouldn’t spend far more on infra: perhaps we should. But if there’s going to be a big increase we ought to build up that increased spending level over a period of years.

Monday, 5 October 2015

The cost of funding a bank just via equity is the same as funding it just via debt.

Banksters have made a good job of persuading politicians and regulators that bank capital is more expensive than bank debt.

The argument behind that claim is all to alluring, and it’s thus. Shareholders get haircuts before other bank creditors when a bank has problems, thus shareholders demand a higher return that other bank creditors. And that leads to the inescapable conclusion that equity or capital is an expensive way of funding a bank, doesn’t it?

The flaw.

One way of demonstrating the flaw in the latter argument is to consider two banks which are identical except that one is funded entirely or almost entirely by equity, while the other is funded entirely or almost entirely by debt (i.e. deposits and/or bonds).

Now if the “capital is inherently expensive” argument is correct, then funding the “equity only” bank should be much more expensive than funding the “debt only” bank. In fact the cost of funding the two is exactly the same, and for the following reasons.

I’ll assume initially that the government of the country where those two banks are located wants to maximise GDP, and to that end, government rules out all forms of subsidy (except where there are good social justifications for a subsidy as is doubtless the case with kid’s education). That is, government offers no subsidy of any sort for banks or depositors in the form of rescuing banks with taxpayers’ money.

Now the risks run by a bank are determined ENTIRELY by the nature of its assets - e.g. are the assets dodgy NINJA mortgages or more conservative mortgages? So let’s say the chance of the value of those banks assets declining to say 90% of book value in any one year is 1:20. (Replace 90% and 1:20 with X and Y if you like algebra).

So in the case of the bank funded just by equity, there’s a one in twenty chance of the assets and hence the value of shares declining to 90% of their book value in any one year. (Incidentally I assumed there that the value of shares is determined JUST BY the value of the bank’s assets and not to any extent by the bank’s perceived prospects, a factor which in the real world obviously also influences share prices. However, the latter “prospect” factor is as likely to boost share prices as to depress them, thus ignoring “prospects” is not wildly unrealistic.)

Funding a bank just with debt.

Now for the bank funded just by debt.

In this scenario, it’s debatable as to what happens when the assets of the bank decline to 90% of book value: the bank might be tipped into insolvency or it might not. But to keep things simple, let’s say there’s a law stating that when assets fall below 95% of book value, that the bank must be wound up, and that in the specific case of our hypothetical bank, assets actually fall to 90%, so the bank is in fact wound up.

Now what do bank creditors get by way cents in the dollar? Well obviously they get 90 cents in the dollar (ignoring the cost of insolvency proceedings).

But 90 cents in the dollar was exactly what those shareholders ended up with when assets fell to 90% of book value! So the risks run by shareholders and debt holders in the above two hypothetical banks is the same!

Ergo the return those two types of bank funder (shareholders and debt holders) will demand is also the same!

How does that come to be?

Now that’s an odd result. Part of the explanation is that as a bank’s capital ratio falls from 100% to 0%, the nature of debt changes from genuine debt into equity.

To illustrate, where a bank is funded about 90% by capital and about 10% by debt, the chances of debt holders losing out are very small. Thus their so called “debt” is genuine debt: that is, there’s a near 100% chance they’ll get $Z back for every $Z they deposit at or lend to the bank.

In contrast, where a bank is funded say 1% by capital and 99% by debt, it’s a complete delusion to think that debt holders don’t run a risk. That is, debt holders have in effect become shareholders: that’s shareholders as in “someone who stands to lose a significant portion of their stake in a corporation when the corporation has problems”.

Let’s assume deposit insurance.

It was assumed above that government offers no assistance to depositors where a bank goes under. If we make the alternative assumption, namely that government runs some sort of FDIC type deposit insurance scheme, and if we assume that the insurance premium is realistic, that makes no difference to the above conclusion.

Reason is that if depositors are aware of the risks they run, and demand the correct return in compensation for that, then that return will be equal to the premium that the FDIC deposit insurance system would charge.

Saturday, 3 October 2015

Pro austerity pillocks.

It is important to remember that it’s not just the political right which has advocated austerity, i.e. rapid deficit reduction, since the crisis started. First, a large number of so called “professional” economists have advocated austerity. There’s a list of 20 of them here.

Most of the latter 20 subsequently backtracked.

Also the IMF and OECD attributed supreme importance to so called “consolidation”, i.e. cutting debts and deficits, at the height of the crisis.

Bill Mitchell has gone into IMF and OECD incompetence in some detail. Google the name of Bill’s blog “Billyblog” and IMF and OECD for details.

For more on this, see this article by Simon Wren-Lewis from whom I got the above two links.