Wednesday, 1 April 2015

Doug Elliott’s flawed arguments against more bank capital.

Doug Elliott describes himself as a “fellow in economic studies” at the Brookings Institution. In this Brookings article (published in March 2015) he argues that while SOME additional bank capital is needed, having banks hold MORE CAPITAL than required by Basel III Accord would be counterproductive.

The basic flaw in the idea that additional capital adds to the cost of funding banks (or indeed any corporation) was explained by two economics Nobel laureates, Franco Modigliani and Merton Miller. And the flaw is thus. Obviously shareholders take a bigger risk than debt holders (i.e. depositors and bond holders). But if the proportion of a bank’s funding that comes from shares is raised, that in no way affects the TOTAL RISK involved in running the bank. That total risk is after all determined just by the nature of the loans and investments made by the bank: they may be high risk (e.g. NINJA mortgages) or low risk. And if the total risk is unchanged, then the total cost of funding the bank remains unchanged when the bank’s capital ratio is raised. I.e. when bank capital is raised, the risk PER SHARE falls, thus the return demanded by shareholders PER SHARE will fall.

Thankfully Elliott at least understands the basics of the Modigliani Miller theory (MM). As he puts it: 

“At first blush, it seems obvious that higher capital levels come with a cost, since shareholders demand higher returns than depositors or bond buyers, to compensate shareholders for taking the most risk. However, Modigliani and Miller, two Nobel-Prize winning economists, showed years ago that the increased safety that comes with more capital reduces the unit cost of all forms of funding in a way that exactly offsets the use of more of the expensive form – in idealized conditions. Some academics have built on this to argue strongly for much higher levels of required capital and gone so far as to claim that it is free from society’s point of view.”

The alleged tax flaw in MM.

However, Elliott claims there are flaws in MM, the biggest of which, apparently, is the fact that the tax treatment of equity and debt is different. (See the para of his just after the above quoted para).

Well there’s a phenomenally simple flaw in that tax point, which is that tax is an ENTIRELY ARTIFICIAL imposition: that is, the AFTER TAX price of any item is not a reflection of that item’s REAL COST. The only exception to that is where a tax is imposed SPECIFICALLY to take account of a cost like the costs of pollution. For example if the tax on fuel for vehicles accurately reflects the environmental costs of burning carbon based fuels, then the after tax cost of such fuel is an accurate measure of the TOTAL cost of that fuel.

To summarise, the “main” objection to MM raised by Doug Elliott is easily demolished.

Elliott’s second criticism of MM.

The above article of Elliott’s refers readers to another of his Brookings Institution articles where he sets out further alleged weaknesses in MM.

Under the heading “The second area of disagreement: government guarantees” Elliott puts the bizarre argument that governments provide explicit and implicit guarantees for debt, thus banks can fund themselves relatively cheaply with debt. Ergo (apparently) debt is an inherently cheaper method of funding banks than equity.

Did you die of laughter at that one? I nearly did.

But just in case you didn’t spot the flaw in that argument, it’s very similar to the above first tax point. That is, government subsidies for X, Y or Z do not reduce the REAL COST of X, Y or Z. When government subsidises something, the APPARENT COST declines, but the REAL COST remains unaltered: all that happens is that taxpayers carry some of the cost. (It’s amazing that I need to explain that elementary point).


Given the above glaring mistakes in Doug Elliott’s ideas on bank capital, I’ve got better things to do than investigate them any further. Plus as Elliott himself says that the above “tax” point is his MAIN objection to Modigliani Miller, thus I conclude that Elliott needs to go back to the drawing board.

And while Elliott is back at the drawing board, hopefully he will contemplate the fact that the average capital ratio of stock exchange quoted corporations in the UK is 37% according to this Economist article. That’s way above the 5% or so which is typical for a bank. If capital is inherently expensive, one has to wonder what those non-bank corporations think they’re doing.

Thursday, 26 March 2015

The Canadian “Committee for Monetary and Economic Reform” lawsuit.

CMER is taking legal action with a view to forcing Canada’s central bank, the Bank of Canada, to revert to one of its founding principles which was to provide government with interest free loans. CMER has my full backing.

Far as I can see, the latter interest free loans come to much the same thing as the combined monetary and fiscal policy system advocated by Positive Money. That consists of having the central bank supply government with money (which government can spend any way it likes) when the central bank thinks inflation and unemployment justify extra demand.

If bank capital is expensive, how come bond mutual funds survive?

Bank regulators and politicians are suckers: they fall for every sob story spun to them by banks. In the case of politicians, an additional motive to fall for the sob stories is of course the cash in brown envelopes offered to politicians by banks - or perhaps the phrase “cash in brown envelopes” is impolite. Let’s re-phrase that and call it “contributions to election expenses”.

Anyway, one of the main sob stories is that bank capital ratios cannot be raised too much because bank capital is allegedly a more expensive way of funding banks than debt (i.e. deposits or bonds).

Modigliani Miller.

The most naïve reason for thinking that capital is expensive is the fact that bank shareholders demand a higher return than depositors or bond holders. That’s because when a bank is in trouble, it’s shareholders who lose out before debt holders.

However, that does not prove that if capital ratios are raised, that the TOTAL cost of funding a bank rises. Reason is that the total risk involved in running a bank is determined by how risky its loans and investments are, not by how it is funded. E.g. a bank which concentrates on NINJA mortgages is riskier than one that concentrates on standard mortgages.

Thus if a bank is funded by more capital and less debt, that has no effect on the total risk the bank runs. I.e. given a rise in the capital ratio, all that happens is that return demanded PER SHAREHOLDER or PER SHARE will fall, leaving the TOTAL return demanded by shareholders and debt-holders unchanged, as explained by the two economics Nobel laureates Modigliani and Miller.

Bond mutual funds.

Now a mutual fund (“unit trust” in the UK) which invests just in bonds (and there are plenty of funds which do that), comes to very much the same thing as a bank which is funded just by shareholders.

The stakes obtained in those funds by those who buy into such funds are not actually CALLED SHARES. But that’s what those stakes are, to all intents and purposes. For example the value of those stakes rise and fall in line with the value of the underlying assets just as shares tend to. Plus the money put into those funds is effectively loaned to a variety of corporations and perhaps cities or local or national governments (depending on what the fund specialises in). And what do you know? That’s what banks do: lend to a variety of borrowers.

So for those who want to claim that bank capital is expensive, I have a question: how do bond mutual funds survive, given that they amount pretty much to banks funded just by capital?

Capital ratios.

What makes this whole argument very silly is the MINUTE increases in bank capital proposed by for example the Basel regulators and the UK’s Independent Commission on Banking. According to Martin Wolf (chief economics commentator at the Financial Times), the ICB proposed increasing that ratio from a measly 3% to a measly 4%. And the ICB spend hundreds of hours scratching their heads over whether to raise the ratio any further.

Well the “3% - 4%” argument is a COMPLETE IRRELEVANCE given that it can well be argued that a 100% ratio (i.e. having banks funded JUST BY shares) would not raise bank funding costs.

Or as an alternative, you might prefer the 25% or so ratio advocated by Martin Wolf and Anat Admati of Stanford. But certainly the “3%-4%” argument is a joke.

Monday, 23 March 2015

Sectoral balances make a mockery of debt-phobes.

The world economy can be split into any number of sectors you like. You can split it into different countries, or into households occupied by single people, married couples and non-married couples. Sectoral balance analysis was used extensively by the UK economist Wynne Godley decades ago, and MMTers have been keen on sectoral balance analysis for many years.

However when it comes to the sectoral balance idea as it affects an individual country, the world is normally split into three sectors: 1, the country’s government or public sector, 2, the country’s private sector, and 3, the rest of the world, i.e. the “foreign sector” as it’s normally called.

The basic idea of sectoral analysis is that flows of money out of one sector must be balanced by flows of money INTO one or more other sectors. And sectoral balance analysis gives you a good idea of what’s going on in an economy over a given period, all of which might sound a bit boring. However, there’s a sting in the tail, as follows.

Deficit-phobes and debt-phobes are for ever warning us of the dangers of government deficits and debt. Deficits and national debts are by definition “bad”. Indeed most of the Harvard department of economics (certainly Kenneth Rogoff and Carmen Reinhart) have been constantly tearing their hair out over the debt over the last few years. And Congress has recently imposed yet another cap on the debt.

And in the UK in the run-up to the forthcoming election, politicians are screaming B.S. laden insults at each other on the subject of the debt – that’s when they aren’t screaming B.S. laden insults at each other on some other subject.

However, money flowing out of the government sector (the deficit) equals private sector SAVINGS. And saving is widely regarded as “good”. Indeed, we have dozens of schemes which keep thousands of bureaucrats employed aimed at encouraging saving.

So get this, and try not to die laughing. When money flows OUT OF the public sector, that’s “bad”. But that money absolutely has to go SOMEWHERE. And when it flows INTO the private sector, the flow immediately becomes “good”.

Mad or what?

Of course there's the foreign sector to consider, but assuming there are no dramatic flows from or to that sector, then $X leaving the public sector will be balanced by about $X entering the domestic private sector. And even if THERE ARE significant flows to the foreign sector, the latter is itself composed to a significant extent if not mainly of the private sectors of sundry other countries.

It should also be said that saving in the above sense (as already intimated) refers to the accumulation of money or (much the same thing) government debt. I.e. saving in the form of accumulating cars, houses, etc is not what sectoral balance analysis is about.

But there are plenty of schemes (employing thousands of bureaucrats) aimed at saving in the “accumulating money or government bonds” sense.

And finally, the above is not to suggest that government debt is NEVER a problem. As I’ve pointed out before, it’s a problem when INTEREST on the debt rises significantly above zero.

But debt AS SUCH is not a problem. In fact you might as well call it – er – “private savings”.

Saturday, 21 March 2015

Green QE.

With the recession now largely over, discussing stimulatory measures is no longer of any IMMEDIATE practical significance. However, many of the THEORETICAL questions surrounding stimulus are still not settled, and the paragraphs below are concerned with some of those theoretical points.

Printing money and spending it on infrastructure, renewables, etc boosts GDP by more than printing money and buying government debt (conventional QE). That has induced large numbers of less than entirely clued up folk to conclude that the latter is preferable to the former.

There is a flaw in that argument, namely that it assumes there is some sort of limit to the amount of money that can be printed. Therefor we have to choose between the above two options. (Incidentally when I say “printed”, I don’t of course mean literally “printed” as in turning out £10 notes: I mean “create new money” in the way that at least 90% of new money is created nowadays (by central or commercial banks), namely via book keeping entries).

There is actually NO LIMIT to the amount of money that can be printed / created. To take a silly example, if it became fashionable to decorate one’s living room with a modern art exhibit that consisted of £1bn of £10 notes stacked inside a glass cage (the sort of thing that might actually win you the Turner Prize), there’d be no harm in printing trillions of pounds of £10 notes and distributing them to all and sundry so as to satisfy demand for the above modern art. Of course there’d have to be some way of ensuring the £10 notes didn’t actually get spent. But let’s assume that problem can be solved.

The above modern art would have almost no effect on aggregate demand or jobs (though a few more people would be employed making paper and printing £10 notes.)

And something similar applies to conventional QE. That is, conventional QE is widely regarded (I think rightly) as not having a HUGE stimulatory or “job creating” effect. Thus if large amounts of money are printed and used to effect conventional QE, that DOES NOT STOP further amounts being printed and used to fund Green QE or some other form of stimulus which brings more jobs per pound of “printing”. Put another way, the merits of conventional QE and Green QE should be considered SEPARATELY: they should not be seen as alternatives.

In fact I set out some ideas on the pros and cons of conventional QE here recently. And concluded the conventional QE was in fact justified, even though the employment creating effects are not spectacular.

As to Green QE, the fact that the phrase “Green QE” includes the word “green” attracts large numbers of woolly minded individuals, as does any fashionable word.

The truth is that the decision as to whether to implement more green investment is almost ENTIRELY SEPARATE from the question as to whether more stimulus is required.

That is, if a particular investment (green or otherwise) makes sense, it should go ahead even if the economy is at capacity (aka full employment). Of course, assuming an economy IS AT capacity, then demand will have to be restrained in some way (e.g. via tax or borrowing) so as to make room for the investment spending. But is not an argument AGAINST that investment spending.


There’s an awful lot of hot air and twaddle talked about “green QE”. First, advocates of green QE tend not to get the point that green QE and conventional QE are not alternatives: i.e. we can do BOTH.

Second, investment spending (including green investment) has nothing to do with escaping recessions. That’s first because if an investment makes sense (from the economic and environmental perspective) it should go ahead EVEN IF the country is NOT IN recession. Second, investments (particularly infrastructure investments) are a poor way of escaping recessions. Reason is that they normally take YEARS to get going, plus the relevant spending goes on for YEARS, which means that infrastructure spending is as likely to stoke the next boom as to cure the current recession.

Of course I’ve made the latter point dozens of times before, but unfortunately the only way to get a message across to 90% of the human race is to repeat the message ad nausiam.

Friday, 20 March 2015

Revelation: central banks can print money.

Positive Money has just produced this paper entitled "Would a Sovereign Money System be Flexible Enough". The paper deals with full reserve banking: that's a system where private banks cannot "print" or create money - only the central bank is allowed to. Certainly I see no reason why the profits derived from seigniorage (aka money printing) should be captured by private banks. 

The paper refers to a mysterious critic of PM’s ideas who claims that a Sovereign money system would result in “a shortage of money, high unemployment and low economic activity..”. But the critic is not actually named. Well after approximately 30 seconds of Googling, I tracked down the offender: it’s Ann Pettifor.

Tee hee.

Evidently Ms Pettifor hasn't tumbled the fact that the UK’s finance minister at the height of the crises, Alistair Darling, created £60bn of sovereign money (aka base money) at the click of a computer mouse for the benefit of two failing bank. Plus she is presumably unaware that the British state created vastly more than that amount of base money (also at the click of a computer mouse) to fund QE.

Lack of flexibility - my ar*e. Under a Sovereign money system, government and the central bank would have no more difficulty implementing stimulus (via creating and spending base money) than implementing the right amount of stimulus under the EXISTING system.

22nd March 2015.  On closer inspection I see the paper DOES ACTUALLY mention Ann Pettifor. Sorry about that mistake.

Thursday, 19 March 2015

Drivel from the Financial Times on Grexit.

Today’s leading editorial in the FT argues against Grexit.

The first sentence says that the word “Grexit” is “ugly”. Gosh – so the FT’s personal taste in words says something about the underlying ideas does it? I find the word “gravity” ugly: which proves according to FT logic that apples don’t fall from trees, I suppose.

The second sentence says that “the decision to walk away from a currency is more akin to ripping up the rules of the game”. Oh yes? Well every single EXISTING member of the Eurozone “walked way” from its own national currency when joining the Euro. Looks like the FT hoists itself by its own petard there.

Plus the Scots are talking about “walking away” from the pound sterling if they become independent. Personally I don’t favour Scottish independence, but I don’t see a huge problem in quitting one currency block and joining another.

Well that’s the first two sentences of the FT article dealt with. Rest assured that the rest of the article is equally garbage strewn. But if you want a few details, read on.

The third para says that Grexit would constitute an “existential” threat for Europe. Ooooh, that’s an important sounding word: “existential”. The word used to refer just to Jean Paul Sartre’s existentialism. But sundry pseudo sophisticates and academic poseurs, like the ones who write for the FT reckoned the word sounded technical and important, since which time they’ve flogged the word to death.

Though credit where credit is due: important sounding words do fool about 90% of the population, so the FT’s use of the word “existential” is a good propaganda ploy.

Next, the article makes the extraordinary claim in connection with returning to the Drachma and devaluing that “If devaluation is so beneficial, Greece would never have joined the Euro in the first place”.

Well I wouldn’t expect the economic illiterates who write for the FT to know this, but given a fall in a country’s competitiveness in the Euro, the solution adopted is INTERNAL DEVALUATION in contrast to what might be called standard devaluation which is what happens to a country with its OWN CURRENCY given a fall in competitiveness. And there’s not much difference between internal and standard devaluation, except that internal devaluation takes much longer to effect and involves heavy social costs.

Thus the FT’s next point, namely that “A weaker currency makes imports more expensive” applies just as much to internal as to standard devaluations.


I keep trying to persuade the FT to have one of the snails in my garden write their editorials: that would work out cheaper than employing a human journalist. But they haven’t taken up the offer so far.