Tuesday, 28 February 2012

Modern Monetary Theory will not solve Europe’s problems.

Some MMTers currently seem to claim that MMT offers a solution to Europe’s problems. I doubt it.

Describing the recent MMT meeting in Rimini in Italy, Michael Hudson says, “So what then is the key? It is to have a central bank that does what central banks were founded to do: monetize government budget deficits so as to spend money into the economy, in a way best intended to promote economic growth and full employment.” And there is more in roughly similar vein from Warren Mosler.

Well obviously that would bring back full employment in Euro periphery countries. Problem is that it does not deal with the fundamental problem (correctly identified by Paul Krugman), namely that periphery countries are not competitive. And that lack of competitiveness explains why periphery countries are in debt.

That is not to say that the EZ’s method of dealing with lack of competitiveness is all that wonderful: Greece is obviously a disaster area. But imposing severe deflation on uncompetitive countries so as to get their costs down (in Euro terms) is the only method or tool they’ve got.

Euro core countries are reluctant to allow the periphery any more credit because the periphery’s EXISTING debts are arguably not worth the paper they are printed on – never mind further debts. The continual granting of pocket money to uncompetitive debtors is of course a subsidy of those debtors. And no country joined the EZ on the basis that it was going to have to subsidise another country.


Monday, 27 February 2012

Andrew Haldane’s ideas on banks and risk can be improved.

Summary. Haldane says banks profit from the risks they take at the taxpayer’s expense. Agreed. He then argues that we need to take account of this “fake” contribution to GDP made by banks, but he is vague on exactly how to do this.

I argue below that the way to do it is to drastically curtail or even ban maturity transformation. Plus the other risks that banks take at the taxpayer’s expense should be banned.  Banks’ profit and loss accounts would then show a realistic profit or loss.


Haldane argues that the rise in bank profits over recent decades is due to the increased risks banks have taken, but that those risks are underwritten by the taxpayer. Thus to that extent, bank profits are illusory: that is, they don’t actually contribute to GDP even though they are counted as part of GDP. Agreed.

And his final sentence is, “Investors, regulators and statisticians now need to adjust their measuring rods to ensure they are not blind to risk when next evaluating the return to banking.”

Well that conclusion is right as far as it goes, but Haldane does not give us much idea as to exactly HOW regulators etc ought to do their “evaluating”. That is, exactly how much does one subtract from bank profits in order to arrive at the correct figure? Indeed, when it comes to the actual figures for the implicit too big to fail subsidy, Haldane himself is vague. See his paragraph starting, “Elsewhere, we have sought to estimate…”. (Though congratulations to him for at least ATTEMPTING to estimate the size of this subsidy.)

I suggest that part of the answer to this problem lies in the fact that maturity transformation (i.e. “borrow short and lend long”) is a complete nonsense and should be banned or drastically curtailed.

And having done that, the profit figure that banks produce would then be more realistic.

But that obviously calls for an explanation as to why maturity transformation (MT) is nonsense. So here goes.

Maturity transformation.

From the perspective of a micro economic entity, MT makes sense. E.g. from my own personal perspective, money is an asset, and it pays me to make the best use I can of that asset: it would not pay me to leave large amounts of money for months on end in a zero interest current account or “checking” account if I can get a significant rate of interest on a deposit account.

However, from the perspective of a country as a whole, money is simply numbers in computers: worthless. Or as Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances. (Ch 3 of his book, “A Program for Monetary Stability”).

Thus it makes no sense for a country to allow or encourage the banking system to economise on the stock of money the banking system holds if in doing so any sort of risk is entailed.

Thus what is required is to ban MT, or at least to drastically curtail MT -  to the point where the risks deriving from MT are next to non-existent.

Now the effect of that curtailment would obviously be deflationary. But that is easily compensated for by increasing the total stock of money, which, to repeat, can be done at no cost.

Incidentally, the Vickers commission failed to get this point. That is they were very concerned about the deflationary effect of what they called “trapped deposits”: that is money sitting in bank accounts which cannot be used due to a tightening up in the rules that govern what banks can do. To repeat, any such deflationary effects can be countered by increasing the total stock of money.

Of course curtailing MT is difficult in practice: banks and shadow banks would continually try to indulge in more MT than they were supposed to, just as they currently try to take risks at the taxpayer’s expense. But regulating banks will always be a game of cat and mouse.

Having said that the deflationary effect of drastically curtailing MT can be countered by expanding the money supply,  that is not to suggest that there’d be no NET EFFECT on the size of the banking industry. One effect of curtailing MT and expanding the money supply would be that there’d be more money in the average citizen’s bank account, which would REDUCE the need for the average citizen to resort to bank loans. Given the VAST increase in bank assets, liabilities and turnover relative to GDP over the last two decades, it is hard to see that much harm would come from reducing the overall size of the bank industry: people were not impoverished prior to 1980 through reason of an inadequately sized banking industry as far as I know.

Another change that curtailing MT would bring would be that banks would rely for funding more on shareholders at the expense of depositors. But that would not do much harm. Indeed, regulators are currently trying to get banks to do just that: rely more on shareholders.

Other risks.

MT is not the only risk that banks can take while having the taxpayer stand behind the risk. Another risk is lending risky borrowers. That is, depositors can in a sense “have their cake and eat it”: they can reap some of the benefit of their bank lending to risky borrowers, while not paying any penalty when it all goes wrong. So how do we insulate the taxpayer from this risk? Well it’s easy, and as follows.

Depositors must be made to come clean and make a choice between two sorts of account, as advocated in this submission to the Vickers commission.  First, depositors can have 100% safe and taxpayer backed accounts. The relevant money would be lodged in as safe a way as possible: perhaps it could be deposited at the central bank. Plus the money would be instant access.  But the money would not be doing anything, so it would earn little or no interest.
Second, depositors wanting the bank to invest their money could have an “investment” account (for want of a better word). Those accounts WOULD earn a significant rate of interest – reflecting the fact that the relevant money was doing something. But this is COMMERCIAL activity, and there is no obligation on taxpayers to subsidise commercial activity. Thus if the relevant bank went bust, there’d be no taxpayer backed guarantee for depositors.

Hey presto: taxpayers are almost entirely insulated from risk.


Maturity transformation should be banned or drastically curtailed.

Plus we need to abolish taxpayer backing for commercial activity in the form of money deposited at banks which is then loaned on. Then bank profits can be taken at face value.


Sunday, 26 February 2012

U.S. imports from China.

Notice anything wrong with this St Louis Fed chart showing U.S. imports from China?


Look at the figures down the left hand side. Imports are given as roughly $30,000 million: i.e. $30,000,000,000.

Still not got it?

Divide current imports from China by the U.S. population (roughly 300 million) and the answer is $100 per U.S. citizen per year.

Er . . . I think that’s a bit low. In fact I think there is a zero missing from those numbers down the left hand side.

I contacted the St Louis Fed to tell them. And they’ll probably write back to say it’s me that is talking bo**ocks (which it usually is).


Oxford Prof thinks along Modern Monetary Theory lines.

Simon Wren-Lewis is an economics prof at Oxford. He says:

“We seem to be in a strange prisoners dilemma where it is absolutely clear that the world wants more safe assets (the rate of interest on indexed debt is zero if not negative), but every individual government thinks that if it provides them lenders will suddenly panic, and think they are no longer safe. I think this fear is irrational, but unfortunately events in the Eurozone feed this fear on a daily basis. (It should not, because governments without their own central banks are in a different position from those that have . . . )”

Can’t quarrel with that (much as I like quarrelling). In particular, what he calls “safe assets” are much the same as what MMTers call “private sector net financial assets”.

He then goes astray by ACCEPTING the demand by economic conservatives for a balanced budget, and looks for ways to boost demand WITHIN that balanced budget. The ploy he advocates is to raise taxes and public spending by the same amount.

The reasons why that raises demand are a bit technical, and I won’t go into those technicalities. But the more important point is that the whole balanced budget idea is complete and total B.S.

That means that any proposal based on the balanced budget assumption has to have flaws somewhere. And the flaws in the “raise taxes and public spending” idea are thus.

First, the idea WOULD raise aggregate employment. But the problem is that the idea only works by raising PUBLIC SECTOR employment. Now that is a severe weakness because any half decent system or idea for raising employment ought to work given RISING OR FALLING public sector employment. Plus it ought to work assuming the aim is keep public sector employment CONSTANT as a proportion of total numbers employed.

Second, going for the “raise taxes and public spending” idea involves government in a self-contradiction as follows. Where government decides that the optimum split of GDP as between private and public sectors is some given ratio, that ratio will be disturbed if government goes for the “raise taxes and public spending”. Or to put it in less general terms, the current Tory led regime in the U.K. is aiming to REDUCE public spending relative to GDP, so it is unlikely to accept the “raise taxes and public spending” idea.

The Social Market Foundation.

On the subject of balanced budget ways of raising employment, Wren-Lewis then supports the ideas recently put by the Social Market Foundation. See W-L’s last paragraph here. These ideas are complete hogwash, as I explained here.


Saturday, 25 February 2012

Kenneth Rogoff is 250 years behind the times.

Kenneth Rogoff has not caught up with a point made by David Hume 250 years ago, namely that additions to the money supply will not be inflationary unless the extra money is actually SPENT. I’ll explain.

Rogoff thinks that imparting enough stimulus to effect a quick recovery from the recession is not possible. His reason is the currently elevated levels of debt (national and household).

Household debt.

As to HOUSEHOLD debt, he does not give any actual REASONS as to why household debt prevents stimulus. At least he does not give any reasons in this Bloomberg article of his, or this Project Syndicate article.

And if he doesn’t give a REASON, then I conclude that he doesn’t have one. Indeed, I conclude, as does Krugman, that Rogoff’s concerns about debt stem from emotional problems with the word “debt” and the negative overtones of the word (“foreclosure”, “bailiff”, etc). As Krugman puts it, “So where does Ken’s call for short-run austerity come from? As best I can tell, it comes from a generalized sense that debt is dangerous…”

The above tendency to be swayed by the emotional overtones of the word debt explains the general public’s concern about national debts. But so called professional economists ought to be able to analyse the ACTUAL NATURE of national debts and see that they are very different from micro economic debts: debts of households or firms.

National debt.

As to national debt, Rogoff is under the popular misapprehension that increasing the deficit requires more debt. As I’ve point out a hundred times on this blog, both Keynes and Milton Friedman made it clear that deficits can be funded EITHER by borrowed money or by printed money. (Be nice if professors of economics at Harvard, like Rogoff, had actually studied Keynes and Friedman, wouldn’t it?)

Anyway, Rogoff’s solution to all this (proposed in 2008) is to deliberately stoke inflation, which would have the effect of writing down debts (see 2nd last paragraph here). And he proposes doing it by QE. As he puts it, “Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt.”

Well the first and glaring problem there is that the U.S. has actually implemented QE on an unprecedented scale over the last three years or so (just in case you hadn’t noticed) . . . . but where’s the elevated rate of inflation??? Nowhere to be seen!!!

In fact many of us predicted this “non-inflationary” result before QE even got started. But that’s not the important point. The really important point is as follows.

As David Hume pointed out around 250 years ago, money supply increases will not be inflationary unless those increases are actually SPENT. See para starting “It is also evident…” here.

Now investors can only do one of two things with the cash they get as a result of QE: spend it or not spend it.

To the extent that they DO SPEND the money on consumer goods and so on, the effect will be inflationary IF THE ECONOMY HAS LITTLE SPARE CAPACITY. But in a recession, the economy DOES HAVE spare capacity!!! Thus the effect of the extra spending will probably be to boost demand, create jobs and get us out of the recession.

Which according to Rogoff is impossible. Let’s be clear: he is saying in effect that a rise in demand, given ample spare capacity will not expand GDP because of all those debts. God first makes mad.

To the extent that the extra money is NOT SPENT, well there won’t be any effect on inflation, so the great “Rogoff let’s boost inflation wheeze” does not work. Or as David Hume put it, “if the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated”.

Having said that if investors spend their money, it will be spent on CONSUMER goods, an alternative is of course that they spend the money on purchasing other assets or investments. But the effect there is not nearly as inflationary.

At a guess, a rise in stock markets has next to no effect on inflation. As to a rise in house prices, that’s inflationary, on the other hand a rise in house prices induces builders to create jobs and build more houses: an outcome which Rogoff, remember, claims to be impossible.

As to speculation in commodities, this looks like it has been exacerbated by QE: commodity prices may have been boosted by QE. However, neither house or commodity price increases have been enough to give a SUBSTANTIAL boost to inflation.


So the conclusion is that David Hume was essentially right and Rogoff is wrong. A money supply increase can do three things. First in that the extra money is NOT SPENT, there is no effect on inflation or output.

Second, in that the money IS SPENT, and there is ample spare capacity, the result is a rise in demand and GDP. Third, in that the money IS SPENT, and there is LITTLE SPARE CAPACITY, the result is inflation.

But a “no spare capacity” scenario does not sound to me like a recession! Or if extra demand does cause inflation at relatively high unemployment levels, the explanation must be inadequate amount of or types of capital equipment or it could signal a change in the pattern of demand for different skills.

In short, Rogoff advocates a cure for our problems which is nonsense in theory, and which has been shown not to work in practice. How much lower can you get?


Thursday, 23 February 2012

Whose side is Bernanke on – the criminals or the victims of crime?

Good article here by Simon Johnson pointing out that large banks have easy access to Fed on the subject of financial reform – and of course the large banks are keen as mustard to reform the system aren’t they? – ha, ha.

In contrast, those genuinely concerned to reform the system find such access much more difficult.

Why not just replace Bernanke with Bernie Madoff?

P.S. (24th Feb). More from Simon Johnson on bankster criminality here.


Tuesday, 21 February 2012

Nonsense from the Social Market Foundation.

This article in the Financial Times by Ian Mulheirn of the Social Market Foundation is nothing more than a collection of popular economic myths.

In his first four paragraphs Mulheim makes it clear that he thinks stimulus is not possible without raising the debt. He needs to study economics: as I’ve pointed out a hundred times on this blog, both Keynes and Milton Friedman pointed out that a deficit can be funded from borrowed or printed money. I.e. if you want stimulus, but don’t want more debt, then print. (Cue chants of “Mugabwe” and “Weimar” from economic illiterates.)

For a more detailed explanation of the latter “print” point, see here.

In his second paragraph Mulheirn says “Weak growth is putting pressure on plans to cut the deficit.” Hang on – what’s the point of trying to “cut the deficit”? Absolutely none!!

That is, the deficit needs to continue for as long as it is needed for stimulus purposes. And if that is ten years, so be it. In contrast if there is a big rise in consumer confidence next year, the deficit might need to be abandoned, and possibly even turned into a surplus. Or as Keynes put it, “look after unemployment, and the budget will look after itself”.

Of course there are numerous economic illiterates is high places who don’t understand the latter point, but it would be nice if authors of articles in the FT had got it.

In Mulheim’s third paragraph comes the old cliché about creditors losing confidence in government debt if the debt is not reduced. Well if they do lose confidence - who cares? Just stop borrowing and go for the above mentioned form of stimulus that both Keynes and Milton Friedman advocated.

Bang per buck.

In the second half of the article Mulheirn sets out a number of alleged cures for our economic problems which are all based on the “bang per buck” myth. I’ll explain.

Mulheim advocates scrapping a number of government programmes which involve a relatively large amount of government spending per job created, like Winter fuel payments for wealthy pensioners. He then wants to divert the money saved to areas where more jobs are created per pound of government spending.

Well the reality is that there no merit whatever in trying to maximise the number of jobs created per additional pound of government spending. I explained the reasons here under the heading “Bang per Buck” here.

But briefly, the flaw in the Bang per Buck idea is that inflation (which is THE CONSTRAINT on job creation) is determined by the number of jobs created, not by the amount of money spent. Thus the inflationary effect of creating a thousand jobs is the same regardless of the amount of money that has to be spent to create those jobs.


Monday, 20 February 2012

As full employment of labour is approached, the economy runs short of . . . . . . . . labour!!!!!!

You might think that was obvious. But there are hundreds of instances of self-styled economists who don’t get the point. But perhaps they can’t be blamed: George Orwell said, "To see what is in front of one's nose needs a constant struggle."

There are three areas where failure to take account of the above obvious point results in mistakes. 1, Bang per buck. 2, shortening the working week as a cure for unemployment, and 3, the marginal employment subsidy idea.

Bang per buck.

That’s a slang expression sometimes used to refer to the idea that government should try to create as many jobs as possible per million dollars of additional spending. The actual reasons for minimising expenditure per job are rarely spelled out, so one can only guess at them. One reason is presumably that more expenditure means more inflation, all else equal, thus the more jobs created per given amount of expenditure the better.

The flaw in that idea is that it’s not spending money as such that can exacerbate inflation. It’s the extent to which such spending puts pressure on the ultimate source of all supply – the labour market – that is of supreme relevance.

For example, if the economy has ample spare capacity, including excess numbers of unemployed, then a spending increase will not be inflationary. And if the economy were at capacity, but the labour force dropped dramatically (say because bubonic plague wiped out 10% of the workforce), then we’d get inflation even if the level of spending were constant.

To explain the relevance of the latter point to bang per buck, let’s take a classic bang per buck dilemma: government can choose between placing orders in a sector of the economy where employees are relatively thrifty, or in contrast, placing the order in sectors where employees are relatively spendthrift.

Obviously the multiplier will be larger in the case of the spendthrift option, thus relatively little “taxpayer’s” money is required per job created. But the inflationary effect depends entirely on the number of jobs created: i.e. pressure put on labour markets. Thus as far as inflation per job created goes, it does not make a scrap of difference whether government goes for the thrifty or the spendthrift option.

A second reason for trying to minimise expenditure per job is presumably that bang per buck enthusiasts think that the money used for stimulus needs to be spent carefully because creating that money involves some sort of REAL sacrifice.

The truth is that under a fiat currency, money is just bits of paper or numbers in computers. Adding to those numbers is costless. Or as Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances. (That’s from Ch 3 of his book, “A Program for Monetary Stability).

Bang per buck: the conclusion.

There is no point in government aiming to maximise bang per buck. In considering which additional jobs to create, government should concentrate solely on creating whichever jobs seem to be the most productive. After all, what is the basic objective in economics? It is to maximise output per head within environment constraints, while trying to produce jobs for those who want work (or something like that).

Labour supply reduction is no cure for unemployment.

“Labour supply reduction” is a name sometimes given to a collection of alleged cures for unemployment: shortening the working week, early retirement, delayed entry into the labour force for youths, etc. These ideas have in common the notion that if labour supply is reduced, with demand for labour being left constant, then unemployment will decline.

And indeed it will. But if labour supply can be reduced relative to demand for labour without inflationary consequences, why not raise demand relative to supply? The inflationary effect is the same, but there’d be the advantage that more people who wanted work would find it, and/or more people being able work the hours they wanted. Doh!

However, the above is a bit of a “broad brush” rebuttal of the labour supply reduction myth. A more detailed rebuttal means invoking the above point about labour shortages. So here goes.

Inflation becomes a problem when the variety of unemployed labour available from the dole queue drops too far: the result is that employers cannot find the labour they want, and thus opt to poach labour from rival firms, or give in more easily to union demands so as to retain their own workforces, etc. And that means inflation.

Now if working hours are artificially reduced, the level of unemployment at which employers experience some specific level of difficulty in finding the types of labour they want REMAINS EXACTLY THE SAME!!!!!! E.g. if the chances of finding an unemployed plumber amongst the unemployed in town X drop to near zero at unemployment level Y, then those chances will also drop to near zero when unemployment is at level Y under an artificially shortened working hours regime!!!!! Put another way, simply cutting hours does nothing whatever for the variety of labour on your local dole queue. I.e. labour supply reduction cures for unemployment do not reduce NAIRU (or the “natural level” or whatever you want to call it).

Marginal employment subsidies.

Another area where there is failure to see the “obvious” point mentioned at the outset, has to do with marginal employment subsidies (MES).

MES is the ever popular idea for raising employment namely that government could reward employers for any NET INCREASE in numbers they employ, compared to some base or “starting date”. E.g. see here, here and here.

And the Obama administration proposed the idea a few months back, though they’ve gone quiet on the idea more recently.

The flaws in the Marginal Employment Subsidy idea.

Two flaws in MES are pretty obvious. First there are the administration costs and second is the fact that MES puts firms that are not expanding or even shrinking (and for perfectly legitimate reasons) at a disadvantage.

But a third flaw is closely connected with the “obvious” point about labour shortages mentioned at the outset, and it is thus.

Given that inflation kicks in when it becomes excessively difficult for employers to source suitable labour from their local dole queue, a subsidy of each additional employee will certainly induce firms to expand numbers employed, but the problem is that it gives them no more incentive to expand by taking on dole queue labour than by poaching employees from rival firms.

To that extent, MES has no effect on NAIRU. At least that would certainly be the case if the subsidy came in the form of a straight percentage subsidy of each firm’s total payroll bill. In the latter case, the subsidy of highly paid employees ‘wage, as a proportion of their wages would be the same as the equivalent proportion for the lower paid. Thus there would be little inducement for an employer to alter the ratio in which the employer took on skilled and less skilled people.

In contrast, the subsidy COULD come in the form of a fixed amount per capita, and that would be more likely to induce employers to take on the lower paid. But in that case the so called “marginal” subsidy only works IN THAT it is a subsidy of the lower paid. And indeed there might be something to be said for a “low pay” subsidy (Edmund Phelps advocated the idea, I think).

Well if a subsidy for the low paid is beneficial, then let’s have such a subsidy. But that is not a marginal subsidy.


Saturday, 18 February 2012

Inept Austrians: they want to add the sale of intermediate goods to GDP!!!!!

GDP can to totted up in different ways. E.g. in a very simple economy consisting just of firms selling goods to people, GDP would equal the total of goods sold to people, plus it would equal total wages paid by firms to people.

In the case of “total goods sold to people”, note that stuff sold by firms to other firms (i.e. “intermediate” stuff) is not counted. But Austrians, it seems, DO WANT to include this intermediate stuff.

E.g. see Huerta de Soto’s “Money, Bank Credit and Economic Cycles” p.305 under the heading “Criticisms of the Measures in National Income Accounting”.

For another Austrian making the same point, see here. (Hat tip to Lord Keynes).

So let’s get this straight. Say there is a widget factory where the final stage in the production process is to paint the widgets, which is done in a special paint shop building. One day there is a management buy-out of the paint shop, but they continue just as before: painting the widgets, and selling them on at the same price as before.

Anyone with some common sense can see that nothing much has changed. Certainly neither national income or output have risen. But according to Austrians, national output or income or something HAS risen (by the total amount the new paint firm pays for unpainted widgets).

To be fair to de Soto, he does not make it 100% clear whether his “including intermediates” measure of GDP is just for the purposes of analysing the economy the way he wants to analyse it, or whether he is saying this new measure really does measure total output or total consumption. But I’m 99% sure he is saying BOTH.

He should certainly have made the latter point 110% clear.


Friday, 17 February 2012

The deficit: Martin Wolf struggles manfully with problems solved long ago by Modern Monetary Theory.

In this Financial Times article, Martin Wolf claims that deficit reduction will have to come about mainly by “lower desired savings”.

Incidentally Martin Wolf rather glosses over the distinction between flows (deficit) and stocks (debt). But that over-simplification does not of itself weaken his argument too much, and I’ll continue with the over-simplification.

Anyway, Wolf’s basic point is a classic piece of the nonsensical “conventional wisdom” that plagues discussions about the debt and deficit. That is, he assumes that deficit or debt reduction are some sort of end in themselves. He puts the cart before the horse.

The reality is that the private sector’s savings desires vary over time, and if those desires RISE, then government just has to accommodate them, else we get paradox of thrift unemployment. And if those desires STAY HIGH, then government will just have to leave the debt at a higher level than would otherwise be the case. (By the way, “savings desires” are normally referred to in Modern Monetary Theory literature as “private sector net financial assets”).

As to exactly what is wrong with a relatively high debt, Martin Wolf does not tell us. But presumably it’s the interest rate burden that worries him. Well the first answer to that is the Britain (like some other countries) is currently paying a near zero real rate of interest on money borrowed (i.e. after adjusting for inflation).

Second, and regarding the possibility that the real rate might rise significantly, that is not a problem. A rise in interest rates indicates an unwillingness by the private sector to hold as much debt. Well the solution to that problem is easy: stop borrowing until the interest on debt falls again to the near zero level.

Of course the latter wheeze involves printing money and paying back debt as it matures, that could easily be too stimulatory or inflationary. But that’s not a problem: just raise taxes by whatever amount is needed to counteract the above stimulatory / inflationary effect.


Thursday, 16 February 2012

The flaws in Austrian Business Cycle Theory.

Austrian Business Cycle Theory (ABCT) consists of the following.

Fractional reserve banking allows commercial banks to lend at an artificially low rate of interest – a process which some Austrians claim is assisted by central banks. And that low rate of interest induces businesses to invest more than is optimum. At least that is what ABCT consists of to judge by this Wiki explanation, and these two von Mises explanations. See here and here.

The result is what Austrians call “malinvestments”, and so far so good. I.e. I agree with the argument so far. Indeed I argued that fractional reserve brings artificially low rates of interest here.

Moreover, the above Austrian argument could be STRENGTHENED by pointing out that it is not just BUSINESSES that invest too much: artificially low rates of interest also induce HOUSEHOLDS to invest more than is optimum in housing, cars and other “investment-type” consumer items. Certainly those who obtained NINJA mortgages were suckered into those mortgages by artificially low initial rates of interest or artificially low “repayment of capital” conditions.

Next, ABCT claims that the savings or resources to make the above malinvestments are just not there, particularly as the low interest rates will have induced less saving that would otherwise be the case. Thus the whole edifice supposedly collapses.

A fiat currency.

ABCT obviously works (or does not work) in slightly different ways depending on what monetary regime is involved. I’ll start with a bog standard 21st millennium economy and monetary set up: i.e. a fiat currency.

Assuming the economy is at full employment, the extra demand that that extra investment represents will result in excess demand which means inflation will start to loom. The relevant central bank / government will react by cutting demand (e.g. by raising taxes and/or interest rates), and that FORCES reduced consumption on the population at large.

Thus the Austrian claim that the resources are not there to bring about excess investment is not valid: the resources come from the above mentioned forced reduction in consumption.

An alternative to a fiat currency is a currency based on some commodity, like gold. But this makes little difference. Instead of inflation being controlled by governments and central banks, inflation is controlled by currency units being tied to gold. The result is the same as above: reduced consumption is forced on the population.

Inflation is not controlled.

Another possibility is that government / central bank FAILS to control inflation. Well in this case, those in possession of the extra money / credit created by banks simply steal purchasing power from existing holders of money (as indeed Austrians never tire of telling us). So here again, it is not true to say that the resources are not there to bring about the excess investment: the resources are effectively just stolen.

In fact, one of the above three explanations of ABCT is slightly different from the other two in that it claims the additional demand caused by banks’ creation of excessive credit / money results in inflation. Then, allegedly, when everyone realises the inflation will persist, panic sets in, as everyone tries to flee the currency and get into other assets, which exacerbates inflation still further.

That is certainly a plausible hypothesis. And certainly there is a hysteresis or “feed back” effect there. But it does not in practice seem to be a powerful effect: the rise in inflation in the 1970s did not lead to panic or hyperinflation. And where hyperinflation HAS taken place (Mugabwe, Weimar, etc), the prime cause was clearly irresponsible money printing.


Another flawed element of ABCT is thus. When the crash comes, according to ABCT, it allegedly takes a long time for the excess investments to be purged and replaced with more viable investments. This is nonsense and for several reasons, as follows.

1. The AMOUNT of excess investment is unlikely to be large for the simple reason that the EXTENT of interest rate reduction brought about by fractional reserve is small compared to the other costs involved in running a capital investment. To illustrate, in addition to interest rate charges, a capital investment involves writing off a portion of the investment every year – say roughly 10%. Plus there are other costs inevitably tied to any capital investment: energy consumption, repairs, etc: another 10%? In contrast, what is the extent of interest rate reduction brought about by fractional reserve? Impossible to say, but I’d guess one to four percent: that’s compared to the above 10 + 10 = 20%.

The latter 1 – 4% is also small compared to the loss or profit that can be made in individual investments. That is 30% p.a. losses or profits are common on individual investments.

2. The fact that an investment turns out to be excessive is not normally a reason to scrap the investment. It is near impossible to build a plant that is of EXACTLY the right capacity to meet demand over the next decade or so. Businesses never get this right. If a plant is 10% too large, it will just get run at 90% capacity. Indeed, the AVERAGE plant runs at only 80% capacity, or thereabouts.

3. Even if an investment IS SCRAPPED, what of it? The building, house, plant, etc can just sit there rotting away, or it can be bulldozed. That in itself does not stop those who were employed running the asset from finding alternative work. So the crucial question is whether those displaced from creating or running said assets can be easily allocated to other jobs.

Well the evidence seems to be, at least in the case of the current recession, that those thrown out of work in the construction sector (the sector most badly hit) have had no more difficulty finding alternative jobs than those in other sectors. See p.8 here and here.


I agree with the Austrian claim that fractional reserve brings an artificially low rate of interest. I agree that will probably tend to exacerbate economic instabilities. But the idea that fractional reserve is the FUNDAMENTAL CAUSE of instabilities or that fractional reserve is the basic cause of any sort of CYCLE is decidedly weak.

Put another way, I suggest the introduction of fractional reserve to a full reserve economy would result in superfluous investment rising to a new EQUILIBRIUM, and just staying there. There is little reason for artificially low interest rates to cause any sort of “cycle” as per the “Austrian Business Cycle Theory”.

P.S. (same day). Lengthening production processes. 

I should have mentioned that ABCT also claims that when interest rates drop, one of the forms of extra investment that employers go for is to LENGTHEN production processes. E.g. (to take a very crude example) people dig holes by making spades and using the spades to dig holes, rather than dig holes with their bare hands.) However, this lengthening of production processes inevitably involves extra capital investment, thus I don’t see much difference between straightforward extra investment which involves no lengthening of production processes and extra investment that does involve lengthening production processes. All the arguments that apply to the former, apply to the latter.

P.S. (same day). “money confers on those with authority to issue new money the power to pre-empt resources” – Victoria Chick, p.141, On Money, Method and Keynes. (Hat tip to Mary Mellor).


Wednesday, 15 February 2012

Osborne gives £200m to unviable business, paid for by viable businesses – pure genius.

George Osborne, the UK’s finance minister, is to give £200m to a scheme to help small and medium size businesses (SMEs) obtain loans: a touchy feely idea which will doubtless win votes from the more woolly minded section of the electorate.

Of course the £200m has to come from somewhere, and it inevitably comes from more viable businesses: that’s businesses which manage to fund themselves WITHOUT any artificial assistance.

The “logic” behind Osborne’s wheeze is presumably that banks are more cautious than prior to the crunch, which means some SMEs can’t get loans, which proves that taxpayers’ money should be used to subsidise such loans.

A more credible argument is thus. Banks were undoubtedly too lax with loans prior to the crunch. Thus banks’ CURRENT lending regime is now at a more sensible or rational level.

Thus SMEs which whine about difficulty in obtaining loans need to catch up with the new reality.

As to the possibility that the £200m represents new money or stimulus, the purpose of the economy is to provide the consumer with what the consumer wants (in the form of stuff produced by the private AND public sectors). Thus £200m should be handed to the consumer and be used to boost public sector spending, as suggested by Simon Jenkins in this and similar articles. As to which firms succeed in meeting that extra demand, that’s up to the market – the capitalist system (which I thought Obsborne favoured).

Moreover, the extra demand will enable a proportion of those “can’t get a loan” SMEs to actually get loans: nothing impresses a bank manager like a healthy order book. In contrast, bank managers are not impressed by businesses kept afloat by artificial taxpayer funded assistance: the latter is liable to be withdrawn when the next fad as to how politicians can “help” the economy comes along.


Tuesday, 14 February 2012

Economic illiteracy from “Professor” Moorad Choudhry.

I’m not surprised the Royal Bank of Scotland went bust. “Professor” Moorad Choudhry, senior RBS official, is totally clueless on the subject of money.

First, he claims that quantitative easing (QE) is a euphemism for printing money. Well QE is certainly referred to by journalists in the populist press as “printing money”. Perhaps that’s where Choudhry gets his information. But the truth is that it is very debatable as to what extent QE really equals printing money.

Money (or to be accurate, “monetary base”) is simply a central bank liability that pays no interest. In contrast, traditional government debt DOES PAY interest. But rates of interest are currently so low that its debatable as to whether there is any significant difference between traditional debt and monetary base. To the extent that there is no difference, QE does not equal printing money.

He then says, “There is only so much a government and a central bank can do to assist recovery, and after that it’s a question of sitting back and letting events take their course.” But he immediately contradicts that by saying that (at least in the case of the EU) governments can do more.

He then comes out with the standard right-wing or conservative claim that “We need to do more to tackle labor market constraints…”. Well obviously it’s always desirable to deal with labour market constraints or any other type of constraint.

The more relevant question is, whether these constraints explain the credit crunch, and hence whether reducing these constraints will contribute significantly to escaping the recession.

Well labour market constraints today are much the same as they were prior to the crunch, thus these constraints do not explain the crunch. Ergo the claim that reducing these constraints will do much to get us out of the recession is implausible, to put it politely.


Sunday, 12 February 2012

The jobless recovery.

The geniuses who run the West’s economies continue with their hair-brained attempts at stimulus: QE continues, while fiscal stimulus according to these geniuses is near irrelevant.

The result is that employers are encouraged to invest, at the same time there is little increase in demand for the products that such investments produce. No one with any common sense would invest in more capital equipment knowing that demand for their products was likely to remain flat. But then the above geniuses do not have the common sense of a convenience store owner or whelk stall proprietor.

Incidentally there is of course the point that investments are an injection which will presumably raise aggregate demand a bit, by why go for the above daft way of raising demand? Darned if I know.

Low interest rates encourage LABOUR SAVING investments!

Having said that no one would invest to the extent that demand for the relevant product will remain flat, there is an exception: where interest rates drop. That drop is an inducement to borrow and invest in labour saving capital equipment: extra profits can be earned that way.

And wouldn’t you know it: investment (both physical and in software) has held up nicely over the last two years as have profits. And corporate borrowing is in full swing (although it was not in full swing two years ago).

And the real “bonus” of the above hair-brained form of stimulus is that I would imagine it requires relatively skilled labour to produce capital equipment (software in particular). That means that demand for skilled labour rises which causes a shortage of skilled labour at a higher level of aggregate employment than would other words be the case. I.e. the above “genius” form of stimulus raises NAIRU.

And wouldn’t you know it: inflation remains stubbornly high despite high unemployment levels.


Saturday, 11 February 2012

Real democracy tends to cut public spending.

Switzerland is very democratic. They have far more referendums (national and local) than other countries.

This study looks at the relationship between the level of public spending in different Swiss cantons, and how that relates to the frequency of referendums on public spending proposals. Seems that the more referendums there are, the lower the level of public spening.

My interpretation is that when people can choose more public spending proposals and at the same time are made aware of what it will cost them, they tend to reject those proposals. Put another way, if politicians are given the freedom to promise the Moon, while being evasive about where the money will come from, they’ll do just that. And the average voter falls for the trick.


Friday, 10 February 2012

The big FDIC anomaly.

If you invest in the stock exchange or your own business, there is no government sponsored insurance for you. And quite right: engaging in commerce is laudable, but the risk is entirely yours. You might make a million, or you might lose your investment.

In contrast, if you deposit money in a bank, and the bank lends to, or invests in businesses or mortgages, you get government sponsored insurance: (FDIC in the U.S., and something similar in most other countries).

Now why does government sponsor (or even subsidise) the insurance of commercial activity in the latter case but not the former? There is absolutely no reason.

Of course those who deposit money in banks want to have their cake and eat it: they want 100% safety plus the nice rates of interest that come from investing in commercial activity. And banks are more than willing to accommodate this “have your cake and eat it” activity – as long as government sponsored insurance is there to underwrite the charade.

This charade should be closed down. Depositors should have to come clean: they should be given the choice of 100% safe accounts, and in contrast, accounts where their money is invested in businesses, mortgages, etc.

Money in safe accounts should not be invested: it should not even be invested in government bonds since the value of the latter can rise and fall. Perhaps the money should be deposited at the central bank, where it will earn little or no interest.

But depositors WOULD HAVE instant access to their money, since the money has not been locked away in some business or mortgage. Plus there is a good argument for offering government sponsored insurance for this money. There is possibly no STRICTLY ECONOMIC argument for this insurance, but there is certainly what might be called a “human rights” argument: i.e. everyone should have the right to a 100% safe bank account.

In contrast, there is no reason for government to organise insurance for money in “investment” accounts. Nor is there any reason to allow depositors instant access to their money: the money has been locked away in businesses or mortgages. That’s where the money is. Investors in General Motors cannot all withdraw their investment at once, so why should those who lend to banks who in turn lend to General Motors have instant access to their money?

Bank runs.

One big advantage of the above “two account” system is that it would greatly slow down bank runs. As regards 100% safe accounts, there would be no reason for depositors to take part in a run because their money is safe. But if they wanted to take part in a run, they’d get their money.

As to those with investment accounts, they just can’t have instant access their money. So they COULD take part in a run, but the run would take place more slowly than under current arrangements.

The non-existent deflationary effect.

An apparent disadvantage of the above “two types of account” system is that it places restrictions on what can be done with money. And that would certainly have a deflationary effect, all else equal.

But that deflationary effect is easily countered simply by expanding the total stock of money. Various governments / central banks have implemented a HUGE rise in their monetary bases over the last two years in response to the credit crunch, so expanding the stock of money is not difficult.

Of course the twits in high places in the Western world have channelled this extra money into the pockets of precisely the section of the population LEAST likely to spend it: that is the rich. Doh! But that’s a minor technical point. The important point is that channelling extra money into the pockets of the population at large is not difficult.

Or as Milton Friedman put it in Chapter 3 of his book “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

Maturity transformation.

Astute readers will have noticed that the above system curtails maturity transformation: that’s the ability of banks to borrow short and lend long. Indeed, the above system could be taken to the extreme of outlawing maturity transformation. That could be done by forcing banks and shadow banks to match the maturity of the loans they make to the maturity of those with investment accounts.

So would banning maturity transformation do any harm?

Well the basic argument for maturity transformation is that allegedly makes more efficient use of the money deposited at banks. But the flaw in that argument is that money is simply numbers in computers. Thus making efficient use of money is a totally different kettle of fish to making efficient use of buildings or machinery.

Put another way, viewed from the perspective of microeconomic entities (households and firms), it makes sense to make efficient use of money. But this idea breaks down at the macro-economic level. That is because, as pointed out above, expanding the total stock of money costs nothing.

P.S. (c.9.30am same day). The above system also largely disposes of the implicit subsidy that banks get: that’s the artificially low rates they can borrow at on account of government guarantees. This subsidy was estimated by Britain’s Independent Banking Commission Final Report (p.130) as being well over £10bn a year in a NORMAL year (i.e. bank subsidies in the recent credit crunch years have clearly been higher).

Second P.S. (same day). Far as I can see from this paper by Andrew Haldane, the implicit subsidies that banks get are larger than their profits. (See just before his conclusion.) LOL.


Wednesday, 8 February 2012

Institute of Fiscal Studies thinks tax increases reduce the deficit. LOL.

95% or so of the population who haven’t grasped the difference between macro and micro economics. As a result they tend to think that governments (macroeconomics) can be viewed the same way as households or firms (microeconomics). For example, cut the expenditure of a household or firm by $X a year, and all else equal, its deficit will decline by $X a year.

The same does NOT APPLY to government deficits (or surpluses). Indeed a paper by Victoria Chick and Ann Pettifor claims that alterations to tax or government spending have the OPPOSITE of the expected effect. That is for example, raise taxes, and (all else equal) far from the deficit declining, it actually RISES. That’s because (amongst other reasons) the automatic stabilisers kick in, which tends to nullify the effect of the tax increase.

The above “Chick” claim might be a bit extreme. But certainly the effect of tax and government expenditure changes are counter-intuitive: or at least counter-intuitive for those who have not studied economics.

The Institute of Fiscal Studies’s 2012 Green Budget.

Section 3 of this recent publication by the Institute of Fiscal Studies (IFS) makes all the above sorts of errors – and more.

The IFS, as its name implies, has concentrated since its foundation mainly on matters connected with tax. Many matters in connection with tax are essentially microeconomic, and I would not challenge their expertise there. But in section three of the above publication they have strayed well and truly into macroeconomics and tripped up as a result.

Section three of this publication starts with the sort of emotive language on the deficit that you’d expect from a Republican member of Congress. But then as Bill Mitchell has pointed out time and again, the political left has fallen hook line and sinker for the anti-deficit rhetoric of the political right. Section 3 of the IFS work reads very much like the “Citizens Guide” to the deficit produced by the right wing Peterson Institute in the US, or the equally ridiculous Peterson publication “A Path to Balance”.

The Peterson “Path to Balance” starts with the archaic assumption that the budget needs to balance. That’s the main objective. Anything more sophisticated, like trying to maximise GDP is way beyond the Peterson Institute or the authors of the IFS work.

The first paragraph of section three of the IFS work refers to the fact that the “financial crisis” has “punched a permanent hole in the public finances”. Oooh. Shock horror. Punching holes in things: that’s bad bad bad. Very emotive.

The fashionable word “sustainable”.

Next, the IFS makes frequent use of the fashionable word “sustainable”. Frequent use of fashionable words is always a good evidence of B.S.

The first problem with the “sustainable” point is this. The IFS claims that British national debt as a proportion of GDP is around 75% and rising (see their figure 3.14). And that, so they argue is not “sustainable”. But they don’t mention that the relevant percentage for Britain just after WWII was over 200% without any catastrophic problems. And the same goes for Japan, where the percentage is currently also around 200%. The sky is not falling in in Japan, far as I know. Now if 200% is sustainable, it’s hard to see why 100% or 150% should not be sustainable.

Next, the fact that a current trend is not sustainable in the long run is not an argument against letting the trend continue for the time being. When a typical family car is doing 10mph and is accelerating at 5mph/sec, that trend is not “sustainable” in the long run because after 14 seconds the car will be doing 80mph. And that’s about the maximum speed for a typical family car.

But that would be a ridiculous argument against limiting car speeds to 10mph.

Next, what is the merit in “sustainability”? Obviously a government does not want to get into the position where its debt becomes so large that creditors begin doubting its ability of pay interest or repay capital. And for those who do not understand macroeconomics there seems to be a feed-back mechanism there: doubts about ability of a debtor to pay result in the interest charged to the debtor rising, which puts the debtor in an even worse position. The latter idea certainly applies to a microeconomic entity.

However, the government of a monetarily sovereign country like Britain is in a totally different position: if creditors do not want to lend to it, it can simply print money.

For more detailed explanation of the latter point, see here. You don’t need much of a brain to understand this explanation – though you’ll need far more brain that is possessed by Peterson Institute authors. And in contrast to the IFS publication and Peterson Institute publications, you won’t find the word sustainable there. In contrast, the prime consideration is the question as to what level of debt maximises GDP.

And finally, the fact that debt IS SUSTAINABLE does not prove that that debt makes sense. To illustrate, if someone with a healthy income, plenty of money in the bank and no debts actually goes into debt to buy a PC for example, that is highly unlikely to make sense (assuming the person has more than enough cash to buy the PC). Unless the PC vendors are shooting themselves in the foot by offering a ridiculously low rate of interest, it purchaser will not benefit from buying the PC on credit. But given that the purchaser has a healthy income, the debt will certainly be “sustainable”.

Conclusion. The word “sustainable” is a great word for dedicated followers of fashionable phraseology. So far as anyone with a grasp of economics goes, the word is near irrelevant.


Tuesday, 7 February 2012

An alternative sectoral balance equation.

This is a popular equation with Modern Monetary Theory sectoral balance enthusiasts:

(I – S) + (G – T) + (X – M) = 0

I=investment, S=savings, G=government spending, T=tax, X=exports, and M=imports. The equation is cited for example here, here, here and here.

And there is a picture of Warren Mosler displaying the equation here!

However, the equation and the reasoning leading to it are flawed. I’ll argue below that investment (I) should be omitted from the equation.

Here is Bill Mitchell’s reasoning (in grey italics), leading to the equation.

From the sources perspective we write:

GDP = C + I + G + (X – M)

which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

However, there is a problem here: in the real world there is no clear distinction between consumption items (C) and investment items (I). To illustrate, is something designed to last three months an investment? How about one year . . . three years? The distinction between the two is arbitrary.

Bill continues:

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made

Hang on: why doesn’t investment (I) appear on the right hand side? If we define anything designed to last more than say five years as an investment (e.g. cars), then rather a large proportion of what the average household “consumes” has been omitted (cars in particular).

Bill continues:

Equating these two perspectives we get:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero. The sectoral balances derived are:

• The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
• The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
• The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

I suggest the above should read:

Equating these two perspectives we get:

C + I + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

S + (G – T) + (X – M) = 0

Perhaps the above mistake occurred because some microeconomics was applied at the macroeconomic level. That is, if a household or firm makes an investment, it normally runs down its savings. However, that idea does not apply at the macroeconomic level. That is, all else equal (external balance and budget deficit in particular), one household or firm running down its savings must cause another household or firm accumulating savings.

P.S. 23rd Feb. More discussion of the above points here, and here.


Friday, 3 February 2012

Why sack people before there’s an alternative job for them?

The British government is currently reducing the size of the public sector which involves sacking public sector employees.

But there is a huge nonsense here: where those employees become unemployed they STILL GET PAID BY GOVERNMENT! That is, they are paid unemployment benefit. I.e. the net effect is (roughly speaking) that the employees pay is halved, but far from doing half the amount of work, they do NO WORK AT ALL!

Er – there is something wrong there (to put it mildly).

There is an obvious solution to the above anomaly: leave the relevant employees in their jobs, but halve their pay and halve the hours they do. Let’s call these people “half time workers” (HTWs). (It would probably not be worth catering for those ALREADY doing part time work, under the system advocated here.)

Since HTWs are after full time jobs they’d still have an inducement to seek alternative jobs. Thus aggregate labour supply is not reduced. Meanwhile more of the people who claim to want work are actually employed, and we all benefit from the increased GDP.

The “aggregate labour supply” point is important. The purpose of unemployment (to use the word “purpose” in a somewhat unusual sense) is to counter inflation by maintaining an adequate level of aggregate labour supply. This level of labour supply is hopefully maintained under the HTW scheme advocated here.

The private sector.

Now if that all works in the case of PUBLIC sector redundancies, would it work for PRIVATE sector redundancies: i.e. could we have a system under which NO ONE quits a job till there is an alternative? Well the idea that an economy can guarantee 100% full employment 100% of the time is unrealistic, unless you are prepared to create totally senseless jobs. But would AN ATTEMPT to delay redundancies in the private sector as in the above public sector redundancy delaying system bring benefits?

Suppose a private sector employer wants to make an employee redundant. As an alternative, the employer (or employee) could apply to government for a subsidy to keep the employee on, and working fewer hours, till alternative work is found. Or at the very least, the redundancy could be delayed for a month or two.

But there is a problem, as follows. The HTW subsidy would be an inducement for employers to claim the subsidy in respect of those they knew were going to be on part time only temporarily. (This problem actually occurred with one of the employment subsidies implemented in Britain about 30 years ago – the Small Firms Employment Subsidy, I think.)

Well there is an easy solution to the above potential abuse, namely to incorporate the sort of anti-abuse measures I set out under the heading “Anti-fraud measures” here.

Now there should be alarm bells ringing in the brains of anyone reading this who is also at least half acquainted with the posts I’ve written over the last three weeks on the subject of Job Guarantee. The alarm bells should be saying “this redundancy delaying subsidy comes to the same thing as offering Job Guarantee jobs with existing employers to those who already have jobs but are threatened with redundancy.”

Congratulations to anyone experiencing such alarm bell. Those alarm bells “ring true” (forgive the pun).

Finding work for the long term unemployed is probably more urgent from the social point of view (whatever the word “social” means) than delaying redundancies. On the other hand, redundancy delaying subsidy probably brings bigger strictly economic benefits in that those who have been in an unsubsidised job for some time will tend to be well suited to such jobs.

Hundreds of millions have been spent in Britain over the last fifty years trying to delay redundancies in declining industries: shipbuilding, coal mining, British Leyland, and so on. Those subsidies came about because of political expediency – i.e. so as to buy votes. If we are going to have any sort of redundancy delaying subsidy, it should be based on economics, not politics.

P.S. (same day). A possibly relevant statistic . . . according to J.P.Mattila in an article in the American Economic Review entitled “Job Quitting and Frictional Unemployment” (1974), 50 to 60% of those changing jobs in the US do so with no intervening unemployment.


Wednesday, 1 February 2012

Does expanding the amount of debt free money reduce indebtedness?

Money can be split into numerous different categories. But one type of categorisation is to split money into so called “debt free” money, and in contrast, money which consists of a debt which is passed from hand to hand.

Central bank created money (monetary base) is essentially debt free. In THEORY this money is a debt owed by the central bank to the holder of such money, but central banks make absolutely no promise to give anyone anything (e.g. gold) in exchange for this money. Thus it is essentially debt free.

In contrast, commercial bank created money is essentially a debt which is passed from hand to hand. I’ll call this “debt-encumbered” money.

There is a wide-spread perception that banning debt-encumbered money and replacing it as necessary with debt-free money would reduce the total amount of debt. (The latter “replacement” equals imposing full reserve banking.). E.g. see here.

That perception is mistaken, and for the following reasons.

1. Under full reserve there is nothing to stop borrowers borrowing or to stop lenders lending as they see fit.

2. People and firms incur debt precisely because they “see fit” to do so. E.g. people looking for a place to live don’t HAVE TO BORROW with a view to buying a house. They can always rent. Indeed, renting is particularly popular in the wealthiest large country in Europe: Germany. The rate of owner occupation in Germany is the lowest in Europe.

3. I see no reason to suppose that the proportion of the population who choose to buy rather than rent will change just because a country abandons fractional reserve and goes for full reserve. Ergo the total amount of indebtedness will remain unaltered.

4. One argument for the idea that debt-encumbered money causes indebtedness runs as follows. The economy needs a form of money and about 97% of the money in circulation is debt-encumbered. Therefor to obtain money or to obtain an increased supply of money, participants in the economy are pretty well forced to go into debt. E.g. as Michael Rowbotham puts it in Ch 1 of his book “The Grip of Death”, “Thus the supply of money depends on people going into debt….”

Well that argument has been comprehensively demolished by events over the two or three years. That is, households and firms have deleveraged over recent years, which has cut the amount of debt-encumbered money. And to compensate, central banks have vastly increased the amount of central bank money!

Or take it to the extreme, if for some strange reason it became unfashionable to incur any debt at all, and households and firms paid off all or nearly all their debt, the effect would obviously be deflationary. But there’d be nothing to stop the central bank stepping in and supplying whatever amount of money was needed to get the economy back to full employment.

P.S. (same day). Here are more authors who seem to accept the idea that debt encumbered money increases indebtedness.

According to Joseph Huber and James Robertson in their New Economics Foundation publication “Creating New Money”:

“More specifically, many advocates of monetary reform (e.g. Rowbotham 1998, Armstrong 1996, Kennedy 1995) argue that issuing an overwhelming proportion of new money as interest-bearing debt has damaging social impacts. One argument, briefly, is that issuing money as debt creates more indebtedness in society than issuing it debt-free will do….”