Supposedly august economics institutions continue to repeat a popular bit of nonsense on the subject of fiscal consolidation.
The nonsense is nicely encapsulated by a passage written by John Plender in the Financial Times. He refers to “The unbearable tension between the short-term requirement to lift the economy and the longer-term need for fiscal consolidation..”
If you don’t immediately see the nonsense there, then I suggest you’re not up to speed on deficits, national debts, consolidation, etc.
Much the same nonsense appears in the National Institute Economic Review. They say, “…it is clearly the case that over the medium to long term fiscal consolidation is essential for debt sustainability . . . . In this paper we assess the impact of the scale and timing of this fiscal consolidation programme on output and unemployment in the UK.” (That publication is produced by the National Institute of Economic and Social Research (NIESR)).
You’ll have no trouble finding other articles and papers that repeat the “Plender / NIESR consolidation” nonsense. E.g. see the passage starting, “The calculations do not take into account…” in this OECD paper.
The flaw in the above quotes is thus. (Incidentally it’s just monetarily sovereign countries like the U.S., Japan or the U.K. considered here. Individual Eurozone countries have a very different set of problems.)
The above quotes imply that a country with a national debt that is expanding relative to GDP as a result of its deficit must at some point put the process into reverse, or at least bring the debt expansion to a halt. But – shock horror – reversing the process will hit the recovery, or at least be deflationary.
And that gives rise the $64k allegedly difficult question as to WHEN TO REVERSE the process and by how much, a question which keeps hundreds of so called economists employed at the taxpayers’ expense.
Deficits no not necessitate rising debts.
The first bit of nonsense in the Plender / NIESR idea is the assumption that a deficit means an expanding debt. As both Keynes and Milton Friedman (and numerous other economists) have pointed out:
DEFICITS CAN ACCUMULATE AS EXTRA MONETARY BASE RATHER THAN AS EXTRA DEBT.
Thought I’d put that in capitals and in colour for the benefit of NIESR and OECD staff have never heard of Keynes or Friedman.
Oooh la la, but money printing is inflationary, isn’t it?
A possible response from the above is that having a deficit accumulate as monetary base equals money printing or “monetising the debt”, the effect of which is inflationary.
Well David Hume answered the latter point 250 years ago. As he pointed out, a money supply increase only has an effect on inflation to the extent that it is SPENT.
To be more accurate, given significant spare capacity, a money supply increase, EVEN IF IT IS SPENT, will initially just affect demand rather than inflation. And that’s exactly the effect required! Raising demand gets us out of the recession.
(Provisional conclusion: the NIESR, the OECD etc are 250 years behind the times.)
Why monetisation makes sense.
To repeat, Keyes and Friedman pointed out that a deficit can accumulate as DEBT OR BASE. When it accumulates as debt, the effect (surprise surprise) is to expand the amount of debt held by traditional holders of debt: wealthy individuals, pension funds, etc.
However, the continued recession is being caused to a far greater extent by reluctance by households, particularly underwater households to spend rather than by reluctance of wealthy individuals or pension funds to spend. Thus we’d probably get a lot more “bang per buck” for what that’s worth from having the deficit accumulate as base, and channelling that extra base into the pockets of ordinary households rather than channelling extra debt into the pockets of the wealthy and pension funds.
Let’s assume no monetisation.
However, let’s assume no monetisation, i.e. let’s assume the standard “deficit expands the debt” scenario.
The Plender / NIESR / OECD argument, to repeat, is that the expansion of the debt must come to a halt or be reversed at some stage, therefor we might as well start thinking about how and when to “halt / reverse” even if the effect hits economic growth a bit.
The REALITY is that national debt is an ASSET as viewed by the private sector entities holding that debt, and those entities will not continue expanding their holding of said assets indefinitely. That is, a point must come at which they start trying to spend or divest themselves of those assets. In particular, debt holders receiving cash for debt that reaches maturity will not re-invest the cash in new government debt: they’ll try to spend the cash. And when that happens, demand rises: the recession comes to an end.
I’ll put that in more graphic form for the benefit of the NIESR, OECD, etc. If you steadily increase the bank balance of a household, what's the household likely to do? Just continue to let the balance increase ad infinitum?
Anyone with a grain of common sense appreciates that the effect is to increase the household’s spending. What do people or households do when they get a tax rebate or win money on a lottery?
Difficult one that, isnt’t it? Um . . . er . . . THEY SPEND SOME OF THE RELEVANT MONEY!!!!! Doh.
In short, the fact that at some point the expansion of the debt will have to be stopped is not an argument for stopping it BEFORE it looks like the recession has ended. That is, the point at which to stop the debt expanding is when the private sector starts spending at a rate that brings full employment.
And taking the point even further, the point at which to run a surplus and contract the debt is when the private sector gets too confident, or goes into “irrational exuberance” mode, and starts spending at a rate that looks likely to exacerbate inflation in a serious way.
The NIESR gets it right in the end.
But credit where credit is due: the NIESR article does come to the right conclusion in the end (after spending probably tens of thousands of taxpayers’ money in the process). But they needn’t have bothered. The conclusion is intuitively obvious to anyone with a grasp of economics.
MMT speak.
To put the above point in “Modern Monetary Theory speak”, a monetarily sovereign government does not need to tax or borrow because it can print money anytime. Therefor tax and borrowing must have some other purpose.
The purpose of tax is to counteract the inflationary effect that would arise from a simple “print and spend” operation. And the purpose of borrowing is to provide the private sector with a stock of net financial assets such that the private sector spends at a rate that brings full employment (though quite what the point of issuing INTEREST PAYING debt is, rather than NON-INTEREST PAYING DEBT (i.e. cash) is, is a mystery). Milton Friedman advocated the abolition of interest paying debt.
First, for the benefit of any readers new to “narrow banking”, the term means much the same as “full reserve banking”, as indeed Kregel himself implies. “Narrow / full reserve banking” is a system in which only the state creates money. I.e. private banks cannot create money or “lend money into existence” in the way they do under the present fractional reserve system.
There are of course different ways of organising a narrow / full reserve system. And equally, there are variations on the “fractional reserve” theme. The variation on the narrow banking theme which Kregel considers is the one proposed by Minsky. And this incorporates a “Glass-Stegall element”: the bank industry is split into two halves: a retail or “basic payments system” half, and an investment banking half.
Under Minsky’s proposal, the retail half would invest in nothing apart supposedly safe securities like government debt. While the investment half would be funded not by deposits of any sort, but entirely by equity.
Is government debt safe?
Of course the idea that government debt is safe is of now a joke in view of the price at which Euro periphery debt now trades. Indeed even the price of non-Eurozone government debt bobs up and down by significant amounts. Thus personally I wouldn’t even allow investment in government debt: I’d forbid any investment of any kind. That would nice and simple.
Indeed as the second paragraph of the preface to Kregel’s article points out, what we desperately need is to simplify the system: the big advantage of complexity for banks is that they can bribe politicians and nibble away at the regulations, bit at a time. In short, we need clear lines in the sand: not complexity.
And if anyone thinks that preventing the above investment in government debt would make it more difficult for government to fund itself, my answer is that government borrowing is a farce. That is, it is pointless for a government which issues its own currency to borrow the stuff which government itself can produce at any time at no cost (i.e. money). Thus if government cannot borrow, it can perfectly well just print new money and spend it into the economy, as indeed Keynes and Milton Friedman amongst others pointed out. I’ve dealt with the farcical nature of government borrowing in more detail here.
Minsky’s proposal is just a variation on a theme.
The above set up proposed by Minsky (the retail banks investing only in supposedly safe securities and investment banks being funded entirely by equity) actually comes to much the same thing as the set up proposed by a much more recent advocate of narrow banking: Laurence Kotlikoff. Kotlikoff suggests having mutual funds (unit trusts in UK parlance) specialising in retail stuff and other funds specialising in investment banking activities. However, I’m not concerned with which is the best variation on the basic theme: it’s the basic principles I’ll consider here.
Voluntary versus forced saving.
Kregel’ first criticism of narrow banking is that it “would create a financial system . . . in which all investment decisions are the consequence of the voluntary savings decisions of individuals.”
Wow! So what exactly is wrong with that? In a desert island economy, Robinson Crusoe cannot “invest” in a new fishing rod unless he makes a “voluntary saving decision”. If there is a problem there, I don’t see it.
Moreover, are we supposed to think that “investment decisions” should be funded by INVOLUNTARY or FORCED savings? Because the latter (and here comes the real joke) is EXACTLY WHAT FRACTIONAL RESERVE INVOLVES!!!! I’ll explain.
Under fractional reserve, when a bank creates money out of thin air and makes a loan, there is an increase in demand. And assuming the economy is at capacity, the result will be inflation unless the authorities curb demand in some way, e.g. by raising interest rates or cutting public spending on roads, schools, health, the military or whatever. In short, when a bank makes a loan under fractional reserve, the necessary saving or reduced consumption is quite likely to be FORCED ONTO a random group of people or consumers: e.g. consumers of educational services, roads, or health care. And if that makes sense, I’m baffled.
It would make far more logical, where additional funds for investment seem to make sense, to get the funds from those most willing to save, which is what happens under full reserve.
So that rather knocks a hole in Kregel’s “voluntary” point.
Other criticisms.
However, Kregel’s central criticisms come in a passage which is riddled with mistakes, and which is thus.
". . .a financial system that was regulated via a 100 percent reserve requirement on deposits and a 100 percent ratio of capital to assets for investment trusts. . . .could neither ensure the stability of the real economy nor assure stability of the capital financing institutions. First, the real investments chosen could still fail to produce the anticipated rate of return; and second, sectoral over investment and financial bubbles could still exist if there were herding behavior by the investment advisers of the trusts that produced procyclical financing behavior. There would always be a risk of investors calling on the government to save them from financial ruin.”
As regards “stability” who ever said full reserve would bring perfect stability? No one I know of. What the advocates of narrow banking or full reserve DO CLAIM is that a system under which the private bank system can create money and lend it out whenever it feels like it, EXACERBATES asset price bubbles. That is, banks create and lend money to for example those speculating in house price appreciation. That pushes up house prices, which in turn makes houses a better form of collateral, which in turn encourages more borrowing, etc etc. I.e. there is a clear feed-back loop there. Indeed, there is a nice chart here showing the expansion of private bank created money relative to monetary base in the UK in the four years or so prior to the crunch. But no advocate of narrow or full reserve banking ever said, far as I know, that removing that loop totally rules out “irrational exuberance”.
(Hat tip to “tutor2u”)
As regards the idea that under narrow banking, those making investments will go running to government when their investments show a loss, attempts to pick taxpayers’ pockets go on all the time under the EXISTING SYSTEM. Attempts by the rich to organise so called “socialism for the rich” are rife.
And it may be that in the near future the rich will organise taxpayer funded bail outs for anyone losing money on the stock exchange. Though thankfully they don’t seem to have thought of this wheeze yet.
Anyway the CRUCIAL question here is whether this sort of begging would be MORE RIFE under narrow banking than under the existing fractional reserve system. And there is a VERY GOOD REASON for thinking it would not, which is thus.
The big confidence trick perpetrated by banks under fractional reserve is that they take deposits (including grandma’s life savings) and invest those savings in less than 100% loans and investments. That trick works for much of the time, but sooner or later it’s bound to go wrong. And when it does, banks have the PERFECT EXCUSE for relieving taxpayers of trillions: “if we aren’t rescued” they’ll tell you, “grandma’s savings disappear”. Cue crocodile tears, contrived weeping, wailing, gnashing of teeth, etc etc. (Personally I’m moved to vomit rather than burst into tears.)
That problem arises because banks have on the liabilities side of their balance sheet a commitment to return $X (or thereabouts) to depositors for every $X deposited, while on the asset side, the total value of assets can easily fall to less than total liabilities, in which case the bank is bust.
Now there’s a beautifully simple solution to the latter problem: narrow banking.
Under narrow banking when a bank expands its loan book, that expansion can only come from funds supplied by equity investors. I.e. balancing the additional loans on the asset side of the balance sheet is additional equity (or as yet unused equity). And NORMALLY, when equity loses its value, the relevant shareholders do not get away with running to government with a begging bowl. For example, at the time of writing Facebooks shares have dropped dramatically, but I haven’t heard anything about shareholders running to government for a bail out.
Narrow banking destroys capitalism?
Kregel continues:
“Indeed, for Minsky and Schumpeter, such a “narrow banking” system could not be considered a modern “capitalist” system; it would be akin to what John Maynard Keynes defined as a “real wage,” as opposed to a “monetary production,” economy. In a monetary economy, it is the role of the financial sector to ensure the financing of the acquisition and control of capital assets by increasing the liquidity of the liabilities of the business sector.”
Not true. Dictionary definitions of the word “capitalism” vary, but most of them give it as something like “a combination of private ownership of the means of production and free markets”.
Now under narrow banking, there is precisely NO NATIONALISATION whatever. In particular, banks are not nationalised. Plus (taking Kotlikoff’s variation on the narrow banking theme) mutual funds are not nationalised.
As to abolishing free markets, markets are just as free as under fractional reserve, with just one exception, namely that banks cannot indulge in the above mentioned “confidence trick”. But making confidence tricks illegal is hardly to destroy the free market. We already have dozens of free market activities which are banned because they are regarded as fraud, confidence tricks, etc.
Moreover, any idea that the current banking system is capitalist is just a joke. It requires an annual too big to fail subsidy plus the occasional trillion dollar bail out. That’s what I call “socialism for the rich”, not capitalism.
Next let’s consider Kregel’s claim that “, in a monetary economy, it is the role of the financial sector to ensure the financing of the acquisition and control of capital assets by increasing the liquidity of the liabilities of the business sector.” I assume that by “increasing . . the liabilities of the business sector” he means money creation. If so, that just begs the question under discussion. That is, the central question here is whether the “business sector” should be able to “lend money into existence” as the saying goes, or whether money creation should be the preserve of the central bank and government (as per narrow banking).
Is narrow banking deflationary?
Kregel’s next criticism runs as follows. “In a narrow banking system the liabilities of the financial system would be composed of (1) investment fund shares representing household savings and business profits used to finance real investments; (2) deposits held by households and businesses in the narrow banks backed by government debt or currency and coin; and (3) government-issued coin and currency held by households and firms. In such a system it is evident that total private saving would exceed investment by the private sector’s holdings of narrow bank deposits and government currency, creating a tendency toward deflation or recession. Price and/or output stability would require an exogenous addition to demand to offset this imbalance, such as might be provided by government expenditures....”
Well it’s stark staring obvious that if restrictions are put on bank lending, then there’ll be a deflationary effect, all else equal. But the simple solution, as indeed Kregel rightly says, is government organised stimulus. And what’s the problem with that? Kregel doesn’t tell us.
Put another way, if the private sector creates and spends less money, that will almost certainly have to be countered by having the central bank / government create and spend some extra money (and/or reduce taxes). I’m baffled as where the problem is.
In particular, the cost, in REAL TERMS of implementing stimulus is precisely and exactly ZERO. (That’s assuming the stimulus is done in a competent manner: if stimulus is effected by the clowns currently running Western economies, the outcome can easily be a complete shambles. But I’ll assume those organising the stimulus have I.Q.s above average.)
To enlarge on that, if stimulus takes the form of the government / central bank machine printing new money and spending it into the economy (and/or reducing taxes), that operation does not COST ANYTHING IN REAL TERMS. 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.”
Narrow banking requires a once and for all bout of stimulus.
Also, the latter stimulus is only a ONCE AND FOR ALL bout of stimulus. That is, on introducing narrow banking, bank’s freedom to lend is somewhat restricted, which in turn means more money needs to be put into the pockets of the average household and business.
Having expanded the bank balance of the average household and business (and/or reduced the amount they borrow from banks), there is then nor further need for stimulus arising from the switch to narrow banking. (Of course stimulus may be needed for other reasons, but that’s incidental.)
Less power for those criminals and fraudsters – thank God.
Moreover, what’s wrong with the incompetents, criminals and fraudsters who currently run banks having less say in the allocation of the nation’s resources? The people running banks are quite clearly a bunch of buffoons, charlatans, fraudsters and criminals. If they have a bit less say in allocating resources, and the proprietor of the average Main Street small business plus its customers have a bit MORE SAY, I’m all in favour.
The basic risk run by a bank is thus. First, it accepts $X of deposits, second it promises to return the $X to the depositor (maybe plus interest and maybe less bank charges) and third, it lends on or invests the money in ways that are less than 100% safe. Well that’s a bet which is guaranteed to fail at some point: when the loans or investments go bad.
Of course the crooks and fraudsters who run banks will tell you the risk of bank failure is minimal if the AMOUNT loaned on or invested is SMALL compared to total deposits and loss absorbing buffers (like capital). And Tories or other politicians who are funded by said crooks and fraudsters will agree (they’re paid to).
However, the above ratio is NOT SMALL: the latest “ratio” or degree of leverage as proposed by the Basle regulators is a staggering 33:1. That is, if bank assets decline by a mere 3%, shareholders are wiped out! That might be safe compared to the lax standards of banking in recent years. But basically you’d have to be RAVING BONKERS to call that safe. (For verification of the 33:1 point, see pages 8-9 of the Vickers final report.)
What does the risk achieve?
Does it increase the TOTAL AMOUNT loaned or invested? Let’s examine that question.
Anyone contemplating investing has two options. The first is to invest or lend DIRECT: e.g. in the stock exchange or for example invest in their own business or lend to a relative for the latter’s business. The second option is to invest via a bank: i.e. deposit money in a bank and let the bank do the investing or lending.
And the attraction of the second option is that you’re guaranteed your money back, or so says the bank. But that guarantee can only be made fool-proof with taxpayer backing.
Thus the “invest via a bank” route WILL RESULT in more investment, but partially as result of the taxpayer guarantee, or taxpayer funded subsidy: a ridiculous justification for the latter increase in amounts invested.
Expertise.
Additional lending will also come about as a result of bank expertise. First, banks have the lawyers, etc needed to draw up mortgage agreements, etc. That is, the mortgage business functions more efficiently when bank lawyers draw up mortgage agreements than where INDIVIDUALS lend to each other on an informal basis.
Incidentally, banks are also supposedly experts (hilarious this one) at gauging the creditworthiness of potential mortgagors. Which of course explains why they dished out mortgages to those with “no income, no job or assets” (NINJA mortgages). But we’ll let that one pass.
Anyway, back to “expertise in drawing up mortgage agreements”. The important point to appreciate about this expertise is that is has NOTHING TO DO WITH the “promise to return $X” point. That is, it would be perfectly feasible to have organisations (e.g. existing banks) which deploy their mortgage arranging expertise AND in which people can deposit their money, but where depositors carry the loss if a significant proportion of the mortgages turn out to be “non-performing”.
Indeed, organisations of this sort already exist. They’re called “unit trusts” in the UK and “mutual funds” in the US. That is people can invest in these entities. And the actual investment decisions are taken by people who are supposedly experts at investing (although their actual performance in that regard is miserable). And any losses are carried by the investors.
The 64k question.
So the $64k question is this. Should banks promise to return $X for every $X deposited – a promise that can only be made with 100% certainty if the taxpayer stands in the background. Or should depositors, in the event of the underlying assets falling in value, have to carry the relevant loss, just as they do when investing in the stock exchange?
Well it’s a no brainer isn’t it? If a bank makes ANY LOAN OR INVESTMENT based on the “guaranteed your $X back basis” there is a finite risk, however small, of taxpayers having to come to the rescue. That is, the latter arrangement INEVITABLY INVOLVES a taxpayer subsidy, however small. And banks are supposedly COMMERCIAL organisations. Thus any activity they pursue which involves a subsidy should be OUTLAWED. It’s that simple.
Put another way, if depositors want to act in a commercial manner – i.e. get interest on their investments / deposits – they should have to carry the losses normally involved in commercial activity.
And what’s the problem with that? Facebook shares have recently taken a battering. That’s capitalism. Has the sky fallen in?
Genuinely 100% safe deposits.
Of course if depositors REALLY WANT 100% safety they should be allowed it. But investing or “lending on” is not 100% safe. Thus any money such depositors put into banks should not be loaned on or invested. In consequence, such depositors will get no interest.
Full reserve banking.
Now what do you know? A system under which, 1, depositors who want interest have to carry any losses stemming from the underlying investments and in which, 2, depositors who want 100% safety get no interest is called “full reserve banking”.
Under fractional reserve banking, banks “lend money into existence” as the saying goes. That is, private banks create money. Under full reserve they can’t do this.
And in a system where depositors who want interest have to carry the loss on underlying assets, what such depositors have in banks is no longer money: it’s more in the nature of unit trust units. And the latter are never counted as part of the money supply in any country I know of. Thus no money creation takes place here. This is full reserve, not fractional reserve.
As to those who want 100% safety (and who get no interest), their money is not loaned on, so no money creation takes place there either.
Conclusion.
The ideal rules or regulations governing FRACTIONAL reserve are the rules or regulations governing FULL reserve.
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The massed ranks of economic illiterates is high places have been getting all worked up about the fact that the British government borrowed £600m more than expected in July. MSN describes the £600m as a “shock figure”. “Accountancy Live” says the government’s policies look “troubled”. Well all accountants can do is bean counting: they can’t do macroeconomics. Even Huffington is huffing and puffing about the figure.
The reality is that government borrowing is simply a balancing figure of no huge relevance.
As Keynes said, “Look after unemployment and the budget looks after itself”. I.e. if the private sector is saving, the government will just HAVE TO NET SPEND if demand is to be maintained. And incidentally, government does not even need to borrow: as Keynes and Milton Friedman pointed out, the deficit can perfectly well accumulate as monetary base rather than debt (which is actually what has happened to a large extent over the last two years as a result of QE).
Conversely, if the private sector is in “irrational exuberance” mode, government will just HAVE TO run a surplus if it wants to avoid inflation. There is NO MERIT WHATEVER in such a surplus. It is simply a balancing figure. It’s a figure that “comes out in the wash”, if you want a different phrase.
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Paying off or reducing the national debt is easy. It can be reduced anytime.
The main reason the debt is seen as a problem is that there are numerous loud mouthed economic illiterates in high places who have no grasp of the distinction between macroeconomics and microeconomics: they treat national debts (which are macro) in the same way as debt owed by a microeconomic entity, like a household or firm.
Bowles and Simpson.
For example Bowles and Simpson think the only way to reduce the deficit and/or debt, is to do what a household or firm would do where the household or firm wants to reduce its deficit or debt: cut spending and/or raise income. And “income” for government of course consists of tax. So B&S think the debt and/or deficit should be cut by raising taxes or cutting government spending.
Now the problem there is that spending cuts or tax increases are deflationary: not what we need in a recession. And that problem causes much consternation and scratching of brainless heads in high places.
Well the solution to that little problem is easy: just print money and buy back the debt (or cease rolling it over). There you are: the whole “debt” problem solved in about ten words.
Of course there are a number of boringly predictable objections to the latter ultra-simple solution to the alleged problem, which I’ll now deal with.
Printing money is inflationary?
Not given a recession. That is, assuming plenty of spare resources, e.g. surplus or “unemployed” labour and capital equipment, the extra demand stemming from an increased money supply will initially just boost output and employment. Of course IF THE MONEY SUPPLY INCREASE is excessive, then inflation will ensue. But not otherwise.
In contrast to a recession, if a country wants to reduce its national debt during normal or “non-recessionary” times, all it need do is (as above) just print money and buy back debt – which of course will be inflationary. And how do we deal with the latter? Easy: raise taxes (and/or cut public spending).
And the latter tax increase / public spending cut WILL NOT have any sort of deflationary or “income reducing” effect. That’s because the sole purpose of those tax increases / spending cut is to counter the stimulatory or inflationary effect of the debt buy back. I.e.there is no net stimulatory or deflationary effect.
Adam Smith Institute.
This article by Eamonn Butler (director and co-founder of the institute) starts by claiming that “Debt imposes a large interest-payments tax on citizens..”
Whaaaat? Doesn’t he realise that the REAL or “inflation adjusted” rate of interest on the debt of monetarily sovereign countries’ debt is about zero? In fact the rate of interest on British debt for much of the last three years or so has been LESS THAN the rate of inflation. Far from the debt costing British citizens anything, Britain is MAKING A PROFIT out of supplying sundry private sector entities with the financial assets they want. Or to put that in more blunt plain English, the British are ripping their creditors off (as indeed Germans and Americans have been doing in recent years).
After the above initial blunder, the article is just a repeat of standard Bowles & Simpson nonsense: it runs through a list of possible spending cuts.
Niall Ferguson.
Niall Ferguson is one of the world’s leading and most vociferous debt-phobes.
In this Reith Lecture, he starts with a classic mistake: lumping Eurozone periphery countries together with monetarily sovereign countries. The problems affecting each type of country are so different that you can be 99% sure that anyone lumping the two together has no idea what they’re on about. (A “monetarily sovereign” country is one that issues its OWN currency, unlike, for example Eurozone counties.)
The future generation myth.
Next, Ferguson repeats the popular myth that national debts are some sort of “burden” passed on to the next generation. He says, “The heart of the matter is the way public debt allows the current generation of voters to live at the expense of those as yet too young to vote or as yet unborn.”
The REALITY is that national debt is simply a debt owed by one section of the population to another. Thus HOLDERS of this debt pass on an ASSET to their children, while those who don’t hold any debt pass on a LIABILITY. On balance, each generation passes on NOTHING to the next generation.
Indeed that is simply a reflection of the fact that time travel is not possible. To illustrate, another popular myth is that if a public sector investment is funded by national debt, that forces subsequent generations to bear part of the cost of the investment. And indeed, were time travel possible, there would be a good case for making the next generation pay because that generation reaps some of the benefit of the investment.
But the reality is that concrete and steel produced in 2030 by the blood, sweat and tears of people in 2030 cannot be used to build a bridge in 2012.
The only exception to the above “time travel” point comes, as pointed out by Nick Rowe, where the YOUTH of one generation can be made to pay for and accumulate assets, which it consumes in its old age, with the next generation of youngsters repeating the process: working its guts out and saving up.
However the latter exception is not very realistic: that is, the REALITY is that we shower gifts on youngsters in the form of free education, health care and so. And there is little prospect of our imposing any significant burden of the above sort on youngsters.
So what’s the optimum level of national debt?
Since debt can be reduced (or increased) by any amount any time, that raises the obvious question as to what the OPTIMUM level of debt is. The answer is thus.
The optimum level of “debt plus monetary base” is the level that induces the private sector to spend at a rate that brings full employment. Or as advocates of Modern Monetary Theory have pointed out ad nausiam, if the private sector has an inadequate stock of net financial assets, it will tend to save, which will bring about Keynsian “paradox of thrift” unemployment.
And that in turn raises the obvious question: how much of that stock of “debt plus base” should be base and how much should be debt. Well the answer is that it’s pretty pointless for a government to pay anyone to borrow stuff (money) which that government can produce in infinite quantities any time. In short, the debt might as well be abolished.
And what do you know? That’s exactly what Milton Friedman advocated, i.e. a “zero debt” monetary system. See paragraph starting “Under the proposal…” (p.250) here.
Foreign debt holders.
Finally, the above argument assumes a closed economy. That is, I’ve assumed no FOREIGN holders of national debt. However, introducing foreigners to the argument does not substantially alter the conclusions. For more details, see here.
Another caveat which should be added is that the basic point of the above argument is to point out that there is no TECHNICAL OR ECONOMIC difficulty in dealing with debt. In contrast, there is big potential problem, namely that handling this debt is in the hands of politicians. It is more than possible than when expanding or contracting the debt (or doing anything else) they make a total hash of the job.
So debt IS A PROBLEM in that it’s like letting a child play with a firearm.
“The Chicago Plan Revisited” is the title of an IMF paper by Jaromir Benes and Michael Kumhof which supports full reserve banking: a system advocated in the 1930s by Irving Fisher and others and later by Milton Friedman. Unfortunately there is a big mistake at the start of this paper, as follows.
The authors envisage converting from fractional to full reserve essentially by having the central bank print some truly astronomic quantities of new money, and pay off all the country’s debtors. And when I say “astronomic” I mean something like 200% of GDP: which makes QE look like extremely small damp squib.
There is a summary of the bank sector’s balance sheets before and after the transition on pages 64-6, and for the authors’ explanation of these balance sheets, see p.7.
As they say on p.7 “the principal of all bank loans to the government (20% of GDP), and of all bank loans to the private sector except investment loans (100% of GDP), is cancelled against treasury credit.” And later,“The cancellation of private debts reduces both treasury credit and government equity by 100% of GDP.” And again: “These buy-backs in turn mean that the private sector is left with a much lower debt burden, while its deposits remain unchanged.”
Well now, if you happen to be an indebted private sector entity, this is too good to be true isn’t it? Christmas will definitely have come early under this scenario for mortgagors. In fact the effect will be rampant inflation.
Mortgagors will find the tranche of their income previously devoted to paying interest on their mortgage is no longer needed for that purpose. There’ll be a HUGE increased demand for new cars, foreign holidays, and so on.
Moreover, since most mortgagors are comfortable with their mortgage and have borrowed responsibly, the effect of getting a letter saying their mortgage has been wiped out will just induce them to run out and borrow some more: most likely with a view to getting a better house. Demand for housing will sky-rocket.
Social justice?
While wiping out debts sounds like it involves oodles of social justice, this is far from the case. People with big mortgages, at least in Britain, are NOT the poorest section of the community. The poorest are just not credit worthy: they cannot get mortgages. They live in council houses or other forms of social housing.
The biggest debtors are those in the middle of the income range. As to the very rich, they certainly TEND not to need mortgages, on the other hand there is no shortage of people with incomes twenty times the national average who live in houses worth several million, with mortgages to match.
So if you think wiping out debt equals social justice, forget it.
The two account system.
The mistake in the IMF paper stems from a failure to understand a basic feature of full reserve, as follows.
Full reserve is a system under which private banks cannot create money. Only government and central bank can do that. But commercial banks CAN LEND as long as they find depositors willing to have their money lent on by commercial banks.
However, if a commercial bank were to lend on £X at the same time as allowing the money to be still available for use by the depositor, then the bank would effectively have created extra money: both the depositor and borrower would regard themselves as having £X in the bank (that’s until the borrower spent the money, in which case the borrower’s £X is someone else’s £X).
Thus a central feature of full reserve is that depositors must choose how much of their money they want to be “instant access”, and in contrast, how much they want to be loaned on or invested. Indeed, the latter choice that depositors must make is spelled out quite clearly by two contemporary advocates of full reserve: Laurence Kotlikoff and Richard Werner. (Incidentally, while the ideas advocated by these two economists are employed below, this should not be taken to imply their agreement with anything here.)
The actual balance sheet changes.
In the light of the above, let’s now consider the balance sheet changes that occur when making the change from fractional to full reserve. I’ll assume as per the IMF paper that the transition is done more or less instantaneously. (A more gradual transition might easily make more sense, but I won’t go into that here.)
Under Kotlikoff regime, depositors who want their money loaned on or invested, put their money into a mutual fund of their choosing (“unit trust” in UK parlance). That money is then no longer a liability of the bank, and (as is the case with existing mutual funds) the depositor no longer has instant access to the money.
Werner proposes a slightly different system: the bank does the lending or investing, but it is made clear to depositors who want to earn interest from having their money loaned on that they cannot have their money back immediately. Plus there is a sliding scale of interest payable to depositors depending on how long they lock their money up for and what proportion of the losses they carry when the loans or investments go wrong. But to repeat, deposits are no longer an IMMEDIATE liability of the bank.
Personally I prefer the Kotlikoff option when it comes to money that is loaned on or invested. It is simpler, which amongst other things makes explaining the balance sheet changes easier.
In contrast, I prefer the Werner option when it comes to instant access money. Under Kotlikoff, instant access money is handled by cash mutual funds. That would seem to imply that the whole business of operating cheques, plastic cards, etc is taken over by such funds. Personally I don’t see the sense in that. Banks have expertise in operating “checking accounts” as they are called in the U.S. Plus they have expertise in operating plastic card systems.
So I’ll assume a Kotlikoff system for money that is to be loaned on or invested and a Werner system for instant access money.
Balance sheet changes.
To keep things simple, let’s say banks’ balance sheet prior to the change consists of liabilities in the form of deposits equal to 100% of GDP, while assets consist just of mortgages equal to 100% of GDP. For “mortgage” read “mortgage, loans and investments” if you like.
I COULD add equity to the liability side and reserves at the central bank to the assets side, but these two items are small compared to deposits and loans, so I’ll ignore them.
During the transition, depositors have to decide how much of their money they want loaned on / invested, and how much they want to have in the “instant access” form. Let’s say depositors want 75% of their money loaned on and 25% to be instant access.
75% of banks’ liabilities and assets are then wiped out: under Kotlikoff’s proposals, depositors would withdraw the money and put it into mutual funds, while the latter would buy 75% of all mortgages off banks.
Instant access money.
Now for the 25% of deposits that are to be instant access.
As to the mortgages balancing that 25%, the central bank buys these off commercial banks with newly created CB money. And of course mortgagors then pay off their debt to the CB which destroys or “unprints” the relevant money (balancing the money it created to give commercial banks in exchange for the mortgages).
The net result.
The net result is thus. As regards money that depositors want loaned on or invested, that money is transferred to mutual funds as are the relevant loans and investments. So bank balance sheets shrink by a large amount.
As to instant access money, commercial banks owe 25% of GDP to depositors, while in turn the central bank owes central bank money to the tune of 25% of GDP to commercial banks. I.e. commercial banks have reserves equal to 25% of GDP.
Note that there has been no increase in private sector net financial assets, never mind ASTRONOMIC increase therein that occurs under the IMF paper proposals.
Of course, if the net effect of the balance sheet changes done in “Kotlikoff/Werner” style were excessively deflationary, that could easily be countered by the standard cure for excess deflation advocated by we advocates of full reserve: just have government and central bank create new money and spend it into the economy (and/or cut taxes).
1. The purpose of QE and interest rate reductions is amongst other things to encourage investment, which in turn would boost aggregate demand (AD). However, in a recession – certainly at the START OF a recession, there is a SURPLUS of capital equipment! Trying to encourage the production of capital equipment in that scenario is raving bonkers.
2. There is no reason whatever to think that because there is a recession, that the OPTIMUM ratio in which different factors of production ought be employed has changed. In particular there is no reason to think ratio “capital equipment to labour and materials” ratio will have changed. Thus there is no reason to skew demand toward investment rather than towards the employment of labour, materials, hair dressers, computer programing, or anything else.
Indeed, the latter point would seem to be a mile above the heads of the pro-QE brigade since, far as I can see, they’ve never even raised the point.
3. It is common for employers to make a 20% or even 100% profit on a capital investment, or indeed a 20% or 100% loss. Thus, interest rate changes of two or three percent are irrelevant. Same goes for the small change in the availability of funds to borrow that stems from QE.
Or as Keynes put it, “I am now somewhat skeptical of the success of a merely monetary policy directed towards influencing the rate of interest...it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital...will be too great to be offset by any practicable changes in the rate of interest." Keynes’s General Theory – near the end of Ch 12. (h/t to skeptonomist).
4. Short term government bonds and cash are near enough the same thing. That is, QE, in that it involves purchasing short term debt is about is fatuous and central bank offering $100 bills in exchange for $20 bills, or vice versa.
5. An investment is a LONG TERM commitment. Revelation of the century that, isn’t it? Thus those making investments (whether firms or families buying a house) are not greatly concerned about SHORT TERM rates. It’s LONG TERM rates that interest them.
We are five years into a recession, and the Fed seems to have only recently worked this one out in that it is only recently they’ve gone for “operation twist”: an attempt to influence long term rates.
6. You think there is a relationship between central bank rates and the rates charged by credit card operators? Sorry: there is no relationship according to this study.
Thus QE will presumably have equally little effect on credit available from card operators.
7. This attempt by the Bank of England to explain QE is a farce. It sets out several reasons as to why QE might work. But it does not say that any of them “would” or “will” work and for reasons based on empirical evidence. It simply says that the various transmission mechanisms “might” work.
8. Radcliffe commission which studied monetary policy in Britain decades ago concluded that ‘there can be no reliance on interest rate policy as a major short-term stabiliser of demand’. So presumably the same goes for QE.
9. An important (if not THE most important) cause of weak demand at the moment is private sector deleveraging: i.e. the desire by private sector entities to pay off debts and/or accumulate cash. That is, the private sector is trying to increase its stock of net financial assets. QE has virtually no effect on the private sector’s stock of net financial assets.
Conclusion.
We’d be better off with Laurel and Hardy running central banks with the Marx Brothers, Bart Simpson and Rosanne Barr in charge of governments.
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P.S. (9th Aug 2012) A possible justification for QE (and/or interest rate reductions) is that the lag between the decision to implement and the desired effect is shorter in the case of monetary policy than fiscal policy. Unfortunately the evidence seems to be that lags are not spectacularly short in the case of monetary policy. E.g. see this Bank of England paper.
P.S. (27th August, 2010). To add insult to injury, a recent Bank of England report on QE says that the lion’s share of the gains from QE went to the richest 5% of the population. Well surprise surprise: some of us predicted that when QE was first mooted.
P.S. (14th Sept 2012). It should be said that QE does have one small saving grace. That is that it is not 100% clear what the crowding out effects of fiscal policy are, and if the effects are significant, then QE nullifies those crowding out effects. But that’s a two edged sword: that is, the latter point is as much a criticism of QE as it is praise. As I’ve been pointing out for years, if the crowding out effects of fiscal are unclear, it’s daft to employ fiscal stimulus alone. Much better is to employ fiscal and monetary in tandem, i.e. print money and spend it into the economy when appropriate, as advocated by Modern Monetary Theory and in this work by Positive Money, Richard Werner and the New Economics foundation.
P.S. (15th Sept 2012). Reason No.10. In boosting asset prices, QE partially insulates those who have made silly investment decisions against full consequences of their silliness. The effect is to encourage asset price speculation and asset bubbles in the future. (h/t to Positive Money).P.S. (25the Oct 2012). Also this article, which seems to be well researched, claims the UK authorities have no idea where QE money actually went.
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The idea that government can act as employer of last resort is as old as the stars. Pericles implemented the idea 2,500 years ago in Ancient Greece.
And certainly there is nothing in theory to stop governments offering SOME FORM OF EMPLOYMENT to every single unemployed individual. Although were the idea taken that far, particularly at times of high unemployment like the present, some of the jobs created would be near fatuous: everything suffers from diminishing returns.
Numerous acronyms are used to refer to the above idea. I’ll use “JG” (short for Job Guarantee).
Two questions are addressed below. First, should JG employees be allocated to SPECIALLY SET UP projects or “employers” (as per the WPA in the US in the 1930s). Or should the employees to allocated to EXISTING EMPLOYERS (as per the UK’s “Work Programme”).
Second, should the system be confined to the public sector.
Specially set up employers.
The big problem with specially set up employers is thus.
In addition to employing those for whom JG is designed (the recently unemployed and not desperately skilled), some minimum amount of capital equipment, permanent skilled labour and materials must be employed. (I’ll refer to the latter factors of production as Other Factors of Production (OFP)).
If the amount of OFP employed is a bare minimum, then JG will be extremely inefficient compared to normal employers (public or private sector). On the other hand, the more the amount of OFP is increased, the more JG becomes indistinguishable from existing employers!
Ergo JG people might as well be allocated to existing employers.
Public versus private employers.
The big attraction of confining JG to the public sector (though JG advocates don’t seem to spell this out very often) is that no extra demand is needed to bring JG jobs into being. Thus there is no limit to the number of JG jobs that can be created – and they can be created without exacerbating inflation.
But there is a problem there as follows.
If the economy has significant spare capacity, there is no point in dealing with excess unemployment via JG: a straight rise in demand would be better. So JG really comes into its own when the economy is at capacity and unemployment is at the supposed minimum: 3-5% or whatever.
Now if unemployment is at the level at which further demand will be inflationary, then JG cannot spend any money on OFP, nor can it pay wages to JG employees that are above what they are getting anyway: benefits. Any such payments constitute an injection, or an increase in demand.
However, there is a simple solution to that problem: allocate JG people to existing employers and for free or at a heavily subsidised rate. That should induce employers to increase the amount of relatively unskilled labour they employ, while the amount of OFP they employ remains constant. At least there is an inducement there for employers to expand the amount of relatively unskilled labour they employ relative to the amount of OFP they employ.
But if JG people are allocated to PRIVATE SECTOR employers, and assuming as per the latter paragraph that employers are induced to employ just additional relatively unskilled people and no extra OFP, then we get exactly the same result: little or no extra inflation! Reason is that inflation stems from demand for OFP, not from demand for the relatively unskilled: members of the dole queue.
Other advantages of private sector JG.
First, the private sector is better at employing the relatively unskilled than the public sector: how many unskilled people can a public sector hospital, tax office or school employ? In contrast, dishing out hamburgers, stacking supermarket shelves or labouring on a building site requires less skill.
Second, the evidence is that temporary subsidised jobs in the private sector result in better subsequent employment chances and histories than temporary subsidised jobs in the public sector (see here and here).
Conclusion.
The UK’s Work Programme is on the right lines, though obviously there are plenty of criticisms that can be made of it. For example paying less than the legal minimum hourly rate is an oddity. Are we supposed to have a legal minimum hourly wage or not in Britain?
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There are two ideas advocated by monetary radicals (for want of a better phrase) that mesh nicely. They’re as follows.
First there is full reserve banking: the idea that private banks should not create money.
Second, there is the idea advocated by Laurence Kotlikoff, Richard Werner and others, namely that those who deposit money at banks should be forced to decide how much of their money they want the bank to lodge in a 100% safe manner, and in contrast, how much they want the bank to lend on or invest.
The reason these two ideas mesh is as follows.
In a Kotlikoff-Werner (K-W) type regime, if $X is deposited at a bank, and the bank lends the money on to a borrower, money creation takes place. That is, the depositor has $X in the bank, and the borrower also has $X in the bank. M4 expands by $X.
In contrast, if $X is deposited at a bank, and the depositor wants the money to be 100% safe, the bank lodges the money in a 100% safe manner. Indeed, the latter “100% safe storage” happens more or less automatically if the bank just does nothing with the relevant money. Reason is that the above $X deposit must have come from some other bank, and that means that at the end of the relevant working day, $X is transferred from the account of the “other bank” in the books of the central bank to the account of the depositor’s bank in the books of the central bank. I.e. where a commercial bank does nothing with money deposited, that money (at least initially) is automatically lodged at the central bank.
To summarise so far, it might seem that where a bank lends on or invests depositor’s money, new money IS CREATED. Whereas if the bank does nothing with the money, the no new money is created.
However, one of the conditions attached to bank accounts under a K-W type regime is that depositors who want their money loaned on or invested do NO HAVE instant access to their money. And quite right: the money has been loaned on or invested, so it makes very good sense to say that the relevant depositors cannot have instant access. If you invest money in a house extension, you DO HAVE access to the money in that you can sell the house. But you certainly DON’T HAVE instant access. Moreover, house prices may drop between your building the extension and selling the house, so you might not get ALL the money or indeed ANY OF THE MONEY back.
Alternatively, you might double your money. In a K-W type regime, depositors who want their money loaned on or invested face similar risks and potential rewards.
Thus depositors’ money which is loaned on or invested under a K-W type regime is no longer money: it is an investment, little different from shares bought on the stock exchange.
So to summarise, under a K-W type regime, private banks CANNOT CREATE MONEY. Money deposited in a 100% safe manner does not result in money creation, and the fact of lending on or investing depositors’ money does not result in money creation either. In short, a K-W regime is INHERENTLY a full reserve banking system.
QED.
My reason for making the above point is that having read tens of thousands of words written by K & W, I don’t remember them making the above point. But it’s quite possible I’m wrong.
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