Only MMTers know what the optimum deficit and national debt are.

I’ve just Googled “optimum” and “national debt” and came across a load of nonsense. So let’s try to work out what the optimum level of national debt is.

And if you want to jump to the conclusion it’s as follows. 1. Interest on the debt should be kept at zero or near zero, which effectively makes it much the same as monetary base. 2. The size of “debt plus base” should be whatever induces the private sector to spend at a rate that brings full employment, which is pretty much a re-statement of Keynes’s dictum: “Look after unemployment and the budget will look after itself”.

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First, national debt and monetary base are similar in nature. For example, both are an asset as viewed by those holding debt and base. And both are a liability of the government / central bank (GCB). At least they are a liability OF A SORT.

Monetary base might not seem like a liability: after all, while a £10 note (a particular form of monetary base) says that the Bank of England promises to “pay the bearer on demand the sum of £10”, that doesn’t amount to much of a promise in the sense that you won’t get a £10 lump of gold from the BoE in exchange for your £10 note. On the other hand, it’s a characteristic of a liability that it can be used to cancel out an equal and opposite liability. E.g. if government demands £1,000 in tax from you, you can cancel out that liability with a bundle of £10 notes.

As to national debt, that’s no more than a promise by government to effectively give you a bundle of £10 notes at some point in the future.

Conclusion: both debt and base are kind of liability of GCB*.

What if the private sector has too much debt and base?

If the private sector has more debt and base than it wants, it will try to spend it away: partly on consumables and partly on other assets: the net effect will be a rise in demand. That’s sometimes called the “hot potato effect”.

But clearly that’s not desirable if demand is already at the maximum that is consistent with acceptable inflation (NAIRU if you like acronyms.)

Likewise, if the private sector has an INADEQUATE stock of base and debt, then Keynes’s “paradox of thrift” kicks in: that is people will try to save so as to build up their stock of money and/or national debt. And that means INADEQUATE demand, which in turn means excess unemployment.

So… the provisional conclusion is that the total of base and debt should be held at the level that keeps demand at it’s optimum level (NAIRU). And note that there NO SAYING what that level might be. It could be 10% of GDP or it could be 200% (as would seem to be the case in Japan at the moment  - at least Japan has a debt/GDP ratio of about 200%).

Interest.

Next, the amount of debt the private sector will hold depends on the interest rate offered: a relatively high rate will induce the private sector to hold more than if a lower rate is offered.

So that raises the question as to what the optimum rate of interest is. As regards government debt which is used to fund infrastructure, that would seem to be a good reason for government debt. Actually that’s debatable, and for reasons explained by Kersten Kellerman: she argues that investments made by government should be funded out of income, not borrowing.

But let’s accept the conventional wisdom, namely that incurring such debt IS JUSTIFIED. That is, let’s assume that infrastructure is funded by bonds, with the interest dependent on income from relevant investments: i.e. there is no government GUARANTEE of ANY RETURN. So those bonds and investments are treated in the same way as PRIVATELY OWNED infrastructure or other investments.

There is then the entirely SEPARATE question as to how much government debt there should be that funds CURRENT SPENDING (as opposed to the above capital spending).

Politicians like debt.

Now we all know why politicians like cutting taxes and borrowing instead: it makes politicians popular with voters (as David Hume pointed out 250 years ago – see paragraph starting “It is very tempting..”). Meanwhile, future voters / citizens have to pay back the debt – by which time incumbent politicians have retired and are making a killing out of writing their memoires and making after dinner speeches.

So the big question is: what’s the justification for funding CURRENT SPENDING out of borrowing rather than via tax? Well the answer is: “absolutely none”!!!!

Borrowing to pay your household electricty bill makes no sense.  I.e. current spending should be funded out of current income.

So . . .  the only real excuse for government debt is the one mentioned above, namely that it (along with monetary base) gives the private sector a stock of paper assets that is sufficient to induce the private sector to spend at a rate that brings full employment.

But there is absolutely no reason to pay the private sector INTEREST for holding that stock of assets. Ergo the rate of interest on the debt should be zero, or thereabouts (as advocated by one of MMT’s leading lights, Warren Mosler). But national debt that yields no interest is pretty much the same as monetary base.

So we seem to have reached the apparently bizarre conclusion that there is no case for government debt (except possibly to fund infrastructure etc). Or put it another way, the conclusion seems to be that if there is to be any debt, the interest offered should be so low that debt almost equals central bank issued money, i.e. monetary base.

But that conclusion is not actually all that bizarre: Milton Friedman advocated that the only liability government should issue should be monetary base. (See Friedman’s paragraph starting “Under the proposal…”).

Govt doesn’t control interest rates.

The conclusion we’ve arrived at, i.e. that interest on the debt should be kept at or near zero implies that GCB should not adjust interest rates. And that in turn imples that adjusting demand should be done only via fiscal adjustments. Now is that a problem? Well no. And for the following reason.

Adjusting demand via interest rate changes  is DISTORTIONARY: that is, channelling stimulus into the economy just via investment makes no more sense than channelling stimulus into the economy just via car production and any other small selection of products (public or private sector) that you care to list at random.

What is “fiscal policy”?

I’ve glossed over an important point so far, namely the question as to exactly what “fiscal policy” consists of. What might be called “pure fiscal policy” consists of having government borrow and spend (and/or cut taxes). But that, as is widely recognised may raise interest rates, and assuming stimulus is justified then an interest rate rise is obviously not called for. So given a dose of fiscal stimulus, the central bank needs to print money and buy up enough government bonds to ensure that rates DON’T rise.

So let’s say “fiscal stimulus” is used here to refer to government borrowing and spending, with the central bank buying back sufficient government bonds to keep interest rates constant. An alternative definition would be to assume that government and central bank are effectively merged, and that £X of so called fiscal spending is funded from the printing press (a policy advocated here.)

Interest rate changes completely ruled out?

The above advocated policy might seem to completely rule out interest rate adjustments. And that is potentially risky in that it removes a tool for adjusting demand. However, there’d actually be nothing to stop the central bank, given excessive private sector irrational exuberance, from wading into the market and offering to borrow at above the going rate of interest (with the interest being funded out of increased tax).

But that’s different to traditional GOVERNMENT BORROWING. The latter borrowing funds spending. In contrast, the form of central bank borrowing described in the above paragraph simply removes money from the private sector with nothing being done with that money: completely different.

The ideal level of national debt is never achieved.

The above arguments are not supposed to suggest that given say excess unemployment, GCB should try to adjust the sum of debt and base to its ideal level IMMEDIATELY. And there is no need to because the simple fact of MOVING TOWARDS that ideal would reduce unemployment. That is, given excess unemployment, if GCB simply prints money and spends it (and/or cuts taxes), that on it’s own cuts unemployment. And the longer that “print and spend” policy lasts, there nearer the sum of debt and base gets to the ideal (assuming that the ideal has not in the meantime changed).

Conclusion.

So what’s the optimum size of the deficit, debt and base?  In just a few words . . .

The optimum sized deficit is the size that keeps unemployment at the minimum level consistent with acceptable inflation (NAIRU). That deficit will always TEND TO move the debt plus base towards a level such that full employment is maintained without any need for a deficit.  

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* P.S. (22nd October 2013). Just to drive home the point that the nature of national debt is elusive, here is Robert Eisner on the  subject. "Everyone talks about the federal debt, but few, literally, know what they are talking about. That is all the more true for the federal deficit, which year after year adds to the total debt outstanding."

 

Adair Turner on credit creation, monetary base, aggregate demand, deficits, GDP, etc.

 Nice clear explanation. H/t to Lars Syll.

Charles Goodhart promotes “Help to Buy”!!!!!

Help to Buy is a recently introduced subsidy for house buyers in the UK. It’s the sort of questionable policy you’d expect from a politician. But Charles Goodhart backs it and he is a highly respected economist. So his arguments should be interesting.

The first reason that he and his co-author (Melanie Baker) give is:

“It will help address to a gap in the market for affordable housing.” Well, yes  - obviously. But it does so by subsidising a large number of house buyers other than those who don’t find housing “affordable”.

You might as well argue men’s incomes should be boosted because some men are poor.

Reason No.2 is that “Supply-side dynamics should respond from historically low levels to this stimulus if house builders have confidence in its duration.” That’s a fancy way of saying that if you subsidise something, more of it will be produced. Well that’s technically correct, but it leaves unanswered a more fundamental problem: is the supply of housing optimum? If it isn't, then obviously there is a case for a subsidy. But numerous so called “professional economists” have a problem with that concept “optimum”.

Moreover, given the arguments over “it” (i.e. Help to Buy) which are being aired in public, no builder will have a huge amount of confidence in Help to Buy staying in place.

Reason No3 is: “The private sector could take over some or all of this role after year 3 – by privatisation of the nascent mortgage indemnity insurer, by introducing private competition, or via re-insurance.”

Oh dear, oh dear. Help to Buy is of course a form of insurance: governemnt  insures lenders against mortgagors defaulting. But  if such insurance is viable or profitable, why aren’t private insurers already in this market? Reason is, of course, that it’s NOT PROFITABLE. Or put it another way, Help to Buy is what we all know it is: a taxpayer funded subsidy.

Reason No4: “It could be used as a powerful macro-prudential tool.”

Macroprudential policy is policy designed to avoid systemic risks: like  - er – people borrowing excessive amounts for housing. NINJA mortgages are an example, and they helped tip us into a credit crunch. So Goodhart and Baker are saying that far from DISCOURAGING excess borrowing, we should encourage it, but that the taxpayer should prevent those risks having systemically dangerous effects. Now that's a very novel use of the word "macroprudential". That needs thinking about.

Next, Goodhart and Baker claim that house building is currently 18% below long term trend. So? Demand for cars, bananas, restaurant meals, you name it may be 20% above or below trend. Who cares? We live in a FREE MARKET, not a communist centrally planned state – at least I hope we do. And in a free market consumers can spend more on housing, or less, just as they please.

Next, Goodhart and Baker twice claim that more house building is “critical” to the economic recovery. They don’t give any reasons, and I’m not surprised.

I can’t for the life of me see why lack of demand for any one consumer product should prevent demand for and supply of other products rising.

Conclusion: Goodhart and Baker need to go back to the drawing board.

Modern Monetary Theory in 1,000 words.

Some MMTers may disagree with this “model”. Let’s see.

Plus there may not be enough detail in the following: it may need expanding to 2,000 words.

1. Government and central bank are treated as one below, and are called “government”. That does not mean that in the ideal MMT world there would be no distinction at all between government and central bank.

2. A government which issues its own currency needs to run a more or less continuous deficit. Reason is that given inflation of 2% or so and real economic growth, the national debt and monetary base will shrink relative to real GDP unless they are constantly topped up: which can only be done via a deficit. So assuming the ratio “(debt plus base)/GDP)” is to remain about constant in the very long term, a more or less constant deficit is required.

3. In a recession, a bigger deficit than normal is needed.  

4. It does not make much sense for a government which issues its own money to borrow money. Indeed Milton Friedman and Warren Mosler (2^nd last paragraph) argued that governments should issue no interest yielding debt whatever. That is, the only liability they should issue should be money (monetary base to be exact).

However, if government DOES ISSUE debt, the rate of interest should be kept to a minimum – ideally less than inflation. (Warren Mosler has advocated a zero rate.) That way government actually profits from its creditors: effectively, creditors pay government to create and lodge money for them.

5. Deficits reduce unemployment for three reasons, as follows.

i) As regards public spending, the fact of government creating vacancies which the unemployed fill, reduces unemployment.

ii) As regards transfers (increased unemployment benefits, state pensions, etc), increased income for those concerned causes them spend more, which raises aggregate demand (AD).

Obviously a significant proportion of the latter increased incomes are saved rather than spent. But the empirical evidence is that a significant proportion of increased incomes is also SPENT. Thus the latter increased incomes WILL RAISE AD.

iii) Deficits increase what MMTers call “private sector net financial assets”: that’s government debt plus monetary base. And the larger is PSNFA, the higher is private sector spending: sometimes called the “hot potato effect”.

6. If there were no inflation or economic growth, there’d be a major problem with the above policy, as follows. It’s politically easy to print money and spend it, but it is politically difficult to do the reverse, that is raise taxes, rein in money and “unprint” it. And given no inflation and no growth, it would be necessary to unprint (i.e. run a surplus) as often as it was necessary to print (i.e. run a deficit).

However, given the need for a more or less constant deficit (see “2” above), the need for that politically unpopular “unprinting” would not occur often. That is, most of the time it’s a case of adjusting the deficit rather than spending as much time running surpluses as deficits.

7. If there is no government debt, or if the interest paid on it is kept a permanently low level (more or less the same thing) that implies downgrading the importance of, or abandoning interest rate adjustments as a means of adjusting AD, and placing more reliance on fiscal adjustments. That is an unconventional idea, but it makes sense because interest rate adjustments (and QE) involve channelling stimulus into the economy JUST VIA investment (and via the day to day spending of the rich). That makes no more sense than channelling stimulus into the economy just via car production and/or any other small selection of products (public or private sector).

However, there are two problems with the latter fiscal adjustment idea. First those adjustments need to be made quickly and second, they require the approval of bunch of economically illiterates known as “politicians”.

The solution is to have a clear distinction between decisions on STIMULUS, which should be in the hands of a committee of economists, and second, strictly political decisions, like what proportion of GDP is allocated to public spending, and how that spending is split between education, defence, etc.  The latter decision should of course stay with the electorate and politicians. E.g. if the above committee decided a boost to fiscal spending was needed, they’d tell politicians, who in turn would spend the money as they saw fit (bearing in mind that stimulus spending is best spread widely, as pointed out above). A system of that sort is actually already been set out here. But in any case, stimulus decisions ARE ALREADY and to a significant extent in the hands of committees of economists, e.g. central bank interest rate committees.    

Indeed, the limit to the debt ceiling which Republicans are trying to impose at the time of writing is an extreme example of the chaos that results from giving politicians a say on stimulus.

8. Expectations do not feature in the above MMT model because the empirical evidence is that expectations or Ricardian effects are feeble, e.g. see here or here . Or as Joseph Stiglitz put it, “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.”

However, if the mere ANNOUNCEMENT of fiscal stimulus augments its effect, that makes little difference to the above arguments.

9. The abolition of government debt (4 above) does not stop the central bank manipulating interest rates in an emergency: it could for example simply wade into the market and offer to borrow at above the going rate.

10. Job Guarantee.

The sort of temporary subsidised employment which is popular with MMTers  (“Job Guarantee”) is not considered here.  One reason is that JG is a complicated issue which could occupy an entire book. Second while JG is doubtless a valid idea, it is essentially SEPARATE to the above monetary aspects of MMT. For example, it’s perfectly feasible to implement JG without implementing the monetary aspects of MMT. And conversely, it’s easy to implement JG type systems (e.g. America’s 1930s WPA) without implementing the monetary aspects of MMT.

10. What’s the difference between MMT and Keynes? Not much. If you like, MMT takes Keynes, cuts out the nonsense and sets out the important bits.

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Afterthought (30 minutes later). I’ve also left out sectoral balances, which MMTers tend to be keen on. So perhaps the above should be entitled “The monetary aspects of MMT in 1,000 words”.