Paul Krugman doesn’t know how to raise aggregate demand at the zero bound!!!

It’s scarcely believable. I’m dumbfounded.

I’ve just stumbled across an articleby Krugman written a few weeks ago which left me gobsmacked. He basically agrees with Lawrence Summer’s ridiculous “secular stagnation” theory. That’s the idea that we’re in for a long and unavoidable period of deficient demand. To quote Krugman’s final paragraph:

“But as Mr. Summers said, the crisis “is not over until it is over” — and economic reality is what it is. And what that reality appears to be right now is one in which depression rules will apply for a very long time.”

That paragraph does not of course specifically say that DEFICIENT DEMAND is the culprit, but read the whole article if you want to verify that deficient demand point. The article is only 700 words or so.

 I expect nonsense from a significant proportion of so called “professional” economists. That is, I wouldn’t expect that proportion to know how to raise demand at the zero bound. But Krugman? I’ve always had a huge amount of respect for him. So how do we raise demand at the zero bound? Well advocates of Modern Monetary Theory have no problem answering that question. The answer is as follows.

Revelation of the century: governments can print money.

You may not be believe the following because of a well-known bit of psychology: it’s the “naked emperor” phenomenon. That’s the fact that most of us are understandably reluctant to believe that important people can make ludicrous mistakes (like wandering around outdoors with no clothes on). But if you check the links and references set out here, you’ll come to see that there are in fact crowds of naked emperors in the economics profession.

In particular, there are numerous so called “professional” economists (Krugman included) who don’t seem to realise that governments can raise demand by any amount simply by printing money and dishing it out to the population (e.g. via tax cuts, or increased social security payments). That’s sometimes called a helicopter drop.

Inflation.

Of course, whenever the words “print” and “money” appear in the same sentence, hoards of economic illiterates pipe up and start chanting “Mugabwe”, “Weimar”, “inflation”, etc. So I better deal with that point, and of course the answer to that point is that printing extra money won’t be inflationary unless and until it leads to excess demand (as David Hume pointed out 250 years ago).

Notice the word “demand” there? That is the alleged problem here is deficient demand, and the solution is to print and distribute enough money to raise demand to the level that brings full employment, but doesn’t bring EXCESS demand.

Of course it may be difficult to judge exactly HOW MUCH money needs to be printed and distributed without bringing excess inflation, but the important point is that (contrary to the claims of Summers, Krugman, etc) there is no limit in principle to the amount of additional demand that can be engineered.

But surely it’s obvious that governments can print money?

Well you’d think it was obvious. But as I pointed out hereand here, there seem to be numerous economists who, strange as it might seem, don’t understand that printing is possible. Robert Mugabwe knows how to print money. But a significant proportion of the West’s “sophisticated and professional” economists just don’t get it. It’s positively weird.

As to Krugman, he doesn’t seem to realise that printing money costs next to nothing. See here.That is, he doesn’t get the point made by Milton Friedman, namely that “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

Economists are robots.

95% of the human race are robots: that is, they’ll believe almost anything they’re told, and think whatever they’re told to think. And if you don’t understand that, then you’re one of the 95%.

To be thoroughly cruel, if I had control of newspapers and television, I’d have no difficulty in persuading 95% of the population to march up and down the street, one arm raised at 45 degrees, chanting “Seig heil”. Plus if I wanted them to take part in an invasion of Poland, that would be no problem.

And the latter robot or “deferring to authority” phenomenon is widespread amongst economists. That is, as soon as someone in authority, like Lawrence Summers makes a widely publicised speech spouting complete nonsense, very few economists question the nonsense. Of course promotion in most professions depends on licking the arses of senior members of the profession, so that accounts for some of the deference. But even economists whose promotion does not depend on deference to authority, nevertheless defer for all they’re worth. For example Martin Wolfgoes along with Summers’s daft ideas, as does FrancesCoppola.

Warren Mosler argues for permanent near zero percent interest rates.

His articleis here. (H/t to MikeNorman).

I’d actually argue for zero rather than “near zero”. And there are two arguments for that, apart from the arguments put by Warren. They are as follows.

The optimum rate of interest is the free market rate (unless market failure can be proved). And governments interfere big time in the free market rate when they borrow to fund current spending (as opposed to capital spending). That “current” strategy is senseless: that is, it makes no more sense for government to borrow to cover current spending than it does for a household to do likewise.

As to capital spending, the arguments there are more complicated.  There’s a paperby a Swiss academic which attacks the conventional idea that governments should borrow to fund capital spending. 

But even if government capital spending is funded by borrowing, those capital projects should be treated in exactly the same way as if they were PRIVATE projects. So it makes no difference if we classify those projects as private.

So if we adopt that classification, that means that government (on the above narrow definition of the word) borrows nothing: the government / central bank machine simply issues enough liabilities (monetary base) to bring full employment. I.e. it issues enough “private sector net financial assets” (to use MMT parlance) to bring full employment, but it pays no interest on those liabilities.

In contrast, where private sector entity X wants Y to build up savings and lend those savings to X, then X will probably have to pay Y  interest for the forgone consumption (and the risk involved in lending).

Second: why increase AD just via extra investment spending?

A second argument for a permanent 0% rate is thus. The conventional wisdom is that the government / central bank machine should influence aggregate demand by adjusting interest rates. However there’s no logic in channelling stimulus into an economy JUST VIA extra borrowing and investment. That is, there is no reason on the face of it to think that the average recession is caused by deficient investment spending rather than a decline in consumer spending or exports. Ergo, come a recession, it’s ALL FORMS OF SPENDING that should be expanded, not just investment. Ergo central banks should leave interest rates to find their own level, while adjusting AD just via fiscal measures, in as far as that is possible.

So is it possible? Well as far as the lag between the decision to implement stimulus and the actual effects go, there isn't much to choose between monetary and fiscal measures.

There may be other practical ways in which monetary measures are better than fiscal or vice versa.  Doubtless an entire book could be written on that.

But certainly in THEORETICAL grounds, aggregate demand should be adjusted via fiscal measures rather than by adjusting interest rates.

The number of “poor” has risen in the EU – or has it?

Francesco Saraceno and the normally very sensible Mark Thomaget all worked up about the fact that the number of “poor” in the EU has risen 1%: from 23.8% of the population in 2008 to 24.8% in 2013.

Personally I’m less than devastated, particularly given the relevant definition of “poor”, which is those living on less than “60% of the national median equivalised disposable income (after social transfers).” See note No.1 here.

In other words if GDP per head were to double in real terms, and every section of the population shared equally in that bonanza (i.e. everyone’s income doubled in real terms) then (shock horror) the number of “poor” would not change one iota!!!

We really need a better definition of “poor” don’t we?

Money creation by commercial banks produces sub-optimum interest rates.

Summary.

Under fractional reserve banking, commercial banks lend money into existence. To make a profit, those banks and those they lend to do not need to cover or match the free market rate of interest: they only need cover other costs, e.g. administration costs. Thus commercial banks tend to depress interest rates to a sub optimum or sub free market level.

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Let us start with a full reserve bank system. That’s a system where the only form of money is monetary base: and that could be some commodity, like gold, or a fiat monetary base. And let’s assume full employment, that is, we’ll assume the economy is at capacity, and that the going rate of interest for a near risk free loan is X%.

Next, let’s assume commercial banks start making loans not only by lending on money deposited with them, but also (as per the existing fractional reserve system) by simply crediting the accounts of credit worthy customers.

Now do those customers and their banks need to get an X% return on capital (assuming, to keep things simple, that the loan and investment are near risk free)? Well of course not! All they need to is to get a return which covers costs. In the case of the bank, that would be enough to cover administration costs. And as to the borrower, they only need to cover the costs normally involved in any investment or business: e.g. the costs of labour, energy, depreciation and so on.

As to where loans involved significant risk, banks would have to make a significant additional charge: for bad debts.

Inflation.

Of course the additional spending involved in the latter loan and investment means that aggregate demand rises, which would be inflationary. But that’s of no concern to the bank or borrower.

As to the bank, when the loan is repaid the REAL VALUE of the dollars repaid will be less than when the loan was first made. But what of it? It didn’t cost the bank anything to create the money it loaned out (administration costs apart).

As to borrowers, if the real value of the money they eventually repay is less than what that money was worth when first borrowed, then they’re quids in!!!

The above lending strategy where banks aim to effectively tell depositors to shove off because banks have no intention of paying interest to anyone will be called the “just cover costs” strategy.

Note that the “just cover costs” strategy will not lead to PERMANENT EXCESSIVE inflation. The inflation only continues until the total of loans made by banks has risen to the point where the costs of lending by banks just covers administration costs and return on investments just covers the costs of labour, energy, etc.

So why do banks pay interest to depositors?

The above argument effectively says that banks do not need to pay interest to depositors because when making a loan, banks can simply create the money they want to lend out of thin air. So why does any bank pay interest to depositors?

One answer is that they don’t!!  At least not in REAL TERMS. That is, the real or inflation adjusted interest on bank deposits has hovered around zero for a long time: since well before the recent crisis.

Second, there is an important distinction between an INDIVIDUAL bank and the commercial banking SYSTEM as a whole, and as follows. An individual bank cannot expand the amount it lends willy nilly even when it spots viable lending opportunities: if it does expand its loan book faster than other banks, it becomes indebted those other banks.

Thus the extent to which banks go for the above “just cover costs” policy depends amongst other things on the extent to which commercial banks act as one as against acting in competition with each other. And it’s not obvious to what extent those alternative policies are adopted by banks.

But even if they tend to go for the “act in competition” option, there will still always be a bank or banks which are flush with reserves, and which are thus more willing to lend that banks which are short of reserves.

This is getting complicated isn't it? Don’t worry: the complexity will be cut short a few paragraphs hence.

Central banks artificially raise interest rates.

Another factor that muddies the picture is that governments borrow huge amounts, which will probably artificially raise interest rates.

And yet another factor is that central banks sometimes artificially starve commercial banks of reserves so as to raise interest rates.

There is actually a limit to how far central banks can take that policy since commercial banks do not absolutely have to have reserves in order to settle up with each other. That is they could use almost anything: shares, real estate, you name it.  In fact commercial banks already by-pass the central bank settling up system in that commercial banks run up significant debts to each other.

Conclusion.

Now this is all getting a bit complicated. But hopefully I’ve established that there is a TENDENCY for interest rates to be artificially low in fractional reserve system. 

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Afterthought (5^th Dec 2013): Messers Huber and Robertson have slightly different ideas as to how commercial banks exploit fractional reserve. They claim (p.31) that banks’ ability to create and lend out money at no cost to themselves enables them (in the words of H&R) to “cream off a special profit”: they charge borrowers the full rate of interest, while not themselves having to borrow that money from anyone.

Strikes me the problem with that idea is that you don’t get extra customers or sales by selling at the standard or existing rate, however big your profit might be. That is, any business that finds a cheaper way of producing something can certainly profit from that, but it can only do so by dropping its price: i.e. sharing the bonanza so to speak with customers. And that’s the sort of scenario set out above: that is, on introducing fractional reserve, banks will charge borrowers less than the rate of interest that would prevail under full reserve.