Saturday, 27 February 2010

Och ai Hamish.

As I pointed out yesterday, two defective articles appeared on Feb 24th by normally reliable U.K. economics commentators, Martin Wolf and Hamish McRae. I dealt with the former yesterday. Now for Hamish.

He starts well: “Stand by for a double dip, and a double dip lead by America”. Agreed.

Hamish’s reason is simply that various forms of stimulus are coming to an end in the U.S. He doesn’t identify the reason, which is that Congress has allowed a finite amount of stimulus, but is balking at any more. Reason is that Congressmen think government accounts work like household accounts: the books must balance in the long run, and all that nonsense.

The books haven’t balanced for the last century in the U.S., nor anywhere else. This has not proved a long term problem.

In his concluding paragraphs, Hamish claims:

I know it seems ridiculous that if governments can rescue banks and central banks can pump in so much money that they turn around house prices, that they cannot also ensure that the recovery is solid and sustained. But they can't.

We are this spring seeing the limits of government power, and we are seeing it in the US, here in Britain, in Europe, everywhere. You can pile in additional demand for an economy for a while. That has happened right around the world and it has been successful. But you cannot follow those policies indefinitely, and if you try you reach a tipping point where your actions start to have perverse effects. I suppose that is where Greece is now.

False logic. There is a world of difference between government borrowing AS A SUBSTITUTE FOR TAX which is what Greece has done over the years and the various stimulatory measures which governments can take to escape a recession (which may or may not include increased government debt).

Certainly one of the popular alleged ways of escaping a recession is Keynsian “borrow and spend”. But this is a daft policy, as I point out here.

Or as the German academic Claude Hillinger puts it (p.3).

An aspect of the crisis discussions that has irritated me the most is the implicit, or explicit claim that there is no alternative to governmental borrowing to finance the deficits incurred for stabilization purposes. It baffles me how such nonsense can be so universally accepted. Of course, there is a much better alternative: to finance the deficits with fresh money.

Of course, as I pointed out yesterday, producing “fresh money” involves a nominal increase in the government borrowing. But as I also explained yesterday this form of borrowing is really nothing of the sort.

In short, assuming the recession is dealt with by additional “fresh money”, borrowing (unlike the situation in Greece) is not an obstacle.

This is not to say there are no obstacles. There is an obvious obstacle to “fresh money” or “money printing” at some stage: inflation. (Plus where a relatively small country with its own currency wants to attempt more reflation than other countries, there is the possibility of its currency losing value too quickly relative to other currencies. But this is not really relevant here because Hamish is considering “countries” not an individual country).

Conclusion: government debt is not an obstacle to further stimulation.

Friday, 26 February 2010

Martin Wolf should read this blog.

Two normally reliable U.K. economic commentators went off the rails on Feb 24th: Martin Wolf in the Financial Times and Hamish McRae in The Independent. I’ll deal with the latter in a day or two.

Wolf considers what he calls “successful” and “failed” exits from the recession, and claims that both lead to disaster. He says:

By “success”, I mean recognition of the credit engine in high-income deficit countries. So private sector spending surges anew, fiscal deficits shrink and the economy appears to being going back to normal, at last. By “failure” I mean that the deleveraging continues, private spending fails to pick up with any real vigour and fiscal deficits remain far bigger, for far longer, than almost anybody now dares to imagine. This would be post-bubble Japan on a far wider scale.

Unhappily, the result of what I call success would probably be a still bigger financial crisis in future, while the results of what I call failure would be that the fiscal rope would run out, even though reaching the end might take longer than worrywarts fear. Yet the big point is that either outcome ultimately leads us to a sovereign debt crisis. This, in turn, would surely result in defaults, probably via inflation. In essence, stretched balance sheets threaten mass private sector bankruptcy and a depression, or sovereign bankruptcy and inflation, or some combination of the two.

I can envisage two ways by which the world might grow out of its debt overhangs without such a collapse: a surge in private and public investment in the deficit countries or a surge in demand from the emerging countries. Under the former, higher future income would make today’s borrowing sustainable. Under the latter, the savings generated by the deleveraging private sectors of deficit countries would flow naturally into increased investment in emerging countries.

To the extent that Wolf is right about burgeoning government debt, this just proves the lunacy of Keynsian borrow and spend (B&S), which I dealt with here. To summarise, the big problem with B&S is crowding out: that is, B&S involves government running into debt with a view to boosting the economy. But the extent of the boost is always questionable because crowding out may to some degree stymie it. And there is much disagreement over the extent of crowding out. At worst, governments may be running into debt with ABSOLUTELY NOTHING TO SHOW FOR IT by way of stimulus (though that is an extreme and probably unrealistic view).

More likely, is that some governments are running up relatively large debts with relatively little to show for it. (Kind of rings true that, doesn’t it?).

So why bother with B&S? It’s bonkers. Instead of “borrow and spend” why not just “print and spend”: the effects are much more certain. And if anyone is tempted to scream “Mugabwe” or “Weimar”, the answer is that print and spend was exactly what the U.K. did in 2009: the entire deficit (about £200bn) was quantitatively eased. I.e. the U.K. just printed an extra £200bn, and the sky hasn’t fallen in.

Moreover, print and spend OSTENSIBLY results in as much debt as B&S, but in the case of print and spend, the nature of the debt is a nonsense. It’s not really a debt at all. That is, under print and spend, because of the convoluted way that the “government central bank machine” prints money, for every £X of print and spend the central bank ends up holding government debt worth £X: that is the Treasury supposedly “owes” £X to the central bank.

Well that’s a big nonsense isn’t it? One arm of government owing money to another arm of government: that’s not a debt. Or as Willem Buiter put it, “These monetary base ‘liabilities’ of the central bank are not in any meaningful sense liabilities, because they are irredeemable.”

Thus there is no “sovereign debt crisis” to worry about, as Wolf claims – at least not in the case of the U.K. There IS a potential problem: the increased monetary base. This has occurred because of the private sector’s desire to net save: or put another way because of the private sector’s increased desire for net financial assets.

As long as the private sector wishes to retain this increased amount of “money in the piggy bank”, there will be no inflationary effect. As David Hume in his essay “Of Money” pointed out 250 years ago, a money supply increase cannot be inflationary unless the money comes to market (and even then it’s not necessarily inflationary).

Alternatively, if at some point in the future the private sector attempts to dissave a significant portion of its stock of monetary base, the effect could easily be inflation, unless governments take deflationary countermeasures. Given the slow and inadequate response to the private sector’s recent increased desire to save, governments’ response to the opposite, i.e. a private sector attempt to dissave might be equally slow, and the result could be excess inflation.

And for those still worried about monetary base increases, even in the absence of such increases, there is not much to stop everyone going wild with their credit cards and borrowing up to the hilt to buy larger houses, cars, etc. Inflation would be the result if such an increase in “confidence” or “animal spirits” went too far.


The third para quoted above from Wolf’s article claims that about the only way out of the problem is large scale investment in deficit countries (a conclusion that seems to be endorsed by Krugman)

Given that we are in a recession and have record amounts of plant, machinery and office space lying idle, investment isn’t exactly priority number one. Though industrial capacity has declined by around 1% in the last year, at least in the U.S. So some sort of investment “catch up” is doubtless needed. (See bottom right hand column here.)

Afterthought (27th Feb): Martin Wolf's article is also criticised by Bill Mitchell.

Thursday, 25 February 2010

Does the U.S.central bank understand economics?

Warren Mosler has produced a wealth of evidence that the U.S. central bank the Federal Reserve or “Fed” does not understand how the banking system works. This is just his latest post on the subject.

In addition to the above, the amount of nonsense emanating from the Fed is disturbing, e.g. see here.

And this from a former Fed staffer.

The latest bit of nonsense is from Gauti B. Eggertsson, of the New York Fed.

This paper sets out an idea which is of less than earth shattering significance: he calls it the “paradox of toil”. Basically the argument is that if more people look for work, this may cut wages, which in turn may cut prices, which given the very low interest rates that currently obtain may mean negative interest rates, which in turn may mean a deflationary effect.

Well if crude oil prices decline one could get the same effect. But I’ve no intention of erecting a “paradox of crude oil price cuts”.

There are a hundred and one deflationary and reflationary effects influencing economies all the time. Governments and central banks SHOULD respond to these by taking appropriate counter measures, though how good governments and central banks are at actually doing this is debatable.

When your car is going uphill it will go slower, other things being equal: shock horror. So assuming you want to go at a constant speed, what’s the solution? Er...Um...I’ve got it: depress the accelerator!

Tuesday, 23 February 2010

Hypocrisy of the year.

Hypocrisy of the year prize (2009) undoubtedly went to Lloyd Blankfein of Goldman Sachs for his claim to be doing “God’s work”.

It looks very much as though hypocrisy of the year 2010 will also go to Goldmans. Gerald Corrigan, managing director of Goldmans, claimed (according to The Times, Feb 23rd) that “I do have concerns that some point we could see animal spirits beginning to pop up again”.

Now what encourages animal spirits and what causes them to be a problem? It's those morally dubious, casino type activities isn't it? The activities that Goldmans along with fellow Wall Street crooks / banksters (take your pick) have campaigned to have preserved. And this results is the unemployment, poverty and homelessness which are now at unprecedented levels. But let's look on the bright side: Goldman partners, Godly people that they are, will by crying their eyes out over the latter problems.

Friday, 19 February 2010

Did the UK national debt increase in 2009?

Ostensibly the debt increased in 2009 by about £200bn. But the entire lot was quantitatively eased. That is, arguably, there was NO increase in the debt at all. All that happened was that the government central bank machine printed an extra £200bn.

Do you regard the £20 notes in your wallet as a “debt owed by the government to you”? That’s not the way I see the £20 notes in my wallet.

Money, or more accurately, the monetary base appears on the liabilities side of a central bank’s balance sheet. But as former Bank of England Monetary Policy Committee member Willem Buiter put it, “These monetary base ‘liabilities’ of the central bank are not in any meaningful sense liabilities, because they are irredeemable.”

As to the interest paid on this “debt”, this is paid by the Treasury to the Bank of England. But the Bank of England sends all profits it makes at the end of the year back to the Treasury!

This charade does have SOME purpose: it helps maintain a distinction between the Treasury and the central bank. Other than that, it’s a charade. So will everyone please stop worrying about the so called interest paid on the 2009 national debt increase?

Thursday, 18 February 2010

Strange ideas on banking at the Fed.

Thanks to Warren Mosler for drawing attention to a recent speech by Narayana Kocherlakota the new president of the Federal Reserve Bank of Minneapolis.

Kocherlakota’s grasp of banking is not what it might be. He claims that

“Deposit institutions are holding over a trillion dollars of excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling."

This is nonsense.

Of course there is such a thing as inflationary expectations. If a significant proportion of businesses, households, union leaders etc think prices will rise, then everyone builds inflation into their calculations, and inflation becomes self fulfilling.

But the transmission mechanism proposed by Kocherlakota does not stand inspection and for the following reasons.

First, why are households suddenly going to decide that large reserves might be inflationary, if this is what Kocherlakota is saying? Second, reserves are high mainly because of quantitative easing. I.e. central banks have printed money and bought securities. Owners of said securities have then dumped their cash in commercial banks.

If “households believe that prices will rise” they would certainly WANT additional deposits in proportion. But banks cannot just GIVE any such additional deposits to households. They cannot just pinch “deposit” from the accounts of those who have dumped the above mentioned cash and donate the money to any old household.

If the exceptionally high level of reserves to which Kocherlskota refers somehow boosted GDP, that WOULD increase the viability of loan applications in the eyes of banks. Such loans would boost household deposits. But why should a high level of reserves boost GDP? Neither the theory nor the evidence supports this idea. As to the theory, banks are capital constrained, not reserved constrained.

As to the evidence, reserves have been at record levels for a YEAR, and banks are still cautious about lending. Has Mr Kocherlakota not noticed this?

The Atlanta Fed.

The Atlanta Fed seems to think in similar terms to Minneapolis Fed. See “Steps 1,2 & 3” here.

Having criticised the above two Feds for thinking that increasing reserves increases bank lending, this is not to say expanding bank reserves has absolutely no influence on lending.

If a collection of cash rich customers suddenly increase a bank’s deposits by significant proportion, that makes investing in the bank’s equity more attractive. This may lead to an increase in bank’s capital, which in turn leads to increased lending. But this is an indirect transmission mechanism.

Moreover, in 2009 and 2010, banks know perfectly well that their reserves have increased because of quantitative easing. Potential investors in bank equity also know this. Both of these groups also know that Q.E. will at some stage be partially or wholly reversed. Thus the current large reserves are not much of a basis for long term investment decisions!

Monday, 15 February 2010

Four Solutions for Greece.

This is a modern reproduction of a Trireme (ancient Greek warship). Thanks to the Trireme Trust for permission to reproduce the picture (taken in Greece). Photo by Mary Pridgen.

Solution No. 1.

Cut all wages in Greece by 50% or thereabouts. This would NOT, repeat NOT reduce living standards in Greece by 50% or anywhere near. This solution amounts to the same as devaluing the Drachma in the old days when Greece had its own currency. And that was never a big problem for Greeks.

Unfortunately it would be very difficult to explain this to Greeks. Greeks are even more childish and self-centred than the rest of the human race –which is saying something. And that’s not my opinion: it’s the opinion of Greeks themselves. E.g. see here and here and here.

Solution No. 2.

Re-introduce the Drachma and have it run alongside the Euro, as suggested here. Not a bad idea. Given high unemployment in a particular area, a market opens up for a secondary currency in that area. This has been tried in numerous towns round the World, and it seems to work moderately well. See here.

Solution No 3.

The Warren Mosler suggestion. This involves printing and distributing one trillion extra Euros to Euro countries on a per capita basis.

I don’t understand this solution. Seems to me that the basic problem is the DIFFERENT performance of Euro economies. A measure which treats all countries in a similar fashion may be a temporary solution, but I don’t see how it’s a permanent solution.

Solution No 4.

The rest of the Europe bails Greece out. The big problem here is moral hazard: every PIG country will then want to get its nose in the trough. But on the bright side, the acronym and metaphor align nicely.

And finally please note that my main qualification for pronouncing on matters Greek is that I rowed the Trireme up the river Thames in London (with the help of about 200 others).

Afterthough dated 17th Feb. Fifth solution: Greece leaves the Eurozone and returns after devaluing the Drachma, as proposed by Martin Feldstein.

Sunday, 14 February 2010

Nonsense from Alistair Darling and 20 economists.

Alistair Darling, Britain’s finance minister, suffers from the popular delusion that if the deficit is cut, e.g. by cutting public spending, this will hinder the recovery (1). And twenty economists who signed a letter to the Sunday Times (14th Feb 2010) advocating a plan to reduce the deficit are not much better (2).

The idea that cutting public spending or raising taxes will be deflationary is understandable because deflation certainly is the effect OTHER THINGS BEING EQUAL. But we aren’t in an “other things being equal” situation: the proposal is to raise tax and/or cut spending PLUS cut borrowing. So what is the overall effect of this?

The U.K. government currently pays for roughly 10% of expenditure by borrowing. The latter involves inducing people and institutions to part with £Xbn in exchange for government I.O.U.s. This prevents people and institutions spending such money and enables government to spend it.

Now suppose as an alternative, government collects £Xbn via tax. This prevents owners of the £Xbn spending such money and enables government to spend it. Ring any bells? Put another way, borrowing and tax are not vastly different from each other. Most important: the effect of each on aggregate demand is much the same. Thus a drastic and immediate cut in borrowing, balanced by a significant tax increase (and/or cut in government spending) would NOT have a huge deflationary effect and would NOT significantly hinder the recovery.

Is there a difference between tax and borrowing?

The main difference between tax and borrowing is that the population SEES tax increases as being much more of a disaster than borrowing increases. There are two reasons for this delusion.

First, an increase in income tax or sales tax is obvious to everyone. For example if an extra £20 a month worth of income tax is deducted from your pay packet, you’ll notice it. In contrast, if borrowing becomes a bit more difficult for those wanting to build an extension or buy a car (because government has swept up much of the money available to borrow), that is not immediately obvious. Moreover, those who fail to get a loan for a new kitchen probably won’t attribute this failure to government.

Second, government borrowing involves giving those who lend pretty pieces of paper: government I.O.U.s Lenders SEE these pieces of paper as wealth. And for INDIVIDUAL lenders they certainly are wealth in that such lenders can cash the I.O.U.s at any time (either on maturity or by selling the I.O.U. to any willing buyer).

But in the aggregate these I.O.U.s are worthless. That is, if everyone tried to cash them at once, the value of the I.O.U.s would collapse to nothing. This simply reflects the fact that these I.O.U.s are simply pieces of paper or book keeping entries.

A small amount of government borrowing may make sense (though I doubt it). As to LARGE amounts of government borrowing, this involves moving in to South Sea Bubble territory.

Is Keynsian borrow and spend pointless?

Astute readers will notice that I have assumed above that crowding out completely nullifies Keynsian borrow and spend. I certainly think that assuming constant interest rates “borrow and spend” is pointless for reasons given here.

Of course if borrow and spend DOES have a reflationary effect, then the above proposal (i.e. cut borrowing and raise taxes/cut spending) will be DEFLATIONARY. But that’s not a problem: just effect whatever amount of unfunded budget deficit is needed to counter the deflationary effect.

The latter of course involves replacing a certain amount of government debt with base money. But what’s the problem with this? As the advocates of modern monetary theory have pointed out a million times, private savings are the counterpart of public sector deficits; and the total stock of private savings should be whatever induces the private sector to spend at a rate that brings full employment.

Or would it be a good idea to remain in a permanent “paradox of thrift” scenario where household net financial assets are inadequate?

A further problem with sticking to borrow and spend at a time when we are trying to reduce borrowing is that the reflationary effect of borrow and spend (at constant interest rates) could be minimal. If the effect IS minimal, then we are in the truly farcical situation of desperately trying to reduce borrowing at the same time as INCREASING borrowing in a vain attempt to keep aggregate demand up.

As to any concerns anyone might have about the inflationary effect of increasing the monetary base, well the ENTIRE U.K. deficit in 2009 was financed by new money – i.e. additional monetary base. Some people cannot see the wood for the trees.

And anyone with worries about the possible inflationary effect of this increased monetary base doesn’t understand how banks work. In particular, commercial banks are capital constrained, not reserve constrained (reserves are the main constituent of the monetary base). Nor, to coin a phrase, are they “reserve encouraged”. That is, a big increase in their reserves will not of itself encourage them to lend: witness the astronomic increase in U.S. bank reserves in 2009 combined with a thoroughly stingy attitude towards anyone wanting to borrow.


1. A.Darling said, “The case for maintaining public spending until recovery is established is overwhelming. Most countries are taking the same approach, because to cut now would be extremely risky and dangerous. But once the economy is back on track, we are setting a much tighter public spending environment.”

2. 20 economists argue in a letter to The Sunday Times for a clear plan to cut the deficit more quickly than the Labour Party envisages. They say amongst other things, “The exact timing of measures should sensitive to developments in the economy, particularly the fragility of the recovery.” If this is saying anything at all, the implication is presumably supposed to be that too fast a cut in the deficit will be deflationary.

They continue with more non-committal weasel words “The bulk of this fiscal consolidation should be borne by reductions in government spending, but that process should be mindful of its impact on society’s more vulnerable groups.” Well that’s easy to say, isn’t it? These economists don’t actually have to face elderly voters on the door step at election time who can’t pay their heating bills !

Saturday, 13 February 2010

China's stimulus too large?

China’s stimulus was large compared to most countries’. On the other hand it wasn’t large compared to the U.S. stimulus – see here.

However, it seems that China’s stimulus was much too large – see here. Which might seem to suggest that the U.S. stimulus was too large. But the latter is clearly not the case. Why?

Is it because the source of the problem was largely in the U.S.? Put another way, the loss in aggregate demand in the U.S. as a result of the collapse of household balance sheets and bank jitters was presumably larger (as a proportion of GDP) than equivalent figure in China. That is, all China suffered was presumably just an inconvenient drop in export orders - nothing catastrophic.

Anyway, thanks to China for doing more than its fair share of stimulus. Seems we need to keep quiet about China's allegedly under valued currency for several months.

Natixis claims that both the shock and the size of stimulus was three times larger in the U.S. than in Europe. So the shock to stimulus ratio for Europe the U.S. seems to be similar, though clearly the stimulus has been too small in both cases.

Thursday, 11 February 2010

Nonsense from Niall Ferguson.

Niall Ferguson has an article in today’s Financial Times, unfortunately endorsed by George Washington. The central claim of the article is that large government debts worldwide will lead to permanently higher interest rates, which in turn will seriously impede economic growth.

It’s all doom and gloom according to Ferguson: “Higher real rates, in turn, act as drag on growth, especially when the private sector is also heavily indebted – as is the case in most western economies, not least the US.”

But we are not in a situation where interest rates on government debt are high (or higher than they might otherwise be) because of need to damp demand. We are in situation where rates and debt are high because governments for a series of daft reasons have chosen to go into debt rather than collect tax to cover their spending.

Governments have gone into debt because they THINK that collecting taxes would be deflationary; plus they THINK that Keynsian “borrow and spend” is reflationary. But as I point out here, Keynsian borrow and spend is clap trap. It should be abandonned.

But we are where we are: with governments deeply in debt. Is this a problem? No. Deficits and national debts are high, but this doesn’t preclude boosting demand to the maximum level consistent with acceptable inflation AT THE SAME TIMES AS reducing deficits and national debts. The best way to do this in the circumstances would be to stop rolling over government debt (or only partially roll it over). That would increase the money supply. If the latter boosted demand too much – no problem. We can just bump up tax, i.e. confiscate some of this new money and extinguish such money.

Note that this additional money supply would probably NOT be all that inflationary. Reason is that bond holders regard said bonds as SAVINGS: that is, a chunk of their wealth they do NOT intend spending on consumption. Likewise, they would not spend the cash obtained by selling such bonds on consumption.

Economic Neanderthals need to understand that money collected in tax is not necessarily spent: it can be simply extinguished. Likewise, the money that government – central bank machines spend is not necessarily collected in tax or borrowed: such money can be created out of thin air.

A healthy level of demand combined with a declining government debt really isn’t too difficult to arrange.

Afterthought (18th Feb 2010).

Seems I'm not the only one with a dim view of Ferguson's article.

Wednesday, 10 February 2010

Is the National Debt a burden on future generations?

Most of the national debt is NOT a burden on future generations. Reasons are thus.

Suppose government borrows $X to build a highway, and assume for the moment that all the money is borrowed from natives, not foreigners. Assume also that the economy is working at capacity, i.e. that the relevant economy enjoys full employment. I’ll relax these assumptions later.

Creating a capital investment, like a highway, requires a sacrifice of current consumption. That is, the highway needs steel. So people will have to consume fewer cars and other products made of steel. Highways also need concrete. So people will have to consume less concrete in for example house foundations.

(To be more accurate, steel consumption for cars for example COULD be left unaffected if resources can be transferred from the rest of the economy to boost steel production. But in this case the country just sacrifices consumption of whatever is produced in “the rest of the economy”.)


Apart from steel and concrete, labour is required to build highways. And this labour will have to cease producing stuff for current consumption, and instead, help build highways.

Now where does this labour come from? Well it’s a bit difficult for the future generation to supply the labour. To illustrate, having new-born babies build highways might pose a few problems. As for having those due to be born in 2020 build highways in 2010, the problems are just insurmountable.

And where does the steel and concrete come from? Well you cannot consume steel in 2010 that is produced in 2030 ! In short, the “burden” involved in building the highway absolutely has to come from the current generation.

Debts and financial assets ARE passed on to the next generation.

Having established that the REAL BURDEN involved in building the highway is born by the current generation, it is nevertheless true that SOMETHING passes on to the next generation. To be more accurate, two things are passed on. First and most obviously when government borrows to build the highway, extra government debt is created (e.g.Treasuries in the U.S.). And the owners of these Treasuries pass them on to their children (or to a cats’ home, or to whoever they like).

But also, EVERYONE inherits a liability, namely the obligation to pay interest and eventually return the capital sum to the owners of the Treasuries. Alternatively they might inherit the obligation to pay a toll for using the highway.

But the important point is that IN THE AGGREGATE, nothing passes to future generations apart from the highway.

Borrowing to fund current spending.

Sometimes governments borrow to fund current spending as opposed to capital spending, like highways. In this case, obviously no physical asset passes to the next generation. All that passes (as above) are a set of financial assets and liabilities. I.e. in the aggregate, NOTHING passes to future generations.

Having future generations pay would be fair.

Given that future generations will use highways, it would certainly be fair to make them contribute. Unfortunately this is just not possible, ASSUMING natives rather than foreigners fund the highway.

Of course, if the money is borrowed from abroad, then foreigners (at least to some extent) sacrifice current consumption to finance the highway. And likewise, a genuine or real sacrifice in living standards may be made by future generations in the country with the new highway when they repay foreigners. (Coincidentally a namesake of mine made more or less this point in a paper in the American Economic Review seventy years ago.*)

But whether a standard of living hit is involved depends on exactly what form the above “repayment” takes. For example if foreign holders of government debt are given cash in exchange for such debt (e.g. on maturity of the debt), and this cash is deposited in a bank in the country with the new highway, then there is virtually no effect on living standards. After all cash (at least nominally) is a liability of a government – central bank machine, and government debt is much the same in nature.

In contrast, if the above cash is exchanged for another currency and taken out of the country, then the country’s currency declines relative to other currencies. That means a standard of living hit for the country’s citizens. This is what might be called “genuine debt repayment”.

Another example of genuine debt repayment would occur if say China wanted to halve its holding of U.S.Treasuries, and use the money concerned to buy U.S. products for consumption in China. In this case real and valuable goods move from the U.S. to China and U.S. citizens have to forgo current consumption to make such goods.

Having shown that borrowing from foreigners to fund infrastructure investments enables a country to force future generations to pay their fair share of the cost of such investments, does prove that there is any point in doing this? Probably not: after all if every country engages in this policy, it turns into a zero sum game!

Relaxing the full employment assumption.

Of course economies are not always at capacity or, put another way, at full employment. That is given an economy with excess unemployment, the highway could be financed by boosting aggregate demand. But likewise, this boost in AD could be used to fund consumption. Thus in this scenario, the country concerned is still sacrificing consumption to fund the highway.

* Richard A Musgrave, (1939). The Nature of Budgetary Balance and the Case for the Capital Budget. The American Economic Review, 29 (2): 260-271. As Richard Musgrave (no relation) put it, “collection of funds from out- side the tax jurisdiction and gradual repayment out of tax revenues will permit a spreading of the burden.”

Tuesday, 9 February 2010

China makes the same mistake as the West.

An article in the Wall Street Journal describes China’s stimulus package. $4trillion worth has gone to local authorities which have set up “investment companies”. Exactly what these “investment companies” have spent their money on seems to be a bit of a mystery.

Do doubt it is extremely profitable being on friendly terms with those running these investment companies, just as it is profitable for Goldman Sachs to be on friendly terms with those running the U.S. dollar bill printing press.

The ultimate source of demand is the consumer. Thus if one wants more demand, such demand needs to come from consumers. But powerful, important people dressed in smart suits and shiny shoes just cannot abide ordinary people – ordinary consumers. After all, ordinary consumers don’t wear smart suits and shiny shoes. So called “communist” leaders in China and so called “socialist” members of the Labour Party in the UK regard anyone not dressed in a smart suit and shiny shoes with contempt.

For a good description of Gordon Brown’s infatuation with bankers, see here.

Japan builds bridges to nowhere. China sets up “investment companies” which make equally doubtful investments. The U.S. prints billions of extra dollars, hands it banks, who then sit on it. You don’t know whether to laugh or cry.

Thursday, 4 February 2010

Quantitative easing bed time stories.

Once upon a time there was a cafe owner who had one of those orange squash dispensers where the squash is contained in a transparent tank – so customers can see the orange squash.

Orange squash sales were not doing too well. So the cafe owner had a bright idea. Since the squash tank was only half full, the cafe owner figured that if he put more squash in the tank, people would buy more squash.

So he topped the tank up. And what do you know? People DIDN’T buy more squash.

Second story.

Once upon a time there were some central bankers who wanted to stimulate their economies. So they reduced interest rates to near zero. But the effect was not sufficient. So they printed loads of extra money and gave it to commercial banks. Or rather, they gave it to commercial banks in exchange for securities. And, most important of all, they gave the process an important sounding name: “quantitative easing”. (Incompetence or skullduggery can always be disguised if you give them an important technical sounding name: “weapons of mass destruction” springs to mind.)

Anyway these silly central bankers thought that giving banks lorry loads of cash, for some bizarre reason, would result in increased orders for the output of local engineering firms, house builders etc.

Well it didn’t work too well. Banks just kept the money and did nothing with it. In fact the banks’ reserves shot up at an all time record rate. Piles of money doing nothing. Piles of orange squash doing nothing. (See extreme right of chart, and notice the extent of the excess reserves: about one trillion dollars.)

So what’s the solution, children? The solution is give the additional money to the cafe’s CUSTOMERS – or more to be more accurate, consumers in general. The latter would then buy more stuff from the cafe (and from other businesses). This would induce the cafe owner to hire more staff, thus reducing local unemployment. Plus the cafe owner (and other businesses) would run along to the local bank asking for loans to expand said businesses.

The payroll tax holiday long advocated by Warren Mosler would more or less fit the bill: feeding stimulus direct to consumers.

Feeding stimulus direct to consumers makes sense, first, because consumers are the source of all domestic private sector demand. Secondly this policy is not DIRECTIONAL. That is, it does not boost one or relatively few sectors of the economy: making borrowing easy or cheap boosts just those sectors of the economy that borrow significant sums: e.g. people buying houses.

And to make stimulus even more non-directional, government spending needs to be boosted by about the same amount as consumer spending.

Footnote: some interesting stuff on stimulus, banks, etc.

First, a study from Manchester University giving amongst other things figures for bailout costs per person in the UK: see p.33.

Second, some pie charts giving an idea of the total amounts devoted to stimulus in different countries, and the proportion of this going to banks.

I came across the above two items on Bill Mitchell’s site.

Tuesday, 2 February 2010

Taxing profits does not discourage entrepreneurship.

The knee jerk reaction of Republicans and other economic conservatives to any proposed increase in profits tax is that this discourages “wealth creation” or entrepreneurship. This idea is flawed.

The first weakness in this argument is the Laffer Curve: that is, the higher the rate of tax, the more the effort put into avoiding and evading tax. But even assuming employers are entirely honest, and happy to pay any amount of tax, increasing tax on profits still won’t discourage entrepreneurship.

A tax on apples WOULD discourage the production and consumption of apples. However, this sort of reasoning does not apply to entrepreneurs and for the following reasons.

Apple sales probably make up 1% of GDP or less, thus apples are microeconomic. In contrast, when considering entrepreneurs (that is, ALL entrepreneurs in a given country) one moves into macroeconomics: a totally different ball game. (I'll assume constant aggregate demand, by the way: i.e. assume any increase in tax is matched by an equivalent increase in government spending.)

A nation’s entire output flows through the hands of its employers. That is, the proceeds of ALL goods and services sold flows through their hands. Thus when considering employers (that’s ALL employers in a given country), one is into macroeconomics.

It could be argued against the above that entrepreneurship involves risk taking and a significant proportion of “employers” nowadays are state and local government, and other public sector entities, and that running these operations involves relatively little risk for those involved. Thus these entities are not really entrepreneurs. That is true. But it still leaves an awful lot of money, indeed the majority of GDP in most countries, flowing through the hands of “genuine entrepreneurs”.

Certainly the INITIAL effect of an increased tax on profits is to discourage entrepreneurship. A portion of entrepreneurs will react by seeking alternative employment: as employees rather than employers. Some will flee the country, and seek employment abroad, plus some will seek jobs in the public sector. And the employees of the employers who have “given up” will become unemployed.

But assuming constant aggregate demand, the demand met by former entrepreneurs will shift to those who have decided to remain entrepreneurs. The latters’ profits will rise. And that will encourage some of the “quitter entrepreneurs” to return to running businesses.

Indeed, is there anything to stop post tax profits returning to their former level? Post tax profits certainly NEED to return to this level if a country is to have an optimum number of employers, because it is post tax rewards that people look at in deciding between different forms of economic activity, not pre-tax rewards.

The only thing to stop post tax profits returning to their previous level would be some sort of interference with market forces. Something along these lines was in evidence about thirty years ago in the UK: British trade unions often cited profits and the pay of the self employed as justification for wage increases. Where a country’s workforce is heavily unionised and unions demand remuneration for their members that is fixed relative to profits and the pay of the self employed, then the relevant market forces are thwarted. However, this trade union behaviour is less evident nowadays in the UK.

Conclusion: increasing the tax on profits does not discourage entrepreneurship because pre tax profits will rise to whatever level is required to bring post tax profits back to the level that obtained before the tax increase.