Monday, 31 December 2012

The fiscal cliff.

The fiscal cliff is an extreme example of what can go wrong when politicians are given a say in what stimulus an economy should get: they use disagreements (fake or real) on what stimulus an economy should get to push their own ideological agenda.
I’ve argued on this blog more than once that politicians and the electorate should decide what proportion of GDP is allocated to the public sector and how that money should be split as between education, health, defence, etc. But stimulus decisions should be left to technicians, which to a significant extent they already are. E.g. central banks have a say in interest rates which in turn affect stimulus.
The latter split of responsibilities as between politicians and technicians is also advocated in this work which argues for full reserve banking. We’re a bright lot we advocates of full reserve. Fiscal cliffs just wouldn’t happen if we ruled the world.

Saturday, 22 December 2012

How to get a Nobel Prize in economics, or at least become a household name economist.

First: don’t under any circumstances say anything original. The problem with saying something original is this. Only about 0.1% of the human race produce original ideas, and only about 1% recognise an original idea when it stares them in the face.
Thus if you set out an original idea and send it in to some journal, there is only about a 1% chance of it being published.
Second: far better is to take some utterly banal idea, and present it in a slightly novel format, and add some maths to make it look scientific. Here are some examples.
The Phillips Curve. It’s stark staring bollocking obvious that there is some sort of relationship between inflation and unemployment all else equal. That was known to anyone with more than three brain cells long before Phillips took the idea and drew a graph to represent the idea. David Hume (who had far more than three brain cells) pointed to the relationship between inflation and unemployment about 200 years ago. But that didn’t stop Phillips becoming a household name for his graph.
NAIRU. Well NAIRU is just a trivial alteration to the Phillips curve. “Non Accelerating Inflation Rate of Unemployment” just adds the idea that instead of inflation rising to some fixed level when unemployment gets too low, it ACCELERATES.  Yawn yawn.
The Laffer curve. For details on the history of this, see Mike Norman here.
Or am I being too cycnical? 


P.S. (26th Dec. 2012). The much heralded “Diamond-Dybvig” banking model is another example.  Essentially all this model says is that “borrow short and lend long”, which is what banks do, is risky. Only problem is that that’s pretty much a statement of the obvious. Bagehot pointed to the dangers of borrow short and lend long about 150 years ago. He said in reference to the banking system, “But in exact proportion to the power of the system is its delicacy, I should hardly say too much if I said its danger. . . . . Of the many millions on Lombard Street, infinitely the greater proportion is held by bankers or others on short notice or on demand; that is to say, the owners could ask for it all  any day they please: in a panic some of the do as for some of it. If any large fraction of that money really was demanded, our banking system and our industrial system too would be in great danger.” (p.8 of “Lombard Street”).
And for comparison, here are the first few sentences of the explanation of the DD model as set out by Wiki.
“The Diamond–Dybvig model is an influential model of bank runs and related financial crises. The model shows how banks' mix of illiquid assets (such as business or mortgage loans) and liquid liabilities (deposits which may be withdrawn at any time) may give rise to self-fulfilling panics among depositors. The model, published in 1983 by Douglas W. Diamond of the University of Chicago and Philip H. Dybvig, then of Yale University and now of Washington University in St. Louis, provides a mathematical statement of the idea that an institution with long-maturity assets and short-maturity liabilities may be unstable.
Presumably if someone set out a mathematical statement to the effect that daffodils flower in spring time, they'd be credited with discovering that daffodils flower in spring time.

Thursday, 20 December 2012

George Selgin’s flawed criticism of the Chicago full reservers.

George Selgin is an economics prof at University of Georgia, and I recommend his articles and books to anyone. He has an encyclopedic knowledge of the history of banking. Plus he writes in a clear, simple, witty style.
But in this article he makes a criticism of the pro-full reserve Chicago school which does not stand inspection. The particular Chicago individuals he cites are Irving Fisher, Milton Friedman, Henry Simons and Loyd Mints.
But beware: the arguments and counter-arguments are a bit complicated.
Selgin claims that the above “full reservers” thought that the bank instability they attributed to fractional reserve stemmed from variations in the public’s desire to hold banknotes (as distinct from holding money in the form of deposits at banks)
Selgin then points out that by the 1930s, the production of banknotes by private banks was virtually forbidden: i.e. the only form of banknotes were central bank or Fed notes. And as he rightly points out, any increased desire by the public to hold banknotes is a much bigger problem for a commercial bank where that bank cannot produce their own notes, as compared to where it can. Reason is that when the public withdraw central bank produced notes, that is a drain on a commercial bank’s reserves, whereas if the commercial bank can produce its own notes there is no such drain (and I’ll enlarge on that point below).  
So, argues Selgin, the instability was attributable not to any inherent flaw in fractional reserve, but rather to commercial banks’ inability to  produce their own banknotes.

What did the Chicago school actually say?
However, the first big problem with Selgin’s argument is that the Chicago school advocates of  full reserve banking just didn’t attribute instabilities to anything to do with banknotes - at least not as far as I can see.
For example, Fisher’s work “100% Money and the Public Debt” doesn’t say anything about note withdrawal contributing to bank failures. What Fisher does say (p.10-11) is that BANK RUNS were a big problem. And a bank run stems not from a change in how the public wants to hold its money, but from a complete and total distrust of particular banks.
And in a paper of about 6,000 words in Econometrica entitled “The Debt-Deflation Theory of Great Depressions” by Fisher, the words “banknote”, “note” and “cash” do not appear.
As for Friedman, he advocated full reserve in his 1948 paper “A Monetary and Fiscal Framework for Economic Stability.”
But Friedman certainly didn’t say anything about the demand for notes vis a vis demand for deposits. Friedman just seems to be concerned about stability in general.
Moreover, it is well known that Friedman’s main explanation for the 1930s depression was Fed incompetence.

Whence the big cash withdrawals in the 1930s?
The next big problem in Selgin’s argument concerns the REASON why cash withdrawals were taking place in the 1930s. Well it’s not too hard to fathom, and it’s nothing to do with random variations in the amount of physical cash that people wanted to hold. The explanation was that banks were toppling like nine pins in that decade, thus many people rather than keep a deposit in their local tinpot bank, preferred to hold notes produced by the Fed, the US central bank. Those notes were as good as gold. Deposits in your local tinpot bank were quite likely nowhere near as good as gold.
Selgin tries to wriggle out of the latter point with the following.
“But while the notes of certain banks would undoubtedly have been distrusted . . . .  plenty of banks remained both trusted and solvent, and their notes could have supplied the needs of the country as a whole, since notes (unlike bank deposits) can travel wherever they are most wanted.”
Well I suggest that is just plain unrealistic for 1930s America. To illustrate, if you lived in Southern Missouri were you really likely to see many banknotes issued by the Bank of San Francisco? And even if you did see some of them, would you really trust them given that you’d have known that banks were failing left, right and centre? Is a farmer in Southern Missouri really likely to be an expert on the credit worthiness of the ten thousand banks that existed around America at that time?

The demand for physical cash at harvest time.
Another possible explanation for withdrawals of banknotes is a phenomenon to which Selgin himself draws attention on some of his articles, namely that in the 1800s and early 1900s there was a significant increase in demand for banknotes at harvest time. Reason is that farmers came by large amounts of money at that time of year on selling their crops and they then spend a proportion of that in goods in their local town. In short, given a rise in economic activity, there is a rise in demand for banknotes.
But the 1930s were hardly a period of above normal “economic activity”. Quite the reverse.
That is, far from the increased demand for banknotes being attributable to a boom, there must have been some other reason for people withdrawing banknotes from banks. And it’s obvious enough what that reason was: it was, to repeat, the fact that they didn’t trust their local tinpot bank.
To summarise so far, it looks like Selgin’s criticism of the Chicago school full reservers needs a lot more work before his argument can be described as “robust”.
And finally I’ll expand, as promised, on the private bank note production versus central bank note production question.

Private banknote production.
Where private banks can issue their own banknotes, those notes as far as the bank is concerned are little different to deposits. That is, if customers of a particular bank suddenly decide they want to raise the proportion of their money held in physical cash rather than in deposits, that is of no great concern to the bank: the bank can quickly print extra notes if need be. As mentioned above, that happened regularly at harvest time.
In contrast to letting private banks print their own notes, there is the regime we are all used to nowadays, namely a regime under which only the central bank produces banknotes. But that raises a problem for private banks when their customers want to hold more banknotes: the problem is that private banks have to eat into their reserves to obtain those central bank banknotes, as pointed out above.
Now if a bank is going to stick to a prudent level of reserves, or to a legally enforced level of reserves, that means that when customers decide to hold more banknotes, a private bank will have to call in loans, or temporarily cease granting loans, which of course has a deflationary effect. And it’s an effect you just don’t need in the middle of a depression like the 1930s depression.
Worse still, if the relevant bank COULD NOT call in loans then bank faced insolvency. So Selgin’s claim that forbidding private banks from issuing their own notes makes life more difficult for commercial banks than if the latter are able to produce their own notes is certainly valid. But that point is completely irrelevant where withdrawals take place because people DON’T TRUST the bank at all.

Japan: don’t pay any attention to ING and Tanweer Akram.

Japan would be well advised to take the advice given them by this recent ING publication authored by Tanweer  Akram with a large pinch of salt.
The one good bit of advice is that Japan should not “obsess about fiscal consolidation”. That is simply a re-wording of Keynes’s entirely correct observation: “Look after unemployment and the budget will look after itself”.
But its downhill from there on. For example Akram tells the Japanese (p.24) to “increase the public investment share of real GDP”. Why on Earth? If there was evidence that Japan had insufficient public investment, then OK. But Akram produces no such evidence. In fact Japan is littered with examples of EXCESS investment in public sector stuff: those famous “bridges to nowhere”.
Next, the Japanese are told to focus on policies that “promote labor-intensive aggregate demand”. Well I’m afraid the idea that concentrating on labour intensive activity creates more jobs than capital intensive activity is a hoary old myth. Reason is that there are only about three ultimate costs of which labour is much the biggest.
What I mean by “ultimate cost” is this. In the case of capital intensive production, the capital equipment requires labour and capital equipment for its production. And the latter capital equipment requires labour and capital equipment for its production. And the latter capital equipment requires labour and capital equipment for its production. Get the picture? The ULTIMATE cost is labour. So the amount of work created by spending $X on a capital intensive activity is ultimately the same as that created by spending $X on a labour intensive activity.
As to how many “ultimate costs” there are, that’s a bit debatable. There are arguably four: labour, interest for capital, rent for land and profits. However, interest on capital and profit could be construed as the “labour” of the entrepreneur. So there are arguably between two and four ultimate costs depending on your definitions.
So to put it more accurately, there is no reason to suppose that ratio of ultimate costs involved in labour intensive activity is any different to the equivalent ratio for capital intensive activity. Thus the idea that spending $X on labour intensive activity ultimately creates more jobs than spending the same amount of capital intensive activity is not true.

International trade.
The above point about capital / labour intensivity being irrelevant is certainly true for a closed economy. As to open economies, the point is basically also true – it’s just that the arguments are a bit more complicated. For example if a country spends on capital intensive activity, a fair proportion of the capital equipment can be IMPORTED. And that of course creates work abroad rather than at home.
However, that just causes a deterioration in the balance of payments, which depresses the currency relative to other currencies, which (if market forces are working) will bring the balance of payments back into balance.

“Employment programs”.
Next Akram advocatres  “large-scale employment programs — in health care, services for the elderly, environmental protection….”. Well hang on – governments already spend large amounts on “health care, services for the elderly and environmental protection”. What’s the point of “employment programs” that duplicate that effort?
Given a GENERAL EXPANSION in Japanese GDP, both private and public sectors will expand. And expanding the latter will AUTOMATICALLY bring an expansion in spending on “health care, services for the elderly and environmental protection”. It’s all hogwash.
Of course Akram could have argued that if the economy is at capacity, i.e. the point where attempts to boost economic activity result in inflation rather than additional output, there is arguably a case for his “large-scale employment programs”. Unfortunately he is light years behind the times on this subject. He is still wet behind the ears. Put another way, he has almost got as far as understanding the opening sentences of this work of mine that looked at “large-scale employment programs”.
Hopefully he will study the literature on this subject before expressing any more views on it.