Sunday, 22 January 2017

A short Positive Money video.


I support Positive Money, but their spokespeople do make one mistake after another.



And it’s best not to make mistakes because your opponents, if they’ve got half a brain, will exploit those mistakes, though luckily for PM, it’s opponents are about as clueless as its supporters.

The above short 45 second video makes three points, all of which are flawed or least very debatable.

The video starts with the odd claim by “professor” Tim Jackson that if we had a system where only the state creates money then “it would be perfectly legitimate for government to invest” in green stuff. Well it’s “perfectly legitimate” for government to invest in green stuff even if we continue with the existing banking and monetary system!!! Indeed, governments around the world are making those investments even as you read this. Doh!

Next, it is claimed that a state money only system would reduce inflation. Well since the serious 1970s inflationary episode, inflation has been well under control – and all without a “state money only” system!

As to that 1970s inflation, that was brought to a halt by a severe limitation of the money supply which (as predicted) caused widespread unemployment. All in all, the fact that state control of the money supply enables us to control inflation is not really anything to shout about.

And finally, it is claimed a state money only system would give us a much more stable financial system. Well true, but there’s a catch. That increased stability comes from the big increase in bank capital ratios that is inherent to a state money only system: in fact that ratio is 100% and that’s overkill. To illustrate, the actual increase in capital ratios that is needed according to regulators is only a couple of percent (well they would say that, wouldn’t they). While Martin Wolf and Anat Admati (economics prof at Stanford who specialises in banking) want about 25%. But that’s all a long way from 100%. Ergo the “increased stability” point is a very poor justification for a state money only system. I.e. the justification/s lie elsewhere.

Saturday, 21 January 2017

Steve Keen thinks he’s spotted a flaw in comparative advantage.


That’s in this Forbes article by him entitled “Trump's Truthful Heresy On Globalization And Free Trade”.

Keen’s central point is that when switching from a restricted trade to a free trade scenario, the capital equipment in the industries which do not have comparative advantage has to be scrapped (nicely illustrated by the empty factories in the US rust belt). And according to Keen, that is not taken into account by standard ideas on comparative advantage. The relevant passage of Keen’s runs thus (in italics):

“Ricardo’s model assumed that you could produce wine or cloth with only labour, but of course you can’t. You need machines as well, and machinery is specific to each industry. The essential machinery for making wine can’t be used to make anything else, if its use becomes unprofitable. It is either scrapped, sold at a large loss, or shipped overseas. Ditto a spinning jenny, or a steel mill: if making steel becomes unprofitable, the capital involved in its production is effectively destroyed.

Ricardo ignored this little detail in his example, pretending that goods could be produced using labour alone. Later economists have made Ricardo’s example more complicated, and included the need to have machines as well as labour to make output. But they have been even worse than Ricardo, because they pretend that you can shift a machine (they call it “capital”) from one industry to another without loss.

That is simply nonsense.

The theory ignores the reality that, when foreign competition undercuts the profitability of a domestic industry, the capital in it can’t be “transformed” into an equal amount of capital in another industry. Sometimes it’s sold at a fire-sale price, often to overseas buyers. Most of the time, as ex-steel-mill workers throughout the Midwest know, it simply turns to rust.

Ricardo’s little shell and pea trick is therefore like most conventional economic theory: it’s neat, plausible, and wrong. It’s the product of armchair thinking by people who never put foot in the factories that their economic theories turned into rust buckets.”

Well there’s a simple flaw in Keen’s argument, namely his assumption that those who talk about transferring capital from industry to another are assuming you can magically turn steel mills into textile making machinery or whatever. In fact the very idea that it’s possible to turn one form of capital equipment into another is patently absurd (about 99% of the time). The average ten year old knows that!! So Keen is simply putting a straw man argument.

What those who talk about transferring capital from one industry to another mean (unless they are round the twist) is that the labour, materials, machinery etc that is used to produce capital equipment for one industry can be switched to producing capital equipment for another industry (a transition which will in most cases require a proportion of the relevant workforce to be retrained, no doubt).

A nice illustration of that was the the very large scale and quick conversion of motor vehicle factories in WWII to making aircraft, tanks, etc.

Moreover, as regards the LONG TERM changes in the pattern of trade which Ricardo was considering, the all important consideration for those contemplating setting up industries that are new to a particular country is the LONG TERM costs involved in doing that: i.e. the LONG TERM viability of the new industry.

Compared to those LONG TERM considerations, the cost of converting labour and machinery to producing new forms of capital equipment is near irrelevant.

Thursday, 19 January 2017

Criticisms of Positive Money by “Critical Macro Finance”.



Summary / introduction.

An organisaton called “Critical Macro Finance” recently published an article entitled “Full Reserve Banking: The Wrong Cure for the Wrong Disease”, which is basically a criticism of Positive Money’s ideas on full reserve banking.  Critical Macro Finance is a group of economists based at the University of the West of England.

No authors are given for this article, so I’ll refer to the authors as “the authors”. The authors have done plenty of homework, and the article contains plenty of references.

While I support Positive Money, the authors’ arguments are among the best criticisms of PM I’ve seen and I agree with several of those criticisms. I’ve always thought PM was skating on thin ice with some of its claims and I’ve been amazed at how slow the economics profession has been to identify the weaknesses in PM’s arguments. However, the authors do not manage to demolish the case for full reserve. But the reasons for saying that are many and complicated and are as follows. I’ll take the authors’ points in turn.



Continuous economic growth and the environment.

First, the authors attack the idea put by Positive Money (or at least by PM supporters, like the Green Party) that the existing monetary system requires continuous economic growth and that for that or other reasons, the existing system harms the environment.

I fully agree with the authors there: indeed I have debunked the “continuous economic growth” and the “environment” idea on this blog.

The human race demands continuous economic growth because of its insatiable desire for ever more consumer goodies. That desire will be there regardless of what monetary or banking system we have.


Psychology.

Next, (para starting “To the average person…”) the authors accuse PM of using psychological tricks to make people feel uneasy about the existing monetary system. Well fair enough: PM is a pressure group, not an economics text book. Other pressure groups, political parties etc use psychological tricks. That’s normal.


The Chicago Plan.

The authors then correctly trace PM’s ideas back to a group of economists based in Chicago in the 1930s (para starting “The original blueprint..”). In fact PM makes no secret about those origins of PM’s ideas.


Loans create deposits.

The authors then make the following false assertion: “When a bank lends £100 to a customer, both ‘loans’ and ‘deposits’ increase by £100.” Well that is true where the money loaned out is paid to someone who banks at the same bank, but not otherwise. I.e. the latter sentence of the authors’ should have been something like, “When the private bank SYSTEM lends £100 to a customer, ‘loans’ and ‘deposits’ of the aggregate private banks system increase by £100”. But that’s not a crucial error, so lets continue.


Full reserve prevents bank lending?

The authors then claim that banks do not lend under full reserve banking. To quote, he says “Under the proposal, banks would not be allowed to make loans.”

Well as PM literature makes clear (and indeed as other advocates of full reserve like Milton Friedman and Lawrence Kotlikoff make equally clear) banks ARE ALLOWED to lend under full reserve: it’s just that the bank industry under full reserve is split into two halves, one of which lends and is funded by equity or something similar, while the second half simply accepts and stores deposits and is not  allowed to lend.

But possibly that point is a bit semantic: i.e. if what one means by the word “bank” is something like “an entity that accepts deposits”, then it is true to say that under full reserve, banks cannot lend.


Privately issued money increases debts?

The authors then attack an idea long pushed by PM (specifically here) which is along the lines that private banks create money when they make loans (on which interest is paid) ergo privately created money forces people to pay interest to private banks, or an unnecessarily large amount of interest to private banks.

I agree with the authors there: i.e. that that argument of PM’s is flawed. However, the authors explanation of where the flaw in PM’s argument lies is unnecessarily long and convoluted.  As I’ve explained in earlier articles on this blog, the ACTUAL REASON why PM are wrong there is actually quite simple, and is thus (skip to the next heading if you are not interested in where I think PM have gone wrong here).

First, the above PM argument is actually false logic: that is, the fact that in the case of private banks some money is created as a by product of loans (on which interest is paid) does not mean that private banks are unable to create money WITHOUT charging interest.  The fact that rain makes roofs wet does not prove that the fact that a roof or roofs are wet proves it must have been raining. And in fact private banks do to some extent create money without charging interest. Reasons are as follows.

There are actually two quite different types of “loan” granted by banks. First, banks to some extent are into the business of supplying customers with a form of money or “float” to enable customers to do daily transactions. But in as far as that is ALL THAT banks do, there is no reason for the bank to charge anyone any interest. To illustrate, a private bank, having supplied person A,B,C, etc with say £1,000 floats, the balance on A, B  & C’s account will bob up and down over the year, above and below £1,000, thus there is no reason, over the year as a whole for the bank to charge anyone any interest: simply crediting £1,000 to someone’s account does not involve transferring any REAL RESOURCES to that person. Thus there is no reason to charge interest.

In contrast, there certainly IS A REASON for banks to charge for ADMINISTRATION COSTS: that is, there are very real costs involved in checking up on the creditworthiness of A, B, C, etc, and taking collateral off them. Indeed, that is a strong argument against privately issued money: it’s costly to issue. In contrast, issuing state created money (base money) is virtually costless (as pointed out by Milton Friedman).

In contrast to simply supplying customers with a float, banks are also into the business of supplying customers with LONG TERM loans like mortgages. That's the second type of loan. In that case, and having supplied a customer with say £100k worth of mortgage, the balance on that customers account very definitely DOES NOT bob up and down above and below the £100k mark. Quite the contrary: the customer will spend nearly all the £100k and not pay it back for years or decades. In that case, the bank certainly will charge what might be called “genuine interest” (in addition to administration costs). Plus it will have to pay interest to some set of depositors who have put money into term accounts at the relevant bank. In that case, real resources certainly ARE TRANSFERRED  to the borrower: about £100k worth of house, to be exact.


Should government print money or borrow it?


The authors then deal with PM’s claim that stimulus should come in the form of the state simply printing new money and spending it, and/or cutting taxes. See paragraph starting “Oddly, despite the environmental argument…”.
Unbeknown to the authors, and possibly also unbeknown to PM, that idea is actually quite separate from the arguments for and against full reserve. E.g. we could perfectly well continue with the existing “fractional reserve” bank system while abolishing all government borrowing.

On the latter grounds, I could simply ignore the “borrow versus print” argument. However, I’ll say a bit about it.

The authors say,

 “Oddly, despite the environmental argument, we can also find arguments from PM about ways that monetary mechanisms can be used to induce higher output and employment. These proposals, which go by titles such as ‘Green QE’ and ‘People’s QE’, argue that the government should issue new money and use it to pay for infrastructure spending.”

The authors continue,

“An increase in government infrastructure spending is undoubtedly a good idea. But we don’t need to change the monetary system to achieve it. The public sector can do what it has always done and issue bonds to finance expenditures. (This sentence will inevitably raise the ire of the Modern Money Theory crowd, but I don’t want to get sidetracked by that debate here.)”

Well the answer to that is that PM, far as I know, does not argue that “we need to change the monetary system” in order to implement spending on infrastructure. Indeed, it’s blindingly obvious that we have spent billions on infrastructure over the last century without implementing totally new monetary systems. PM (and indeed the many other organisations and individual economists who back full reserve) argue that a system where only the state issues money is OVERALL a better system. Infrastructure in particular has nothing much to do with it.

Moreover, the very idea that a government which can print money should borrow money is odd, as Friedman (1948) said. Why borrow money at interest when you can print the stuff?

Also Keynes (1933, 5th para) said that having the state print and spend money in a recession was a perfectly acceptable alternative to having the state borrow and spend. Thus contrary to the authors’ suggestions, there’s a fair amount of brain power behind the idea that government borrowing is a nonsense, and that government should be funded just via tax and money printing.

Incidentally, the fact that Keynes advocated money printing without at the same time advocating full reserve nicely illustrates my above point that the “print versus borrow” argument is separate from the “full versus fractional reserve” argument.

And there’s another glaring anomoly with government borrowing which is thus. The purpose of having government borrow and spend is often stimulus, but the fact of borrowing considered in isolation is DEFLATIONARY!! I.e. the effect of borrowing is the opposite of the desired effect. Thus to have the state borrow and spend with a view to stimulus is a bit like throwing dirt over your car before washing it: barmy!

And if you want to know why government borrowing has proved so popular over the centuries despite its obvious defects, I suggest a big part of the answer was given by David Hume writing about 250 years ago. As Hume said, politicians borrow money rather than raise taxes so as to ingratiate themselves with voters (Hume 1742, II.IX.5).

Yet another nail in the “government borrowing” coffin was set out by Kellerman (2006). She demolished the popular claim that it makes sense for governments to borrow to fund INVESTMENTS: the so called “golden rule”.

Also Warren Mosler opposes government borrowing (Mosler (2010), 2nd last para).


Give £7,000 to everyone instead of traditonal QE?

The authors then say “Further, the conflation of QE with the use of newly printed money for government spending is another example of sleight of hand by Positive Money.” That’s a valid criticism. Indeed PM have been publishing tweets recently (see below) to the effect that the average household would have enjoyed spectacular increases in income if the £7,000 or so of new money created per head to enable QE had instead been paid direct to households or spent on increastructure or similar.  Reason why that’s a sleight of hand is that QE has little effect on demand, whereas spending £7,000 for every UK resident on infrastructure or similar would have a HUGE EFFECT on demand: indeed it would be positively inflationary.







Small banks, shadow banks, etc.

Next, in a para starting “The same is true..” the authors trott out a criticism of full reserve banking which has been made a dozen times before, and demolished an equal number of times. It’s the idea that full reserve would deal only with large regular banks, while failing to deal with the smaller unregulated banks or quasi banks.

The answer to that was given by Adair Turner when he said “If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safeguards…”. I.e. no organisation which acts like a bank should be excused obeying bank regulations. Building firms, whether they employ three or three thousand people have to obey similar rules, e.g. as regards health and safety. There is no reason why banks cannot be regulated similarly.

Moreover, even if the smallest shadow banks manage to escape regulation that does not matter too much: if say the hundred largest banks, regular and shadow, ARE REGULATED, that cracks the problem basically.


Seigniorage.

The authors then criticise the claim by PM that the freedom private banks have to print or create money enables them to enjoy seigniorage profits. As the authors put it, “There is simply no reason why the act of issuing money generates profits in itself.” Well a quick answer to that is: “tell that to a backstreet counterfeiter”.

However, that’s a flippant answer to the authors’  point. I.e. the exact way and extent to which private banks enjoy seingiorage profits is complicated and the authors are probably right to say PM overestimate the size of seigniorage profits.

But to say private banks make no seigniorage profits at all is equally wide of the mark. Joseph Huber in his work “Creating New Money” illustrated how seigniorate profits arise. As he put it,

“Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves. So their profit on this part of their business is not, say, 9% credit-interest less 4% debit-interest = 5% normal profit; it is 9% credit-interest less 0% debit-interest = 9% profit = 5% normal profit plus 4% additional special profit.”

That can be put another way, as follows.

Some of the money created by the state comes in the form of PHYSICAL money like £10 notes. But holders of that money (you and me) get no interest whatever on that money. But the state obtains various assets (e.g. schools and hospitals) in exchange for the money it prints (both in physical form and digital form). And that’s a nice little earner for the state. That’s seigniorate profit.

But in additon to zero interest earning physical money, there is also zero interest earning digital money: the money that you and I have in our current accounts (“checking accounts” in US parlance). Certainly my high street bank pays me a derisory rate of interest (0.1%) while making a specific charge for each cheque, debit card or other transaction.

In short, the authors’ claim that private banks simply intermediate between lenders (i.e. depositors) and borrowers is not entirely true: to some extent, private banks (along with those they lend to) simply print money, which is happily held by depositors without their getting any interest, as long as they have instant access to that money. I.e. in effect, private banks and those they lend to obtain real assets (e.g. houses) in exchange for inherently worthless bits of paper. That’s seigniorage profit.


Milton Friedman.

The authors end with a short discussion of Friedman’s ideas, which is of relevance since Friedman backed full reserve banking. But the authors make the following strange claim about Friedman, “Like PM, he favoured a simple monetary solution: the Fed should print money to counteract the effect of bank failures.”

Well I’ve just looked at Friedman’s 1948 paper “A Monetary and Fiscal Framework for Economic Stability” in which Friedman advocates full reserve and money printing by the state. The phrase “bank failure” does not appear. Moreover, while the word “bank” appears about fifteen times, there is no suggestion that Friedman wants to have the state print money so as to rescue banks.

Indeed Friedman is quite clear that when entities in the half of the bank system which lend make poor lending decisions, shareholders take a hit. That’s very much in line with Friedman’s pro-free market outlook.  In contrast the ACTUAL PURPOSE of money creation by the state as far as Friedman is concerned is exactly as envisaged by PM: it’s to provide general STIMULUS. Friedman is not bothered about the extent to which banks or “lending entities” benefit from that stimulus.


Financial instability.

Finally, there is an important omission from the article as follows.

It says quite rightly that one of PM’s central claims is that full reserve reduces “financial instability”.  The authors however do not say whether they think PM is right or wrong there.

In fact full reserve brings a HUGE INCREASE in financial stability in that it’s plain impossible for a bank to fail under full reserve. Reasons are simple and as follows.

As regards the half of the bank industry which simply accepts deposits, it cannot go bust because all those deposits are lodged at the central bank. And as to the half of the industry which makes loans, it cannot go bust because it is funded by shareholders (or something similar like bonds which can be bailed in). Thus if (to take an extreme scenario) a bank makes a series of seriously stupid loans, and the bank’s assets (i.e. those loans) become worthless, then the value of its shares and bonds become worthless as well. But the bank is not bust in the sense that its liabilities exceed its assets.


Overkill.

Indeed, if there’s a criticism to be made of full reserve as a solution to bank instability: it’s that full reserve constitutes overkill. It involves using a sledge hammer to crack a nut. That is, under full reserve, lending entities have 100% capital ratios, and as is widely accepted, a significant rise in capital ratios is certainly needed, but 100% is way too much as far as bank stability is concerned. (For example Martin Wolf and Anat Admati (professor of economic at Stanford) want far higher capital ratios than the UK government or Vickers commission want, but even Wolf and Admati only advocate a ratio of around 25%.)



So what’s the argument for full reserve?

Astute readers will now be wondering what the arguments for full reserve are, given that so many of the authors’ criticisms of pro full reserve arguments seem to be valid.

My answer (very briefly) to that is there is pretty obviously a difference between two systems: 1. Full reserve, under which just the state issues money while private banks cannot, and 2, the existing or “fractional reserve” system under which private banks are allowed to issue money. One of those systems must be better than the other.

Now there is no reason to suppose that under full reserve, interest rates do not settle down to some sort of GDP maximising free market rate. Nor is there any reason why, under full reserve, full employment is not attainable: all the state has to do is issue enough money to the private sector to induce the private sector to spend at a rate that brings full employment.

But if private banks are to start issuing money, they have to offer loans at below the above free market rate, which you might think means they’d make a loss. Well the answer is “Oh no they wouldn’t”: reason is those banks do not need to pay anything for the  money the lend out (as Joseph Huber explained – see above).

But that new lending increases demand, which means the state has to rein in demand, e.g. by raising taxes and confiscating some of the private sector’s stock of base money. Net result: interest rates fall to below their free market level and debts rise to above their free market level. And given the usual assumption in economics, namely that GDP is maximised when prices (including the price of borrowed money) are at their free market levels (unless market failure can be demonstrated), it follows that GDP will be larger under full reserve than under the existing or “fractional reserve” bank system.

_____________



References.

Friedman, Milton, (1948). “A Monetary and Fiscal Framework for Economic Stability”, American Economic Review.
http://0055d26.netsolhost.com/friedman/pdfs/aea/AEA-AER.06.01.1948.pdf

Hume, David (1742) ‘Of Public Credit’.
http://www.econlib.org/library/LFBooks/Hume/hmMPL32.html

Kellerman, Kersten, (2006)    ‘Debt financing of public investment: On a popular misinterpretation of “the golden rule of public sector borrowing.”’ Published by Science Direct and the European Journal of Political Economy.

Keynes, M. (1933) ‘An Open Letter to President Roosevelt’.
https://www.scribd.com/document/33886843/Keynes-NYT-Dec-31-1933

Mosler, Warren (2010). ‘Proposals for the Banking System’. Huffington Post Business.
http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

Wednesday, 18 January 2017

Random Charts XI.


My collection of random charts collected during my daily aimless wanderings around the internet continues...:-)



























Tuesday, 17 January 2017

True quantitative easing.



Richard Werner (economics prof at Southampton in the UK) is widely credited with originating the term “Quantitative Easing”, something which he himself does not deny, far as I know. But in a short paper published in 2012, and entitled “The Euro-Crisis: A To-Do-List for the ECB”, he claims that QE as now widely understood is not in line with what he originally proposed. However, it strikes me this paper has a number of defects, as follows.

First, in an attempt to claim that more bank lending would be beneficial he says “Our  research  has  demonstrated  that  domestic  demand  is  a  function  of credit  creation.” True, (as indeed Steve Keen keeps pointing out). However, it’s not the only source of demand: demand will rise if the state simply creates new base money and spends it into the private sector (and/or cuts taxes and/or raises public spending).

I.e. you can’t argue that because X has effect Y that therefor X is the BEST WAY to bring Y about.  Indeed the defectiveness of the latter “XY” bit of logic is nicely illustrated by the next of Werner’s questionable claims….

He says on p.3 “there is simply no demand for loans.” But p.5 suggests a way out of the problem is for banks to lend more. Well if there is little demand for loans, that rather suggests that while more loans would increase economic activity a bit, it’s not a brilliant way of doing so.

P.5 says “1. The ECB should purchase all non-performing assets from all Eurozone banks at face value, in exchange for banks agreeing to comply with a new ‘credit guidance regime’ run by the ECB.”

Well that’s a HUGE subsidy for the private bank industry. We’ve had enough of state funded subsidies for private banks what with the TBTF subsidy and the fact that governments have allowed private banks to do pretty much what backstreet counterfeiters do, namely print their own money.


GDP increasing transactions.

The rest of Werner’s paper divides loans into “GDP transactions” and “non-GDP transactions”. Presumably that’s the popular idea that a loan for example to have a house BUILT is somehow better than a loan to purchase an EXISTING house because the former results in about two person YEARS of employment (for bricklayers, carpenters, etc), whereas the latter only results in about two person WEEKS of employment (for estate agents etc).  I explained the flaws in the latter “GDP” idea in an article entitled “Do non-productive loans matter? Nope” published about two years ago.


The basic problem with the Eurozone.

Finally, Werner’s proposals do not address the BASIC problem in the Eurozone (EZ): that’s the fact that EZ members cannot devalue their currencies when they become uncompetitive. Instead, uncompetititve countries have to endure years of austerity in an attempt to get their costs down and in line with more competitive countries, like Germany.

Thus even if the increased lending by private banks that Werner advocates WERE TO bring about increased economic activity and demand in problem countries, that would just increase inflation in those countries (and/or slow down the pace at which prices were falling in those countries). That would just mean those countries going further into debt (Greece style) and delaying the point at which they become competitive with core countries like Germany.

Of course it can be argued (and indeed has been argued) that the “Greek treatment” is too harsh, and that a longer but less harsh recuperation period would be better. But that’s really just tinkering: there isn't a HUGE AMOUNT to choose between a short harsh recuperation period and a longer but less harsh recuperation period. The total amount of “harshness” is about the same in each case.


Monday, 16 January 2017

Simon Wren-Lewis’s odd criticisms of the Pigou effect.


The Pigou effect is the fact that in a perfectly functioning free market, and given some sort of shock which causes a recession, wages and prices will fall, which increases the REAL VALUE of money, base money in particular. That increases the value of private sector liquid assets,  will induce the private sector to spend more, which cures the recession.

Incidentally, not only does the real value of the stock of base money rise: so too does the real value of government debt. But as Warren Mosler (founder of Modern Monetary Theory) pointed out, government debt can be seen simply as a term account at a bank called “government”. That is, government debt is almost indistinguishable from base money (a point also made by Martin Wolf). Base money and government debt are both assets as viewed by the private sector.

The reason the Pigou effect does not work very well in the real world is Keynes’s famous “sticky downwards” point: that is, given deficient demand for labour, the price of labour DOES NOT FALL very much and for the simple reason that if it does you tend to get strikes, riots and so on. The year long coal miners’ strike in the UK in 1926 nicely illustrated that.

The Pigou effect might seem arcane, give that it does not work too well in the real world, but it’s actually quite important. Reason is thus. It is generally accepted in economics that free markets product an optimum outcome, or tend to maximise GDP, unless market failure can be demonstrated. E.g. it is normally accepted that governments should not interfere with the market in apples unless for example it can be shown that apple growers have set up a cartel and artificially raised the price of apples, in which case government intervention is justified. That is, government should punish the cartel ring-leaders and restore something like a genuine free market in apples.

Something similar applies to the Pigou effect: that is, since the Pigou effect works in a hypothetical and ideal free market, it is a guide to what sort of policies will maximise GDP in the real world, and more on that below.

Wren-Lewis takes issue with the Pigou effect in an article entitled “Why the Pigou Effect does not get you out of a liquidity trap”. His first salvo against the Pigou effect is thus.

“The Pigou effect is when the authorities keep the current stock of money constant, and falling prices mean that its real value increases. The idea is that at some point people feel sufficiently wealthier that they spend more, which adds to demand. For this to work, we have to assume that the nominal stock of money will remain unchanged, unaffected by falling prices. Now you might say fine, let’s assume that. But if you do, you might also agree that the fall in prices is temporary. Simple neutrality implies that if you hold the money stock constant, falling prices today will mean higher prices tomorrow.”

As you’ll see, there is not much difference between my definition of the Pigou effect and Wren-Lewis’s. The only slight difference is that he says (first half of the above quote) that the nominal stock of money has to stay CONSTANT. Actually the Pigou effect would still work (or not) given a small annual increase or contraction of the nominal stock of money.

Indeed, the latter point is more than just a theoretical point: in an economy on the gold standard, a fall in prices would equal an increase in the real value of gold, which would induce gold miners to dig up more gold. So in that scenario, the Pigou effect would increase BOTH the nominal stock of money and real value of each unit of that money.

But to repeat, the latter point is a minor one, so I won’t dwell on it any further.

 Wren-Lewis then says (second half of the above quote):

“Now you might say fine, let’s assume that. But if you do, you might also agree that the fall in prices is temporary. Simple neutrality implies that if you hold the money stock constant, falling prices today will mean higher prices tomorrow.”

Eh? Why “might” I agree that the fall in prices is “temporary”? I’m baffled.

In common with others who accept the Pigou effect would work in a perfectly flexible free market (I assume), it strikes me the Pigou effect works as follows.

1. Assume demand is deficient. 2. Prices fall and the real value of the stock of base money rises. 3. Given a larger stock of money in real terms, people tend to spend more (as the empirical evidence confirms).  4. The most reasonable and simple assumption is that the real value of the stock of money continues to increase until the additional demand brings the fall in wages and prices to a halt, and that point equals an equilibrium which is maintained until some sort of new shock knocks the economy off equilibrium again.

So where does Wren-Lewis get his “higher prices tomorrow” from? Following straight on from the above quote, he continues:

“But we have already established that in that case you do not need a Pigou effect, because higher inflation tomorrow at the ZLB will mean lower real interest rates, and you get the demand stimulus the good old real interest rate route. Furthermore, if people understand that prices will rise, they are not really wealthier in an intertemporal sense, because their extra real money balances will be inflated away. If you like, they save their extra real money balances today to pay for future inflation taxes.”

Well the fact that one does not “need” a particular solution to a problem does not prove that solution doesn’t work. Taking your foot off the accelerator in a car will slow the car down because it requires energy to make the engine revolve at a speed faster than ticking over speed, and that energy can only come from taking kinetic energy from the car as a whole: i.e. slowing it down. However, the fact that one does not “need” that method of slowing the car down because one can always use the brakes does not prove that taking you foot off the accelerator won’t slow the car down, (my dear Watson).

Then in the second half of the latter quote, Wren-Lewis invokes Ricardianism: that’s (roughly speaking) the idea that peoples’ income rises, they do not spend their increased income because their income is determined just by what they perceive their life-time earings to be. Put another way, Ricardianism claims that households ignore what are possibly temporary increases or falls in income and instead go in for a large amount of “lifetime income smoothing”.

Now the only people who seriously believe that are people with PhDs in economics. I.e. anyone with a grain of common sense knows that when people come by windfall increases in income (e.g. when they win a lottery) they spend a significant amount of that windfall. Indeed the empirical evidence supports that.

Or as the Nobel laureate economist Joseph Stiglitz put it, “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense”. Or as the Cambridge economist Ha Joon Chang put it “Unfortunately a lot of my academic colleagues not only do not work on the real world, but are not even interested in the real world.”

Towards the end of his article, Wren-Lewis says, “We can sum this up rather neatly, as Willem Buiter did with the aid of lots of maths, by saying that what matters is the terminal stock of money, not its current value. The government can only make people feel wealthier by printing money if people believe that the increase in its real value is permanent.”

Well the first flaw there is that Buiter (like Wren-Lewis) assumes the validity of Ricardian equivalence, which everyone (apart from economics PhDs) knows is largely nonsense.

Next, Wren-Lewis says (to repeat), “The government can only make people feel wealthier by printing money if people believe that the increase in its real value is permanent.”

Well sure! And in the simple Pigou effect scenario set out above where a shock requires an increase in the real value of the stock of money, that increase IS PERMANENT – unless and until some new shock comes along.


Conclusion.

Buiter and Wren-Lewis do not succeed in denting the Pigou effect, far as I can see. And there is another very simple point that supports the Pigou effect, as follows.

The purpose of economic activity is to produce what people want. So if there is insufficient economic activity, i.e. not enough of “what people want” is being produced, then the solution would seem to be to give people more of what they need to purchase what they want, i.e. MONEY!!!! That is, a good solution to a recession is tax cuts and increases in social security payments.

And given that when it comes to what people want, they normally express a desire for having about a third of their income come to them in the form of public spending, any cure for a recession should include some of the new money being used to increase in public spending.

Sunday, 15 January 2017

Krugman says excess deficits will raise interest rates. “Progressives” object.


Krugman recently wrote a short article making the entirely reasonable point that large deficits are OK in a recession, but that come the recovery, one needs to be more careful with deficits.
 

That produced a storm of protest from people, who can loosely be called “progressive”, e.g. here, here, here, and here.

One of the objections to Krugman’s article was that in saying a large deficit would crowd out private investment, Krugman invoked the loanable funds idea.

Well, not so fast. The fact of saying that an excessively large deficit will crowd out private investment does not prove one is invoking the loanable funds idea. One could equally well be invoking Scott Sumner’s “monetary offset” idea: the idea that when a central bank spots what it thinks is an excessively large deficit, it will raise interest rates so as to counter that excess. And that rise in interest rates will of course crowd out some private investment.

Incidentally, Sumner is far from the first person to tumble to the point that an independent central bank on spotting what it thinks is an excessive deficit will raise interest rates to compensate. But Sumner is a keen advocate of the idea, so I thought I’d give him a mention.


So my conclusion, at least as regards the charge that Krugman invoked the loanable funds idea is: case not proven.