Sunday, 21 January 2018
The fact that stricter bank regulations raise interest rates does not mean GDP is reduced as a result.
It’s obviously tempting to think that if stricter bank regulations raise interest rates, that’s an additional cost for mortgagors and businesses which need to borrow. Thus it would seem we’re all worse off. The UK’s “Vickers Commission” fell hook, line and sinker for that argument. So too does Congressman Keith Rothfus: see the second para of this recent “Money and Banking” article (entitled “Money Funds – The Empire Strikes Back”).
Of course I’m aware that Rothfus’s motives for wanting to get back to the old “heads the banks win and tails the taxpayer loses” arrangement is possibly not entirely altruistic: he may have had wads of $100 stuffed into his back pocket by banks. But corruption is not the central issue I’m addressing here.
I’ve been thru the flaws in the above “higher interest rates makes us worse off” argument at least once before in this blog, but I’ll run thru them again.
The first obvious flaw in that argument is that every additional pound or dollar of interest paid is an additional pound or dollar for creditors, thus to that extent interest rate changes have no effect on GDP.
However it is widely accepted that a rise in interest rates does have a deflationary effect: indeed interest rate adjustments are one of the main weapons used to regulate aggregate demand. Thus a rise in rates stemming from stricter bank regulations would indeed cut demand and thus GDP. But that effect is very easily countered by standard stimulatory measures, monetary and/or fiscal and the latter measures cost nothing in real terms. As Milton Friedman and others have pointed out ad nausiam (figuratively), having the state print money and spend it and/or cut taxes costs nothing.
To summarise so far, the fact that stricter bank regulation cuts GDP via the above “higher interest rates cuts GDP” channel is completely irrelevant.
The really important question is whether the higher rates that stem from stricter regulations give us something nearer the genuine free market rate of interest. If they do, then GDP will rise: reason being that, as is widely accepted in economics, GDP is maximised when prices are at free market prices, unless there are good social reasons for thinking free market prices should not prevail: i.e. where there is “market failure” to use the jargon.
Now it might seem that conventional or “fractional reserve” banking under which loans are largely funded via deposits and under which those deposits are insured by government (with banks being charged an insurance premium by government) is very much a free market system: at least it seems to be free market in that all costs, in particular the cost of insuring banks seem to charged to banks.
But there’s just one problem: the only reason government can afford to insure dozens of banks with assets and liabilities running to hundreds of billions is that government has access to two near infinitely large sources of cash: first the taxpayer and second the right to print money. Normal, or “free market / commercial” insurers do not enjoy the latter two luxuries.
Indeed, in the US, large banks are not insured via FDIC: what happened during the crisis was that the Fed rescued large banks with loans totaling billions at derisory rates of interest: an obvious subsidy or “non free market” ploy.
In contrast, a system under which bank loans are funded via equity or “floating net asset value” stakes in banks is entirely subsidy free: if a bank makes silly loans, all that happens is the value of its shares or “net asset value stakes” falls. There is no danger of the bank collapsing and no need for taxpayer funded rescues.
And a further point is that funding private banks via deposits actually enables private banks to create or “print” money. That is, private banks can use the profits of seigniorage to subsidise the lending process, as I explained here recently.*
And finally, if the widespread belief that there is too much debt is valid, then a rise in interest rates would cut the total amount of lending and debt, which according to the latter “too much debt” theory would be beneficial.
* Article title: "Why private banks are counterfeiters in 300 words."
Saturday, 20 January 2018
Thursday, 18 January 2018
This article in the Wall Street Journal is a laugh. It’s by Neel Kashkari (president and CEO of the Federal Reserve Bank of Minneapolis and participant in the Federal Open Market Committee.) Article title: “Immigration Is Practically a Free Lunch for America.”
He argues, first, that immigration raises GDP (as distinct from GDP per head). Well that’s pretty obvious: the more people there are in a country, the larger will its GDP be all else equal. In fact even if all else is not equal (e.g. if immigrants are all unproductive, lay-abouts) GDP will STILL RISE. As long as a bunch of immigrants produce at least SOMETHING, however little, then the effect of their arrival will be to raise GDP.
Kashkari then says “Legislators of both parties, policy makers and families all want faster economic growth because it produces more resources to fund national priorities and raise living standards.” He doesn’t tell us what “national priorities” are, but I assume he’s referring to infrastructure, schools, hospitals, etc.
Now assuming you have more brain than Kashkari, you ought to have spotted the flaw there: it’s that the larger the population, the more infrastructure, schools etc are needed!! Thus immigrants have no effect whatever on a country’s ability to afford those items unless the effect of immigration is to raise GDP per head. But Kashkari doesn’t address the question as to whether immigrants increase GDP per head!
Kashkari also trotts out the old canard about stimulus not being possible without increasing the national debt (3rd para). In fact as Keynes pointed out almost 100 years ago, stimulus can be funded either by more debt or by new money created by the central bank. Indeed that’s exactly what numerous countries have done over the last five years or so. That is, their governments have borrowed and spent more, with their central banks then printing money and buying back almost all that new debt. The net effect of that is: “the state prints money and spends it and/or cuts taxes”. Seems Kashkari is not aware of what has been going on. Evidently studying economics is not a requirement when seeking a nice well paid job at the Fed.
Why do I have to waste my time combating this nonsense?
Tuesday, 16 January 2018
Take a country which switches from barter to using money for the first time. It has the choice between state issued money, which I’ll call base money, and money issued by commercial / private banks. Base money is cheaper – indeed it’s costless as Milton Friedman and others pointed out. In contrast, when a private bank supplies money to a customer, the bank has to check up on the customer’s creditworthiness, perhaps take security off the customer, allow for bad debts, etc etc. Those are very real costs.
Having supplied the economy with enough base money to ensure full employment, people and employers would lend to each other, either direct (person to person) or via commercial banks. However, there is then a trick which private banks can pull: supply money to customers WITHOUT first having obtained necessary funds from saver / depositors. I.e. private banks could (as in the real world) in effect just print money. And printing money is clearly a cheaper way of obtaining money than borrowing or earning it. Thus private banks in our hypothetical economy are able to undercut the free market rate of interest. And that would reduce GDP because the GDP maximizing price for anything, including the price of borrowed money, is the free market rate (absent what economists call “market failure”).
But that extra lending would raise demand to above the above mentioned full employment level: excess inflation would ensue. Thus government would have to impose some sort of deflationary measure, like raising taxes and confiscating base money from citizens.
Now that’s exactly what happens when traditional backstreet counterfeiters print and spend $Xmillion of forged dollar bills: government has to confiscate about $Xmillion from citizens. QED.
Saturday, 13 January 2018
The Oxford Review of Economic Policy has published a special issue entitled “Rebuilding Macroeconomic Theory.”
There’s just one fly in the ointment, which is that one of the contributors is Oliver Blanchard (chief economist at the IMF, 2008 – 2015). Now the problem with Blanchard is that he has been one of the main promoters of austerity during the recent crisis and subsequent recession. That’s austerity in the “inadequate aggregate demand” sense rather than the “% of GDP allocated to public spending is too small” sense: i.e. the word austerity actually has two quite distinct meanings – unbeknown to 90% of those who witter on about austerity.
Of course Blanchard, like others who have managed to damage the World economy with excessive amounts of austerity, has never SPECIFICALLY advocated inadequate demand. But what he and like-minded individuals (e.g. Ken Rogoff and Carmen Reinhart) have done is to argue, first that stimulus is funded via more national debt and second, that that debt cannot be allowed to rise above some arbitrary level (90% of GDP is a popular figure). And that artificial limitation on stimulus can clearly lead to austerity when large dollops of stimulus are needed.
As to the idea that stimulus must be funded via debt, that’s nonsense: as Keynes pointed out almost a century ago, it can be funded simply by printing money. And as to the idea that the debt cannot be allowed to rise above 90% of GDP, that’s a bit hard to square with the fact that the UK’s debt stood at about 250% of GDP just after WWII. For some strange reason the sky did not fall in. In fact economic growth during the 1950s and 60s during which time the debt declined dramatically was very respectable.
In short, the very last person who is likely to produce worthwhile ideas when it comes to “rebuilding” economics is Blanchard. But economics is a respectable middle class profession, and members of every profession cover for each other, rather than point to each other’s faults. Or as Adam Smith put it, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public...”
For details on the cluelessness of Blanchard and the IMF, see sundry articles by Bill Mitchell, e.g. here and here.
Thursday, 11 January 2018
Tuesday, 9 January 2018
The Cambridge economist Ha-Joon Chang said “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.”
Nothing illustrates that lack of interest in reality better than Ricardian Equivalence (RE). For those not acquainted with RE, it’s an idea which is about as realistic as witchcraft or astrology, and it’s as follows.
It’s the idea that if government deals with a recession by spending more and funding that extra spending via more debt, then it will have to raise taxes to repay that debt at some time, and the average individual or employer will realize that tax hike is in the pipeline, thus they’ll try to save so as to meet that tax obligation. Plus that saving will partially or wholly nullify the latter extra spending.
Incidentally I’ve dealt with the nonsense that is RE before on this blog, but a bit of repetition never goes astray when trying to get a point across. Plus the paragraphs below make a few points not made in earlier articles on this subject.
The first obviously unrealistic aspect of RE is the idea that the average individual, household or employer actually knows what the deficit is in terms of dollars, pounds, etc, and sits down with a calculator to work out what the resulting future increased tax liability might be. I suspect the proportion of the population (individuals and employers) who know what the deficit is in terms of dollars or as a percentage of GDP is around 1%. But perhaps I’m out by a two or three hundred percent there, and the real percentage is 2% or 3%. Makes no difference: it remains true that almost NOBODY does or event tries to do the sort of calculation that RE enthusiasts claim they do.
How many of your friends spend time with their calculators working out the alleged effect of a deficit on their future tax liability? None of mine do, and I’ve never known anyone do that. Provisional conclusion: RE is an idea straight out of La-la land.
But that hasn’t stopped hundreds of economists, if not thousands, turning out papers where the validity of RE is explicitly assumed, or at least in which its partial validity is assumed.
Inflation and increased real GDP.
The second blatantly unrealistic aspect of RE is that governments basically just don’t repay their debts via increased tax. What actually happens is that a higher than normal debt relative to GDP declines over the years and decades, first because inflation eats away at the real value of the debt, and second because of increased GDP in real terms (which cuts the debt/GDP ratio assuming the debt remains constant or more or less constant in terms of dollars).
A classic example is the UK’s public debt which just after WWII was around 250% of GDP and declined to around 50% in the 1990s. But according to the chart just below, produced by Roger Farmer, economics prof in California, the whole of that debt reduction took place because of the latter two factors: inflation and increased real GDP. Put another way, according to Farmer’s chart there was a deficit every single year between WWII and the 1990s, i.e. no surplus (which would indicate repayment of debt).
Actually Farmer’s chart is not quite right: I believe there were one or two years in which THERE WAS a surplus. But never mind: the chart is BASICALLY RIGHT. That is, the vast bulk of the fall in the UK’s debt/GDP ratio came about because of the above two factors: inflation and increased real GDP and not because the debt was repaid in the conventional sense of “repay a debt”.
Conclusion: for anyone interested in reality, RE is complete nonsense. Or as the Nobel laureate economists Joseph Stiglitz put it, “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.”
A third flaw in Ricardian Equivalence.
Just by way of driving a final nail into this coffin, there is actually a third flaw in RE which is relevant where there is no inflation or real growth. Of course that “no growth or inflation” assumption is a bit unrealistic, but this is worth pursuing since the above demolition of RE was based on the assumption that THERE IS inflation and real growth. I.e. by way of closing off every possible escape route for RE supporters, it is worth explaining why RE is nonsense even where there is no real growth or inflation.
But a word of warning: this third flaw in RE is a bit complicated. Plus my explanation of this third flaw doubtless leaves much to be desired. So stop reading now if you like: arguably you won’t have missed much. Anyway, here goes.
First, as is little more than common sense, there are numerous factors that determine aggregate demand (AD ): there is for example consumer and business confidence. Thus to keep things simple, let’s assume (as per standard scientific experiment) that all variables other than the ones we’re interested in are constant.
The variables we’re interested in are AD, the deficit and the resultant stock of base money and public debt held by the average person.
(The idea that there is some sort of average person who holds a stock of base money and government debt is of course itself a simplification in that private individuals do not DIRECTLY hold a huge amount of public debt: in as far as they do hold it, they hold it (in the UK) via accounts at National Savings and Investments, unit trust holdings and via pension funds. But never mind: individuals in the UK and elsewhere are effectively owners of public debt).
Next, bear in mind that public debt is effectively more or less the same thing as money (as explained for example by Martin Wolf in the Financial Times).
Now the more money people have (both base money and public debt, which is the sense in which I’ll use the word “money” from now on) the more they’re liable to spend. Thus there must be some stock of money per average person which gives a level of AD which results in full employment.
And given a recession, governments run deficits which result in the average person’s stock of money rising, which in turn encourages more spending, which in turn brings and end to the recession. (Of course demand is also raised by the mere fact of additional public spending.)
Now why in a “no growth / no inflation” scenario does it not make sense for people to save so as to meet the tax liability that RE enthusiasts are so keen on? Well first people cannot be sure that that tax liability will ever arise: that is, if there’s been a PERMANENT increase in the amount of money people want to hold, there is no point in government withdrawing that money from people. If government does, that will simply lead to a recession.
Alternatively, suppose the increased money supply deals with a recession till the end of year X, at which point there’s an increase in consumer and business confidence, which more or less equals a reduced demand for money (aka increased desire to spend) by the private sector, so government has to withdraw some of the private sector’s stock of money.
If people save BEFORE the end of year X, that will tend to prolong the recession, in which case government will have to feed yet more money into peoples’ pockets.
Thus we are led to the absurd conclusion that if a tax increase is actually necessary at the end of year X, and people save before that time in order to meet that tax liability, that will force government to deal with the deflationary effect of that saving by running an even bigger deficit, which will presumably induce people to save even more in order meet the even bigger tax liability, which in turn exacerbates the recession even further! We appear to be going round in circles!
In short, if people do have the amazing foresight that RE supporters claim they do, people will not save in order to meet any alleged future tax liability because the mere fact of that saving means government will run an even bigger deficit, which increases the future tax liability even further.
Conclusion: this is clearly a total and complete farce.
Final conclusion: Ricardian Equivalence is a farce.