Saturday, December 31, 2011

Keeping the JG during a boom and private sector business formation

This is a followup to my previous post, as further need for clarification came about from comments (hat tip Mario). I don't object to the JG itself, as you may already know from past posts, I advocate a government jobs program during a deep cyclical downturn, I just have issues to the permanence being proposed. To me it comes down to either not making JG permanent OR if you want to make it permanent in order to set a stable price level, it should pay at a much lower wage than private sector, especially when going into an economic upturn.  Otherwise, why would anyone take a private sector job that can someday be made obsolete by the market when you can always take a safe government-guaranteed JG job that will always be there no matter what.  In an upturn, keeping the JG would make the cost to hire more prohibitive for new businesses, and looking at tradeoffs for both employees and would-be employers, it would entail a much higher assured premium for private business to make up for the higher risk of joining or setting up in private industry, when there are government-assured jobs for the taking for all posterity. Usually no one changes jobs unless it's for a higher wage, and no one will want to make the risk for so low a spread over riskless government positions. 

I'm not thinking of the big multi-national corporations as those who may suffer here. I'm thinking of your neighbourhood shopkeeper or your local smallscale job creator who only hires 10-20 people at a time. Their profits are not that high, and their tradeoff with starting a business vs just getting a JG may not amount to a lot. Workers will have options when the economy booms again, and this will increase the cost to private businesses, most particularly for those who are small-scale. The JG could very well just crowd out the smallest firms permanently. If their wage costs for hiring 10 people have risen from $400K to $700K a year because of having a JG during a booming economy, that difference could very well be their profit already. And why would anyone continue risking his capital (which could very well be his retirement nest egg) when the JG assures him an assured income/wage for himself, and he also knows his own workers also have the same tradeoffs, and hence, could leave the firm much more easily during the booming economy when his competition for their services is not just other private firms, but government as well?

By keeping the JG in a boom, the wage competition will start at a higher level because of the need to attract workers at the now higher lowest level. This dynamic affects the whole salary structure all the way up to the top. It's just the way it is in a private sector firm, working in a free market.

For example, if there is still a JG program in an upturn, and government is offering $10/hr, then businesses would have to offer maybe $15/hr to attract its most basic workers away from the JG, and therefore, wages for more crucial skills would probably rise from $50/hr to $70/hr, and these could very well be the skills that new developing industries would need to develop their new products and the new markets. And if government increases the minimum JG wage to $15/hr, then perhaps the crucial skills business startups need to hire will now cost $90-100/hr. The JG wage doesn't have to increase much because it has a potentially magnifying effect on all private sector wages during booms. It won't be long before overall wage costs increase 50%, especially if the company employs more of the higher earning people who will now be compensated higher as well. This includes programmers, doctors, lawyers, tradespeople, equipment handlers. It depends on the business, and what the skilled worker brings to it. These people work for firms directly or as contractors, too. And the small businesses work a contractors for other businesses, whose costs also increase when the small business' costs increase. This can be a self-reinforcing cycle during boom times.  The skills developed through JG may be good for private business if the workers are going to be available when they are already hiring. But while the demand floor will be a decent life wage during a recession, the higher wage floor will price small businesses out during an upturn. It would not be illogical to think that a permanent JG could actually entrench current big players of the private sector because small up and comers will be priced out of the market for people. 

I'm not saying a JG wouldn't advantage workers. They would actually benefit greatly, because the JD gives them more leverage to negotiate during a boom. But what are the costs long-term? Some businesses may get workers, others not without extensive premium. Different situations for different people, but during boom times, there will definitely be a crowding out and/or inflationary effect of government competing for scarce workers during a boom. I wouldn't characterize a JG during a boom a completely free market. If there's a monopoly issuer of currency that competes for scarce resources with private firms that need to generate positive cash flow to survive, it's an uneven paying field. 

I applaud efforts to launch community-based JG-sponsored jobs programs that provide livable wages. But you don't want people to keep staying with the same community jobs their whole life. You want them to have opportunities to get back into private industry, and you want private industry to have incentives too to make their risky investments (when we are finally out of this recession). You don't want the JG making the hurdle to profitability much higher for these risky investments. And you don't want these prospective entrepreneurs ending up not being as proactive in developing and investing in their businesses, because they can always go back to getting a JG job if things start to become too difficult with the business. There's just less incentive for risk-taking in this scenario.

There's a difference between having a program with a known end date, where everyone employed there has no choice but to find a job in private industry; and having an open-ended program, that can be used by workers to out-negotiate small businesses the way large businesses used union-busting to out-negotiate the workers. Workers can game the new system to their advantage, negotiate for much higher wages, and then quitting much more easily over the triflest of things, because they can always go back to the JG. If you were the small scale employer, this changes your planning dynamics.  At a certain price point, the entrepreneur himself would probably be also thinking he should just take a government job himself. 

If we had a JG a hundred years ago, we might still have horse-tending positions, manual candlemaking jobs, and manual weaving positions. We may never have transitioned to the automobile, to the electricity economy, or to mass-produced goods. It would have been up to the government to invent the automobile, innovate the mass-market economy, and to develop the electrical industry. The JG's main aim, if it is instituted, will be to provide jobs to those looking for work, not to come up with new products, or obsoletize those that are currently being offered. I'm not sure progress would have been as great as we have it if everything had been done by an entity that monopolizes the economy like government does. During a boom, a continuing JG could actually lower productivity, innovation and pioneering.

Addendum: I appreciate that MMT acknowledges that price distortions will happen when JG is introduced. But if it stays during a subsequent boom, these distortions will stay, and they will permanently alter the cost structure for private businesses. No need for the JG to chase after private sector wages, because in the first instance, it may already have killed all lowest skilled jobs in the private sector (capitalism makes businesses very tight on cost structure) Perhaps all businesses will just end up outsourcing all lowest skilled jobs to the government. I don't advocate for this to happen, where all businesses could start expecting government to pay for all their minimum wage workers. Wouldn't this be some sort of permanent subsidy to capitalists, a sort of crony assistance to the biggest employers of minimum wage jobs? Ex. Under a JG regime, Walmart could start justifying that they are a JG supporting company that creates a lot of jobs for the JG, so the government better start paying their line workers. I'm sure MMT doesn't intend for this to happen, but capitalism has a way of going around these new distortions, maybe for the worse.

PPS. Re: 100% employment, I agree it's a noble goal. But isn’t it a better goal to just get enough people employed to jumpstart aggregate demand and get the economy working again? Going for 100% at all times puts the economy at risk of becoming dependent on the JG for good. Otherwise, it stops being a countercyclical program, and becomes another alternative economy unto itself, since ensuring everybody has a JG job offer ensures that nobody takes a private sector job unless it’s for a premium above the JG wage. This prices out many small businesses for labour, and probably most startups. And it completely shields workers from making the difficult decisions of making the necessary adjustments and learning new skills, so that they can rejoin the regular economy, wherever its growth is going to be.

Thursday, December 29, 2011

Should a Job Guarantee program be permanent?

I had been meaning to post on this since I read Cullen Roche's post.  While I subscribe to most points of MMT, this is also my point of minor disagreement with MMT.  I've never really focused much on the Job Guarantee (JG) in this blog, and I prefer to call it Employer of Last Resort (ELR) program instead. ELR sounds more like a countercyclical program, which gets activated to take the place of lost private sector demand during large economic downturns. JG sounds like a more permanent program, one that guarantees that anyone who wants a job, and who is unwilling and unable to find one in the private sector, is guaranteed to get one in government, anytime anywhere. In other words, while i subscribe to the notion that the government should step in to make up for the loss of private sector 'animal spirits' during a downturn (that borders on depression), I believe this program should be a program that is market-oriented, rather than a fixed-in-place government policy instrument.

Why do I believe the ELR shouldn't be fixed and permanent? My main concern is that a permanently-fixed JG program that pays the industry-standard minimum wage could ultimately replace market resilience, and impede its ability to adapt. An important starting point is to make distinctions between structural and cyclical downturns. A structural downturn is  when the private sector is laying off people because they are losing market share in their current realms of activity, and should therefore retool and restructure themselves, in order to better adapt and compete in a changing market.  When private companies are retooling, and need to hire the skills they will need to support their new initiatives, they should not be competing with the government as buyers of labour. A permanent government program will add more market frictions to attracting and allocating labour where they are most needed in the private sector.

Meanwhile, the people who lost their private sector jobs should by default be looking at the market to see who is now hiring, who is growing, and then determine what is needed to be learnt to join these growing and hiring firms.  They cannot just have a default attitude that says 'Hey, why do i need to learn to program a computer, or transition into the healthcare industry, or be a better salesman, or learn a new trade, when I  can get a job in government helping teach kids or clean parks and be at it until the day I retire".  A permanent job guarantee disincentives people from learning that new skill that private industry may be transitioning into, particularly if the skill requires effort, or has some risk that the jobseeker may fail at it.  Venture and possible failure are essential components of capitalism, and those whole fail at a certain venture need to go and venture elsewhere again.  A default program that catches everyone who fails that the first venture will likely make some people too comfortable, and decide that any further risk is probably pointless and unnecessary. A JG program that is expected to disappear, however, once private sector starts hiring in bulk again will make some of those who may otherwise be content with the JG to start planning ahead, even while the government program is still there.

A permanent JG makes it more complicated and expensive for private industry to attract people, because having shifted the risk-return tradeoffs of learning a new trade or joining an new as-yet untested industry, JG could make people less interested in helping new companies succeed, or in helping a new industry to mature. If things start to become too difficult, it may be easier to day "It's okay, we can always just close shop all join the government".  The tradeoffs would also shift for the would be small-scale capitalist. "Why would I risk more of my own capital to grow this company, when if a bigger competitor comes in, I can just sell off all my inventory, then I and all my workers can just join the government." This default thinking does not apply to everyone of course, but since this applies to some, it shifts the tradeoff curve for everybody else. Private sector venture seems so much the riskier when it's not the only game in town. 

So the question we should be tackling is, how do we recognize when a downturn is cyclical vs structural. How do we recognize when private sector is ready to take off on its own, and thus, any existing JG programs should therefore start winding down. (My guess is that the JG program will have some lag, in that it could be taking in the most applicants just when the first embers of private initiative may already be starting to flicker).  And we need to answer how much government participation is needed in turning around the lack of demand.  My guess is that it will come down not just at looking at how many people are applying for the JG. You would need to look at how much deleveraging is still happening in the private sector (If people are still heavily in debt,  with most income going to service it, they aren't likely to spend or invest on their own sometime soon). You would need to look at why the previous jobs disappeared (Did they disappear suddenly due to a fall in aggregate demand, or did they disappear because this industry is no longer competitive, or providing what buyers want).  You would need to see what is in the minds of both the households and industry. 

This is something is have not yet seen in discussions about the JG program. While i agree that in the current environment, such a program is what is needed, i doubt that it would always be, and I don't know if everyone who advocates it now would be as open to dismantling it when it's no longer necessary. After all, government is supposed to be an employer of LAST RESORT only.

discussion continued in this post and question answered in this post.

Sunday, December 18, 2011

3 Laws of risk - 2012 Edition

The European crisis is escalating, and it seems credit default swaps will once again become a transmission agent of crisis to many parts of the financial system. It's time once again to revisit an old post from 2008, now updated with the latest understanding of how this CDS  crisis may play out this time around among the banks. Links courtesy of Bloomberg and Zero Hedge.

The 3 Laws of Risk 

1. For every potential return created, we create an opposite potential risk. If banks wish to earn good income in this volatile environment, they need to be willing to take on risk. Why not sell CDS protection to the more risk-averse parties? Or at least, to those who think they need to rein in some risk.

2. Risk, once created, cannot be destroyed or absolutely decreased. In fact, systemic risk can be doubled just by sharing it with another party (via CDS), and can correspondingly multiply system-wide with the amount of parties involved.

3. In a system where risk has been shared and dispersed among interconnected institutions, any random adverse change in risk in any locality will adversely change the risk in other localities of the system. They are all inter-connected. And all it takes is one party in the chain to not make good on its promise to pay, and many hedges become non-existent. Thus, any additional risk positions entered into by a party, on the expectation that that position had been hedged (with the defaulting counterparty), transforms into pure additional risk for that party. Hence, this party is potentially the next link in the chain to break, and to transfer the additional risk on to its own counterparties, who may have also entered into even more risk positions of their own, with the understanding that they too had been hedged.

These three laws then lead us into extrapolating five major implications of risk on a financial system.

5 implications of risk on a financial system 

1. Any firm that tries to hedge its risk by entering into a swap with another party only succeeds in transferring the original risk to another party. Any firm that expects all of its hedges to hold in a large systemic crisis could end up with all obligations corresponding to that now worthless hedge, plus any additional obligations where it agreed to be the counterparty to another party trying to hedge its own risk.

2. Any firm that tries to take on incremental risk, any of which is greater than its capacity to bear, on the assumption that the additional risk will be hedged, could end up with excess obligations corresponding to that excess risk, once its hedging counterparty to that risk defaults. Any obligations it is unable to meet transfers risk to its counterpartieswho now have more risk, and much less solid position, than they previously thought.

3. Each party in the chain that offers to be a counterparty creates additional counterparty risk that was not there before. Hence the more firms involved in a chain of counterparty swaps and derivatives transactions, the greater the resulting risk created in the system, since each counterparty could be the weak link  that starts to unravel the whole chain.

4. The more interconnected a system, and the more of these types of transactions it has, the greater the likelihood of a systemic meltdown. 

5. There is no such thing as a benign or risk-free environment. You can never create an environment where systemic risk has been controlled or made benign by hedging. It only means risk has been put at rest. But the more risk is put at rest, the greater its potential blowup energy, especially if it masks the excess risks that individual parties took that they, individually, could not meet themselves. You may have only succeeded in causing it to implode more fiercely, once the bubble chain starts to unravel. 

Saturday, December 10, 2011

Rehypothecation and fractional reserve lending

What do these two scenarios have in common:

1. A bank taking its stock of deposits from net savers and using it fund its lending to others, who are net borrowers.

2. A shadow bank taking collateral posted by its own clients and using that same collateral in its own borrowing from other lenders

If you were zero hedge, you would say they are both examples of fractional reserve lending. At its surface, you would be correct (though I would clarify that the second scenario is more like a mirror image of the first, or more specifically, fractional reserve borrowing).

Shadow banks are back in the forefront due to the escalating Euro crisis, as we see panicked 'shadow bank' lenders increasing their collateral requirements from their borrowers who used PIIGS bonds as collateral, as the value of PIIGS bonds falls. This use of collateral to raise funding in the repo market is called hypothecation. From Reuters:

[h]ypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.

…..Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.

Zero hedge:

So let's see: a Prime Broker taking posted collateral, then using the same collateral as an instrument for hypothecation with a net haircut, then repeating the process again, and again... Ring a bell? If you said "fractional reserve lending" - ding ding ding. In essence what re-hypothecation, and subsequent levels thereof, especially once in the shadow banking realm, allows Prime Brokers is to become de facto banks only completely unregulated and using synthetic assets as collateral.

I half agree with zero hedge, in that the first scenario above seems like fractional banking, but it's more than fractional, since banks can and do lend funds even though they don't have the deposits to 'fund' the loans yet. Banks don't lend their deposits, it's loans that create deposits - or net new money. Most loans are purely 'electronic debit and credit' debt transactions made by commercial banks, and balance out as an increase in loans (assets) of the financial system automatically increases its liabilities (deposits). Most don't even have to result in actual newly-printed currency circulating the system if the payments and transfers remain electronic.

But unlike shadow banks raising funds via rehypothecation, commercial bank lending has less danger of turning into a bank run because of the lender of last resort function of the central bank. For as long as banks have adequate capital on their books, the system can be considered sound most of the time. When and if a loan goes sour, it is this equity capital that gets depleted first, and only once all capital has been written off, does its deposit base get into some kind of danger (because the bank might close and depositors will be unable to access their deposit). But a lender of last resort always makes sure that the bank will always have the reserves it needs to pay out its obligations to its depositors.

This kind of safety net comes with a cost though - regulation. Thus far, so-called shadow banks have been free of this regulation simply because they don't deal in retail deposits. Shadow banks will argue that they don't need the safety net of a lender of last resort because their retail clients are not looking for the safety (and the lower yields that go with it) of a commercial bank, otherwise they would have made their dealings with a commercial bank.

But with the repeated financial crises magnified globally by these inter-connected and often too big to fail shadow banks, is it still fair to say they don't need a government safety net? How many more bailouts before we face up to reality?

Saturday, December 3, 2011

Why doesn't capital go where the greatest returns are

This post developed from thoughts from comments here. I think China's ace, which could also be considered its curse, is that it has a glut of people it has to provide employment for, or its society may break down. Hence its policies. I think US's ace, which could also be considered its curse, is that it has a glut of capital it has to provide a return for, or its society may break down. Hence its policies.

Capital tends to congregate in the US because of its perceived safe haven. China population is stuck in China because of the constraints of its nation-state borders. We know why they are stuck, but why does all the world capital necessarily have to congregate in the US? Capital is supposed to be free to go almost anywhere in the world nowadays.

This is something that the proponents of market liberalization had not counted on. Capital mobility was promoted as one of the hallmarks of globalization because its natural inclination was supposed to be to go where the returns are, and hence, it was supposed to go to all corners of the world in search of profit, until all the world's frontiers were finally ushered into the same first world standard of living.

It did not happen that way. In its stead, each unit of capital tended to go lemming-like to anywhere in the world the rest of capital tended to go. Where all other capital-holders were going was where returns were being harvested. And because investment return was self-reinforcing, more capital going to one area tended to increase the asset values of its targets there. Hence, it would induce others to pile on and further magnify the positive returns of those who were coming into that area.

It all goes well until people start to believe pie in the sky visions of ever increasing returns. Then the first few capitalists start getting out, stopping the upward trajectory, and thus encourages further others to also cash out. This then now leads to a downward cascade of asset values, leaving those who are slower to move to panic, and finally to leave the area, sometimes, worse off than before the capital ever came.

We see this happening again and again, everywhere. When the barriers to capital mobility first came down, capital did go to the farthest frontiers of the earth, in search for its pot of gold. But once this reflexivity process has driven a local area into manic booms and panicked busts, capital once again leaves that area, and because capital mobility goes both ways, it now brings back with it previously indigenous capital and takes it along for the next wild ride. Example, when barriers to Eastern Europe and to China investment first fell, first world capital came to Eastern Europe/China. Then when capital jacks up the rate of return to the zenith there, capital will once again leave, taking along some home-grown capital, which should have stayed there and built a more sustainable growth, because local capitalists now realize that the piling up of foreign capital to domestic assets has now led to asset values ripe for a crash. Where they want to be is in a safe haven.

Because of the great losses that a crash unleashes on the local populace, especially those who who were the last ones into the headiest assets that crashed, it would likely be years before local capital will once again brave the market again. The aftershocks of the locust-like rampage of capital has probably left an economy over-invested in sectors that now stand devoid of demand, and under prepared in others where a flicker of demand can lead back to a more sustained growth across all sectors.

The irony of it all is that with the liberalization of capital also came the dismantling of laws and institutions of government that would have enabled it to be the investor of last resort in the face of such manic capital merry-go-round. Not only did liberalized markets leave the gates open for some capitalists who turned out to be mere short-term speculators (barbarians), they also threw away the tools that they would need to rebuild once the barbarians have come and gone. All that's left is finger-pointing as to who's at fault. Such is the behaviour of people who have no other choice but to sit, close their eyes, and wait for either a miracle or for it all to end. Moral of story is, when you liberalize the market, you also need to strengthen government to act as cleanup crew in case things get out of hand.

Sunday, November 27, 2011

What about European mobility?

If we are to believe the latest new, France and Germany are now talking about a European fiscal union, widely-held to be what is missing from the failed Euro monetary experiment. It is commonly believed that when a supra-national fiscal body can spend to compensate for private sector losses and/or dissaving in a particular region, this European experiment will be all hunky dory.

But what about labour mobility? Can Greeks or Irish just decide to uproot themselves and start anew in Germany? Can the French do it? Or vise-versa, can Germans just decide to look for jobs in Greece or Portugal? European financial and market integration can increase prosperity in a particular country or sector, while causing social upheaval in another. Inequality arises because while businesses can take their money and technology anywhere in the common area, their workers cannot follow suit, or counter with similar moves of their own. People cannot mitigate the deflationary effects of capital leaving one region by migrating to another, or mute the harsh consequences of a neighbour country’s continual trade surpluses, by piling on to that country.

While countercyclical fiscal policy can help alleviate these deflationary effects, a lack of mobility will still hamper efficient distribution of the benefits of integration. After all, integration probably wasn't pursued merely to allow one country to capture all its commercial value, while another region ends up perennially on welfare, or on make-work programs. There's probably no true union unless all Europeans consider themselves to be Europeans first, who just chose to live in the region they live in. Without freedom of mobility, they're all probably better off having both fiscal and monetary sovereignty.

Thursday, November 17, 2011

The High-Beta Rich: A review

I don't normally make book reviews here in the blog, but I recently read Robert Frank's The High-Beta Rich. Now this is not the same Robert Frank who wrote an economics textbook with Ben Bernanke. He's WSJ's wealth reporter who also wrote Richistan: A Journey through the American Wealth Boom. In High-Beta Rich, Frank revisits the lives of some of the people he profiled in Richistan, and follows up on what has happened to them in the years since he wrote the first book in 2006. By 2011, some of these rich people have since gone from riches to rags, or merely to less affluence. He also follows up on some people whose jobs it was to serve the needs of the rich, and profiles how many of them are now finding it hard to secure stable jobs from the rich since the 2008 economic crisis.

The book's central theme is how the rich's fortunes now depend largely on rising asset values, and how asset price movements correspondingly affect their over-all wealth, and so affect their consumption of services, and hence, employment of a lot of people. The book tells stories of formerly rich people, how they came into big wealth during the two decades of continuous rise in debt and asset values, and the rise in conspicuous consumption that came with it. It relates anecdotes of people who bought rich man's toys such as Maseratis, yachts, private jets, and hired private armies of household help, from personal chefs, personal masseuses to household managers a.k.a. butlers. It tells of their experiences finding themselves suddenly back in the world of the non-rich, losing mansions, and then letting go of their butlers .

The book tells of how the rich and their money took over previously more egalitarian towns, such as Aspen, and the rising cost of living that drove away the locals and the economy that thrived on serving those locals, and how in its place arose an economy that simply caters to the whims and demands of the very rich. In one of the chapters, this statement sticks out:

When the waves of high-beta wealth come crashing down, they can affect an entire town like Aspen as well as a much larger canvas like the American consumer economy. In a plutonomy, we're all occasional butlers now, relying in the increasingly erratic jobs and spending of the wealthy.

Frank then elevates the discussion to the state government level and profiles California, which as he shows, has over the years grown more dependent on tax revenues from a few large income tax payers who are largely high-beta rich from Silicon Valley. This sentence stands out:

The masses at the bottom require increased funding for entitlements and social programs. But those at the top, who are increasingly paying for those programs, will exert an outsize influence on politicians through their money and will lobby for lower tax rates. The result is that governments will have more booms and busts and permanent deficits.

I have a problem with one of the author's proposed solutions to the problem of over-dependence on the high-beta rich - that governments, companies, and individuals need to save more during booms so they ride out the busts. This coordinated desire by all sectors of the economy to suddenly save simultaneously is precisely what turns the booms into sudden busts. While the author is referring to local governments, which could literally run out of money, it would have been better if he had made a distinction between a local government, which is merely a currency user, and a sovereign currency-issuing federal government. That sovereign assumes the counter-party role of doing the dissaving whenever the other sectors, the companies and individuals, suddenly stop spending, so as to ensure that the whole economy doesn't suddenly grind to a complete halt.

I would also have appreciated a furthering of this idea:

In the age of high-beta wealth, most of the spending and taxpaying in America will be directed by the stock market. As Greenspan noted, stocks are no longer just measurements of growth and decline, but the main drivers of both. In an economy dominated by the rich, S&P is the new GDP.
While I agree with this statement, I would take it further and say that therein lies the main problem: that S&P is the new GDP, and that people have moved away from the idea of acquiring and maintaing wealth via continuous investment in actual companies, and into getting rich by buying and cashing out at the right time. Nobody plays for the long haul anymore, including those who originally got rich the classic way. Many eventually sell out and use the sudden liquidity speculating in short term investments instead, which while in aggregate results in the self-perpetuating effect of increasing the prices of those very same investments, does not really result in creating new productive endeavours, which is a prerequisite for growing GDP, which is then a prerequisite for the continuous rise in S&P. Without real investments and real growth in the real economy, S&P growth coming from just more money chasing the same investments is not sustainable, and the money being taken out of the real economy will eventually make itself evident with the S&P boom and bust. (Author does profile one guy near the end who gets it).

Nonetheless, if you want a change from reading long serious economic tomes of how and why the economy now experiences more frequent booms and busts, and want to lose yourself in amusing stories of the 'high-beta rich', then this book is worth a read. I found it so when reading my review book.

Saturday, November 12, 2011

Was QE any help at all

I found this statement made by a commenter at another blog several months ago:

"I agree; I think the MMT people are too scathing of what is a simplified explanation of how monetary policy works in normal times. In normal times, starting from an equilibrium in which reserves are held according to their cost and utility, selling more reserves makes it profitable for banks to expand their balance sheets, hence the multiplier, but first the financial crisis and then the payment of interest on reserves altered the balance of their cost and utility. The multiplier collapsed, and it was necessary to add reserves just to serve the existing size of banks’ balance sheets. Moreover when QE involves asset purchases from non-bank counterparties, its initial effect is to expand banks’ balance sheets anyway."

I asked the commenter: What do you mean by “selling more reserves makes it profitable for banks to expand their balance sheets”? I'm guessing this statement indicates you believe that banks lend their deposits to other banks, and that they need to have these reserves first before they can leaned and "expand their balance sheets". So what is the point of the Fed flooding the whole system with reserves then? QE2 in flooding the banks with reserves ensured that no bank will need to borrow reserves anymore, and that no one will need deposits anymore.

MMTers explain that loans are made when there are creditworthy borrowers on hand. Extending a loan (which increases the bank's asset) creates a deposit for the borrower (which creates the offsetting bank liability). Reserves are only later obtained when and if the loan is withdrawn from the bank, or otherwise paid to another bank. Because the bank now has an interest earning loan, it can easily acquire the reserves by borrowing from other banks or attracting new deposits. Central bank intervention via "flooding banks with reserves" does not force banks to make more loans if there are no creditworthy borrowers to be found. If you believe having more reserves is what causes banks to lend, then you probably believe that banks scamper to find depositors first before they allow you to use up your credit card.

I also asked: What do you mean “payment of interest on reserves altered the balance of their cost and utility”? That many bank loans were priced out of the market by the interest on reserves? Is that how low lending rates have gone, that a mere 25 bps IOR discourages banks from making any more loans? Again, this begs the question - why would the Fed "flood the market with reserves" only to borrow them again from the banks with interest?

MMTers explain that the Fed pays IOR to keep the federal funds rate at their policy rate. Otherwise, all that new reserve will be lent on the interbank market at zero, and the fed will completely lose monetary policy control.

And I asked: What do you mean by “it was necessary to add reserves just to serve the existing size of banks’ balance sheets”? What did exchanging Treasuries for reserves “add” to “serve the size of bank balance sheets”?

MMTers explain that QE did not really add reserves net financial assets to banks, and only exchanged their interest-paying risk free government bonds with non-interest-paying bank reserves. In taking away their risk-free interest earning assets, QE ensured that banks start considering retail deposits as profit drains rather than the most cost-efficient source of reserves. Rather than encouraging them to make new loans, it likely discouraged them from accepting more deposits, or accepting them without charging bank fees.

The commenter promised a long blog post explaining his view of the money multiplier and how QE enables this "money multiplier" to function again. After seven months, I'm still waiting.

Saturday, November 5, 2011

Similarity of China's USD peg with the Euro monetary union

Many people continue to hold the false notion that foreign creditors like China are keeping the USD (US currency) value afloat, and that when they stop buying US debt, the value of the USD (US currency) will fall. The reality is that China doesn't need to keep buying US bonds to keep the USD from falling. China buying US bonds is not what keeps USD value up. The Chinese are already locked into buying USD indefinitely, whether they buy its bonds or not, because that’s what they do every time they incur a trade surplus with the US denominated in USD. The dollar keeps strong only if, and this is important, China’s trade surplus is in USD.

Now, the Chinese agree to engage in trade with the US in USD denomination because this allows them to keep their peg with the USD, and no matter how big a surplus they incur with the US, all that influx of USD into their economy will not raise the value of their own currency for as long as the surplus is in USD. That means continuing demand for USD for as long as the peg is in place, and the Chinese wish to maintain their trade surplus. The irony is that, only when the US goes MMT, and prints dollars as needed to fund its trade deficits with China while keeping its own local employment up, will the Chinese see the error of their ways and abandon the peg.

For now, the Chinese continue to maintain the peg despite just getting what to them are useless not-to-be-spent USD in order to maintain their trade surplus, and to keep their own employment up, not out of benevolence to the US. It follows, ironically, that all it takes to arrest the unstoppable increase in US borrowings is for China to accept that the hoard it has accumulated all these years is essentially worthless (because the US can just print more of it to pay them), unless it decides to spend it all back in the US (which means they will start incurring net trade deficits with the US).

If China decides to spend their accumulated dollars domestically in China instead, then that ends their sterilization of the surplus, and effectively ends their peg, and the yuan will then rise vis-a-vis the US dollar. Ending the peg would result in US trade surpluses with China, so there will effectively be less Chinese demand for US treasuries. But the lost demand from China will just be a wash since there will be less need for US borrowings that are due to its deficits with China.

I think China’s main concern, rather than attaining a nice return on its US debt investments, should be that their accumulated dollars do not fall in value vs other currencies. I don’t think they’re too happy with the dollar’s recent fall, which is just as well. They should have spent that money back in the US long ago. That's the only real use for their large accumulation of foreign currency.

China's peg and the current monetary union in Europe are very similar in nature and intent (of those who propagate them). Continued monetary union has in effect pegged the core countries' (like Germany's) currency with that of the PIIGS, thereby giving the core the same perpetual trade advantages over the latter that China has with the US. And just like China’s peg to the US dollar, Germany’s currency peg to the PIIGS via the Euro is causing the extensive sovereign borrowings of the latter countries.

This is the reason Europe is now being dragged, German fear of inflation notwithstanding, into the same printing binge as the US dollar. Just look at how the EFSF is supposed to prop up the PIIGS. For how long will this continue before the Germans blink and stop the endless Euro printing? Both the ECB now (and the German banks previously) have continued to pledge buying Greek debt, in order to prop this system up, and to continue with the current status quo. They enjoy continuous trade surpluses with the PIIGS without altering their superior terms of trade, which eventually would happen if each had their own currency. All the Germans need to do to maintain their current terms of trade is to keep the Greeks in a common currency with them. German terms of trade keeps strong only if, and this is important, they keep the common currency with those that currently incur deficits with them. That means continuing Greek demand for the money that Germany ends up with a lot of. So Germany has to ensure that someone keeps buying Greek bonds, to keep their superior terms of trade vis-a-vis the Greeks.

Ironically, all it takes to arrest the unstoppable increase in Greek borrowings is for Germany to accept that the currency hoard it has accumulated all these years is essentially worthless (because the Greeks can't just print more of it to pay them, and will likely default sooner or later), unless Germany decides to spend more of it in Greek products. That's the only real use for their large accumulation of the common currency.

If Germany decides to spend its surplus Euro domestically in Germany instead, then that increases their domestic inflation and ends their superior terms of trade, while the Greek terms of trade rises vis-a-vis theirs. Germans have so far maintained the monetary union despite just getting what to them are useless Greek debt in order to maintain the surplus, and keep their own employment up, and not out of benevolence to the Greeks. The irony is that, only when the EU goes MMT, and prints the Euro as needed to fund trade deficits while keeping Greek employment up, will the Germans see the error of their ways and abandon the peg/common currency.

Sunday, October 30, 2011

Is there a good reason and target for doing QE now

There's been a lot of press for NGDP targeting level lately, which I see as contingent continuous Quantitative Easing. Contingent because as long as NGDP is not up to target level, there'll be QE galore until it does. Continuous because anytime it ever falls below trend, up until the time policymakers say enough with targeting trend level, the monetary nuclear option a la Chuck Norris will be turned to. I've posted on why I think it would be difficult to target NGDP level. Essentially, I think monetary policy would be ineffective now because people are already indebted, many are already unemployed, and rates are already at zero. Putting rates at negative doesn't make the indebted go into more debt, or the unemployed to engage in more spending. The few who who may have most of the money can probably go around the confines of the fed's jurisdiction. A good metaphor for the Fed doing NGP targeting would probably be Charlie Chaplin, who, unable to to control and drive his runaway car, will try to move the road instead to where the car is going so it seems the car is going in the right direction. So is there an alternative target for doing QE?

How about targeting a desired fiscal spending level? If you look at QE as essentially a monetization of sovereign debt, you could look at it as enabling more fiscal policy action. Although excess reserves created by QE may not fund more bank loans, any excess could be put by banks into more liquid marketable securities. If these natural buyers of government bonds suddenly have more cash, and lesser of the bonds, will they be more susceptible to buy bonds in the next auction? Yes. But is QE2 necessary to ensure that funds are available for the next government bond auctions? No. Government deficits, or government spending, by their nature, create private sector income. It is this private sector income which can then be used for consumption in more private sector goods, and eventually result in private sector savings, which go into commercial banks as deposits, which causes bank reserves to increase, which makes banks buy more government securities.

How about targeting currency value? Will it achieve one of the lesser talked about objectives of trade policy – realigning and revaluing of global currency values, to make them more reflective of actual growth rates in various economies? What quantitative easing would do, more than causing the hoped for but largely improbable reflation in the US economy, is to cause this inflation elsewhere, mainly due to shifts in hot money flows and the carry trade, particularly to the countries that peg themselves to the US dollar. A fast-rising inflation will crush these economies. Inflation will end up killing their people’s real income, and hence, their purchasing power, and lead to over-all depression in their economy. They would rather have capital controls, and likely, would rather give up the peg than allow hyperinflation to kill their economies. But will it result in currency war instead, and a race to the bottom? Maybe a good metaphor for QE is releasing the kraken.

Unless QE is actually in the form of a monetary helicopter drop to actual job-creating ventures, both government or private sector-led, let's just stop thinking about QE.

Friday, October 21, 2011

NGDP level targeting, savings, and expected future inflation

I still really cannot get my head around NGDP level targeting. It’s lately been getting traction as the preferred method to get the US out off recession. What am I missing here? Why do I only see pitfalls ? Why are all neoliberal economists now suddenly behind it? Until I can get answers to the following, color me skeptical.

What happens when the fed buys up all of the financial assets from the private sector? I mean, this is how it expects people to go from hoarding money to actually spending it, right? Under NGDP targeting, the fed is expected to buy up all investment outlets (and possibly proponents will eventually propose to broaden the Fed’s mandate to buying up not just government bonds, but all sorts of private sector bonds, equities, commodities, real estate or what not....theoretically until the fed either owns everything, or until people are convinced to start buying stuff before the Fed purchases them out of the market). I mean this is the mechanism in a nutshell, isn’t it?

So let’s lay out some scenarios. Supposing the Fed does buy up most if not all government securities. (This is assuming it takes that much before Investors are actually convinced that gambling, risking money is more preferable to just hoarding in today's economic environment). So there are no more investment outlets for pensions funds, insurance funds, mutual funds. What then? Are we supposed to expect them to start investing in new startups? Risking equities? In even more exotic commodities? What if (and this is what I presume will happen) they just decide to return all that money back to the people? So now we’ve made insurance firms, money market mutual funds, pension funds redundant. And people who wanted to save money (either for retirement, for future education, for future health needs, or whatever rainy day) now can no longer do so, and instead have their money back instead. Will they use it spend on that new car, a bigger home, a new wardrobe? Or maybe they will they still insist on still saving that money? My guess is the latter, and they'd probably save even more, after all they still have to prepare for retirement, for future education, for future health needs, or whatever rainy day, and in the meantime they have no more outlets that earn interest.

And what about banks? Suppose that in the Fed’s quest to ensure that holy grail of consistent 5% inflation (even in the face of 10% unemployment), it ends up buying up most if not all of the banking system’s government bonds. So now banks have no more risk-free outlet. They have to put all their eggs in 100% risk-weighted assets. Basel wouldn’t approve. Will they actually put those new reserves in new loans? I think not. Maybe they’ll just return the depositors’ money, or start charging people for keeping their money. So will the people start spending their deposits instead? My guess is no. They have to save even more just to pay those new excessive banking fees, and have to save even more because, with increased inflation expectations, they now expect to need even greater savings to fund that retirement, future education, future health needs, or whatever rainy day.

So what happens if people are indeed convinced by the fed that inflation will indeed increase, and increase with absolute certainty? What prevents them from putting their money abroad? I mean, what mechanism prevents people who receive this newly-printed currency in exchange for their savings - from deserting to a foreign currency rather than spending it locally? A higher inflation expectation can cut two ways: It can cause people to spend their money now before it loses value, or it can cause people to put their savings in foreign currency, which is expected to keep its value. We’re right back to currency war, and now the US has just escalated the conflict. What would the likely international counterstrike be?

Nick Rowe says that a credible central bank is a bit like Chuck Norris.

Chuck Norris simply looks at the target variable, and it moves to wherever he wants it to go. It looks like magic. But it works because nobody wants Chuck Norris to carry out his implicit threat. So he doesn't need to.

This analogy comes from the market monetarist explanation of the ‘expectations shaping’ mechanism of NGDP targeting. I think the apt analogy would be Chuck Norris strapping himself with a bomb, and telling everyone that if nobody goes for the exits, then he will blow the whole place up. Everybody has to believe that Chuck Norris is willing to blow himself up if people do not follow his intent for them to take to the exits.

So Mr. Bernanke, are you ready to blow yourself and the system up, just so that the people will start spending the money that 99% of them do not really have?

Sunday, October 16, 2011

What is net financial asset

This post follows from comments in the previous post, where the need arose to explain further what Tom Hickey termed in his comment as net financial assets. What Tom means with 'net financial assets' is net private sector savings, which can offset net private sector debt. That phrase means it is money that people can actually spend, not the meaningless generic term 'money' which can pertain to paper that no one owns or can spend. Both the monetarist concept of M and Tom's definition are part of what money is. M focuses on its changing quantity, Tom focuses on where it comes from. 'Net financial asset' seeks to distinguish how that specific money came about, because some are borrowed into existence, some are government spent into existence. Net financial assets are 'money' the private sector has that was government spent into existence. In our times of high debt, and debt deleveraging, it's also now very important to know how money comes about. Is it borrowed, or printed into existence, or is it structured synthetically? That way you know if that new money is increasing your savings, sinking you in debt, increasing or taking away from your future earnings, will rip your face off, or will blow the whole system up.

Government spending in itself creates the income that the private sector can use to buy government bonds. Put another way, the government's act of using private capacity can create the income that the private sector can use to buy government's borrowing that "funds" the spending (a circuitous process that seems to end up a wash, but with a corresponding higher net financial asset for the private sector). This income from government spending, which becomes 'net financial assets' can then be used by the person who receives it to purchase goods and services from another private person, transferring to that person the 'net financial asset' that he can use to buy other goods and services that he may require. "Net financial asset' then is what enables the private sector to increase aggregate demand without the corresponding liability of paying back that source of purchasing power.

In this system, net borrowing by the private sector is not the most powerful mechanism of increasing money supply or increasing aggregate demand, government spending is. Because the fiscal multiplier effect gave people income, they do not have to borrow the money from the bank anymore to get cash. If you have income from selling to your service to the government, or by selling it to someone who sold his service to the government, neither one of you have to go and borrow the money from the bank to buy your goods and services. The money supply increased without further borrowing. The private sector sold more goods without anyone going into debt.

What happens for example when everyone in the private sector who earned income via the multiplier effect of the fiscal spending suddenly simultaneously decide to withdraw their money from the bank? The bank gives them their money. The money comes from their deposit holdings in the bank, and not as borrowings from the bank. If they withdraw their deposit from the bank, the bank also doesn’t have to borrow it elsewhere. The bank already has the money because the people already put it there (when they earned the income or accumulated the 'net financial asset'), or someone else paying for their service put the money in their deposit. The only time the bank has to borrow the money withdrawn elsewhere is if it already lent that money money elsewhere, and needs the reserves to pay it back. If it’s a deposit, it’s already a deposit. And should the bank ever need the excess reserves to pay back an excess of demanded deposits, where does it get the money/reserves? It gets it from the government/Fed. That's a loan the banks can pay back once they accumulate back the deposits from the people after this roundrobin of withdrawals and redeposits.

Where did the money come from that the government is able to borrow? Monetarists and quasi-monetarists say that for every borrower there is a lender. Monetarists would even say that government deficit does not increase money supply, and government borrowing only crowds the private sector our of being able to borrow that same stock of money. So if the money the government borrows was, as monetarists say, already just sitting idle in some deposit accounts in the private sector, then what gave rise to that private sector deposit? Somebody else borrowing to give that depositor his money? So how is that borrower then getting the money to be able to pay back his own loan? From a further third person borrowing it as well? And how is that 3rd person getting the money to pay back his own loan? This question can go on to infinity. It doesn't make sense to insist that people in the private sector borrowed into existence all the money that the government then afterwards borrowed from them.

If it is true that only bank lending can increase the money supply and government deficits only shifts money from the private sector the government, how would you explain government borrowing rising to the current level it has, $15 Trillion and counting? How is government able to build today’s massive infrastructure projects when at the very beginning, it started off with just 1776 money supply? Where did those trillions of additional money come from? Where did that money come from? Is all of it private bank created? So people are in the hook to pay it all back to some private banks? How did private banks ever get the balls to lend private people, who cannot manufacture money but have to earn it, those trillions of money that just ended up being used to finance government borrowing? More importantly, when the private sector is in balance sheet recession, it would be very erroneous to think that the private sector is the source of government borrowing. At any price. You think you can offer a high enough interest rate to induce folks currently on food stamps to buy more government bonds? What about businessmen now losing sales, what interest rate will make them buy up more bonds? How about those with negative equity, how much you think you can sell to them if we double the current rate?

In that view of the world where every circulating money came from a bank loan, everything will crash one day. That’s an inevitability, because eventually, in that view of the world, people will never earn enough to pay back the loans plus the interest. That world, if it were the real world, is a ticking time bomb one day bound to collapse, when the last person who borrows money decides not to pay the second last person to borrow, and so on. Everything in this view of the world will come crashing down when that day comes, and all it takes is a few unscrupulous people to untangle that ponzi scheme. And once indeed this ponzi scheme stops, how will the system ever get back to work? No one in the private sector can start the process again without having to borrow what he spends. If the government were to be timid to increase spending when private sector stops spending, because of the notion that 'the law forbids anyone or any entity from spending first before funding', then it's game over.

It also doesn't make sense to reform this view of the system by mandating that banks only loan the deposits that they already have. In this scenario, no new money will be created at all. If bank lending were limited to deposits, all loans will have to be callable at any time when the depositor demands his money back. It would be wrong again to assume that since for every borrower, there is a lender, those who would have been lenders just need to start the spending process. Who are these net lenders? Aren't these mostly banks who are in the business of lending, and not of spending? if they cannot make any new loans, they go out of business. And I wouldn't put much confidence either in non-bank private sector people who are hoarding money to re-start the spending process.

I've always wondered why many so-called free market thinkers are monetarists. Just because monetarism enables certain capitalists to make money regardless of what happens to the real economy doesn't mean monetary policy assists in attaining a really free market. Monetarists justify the power of monetary policy via its ability to instil 'animal spirits' or confidence in the private sector. Because the central bank is lowering interest rates or increasing money supply, they believe that that is enough to instil confidence. But increasing money in itself doesn't necessarily mean it increases people's income, or 'net financial assets'. Because the only transmission mechanism that enables this increased money to go from the banks (which are the only entities that deal directly with the central bank) to the people who will actually use it is more borrowing, increasing money supply does not necessarily lead to increased demand. How common is it for example for the fed to buy treasuries from the non-bank sector?

Society doesn't become more confident without an increase in what Tom calls 'net financial assets'. Without this, there'll be no increase in aggregate demand. Without increasing demand, there's no increasing aggregate sales, and no additional borrowing. It's as simple as that. Confidence by itself is just hot air. Inspiring market confidence by itself does not make dollars magically appear in someone’s bank account. Neither does it make someone who didn’t have an iota of cashflow any more creditworthy.

P.S. More from Tom below. And here's a useful visualization of sector balances from HBL.

Sunday, October 9, 2011

Is inflation always and everywhere a monetary phenomenon

Ellen further asks if MMTers agree with Milton Friedman: "'Inflation is always and everywhere a monetary phenomenon."

Again, not being an MMT intellectual forefront leader, what I can put in here is my own interpretation, as influenced by MMT. I think inflation is a phenomenon caused by more demand than supply for a certain or all goods. I believe nominal inflation can be greatly caused by the amount of money in the system because everything is bought with money. But for the most part, there should be increasing demand for the thing being bought over its supply.

A phenomenon caused by more demand than supply for a certain or all goods

What causes an increase in aggregate demand? Increase in aggregate income, which should come as a consequence of creating jobs that produce sellable goods. It is income which creates the demand for the goods being produced by the jobs created. So income should not come by itself as a handout. It should come as a byproduct of a labour force able to find jobs when they are truly looking. Neither should jobs being created provide insufficient income to the jobholder, otherwise, demand will not be sufficiently restored. Of course, each job created must also be productive to society, because income created without the commensurate increase in productivity only leads to a supply shock. A supply shock here is a sudden shortage of supply vi-a-vis demand. If demand increases while supply remains stagnant, the supply shock will lead to goods inflation.

Nominal inflation can be greatly caused by the amount of money in the system because everything is bought with money

I would take exception to the position that nobody notices when the government adds zeros to the currency. This cannot go unnoticed in a global world. For example, the Canadian dollar is at equal parity with the US dollar. Suddenly Bernanke decides to put an additional zero to the US price level. Now the US dollar will be worth 10 Canadian cents. People will notice, and Americans will strive to flee to the Canadian currency ahead of such a move.

But for such a price level move to be effective, if Bernanke were ever to be mad enough to do it, will have to be done by tweaking the exchange rate value of the currency. To do this, Bernanke will have to be ready to print as much as necessary to add the zero to the price level, not just say he's adding a few hundred million to bank reserves. Reserves have nothing to do with how much banks will lend, and does not determine whether and how much inflation can happen. Banks will lend when they want to lend, whether they already have the reserves beforehand, and even if they can’t get at any more new reserves, will securitize if they have to.

Central banks cannot fully control the money supply if they will only target a particular money supply level, because private loan demand and government spending is what primarily increases it. But if Bernanke will target the price of US dollar relative to other currencies, he can definitely increase inflation. The risk here, as I mentioned, could be a general loss of faith in a currency, and mass flights out of it. You cannot just arbitrarily change the value of your currency or people will not trust it enough to hold it.

For the most part, there should be increasing demand for the thing being bought over its supply

But if the challenge is increasing demand, as is the case in the US right now, you have to address several factors. A few things that put a limit on demand at the individual level are level of current income, level of current expenses, current level of indebtedness, capacity to service existing debt, capacity to borrow more-to financing more spending, confidence in stability of future income, expectations about future increases in fixed expenses, confidence in future value of purchasing power of current savings (if you have any), non-existence of any lender calling on your debt, confidence in future positive value of existing savings/investments/net worth, ease of liquidating current savings –to finance current spending, tax implications of using current income/net worth to spend now vs. later, confidence about over-all economy, and how it is being run… the current condition on many of these factors indicate there will be disinflation or deflation rather than inflation.

The conventional monetary theory is that if you increase the stock of money, this increases the price level, holding everything else constant (MV=PQ). Further, if you increase the money stock, this causes people to not want to hold on to money, passing it along like a ‘hot potato’ to the next spender by quickly spending it before it loses value (due to inflation). But the end result could just as well be a decrease in velocity. The resulting high prices could just be that the increasingly few transactions are clearing at the ever increasing price. If the money stock keeps increasing, this supports an increasing price level even though the velocity and the volumes may already be decreasing.

And the same stock of money flowing more quickly should not in itself lead to higher price levels unless people are bidding up the prices while getting rid of money. But people can only bid higher if they already have more money to pay with. This necessitates a growing money stock. But how do people get to more money? By earning it or by borrowing it. Whether you earn it or you have to borrow it, sufficient income prospect is the more important consideration than increasing nominal values. But higher nominal values will only happen AFTER people already have in their hands the higher money stock level to buy more dearly with, not when it's still in banks as newly-created reserves.

Inducing inflation via rising inflation expectations cuts both ways and may end up just a wash. If a lender is going to lend to a borrower to buy goods now, with rising expectations it's now going to lend him at the rate that incorporates the higher inflation expectations for next year. So the higher borrowing rate effectively offsets the value of buying today vs. tomorrow. And if sellers and owners know that inflation will be higher next year, they won't sell their wares and properties now. Or they will sell their wares at a price that reflects the higher inflation. Intentional buyers may end up not wanting to buy anymore.

I think it depends on the specific circumstance whether Friedman is correct or not. Perhaps when he said it, increasing the money supply easily increased inflation. I think he said that prior to the 1971 abandonment if the gold-dollar peg. It didn't take much printing to increase inflation. This was also a time when bank lending was still growing from a small starting baseline.

Now people are over-indebted, we are in balance sheet recession, and banks are already reluctant to lend. The dollar-gold standard has long been abandoned, and the Fed stands ready to lend banks all the reserves they need, and has in fact, already exchanged their treasury holdings for reserves. Nowadays, you can no longer easily say that increasing the money supply will increase inflation, at least if by money supply you mean reserves. The only way to increase inflation is to explicitly devalue the currency, a la Zimbabwe or Ghana. Now is this an experiment worth the consequences to prove Friedman was right?

P.S. Tom Hickey adds more points in comments

Monday, October 3, 2011

What is money, and how is it created?

Reader Ellen in a comment writes: "I'm interested in MMT's definition of "money" primarily because I want to be able to identify, among other things, 1) the "money" supply at some time (t0) and 2) the change in the "money" supply from/to another time (t-1, t+1)."

I'm not an intellectual leader of MMT, though I would claim to be influenced by it. Hopefully, Scott Fulwiller would chime into the discussion at some point, and enlighten us with the real deal. Quick definitions here and here. As for my own interpretation, I view Money as a token that can equate to the value of a good or service you provide, that you can then use to purchase something else of equal value. I buy into the idea that its value as a token is greatly assisted by government fiat. If it's privately-issued, it can easily lose its acceptability as a token of value. So why does government issue money?

1. To pay for private services bought by the government - fiscal policy

2. To support private transactions that need the money/currency/reserves to facilitate trade - via Fed discount rate, and/or via explicitly backing the banking system's electronic creation of fiat money.

When the government injects money into the private economy via spending, or by printing money to support banking activities, it enables the private sector to function, to grow, and to create new income via productive ventures. So a better way to state one of my sentences in my previous post was probably: G creates the Y that enables both domestic and foreign investors of Treasuries, for whatever reason they are issued and sold. If you have no deficit spending, there's no new currency to go around, nothing to save, no money to use to spend, no money to buy Treasuries with.

This is a complete mirror image of the mainstream view of how money is created, which is that the private sector creates it via its private market activities, while government only taxes it later on to fund its own spending. While this view is easier to digest, and more intuitive, this view does bring up some thorny questions that could only be answered by looking at money creation backwards. After all, why is the belief that money should be existing first before government can borrow it more believable than the view that government has to issue money first by spending before people have the money to lend to government?

Some questions I could think of that pokes holes in the mainstream view are: Did a certain group of people at some point in history suddenly decide amongst themselves to create money first, and only years (decades?) later did government decide that all this one creation could be a lucrative way to fund its own consumption? So how did those first group of pioneering people decide to start using money instead of barter? How did this custom reach a network effect, such that everyone else opted into the monetary system and fully abandoned bartering?

And how did all these disparate market actors all agree (at a network effect level) to stop creating money via private spending? How did they all know (as a people) that they had created a sufficiently large pool for everyone that from then on, money could only be created by 'fractional reserve lending'? How did this massive private market coordination come about? By what mechanism, or event, was everyone made to stop creating new money altogether? And why would everyone agree to stop, when private money creation by citizen merchants (if it ever happened at any time at all) facilitated more spending (by these same creators) without having to earn it first? How was everyone suddenly forced to only spend more via the more painful method of borrowing?

These holes in logic makes it easier to just believe that a tribal chieftain, monarch, council of senate leaders, or early government body was the one who first created money by fiat, and everybody else had to follow. This process started with government using fit to pay for money that at the very start, no one had to begin with. After all, government paying you the income you never would have otherwise is like me renting you my lawnmower so that you can mow my lawn and every other house on the street for money. You never had money to pay this rent in the first place, so by yourself, you'll never ever find a way to make any money. But if someone lends you the mower in exchange for service, you get the money to pay for it as well as earn income for yourself. Same principle happens with government spending. The act of the government using private capacity, and paying for it with fiat money, can create the income that the private sector can use to buy government's borrowing that fund the spending.

So we can then conclude that money used to finance all those government borrowings came from income created by government spending. This private income creation, leading to aggregate money creation, is what enabled government rachet up its debt level to that amount and still people could not have enough of it. How else would you explain government borrowing rising to the current level it has, $15 Trillion and counting? Where did all that money come from, if not from itself? Can all of it really be private bank created? if so, then private people are in the hook to pay it all back to some private banks? How did private bankers ever have the balls to lend private people, who cannot after all manufacture money but have to earn it to pay the loan back, then only to see those trillions of money just end up being used to finance government borrowing?

In a world where government cannot create fiat money, all money has to be borrowed into existence. And we know that a loan is riskier, and eventually gets unprinted when it's paid back. Also, since it has to be paid back, it needs a creditworthy borrower that will have the income to pay it back. Government spending, meanwhile, never has to be paid back if it was paid for services rendered. If all government spending is just facilitated by borrowing from the private sector, then deficit spending does not solve the problem of balance sheet recession, as you would be merely exchanging one indebtedness with another. Such is not what I am espousing here, otherwise I would be joining the chorus of people shouting that deficit spending is not sustainable.

And while I agree that deficit spending doesn't change aggregate level of reserves when it is funded by an equal amount of government borrowing, I stress that if it is done by crediting new reserves to recipients in excess of borrowing, then it does increase reserves. (And if a greater amount is taxed than the excess credited, then it decreases reserves).

If our world were a world where every currency/money has to be borrowed into existence, then it would be a ticking time bomb one day bound to collapse, when the last person who borrows money decides not to pay the second last person to borrow, and so on. Everything in our world will come crashing down when that day comes, and all it takes is a few unscrupulous people to untangle that ponzi scheme.

How will it ever get back to work, if such were the case? if no one single person can start the money creation process again without having to borrow first, then it's game over. Because the law forbids any private person or entity from spending money he doesn't already have, he cannot spend first before borrowing it later when he has the money to pay it back. And even if some people do have all the money now, and are hoarding it for fear of not getting it back (because everybody else wants to hoard money), and if people are too afraid to borrow again, then money in our world will cease to exist (in the sense that it will stop being used to facilitate trading in the economy). It's not so much that I believe in a valueless dollar, but if nobody is spending, and nobody is earning, all the money in the world will not do anything for anyone.