Friday, April 29, 2011

Austrians and MMTers should be on the same side

Austrians and MMTers should be on the same side. After all, both camps understand the relationship between money and credit, and both understand the full ramifications of having fiat money. They should be on the same side arguing against economists who argue that demand can be created by flooding the banking system with reserves, and both should be on the same side arguing against those who think that increasing inflation expectations is an effective way to get an already over-indebted economy to take on more debt.

As it turns out, these two groups are the most ardent critics of each other, thereby giving the mainstream enough bullets to shoot both of them both down with each other's bullets. MMTers are shot down with the branding that they don't care about inflation, while Austrians are shot down with being crazy gold bugs.

As I see it, both have a good understanding of monetary transmission, except each follows this understanding to two of its logical outcomes. Austrians believe that having fiat money in the economy will lead to continuous malinvestments, endless bubbles, and will eventually destroy the credibility of the currency. MMTers embrace fiat, and believe that it is precisely the government's ability to spend fiat that enables it to offset the private sector's need to save, to take over when the private sector is deleveraging, restructuring, or just plain fearful of investment, so that the economy does not spiral into cascading deflation.

MMTers are different from the mainstream because they distiniguish between fiat being used to fuel government spending, which translates into actual income for the economy, and fiat being issued just to encourage people to spend today what they would otherwise spend at some future date. MMTers recognize that when a person is devoid of income, no amount of inflationary push will nudge him to spend money he does not have, or borrow money that no lender will ever prudently provide him.

But MMTers, just like Austrians, recognize that having fiat money could lead the private sector to extend more credit than is prudent during a boom, and this excess lending eventually leads to a ponzi scheme where the last person holding the now bust asset is unable to pay his debt, and the last person holding the bad debt loses his ability and compunction to lend some more.

Austrians, however, prescribe that the best way to handle a bust is to let it take its natural course, so that people who made bad investments lose, and those who plan to invest do so when the economy settles at a stable floor. MMTers, on the other hand, do not believe it logical for government to leave a private sector bust to itself, precisely because people who have just lost income will not be the right ones to start spending again, and investors who just lost equity are not the best ones to start investing again.

But regardless, both can look at the economy granurally, and see debtors and creditors, investors and investees. Mainstreamers only see buyers and sellers, and believe that just dropping money will solve the problem of non-existent buyers. Mainstream do not see how this money will be transmitted from fiat issuer to end consumer without agravating consumer's already heavy debt load. There is no such thing as balance sheet recession to the mainstream, no such thing as leveraging and deleveraging.

Austrians and MMters see this dynamic, and so should take a common stand against the mainstream who can easily shoot them both down like fleeing rabbits. For my part, though, while I see how Austrians see the dangers of fiat, and therefore want to take it away from those who can issue it - from the government, by going back to the gold standard, and from the banks, by advocating a 100% reserve lending, I don't share the same prescription.

As I've mentioned it previous posts, I don't believe the gold standard is apt to our current level of economic development and population. I don't believe 100% reserve lending addresses the needs of today's economic reality, or ever did the reality of a growing economy at any time in the past. And I also believe that recessions cannot be left alone, particularly when private businesses are no longer willing or able to do their regular job of investing, producing, hiring, and selling. I do believe though that government should support a more organic revival of the private sector by supporting the local businesses who hire the most people in aggregate. It should also respect that a recession is the best way also to reverse and break the previous boom's tendencies towards monopoly and concentrated market power. Government should not use fiat spending to perpetuate that status quo.

Fiat is now the reality. The best way to control politicians and bankers from abusing it is to strictly enforce macroprudential monitors and controls.

Friday, April 22, 2011

What are taxes for?

A few days ago, sporting enthusiasts announced the start of the annual fox hunting season. The fox hunt is important because this is how the nation procures the population's meat supply.

On a related note, the nation also recently just concluded the annual tax season. Tax is important because this is how a sovereign, fiat-issuing nation pays for its spending.

Thursday, April 21, 2011

A note on the recent Fed accounting change

This was a response to Detroit Dan in comments here, but since the comment is about an Yves Smith post that I have to linked to here and here, I'm posting my reply here for those who may also be wondering about the recent Fed accounting change. The Yves Smith post is a discussion of how the Fed plans to handle any interest rate/market loss it could incur if it decides to sell the hoard of Treasuries it bought via QE2.

Basically, if the selling results in a net loss to the Fed, it will just consider the current loss to be deductible from the amount of profit it sends to the Treasury the next time it has a profitable year. So during the year that it incurs the loss, it actually receives a "credit" from Treasury.

A comparable scenario in private business is if you have a business that incurs a loss this year, you just say "it's okay,I will in the meantime just consider the loss as a shareholder loan from me payable to me the next time the business is able to". This can go on indefinitely if you are like the Treasury, which can just debit-credit the losses until the Fed finally is able to pay again. But you, as a currency user, will have to fund the loss with actual money, while the Treasury, a currency issuer, doesn't.

Wednesday, April 20, 2011

One day during an S&P ratings exam

One day during an S&P officer ratings exam

What do you rate the senior tranche of an issue 100% composed of subprime loans?


Q: What do you rate the senior tranche of a resecuritization of the mezzanine tranche of a subprime issue?


Q: What do you rate an insurer with a sizeable holding of CDS to subprime issues?


Q: What do you rate a sovereign country that issues the global default currency, and has 100% of its debt in its own currency?

S&P: Uhm……A-?

We got potential here...

Monday, April 18, 2011

What would happen if we went back to the Gold Standard?

So many people have lately been advocating for a return to the Gold Standard. Many have been very vocal about it. So for this post, I will speculate on what would happen should this elusive goal ever come to reality.

Because the Gold Standard entails that money be backed by a fixed price of gold, which has a finite supply, this means that the supply of money will be finite and will grow only as the supply of gold grows (which is hardly at all). So with a return to the Gold Standard, I expect:

1. People will rank their needs and demands in a strict hierarchy. Because of the Standard, people will equate money with gold, and will treat it accordingly. They will hoard and conserve it, and only use it for the most important things, such as for life-saving services.

2. If one part of the economy grows, another part will have to decline correspondingly. There just isn’t enough gold-backed money to go around. If some people become richer, others will correspondingly have to get poorer.

3. Global trade will stop to a standstill. No nation could anymore afford to have a trade deficit, because a deficit entails a loss of gold to the nation that incurs the surplus with them. A loss of gold, and the correspondingly money supply, means a deflation in their entire economy. So every nation will strive even more to be net exporters. No buyers will be left to trade with.

4. Eventually, in this kind of economy, people who still have to make a living will start bartering with one another. Or, and this is my pet speculation, people will eventually develop shadow currency systems. Or call it parallel payment systems. If a gold-backed currency only enables life-savers to get paid for their services, a shadow silver-backed currency will enable people to purchase and pay for education. A parallel copper or aluminum-backed currency will enable people to pay for home builders and tailors. Maybe a shadow currency based on rocks will let people pay for those who cut their hair.

Eventually, maybe even money based on belly lint will let them donate money to blog tip jars, and pay for more episodes of American Idol. Maybe then, only nations that are able to produce a surplus of belly lint can pay for their net imports of American Idol.

In other words, should we ever go back to a Gold Standard, I believe the market itself will form a fiat currency system to allow for more trades and businesses to flourish. Heck, if a shadow banking system can somehow flourish in a system that already has fiat currency, I believe a limited currency system will grow a shadow currency system. (Without a state to back them up though, they can unravel just like the shadow banking system)

What, did you think only those with gold will inherit the earth?

Update: I added this here: I would add that the state's option to be able to spend more, in place of disappearing private spenders during times of escalating private sector desire to save, is an invaluable lifeline during a severe depression, and if we had a gold standard, government spending will only likely crowd out what little private spending is still there.

Thursday, April 14, 2011

It's wrong to think of Fed transactions in terms of its profitability for the Fed

James Hamilton has a post stating that QE has added no interest rate risk for the Fed’s balance sheet, and that it has actually proven to be hugely profitable for the Fed. (H/T Mark Thoma) Where did the Fed get the money to buy all this stuff? The answer is, whenever somebody sold these items to the Fed, the Fed credited an account that the seller's bank maintains with the Fed in the form of new Federal Reserve deposits. At the moment, most of those new reserves are just sitting there at the end of each day on some bank's balance sheet. Reserve balances with Federal Reserve banks have gone from $9 billion in April 2007 to almost $1.5 trillion today.

The Fed is currently paying banks 0.25% interest on those reserves, and is collecting an average interest rate of 4% on its long-term securities. That netted the Fed a healthy profit of $80 billion in 2010, which it returned to the U.S. Treasury. In effect, the Fed is borrowing short and lending long, making a huge profit on the difference, and handing it back to the Treasury.

Prof. Hamilton’s analysis is wrong on several levels.
1. The Fed, which has the capability to credit money to accounts, i.e., print money from ‘thin air’ can never lose money, so it doesn’t make sense to justify its actions on the basis of it being profitable for the Fed.

2. In fact, if we were to take this line of thinking, and QE is such a good profit-making strategy for the Fed, then it should just keep on printing/crediting bank accounts for as much as needed to buy out all existing positive carry securities in the market, then pay correspondingly less interest (IOR) on the reserves such move creates for the banks. If the prevailing logic is to be believed, this takes away all market risks from the banks, puts them into the Fed’s balance sheet, and it provides banks with a high level of reserves with which “"to fund more lending"”, while at the same time piling on more profits for the Fed. What’s not to like?

3. But not all is hunky-dory, and the whole structure just manages to keep standing precisely because the Fed could print fiat money at will. Hence, it doesn’t make sense to justify the Fed’s moves on the basis of its profit-making effect on the Fed’s income statement. If you’re a private sector entity, which unlike the Fed, has revenue and cost constraints, doing exactly what the Fed is doing is a recipe for money-losing disaster. Where in the private sector will it make sense to buy out another party’s securities, at market cost, and then turn around and compensate that third part by paying him interest (IOR) on the money he ends up with from your buying? Where do you get off paying someone for value, then paying him again interest for the money you just gave him, then booking profits just because you paid him less than what you earned from the securities you bought from him? If you bought at market value, then you’ve already paid the value of all future interest to him, and you are just breaking even when you in turn receive it over time from the security. Any additional you pay on interest to the third party will already be a loss to you.

4. The risk of accounting loss for the Fed does not come from ever having to pay more in IOR than it’s earning from the securities it just bought (Why would that ever happen when it already paid the banks just compensation for the securities?) The risk of loss will come when the Fed decides to reverse its market buying, and start selling the securities back to the market. Because the Fed is a large entity undertaking a large market transaction, anything it does moves the market – against itself. When its buys, it adds demand to the securities, making it more expensive for itself when it buys. When it sells, it does the opposite. It removes a large block of demand from the market, causing a price decline when it sells to the market. What the market gains from this, the Fed will lose.

5. So will all this QE end up making a profit for the fed? No, it never did, and the fact it’s paying IOR normally should be a loss to the Fed. But it doesn’t because the Fed just prints the IOR it pays. And if it ever decides to reverse QE, money printer or not, it will incur an accounting loss. But don’t fret, the Fed is already on it.

Addendum: This is to address Detroit Dan in comments, about the Yves Smith post in the link - The Yves Smith post is a discussion of how the Fed plans to handle any interest rate/market loss it could incur if it decides to sell the hoard of Treasuries it bought via QE2.

Basically, if the selling results in a net loss to the Fed, it will just consider the current loss to be deductible from the amount of profit it sends to the Treasury the next time it has a profitable year. So during the year that it incurs the loss, it actually receives a "credit" from Treasury.

A comparable scenario in private business is if you have a business that incurs a loss this year, you just say "it's okay,I will in the meantime just consider the loss as a shareholder loan from me payable to me the next time the business is able to". This can go on indefinitely if you are like the Treasury, which can just debit-credit the losses until the Fed finally is able to pay again. But you, as a currency user, will have to fund the loss with actual money, while the Treasury, a currency issuer, doesn't.

Friday, April 8, 2011

Allocating stimulus between unemployed and would-be employer

This post grew out of an interesting discussion at Mark Thoma’s blog, where he asked “What can we do to help the unemployed?” One statement by a commenter, Britonomist, jumped out at me: “What if there was a guaranteed citizens income, as in, you are always guaranteed at least a minimum amount of income whether you are employed or not, BUT, the minimum wage is also abolished? The minimum wage wouldn't be needed as workers would already have a very large bargaining position, since they do not depend on employment to survive.”

I chimed in that perhaps the better idea would be to increase incentives for employers to hire and expand. Giving people an alternative to getting employment (because of guaranteed income) might actually take away incentives to look for work.

My default is that all businesses want to create and develop customers, that nothing can ever take away that incentive, otherwise they wouldn't be in business. It's just that cost pressures sometimes get in the way of hiring. They may have competitors who have cheaper costs because they produce from or outsource to cheaper locales. The hurdle I see is not of businesses shying away from winning new markets, but of businesses shying away from hiring people because it's cheaper to just automate or to outsource jobs abroad.

So the idea is for government to countervail that cost arbitrage a bit. And with more locals being given employment, that should create more potential customers all around, too.

I don't see my approach as socialism for the affluent, but creating aggregate demand where it matters, which is via employment, and pushing for employment where they are created - at the company/private sector level. We're not going make anyone unduly rich here, as I mentioned in a previous post, because all the government will have to compensate the business for is a nominal return for its effort (There should be no extra premium for business risk that is being mitigated by the government support).

But the support must be such that it makes some businesses feasible that would otherwise not be feasible with regularly paid workers, when there are foreign competitors paying slave wages. Additionally, as commenter, beezer, said in my previous post, the support need not even be an actual subsidy, but a tariff levied on imports that are killing off labour-intensive local industries.*

The companies I have in mind for such a program are not your run-of-the-mill TBTF firms run by your run-of the-mill plutocrats. Instead I’m thinking about your run-of-the-mill small and medium scale businesses that typically hire local members of the community, but whose markets are slowly being eaten up by the TBTF, who have arbitraged their costs, whether operational or tax, by spreading their tentacles worldwide.

Of course, giving the unemployed some form of income support is also important. What Britonomist and Ohm, the Economists’ View commenters I engaged discussion with, were hinting at is a minimum guaranteed income. High enough that whether one is employed or not, it ensures one can survive with or without additional employment income. This is a noble aim, and as Britonomist said, at a pragmatic level, it takes away the need for a mandated minimum wage.

My position is we also have to find a cut-off point so we don’t give too much assurance of survival that it counters with the goal of putting every able person in productive employment. Unemployment would not be solved if we create alternatives to seeking employment. But it just might be solved if we take away business' alternatives to seeking local employees. With employment comes productive income. Keywords being “productive” and “income”. Providing income to would-be consumers leads to aggregate demand creation. Productive means the demand growth is matched by supply growth. Otherwise, we’re just increasing the supply of money chasing the same amount of output.

But I also realize we could be talking about 2 parts of a single multi-pronged stimulus plan.

*I also realize that some companies might try to game the stimulus, if it comes in the form of subsidies. So government should thoroughly audit the companies it supports in this program (That’s already a job stimulus there for auditors). But perhaps the tariff solution in fact would be an easier solution to implement.

Wednesday, April 6, 2011

The Euro and what it does to individual European countries

This is a repost, of one I did 14 months back, that’s once again relevant to what’s happening in Europe today. (I name actual countries this time in the post).

There are two countries, Germany and Portugal (let’s use Portugal as proxy for all PIIGS), who both use the common currency Euro. Neither of them issues its own currency. Currency is issued by a pan-European ECB (European Central Bank).

Even before the advent of the Euro, Germany was a more productive economy than Portugal, and Germany continues to experience a string of surpluses, while Portugal does not. In fact, just to try and catch up with Germany’s productivity, Portugal incurs debt (in Euro, of course) to finance its growth programs.

While Germany has its surpluses, Portugal does not, importing more than it exports. Germany’s string of surpluses is making the Euro, a floating currency, more valuable. This makes Portugal’s exports correspondingly more expensive for other countries. Being behind the curve, and now having more debt to carry, Portugal can’t replicate Germany’s surplus.

When Germany incurs its surpluses, ECB prints more Euro, so that other countries can exchange them with their own, and have the currency to buy Germany's goods. Implication is that for as long as Portugal is part of the Euro, and ECB can and will print the Euro when needed, Portugal will never run out Euro to borrow. But ECB normally won’t ‘print’ more of Euro just to hand out to Portugal, because doing so would be detrimental to Germany. (There are also other Euro countries, France, Netherlands, Switzerland, etc., who will also be adversely affected by the depreciating currency and inflation that comes with printing money without corresponding government spending) Neither would it just forgive Portugal’s debt. Moral hazard. Portugal is left in a bind.

Everything would be dandy if Germany would just hand out some of its excess Euro to Portugal. But that was not the point of incurring surplus in the first place. Anything its own citizens do not use, Germany recycles a savings in the default global currency, the USA’s.

How long before Portugal goes down and drags the entire Euro currency down with it? (Though realistically, there would likely be a chain reaction with the other PIIGS first). If Euro goes down, and everybody goes back to national currencies, which each one prints for itself, then that solves Portugal's debt servicing problem (No more Euro, or it can now offer to pay back the ‘equivalent value’ in its own currency).

Tuesday, April 5, 2011

The relationship between trade imbalance and the ballooning debt to other countries

We constantly hear warnings about the ballooning US debt to other countries. The warnings go on to say that the US will eventually find itself unable to pay back the debts. Same warnings forget that the US debts to foreigners are always in US dollars.

The ballooning US debt is actually partially a consequence of the trade deficit. When other countries choose to sell more than they buy, they end up with surplus US dollars, while the US, because of the deficit, has a dollar deficit. Where do the other countries put the net US dollars they earn, since they have their own currencies at home? They won’t convert it to their own currency if they want to avoid an appreciation of their own currency. They will want to recycle most of it back to the US, where it actually gets used. So the surplus trade countries end up buying the US debt, which the US can always pay back by issuing more US dollars. Now it's up to those other countries if they want to continue selling more to the US for money it just continually prints. For as long as the US trade deficit continues, incurring debt will have to continue. This is something that will continue going on unless we stop the global trade imbalance.

I had a post 14 months back that put on a thought experiment, to try and understand the mechanism better. I’m reposting it now word for word, except, now I name actual countries in the experiment. (Maybe doing the thought experiment in complete abstract is hard to follow for some).

Let’s start the thought experiment with the country with the default global currency, which we know to be the USA. USA trades with another country, China. To simplify matters, for now let’s only look at countries USA and China, but know that there are a multitude of other countries that also trade with them and each other, also using USA’s currency.

Now when USA imports more than it exports, it incurs a deficit vis-à-vis China. Because the trade was settled in USA’s currency, China acquires foreign reserves (The reserves will be of course be in USA’s currency). USA, meanwhile, being the issuer of default currency, doesn’t have to do anything more than ‘print’ more currency.

Now what happens when it’s the other way, and China is the one that incurs the deficit? Because its currency is not the default, China has to buy USA’s currency to settle the trade. It therefore borrows in USA’s currency. The more deficits it incurs, the more borrowings it has to make in a foreign currency.

Now over the longer term, if China continually incurs a trade deficit, the net borrowings of China should depreciate its currency vis-à-vis USA’s, which should make its exports cheaper in terms of USA’s currency. Therefore, in the longer term, the balance should tilt back towards China exporting more to USA than USA exporting more to it.

But when China is the surplus country, it ends up holding more of USA’s currency as reserves, and its currency should go up vis-à-vis USA’s currency. Therefore, longer term, USA’s exports should become cheaper when converted to China’s currency. Longer term, in a normal scenario, USA’s imports from China should go down and its exports to China should go up.


Now China has pegged its currency to USA, largely because doing so makes its exports to USA, as well as to the other countries, cheaper. Its continuous surpluses enables it to accumulate more reserves of USA’s currency. But to keep its currency from rising, it will lend its reserves back to USA rather than allowing it to disseminate in it local economy. USA then gets more money to finance even more deficits. China does not lend to USA because USA needs the money (Why would it need more of what it can just print?). China lends to USA because the act of lending enables China to maintain its peg to USA. It is therefore not in China’s interest to stop lending, even when USA’s constant deficits results in USA’s currency depreciating. For one, China needs to keep lending if it wants to keep the peg. Two, precisely because of the peg, China's currency also goes down vis-à-vis other countries’ currencies.


Now, let’s suppose a 3rd country, think of any third world country. For this experiment, let’s use a country with substantial USA dollar borrowing vs its GDP, the Philippines. PHL has had a history of deficits with other countries, and therefore, has a sizeable borrowing in USA’s currency (the currency which settles the trades). PHL, therefore, cannot afford a significant depreciation of its currency in terms of USA's, because that would make its debt servicing more expensive. Then again, a depreciation in PHL's currency makes its exports cheaper in terms of USA’s currency, and therefore enables PHL to export more, and to acquire more of USA’s currency to pay down its debt. The best risk mitigating strategy for PHL is therefore to accumulate more and more reserves of USA , by incurring a trade surplus vi-a-vis the USA. Thus, to make sure it always has the ability to manage potential fluctuations in its currency’s conversion to the USA’s, and therefore always have the ability to pay down its debts, PHL will want to accumulate ever rising reserves of USA. Thus, PHL ‘s demand for USA’s currency provides even more opportunities for USA to finance even more deficits.

Now, USA, even if it eventually acquires significant borrowings from China and PHL, again need not worry much. As far as it’s concerned, either of two things can occur: 1) China and PHL could suddenly stop financing more debts, in which case, USA will just stop incurring deficits. But then USA’s currency will correspondingly fall, which will enable it to export more, and things balance out again, or 2) China and PHL will stick to their original objectives, China continues the peg and they both try to accumulate more USA’s reserves, which means USA will be able to continue financing deficits. Also, whether scenario 1 or 2 happens, USA will always be able to meet its objectives just by printing more money.

USA never has to borrow in anyone else’s currency, or even if it wanted to, can never borrow in most other countries’ currencies because 1) other countries’ currencies are never in sufficient enough supply, and 2) there is not much use for anybody else’s currency when all trades are priced and settled in USA’s currency.

GETTING TO THE GDR (Global Depositary Receipts)

Now, how would a move to a global currency change things? Let’s go back to the thought experiment.

When USA incurs a deficit with China, it has to buy the GDR to finance the deficit. China has to sell GDR currency to get paid the net surplus in its own currency. Over time, USA’s currency goes down in terms of the GDR, while China’s goes up vs. the GDR. Longer term, this should balance things, because the new currency values would eventually lead to China importing more from USA than USA from China.

Because all trades are already in GDR, there is no longer an incentive for China to peg its currency to USA. Even more so, China cannot peg its currency to the GDR because it’s actually a basket of everybody’s currencies. Pegging to GDR causes China to have an endless loop with its own currency. So no more successful pegs.

Because all trades are already in GDR, PHL, which has significant borrowing USA’s currency, will still have an interest in exporting more, so that it has the USA reserves necessary to keep its currency from depreciating. However, because USA will also need to buy the GDR to settles its trades, USA will now no longer have an incentive, or the infinite capability, to continue incurring deficits. This means less opportunities for PHL to accumulate USA reserves. If PHL already had a sizable reserve to begin with, then maybe it will already be safe. But if PHL had accumulated a very sizable borrowing in USA’s currency, then the prevalent use of the GDR will probably cause PHL to have trouble sourcing USA currency, and keeping up with its debt servicing. The only way that PHL can continue to pay is to continue incurring surplus with USA. Thus, maybe USA and PHL will continue settling in USA’s currency, and PHL will continue to finance USA’s deficits, until it feels it has enough reserves to maintain a stable currency.

So net, the GDR will constrain USA’s ability to, in Tom Hickey’s words, “foster the development of emerging nations, by making capital and technology available where it is needed”. It will also stop USA's population from continuing to enjoy spending more than they produce, out of everybody else's need to acquire its currency. It will also entail a (probably temporary) difficulty for countries that have sizable foreign debts. But over-all, it will probably result in less global imbalances.

Friday, April 1, 2011

april fools for greater fools

It’s April Fools again here in the Western world. In commemoration, this post lists some biting posts, more satirical than serious, that have graced these pages, each of them in search of fools to put to a deserved round of searing and roasting. Watch out, and try not to get seared yourself.
And don't let that serious-looking picture on the right fool you.

Confessions of a consummate dollar hoarder
Diary entries of a consummate dollar pegger
The 100 year plan for unceasing growth
Economic recovery team substitutions
Currency war battlefield tactics
EU gets its groove back
Paulson, Bush, and a China strategy

US Banks don't need borrrowers in order to lend
US banks are not capital-constrained
How Bernanke stimulates?
Superfreakin CDO P.I.M.P.
Lehman in Wonderland
Investment bankers, swaps, and ulcer
Investment banker blues