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.