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World Bank boss has a brain attack

The World Bank boss Robert Zoellick claims that we should all return to the Gold Standard to restore economic stability in the World economy. He is crazy. Sorry! The G-20 meeting in Seoul this week will obviously be concentrating on side issues such as the impact of the latest US quantitative easing plans on world inflation and the international currency system which many commentators are now claiming is in turmoil. Zoellick’s proposal will be added to the agenda which will reinforce what a waste of time these meetings are turning out to be. Zoellick’s call for a gold standard is just another one of these conservative smokescreens that attempt to solve the problem by denying it. They are all just expressions of obsessive and moribund fear of fiscal policy and the erroneous allegation that budget deficits cause inflation. So we will get a G-20 communiqué in a few days calling for more international cooperation in trade and currency settings and more fiscal consolidation and the need for on-going discussions about the creation of a new international reserve currency (perhaps a gold standard). But all these words will be in spite of the real policy agenda that is required – more public spending. What will they come up with next?

In a recent Op-ed (November 8, 2010) – The G20 must look beyond Bretton Woods – Zoellick said among other things that:

… the G20 should … build a co-operative monetary system that reflects emerging economic conditions. This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalisation and then an open capital account.

The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.

Why would a return to the Gold Standard be crazy?

Remember as you read on to keep reminding yourself of the obvious – a sovereign nation with a flexible exchange rate can also use fiscal policy to maximise domestic outcomes if they desire notwithstanding external constraints (and domestic constraints like lack of food!).

Zoellick’s proposal is just one of a long line of proposals that get oxygen because governments are scared to use the tools that they already have and which work best when there is an floating exchange rate.

So we get Ireland destroying itself because it gave up both its currency sovereignty and its capacity to float a sovereign currency when it joined the Euro. You might like to read the latest insights from Irish academic Morgan Kelly who presents a dire update on the situation in the nation that the Euro bosses held out as the demonstration state both in the lead up to the crisis and subsequently in embracing austerity the earliest. The nation will collapse before long.

You also see central banks trying once again to revive their flagging economies with quantitative easing – again. This is despite the fact that banks do not lend reserves; US corporations are cashed up to the hilt; and US households are embracing a new period of frugality because they have huge debt overhangs that they know have to be extinguished. As I explained in yesterday’s blog – Religious persecution continues – quantitative easing will not be the silver bullet. So why are they doing it again? Answer: because the US government refuses to implement the appropriate fiscal stimulus.

All the talk about quantitative easing flooding the world with US dollars and creating an inevitable inflation are just hot air.

And that segues in to the largely irrelevant debate about the need to rebalance global trade patterns from which the call for some return to a fixed exchange rate system materialises. If you want to see how a fixed exchange rate system kills nations you just have to look at what is happening in Greece, Ireland and Spain at present.

Trade imbalances (deficits) have to addressed via domestic contraction which biased most economies to permanent states of stagnation – high unemployment and flagging living standards.

Please read my blogs – Twin deficits – another mainstream mythYuan appreciation – just another sideshow – for more analysis of that sideshow.

So it is just another part of the anti-fiscal policy agenda that has resurfaced and gathering pace even when the effects of too little fiscal intervention are staring us in the face and have been doing so for nearly 3 years now.

In part, the anti-fiscal policy agenda is sourced in a deep anxiety about inflation. The contradictions in this stance are stark but that never stops the proponents pushing it. Spending equals income whether it is private or public. The composition of the output that creates the income might be different but you need spending to create income.

Too much spending whether it be public or private will be inflationary. There is not something magical about public spending that makes its more prone to generating inflation. Further, as I have explained before it is the act of spending which introduces an inflation risk (depending on the state of capacity utilisation) and the monetary operations that accompany the spending (for example, debt-issuance) do not alter that risk.

Mainstream macroeconomics is mired in the flawed belief that the government has three sources of funding: (a) taxes; (b) debt-issuance; and (c) printing money. Students rote learn that the degree of expansion is in order of these options and that printing money is “so expansionary” because it also reduces interest rates (in their models) as well as directly impacts on demand that it is inflationary.

Not only do sovereign government not have to “fund” their spending, the government budget constraint (GBC) framework which is the pedagogical device that students learn this nonsense within is deeply flawed.

Students learn that the printing money option – called monetisation – involves the government running a deficit with no external debt issued to “pay for it”. What a nonsensical description of the options facing a sovereign government. When the government spends the recipient receives a credit (say a deposit at a bank) at the same time the government credits the reserve accounts that the particular commercial bank maintains with the central bank. There is nothing more to it than that.

So bank deposits and reserves rise by an equal amount and the recipient expresses the increase in their net financial position (wealth) in the form of an increased deposit at the bank.

The banks now have excess reserves because they can always rely on the central bank to provide them with reserves should they be short. The central bank may offer a support rate on these reserves (as Australia has done for year – 25 basis points below the target rate; or as the US has done since 2008).

If there is no support rate, then the overnight inter-bank interest rate will drop to zero as a result of the desire of banks to seek some overnight return on these reserves. The reality is that these transactions among banks net to zero which means they cannot eliminate a system-wide surplus. Assuming the central bank has a non-zero target rate then it has to “drain” these excess reserves (a liquidity management operation) to prevent the competition among banks to lend their excess reserves.

How does it do this? Answer: sell government bonds. What does this mean for the textbook version of “monetisation”? Answer: it means the mainstream textbook rendition is wrong. The central bank has no choice but to sell debt in this situation or else it has to be prepared to run a zero interest rate regime (as in Japan for two decades).

In the current period, where the central bank offers to target rate to banks holding overnight reserves, these liquidity management operations are no longer required. This means that the central bank can ignore the impacts of the deficit on bank reserves and maintain control over the interest rate by ensuring it pays the same rate on overnight excess reserves as it announces as its policy rate. There are no further complications with this approach.

The national government does not have to issue debt to net spend (that is, run a deficit). So wouldn’t this be more inflationary than if it issued debt? Answer: not at all. The inflation risk is in the spending not the monetary operation.

To understand this one has to come to terms with the stock impacts of the deficit flows. Government deficits increase non-government sector net savings by increasing national income. The stock manifestation of this net saving flow manifests as increased net financial assets (wealth) held by the non-government sector initially as bank deposits.

What if the government issues debt as described above? Answer: the portfolio of the net financial assets held by the banks is changed. The bank debits its reserve account (at the central bank) by the sum of the payment for the government bonds and it now holds paper instead of reserves on its balance sheet. The reserves are “drained” from the system by the monetary operation.

Have the deposits held by the initial recipient (which was the expression of the rise in net financial assets due to the deficit) disappeared? Answer: No, they are still there.

What if the government issues debt to the public? Answer: Bank reserves still decline because the holders of deposits at the bank pay for the bonds via a reduction in their deposit balances. The improved net financial asset position of the non-government is now expressed by the holding of the government debt by the public (not banks) rather than bank deposits. The public have just converted their non-interest bearing wealth into interest-bearing wealth.

Has there been any difference in the change in aggregate demand as a result of these different options? Answer: none, aggregate demand went up by the same amount equal to the net government spending plus the multiplied induced consumption. Please read my blog – Spending multipliers – for more discussion on this point.

So you can see the fallacy in the theories that distinguish between “printing money” and “issuing bonds” and conclude that one is more inflationary than the other. There is no difference for aggregate demand. To understand this you need to also appreciate that banks do not lend reserves.

Bank reserves are an essential part of the clearing or payments or settlements system (different terminology is used in different countries to denote the same mechanism). Accordingly, the funds are used to settle the myriad of transactions that implicate each of the banks each day. Having excess reserves doesn’t increase the capacity of the banks to lend.

In a fiat monetary system, the banks can lend whenever they choose. Their loans create deposits and are not dependent on the existence of “excess” reserves. Banks will lend to anyone who they can make a profit on. If they didn’t have the required reserves at the end of the day then the central bank provides them.

So there is no sense in the logic that holdings of excess reserves are inflationary. Bank reserves are not a component of aggregate demand.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion on this topic.

What about the argument that if the non-government sector has bonds they are less likely to spend these “savings”? Answer: If the holders of either form of net wealth (bank deposits or bonds) wanted to dis-save they could easily do that. In this instance, the budget deficit would fall anyway as the automatic stabilisers increased tax revenue and welfare spending fell. If the automatic stabilisers didn’t reduce government demand enough – that is, nominal demand growth was outstripping the real capacity of the economy to produce more goods and services then further fine-tuning of discretionary fiscal policy would be required to avoid inflation.

The point is that public and private spending works in more or less the same way. Both add to demand and command real resources and both can be excessive in relation to each other and the real capacity of the economy to produce goods and services.

Please read Scott Fullwiler’s excellent coverage of this issue – HERE – for more detail in the US context.

So these deep anxieties about inflation and deficits are ill-founded and should not lead to the policy debate being derailed into sideshows like debates about the merits of a return to a Gold Standard.

Brief review – How did a Gold Standard work?

Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for an introduction to this topic.

I won’t repeat that blog and the nuances of pure commodity currency systems and convertible currency systems backed by gold are explained there.

Zoellick is thinking of a return to a paper currency system where paper money issued by a central bank is backed by gold. So the currency’s value can be expressed in terms of a specified unit of gold. To make this work there has to be convertibility which means that someone who possesses a paper dollar will be able to swap it (convert it) for the relevant amount of gold.

In the early versions of the Gold Standard, central banks would set their currency against the gold parity. As an example, say the Australian Pound was worth 30 grains of gold and the USD was worth 15 grains, then the 2 USDs would be required for every AUD in trading exchanges.

The central banks would maintain the “mint price” of gold fixed by buying or selling gold to meet any supply or demand imbalance as a result of trade between nations. Further, the central bank had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate).

Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries.

So trade surplus nations could expand their domestic money supplies (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the set value of the local currency in terms of grains of gold. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline.

For the deficit nations, the loss of gold reserves forced their governments to withdraw paper currency which was deflationary – leading to rising unemployment and falling output and prices. The latter improved the competitiveness of their economy which also helped resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

The political costs of this imbalance in domestic fortunes ultimately led to the system being abandoned (in an evolved form) in 1971.

The proponents of the gold standard focus on the way it prevents the government from issuing paper currency as a means of stimulating their economies. Under the gold standard, the government could not expand base money if the economy was in trade deficit. It was considered that the gold standard acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balance. The domestic economy however was forced to make the adjustments to the trade imbalances.

Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade). Variations in the gold production levels also influenced the price levels of countries.

In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment).

Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.

After World War 2, the IMF was created to supersede the gold standard and the so-called gold exchange standard emerged. It is this sort of system that Zoellick is proposing.

Convertibility to gold was abandoned and replaced by convertibility into the USD (although Zoellick would like a broader basket of reserve currencies), reflecting the dominance of the US in world trade (and the fact that they won the war!). This new system was built on the agreement that the US government would convert a USD into gold at $USD35 per ounce of gold. This provided the nominal anchor for the exchange rate system.

The Bretton Woods System was introduced in 1946 and created the fixed exchange rates system. Governments could now sell gold to the United States treasury at the price of $USD35 per ounce. So now a country would build up USD reserves and if they were running a trade deficit they could swap their own currency for USD (drawing from their reserves) and then for their own currency and stimulate the economy (to increase imports and reduce the trade deficit).

The fixed exchange rate system however restricted fiscal policy (which goldies consider an advantage) because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).

This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.

So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion. Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.

Whichever system we want to talk off – pure gold standard or USD-convertible system backed by gold – the constraints on government were obvious.

The gold standard as applied domestically meant that existing gold reserves controlled the domestic money supply. Given gold was in finite supply (and no new discoveries had been made for years), it was considered to provide a stable monetary system. But when the supply of gold changed (a new field discovered) then this would create inflation.

So gold reserves restricted the expansion of bank reserves and the supply of high powered money (government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.
As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.

The concept of (and the term) monetisation (as discussed above) comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money. The process was that the government would order some gold and sign a cheque for the delivery. This cheque is deposited by the miner in their bank. The bank then would exchange this cheque with the central bank in return for added reserves. The central bank then accounts for this by reducing the government account at the bank. So the government’s loss is the commercial banks reserve gain.

The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance. As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.

Ultimately, Bretton Woods collapsed in 1971. It was under pressure in the 1960s with a series of “competitive devaluations” by the UK and other countries who were facing chronically high unemployment due to persistent trading problems. Ultimately, the system collapsed because Nixon’s prosecution of the Vietnam war forced him to suspend USD convertibility to allow him to net spend more. This was the final break in the links between a commodity that had intrinsic value and the nominal currencies. From this point in, most governments used fiat currency as the basis of the monetary system.

So would a return to a Gold Standard alter any of this?

Answer: No! We would return to the same problems that led to the system’s downfall. In a sense, the Eurozone is running a version of the Gold Standard – in the form of a fixed exchange rate system (with no prospect even of re- or devaluation). The only way that a Eurozone nation can adjust to a persistent external deficit is to implement a harsh domestic deflation to increase competitiveness. It is a path to falling living standards and ultimately political and social instability.

There are claims that the international currency system is in a state of near collapse.

The UK Guardian economics correspondent Larry Elliott wrote (November 8, 2010) that:

… without doubt, a return to gold has some attractions. The international currency system is in turmoil; countries are adopting beggar-my-neighbour devaluations; the gold price has soared to just shy of $1,400 (£868) an ounce and this week’s G20 meeting in South Korea is shaping up to be an ill-tempered affair.

The devaluations (or managed rates) are also manifestations of the destructive effects of the neo-liberal era exemplified by the IMF and World Bank obsession with export-led growth. The underpinning agenda of this approach can be traced back to a anti-fiscal policy obsession. Export-led growth strategies are not reliable and deprive the citizens of access to the fiscal capacity of their government and the use of their own resources.

Please read my blog – Export-led growth strategies will fail – for more discussion on this point.

Each government can make its own decision about whether they choose to hold USD reserves or diversify, say into Euro. But they would be far better advised to stop seeking to net export as a policy position and instead use their fiscal capacity to stimulate domestic demand. That would solve this “alleged” international currency system turmoil pretty quickly.

I also find it amazing that nations like China and Germany are now lecturing the Americans for “living beyond their means” and demanding the US government cuts back on US demand. If the US did cut back on demand for imports then where are these export goliaths going to make their money from? Answer: this posturing is total hypocrisy.

Elliot does make there good reasons why a return to the gold standard would be disastrous. He said:

Firstly, the world supply of gold is too small to support a global economy with an annual output of $50tn a year. Secondly, the global economy is a lot more diverse than it was in the 19th century, when the scene was dominated by a handful of European nations plus America. Thirdly, pegging currencies to gold would almost certainly prove to be deflationary. Here, the lesson of Britain is apposite, since the 1925 decision by Churchill to return to the gold standard at the pre-war parity following pressure from the Bank of England governor Montagu Norman was one of the great economic blunders of the 20th century. Within six years, deflationary pressure had forced Britain to abandon gold.

All those sovereign nations running current account deficits take note! If they support a return to a gold standard at the current G-20 meeting then they are also signalling they support government policy deliberately creating unemployment and poverty and deflation.

The problem is that the proponents of these mad schemes don’t make that connection. If it was their job at stake maybe they would.

For the Euro nations – they should abandon their monetary union and by floating their reintroduced currencies start improving the living standards of their citizens and eschewing the destructive path they are on at present. Either way the path forward is now going to hurt these nations but in the medium- to long-term these nations will be far better off abandoning the Euro, placing a moratorium on debt, protecting their housing markets and getting people back into work and spending locally.

Conclusion

To move forward the world leaders have to abandon all these neo-liberals manias and see that spending equals income. In normal times, public spending can be moderated by private spending growth to ensure that inflation is contained and employment growth is high. But these are not normal times and there is little to suggest that private demand growth in most of the advanced nations is going to become very robust anytime soon.

In that context, given spending equals income, the only show in town is to expand fiscal policy. By sidetracking into these non-issues – quantitative easing; export-led growth; gold standards etc the leaders are just going to make things worse.

I liked Brad Delong’s conclusion – Zoellick “really may be the Stupidest Man Alive”.

That is enough for today!

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    This Post Has 151 Comments
    1. Dear Bill – the link below in para 6 appears void:

      “You might like to read the ^^^link latest insights /link^^^ from Irish academic Morgan Kelly …”

      Cheers …

      jrbarch

    2. Bill

      >>All the talk about quantitative easing flooding the world with US dollars and creating an inevitable inflation are just hot air

      The banks can use the reserves to buy things from each other, and a US bank can buy Australian dollars from other banks or its customers to bid up the price of Australian dollars and use the dollars to buy assets in Australia.

      The banks can do this anywhere they think they can make a speculative gain. QE appears to be blowing up assets all around the world outside of the countries it is supposed to be most helping

      Something similar happened with Japanese QE which was used by for example Iceland to help inflate assets in scandanavia canada and Europe and with the yen carry trade into Australasia, where now exstraordinary efforts are required to keep those asset prices inflated.

      it is more than just hot air it seems to be very messy and destablising surely?

    3. My only question about this post is the idea that spending via reserve issuance is no more inflationary than via bond sales. When the government sells bonds to ‘finance’ its spending, does the sale of bonds not have the effect of raising interest rates? It seems to me that, relative to direct spending, bond-financing would tend to dampen the multiplier effect of government spending and, in some combination, reduce inflation and reduce output.

      I ask this because it seems to me that there are those normally associated with MMT/PK who now argue that there is absolutely no difference between spending via bond sales or via reserve issuance. This line of thought is then used to support the contention that QE will have absolutely no impact. In fact, Warren Mosler argues that QE is a drag on aggregate demand. I find this contention puzzling given that so many in this camp have previously argued forcefully for a ‘natural rate of zero’ and for direct government spending. Why argue for direct government spending only to later say that QE is completely irrelevant — or even harmful?

    4. Kelly doesn’t hold back on his appraisal of the Irish situation. There appears to be little stomach for Ireland to pull out of the Euro. It’s is perceived as too risky for business continuity.

      A lot of MNC’s have set up manufacturing nodes in Ireland, they like the ease of doing business in a single European currency. The situation would have to get very dire indeed before there was sufficient public clamour for an exit.

      Germany and France would insist on backstopping the situation before that point is reached.

    5. Bill, you claim there is no difference between government “printing money” and “issuing bonds”, and on the grounds that since each dollar printed or obtained from a bond issue is spent, the effect on AD is the same in each case. That’s correct as far as it goes, I think.

      But there is a secondary or portfolio effect, I suggest, as follows. Assuming for the sake of simplicity that the private sector has the assortment of assets it wants before the print money or bond issue, then it will have excess cash after the printing, or excess bonds after a bond issue.

      After the former, the private sector will try to dispose of cash, which will boost AD (still further). After the bond issue, the private sector will try to dispose of bonds and (amongst other things) save cash. That will reduce AD somewhat, though I doubt it would totally negate the initial AD increasing effect of the bond issue.

    6. I agree with Ralph above. There must be some difference with respect to bond sales and ‘printing money’. The yield on Treasuries sets a floor for all other yields. Indeed, the starting point of all lending is the risk-free rate. If the government ‘prints money’ then the risk-free rate is zero, since there are only reserves and no government bonds. In that case, lending rates begin with credit risk with no additional markup created by government bond sales. So the multiplier effect of government spending is enhanced, meaning some combination of higher inflation and output.

    7. I’m no fan of using gold as money mainly because of the waste involved in gold mining and the ease with which gold could be used for money laundering by criminals etc. In principle though I don’t see why gold (or dodo feathers or 1/0000000000 fractions of Van Gough’s sunflowers or whatever) couldn’t be used as a unit for international trade and all currencies be free floating. Currently the gold price is fairly free floating with respect to the various currencies ( Central banks do probably do a bit of loaning out gold to try and depress the gold price). In principle couldn’t say Australia and Indonesia decide to conduct bilateral trade using gold rather than USD? The central banks would not have to be involved and rather than maintaining a certain pegged level of convertability to gold, the exchange rates of the two currencies could shift with respect to gold just as they do now with respect to the USD..

    8. Dear ds (at 2010/11/09 at 21:03)

      You assert:

      There must be some difference with respect to bond sales and ‘printing money’. The yield on Treasuries sets a floor for all other yields. Indeed, the starting point of all lending is the risk-free rate. If the government ‘prints money’ then the risk-free rate is zero, since there are only reserves and no government bonds.

      Which is incorrect. The central bank can pay whatever rate it chooses on overnight reserves and, in doing so, effectively condition the risk-free term structure at any level it chooses – zero or otherwise.

      best wishes
      bill

    9. Thank you for the reply Prof. Mitchell. I agree with you, but if you compare the policy of direct spending with a zero rate on excess reserves versus selling longer-maturity bonds at ‘market rates’, then would not the former be more expansionary than the latter?

    10. Bill

      Surely the text book description of monetization reflects the realities? If you monetize by spending without borrowing then the banks are stuffed full of reserves, interest rates are too low for an effective monetary policy if you need it and you continue to spend without borrowing making the situation daily worse and worse?

    11. The text book model reflects whatever lies are necessary to promote neo=liberalism.

      Reality or truth have never beeen rated high enough to warrant attention amoung neo-liberals.

    12. “then the banks are stuffed full of reserves, interest rates are too low for an effective monetary policy”

      Did you read the bit above about paying interest on reserves?

      In a non-convertible fiat system why are bonds so magical whereas interest on reserves is not?

      And then there’s the argument about what use monetary policy is. Why can’t interest rates be left at zero and demand managed more surgically with taxation measures?

    13. With respect to the Euro it is claimed that the deficit countries (like Greece) have to undergo internal deflation to get rid of the trade imbalances within the Euro structure. Why can’t the surplus countries within the Euro, like Germany, simply increase the cost of their labour (making their exports less competitive and encouraging imports). This can be done by raising the minimum wage and by increasing payroll taxes on domestic producers, then reinvesting this via direct government spending on infrastructure and to promote new industries.

    14. Is there any effect on bank capital positions as a result of QE2? By flattening the long-term interest rate curve, are the prices raised on more poorly performing, but higher rate bond assets, thus strengthening bank balance sheets?

      I think the Fed must know that swapping bonds with reserves is a meaningless exercise and rate reductions aren’t going to increase lending to the productive economy.

      But the increase in lending to fuel commodity speculation isn’t coming from reserve increases, but there appears to be an increased capacity to lend to the investment banks, hedge funds, etc. Where is the source of this increased capacity for this lending (if there is any)?

    15. I also find it amazing that nations like China and Germany are now lecturing the Americans for “living beyond their means” and demanding the US government cuts back on US demand. If the US did cut back on demand for imports then where are these export goliaths going to make their money from? Answer: this posturing is total hypocrisy.

      German Finance Minister Schauble:
      Germany’s exporting success is based on the increased competitiveness of our companies, not on some sort of currency sleight-of-hand. The American growth model, by comparison, is stuck in a deep crisis… The USA lived off credit for too long, inflated its financial sector massively and neglected its industrial base. There are many reasons for America’s problems-German export surpluses aren’t one of them.

    16. @Robert Dudek
      This is a joke or? Although a good one. 99% of economist consiglieri would hyperventilate. They would be all over the place with dire warnings about looming economic armageddon. And most of the media would accomodate their crazy concerns with headlines about tomorrow the sky is falling. The employer associations would try to tear down the fence of the Bundeskanzleramt. The German economic religion has only two commandments: (1) you shall export and (2) you shall not inflate. Haven’t you read the latest wisdom coming from our finance minister Schäuble: German exports are not a problem at all. They are simply the result of German people being so industrious. Translation: all these lazy indulgent foreigners should get their act together and start hard working. As a resident of Germany I can only tell you: we’re at the mercy of some mercantilist lunatics.

    17. Stephan says:
      “This is a joke or?”

      Not completely out of the blue.

      Sanctions from Brussels
      New EU Rules Target Countries with Export Surpluses

      Countries that have chronic import or export surpluses — such as Germany — can expected to be fined under the new rules, which will be announced Wednesday.

      According to draft regulations drawn up by Rehn’s agency, countries with chronic current account surpluses or deficits (in other words, countries that export far more than they import, or vice versa) are to pay an annual fine amounting to 0.1 percent of their gross domestic product (GDP), because they threaten the stability of the euro zone.

      The proposal calls for countries with imbalances to be given early warnings and reprimanded. If their accounts remain out of balance, the European Commission will make political recommendations for their financial and economic policies, as well as for wage increases and structural reforms.

      According to Rehn’s plans, all EU countries will have to introduce binding medium-term financial planning along with financial policy rules that are modeled after Germany’s so-called debt brake (an amendment to Germany’s constitution that requires the government to virtually eliminate the structural deficit by 2016). Rehn says that the objectives of the Stability and Growth Pact now have to be “adopted as national legislation.
      http://www.spiegel.de

      It will of course newer pass, specifically Germany would veto it, in one way or the other.

    18. Thanks Bill. Extremely informative as always and thanks for the repetition. It is important.
      I am still struggling somewhat with reserve accounting and am trying to get a handle on how it works in the UK.

      From an article by a former MPC member in late 2009 I understand that member banks are required to predict average reserves for the subsequent period (month) between MPC rate setting meetings in advance and then get penalised, by the BOE, for deviations outside set margins. The author was suggesting that, as the price and amount of reserves are set in advance this isn’t very clever when things go wrong. Also he suggest that the MPC have no input into how actual OMO’s are put into practice.

      I would be interested for anybody elses views on this and for any additional insight or links to further information on this subject.

      Cheers
      Andy

    19. As a few people above have mentioned, the different inflationary potential between issuing bonds and issuing reserve funds is not in the initial instance of spending for which the new asset (bonds or reserve funds) is created, but in what comes next.

      People’s desire to hold financial assets (bonds or bank balances) will be determined by a number of factors including (1) the interest rate on the asset and (2) the rate of inflation.

      The interest rate on government bonds when traded freely in the market generally always provide adequate compensation for inflation (plus some real return).

      Likewise interest rates on settlement balances also provide compensation for inflation, because the RBA has an inflation targetting policy and keeps the rates above the rate of inflation by design.

      So what is the essential difference? Nothing much. Bonds are much like tradeable term deposits at the central bank. So what is the advantage to be gained by not issuing bonds?

      None. So why does MMT keep going on about it? Unless the intention is to pay a rate of interest on deposits LESS than the rate of inflation, in which case the situation is now totally different.

      This is what people argue when they point out the dangers of monetisation. We’re seeing this situation unfold in front of our very eyes now in the US. Interest rates are less than inflation, which means real interest rates are negative (note the negative yields seen on inflation-linked bonds recently).

      What is happening? People do not want to hold as much in US dollars, and money is moving into other assets like commodities (gold, silver, oil etc), other currencies (eg AUD).

    20. peabird “the increase in lending to fuel commodity speculation isn’t coming from reserve increases, but there appears to be an increased capacity to lend to the investment banks, hedge funds, etc. Where is the source of this increased capacity for this lending (if there is any)?”

      -Bill did say that reserve increases reduce the interest rate at which banks can profitably loan out money. Isn’t that the critical determinant of the amount of profit leveraged day trading can make? The more profitable it is the more the banks will lend to it.

    21. Gamma ” Unless the intention is to pay a rate of interest on deposits LESS than the rate of inflation, in which case the situation is now totally different. “-

      Isn’t it more relevant to compare interest rates to asset price inflation rather than to consumer price inflation? When people decide to remortgage their house to buy a second “investment property” the relevant comparison is between house price inflation and the mortgage rate. Similarly with stocks or gold or farmland or whatever. The price of TVs or milk doesn’t seem related to that decision as far as I can see.

    22. “What is happening? People do not want to hold as much in US dollars, and money is moving into other assets like commodities (gold, silver, oil etc), other currencies (eg AUD).”

      People will continue to save if they are saving. There is much more at stake than the interest rate. Fear of the future overcomes all the financial mumbo jumbo in the world.

      Moves in asset prices are driven by speculators who think they know what is about to happen (or are trying to flush out the ‘greater fools’ who really don’t know what is happening). They have dragged up assets hoping to offload them and pocket the difference based on the supposed ripple you’ll get when the money turns up.

      In Japan when they started QE, shares shot up 17% for a few months and then crashed 40% over the next two years once people realised that nothing much had happened in reality.

      AFAICT there doesn’t appear to be any theory corroborated with evidence that can predict when people will move from net saving to net spending in aggregate. The mechanism by which savings are turned into more spending appear to be conjecture at best and pure religious faith at worse.

    23. Observations/Questions:

      1) To be fair, Bernanke, in his WaPo explanation, did at last (in the last paragraph) explain that QE2 was being done solely because Congress was refusing to do its job. (Everything prior to that paragraph was apparently there just to prevent folks from getting to that last paragraph.)

      2) As “the Eurozone is running a version of the Gold Standard”, isn’t the US also running a version of the Gold Standard, only substituting tax collections for gold? Isn’t that the objection to stimulus, that it would in effect violate this “Tax Standard”?

      3) Isn’t what is happening here is that the entire world is being held hostage to a system whose primary function is to insure stability of prices for rich folks’ assets, regardless of the pain it causes the rest of us? Aren’t we then really talking basic class warfare?

      4) Can Zoellick’s proposal properly be viewed as a move closer to the hyper-feared One-World currency (i.e., precursor to One-World government)?

    24. The (gold bug) blog “jesse cafe americain” says today “The problem is not that dollars are being created but rather that they are being created and diverted over to unproductive activity including war, fraud, and speculation.”-

      -That doesn’t seem far from the MMT position either.

    25. Even if the incomes are flexible in less competitive countries, loans are nominal-they are not served in human labor hours. Gold is leaving the country that has a trade deficit, meaning there is going to be less money around to serve the same amount of debt. There could be inflation in countries with trade surplus and deflation in countries with trade deficit.

      Is Ron Paul now at the BIS? :)

    26. Benedict@LargeCan Zoellick’s proposal properly be viewed as a move closer to the hyper-feared One-World currency (i.e., precursor to One-World government)?

      -Isn’t Stignitz advocating using the SDR basket of currencies as the means of exchange for international trade? If the allocation between the currencies was on the basis of each nations population size (rather than economy size) then that would seem to me to me to be much more sensible and sustainable than the current system of USD being used for international trade. If gold were used for international trade and every currency was free floating with respect to gold then the big problem would be hoarding and manipulation of gold holdings. The idea of each currency being pegged either to each other or to gold seems to me a quite different issue than whether or not to use gold for international trade (pegging currencies is clearly a bad idea).

    27. re: gold/SDRs

      An international trade currency only works if domestic currencies are pegged to it.

      The currency that you buy a good with is not important, it’s the currency that you store your surplus in that matters. If international trade was settled in X, you would still have the problem of exporting nations obtaining X and then selling them for dollars in order to buy dollar assets. It would just be an extra step.

      The exporting countries do not want dollars per se, what they want is to suppress domestic consumption and subsidize domestic investment as part of an investment led growth strategy. I.e. the strategy is based on requiring dynamic inefficiency — e.g. capital is too cheap, and consumption is too expensive, so that both do not grow together in a balanced way. This is a means of supercharging growth over the short term. And this strategy can work, at least for a period of time.

      That necessarily means that they will have too much capacity to service their domestic market, so there is a requirement to export. Once that requirement is set, then they will store their surpluses in any currency that has a sufficiently deep and open capital market to absorb it. That role is now played by the the U.S. and to a lesser degree the Eurozone. But the casual chain goes from domestic policy to a desire to run a current account surplus to a decision of which foreign capital is the easiest or most feasible to accumulate.

    28. @/L
      Another good joke ;-)

      I read that too. Forget it. Won’t happen. Not on Merkels watch. Look Germany lost the 1st and 2nd world war. And now it is the ruler of Europe. What an irony? You don’t have to mobilize your resources to build tanks and submarines and convince your population to march. Instead you simply invite a lot of European brothers to join the club. Once the club is in place the first item on the agenda is a common currency to avoid the hassle with membership financial transactions. Then you turn around export like there’s no tomorrow and let the rest of the world know very loudly how many idiots joined the club. I don’t think Kohl intended this outcome but eventually this is the story.

    29. Assuming for the sake of simplicity that the private sector has the assortment of assets it wants before the print money or bond issue, then it will have excess cash after the printing, or excess bonds after a bond issue.

      Who is this private sector? Households hold the types of assets that they want, firms and government sell the types of the liabilities that they want, and the financial sector absorbs the difference.

      Government is not seizing bonds from households, but selling them to willing to buyers at indifference prices. That means that if the household is willing to sell the bond, then they already have some other investment opportunity to buy, otherwise they wouldn’t sell the bond at that price.

      Alternately, if the household wanted to sell the government bond and consume, then it can do so at any time, as the bond is liquid, without selling it to the government per se. A government bond is as liquid as cash, arguably it is even better than cash.

      If the household sector has $500 Billion in, say, 5 year treasuries, that does not mean that $500 Billion of consumption has been deferred for 5 years, anymore than if the household sector holds $500 Billion in currency.

      When one household wants to consume it sells the bond to another, who sells it when it wants to consume, etc. If every household wanted to consume more, then the bonds could circulate more quickly, and they could circulate less quickly if households wanted to consume less.

      The quantity of assets, in and of itself, doesn’t give you enough information unless you know how quickly those assets circulate.

      But changing the quantity of government bonds as a result of market auctions is not going to cause households to spend more or less, nor will it cause them to hold more or less deposits, or to invest more or less. Rather, it will hit the asset side of the financial sector, as banks would still need to offer households the option of holding commercial paper, equity, or bond liabilities in order to obtain enough household creditors once household deposit demands have been met. But the same banks would be forced to hold more deposits with the CB in the form of excess reserves.

      That is not to say that there aren’t foreign sector effects, or interest rate effects, but you don’t see quantity effects with liquid assets.

      The error is in assuming that the velocity of circulation is fixed, or in the case of bonds, that households must hold them to term prior to spending. I would similarly argue that Bill’s error is in assuming that household deposit behavior is fixed, and that they cannot force surplus deposits back on the financial system by means of purchasing financial sector commercial paper, equity, or bond claims.

      But neither of these two parameters is fixed, at least not under our current institutional arrangements. And trying to take that freedom away by either making bonds non-marketable or not requiring that bank compete with each other to obtain market funding would be extremely harmful — independent of how much, if any, government bonds are sold.

    30. Dear Bill

      Extremely interesting blog. Thankyou.
      Just started diving into MMT, and loving it. Great to discover it’s our money after all.

      Question.

      Why do you think Zoellick is describing a gold standard?

      “The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”

      That system wouldn’t have currencies backed by gold, would it? To measure market expectations of future currency values, surely he’s talking about currencies floating against gold.

      I believe what Zoellick is describing is a system where a deep, liquid, international “currency” is used to store international trade surpluses. That surplus store is internationally recognized, internationally fungible, and cannot easily be impacted by national currency adjustments. It could also be used by any individual worried about inflation caused by national currency issuance. I hate to dig up the barbarous relic in a MMT discussion, but that deep, liquid, international currency would be gold wouldn’t it?

      I guess I’m wondering what the implications of this idea are. If gold was re-valued up to the point that it stored trade surpluses, and removed that role from the current reserve currencies (and re-capitalized central banks in the process) would that make it easier for nations to administer their currencies to their national advantage (using MMT of course)? Would it resolve the Triffin dilemma?

    31. RSJ:


      If the household sector has $500 Billion in, say, 5 year treasuries, that does not mean that $500 Billion of consumption has been deferred for 5 years, anymore than if the household sector holds $500 Billion in currency.

      It means exactly that.


      When one household wants to consume it sells the bond to another, who sells it when it wants to consume, etc. If every household wanted to
      consume more, then the bonds could circulate more quickly, and they could circulate less quickly if households wanted to consume less.

      There are two problems with this fantastic world description:

      1. No matter what the circulation velocity is, the cumulative consumption will be deferred by the bond maturity term. Imagine two people switching one year bond ownership with one microsecond ownership duration, or whatever. Neither of them can consume for half a year during the bond life or one year total.

      2. The bond-to-cash, and vice versa, transaction cost is rather substantial. E.g. TD Ameritrade charges $10 or so. So, after 10 exchanges, the two households playing the shell game would lose $200.

      An associated transactional complication is varying bond price due to interest rate fluctuation and changing cash flows.

      Hence, the T-Bond != cash.

    32. VJK,

      No matter what the circulation velocity is, the cumulative consumption will be deferred by the bond maturity term.

      I’m trying to make sense of this statement — how much time does it take to consume? In what sense is consumption deferred? I have some bonds. I sell them for cash and buy a car. In the process of doing this I supply income, equal to the value of the bonds, to others — some to the auto-dealer, some to the auto employees, etc. That supplies them with enough income to purchase the bonds I sold. A week later, they can sell their bonds and buy something else.

      You are not deferring consumption, you are deferring the purchase of consumption, which doesn’t take very long at all.

      The bond-to-cash, and vice versa, transaction cost is rather substantial. E.g. TD Ameritrade charges $10 or so. So, after 10 exchanges, the two households playing the shell game would lose $200.

      Of course! But if you want to talk about the real world, then what would really happen is that households would purchase bonds in their retirement account while simultaneously taking out an auto loan. They would also contribute to their employee stock purchase program while simultaneously taking out a mortgage to buy a house. They would also carry credit card balances, etc. They care about their net-worth and do not actually need to buy and sell securities at all times.

      But the net effect of all of this is that no consumption needs to be deferred, only the actual purchase times need to be deferred until the transactions settle. That is basically insignificant as a barrier to consuming.

      I can tell you, for example, that when I get a stock grant from my employer, I am not deferring consumption permanently. And when I sell the stock to someone else, they will not be deferring consumption permanently, either.

      It is always dangerous to count assets and imply that this represents a deferral of consumption. What assets represent is an expected stream of future cash-flows, not a present stream of deferred consumption.

    33. Thanks to Bill and the other excellent commentaries. I am slowly coming to terms with the operation and intended purpose of bond markets.

      It seems the intended (or most publicised) social utility of the bond market is to provide the lowest risk of return for retirement savings “A safe haven”. I suppose there are other requirements of saving for deferred consumption (e.g. saving for a rainy day). For the privileged few, they may be saving for the next generation to enjoy. I believe saving for retirement has primacy of purpose.

      There is an obvious practical need to forecast future returns relative to price inflation. It is a deep seated psychological requirement for these future outcomes to be as stable and predictable as possible. For those with savings they do not to intend to consume in one lifetime, asset inflation will also be an important concern.

      Gamma brought up a point that really interested me. “Bonds are much like tradeable term deposits at the central bank. So what is the advantage to be gained by not issuing bonds? None. So why does MMT keep going on about it?”

      The disadvantage of the Bonds market to me is this. The retirement savings of many honest hard working individuals are placed into the voracious hands of the financial services sector. Every cent made bond trading, every fee made shifting financial assets around will deprive the “honest” worker of his retirement savings. There is little social utility provided, but a small number of leeches are made deliriously content. To compound the already bad issue, they invest fortunes mis-educating the world that Governments borrow from bond markets. This gives them great power to distort bond markets and profit immensely. The bond markets and mechanisms are deliberately obtuse and difficult for the average man to understand.

      How does MMT address the important issue of saving for retirement. I’m not sure, I don’t recall reading anything on that specific point. (Shame on me, if I just overlooked it)

      I propose creating a National bank or simply create a Government account similar to CPF cash accounts in Singapore. All pension savings (e.g. superannuation) would be credited to this account. All citizens would be entitled to a basic pension plus an annuity calculated from superannuation payments, top ups, CPI and the retirement age. Discretionary cola payments would be made to pensioners dependent on the status of excess capacity in the economy.

      This would be an incredible boon to most of the citizens. For participants in the scheme, anxieties over means tested pensions, future inflation, stock market performance, bond yields, house prices etc etc would be significantly reduced. Wage negotiation power would be restored as the fear of job loss is diminished. There is nothing to preclude the financial sector and other individuals searching for risk rewards from other investments. However, the financial sector would be precluded from profiting from the lowest risk returns offered by Government.

      This is an incredibly powerful option open to the issuer of a fiat currency. Completely ignored by the common man who would benefit most. Before anyone says, I understand political realty. I’m not holding my breath for it to happen. It’s just one stunningly good idea nobody thinks about much.

    34. Gamma: “So what is the advantage to be gained by not issuing bonds?

      “None.”

      What about economic inequality? To be sure, some creditors are pensioners and ordinary investors, but issuing bonds funnels money to the creditor class. Why should we do that, just to have some money?

      Also, isn’t it stabilizing to have relatively permanent money? Wouldn’t it reduce variability? Perhaps that would reduce the effectiveness of monetary policy, but, OTOH, wouldn’t it also reduce the need for it?

      And what about the politics? The national debt scares people, and is used politically to undermine social programs. If we do not increase the debt when we run deficits, wouldn’t that reduce (and eventually eliminate) that fear?

    35. Andrew Wilkins said:

      “How does MMT address the important issue of saving for retirement. I’m not sure, I don’t recall reading anything on that specific point. (Shame on me, if I just overlooked it)”

      If people don’t have enough hours of work they cannot save for their retirement.

      By allowing everyone that wants a job to have a job is one way to solve the problem (Job Guarentee)

      By not running government surpluses when there is excess capacity and forcing the non-government sector to spend via credit is another way that MMT will allow people to save for their retirement.

      If the current account is in deficit and the government runs a surplus then the non-government sector must be in deficit and therefore cannot save.

      How you could have missed this part of MMT is completely beyond me.

    36. Alan,

      I get everything you said there.

      To clarify. I am interested how MMT manages the purchasing parity of retirement savings relative to CPI.

    37. RSJ “An international trade currency only works if domestic currencies are pegged to it. The currency that you buy a good with is not important, it’s the currency that you store your surplus in that matters.”-

      In principle couldn’t there be a system where international trade was conducted using say cowerie shells, SDR, gold or whatever but individual companies or merchants always converted back to their own national currency to store value?

    38. Would it work if the world bank issued a fiat currency with a fierce negative interest rate (say -10%) such that it was never used as a store of value? But trade treaties meant that that currency was what was used for international trade. People would then convert to that to do the trade and convert back again straight away. It could all be administered on a not for profit basis.

    39. Stone,

      In principle, don’t worry about any intermediate currencies such as seashells. Either you allow a nation to purchase financial assets of another nation or you do not. If you do not allow it, then all trade become pairwise barter, which makes it difficult to conduct global trade. If you do allow this, then either the exchange rate is fixed (or somehow administered) or the exchange rate is floating. If it is fixed, then you lose currency sovereignty, which is bad. If it is floating, then you open the door for one nation to export consumer price deflation/asset price inflation to another, which is also bad.

      The MMT solution is to make it floating, and then just argue that these price distortions are not in fact, bad, but a “benefit”.

      There is no easy solution here, only trade-offs.

      But you can at least be honest about things, and recognize that any price imbalance is harmful. If one nation is suppressing their own labor and subsidizing capital, then via the export channel they can also promote an imbalance in your own economy. In that case, you need to counter somehow. The goal should be to maintain sovereignty, not only of your currency, but also of your economic management.

      There are many options — e.g. tariffs for environmental degradation, or for subsidies to production, for excessively low interest rates, or for poor labor practices, etc. None of the options are particularly good, but then is no good option when a nation decides to waste resources in order to satisfy some domestic agenda.

      But it is better to recognize the trade offs instead of putting your head in the sand and pretending that you are receiving some benefit in the form of artificially high asset prices and/or artificially low consumption costs. The idea that there is some santa claus that will drop down and give you free consumption goods with no harmful effects is about as intellectually honest as the household budget analogy.

      An economy is not children receiving stuff, but a collection of feedbacks and trade-offs in which the price of any consumption good needs to represent the cost of producing that good in a sustainable way. If that isn’t the case, then either too few or too many resources will be allocated towards producing that good, with the result that the economy will not produce the things that households need at a price that they can afford to pay. Similarly, the discount rate of capital needs to be equal to the highest return that the use of resources can supply. This is because loans create deposits — dissaving is not a voluntary agreement between savers and investors, but the granting of a claim on real resources that could have been used by someone else. Therefore borrowers should only be able to do this if they can offer the best possible return for those resources, not just any return.

      A good example is the situation between Germany and Greece, since these are two different economies that were forced to use the same currency. The Greek currency should have fallen against the German currency sufficiently enough to roughly bring trade back into balance. But that didn’t happen, and so Greece “enjoyed” the benefit of subsidized German goods for years, and both the Greek and German economies adjusted to these prices.

      When the crisis came, Greek citizens suddenly discover that they cannot afford to buy German goods that were effectively subsidized, whereas German firms suddenly realize that without these subsidies they cannot remain profitable. If those subsidies were never supplied, then perhaps Greece could have developed their own industries to supply goods at the more natural higher prices (in Greece, relative to Germany), and those industries would be profitable. Then no one would be talking about Greek labor costs needing to fall.

      Similarly, if Germany had increased wages high enough so that Germans could afford to buy the goods that they produce, then German firms could have become truly competitive, instead of being reliant on artificially high export income (From Greece, in relation to Germany).

      No one receives a benefit from false price signals, and the adjustment forces both economies to contract. Everyone suddenly discovers that the current use of resources is not economically profitable, and liquidation ensues. Firms made long term irreversible investments based on artificial cost and revenue projections. Similarly households agreed to accept wages based on an artificial estimate of their purchasing power. It’s already hard enough to do that right without making it more difficult.

      The problem of maintaining true sovereignty while trading with others is a difficult one, and I wish the MMT proponents would take it seriously, instead of treating the situation as one of children receiving Christmas presents from a German or Chinese Santa. But seashells or gold wont get you a solution.

    40. RSJ “The problem of maintaining true sovereignty while trading with others is a difficult one, and I wish the MMT proponents would take it seriously, instead of treating the situation as one of children receiving Christmas presents from a German or Chinese Santa.

      The problems you describe are those that come from for instance USD being accumulated in China aren’t they? I totally agree with you about the mess that that situation is creating.

      “Either you allow a nation to purchase financial assets of another nation or you do not. If you do not allow it, then all trade become pairwise barter, which makes it difficult to conduct global trade”-

      Do you think international trade using a world bank issued fiat currency with a severe negative interest rate (so as prevent it from being used for saving) would be workable? Basically from what I can see, so long as everyone only saved in the currency of their own nation, then the floating exchange rate system would start working better. Having the intermediation of the “international trade only” currency would avoid the pairwise barter scenario. The world bank would buy and sell the “international trade only” currency for as many USD or Yen or whatever as it took to prevent the world bank from having any accumulation of any nation’s currency.

    41. RSJ:


      I’m trying to make sense of this statement — how much time does it take to consume?

      It does not matter how much time it takes. The point is one cannot consume for the simple reason one is saving at the memnt by the very act of holding a bond (or any other security or a gold bar).

      You are not deferring consumption, you are deferring the purchase of consumption, which doesn’t take very long at all.
      “deferring consumption” == “deferring the purchase of consumption”, obviously.

      households would purchase bonds in their retirement account while simultaneously taking out an auto loan.
      That would be an unreasonable financial decision that would result in a net loss due to unfavorable interest rates interplay between the instruments. Not that decisions like that do no happen, but they can hardly be used to prove the point.

      They would also contribute to their employee stock purchase program
      They would not because the would have spent the money on the bond and there would none left for anything else but the barest necessities ;)

      Mortgage and other kinds of voluntarily digging oneself into a deeper hole through more debt is not a good recommendation for responsible behavior in these interesting times.

      But the net effect of all of this is that no consumption needs to be deferred
      A cheap shot would be to point out that a lot of American(and not only) households subscribed to this idea wholeheartedly.

      The simple point is that various kinds of securities other than cash possess specific characteristics one of which is consumption deferral. When one starts to blur the differences intentionally, then literally everything becomes “cash” as everything can be exchanged for anything, assuming frictionless market, thus reverting to barter economy.

      We can drop it at that since obviously we’ll remain unconvinced by each other arguments.

    42. VJK- If holding any asset incurred a tax, then wouldn’t that accentuate the special value of cash because the tax could only be paid with cash and so the “frictions” that you mention involved with getting hold of cash by selling assets would keep asset values from straying too far above available supplies of cash?

    43. I guess a big complicating factor in international trade is multinational companies. My better half is employed in the UK by a German company registered in the Netherlands that gets most of its earnings from selling to the USA. I suppose that that is fairly typical now.

    44. VJK,

      I am not saying that bonds are exactly the same as cash, I’m saying that they can be quickly and easily sold for cash, or in the case of government bonds, that cash can be borrowed with the bonds as collateral.

      This property negates the argument that changing the quantity of bonds (or stocks, or any liquid asset) can force a certain amount of savings or consumption to occur.

      “If we increase the supply of money, then people must spend it in order to dispose of excess money balances. If the government buys back bonds, then households must increase real investment or consumption, since they wont be able to park their money in government bonds.”

      The causation runs in the other direction.

      For the sake of argument, if a household plans on spending $10 tomorrow, and $100 next year, and $1000 10 years from now, then they might hold $10 in a cash, $100 in bonds, and $1000 in stocks, based on whatever their preferences happen to be. And suppose this is the proportion of assets in the economy.

      Now assume, for the sake of argument, that government or some other entity somehow changes the underlying asset to be $560 in cash and $50 in bonds, and $500 in stocks.

      That does not mean that households will spend $560 tomorrow, $50 next year, and $500 10 years from now. The reason why is the velocity of those assets will change, rather than having the expenditure plans change.

      In the other direction, if the government changes the asset mix to be $1, $500 and $519, then still household expenditure plans wont change. The velocity will change instead.

      And the second example is the normal case, as the government typically drains cash, but the size of MZM continues to roughly follow the cumulative total of government deficits.

      In this second case, your argument — basically that it would be silly to sell bonds to buy chewing gum because of the transaction costs, etc., is beside the point.

      In reality, there will be plenty of intermediaries that would be more than happy to bear the duration risk and transaction costs in exchange for the interest income of the bond. They will supply households with the zero maturity assets they want. We have specialization of labor, so the auto worker need not become a bond trader in order to get paid when someone sells bonds to buy a car.

      Regardless of what the actual securities are, what households end up holding is a function of their preferences and expenditure plans. This is not to say that there aren’t interest rate effects, but there are no quantity effects. Households will continue to hold $10 in zero maturity assets, $100 in intermediate maturity assets, and $1000 in equity assets, even as the CB thrashes about trying to decrease the quantity of bonds and increase the quantity of cash in order to get households to spend more.

    45. Andrew Wilkins said:

      “To clarify. I am interested how MMT manages the purchasing parity of retirement savings relative to CPI.”

      By actually allowing people to accumulate savings in the first place MMT is well ahead of the alternative.

      Where people invest those savings is entirely up to them I would think.

      As for tying performance to the CPI that’s easy enough – just change the composition of the basket of goods – the conservatives worked that little trick out years ago.

      You appear to seek perfection from MMT before you will validate it and yet are willing to accept mass unemployment and a widening gap between rich and poor under the ne0-liberal regime.

      How does neo-liberalism manage the purchasing parity of retirement savings relative to CPI.”

      Answer: By creating mass unemployment, underemployment, instabillity, uncertainty, asset bubbles, inflation, deflation, depression, recession, war, famine, wealth polarisation…….and so on.

    46. Alan,

      You are completely off the mark with my intentions. I have no idea how you came to your conclusion. Did you even read my post?

      I am fully aware that MMT allows net saving in the private sector. I am 100% supportive of full employment. I am not seeking perfection. In fact I am proposing a pension system very similar to a real and practical application in Singapore. The CPF system.

      The major differences between my proposal and CPF are:

      1) Instead of access to CPF accounts in tranches at retirement milestones….. Provide an annuity.

      2) CPF can be used to pay mortgage and make investments in stocks etc…… I would not allow this. It was not allowed in CPF in it’s earliest form, until the neo-libs got their hands on it. Causing great asset and stock price inflation.

      3) I would moderate CPF annuities and variable payments in tune with economic developments. This is needed to stabalise Government deficit (or surplus) spending. This would have to be harmonised with other programs such as JG.

      Maybe you don’t get the proposal because you do not have a clear understanding of the CPF system in Singapore and the opportunities that it gives to a progressive Government. Even though Singapores CPF policy has been hijacked by Neo-libs, it’s still an excellent case study and a potential building block for better societies in the West. I urge you to think a bit harder before dismissing these ideas.

    47. Andrew Wilkins, I just read the wikipedia entry for CPF. it sounds like the National Insurance system that was started in the UK at about the same time as the CPF was started in Singapore. The difference is that the UK National Insurance system now only really exists in name only. The hurley burley of party politics we have in the UK has shredded the function of the National Insurance system. I guess that that is a key issue. Perhaps the CPF system has survived in Singapore only because it is a benign dictatorship. In the UK some state employees (such as teachers, police, central government workers, military) get a pension directly funded by the government. I wish that anyone in the UK who wanted to could join in that scheme and just pay more tax in order to do so (as in the original conception of the National Insurance system). I guess the government likes the idea of private pension schemes with stockholdings because they feel that they are responsible custodians for the private sector. The problem is that they are -as (I think) Warren Mosler put it- bloated whales constantly fed upon by the sharks in the markets.

    48. VJK:

      1. No matter what the circulation velocity is, the cumulative consumption will be deferred by the bond maturity term. Imagine two people switching one year bond ownership with one microsecond ownership duration, or whatever. Neither of them can consume for half a year during the bond life or one year total.

      This is something I believed not too long ago, and tried to argue here and on the Mosler site. However, I eventually recognized at least one flaw in this argument …. which is ….. if banks will willing loan funds to any creditworthy customer, and the ability to post a Govt bond as collateral makes one creditworthy almost by definition, then the bond can be monetized at any time by the banking system, with freshly created bank money. Thus there need be no deferred consumption in aggregate no matter what mix of bonds/reserves the Govt initially issues.

      There may be other reasons why the deferred consumption argument is wrong, but this is the one that convinced me.

      Ken

    49. RSJ:

      I may be very well missing something, but fully prepared to be educated.

      Let’s consider actors motivations, perhaps we can see where it leads us.

      Let’s assume you are a treasury holder, either direct or through a mutual fund. The government offers to QE2 your T-holdings:

      1. In what specific financial circumstances (hypothetically of course) you would be willing to sell.

      2. Would you hoard the cash and why. Why would it be more beneficial to hold a non interest bearing instrument ?

    50. Ken:

      It’s not a bad argument, but as wrote before :


      Mortgage and other kinds of voluntarily digging oneself into a deeper hole through more debt is not a good recommendation for responsible behavior in these interesting times.

      In other words, you will sacrifice your future consumption because you will need to repay the debt. It may make more sense to sell the bond outright rather then borrow.

      Whatever way you lay it out, consumption power is diminished in both cases simply because you either save now and therefore cannot consume, or will have to pay with consumption forbearance in future due to the need to repay the loan (or default in which case the argument reduces to the outright bond sale).

    51. VJK: Yes, as an individual actor you have the choice to hold the bond, sell it or borrow against, to spend or to defer consumption. However, the Government isn’t imposing these choices in aggregate by the mix of bond vs reserves it issues, since the bonds can be monetized **if desired**. Doesn’t mean they will be … if the private sector has a desire to net save, it will … if it desires to net dis-save, it will do that as well. The choice won’t be determined by the Gov’t decision to issue bonds vs reserves, so it would be wrong to conclude that one causes inflation and the other one doesn’t.

      Again … a few months ago I would have agreed with what you’re saying, but it seems I’ve drunk the Kool-Aid…..

      Ken

    52. Ken:

      Of course, everything will depend on your investment preferences after you have decided to QE2 your bond.

      The simple accounting fact is that the former bondholders will become cash-holders, willingly.

      What they will do with the newly acquired cash is not altogether clear.

      They may compete for the same pair of socks, as someone put at Mosler’s site, they may increase “aggregate demand”, they may hoard, they may combine all of the above in some proportion. Who knows.

      The show is starting tomorrow with the first $6B.

    53. VJK,

      Would you hoard the cash and why. Why would it be more beneficial to hold a non interest bearing instrument ?

      You would not hoard cash. I ignore currency entirely, as it moves according to more or less its own factors, and currency demand is irrelevant to macro considerations in a modern nation with deposit insurance.

      I would consolidate all the financial actors into a big “F”, and assume that instead of holding cash, the non-financial sector holds some form of deposit claim on F, with all the cash held only by F. This deposit is a non-interest or low interest bearing instrument, and the reason for holding it is the utility provided. No need to sell bonds first, no risk of incurring a capital loss, and very low transaction costs. Even if you hold cash in brokerage account, when you signed up for the account, you designated what “cash” would be, and it was some form of money market account. There are no trucks filled with currency zooming around as you buy and sell securities, but for the non-financial side or retail side, bonds are converted into deposits and vice versa, and cash-settlement occurs within F, but is invisible to the investor.

      Banks earn money by providing deposits in exchange for the interest income relinquished by those who purchase the deposits, so that the flow of utility provided to households is paid for by the net interest income earned by banks. This is the value that they provide (in addition to the general value of providing financial services).

      As an aside, this is why it would be harmful to allow banks to fund themselves entirely with overnight CB loans, or why it is wrong to try to force individual banks to not be subject to market competition for funds when they cannot on the margin, obtain deposits.

      Banks should only be able to borrow short and lend long to the degree that households are willing to relinquish long term assets in exchange for the utility and safety of the short term assets — when the utility benefit of the service that banks provide is equal to the net interest income that banks receive (net of loan losses and other expenses).

      As soon as banks start to compete with households by using CB funding to buy assets that households would prefer to own, then they are earning net interest income in excess of the utility provided, and are destroying value. Here, I do not just mean purchasing third party assets, but even the loans that banks originate:

      When F makes a mortgage loan for X, someone in the non-financial sector incurs, say, a 10 year liability for X, and someone else in the non-financial sector receives income equal to X. The one receiving the income can force, at the margin, banks to sell bonds or issue longer term assets if the recipient does not want to keep X as a non-interest bearing deposit. So if the non-financial sector has a lender that wants to lend for 10 years, and a borrower that wants to borrow for 10 years, then all that the banks should do is make a loan to the borrower and sell a covered bond to the lender. They should intermediate as little as possible.

      Only to the degree that there is a discrepancy between those who want to borrow for 10 years, and those who want to store their wealth in 10 year assets should the bank earn money from the spread. In general there will be some discrepancy, so there is a “right” amount of net interest income that banks can earn, but this amount is bounded by the convenience benefit received by households — it is small.

      But if banks are allowed to fund themselves by rolling over CB debt and are not subject to market discipline on the liability side, then they could, in theory, force the non-financial sector to store the income as deposits. Then you get into financial repression and misallocation of capital.

      In that case, banks are no longer matching willing borrowers to willing creditors, but are competing with creditors. In this way, they siphon off interest income from the productive sector in excess of the utility provided; that is a wealth transfer from households that do not own banks to the smaller group of households that do.

      I’ll post a response to #1 later.

    54. They may compete for the same pair of socks, as someone put at Mosler’s site, they may increase “aggregate demand”, they may hoard, they may combine all of the above in some proportion. Who knows.

      It’s the proportion of allocation that counts. The presumption is that since the bondholders that cash out were savers rather than consumers, the probability is that most will continue to save in some other asset form, more likely a financial asset rather than a real one, since bonds are highly liquid financial assets. One effect of QE is portfolio shifting. Since the amount of lower risk financial assets has declined through Fed bond purchases, the presumption is that risk will increase through portfolio shifting. This indeed seems to be the intention of the Fed in pursuing QE2.

      The Fed is presuming that there will be a change in asset composition from low risk to higher risk, specifically from bonds to equities and probably some speculative RE that has been greatly discounted. I don’t think that the Fed expects QE2 to result directly in increased NAD through consumption for saving but rather due to an eventual wealth effect resulting from a “bull market” in equities and rising housing prices.

      This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
      — Ben Bernanke, Washington Post op-Ed, Nov 4, 2010, What the Fed did and why: supporting the recovery and sustaining price stability

    55. Strikes me Tom that the people who sell out of bonds would be selling out anyway and the buyers in the bond market at the time the Fed intervenes will just pay a higher price and get a lower yield – selling their current assets for a higher price at the same time – probably to the people selling out of bonds.

      I doubt there will be any composition change, just a general rise in asset prices until the percentage of cash drops to what it was before. A silly merry-go-round.

    56. RSJ:

      Thanks for you input, especially wrt the bank “aside”.

      Still, I am curious as to #1 and more input on #2 regarding what realistic investment option a hypothetical investor might have on a less consolidated basis(an individual, pension fund manages, mutual fund manager, etc).


      Even if you hold cash in brokerage account, when you signed up for the account, you designated what “cash” would be, and it was some form of money market account.

      Not necessarily. You may choose to have your cash sitting idle in the custodian bank account the broker uses if you are distrustful of a specific money market arrangement (eg ABCP).

    57. Tom Hickey, when Bernanke says, ” And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”-

      -It sounds as though Bernanke’s reason for conducting QE2 is the reason I’m scared of it. I realize some people claim that it will not increase asset prices but if Bernanke is correct and it does, won’t it just raise them up that bit higher above the level that they will duly crash back down to? If rents on farmland or earnings on stocks are unable to rise because of lack of aggregate demand, then investors will all be nervously keeping a finger near the sell button. I guess it will both increase overall asset prices but also increase asset price volatility. Both factors transfer wealth to the oligarchs.

    58. VJK,

      re: choosing a custodial account, then this is just another form of deposit — it’s not currency, and it’s not vault cash, and it’s not reserves. It’s just a claim on a bank.

      re: #1, I wouldn’t think in terms of what an investor would “do” with newly created CB cash. The investors buys and sells to the market, for their own reasons — wanting to spend the money, portfolio shifts, etc. The CB just happens to be on the other side of the trade. I don’t think this line of reasoning will get you anywhere.

      No trade settles bilaterally. You have to start with some equilibrium, then disturb the equilibrium with an intervention, and obtain a new equilibrium. The new state will be the result of many trades. All of this will happen simultaneously, at least simultaneously in terms of any given accounting period.

      For example, a bank makes a loan and creates a deposit. Sure, but that is not the new equilibrium, because the household or business receiving the deposit is not going to keep all of their proceeds as a deposit. The depositor will withdraw money from the bank (or a MMF, or their brokerage account, etc) to buy a bond or longer term investment, or even socks, at which point the institution servicing that account will need to either sell some of its assets (shrinking its balance sheet) or issue more bonds/paper. In this way, the non-financial sector can force the bank to offer non-deposit liabilities and rid themselves of unwanted deposits. It’s enough to withdraw funds from one bank and buy something else. The bank will then shift, offering higher deposit rates, or selling more bonds, etc.

      Therefore the new equilibrium that arises from a bank making a loan is not that the deposits of households increase — that is the specific transaction that generates the disturbance — but the final state reached will be that assets of households increase more generally, with the quantity held as deposits reflecting near term expenditure plans, and the quantity of assets held as longer maturity assets reflecting longer term expenditure plans.

      As another example, suppose the government deficit spends but does not drain with bonds. Just because this specific transaction creates an additional deposit but not an additional bond liability does not mean that this is the equilibrium reached.

      The flow of deficit spending creates profits for the business sector, and this increases their enterprise value, allowing them to sell more bonds or stocks, so that the households have “enough assets” to purchase and are not forced to hold deposits.

      Incidentally, the same dynamic appears when households borrow more and spend some of the proceeds on goods. Some of the deposits created end up transformed into claims on the profits of the goods seller. That’s the example model I promised you :P

      In general, for every disturbance there will be a whole series of responses to that disturbance, and the macro balance sheet will evolve according to all these transactions, rather than just the initial disturbance. In fact, just looking at a macro time series, you may not even determine what, if any disturbances are driving the behavior.

      Back to how I see QE2 playing out:

      Once you accept that the non-financial sector can allocate its wealth into whatever combination of deposits and assets they want, then you see why QE2 is ineffectual.

      1. CB purchases are not going to change the total wealth of the non-financial sector.
      2. Who an investor sells a bond to is not going to change their expenditure plans.
      3. Therefore CB purchases will not change the desired asset allocations of the non-financial sector.
      4. CB purchases will not incentivize the non-financial sector to borrow more.

      In that case, if the CB intervenes by purchasing $X of assets from the non-financial sector, but the non-financial sector does not want to keep the additional deposits, but would prefer to continue holding $X of assets, then by the simple process of making withdrawals and purchases of assets, the non-financial sector can force the financial sector to sell $X worth of assets to them.

      Unless the non-financial sector decides to simultaneously borrow more from the financial sector, then Financial Sector’s balance sheet will remain at the same size, and therefore the $X of asset sales will be realized as outright sales of existing assets, rather than the issuance of net new financial sector debt.

      The assets displaced will not be loans that banks hold to term, but it will be marketable securities that the financial sector holds, and these must be sold to the non-financial sector as it rotates out of treasuries and into some other asset — agencies, munis, commercial paper — who knows?

      Therefore the new equilibrium will be as if the CB had intervened on the asset side of the financial sector, rather than on the asset side of the non-financial sector.

      Households will have neither more nor less money with which to buy stocks or socks.

      Rather, the amount of vault cash and reserves backing household deposits will increase, and the amount of bonds/paper/etc. backing their deposits will decrease. The total amount of deposits will remain the same. The total amount of assets held by households will remain the same, but households will hold fewer treasuries and more agencies/paper, whereas the financial sector will hold fewer agencies/paper and more cash.

      Note that the actual trades need not occur between the CB and the financial sector, but trades do not settle bilaterally.

    59. RSJ:

      re: choosing a custodial account, then this is just another form of deposit — it’s not currency, and it’s not vault cash, and it’s not reserves. It’s just a claim on a bank.

      Right, I misunderstood your statement as the broker deciding where invest the cash. The bank of course is free to do with your deposit whatever it wants.

      The flow of deficit spending creates profits for the business sector
      Are you saying that government deficit spending is the sole way of monetizing profits assuming that households do not want to borrow ?
      (returning to my old question about profit monetization).

      I wouldn’t think in terms of what an investor would “do” with newly created CB cash.
      That’s a pity that you do not want consider QE2 from this angle because I think economists underestimate psychological and behavioral aspect of economic decisions people make and tend to consider economic actors as remotely controlled sheep responding to various stimuli.

      It would be interesting to consider effects of QE2 as a set of non-bank behavioral decisions, the resulting asset re-allocation and attendant price dynamics. For example, I am not convinced that agency(GSE toxic MBS?) paper would be an attractive substitute for government securities, perhaps commodities however irrational the choice might be would be a better substitute for some players thus driving prices of the latter up, or buying a flat screen TV which arguably would improve aggregate demand and stimulate the moribund economy. I am looking at QE2 from the point of view: I sold my bond, have a bundle of cash, now what ? Maybe nothing — and I tend to agree more with you than disagree.

      P.S.
      Of course, the wealth as measured in quantity of government paper will remain the same — it’s simple arithmetic, but portfolio allocation decisions may affect economy in a substantial way.

    60. RSJ:

      Something else was bothering me regarding QE2.

      1. Let’s say Paul buys a 5 year T-note at an auction.

      2. The Treasury spends the proceeds by mailing a check to Peter.

      3. The Feds QE2 Paul’s note.

      4. Paul buys another 5 year T-note at the next auction.

      5. The Treasury spends the proceeds by mailing a check to Mary/crediting her bank account.

      5.The Feds QE2 Paul’s note.

      et cetera ad infinitum.

      With Paul being a conduit between the Treasury and the Feds, does not QE2 reduce to a de facto fiscal policy with the Fed financing government spending ? I know it is a simplistic scenario but still…

      I must be missing some subtlety after having though too much about QE2 human factors ;)

    61. Students learn that the printing money option – called monetisation – involves the government running a deficit with no external debt issued to “pay for it”. What a nonsensical description of the options facing a sovereign government. When the government spends the recipient receives a credit (say a deposit at a bank) at the same time the government credits the reserve accounts that the particular commercial bank maintains with the central bank. There is nothing more to it than that.

      . . .

      The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance. As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.

      ??

      A government in a gold-standard spends by instructing the central bank to transfer funds from its account at the central bank to the recipient’s account. Same for the present system. Plus its a mixup of a proposed fantasy world in which the government deficit spends without considering the external sector. In the Gold-Standard, governments would go into austerity which was a function of the amount of Gold held by the central bank amongst other things. In the present institutional setup, one factor is the balance of payments situation.

      If you assign an exogenous money view to the gold-standard system, then all discussion on international trade is bound to create a confused discussion.

      Robert Mundell had his share of confusions.

      The fundamental proposition of classical international trade theory, that there is an automatic mechanism ensuring balance-of-payments equilibrium, enabled the classical economists to isolate the short-run, dynamic process of international adjustment from the long-run, static theory of international barter. To this analytical separation we owe many of the important theorems that have come down to us from classical economics, and on it is based a good deal of modern international trade theory. This is despite the fact that the history of international economic relations in the past 30 years has not been characterized by a persistent tendency toward balance-of-payments equilibrium; the assumption of automaticity now appears to be an anachronism.

      The decline of automaticity dates from the first attempts of central banks to adjust the domestic supply of notes to accord with the needs of trade (the banking principle) instead of the requirements of external equilibrium (the bullionist principle);

      . . .

      from The International Disequilibrium System Kyklos, 14, 154–172 (1961).

      So Robert Mundell “wanted” the central banks to contract the money supply but recognized that it is endogenous! (though didn’t recognize its significance)

      The confusion comes from literally believing in central banks’s promise of conversion of money into Gold. Of course, one may take a stand and say that central bankers were doing what they were supposed to be not doing etc (but thats mere moral policing).

      The central bank and the Treasury in a fixed exchange rate regime can set the yield curve. (Operation Twist is a proof ?)

      As long as the nation is away from any crisis point, government spending creates demand and increases tax payments and increases in income and wealth chases government securities. So spending can be “independent” of taxes and bond issuance.

      More importantly, in textbook models one sees all settlement of international trade in Gold. However, in reality there were capital flows too! As long as foreigners are financing the trade deficits, a nation can expand demand without worrying about the external sector trade deficits or money supply (upto some point of course!) In the end such systems had to give in with no automatic mechanism to resolve the balance of payments issues. But the same is true for the present system (hence so much talks of currency wars, protectionism etc in G-20). External debt cannot go to some 100% or such huge number – contrary to MMT claims that “imports are costs, exports are benefits” which is trade indiscipline.

    62. Ramanan

      >>If you assign an exogenous money view to the gold-standard system, then all discussion on international trade is bound to create a confused discussion.

      Depending on how exactly we define the word exogenous this appears incorrect. A gold standard private bank which has pre-agreed lines of credit for gold can easily loan 1000 and deal with the demand for gold this creates, when it has no or little gold, to create private deposit money and expand the money supply. This is just normal fractional reserve banking where the amount of deposits is levered against the amount of gold in the system.

      And of course todays system is essentially the same kind of system because principally central bank lending is done via collateral where only a reduction of the value of reserves or a fantasy valuation of collateral can enable more reserves to be issued when in reality the system is objecting to the amount of leverage and wants to return to more fundamental valuations and basic principals of affordability and so forth.

    63. Andrew,

      You are saying that the money multiplier holds in the Gold Standard but doesn’t hold in the present system.

      Careful. Did banks hold Gold – maybe they did – any constraint on their deposits compared to the gold they held ? Or was the rule more general ? Imagine I am a banker owner. I don’t need Gold. I can lend as much as I want as long as I able to finance the deposit outflows.

      … and the central bank – would have no choice but to accommodate the reserve requirements. It is generally said that if the amount of Gold decreases, reserve would also decrease. However in reality, the central bank’s holding of government bonds would go up, or the central banks’ claims on the banking system would go up or both.

      Mundell’s quote above is a proof.

    64. Ramanan

      >>You are saying that the money multiplier holds in the Gold Standard but doesn’t hold in the present system.

      I am definately not thinking i am saying that.

      Maybe i do not understand what the money multiplier is? I thought it was about lending money you have. If i dont have any money but i can borrow money that is not money multiplier theory is it??

      I am actually thinking i am saying that the money multipier has ****never**** valid. System leverage to create money happened and it was followed by busts when the leverage became excessive.

      In the gold standard, countries came off the gold standard if they could not stomache the required austerity after they had become excessively levered.

    65. Andrew,

      Good we agree on the fact that the money multiplier was never valid.

      On the hand, the Gold Standard had to be abandoned because there was no mechanism to resolve the balance of payments problems. So nations would find themselves will continuous reduction in the amount of gold they hold. No amount of interest rate hikes or going into austerity would help. They may have to devalue and/or make discretionary attempts to increase exports.

      On the other hand, in the present system even the United States is facing issues because of external sector. In the present system, of course the landing was hard or soft depending on how you look at it. Also in the present, nations simultaneously took action through fiscal stimulus but of course it has not solved all the problems. Nations are still constrained by the external sector and that includes the United States!

      So different dynamics but many similarities.

      Where did we start – from the usage of the world exogenous. The reason I wrote what I wrote was because the money multiplier was still a credit divisor in the gold standard or any fixed exchange rate system. The specie-flow mechanism didn’t work. Neoclassical economics is not valid in any monetary economy.

    66. Hi Ramanan,
      ” External debt cannot go to some 100% or such huge number ”

      Ive been following your concerns about the external sector, and if nothing else, I must say that it has sensitized my thoughts to pay a mind to the external sector in general and at all times, and thanks for this…

      Is your hypothesis (100%) here based on history or some sort of historic precedence (a la Reinhart/Rogoff) where just based on history, this number seems to have hit a limit before this? Consider here in The West we are probably in the longest recent period without major western powers trying to wipe each other out via warfare…. the now going on 65 years since WW2 that is.

      Maybe times have changed (fingers crossed!), and with this type of relative stability, this number can exceed what is perceived to be it’s long term maximum, previous climbs in this number interupted by open warfare within The West, etc.

      Also, there is the element of corruption, it would seem to me that the larger the number of US Treasury securites held, the easier it would be to hide kickbacks/bribes etc in USD… in the maintenance of those portfolios. Tiny percentages can mean a great deal of money to a small group of insiders, that kind of thing. So foreign govts develop a zealous desire to acquire/maintain USTs to churn.

      I guess I’m positing there may be other than objective/empirical reasons why the apparent 100% limit figure of precedence could perhaps be exceeded (at least for a while until those other factors may re-surface?).

      Resp,

    67. Ramanan

      My thinking is that we do essentially have an identical system operating as was operating via a gold standard. The difference is just that governments can issue money at below its true value. Essentially they have a secret gold mine, so that the true value of gold is much lower than believed. It is surely devaluation when a government supplies money to meet an inflation target over a long period of time? Do we agree that today we have essentially the same fractional reserve system that operated under a gold standard? The only difference being that central banking and supplying money at below true value means leverage and therefore system risk is much much higher? Right now until interest rates go back up to neutral, money is being constantly discounted to prevent deleveraging, where if deleveraging plays out money rises in value so that assets are correctly valued. Are we seeing this similarly?

    68. Matt,

      Yes I have been writing on this for long. Don’t get me wrong – the external debt can go anywhere it likes – it depends on the nation’s creditors. They can allow the game to go on as long as they like. However, in reality nations quickly run into troubles. The only way to pay off external debt is by exporting to the rest of the world. A nation which is building external debt faces the prospects of limited growth because it will be tortured by the currency markets. In order to expand and grow, the only way mostly is by reducing the external debt.

      This is what has been happening in recent times. China is the best example. It is said that the Chinese government played an active role through fiscal policy. However, China expanded because its external situation allowed it to. Most Asian nations followed this strategy and the US acted as the consumer of the last resort. One may think that this is a neoclassical description but its not! Such things have been clarified in the Post Keynesian literature.

      Not that I am advocating that everyone should do what China has been doing and transfer resources to the rest of the world, but this strategy has paid off. Nations which haven’t done this have being left behind. Of course nations can grow domestically as well – but only as long as the external sector allows it to! In a recent post here, it was suggested that twin deficits are a myth. Budget deficits do not cause trade deficits. The statement all alone is not right but the relation between budget deficits and the external deficit is through the how output changes compared to the output in the rest of the world. If a nation has a low propensity to import, it can expand fiscally easily. However if its high, you have situations in which there is leakage. Its also possible that the rest of the world is expanding and in that case it may not happen. So complicated dynamical relationships there!

      How did the US survive for so long? The answer is that the US was once the world’s biggest creditor and now it is the world’s biggest debtor. The US external debt can still go on increasing for some time while they import stuff. Why did it take so long ? It went from a situation where its net external assets was around +30% (?) to about -30/40%. Now there is some debate on the accuracy of the latter number – its called the dark matter problem a phrase which is derived from an analogy with Cosmology where people are clueless about certain matter in the intergalactic space. As it went in that direction, United States’ external assets started earning a lot – a posteriori not surprising since huge returns from FDIs was the main factor. Also interest rates in other nations are typically higher than the US and there are many such complications. (Please note when I talk of external assets/liabilities, I include private sector debt/equity as well – foreigners don’t just purchase both government bonds)

      Why are current account deficits and the external debt a problem ? Firstly given a fiscal policy, imports tend to reduce aggregate demand. Now its difficult to see this empirically directly because at the same time, there are other factors at play such as a domestic debt led expansion – which is what happened in the US. Secondly, the only way to service the external debt is by going into higher debt – a classic road to ruin! However there are ways to escape – become net exporter or through currency depreciation. Now currency depreciation is not always going to do the trick for you – there are complications I am avoiding but suffice to say, discretionary attempts to increase exports need to be taken.

      Now it is said that if the invoices for imports are in the local currency its not a problem. My opinion is that it doesn’t matter. Maybe problems appear more slowly in the case where the invoices are in the local currency but trade deficits cannot continue forever. The external debt keeps increasing forever. It has also been suggested that perhaps growth can stabilize the external debt, but simple calculation gives a revealing picture. A trade deficit of 5% with the assumption that the difference in the growth rate and the effective interest rate paid to foreigners is 2% stabilizes the external debt at 250% of GDP! No country can ever dare go there. The highest is Australia – around 56% (not counting Euro Zone countries some of which have it in the range 80-120%).

      More importantly, the currency invoices are limited to the reserve or the refuge currencies. Australia’s RBA for example provides statistics on this.

      Source_http://www.abs.gov.au/ausstats/abs@.nsf/Previousproducts/5368.0Feature%20Article1Dec%202009?opendocument&tabname=Summary&prodno=5368.0&issue=Dec%202009&num=&view=

      How do the citizens get the foreign currency to purchase imports – either by selling their external assets or through credit. Here is how the transactions happen if an importer makes a purchase. For that one need’s to know correspondent banking. I had been struggling to get this right and had been using multinational banks in my example. I believe the transactions were right but its easier to see it like this:

      IMF’s book_http://books.google.com/books?id=2KQJ1vYi56QC&lpg=PP1&dq=The%20Payment%20system%3A%20design%2C%20management%2C%20and%20supervision&pg=PA19#v=onepage&q&f=false The Payment system: design, management, and supervision, page 19 says this.

      The account that one bank holds with another bank is referred to using two different names, depending on whether the reference is made from the standpoint of the bank providing the account service or the bank using the account service, although it is the same account. Say that bank X is the bank that uses the account service of another bank and owns the balances maintained in that account. Say that bank Y is the bank that provides the account service and is therefore the bank on whose books the account is maintained. For the bank using the account service (bank X), the account is known as the nostro account and bank X is the nostro bank. For the bank providing the account service (bank Y), the account is the vostro account and bank Y is the vostro bank. In some countries, vostro banks are referred to as correspondent banks and nostro banks as respondent banks.
      The nostro bank owns the funds held in its nostro account and alone controls the disposition of those funds. Only the nostro bank can order funds transfers from its account. In this sense, thc vostro bank is simply the administrator of payment orders made by the nostro bank.

      The vostro bank, however, establishes the terms and conditions under which the nostro account can be used. For example, the vostro bank will specify the level of service it will provide, including the timeliness and accuracy with which it processes deposits to and withdrawals from the account. It will also establish a fee schedule governing the payment services it provides and may set minimum balance requirements. Finally, and most important, the vostro bank will exercise control over the amount of credit it extends to the nostro bank through the account by limiting the amount of overdrafts it will permit, either intraday or overnight.

      An example of how interbank settlement takes place using the mutual accounts that commercial banks hold with one another is illustrated in Table 1. The notation used is as follows:

      DDx = customer demand deposits held with bank X;
      DDy = customer demand deposits held with bank Y:
      VDs = the vostro deposit that bank Y holds for bank X:
      VDy = the vostro deposit that bank X holds for bank Y:
      NDx = bank Y’s nostro deposit held with bank X:
      NDy = bank X’s nostro deposit held with bank Y;
      OAy = other assets on bank Y’s balance sheet;
      OAx = other assets on bank X’s balance sheet;
      OLy = other liabilities on bank Y’s balance sheet:
      OLx = other Liabilities on bank X’s balance sheet;
      TA x or y = total assets for the respective banks; and
      TL x or y = total liabilities for the respective banks.

      In this simplified example, the entire commercial banking system consists of two commercial banks, whose initial balance sheets are shown in Part I of Table 1. There is no central bank nor are here required reserves. In this system, the otal deposits or the bank and nonbank public equal

      DDx + DDy + VDy + VDx.
      Some simple identifies hold:

      TAx = TLx; TAy = TLx; NDy = VDx; NDx = VDy.

      So if an Australian importer imports, his bank debits his account and local bank’s correspondent bank debits the respondent bank’s US dollar account. The respondent here is the Australian bank. Typically the local bank may keep very little at its nostro account and has to fund it. It can fund it in three ways.

      1. Selling local currency for USDs
      2. Borrowing in USDs
      3. Doing a currency swap.

      So its incorrect to say that foreigners are not financing the current account deficit. The above example shows this. There are many entries in the balance of payments statistics and one has to be careful in figuring out the various causalities and how current account deficit is brought into equality with the capital account. Being a flow identity, it is true at all times. However, there are discretionary transactions and there are accommodating transactions. The above example shows that foreigners have to be induced by hook or crook.

      On the other hand, there are other transactions – FDI flows – both inflows and outflows, FII etc so one has to do a very careful analysis of all this.

      At any rate, its intuitive that since invoices are typically in a few currencies, trade deficits lead to more credit.

      Now coming back to the case of the US, which enjoys most invoices in its own currency, one is tempted to ask – is it a problem ? Yes of course: if more fiscal stimulus is provided that will lead to higher imports because of the higher demand created. This strategy leads to both the public debt and the external debt rising to unsustainable levels. One can keep arguing that the US government just credits bank accounts. But do you seriously think that it will have no impact on the currency ? Also currency markets’ movement are far from smooth. A massive devaluation is bound to increase the oil price because of the exchange rate pass-through effect. Tim Geithner is beginning to see this.

      One may ask – if devaluation is bad, why devalue now. The answer is that it is to prevent a bigger fall later!. And many other reasons. Remember devaluation alone doesn’t bring down the trade deficit. It’s a detailed subject of study and is most appropriate to study from the Post Keynesian literature.

      Now don’t get me wrong. I am not arguing against fiscal policy or stimulus. What I am saying is that the external situation has to be looked into as well.

      I do not know Reinhart or Rogoff. My understanding is all from the PKE literature since I am convinced of their ideas and methodologies. I am not claiming that there is a sharp cut-off. However, the behavioural situation (reality) is that nations export to progress and the currency markets enslave them if the continue running trade deficits for long. Hence they have to go into austerity to bring down imports because imports are demand-dependent. Most nations do all kinds of things to their exchange rates such as “crawling pegs” etc. They don’t do it for fun!

    69. should be “I am not claiming that there is a sharp cutoff.” instead of “I am I claiming that there is a sharp cutoff.” toward the end of my previous comment.

    70. Andrew,

      May not seeing it similarly. I think that issuing money below its true value and devaluing money etc. are Austrian to me. Neither do I use the phrase “fractional reserve banking”. In fact we have high unemployment and low demand in the present era because of the Monetarists’ impact.

    71. Ramanan

      Your correspondance bank example is an example of two banks in the same country or currency. If the australian bank sells AUD it can buy USD and have a usd account for its own purposes in the USA. When the overseas deposit is made no net debt exists since both banks have an asset *or* the deposit came into existance via a USD loan.

      Therefore 1. is not financed by foreigners? Is it? The problem arises however when you keep selling AUD and get fewer and fewer USD. 1. could be a balanced situation however.

    72. Yes I should have mentioned that its for two banks in the same country or currency. Doesn’t matter – the relationship is almost similar.

      Didn’t quite get your other points.

    73. Ramanan

      >I think that issuing money below its true value and devaluing money etc. are Austrian to me. Neither do I use the phrase “fractional reserve banking”. In fact we have high unemployment and low demand in the present era because of the Monetarists’ impact.

      We also have inflation. Only house prices in some countries are deflating. And yet the deflationary forces are huge. Only by issuing money against poor quality collateral have central banks prevented a collapse. And inflation is now here it seems? If you issue the same money amount against poor quality collateral you devalue money. If you allow more covered bonds to be issued you devalue depositors money by putting the risk on the taxpayer to cover the ordinary depositors in the same way as the covered bond ‘depositors’ are covered. By gauranteeing all deposits the deflationary impact of bank insolvency is at least delayed because people will not see a point in moving to the safety of cash which is being devalued anyway.

      MMT recognises that inflation is an important factor.

    74. Andrew,

      Money is not the cause of inflation. In fact money is the result of inflation. Inflation happens due to the class struggle in the society – the struggle to claim the output. Loans make deposits and firms borrow from banks. In the 70s, the Monetarists came to power because there was a relation between money and prices. The reason there was a relation at that time is because wages increased a lot. To pay higher wages firms had to borrow more and since prices are cost dependent, this led to higher prices. Higher prices caused workers do demand even higher wages and it turned out of control. The reason the relation was seen was because firms borrowed more, creating more deposits in the process.

      I like this quote from Joan Robinson on the relation MV = PQ.

      If the quantity equation had been read in the usual way, with the dependent variable on the left and the independent variable on the right, though rather vague, it would not have been silly

      Money is not the cause, its a result of something.

    75. “To pay higher wages firms had to borrow more and since prices are cost dependent, this led to higher prices.”

      Prices aren’t just cost dependent. They are margin dependent.

      Higher prices should only occur if there is sufficient demand. Something wasn’t eliminating the demand properly to force margins to be squeezed and for innovation and productivity to sail to the rescue.

    76. Neil,

      Firms set prices according to how much they want to markup (and competitive pressures as well of course). They have to pay wages and have expectations of sales. They have target for profits and hence the pricing depends on these things. So it (pricing) depends both on (unit) costs and margins.

    77. Ramanan

      You are agreeing that when more money is created by private banking to meet the demand for wages by firms it can lead to inflation. The beginning point of money creation where no money is spent is no net debt. both the bank and borrower owe each other. Loan creation however increases the leverage of a bank because it owes money now but is due money in the future. Only if X% amount of new central bank money is added, can the private banking system increase deposits by X% *and* maintain the same leverage. If we forget about excesive leverage we then ignore system risk.

      So if private firms demand more loans then banks become more levered and there is more private bank risk. Only if the central bank introduces more money can the leverage of the private banks be reduced. More demand leads to higher prices and/or higher risk unless the central bank restricts how much money it issues.

      Because of leverage needing to remain constant for constant risk, we have therefore a fractional reserve banking system.

    78. The present situation is politically unsustainable for the US not because the perception is that the US is importing too much but rather because the US is exporting too much. That is, workers are convinced that too many jobs are being outsourced and too many immigrants are entering illegally, undercutting US workers. The always tenuous thread tying business and labor is fraying and ready to break as their interests diverge more widely.

      Jobs will be the big issue in the coming general. Protectionism of one sort or another is on the way unless the US real economy turns on a dime, which is very unlikely given present circumstances. Much more likely that the Fed is blowing another financial bubble, with predictable results. But in each successive attempt, the time period shortens.

    79. VJK,

      Are you saying that government deficit spending is the sole way of monetizing profits assuming that households do not want to borrow ?

      No, anyone can deficit spend. The foreign sector, government, other households, firms, etc.

      There are N markets. You can earn a profit in one market if you have a corresponding deficit in the other N-1 markets. The only requirement is that the sum of receipts from all sources is equal to the sum of expenditures on all uses. Now one of these markets is the credit market. Then you can earn a profit in the goods markets (spend less than you earn), provided that you use your proceeds to buy financial assets. Others who are deficit spending in the goods markets borrow from you in the credit market by selling assets. The money circulates — this is not difficult.

      Everyone can save, provided that the economy is growing. Then total debts increase but in a sustainable way, since a growing national income can justify a growing stock of assets without rising P/E ratios.

      If the economy is not growing, then you can still save while young and dissave when old, for a constant level of total assets in the constant income economy.


      That’s a pity that you do not want consider QE2 from this angle because I think economists underestimate psychological and behavioral aspect of economic decisions people make and tend to consider economic actors as remotely controlled sheep responding to various stimuli.

      I’m not considering QE2 from this angle because it is a fallacy of composition. You asking me what households will do with the extra weight they put on by enlarging their belts. How can I possibly answer, other than to say that there is no extra weight, and that this is the wrong question to ask? How is this denying the autonomy of households? My argument is rooted in household autonomy, namely that households control the level of deposits and currency that they want, irrespective of what the CB does.

      As far as the non-financial sector is concerned, there aren’t going to be any extra deposits, or fewer assets, or more currency as a result of QE2, and so no one will be outbidding each other for a decreased pool of assets, or suffering from lost interest income, or spending their extra deposits. These are all fallacies that arise from not looking at the overall equilibrium and assuming that trades settle bilaterally.

      QE is a duration shift, but it is not a duration shift to the non-financial sector. The change will only hit the financial sector.

      Here is how you can see this. Start with the equilibrium before the intervention.

      Some households are withdrawing deposits and using them to buy assets. Other households are selling assets in order to obtain deposits. At the individual level, some banks face an outflow of deposits and so must sell more bonds. If this outflow is matched by an inflow into another bank, then that other bank will sell fewer bonds. Note that just because, in aggregate, a deposit outflow from one bank is a deposit inflow to another does not mean that the individual banks are not forced to sell bonds in order to make up for deposit outflows. Therefore we have the key insight that is a pre-requisite before we can meaningfully discuss the effects of QE, government bond sales, current account deficits, and all other external interventions to the balance sheet of the non-financial domestic sector:

      Anytime there is an increased demand for bonds and decreased demand for deposits, the financial sector is forced to sell more bonds in order to prevent deposit outflows.

      Now let’s apply this insight into considering the effects of two types of external interventions:

      First, the foreign sector.

      If the foreign sector is running surpluses, then this might come at the expense of reduced domestic incomes –e.g. “draining demand’ — so that households are forced to sell assets to the foreign sector, or otherwise reduce their deposit holdings.

      But it generally doesn’t.

      The current account deficit is funded primarily by borrowing. Households borrow more income and spend some of the proceeds on foreign goods. Of course, the individual household doesn’t borrow income, but by borrowing and spending the proceeds, some other household or firm gets more income, and so the domestic non-financial sector as whole can be viewed as creating more income for itself by borrowing. As long as this sector continue to increase its income to counteract the demand drain, then this sector will not see its assets or deposits change as a result of the foreign sector.

      What does this mean for the financial sector? Banks are creating more deposits for households, and households withdraw those deposits to spend on foreign goods, and the recipients purchase bonds. Therefore there is a decreased demand for deposits and increased demand for bonds. By our key insight, this forces the financial sector to sell more bonds, and the foreign sector ends up “effectively” purchasing all of its bonds from the financial sector, not from households. Household deposit and asset levels are unchanged, but the financial sector is squeezed. This is irrespective of who the foreign sector purchases its bonds from, or which instruments they hold.

      None of that matters in the macro picture, because no trade settles bilaterally.

      I also compiled a longer term chart (using proportions instead of nominal amounts) here, so you can see the squeeze on the financial sector as a result of the foreign sector, whereas you can see the assets of the households shifting in response to real economic effects — e.g. the Reagan/Bush deficits and the the Clinton surpluses, recessions, etc. Note that most of the assets held in the “investment” sector are really held indirectly by households. Also note that I am only talking about vanilla marketable debt — I’m ignoring commercial paper, repos, interbank liabilities, etc. This is because these assets are primarily on both the asset and liability side of the financial sector, and can only be used to cover short-term funding shortfalls. Neither these assets, nor loans, can be sold to the other sectors when a the financial sector needs to obtain funds. When the financial sector became too reliant on short term funding sources while simultaneously not having enough liquid assets, then there is a crisis. Obviously I do not agree with the conclusion that the “lesson” to be learned from this is to remove market discipline from the liability side of bank balance sheets.

      Now let’s consider a second intervention: the CB buys assets.

      Remember, before this, the situation was in equilibrium, so the population of non-financial sellers was matched by non-financial buyers. Total assets were unchanged as were total deposits. Now the CB intervenes to buy a treasury and supplies a household with a deposit. That household was a seller and so it wanted the deposit. But there is still a non-financial buyer that has an excess deposit and a desire to buy bonds. Therefore there is one surplus deposit and one missing bond — i.e. there is an overall increase in the demand for bonds and a decrease in the demand for deposits. What happens? The financial sector is forced to sell more bonds in order to stem deposit outflows.

      Therefore there will not be a “shortage” of bonds. For each bond bought by the CB, the financial sector will sell one more. Neither will there be a “surplus” of deposits. The additional financial sector bond will be bought with the surplus deposit, so that the non-financial sector continues to hold the level of deposits that it wants. Then the financial sector has excess reserves. The assets of the financial sector have a shorter duration, but duration is unchanged for everyone else.

      For example, I am not convinced that agency(GSE toxic MBS?) paper would be an attractive substitute for government securities,

      Let’s take a look at what happened with QE1, when the CB bought 1.2 T of agencies. We can compare Z.1 from Q4 2008 and Q2 2010:

      Household Sector, L.100

      Q4 2008

      Deposits: 7931
      Holdings of Treasuries, Agencies, Munis and Corporates: 3809
      –Treasuries: 243
      –Agencies: 718
      –munis: 902
      –corporates: 1946

      Q2 2010
      Deposits: 7559
      Holdings of Treasuries, Agencies, Munis and Corporates: 4319
      –Treasuries: 1063.6
      –Agencies: 189.6
      –munis: 1033
      –corporates: 2033

      So the household sector was not burdened with any extra deposits. They rotated 400b out of Deposits and into credit market assets, and added a bit more.

    80. With Paul being a conduit between the Treasury and the Feds, does not QE2 reduce to a de facto fiscal policy with the Fed financing government spending ? I know it is a simplistic scenario but still…

      I’m always confused by this line of reasoning. Fiscal policy is set by Congress. Congress decides how many checks go out. This has nothing to do with the CB.

      The CB decides the proportion of bonds and cash that are created to finance this spending. For some reason, people believe that it requires more paper and ink to create a bond than to create cash. The MMTers will object to “printing”, so yes, nowadays both bonds and cash are created electronically, and neither needs to be converted into paper form unless there is a specific request to do so.

      In either case, there is no “financing” of the deficit, there is only a political objection to carrying a certain debt (or for that matter, to running a certain deficit). And there is a real economy effect. But the government faces zero funding costs. The private sector is the one with the funding costs, which is why they demand a return for the government bond. And there is a “real” return and a “real” interest rate in the economy. It is not a political question.

      You can allocate your real resources to creating consumption goods with the capital stock you have now, or you can allocate your resources to creating more capital, so that you will get more consumption goods next period, but fewer consumption goods today.

      There is no getting around this trade-off, and therefore there is a “real” rate of interest that the economy can deliver, in terms of consumption today versus consumption next period. That is iron law.

      This real rate has nothing to do with household time preferences, or government preferences, or anyone’s wishful thinking, but is purely determined by things like innovation, increasing returns to scale, and other real factors.

      The issue is what happens when the nominal rate diverges from the real rate.

      In one case, you have the china example, in which the nominal rate is set too low by government fiat, as they have a repressive financial system. In that case, you have enormous growth rates as people invest in capacity in order to produce more capacity.

      At the same time, little of that growth is sustainable and most of it will need to be scrapped when the bubble bursts.

      Alternately, you can have the U.S. problem where the nominal return was too high — corporate profits have doubled as a share of GDP, meaning that the return on capital was unsustainably high, growing faster than the economy.

      Now you get into a situation in which actual prices deviate from sustainable levels, and firms make commitments to invest against unrealistic return rates. The Chinese firms would go broke if they were required to sell goods that their own population can afford to buy. And that means that the economy as a whole is broken.

      Similarly, U.S. firms would go broke for the same reason, except this time, it is because investors have unrealistic earnings growth demands, so that firms cannot sell their output profitably while paying the market rate for capital.

      When the nominal rates are too high or too low, either due to financial repression, or due to ponzi borrowing, then firms go broke in the adjustment process and in both cases prices are out of line with wages. That’s why its important that the actual rates reflect the real rates that the economy can deliver.

      But that is completely independent of the “costs” of government borrowing, as government has no borrowing costs. The real economy has borrowing costs. It requires no more ink to create a bond than it does to create cash. Therefore it is not possible for the government to get a “freebie’ or reduced cost of funds based on QE. And of course, QE cannot lower yields anyway, since it does not reduce the supply of bonds available to purchase.

    81. Ramanan,

      “Money is not the cause of inflation. In fact money is the result of inflation.”

      What evidence do you have for this? Obviously the in the long-run the relationship between money growth and inflation is very strong, and I would describe both money growth and endogenous variables. You describe money growth as caused by inflation–fair enough, I suppose, but this does rather beg the question: what causes inflation?

    82. Vimothy,

      I didn’t mean to see money only grows because of inflation. It also grows because of demand. Plus there are many complex mechanisms.

      Not sure of your comment at 6:36 is supposed to mean – even though you think I know what you mean :)

      In general everything is increasing – prices rise, money stock rises, income rises etc. So there is a trivial relation between all these.

    83. In the long-run, money growth and inflation move one-to-one, and there is no relationship between output and money. This is very well established empirically. Right?

    84. Vimothy,

      Not really. This can be verified by going to FRED (Federal Reserve Economic Data) at St Louis Fed and charting CPI and Money stock such as M1, M2 and GDP (real and nominal)

    85. Actually, yes really. This is a *very* well established empirical regularity. For instance, you can see a summary of the evidence in charts 1 – 3 of this QB paper by Mervyn King, “No money, no inflation”: http://www.bankofengland.co.uk/publications/quarterlybulletin/qb020203.pdf

      You can see that the correlation holds for both narrow and broad money, that the correlation is stronger at longer time horizons, and that there is no correlation between broad money growth and GDP growth over any time horizon.

      If you are interested in the effects of sampling frequency on the results there is another nice (v. brief) paper in QB here, “Long-run evidence on money growth and inflation”: http://www.bankofengland.co.uk/publications/quarterlybulletin/qb050302.pdf

      See esp charts 2 & 4 for the long-run components of inflation and money growth in the UK and US.

    86. Trying again without links:

      Actually, yes really. This is a *very* well established empirical regularity. For instance, you can see a summary of the evidence in charts 1 – 3 of a QB paper by Mervyn King, “No money, no inflation–the role of money in the economy”.

      You can see that the correlation holds for both narrow and broad money, that the correlation is stronger at longer time horizons, and that there is no correlation between broad money growth and GDP growth over any time horizon.

      If you are interested in the effects of sampling frequency on the results there is another nice (v. brief) paper in QB called “Long-run evidence on money growth and inflation”, by Luca Benati.

      See esp charts 2 & 4 for the long-run components of inflation and money growth in the UK and US.

      Google for papers.

    87. Vimothy,

      Amazing how Mervyn King chooses to write something so meaningless. I recently checked he had a good book on banks’ back office operations, settlement procedures etc.

      Take an excel sheet. In cell A1 type =Rand() and drag it for some 1000 cells. In cell B1, type =0.5*A1 and drag it for 1000 cells. Now use the excel correlation function (for which you get 1) and the function SLOPE() which gives the “beta” and find the result.

      You know what I mean ?

      The 45 degree line he draws in Chart 1 for 30 years (and all other charts) is just a 45 degree line, most points seem to lie below that line. Also if you look at points near 10% annual growth and now mentally draw a line from 0 to the point, you will see that it hits the y-axis on right far below 100%.

    88. Ramanan,

      At least one of us is getting confused here.

      King reproduces some very commonly accepted and understood results. Nothing could be more mundane than the long-run relationship between money growth and inflation.

      I’m afraid I have no idea what point you are trying to make re excel. If you take some function y=f(x) and plot a graph for a number of iterations, then I would imagine yes the correlation between x and y is pretty close to 1.

      Chart 1 plots base money growth (%) against inflation (%) across 1, 2, 5, 10, 20 and 30 year time horizons. Chart 2 does the same for broad money growth. Chart 3 plots broad money growth (%) against GDP growth (%) over the same time horizons. The diagonal lines from the origin in charts 1 and 2 are NOT estimated correlation coefficients. They are merely a visual aid. You can clearly see that as you “zoom out” to longer time periods, the data points cluster more tightly about the 45 degree line in both the narrow and broad money charts. Simply from inspecting the charts, the long-run relationship between money growth and inflation is obviously strong while there does not appear to be any relationship between money growth and GDP growth over any time horizon.

      These are not King’s results. He lifted them from an IMF publication, “International Financial Statistics”. They are, however, entirely ubiquitous in economics textbooks. Every intermediate macro text I’ve ever read reproduces them (though typically as a single graph).

      King does produce some of his own results in the paper. But these are a bit more technical and hardly disagree with the charts in any case.

      Benati’s paper uses frequency domain analysis to isolate the low frequency components of money growth and inflation growth above the 30 year mark, with the result that they have been strongly positively correlated across all historical monetary regimes, and this holds for all broad and narrow monetary aggregates in the UK and US (except bas money under the current regime in the UK, which has been negatively correlated).

      What do you mean when you write, “Amazing how Mervyn King chooses to write something so meaningless”? What is so meaningless? It is very straightforward as far as I can see.

    89. vimothy, measuring price stability involves a relationship between nominal and real. Change in the quantity of money alone is meaningless with respect to measuring price stability. The economic issue is the shifting relationship between costs (goods price) and wages (labor price) in real terms. The change involves how much work is required to purchase “core” items. Nominal figures in isolation are just numbers. Who cares how big or small they are? The issue is what money will buy (goods price) and how easy money is to come by (labor price).

      The problem with most economists is that they focus on the nominal instead of the real. Moreover, they define the real too narrowly as that which is priced. Most of their talk is therefore gibberish, having little relationship with the reality of people’s lives. This is what a lot of the rising social unrest is about.

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