Time for a reality check on debt – Part 1

I am now in the US with a hectic week ahead. At present I am in Florida and for those who haven’t been here just imagine taking a landscape and pouring as much concrete as you can mix over as much of that landscape that you can access. Then once that sets, you build massive high-rise buildings and suburbs that span hundreds of kilometres and you have it. Oh, and plant a few palm trees as you concrete. But then there is surf nearby and before work this morning I am off to check it out. Anyway, in between other things I have been reading the so-called public debt exposition that appears in the latest issue of the The Economist magazine. It will take a few blogs to work through it but here is Part 1. It might happen that there will be no Part 2 if I get so sick of reading this nonsense.

As a prelude to today’s blog I thought I might share something from a book of fiction that I am currently reading. At present, I am reading the first of the Stieg Larsson trilogy entitled The Girl with the Dragon Tattoo which is recommended. One of the main characters is a sometime financial journalist and author. On page 91 of the book, there is a narrative covering the first chapter of this character’s book (one Mikael Blomkvist), which is an investigation into “the labyrinth of financial journalism”. Blomkvist is cast in the book as character who is on the outside of the mainstream financial commentary and has a significant disregard for the standard way in which his profession functions. The description of the first chapter of Blomkvist’s book goes like this:

… In the last twenty years, Swedish financial journalists had developed into a group of incompetent lackeys who were puffed up with self-importance and who had no record of thinking critically. He drew this conclusion because time after time, without the least objection, so many financial reporters seemed content to regurgitate the statements issued by C.E.O.s and stock-market speculators – even when this information was plainly wrong or misleading. These reporters were thus either so naive and gullible that they ought to be packed off to other assignments, or they were people who quite consciously betrayed their journalistic function …

He compared the efforts of financial reporters with the way crime reporters or foreign correspondents worked. He painted a picture of the outcry that would result if a legal correspondent began uncritically reproducing the prosecutor’s case as gospel in a murder trial, without consulting the defence arguments or interviewing the victim’s family before forming an opinion of what was likely or unlikely …

I thought this had strong parallels with the view I have about economic journalism (with noted exceptions – and I will name names if asked) in Australia. Mostly lackeys who just reiterate the orthodox line with either little understanding and/or an explicit intention to deceive.

It also serves to introduce the latest waste of trees that I have had the misfortune to encounter. I advise no-one to buy the current edition of The Economist magazine which is running a major disinformation campaign in its – Public debt – The biggest bill in history. The July 11, 2009 edition pretends to tell us what the “The right and wrong ways to deal with the rich world’s fiscal mess” are. Well let me just conclude that most of the discussion is easily forgotten. There are a number of articles in the edition on the same theme and I might cover a few of them over the next week or so.

You get the drift of the lead article in the opening sentence:

THE worst global economic storm since the 1930s may be beginning to clear, but another cloud already looms on the financial horizon: massive public debt. Across the rich world governments are borrowing vast amounts as the recession reduces tax revenue and spending mounts – on bail-outs, unemployment benefits and stimulus plans. New figures from economists at the IMF suggest that the public debt of the ten leading rich countries will rise from 78% of GDP in 2007 to 114% by 2014. These governments will then owe around $50,000 for every one of their citizens …

The language is emotional throughout. We read about “this alarming trajectory” – “today’s debt surge” – “today’s borrowing binge” which is occuring “just before a slow-motion budget-bust caused by the pension and health-care costs of a greying population”. We are presented with three solutions to this huge demographic disaster – “Will they default, inflate or manage their way out?” By manage their way out the writer means – running surpluses.

The lead article recognises that “without stimulus the global recession would be deeper and longer” but then gets back on theme (slapped over the hand by the boss I reckon!) concluding that “in the long run today’s fiscal laxity is unsustainable”.

Then it gets down to business. The inevitable descent into defict nazism and hysteria:

Governments’ thirst for funds will eventually crowd out private investment and reduce economic growth. More alarming, the scale of the coming indebtedness might ultimately induce governments to default or to cut the real cost of their debt through high inflation.

So there you have it. The stimulus was necessary but will result in government killing private investment and economic growth and ultimately governments will default or inflate to clear the legacy of their bad ways. The neo-liberal fightback it is called. Re-read my opening about the financial journalists in the fiction I am reading. Problem is that they are alive and well and have jumped out of Larsson’s book to serve up this drivel. Life imitating art!

This is an example of how journalists twist what is going on to promote an argument that does not reflect the essence of what is going in. In the US at present, 10-year Treasury bond yields have risen over the last six months. The scaremongers want you to believe that this is the direct consequence of the deficit “crowding out” private investment by drawing on scarce funds available in the financial markets.

The Economist exposition on debt continually rehearses this argument – ad nauseum. But then at one point, it admits the following:

Much of this rise stems from confidence about economic recovery rather than fiscal alarm.

Which is more the point of what is really going on in financial markets and as you will appreciate has nothing at all to do with the crowding out story. I will return to this point soon.

In the next sentence, the journalist gets back on theme with “eye-popping deficits” and “printing money to buy government bond” and “concerns that America’s debt might eventually be inflated away”.

The futility of government intervention is rehearsed next. The journalist writes that worries about the inflation whether:

… (j)ustified or not, such worries will themselves wreak damage. The economic recovery could be stillborn if interest rates rise too far too fast. And today’s policy remedies could become increasingly ineffective. Printing more money to buy government debt, for instance, might send long-term bond yields higher rather than lower.

First, if the journalist thinks the views may not be justified then why didn’t he (it is a male) outline the alternative views which would underpin the argument that these fears were irrational? Think about the Larsson above – those lackeys who just spread the case for the prosecution.

Second, if he thinks there is a case to be made that the fears are irrational, then why use the language that incites and perpetuates the fears?

Why not start the article with the point that while deficits are rising due to the severity of the crisis, the stimulus will underwrite production and employment, and provide the conditions for firms to develop the confidence necessary to resume investment? Why not say that while some neo-liberals consider the extent of the expansion a worry because the growth in nominal demand may outstrip the real capacity of the economy to absorb it and thus inflation may ultimately result, there is such a huge spending gap across most economies, as evidenced by the parlous rates of capacity underutilisation and rising unemployment that any such fears are irrational?

Paul Krugman’s latest article which I read on the flight over from Zurich yesterday (in the International Tribune) is worth introducing here as an example of an alternative depiction. He starts with:

The debate over economic policy has taken a predictable yet ominous turn. The crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, its deja vu all over again – literally.

Krugman then recounts three instances in history where monetary policy was stuck in what economists call a liquidity trap where all people want to hold money no matter how low interest rates go rather than spend. First, between 1933 and 1937 after three years of being stuck in depression the US economy grew rapidly on the back of the fiscal stimulus called the New Deal. He notes that while there was strong growth the economy didn’t go close to achieving full employment in this period. But then the conservatives (fiscal policy haters) mounted a rearguard action and peddled the inflation fears which ultimately forced the central bank to tighten monetary policy and Roosevelt tried to balance the budget. Krugman says that:

Sure enough, the economy slumped again, and full recovery had to wait for World War II.

Second, Japan in the 1990s recessed badly and then after a massive fiscal injection grew again (nearly 3 per cent GDP growth in 1996). The naysayers then emerged from their dirty little holes in the gutters and attacked the deficits and invoked the inflation scare campaign. Same old same old. The political pressure forced the Government to start focusing on the size of the deficit and increased taxes and cut spending dramatically. The inevitable double-dip followed soon after and the Japanese economy moved back into recession.

Krugman then concludes that “here we go again”. He says that the “inflation worryers are harassing the Fed”:

The latest example, Arthur Laffer, he of the curve, warns that the Fed’s policies will cause devastating inflation. He recommends, among other things, possibly raising bank’s reserve requirements, which happens to be exactly what the Fed did in 1936 and 1937.

That move was one of the reasons that the US double-dipped during the Great Depression.

In addition to the attacks on the central bank, Krugman says there is a full frontal assault now being launched on the fiscal side of the stimulus. Some want the fiscal plans to be “cancelled”.

Some, especially in Europe, argue that stimulus isn’t needed, because the economy is already turning around. Others claim that government borrowing is driving up interest rates, and this will derail the recovery.

For example, The Economist special feature; the Financial Times (especially the daily blog of Willem Buiter, who for some strange reason is influential).

Krugman then spends the rest of his Opinion piece providing a “reality check” – which I borrowed for my blog title today!

First, unemployment is very high and rising around the world – “that is, we’re not even experiencing the kind of growth that led to the big mistakes of 1937 and 1997.”

Second, “what about the claim that the Fed is risking inflation? It isn’t”

Mr Laffer seems panicked by a rapid rise in the monetary base, the sum of currency in circulation and the reserves of banks. But a rising monetary base isn’t inflationary when you’re in a liquidity trap. America’s monetary base doubled between 1929 and 1939; prices fell 19 per cent; Japan’s monetary base rose 85 per cent between 1997 and 2003, deflation continued apace.

Which is a good time to bring attention to a recent thoughtful comment from Sean Carmody. Sean wonders whether we have any examples of this level of monetary base expansion post Bretton Woods – that is, after the gold standard, convertible monetary system was abandoned and the fiat monetary system ruled! Yes, clearly. Japan!. In an effort to revitalise growth after their policy-induced double dip (noted above – the policy induced bit was because they moved away from sensible policy settings and conceded to the deficit-debt-inflation hysteria), the Japanese government ran massive deficits, issued massive amounts on Yen-denominated debt (and investors queued up for it!), but kept interest rates at near zero by not draining the full reserve add arising from the deficits with bond issues. In issuing bonds, they left just enough excess reserves in the system to let the interbank competition drive and keep the interest rate at zero. And … all the time this was happening deflation was occuring.

Interestingly, The Economist article admits the policy failure in the Japan of 1997.

A sudden fit of fiscal austerity would be a mistake. Even when economies stop shrinking, they will stay weak. Japan’s experience in 1997, when a rise in consumption taxes pushed the economy back into recession, is a reminder that a rush to fiscal tightening is counterproductive, especially after a banking bust. Instead of slashing their deficits now, the rich world’s governments need to promise, credibly, that they will do so once their economies are stronger.

I will return to this in a moment.

Krugman also considers the rising interest rate scare campaign and says of government borrowing:

All it’s doing is offsetting a plunge in private borrowing – total borrowing is down, not up. Indeed, if the government weren’t running a big deficit right now, the economy would probably be well on its way to a full-fledged depression.

You will note that I depart from Krugman here who is a relatively liberal “deficit-dove”. It is true that the public borrowing is offering safe financial assets to the non-government sector who are generally scared of losing their savings in other private (risky) investment vehicles. The private borrowing is thus providing an alternative to non-interest bearing bank reserves. But the hint in Krugman’s narrative that the borrowing is funding the deficits is clearly not correct. The borrowing is serving a monetary function – interest-rate maintenance. But the point that the net spending (deficits) are saving the real economy is valid and categorical.

Krugman also reiterates the point made above about the rising bond yields at present. He says that:

Oh, and investors’ growing confidence that we’ll manage to avoid a full-fledged depression – not the pressure of government borrowing – explains the recent rise in long-term interest rates. These rates, by the way, are still low by historical standards. They just not as low as they were at the peak of the panic, earlier this year.

So you see how an event (yield rises) that signifies growing confidence in the real economy is reinterpreted (and trumpetted) by the conservatives to signal something bad (crowding out). The reason long-term yields are rising is because investors are diversifying their portfolios again and moving back into private financial assets. The yield is a reflection of the last auction bid in the bond issue. So if diversification is occuring reflecting confidence the demand for public debt weakens and yields rise. Nothing at all to do with a declining pool of funds being soaked up by the binging government!

Further, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Say that out aloud thirty times a day when you get up and before you do anything else. Recite it. Pass it on to your children. Its what astute financial market players (not the lacky journalists) call “a wash”. The funds used to buy the government bonds come from the government!

Once you understand that you immediately see that the crowding out claim is nonsensical in a fiat monetary system. The crowding out logic goes like this. There is allegedly a fixed volume of saving out there which are available for loans and private investors are all competing for the finite funds. The price of loans then reflects the volume relative to demand! Along come the evil, profligate government who muscles in and adds to the competition which drives interest rates up and forces some productive private projects out of the market because the cost of funds becomes prohibitive.

Well there is no finite pool of saving. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.

Luigi Passinetti the famous Italian economist had a wonderful sentence I remember from my graduate school days – “investment brings forth its own savings” – which was the basic insight of Keynes and Kalecki – and the insight that knocked out classical loanable funds theory upon which the neo-liberal crowding out theory was originally conceived.

Krugman sums up his article as follows:

… A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual. These demands should be ignored. It’s much too soon to give up on policies that have, at most, pulled us as few inches back from the edge of the abyss.

Juxtapose this with the line taken by The Economist. They want the policy makers to come out with “clear principles on how deficits will be shrunk; new rules to stiffen politicians’ spines”. They want politicians to “pledge to clean up their public finances by cutting future spending rather than raising taxes.” The push now is for widespread imposition of Maastricht-like rules and “independent bodies” to oversee the conduct of fiscal policy. That is, ceding democratic responsibility to a pack of conservative economists who struggle to see beyond the last first-derivative they took while writing their last academic paper on “When do slave-owners whip their slaves?” The main answer that the paper like all the papers they write provides is: when the marginal benefit exceeds the marginal cost.

This recourse to fiscal rules as a basis for fiscal sustainability violates all the rules that underpin that concept. Please read my three part series on this – Part 1Part 2 and Part 3.

The Economist article says;

The next step is to boost the credibility of these principles with rules and institutions to reinforce future politicians’ resolve. Britain’s Conservative Party cleverly wants to create an independent “Office for Budgetary Responsibility” to give an impartial assessment of the government’s plans. Germany is poised to pass a constitutional amendment limiting its structural budget deficit to 0.35% of GDP from 2016. Barack Obama’s team wants to resurrect deficit-control rules … Such corsets need to be carefully designed – and Germany’s may prove too rigid. But experience from Chile to Switzerland suggests that the right budgetary girdles can restrain profligacy.

They seem to be getting kinky – fiscal corsets. In the next blog in this review of the current financial press I will consider these rules and specifically explain why Switzerland’s fiscal brake system is a nonsensical model for us to follow. A reader has asked me to explain the Swiss system and as I was just in Zurich this morning I feel I know all about the place!

More next time … and maybe re-read the introduction and then open any News Limited economic commentary these days! Fiction commenting on fiction.

Saturday Quiz

Coming as usual tomorrow.

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    18 Responses to Time for a reality check on debt – Part 1

    1. Lefty says:

      Even the reserve bank appears to believe that budget deficits are funded by government borrowing from the private sector – http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html#top – Down near the bottom of the page, titled: “The relationship between monetary policy and debt management”

    2. Sean Carmody says:

      I would say that the RBA is correct that budget deficits are funded by Government borrowing, in the sense that current practice is to use that mechanism rather than having the Government simply credit reserve accounts. I believe that Bill would argue that this approach is adopted for obscurist neo-liberal political reasons (apologies if I am putting words in your mouth Bill!), but that nevertheless reflects current practice. Whenever there is a bond tender, the AOFM publishes how much is taken up by the public sector and how much by the Reserve Bank. For example, in the last tender it was all taken up by the public sector, Of course, some of that can and will come back to the Reserve Bank for periods of time through the repurchase agreements used in their open market operations, but to provide some sense of scale, as at March 2009, Commonwealth debt outstanding was $70.8 billion. At the same time, Exchange Settlement Account balances were $3 billion and the reserve bank held $52 billion (see Table A1) in various types of debt securities, including Government debt. While I couldn’t find a breakdown of this number, back at the beginning of 2007 when the RBA held $30 billion in securities, $5 billion was in the form of Government debt. Combining that with the fact that the RBA has broadened the range of securities it will take as repo collateral, I would guess that it would currently less than $7 billion in Government debt (i.e. less than 10% of the debt on issue).

    3. Sean Carmody says:

      Actually, there is one correction for that last comment of mine: Table A1 only shows outright holdings of securities by the Reserve Bank. If they sell bonds on repo overnight, they still appear in their assets in Table A1 (after all, they will come back the next day) and similarly if they buy bonds on repo, they will not be reported as owning the bonds in Table A1. Details of repos appear in Table A3. On average over 2009, the Reserve Bank’s repo position has been to have sold just under $1bn of bonds.

    4. bill says:

      dear Lefty

      Sean’s comment is correct. But remember – this is all voluntary as I have explained previously. To really understand things you have to go the essence – the fundamentals of a system. The arrangements that the RBA uses are not essential to the fiat monetary system that we live in now. The government could have any arrangement it wants – recall – it could go to Alice Springs and collect a $ then run three times around the MCG before allowing itself to spend if it wanted to. All voluntary and nothing intrinsic in terms of the monetary system.

      The interesting question that then arises is: why impose these voluntary constraints? Investigating that question tells you are lot about ideology.

      best wishes
      bill

    5. Ramanan says:

      I need some reference which gives the details of what happened in Japan – fiscal deficit year-wise, Bank of Japan operations and holdings, reserve positions, debt issued plus some explanations. Some of the reports I see are older.

    6. bill says:

      Dear Ramanan

      I will see what I have when I get home next week. The BOJ now has all of its data available via its WWW site: http://www.boj.or.jp/en/ which is always a good place to start. You can reconstruct most of the financial data from this source or from OECD data.

      best wishes
      bill

    7. Lefty says:

      Hi Bill and Sean

      Does this then mean that the supply of money in the economy remains unchanged as a result of the deficit? That they are essentially taking 10 buckets of water from the deep end of the pool, walking around to the shallow end and tipping them back in – net change in pool water volume: nil?

      And that as the bonds mature, the government will repay the sum of what was borrowed plus interest. And that the total sum of the interest payments will equal the expansion of the money supply unless the government voluntarily decides to do what the neo-liberals are saying that it MUST do and gain the money to be repayed by increasing the tax burden and/or cutting expenditure in other areas (though increasing economic activity must surely increase tax receipts without any necessary change in the actual rate of taxation paid by anyone).

      And that when growth resumes, it will eventually run up against constraint in the supply of liquidity, especially if (a) government feels it need to return to surplus quickly and (b) the private sector is desiring to net save. And down we all go again?

    8. Sean Carmody says:

      Lefty: it depends a bit on what you mean by “money”. If you take some broader measure (i.e. currency and certain shorter-term deposits), then as Bill has argued before, these are just the other side of the balance sheet to loans. So I would say that under normal circumstances, the supply of money will be driven by private sector activity. At the moment, many in the private sector are furiously attempting to de-lever (i.e. reduce debt) and Government spending (here and in the US) is certainly not leading to increases in money, but rather just serving to offset private sector deleverage, at least in part. Bill may, of course, see it differently!

    9. Lefty says:

      Hmm. I thought I had acquired a basic grasp of how the system functions but now I am back to square one and more confused then when I first stumbled across this blog. You appear to me to be saying the opposite of what I at least thought Bill was saying – the private sector creates the “money” to fund it’s own economic growth while federal government deficts do not add net financial assets but simply shuffle them around.

      Does the supply of “money” existing in the economy ever change or not? How can the economy as a whole grow perpetually on an unchanging supply?

      The more time I spend trying to understand this subject, the less convinced I become that the public at large will ever understand the basic functioning of the economy. Too many intricate, complicated and esoteric concepts with too many people, all of them with PhD’s, all arguing that everyone else is wrong.

      ?????

    10. bill says:

      Dear Lefty

      Later today or early tomorrow I will try to respond to your ??????????? – hang in there, I think we are making progress. You certainly do not need a PhD to understand this stuff.

      best wishes
      bill

    11. Ramanan says:

      I think ‘Circuitists’ try to solve the problems Lefty is asking – how do firms, workers and banks make money and grow. However the models seem to run into problems – I havent looked into this in detail, but as Bill pointed out in another blog, their theories run into troubles simply because they do not consider the involvement of the Government in this process. Waiting for Bill’s response.

    12. Lefty says:

      Cheers Bill

      Yes Ramanan, this is exactly what I have found. As a layperson, it seems incredible to me that different trained economists have so many differing ideas to as to how the economy functions in a nutshell. For example, if I ask 10 different mechanics to describe in a nutshell how my car engine functions, I will get basically the same answer from all 10. And I would want to hope that I did! If a mechanic does not understand how a car engine functions, the results will likely be immediate disaster. But if I ask 10 different economists to descibe in a nutshell how the economy functions, I am likely to get at least half-a-dozen different answers.

      Now it does not make sense to me that there could be half-a-dozen different correct answers – surely there is only one correct answer. This implies that the majority of economists do not fully understand their own subject. In just about any trade or profession, this would be completely unacceptable.

      Bill is the first one to have given me a full, comprehensive description of the basic functioning of the economy.

      Others with formal economic education have responded to simple questions from me such as “where does Australian currency come from?” with vague, muddy responses such as “productivity creates growth” and “money is only a promise to pay something back”. When I point out that that is not what I asked, most of them simply disengage. Questions such as “if deficit spending automatically triggers runaway inflation, crowds out the private sector etc how is it that successive Australian governments managed to be in defict for decades and that period of time was a golden age of growth and full employment?” are usually ignored.

      It can be very frustrating trying to understand the bare basics of modern economics. As citizens and voters, it is something we should all seek to understand.

    13. bill says:

      Dear Lefty

      I share your frustration about the inability of my own profession to engage with non-economists in providing transparent explanations for the way they see the economy operating. But remember that the dominant paradigm which I call neo-liberal but which within the economics literature is in fact an evolving (not in any Darwinian sense) stream of schools of thought (all differentiated by subtle changes in assumptions relating to how much “perfect competition” there is – the latter being a figment of their imagination in the first place) – essentially set out in the C19th to derail the growing influence of Marxism and create a body of thought that represented capitalism as a “fair system of distribution” – that is, you get out of the production and income generation system what you put in. So it has always been defensive and apologist. Second, mainstream macroeconomics doesn’t really exist in that it is really just an aggregated version of microeconomics which begins with perfect competition. This aggregation is in fact a bastardisation which renders most of the mainstream macroeconomics (even on its own terms) inconsistent. While I don’t want to write about it here – the so-called Cambridge Controversies of the 1960s – essentially destroyed neo-classical distribution theory. The orthodox economists just chose to ignore it after their main player at the time in this debate had to concede defeat. Okay, so we have a theoretical problem – ignore it – now we don’t have a theoretical problem. There are a similar instances in other strands of orthodox thought. It is a hollow edifice.

      But the purpose of my blog is to layout a comprehensive macroeconomic framework for understanding how the real world – a fiat monetary system – operates. Once you understand that you can then overlay your politics and ideologies to your heart’s content. But at least you should be honest enough to accept that by running surpluses you will in usual times create unemployment. Many orthodox economists actually deny that unemployment is anything more than a voluntary preference for leisure over work by the individual who is maximising his/her own real income. When asked what real income is these economists say “anything”. It is devoid of any substance at all.

      Anyway, think back to when you asked your kids what they were up to when you suspect them of high jinks. When they are reluctant to say you know something. So if your other economists fail to answer questions that you ask and which have answers – no doubt about that – then you should apply the same logic. Either they don’t know or they know that by answering they will give the game away (that they don’t know).

      My assessment, based on your comments and interaction on this blog, is that you (as a school janitor) now know more about how the fiat monetary system operates and the difference between that and a gold standard system based on convertibility than the majority of academic economists. You don’t have a PhD – but you have something more important than that – an open mind and a thirst to learn and nut things out that do have answers.

      best wishes
      bill

    14. Ramanan says:

      … “The Pleasure Of Finding Things Out” as Richard Feynman described it.

    15. Lefty says:

      Thanks for the words of encouragement Bill. I certainly do try. Making mistakes is part of the learning process I guess. I was under the impression that the deficit was actually expanding the supply of $AUSD in the economy.The quantitive easing in the US is not doing this?

    16. Sean Carmody says:

      Again, it depends on what you mean by “money supply”. It’s a notoriously difficult notion to pin down satisfactorily and I tend to agree with Fisher Black who argued that it is ultimately a meaningless concept. But, if we stick with conventional approaches, as summarized on Wikipedia, quantitative easing certainly expands M0 money supply as the central bank’s balance sheet expands with an increase in assets (the securities they buy) offsetting an increase in their liabilities (reserve account balances). Since the latter counts as M0 money and the former does not, M0 supply increases. If, however, the quantitative easing is taking place in an environment when the private sector is busily trying to delever (i.e. reduce debt), it may not be the case that higher order measures, such as M1 or M2, do not increase as repayment of loans may result in decreases in the deposit balances counted in these measures as money.

      Looking at real US data, M0 has expanded enormously (hence misguided howls that the Fed is “printing money”), while M1 has not expanded on anything like the same scale and has wobbled up and down, while M2 has not deviated far from a longer term trend.

      I should note that the St Louis Fed “FRED” database from which these charts are sourced is a great data resource.

    17. bill says:

      Dear Lefty

      Sorry it has taken me a while to reply – been a bit busy. When the government net spends (deficit) it creates new (net) financial assets in the non-govermment sector in the form of bank reserves (ultimately after all the transactions associated with the injection are finalised). You can call this new money – some call it high powered money. The form that these net financial assets take depends on what happens next. If the government issues bonds (to maintain interest rate targets) then the added reserves will be swapped for IOUs (bonds). There is no change in the net position of the non-government sector viz the government sector although the composition of the wealth held in the currency of issue has changed (less reserves more bonds).

      So I don’t find it very helpful talking about the money stock. It is better to think in terms of these net changes in financial assets being created (deficits) or destroyed (by surpluses) and then thinking about the options the non-government sector has in terms of the compositional choices. This approach also allows you to understand why the transactions between the government and non-government sector are special because they can change the net positions of the latter sector (create and destroy these financial assets) whereas transactions within the non-government sector cannot create or destroy anything net! All these transactions net to zero – for every asset created/destroyed is a corresponding liability created/destroyed.

      I think you do understand this – so don’t be confused by the terminology. It takes a bit of time to get used to the different terms (net financial assets instead of money) but in the end you will appreciate the purpose – which is to differentiate the analysis from the orthodox terminology which is very misleading.

      best wishes
      bill

    18. David Swan says:

      Lefty – you’re just conflating deficit spending with “borrowing” is all. Spending in deficit *does* create net financial assets, “borrowing” does *not* (it simply swaps one financial asset – reserves – for another, bonds). The “borrowing” is a post hoc operation that is essentially a charade (an interest-bearing charade).

      bill – if you like fiscal corsets, you’ll love the fiscal straitjacket!

      http://www.huffingtonpost.com/otaviano-canuto/a-straitjacket-to-help-br_b_12439988.html

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