Category Archives: Monetary economics

Stop expecting central bankers to grow the economy: They can’t

masthead

Your humble narrator is in City AM today explaining why central bankers can’t grow real GDP so we shouldn’t expect them to.

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Whoever won the debate, economics lost

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You lose

I try to avoid politics on this blog and keep it focused on economics but sometimes politics and politicians just won’t leave economics alone. When that happens you have a right and possibly a duty to check what they are saying. After watching last Monday night’s presidential debate between Hillary Clinton and Donald Trump, one thing we can say with depressing near certainty is that the next president of the United States will be almost totally clueless about economics.

Hillary Clinton

Investment vs spending

Hillary Clinton seems to have discovered Gordon Brown’s old trick of referring to every penny piece of government spending as ‘investment’. She would not be spending money on this, that, or the other, rather she would be investing money in this, that, or the other. “I want us to invest in you. I want us to invest in your future.”

But investment isn’t just another, cuddlier term for spending. It actually means something. When you invest you are spending money in such a way as to increase your future income. If a driving licence will enable you to get a high paying job then paying for driving lessons is investment. If you spend money on food and clothes, necessary as that me to keep you going in the here and now, it is consumption spending, it is not investment. There are greyish areas. A suit bought for a job interview is clothing and also an investment.

Government can invest but it often doesn’t do it very well. Look, for example, at the histories of Britain’s coal and steel industries. Both had vast sums of money lavished on them by government with the aid of dragging them into the late twentieth century. Almost all of that money was wasted, going on higher wages – consumption – rather than actual investment. But that’s politics. Miners and steelworkers vote. Modern machine tools don’t.

Simply put, an enterprise which, via the government, has access to taxpayer funding has no bottom line to worry about. They can be as inefficient as they like, they will be bailed out. And, yes, many banks are an example of this these days. Competitive businesses however, with access to no funds other than those which people will give them willingly (either as loans, investment, or payment for goods and services) have to worry about their bottom lines. They have an incentive to invest profitably, not in whichever direction is most expedient over the election cycle. And if they get it wrong, they carry the can, not the taxpayer, ie, you.

As an illustration, Clinton gave the politically popular area of renewable energy as an example of somewhere she’d invest: “Take clean energy. Some country is going to be the clean- energy superpower of the 21st century”. The experience of Solyndra – a politically well connected solar panel producer which took took $535 million of taxpayers money and went bust without producing a single solar panel – doesn’t bode well.

Tax the rich

Clinton claimed that she would be able to pay for all this ‘investment’ by taxing the rich. “Because what I have proposed…would not add a penny to the debt…What I have proposed would be paid for by raising taxes on the wealthy, because they have made all the gains in the economy. And I think it’s time that the wealthy and corporations paid their fair share to support this country.”

I’ve written before about the futility of British governments trying to wring a greater share of the national income out of the public in tax revenue: “Whether the top rate of income tax is 83%, as it was in the 1970s, or 40%, as it was in the years before 2010, the British people seem to have decided in some mysterious way that 35% of their income is all the government is going to get.”

Something similar applies in the United States. As you see in Figure 1, in the ten years 1972 to 1981 inclusive, the top rate of Federal income tax was 70%. Over those years the share of national income taken in by the Federal government in tax averaged 11.67%. Over the ten years from 2003 to 2012 inclusive the top rate of Federal income tax was half that level, 35%. And, over those years the share of national income taken in by the Federal government in tax averaged 9.83%: a difference of 1.84 percentage points.

Figure 1

picture1

Source: World Bank and the Tax Foundation

You can take any message you like out of Figure 1 depending on which bit you choose. The steep rate cut in 1982 was accompanied by a decline in the share of national income taken by the federal government, but the even steeper cuts of 1987 and 1988 were followed by no such decline. Rises in the top rate of federal income tax from 1991 to 1993 might have started the rise in the federal government’s share of national income beginning in 1993, but this rise continued until 2000, seven years after the rate stopped rising. Indeed, since then, if anything, it looks as though it is changes in the federal government’s share of national income which have led changes in tax rates.

Indeed, as Figure 2 shows, the share of the US national income taken by the federal government in tax seem more closely correlated, in recent years at least, with economic growth.

Figure 2

Picture2.jpg

Source: World Bank and the Tax Foundation

The policy lesson would seem to be that if you want the government’s share of national income to rise you’re better off working to get the economy growing rather than tinkering with tax rates.

Clinton also blamed the housing boom and bust of the 2000s on the Bush tax cuts. “Well, let’s stop for a second and remember where we were eight years ago”, she said, “We had the worst financial crisis, the Great Recession, the worst since the 1930s. That was in large part because of tax policies that slashed taxes on the wealthy, failed to invest in the middle class, took their eyes off of Wall Street, and created a perfect storm.”

In am not aware of a serious economist, in their serious work at least, who thinks that tax cuts were even in part behind the housing bubble and its bursting. Indeed, there is a surprising amount of consensus that the causes were monetary, not fiscal.

Joseph Stiglitz has written that following the burst of the dot com boom in 2000

“…Greenspan lowered interest rates, flooding the market with liquidity…[the lower interest rates] worked – but only by replacing the tech bubble with a housing bubble, which supported a consumption and real estate boom”

Nouriel Roubini wrote

“The bubble eventually burst in 2000, and Greenspan’s Fed responded by slashing interest rates by 5.5 percentage points – from 6.5 percent to 1 percent – between 2001 and 2004. The rising tide of easy money helped cushion the bursting of the tech bubble, but it fed another bigger bubble in housing”

Thomas E Woods writes

“That year [June 2003 to June 2004] saw eleven rate cuts. The unsustainable dot-com boom could not, in the end, be reignited…But the Fed’s easy money and refusal to allow the recession of 2000 to take its course led to an even more perilous bubble elsewhere”

The gender wage gap and the minimum wage 

Beyond this, Clinton showed that she is interested in solving problems that aren’t problems and using solutions that aren’t solutions. Paradoxically, she claimed that, while cutting regulations for small businesses, “We also have to make the economy fairer. That starts with raising the national minimum wage and also guarantee, finally, equal pay for women’s work.”

As has been pointed out time and time again, the gender pay gap is a myth. The oft repeated charge that “the typical woman who works full-time earns 79 cents for every dollar that a typical man makes” is completely bogus. It is derived simply by taking a ratio of the difference between women’s median earnings and men’s median earnings: 21 cents. It takes absolutely no account whatsoever of the different types of work men and women do. When factors like that begin to be figured in the gap disappears.

Indeed, Clinton herself might not actually believe it. At one point in the debate she said “(Trump) doesn’t think women deserve equal pay unless they do as good a job as men”, leaving me asking “Well, what’s wrong with that?”

Clinton also said she would raise the federal minimum wage as part of an effort to help the middle class (a policy Trump also supports). It will do no such thing. Put briefly, if an employer estimates that a worker will add $8ph to their revenue, they will hire that worker at any wage up to $8ph as they will be adding more to their income (the revenue) than their costs (the wages) by doing so. If the minimum wage is raised so that that worker cannot now be hired at any wage less than $10ph, the employer will not hire them. Doing so will add more to costs (the wages) than to income (the revenue). No company that increases costs more than income will be around for very long.

All a raise in the minimum wage from the current $7.25ph to $10ph would do is lock out of the labour market workers whose contributions to turnover employers estimated at less than $10ph. These will be the lower skilled workers Clinton presumably seeks to help. As I wrote recently, one way to help these workers is to help them acquire the skills to raise employers expectations of what revenue they might generate. This is somewhere where genuine government investment could play a part.

Donald Trump

Corporate Tax

Indeed, the first bit of economic sense came from Donald Trump. “So what (companies are) doing is they’re leaving our country, and they’re, believe it or not, leaving because taxes are too high and because some of them have lots of money outside of our country.” He went on to argue that one way to bring them back is to lower the tax on corporate profits.

This makes sense. The United States has the third highest rate of corporate tax in the world. You can’t really blame companies which increasingly do business in multiple political jurisdictions for choosing to domicile in one that doesn’t take nearly four in every ten dollars profit they make.

Indeed, the tax should be abolished completely. Just because a tax is called a ‘corporate tax’ does not mean that corporations pay it. The incidence of the tax, ie, who the burden of paying for it actually falls on, is a different thing altogether. In reality, corporation tax is paid by either consumers, shareholders, or workers.

When tax on cigarettes are put up the cost is not paid by the tobacco companies in lower profits but by the addicted smokers in higher prices. The price elasticity of demand for the product is low so the producer can pass the full cost of the tax on to the consumer.

If the price elasticity of demand for a product is high, ie, an increase in its price will see consumers buying less of it, then the tax will be paid by either shareholders or workers. How the burden is split between these two categories depends on how many of each there are relative to the other. If there are lots of workers around, they will accept wages low enough to offset the burden of the corporate tax. By one estimate, the average share of the corporate tax burden borne by workers is 57.6% of the amount raised by the tax.

Monetary policy

Trump was also onto a winner with his comments about Federal Reserve monetary policy.

“Now, look, we have the worst revival of an economy since the Great Depression. And believe me: We’re in a bubble right now. And the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down.”

“We are in a big, fat, ugly bubble. And we better be awfully careful. And we have a Fed that’s doing political things. This Janet Yellen of the Fed. The Fed is doing political — by keeping the interest rates at this level. And believe me: The day Obama goes off, and he leaves, and goes out to the golf course for the rest of his life to play golf, when they raise interest rates, you’re going to see some very bad things happen, because the Fed is not doing their job. The Fed is being more political than Secretary Clinton.”

This echoes something I wrote three years ago

“As interest rates are lowered in response to an adverse shock investment, calculations change, especially when, like Alan Greenspan, those behind the policy publicly promise its continuance. To the extent that this fosters a wealth effect, consumption, as well as investment, may be stimulated. And this, in fact, is exactly the way the policy is supposed to work.

But the rates cannot stay that low indefinitely, nor, despite the jawboning by monetary policymakers, are they intended to. At some point they will rise. Again, this actually is the way the policy is supposed to work.

And when those rates do rise what happens to those marginal investors who made their decision when rates were at their lowest? What happened to the NINJAs who bought condos in Michigan when interest rates were 1 percent when the rates went up in 2006? They were scuppered. And what will happen to all the enterprises which are currently dependent on interest rates remaining at their historic lows when those rates start to rise? It is because more people are now asking that question that markets have turned skittish recently, since Ben Bernanke even began to discuss a possible future ‘tapering’ of Quantitative Easing.

Those rates will have to rise at some point. But, when they do, whichever bubble we have now will burst. Our monetary authorities have printed themselves into a corner.”

Shortly afterwards I wrote

“On Aug. 15, the London Telegraph reported that British retail sales had risen unexpectedly sharply and that American unemployment had fallen to a six-year low. This would usually be promising macroeconomic news, but that day major indexes—the Dow Jones Industrial Index, the S&P 500, the CAC 40, among others—tumbled. Markets, hooked on the Fed’s cheap liquidity cocktail, were terrified that an improving U.S. economy might see the punch bowl removed with a Fed “taper” of quantitative easing.

A day later, when the results of a U.S. consumer confidence survey came in “far worse than expected,” stock markets rallied. Markets are supposed to be driven by the expectations of a stock’s perceived profitability, not the pursuit of speculative gains caused by the manipulations of central bankers. Now the economy appears to be in a position where the interests of financial markets are precisely at odds with the interests of the rest of the economy.”

International trade

And then he went and blew it. “You look at what China is doing to our country in terms of making our product” he said, “They’re devaluing their currency, and there’s nobody in our government to fight them. And we have a very good fight. And we have a winning fight. Because they’re using our country as a piggy bank to rebuild China, and many other countries are doing the same thing.”

I recently wrote

Indeed, it is true that policymakers in Beijing have tried to keep the yuan weaker against the dollar that market forces might allow…But…this has not been a costless exercise for the Chinese.

By holding down the value of the yuan the Chinese government has held down the purchasing power of Chinese producers. This has effectively worked as a subsidy from Chinese producers, with an average GDP per capita of $14,100, to US consumers, with an average GDP per head of $56,000. If anyone should be angry about this arrangement, it should be Chinese producers.

Indeed, the argument that the Chinese have been using the US as a piggy bank to fund investment in China is exactly the wrong way round. Instead, the US has been using China as a piggy bank to fund American consumption.

Trump often talks of international trade as a struggle with winners and losers. But trade is not a zero sum game in which the benefits for one are offset exactly by losses for another. This fallacy, the root of much modern misguided economic rhetoric, is based, essentially, on the ancient misunderstanding that for two things to exchange for each other these things must have an equal value.

But logically that must be wrong. If I hand over £1.10 for a tuna sandwich I do so because I value the tuna sandwich at more than the £1.10. Conversely, the unnamed supermarket where I buy my lunch values the £1.10 more than the tuna sandwich. If I valued the tuna sandwich as much as I valued the £1.10, why would I exchange the latter for the former? I wouldn’t and the supermarket wouldn’t either. In fact, trade can only take place because people value things differently. ‘Value’ is not a property inherent in a product, it is entirely a function of the human mind and these value different things differently at different times and in different places. Value is entirely subjective.

It follows from this that people trade less valued things for more valued things. They accumulate value through trade. Both parties gain. Trade is a positive sum game.

The verdict

The United States has been woefully governed by both parties for a long time. On the strength of this debate, that won’t be changing for at least another four years.

Helicopter money – An introduction

choppers

Your humble narrator recently had an article in the Wall Street Journal about the new idea in monetary policy, ‘helicopter money’. An earlier draft had a rather tedious discussion of what it was. Mercifully excised from the printed version, I still thought it might be worth sharing. I’ve little doubt you’ll be hearing more about it soon…

Helicopter money takes its name from a 1969 paper by Milton Friedman called The Optimum Quantity of Money. In it Friedman set out to investigate just that. To analyse how people would adjust their cash holdings to achieve this optimum if the money supply were increased, he conducted a thought experiment in which a helicopter flew over a country dropping newly printed money. The point was simply to model an exogenous increase in the money supply, much as David Hume had in his 1752 essay Of Money. Indeed, Friedman also imagined a furnace destroying piles of cash in an effort to model the effects of an exogenous decrease in the money supply. The key point is that when Friedman wrote about helicopter money, he was not advocating anything like the policies currently bearing that title.

How has it come to this? Since the crash of 2008-2009, developed country economies have been stuck with sluggish growth. Their governments also have historically high peacetime levels of debt and new borrowing. With fiscal policy thus constrained, if stimulus is to be administered it is the central banks who will have to do so using monetary policy. Still others think that fiscal policy would be ineffective in any event. Either way, central banks are, as Mohamed El-Erian has written recently, the only game in town.

But the record of monetary policy’s impact is mixed. In 2002, Bernanke gave a speech frequently cited by advocates of activist monetary policy in which he argued that “under a paper-money system, a determined government can always generate higher spending and hence positive inflation”. But in recent years it hasn’t worked like that. Central banks have churned out new base money and pumped it into the banking system in return for (government) bonds, Quantitative Easing. As a result, in Britain, the monetary base has risen by 516% since May 2006. But, for the most part, this money has just sat on bank balance sheets; they have not used it as the basis for the creation of new credit. Hence, over the same period, broad money has risen by just 53%. The transmission mechanism of monetary policy via the banking system is blocked and increases in base money have not filtered through to increases in spending, also known as nominal GDP or aggregate demand. JK Galbraith’s old quip about expansive monetary policy “pushing on a string” has never been truer.

To look at it another way, consider the equation of exchange from your economics textbooks, one form of which is MV=Py. This says that the money supply (M) multiplied by the velocity of circulation (V) equals the price level (P) multiplied by output (y). Velocity of circulation – how many times in a given period a unit of money is spent – can serve as a useful proxy for the demand for money. If the demand to hold money increases, its velocity (V) falls. Conversely, if that demand falls and people want to swap their money holdings for goods or services, V rises. Velocity is the inverse of the demand for money.

When mortgage backed assets tanked in 2008, banks saw their balance sheets ravaged. They desperately demanded cash to shore them up, their V had fallen, in other words. In an effort to ward off a fall in prices and/or output (Py), central banks offset this by increasing M via low interest rates and QE.

But if the aim is to use increases in M to boost Py then the new money must be given to people whose demand to hold money has either fallen or not risen (their V is constant or rising); to put money in the hands of those who would spend it and boost prices rather than hold it as banks have done. This is where the helicopter comes in.

The success of this policy all depends on whether raising a nominal variable (the price level, P) will also raise a real variable (output, or y), that there is a Phillips’ Curve relationship, in other words. This is the notion of an inverse relationship between inflation and employment, which was long presumed dead among the rubble of the Stagflationary 1970s.

This is a point I intend to return to soon. 

 

Central Bankers Are All ‘Corbynistas’ Now

 

papers

Your humble narrator is in the Wall Street Journal Europe again today. I’m arguing that increasingly popular and respectable monetary policies, in this instance ‘helicopter money’, are little different to the People’s Quantitative Easing announced by British Labour Party leader Jeremy Corbyn just less than a year ago, and widely mocked.  “They’re not laughing now”, as the great economist Bob Monkhouse used to joke.

Stock markets gone wild

Today the BBC reported

bbc

I remembered something I wrote in the Wall Street Journal just over two years ago

As a result of this liquidity infusion (Quantitative Easing)—which the Fed last week cut to $75 billion a month—stock markets have nearly doubled since 2009 while the “real” economy has hobbled along with 2% growth. This perverse situation suggests that the stock market has joined government bonds and emerging markets as the latest inflating bubble.

On Aug. 15, the London Telegraph reported that British retail sales had risen unexpectedly sharply and that American unemployment had fallen to a six-year low. This would usually be promising macroeconomic news, but that day major indexes—the Dow Jones Industrial Index, the S&P 500, the CAC 40, among others—tumbled. Markets, hooked on the Fed’s cheap liquidity cocktail, were terrified that an improving U.S. economy might see the punch bowl removed with a Fed “taper” of quantitative easing.

A day later, when the results of a U.S. consumer confidence survey came in “far worse than expected,” stock markets rallied. Markets are supposed to be driven by the expectations of a stock’s perceived profitability, not the pursuit of speculative gains caused by the manipulations of central bankers. Now the economy appears to be in a position where the interests of financial markets are precisely at odds with the interests of the rest of the economy.

Little has changed.

Has monetary policy been ‘loose’ or ‘tight’ in recent years?

One of the policy responses to the economic crisis of 2008 and comparatively subdued economic recovery, was the use of monetary policy.

Central bank policy rates were slashed to the point where the European Central Bank got a reputation for monetary rectitude for having a policy rate higher higher than 0.5%. On top of this, and less conventionally, there was Quantitative Easing, in which central banks printed up new money and used it to buy assets from the financial sector.

Despite this apparent monetary activism, there are some who think that monetary policy was too ‘tight’ – that central bankers were not getting newly printed money out of the door fast enough. Many economists, probably most in fact, think that monetary policy over the period has, by complete contrast, been unprecedentedly loose, for better or worse.

Where does the truth lie? A first step would be to determine what we mean by ‘loose’ or ‘tight’ monetary policy.

I asked this question a while ago. An economist I know told me that monetary looseness could be defined as a situation where MS > MD (money supply, MS, is greater than money demand, MD). It follows from this that monetary tightness would be where MS < MD, and the sweet spot of equilibrium would be where MS = MD. This seems a good place to start.

Well, how do you know whether MS > MD? How do we know when the S of anything is > than the D for it? By a fall in its price.

So what is the price of money? It is the inverse of the price level. To clarify that bit of jargon, think of a DVD that costs £10. That is its price. The inverse of that is that £10 costs one DVD. The DVD buyer gives up £10 to get a DVD, the DVD seller gives up a DVD to get £10.

So, a fall in the price of money would mean that more money could be bought with one DVD. Lets say that the price of money falls so that now the DVD seller only has to give up half of a DVD to get £10. For the buyer, the price of the DVD has risen to £20. In other words, a fall in price of money is better known as inflation.

The same works in reverse. If a DVD seller has to give up two DVDs to get £10, the price of money has risen, in other words, then each DVD will now only cost the buyer £5. As generally understood, prices have fallen and we have deflation.

So if we see inflation we are seeing monetary looseness and if we see deflation we are seeing monetary tightness. What have we seen in recent years?

Consumer Price Indices – RPI indices: 2008 to 2015: September 2008=100

Picture1

Source: Office for National Statistics

The chart above shows a dip from the September 2008 pre-crash peak on an index of prices of 3.8% until January 2009. In the nearly six years since then, the index has risen to 23% above that trough and 19% above the pre-crash peak. This steady, but by historic standards modest, inflation, which equals a fall in the price of money, suggests a degree of monetary looseness, which equals MS > MD.

In short, by analysing money as thought it was like any other good or service, monetary policy in recent years has been loose, but not very.

Paying for government – From Scotland to Greece and beyond

greece

Governments have three ways of getting money to spend

1) They can tax it

2) They can borrow it

3) They can print it

If you can think of anymore, let me know.

I wrote a little while ago about how the government of an independent Scotland would finance itself. I argued that if Scotland adopted a currency board with England its government wouldn’t be able to pursue 3 and if their fiscal situation was poor they’d struggle do 2, at least at a rate they could afford. This would leave them entirely reliant on 1 and I doubted that that avenue would provide the revenue necessary to sustain Scotland’s present levels of government spending.

The case of Greece is interesting. In the euro its government cannot pursue 3. It’s citizens have a famously low tolerance for 1. It has just about exhausted its capacity for 2. That is the Greek crisis in a nutshell.

If Greece left the euro I believe avenues 1 and 2 would still be closed to the Greek government. I don’t think Greeks are going to suddenly start paying lots more tax and I doubt lenders will reassess the country as a sound credit risk. But the Athens government would reopen avenue 3 – it would have control of a new drachma and could print it to finance its spending.

The obvious drawback is that this would be inflationary. All those euros that Greeks are unable to shift out of Greece would be swapped at some rate for x drachma and that rate would, almost certainly, fall and fall quite rapidly as the government printed more drachmas to continue funding pensions which currently amount to 16.2% of Greek GDP. The spending power of Greek citizens will fall just as surely as if their wage had fallen in nominal terms from €1,000 to €800 a month.

But even this has limits. If they could find a counter party (a big if) holders of drachma could switch their currencies, even at heavy discounts, for other currencies in an effort to preserve something of their purchasing power. This is capital flight. Alternatively, they could swap money for goods and services in Greece while their money can still purchase them. The falling demand for money relative to the demand for goods and services would increase the money price of those goods and services – inflation. Less generally, it could push up only a few prices and create asset bubbles. The point to make is that all money is convertible, even fiat paper money. That, after all, is its point.

Governments always and everywhere have to live within the three means listed at the top. 1 is limited by the public’s willingness to pay. 2 is limited by people’s willingness to lend. 3 is limited by people’s ability to swap their money for something else. Hopefully this will be heeded by whoever is in charge in Greece a month or so from now.

EDIT – This post was picked up by the people at the Foundation of Economic Education