Category Archives: The Cobden Centre

Money derivative creation in the modern economy

The money derviatives Bulls turn Bearish

It isn’t often that a Bank of England Quarterly Bulletin starts “A revolution in how we understand economic policy” but, according to some, that is just what Money creation in the modern economy, a much discussed article in the most recent bulletin, has done.

In the article Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate seek to debunk the allegedly commonplace, textbook understanding of money creation. These unnamed textbooks, they claim, describe how the central bank conducts monetary policy by varying the amount of narrow or base money (M0). This monetary base is then multiplied out by banks, via loans, in some multiple into broader monetary measures (e.g. M4).

Not so, say the authors. They begin by noting that most of what we think of as money is actually composed of bank deposits. These deposits are created by banks when they make loans. Banks then borrow the amount of narrow or base money they require to support these deposits from the central bank at the base rate, and the quantity of the monetary base is determined that way. In short, the textbook argument that central bank narrow or base money creation leads to broad money creation is the wrong way round; bank broad money creation leads to central bank narrow money creation. The supposedly revolutionary connotations are that monetary policy is useless, even that there is no limit to the amount of money banks can create.

In fact there is much less to this ‘revolution’ than meets the eye. Economists and their textbooks have long believed that broad money is created and destroyed by banks and borrowers(1). None that I am aware of actually thinks that bank lending is solely or even largely based on the savings deposited with it. Likewise, no one thinks the money multiplier is a fixed ratio. It might be of interest as a descriptive datum, but it is of no use as a prescriptive tool of policy. All the Bank of England economists have really done is to describe fractional reserve banking which is the way that, these days, pretty much every bank works everywhere.

But there’s an important point which the Bank’s article misses; banks do not create money, they create money derivatives. The narrow or base money issued by central banks comprises coins, notes, and reserves which the holder can exchange for coins and notes at the central bank. The economist George Reisman calls this standard money; “money that is not a claim to anything beyond itself…which, when received, constitutes payment”.

This is not the case with the broad money created by banks. If a bank makes a loan and creates deposits of £X in the process, it is creating a claim to £X of standard money. If the borrower makes a cheque payment of £Y they are handing over their claim on £Y of reserve money. The economist Ludwig von Mises called this fiduciary media, as Reisman describes it, “transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists”. They are standard money derivatives, in other words.

Banks know that they are highly unlikely to be called upon to redeem all the fiduciary media claims to standard money in a given period so, as the Bank of England economists explain, they expand their issue of fiduciary media by making loans; they leverage. Between May 2006 and March 2009 the ratio of M4 to M0, how many pounds of broad money each pound of narrow money was supporting, stood around 25:1.

But because central banks and banks create different things consumer preferences between the two, standard money or standard money derivatives, can change. In one state of affairs, call it ‘confidence’, economic agents are happy to hold these derivatives as substitutes for standard money. In another state of affairs, call it ‘panic’, those same economic agents want to swap their derivatives for the standard money it represents a claim on. This is what people were doing when they queued up outside Northern Rock. A bank run can be described as a shift in depositors’ preferences from fiduciary media to standard money.

Why should people’s preferences switch? In the case of Northern Rock people came to doubt that they would be able to actually redeem their fiduciary media for the standard money it entitled them to because of the vast over issue of fiduciary media claims relative to the standard money the bank held to honour them. Indeed, when Northern Rock borrowed from the Bank of England in September 2007 to support the commitments under its broad money expansion it increased the monetary base just as the Bank of England economists argue.

But there are limits to this. A bank will need some quantity of standard money to support its fiduciary media issue, either to honour withdrawals by depositors or settle accounts with other banks. If it perceives its reserves to be inadequate it will need to access new reserves. And the price at which it can access those reserves is the Bank of England base rate. If this base rate is relatively high banks will constrain their fiduciary media/broad money issue because the profits earned from making new loans will not cover the potential cost of the standard/narrow money necessary to support it. And if the base rate is relatively low banks will expand their fiduciary media/broad money issue because the standard/narrow money necessary to support it is relatively cheap.

Some commentators need to calm themselves. As the Bank of England paper says, the central bank does influence broader monetary conditions but it does so via its control of base rates rather than the control of the quantity of bank reserves. The reports of the death of monetary policy have been greatly exaggerated.

Notes:

(1) “Banks create money. Literally. But they don’t do so by printing up more green pieces of paper. Let’s see how it happens. Suppose your application for a loan of $500 from the First National Bank is approved. The lending officer will make out a deposit slip in your name for $500, initial it, and hand it to a teller, who will then credit your checking account with an additional $500. Total demand deposits will immediately increase by $500. The money stock will be larger by that amount. Contrary to what most people believe, the bank does not take the $500 it lends you out of someone else’s account. That person would surely complain if it did! The bank created the $500 it lent you” – The Economic Way of Thinking by Paul Heyne, Peter Boettke, and David Prychitko, 11th ed., 2006, page 403. Perhaps the Bank of England economists need to read a better textbook?

This article originally appeared at The Cobden Centre

Advertisements

Do we have easy money?

The headwaters

This week marked the fifth anniversary of the 0.5% Bank of England base rate and the Bank of England’s Quantitative Easing program which has so far seen the Bank conjure up £375 billion of new base money and spend it on British government debt. It’s difficult to imagine money being any ‘easier’.

Or is it? At his Money Illusion blog this week, Scott Sumner asked

“1.  Japan has had interest rates near zero for nearly 2 decades.  Is this easy money, despite an NGDP that is lower than in 1993?  Despite almost continual deflation?  Despite a stock market at less than one half of 1991 levels.  Despite almost continually falling house prices?  If it’s easy money, how much longer before the high inflation arrives?

2.  The US has had near zero interest rates for more than 5 years.  Is this easy money?  If so, how much longer until the high inflation arrives?  If rates stay near zero for 2 more years, and inflation stays low, will you still call it easy money?  How about 5 more years?  Ten more years?  Twenty? (Sumner 2014)

It is a key tenet of Market Monetarist thought that a low base rate or Fed funds rate is no indicator of whether money is ‘easy’ or not[1]. The correct indicator, they argue, is the growth rate of nominal GDP; if it’s slumping money is too tight, if it’s roaring on it’s too loose, and if it’s ticking along at some predetermined rate all is rosy in the monetary garden. As a result of this analysis Market Monetarists like Sumner believe the Bank of England’s low base rates and vast monetary base expansion do not indicate ‘easy money’. Are they right?

Well, first we have to define what we mean by ‘easy money’. It’s a rhetorical term rather than a textbook one so here’s my definition (which, if you don’t accept it, probably scuppers the following analysis so feel to substitute your own); money is ‘easier’ the more people who want credit can get it[2].

There are two points to make. First, the choice of ‘credit’ rather than ‘money’ is deliberate. When most of us ‘borrow money’ we are, in fact, accessing credit which is some derivative of, or claim on money. Secondly, a point I’ve made previously (Phelan 2013), economy wide aggregates often tell us little of interest or use. Often more useful and interesting is to disaggregate. Instead of looking at the availability of credit to the British economy look instead at the availability of credit to different bits of it.

Looked at like this we would have to say that for most businesses and individuals in the UK, despite the tripling of the monetary base since March 2009, credit is not easily available and money cannot be said to be ‘easy’. The most recent Bank of England lending report in January noted that “The rate of decline in the stock of lending to UK businesses eased slightly in the year to November compared to 2012. The annual rate of growth in the stock of secured lending to individuals rose slightly to 0.8% in the three months to November” (Bank of England 2014) –November’s fall in business lending being the biggest in six months.

But banks certainly do have ‘easy’ money. That tripling of the monetary base, as I wrote recently (Phelan 2014), has flowed onto their balance sheets and stayed there. The money multiplier has collapsed and growth of base money, M0, has not led to growth in broader monetary aggregates such as M4, which would influence nominal GDP. The open handed stance of the Bank of England isn’t showing up as ‘easy’ money as Market Monetarists see it because ‘easy’ money for banks isn’t translating into ‘easy’ money for the rest of the economy[3].

Do we have easy money? On my definition that depends on who ‘we’ is. Banks face little constraint on their ability to access credit from the Bank of England so for them the answer is yes. The rest of us who rely on those banks find it rather tighter.

References

Bank of England. 2014. “Trends in Lending” January.

Friedman, Milton. 1998. http://www.hoover.org/publications/hoover-digest/article/6549

Phelan, John. 2013. “Output gaps and heterogeneity.” Accessed March 6th.

http://www.cobdencentre.org/2013/11/output-gaps-and-heterogeneity/

Phelan, John. 2014. “Britain’s inflationary outlook.” Accessed March 6th.

http://www.cobdencentre.org/2014/01/britains-inflationary-outlook/

Sumner, Scott. 2010. “Milton Friedman vs. the conservatives” Money Illusion, August 24th.

http://www.themoneyillusion.com/?p=6564

Sumner, Scott. 2014. “How much longer?” Money Illusion, March 3rd.

http://www.themoneyillusion.com/?p=26274


[1] Sumner (2010), for example, draws on Friedman’s analysis of Japan in the 1990s (Friedman 1998)

[2] For fans of mathematical notation, if E is monetary ease and C is availability of credit then E=f(C)

[3] If we think of a river, with M0 pouring out of the spring at Threadneedle Street and the broad delta downriver being M4, banks’ demand for money has built a big dam stopping the river flowing. The Market Monetarist solution to this is to get the spring pouring out enough money that it flows over the top of this dam – in Quantity Theory notation to offset the decline in V stemming from banks’ increased money demand (which with downwardly sticky P would pull down y) with sufficient expansion of M

Britain’s inflationary outlook

I’ve recently written for Save Our Savers attempting to square the massive expansion of Britain’s monetary base since March 2009 with the fact that inflation has now been within the Bank of England’s target range of 2% (+/- 1%) since June 2012. Here I’d like to expand a little.

Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009

https://i2.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/Untitled.png

Source:The Bank of England, series Notes in circulation – RPWB55A, and Reserve Balances – RPWB56A

This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.

https://i0.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/Untitled2.png

Source:The Bank of England, series Notes in circulation (RPWB55A) and Reserve Balances (RPWB56A) (M0), and Monthly amounts outstanding of M4 (monetary financial institutions’ sterling M4 liabilities to private sector) (in sterling millions) seasonally adjusted  (LPMAUYN) (M4)

This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.

https://i1.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/Untitled3.png

The chart above shows the ratio of M0 to M4 since May 2006; how many pounds of broad money each pound of narrow money is supporting. From 25:1 between May 2006 and March 2009, it slumped via successive bouts of Quantitative Easing to about 6:1 since September 2012.

Now, on the one hand banks might stick to this new, lower ratio. Chastened by their experiences with mortgage backed assets they might desire a permanently lower reserve to asset ratio and all QE will have been is a vast recapitalisation of banks.

On the other hand, as ‘recovery’ kicks in they might start to increase their reserve to asset ratio. They might not scale the giddy heights of 25:1 again, but they will be multiplying out from a monetary base which has tripled in size. Britain’s monetary base is now £362 billion and M4 is about six times that, £2.2 trillion. But if renewed confidence in the banking sector saw banks return to higher ratios, the resulting M4 figures would be as follows:

https://i0.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/Untitled4.png

Here, we are told, the Bank of England will be able to ‘drain’ this liquidity from the system. It would do this by reversing QE; selling bonds to banks and effectively destroying the base money it receives in return. But a massive increase in the supply of bonds relative to the demand for them will lower their price. This is the same as raising their yield and this is the same as raising a key interest rate.

It is worth pondering for a moment the scale of bond sales and consequent rise in interest rates which might be necessary to drain this base money from the financial system. We must hope either that the economy can stand it or that banks keep holding these reserves.

This article originally appeared at The Cobden Centre

The economics of the minimum wage

Minimum wages are a popular topic. Barack Obama proposes a nearly 40% increase from $7.25 per hour to $10.10 and David Cameron has faced calls from some of his own backbenchers to raise Britain’s minimum wage of £6.31 per hour for over 21s. What are the economics?

A wage is the price of labour. At a given price/wage (W1) a certain amount of labour will be purchased (L1). We can show that with the following chart

https://i2.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w1.png

Many argue that we can make people better off by either setting minimum wages or raising those that there already are. But what are the effects of this? Put another way, what is the effect of raising the price of labour? We can show that with the following chart

https://i2.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w21.png

As with anything, if you raise its price the quantity of it demanded falls (caveats discussed below); there is less employment, in other words. As economists Paul Krugman and Robin Wells put it, “when the minimum wage is above the equilibrium wage rate, some people who are willing to work  that is, sell labor  cannot find buyers – that is, employers willing to give them jobs.” (Krugman and Wells 2008) Indeed, most supporters of higher minimum wages tacitly accept this. When you ask them “If raising minimum wages makes people better off, why not raise them to £/$50 per hour?” they generally reply “Don’t be so silly”. Well, indeed. A minimum wage that high would be unaffordable for many employers and unemployment would increase.

But by acknowledging that at a higher price a lower quantity of labour will be demanded they are acknowledging that the demand curve for labour slopes downwards as shown in the following chart

https://i1.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w3.png

But if the labour demand curve slopes downwards between £/$50 per hour and the current minimum wage why would anyone assume that it doesn’t continue to slope downwards below the minimum wage? In other words, might we not see an increase in employment if we reduced the minimum wage (in real or nominal terms) or eliminated it? At that point the conversation often moves to whether people should be able to hire/work at those lower wages, a question outside the scope of economics.

Now for those caveats. I recently asked some friends whether they would continue to buy the same amount of something if its price went up 25%. One answered “Well, cigarettes pretty much have (over a comparatively short time), and I pretty much have continued to buy them. But I admit that my sickness at having to pay that much for my brand has now driven me to tobacco during the week and the odd cigar at the weekend now (rather than the fiver per day for a pack of Embassy)”

What my friend Miguel has identified here is the notion of elasticity, the change in the quantity of something demanded resulting from a change in its price. If the quantity of something demanded varies greatly with changes in price then demand is ‘elastic’, if the quantity demanded changes very little (or not at all) with changes in price it is, like Miguel’s cigarettes, ‘inelastic’. We can show an inelastic demand for labour with the following chart

https://i2.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w4.png

Here, with the steep curve given by the inelastic demand for labour, a large rise in the wage from W1 to W2 gives a comparatively small drop in employment, from L1 to L2.

But is labour demand inelastic? One of the factors determining elasticity is the availability of substitutes. If nothing else can fulfil the role of the good which is rising in price you will have to pay more (up to a point) but if something else will do well enough you will switch to buying that instead. And there is a substitute for labour; capital, the price of which is falling thanks to technological innovations just as people campaign to raise the price of labour. In a supermarket lately you might have used a machine to scan your own shopping. Those machines are direct substitutes for the labour of checkout staff. Or, as a meme humorously put it recently,

https://i1.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w5.png

Another friend replied “Depends on the price to start with, the income of the person and their lifestyle. If Nigella Lawson was on a fixed rate water bill and it went up 25% then I think we can be pretty certain she would buy and consume the same amount.”

Indeed, as Tom says, rises in prices are felt differently by different people – and companies. Raising the price of labour by 40% might not have much of an effect on a big business operating on wide profit margins but it would be crippling for a smaller business with its much thinner margins. It’s curious that many supporters of ‘Buy Local’ also support minimum wage policies which give big businesses a crushing competitive advantage over smaller businesses.

So much for the theory, what about the practice? An extensive review of studies into the effects of minimum wages carried out in 2006 by economists David Neumark and William Wascher (Neumark and Wascher 2006) found that

“the oft-stated assertion that recent research fails to support the traditional view that the minimum wage reduces the employment of low-wage workers is clearly incorrect. A sizable majority of the studies surveyed in this monograph give a relatively consistent (although not always statistically significant) indication of negative employment effects of minimum wages. In addition, among the papers we view as providing the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries. Two other important conclusions emerge from our review. First, we see very few – if any – studies that provide convincing evidence of positive employment effects of minimum wages, especially from those studies that focus on the broader groups (rather than a narrow industry) for which the competitive model predicts disemployment effects. Second, the studies that focus on the least-skilled groups provide relatively overwhelming evidence of stronger disemployment effects for these groups.”

Neumark and Wascher updated and expanded this study in their 2009 book Minimum Wages (Neumark and Wascher 2009), concluding that

“minimum wages do not achieve the main goals set forth by their supporters. They reduce employment opportunities for less-skilled workers and tend to reduce their earnings; they are not an effective means of reducing poverty; and they appear to have adverse longer-term effects on wages and earnings, in part by reducing the acquisition of human capital.”

A fitting conclusion here also.

References

This article originally appeared at The Cobden Centre

Economics – orthodox and heterodox

Any old iron

In 2008 as The Great Moderation came to an end, Queen Elizabeth II asked Mervyn King “Why did no-one see this coming?” Her Majesty had clearly not read either Irrational Exuberance by recent Nobel laureate Robert Shiller, or Crash Proof by Peter Schiff (probably not a Nobel candidate). If she had she would have realised that, in fact, at least two economists, albeit with very different approaches, did see this coming. There were warnings, but many chose to ignore them. But Her Majesty was on to something, the belief that the crash had caught economists napping became quite widespread.

This dissatisfaction with the orthodox macroeconomics practiced by policymakers and taught in universities on both sides of the Atlantic has sparked an increased interest in heterodox economics, such as inspired Manchester University’s Post-Crash Economics Society which declares “The world has changed, the syllabus hasn’t”. There is much to commend this trend – much orthodox macroeconomics is mathematically overelaborate bunk. But what exactly is the orthodox we should be shunning and the heterodox we should be embracing?

According to the Guardian, one of the economists backing the efforts of students like those in Manchester is Cambridge University’s Ha-Joon Chang who says “Students are not even prepared for the commercial world. Few [students] know what is going on in China and how it influences the global economic situation. Even worse, I’ve met American students who have never heard of Keynes.”

Really? I did my economics degree at Birkbeck College between 2007-2011. One of my modules was Macroeconomic Theory and Policy and the course text was 2007’s Macroeconomics by N. Gregory Mankiw and Mark P. Taylor. It contains eleven index entries under ‘Keynes, John Maynard’  (‘consumption function’, ‘economic theory’, ‘gold standard’, ‘inflation’, ‘inflation as taxation’, ‘interest rate determination’, ‘investments’, ‘IS curve’, ‘IS-LM model’, ‘real wages, cyclical behaviour of’, and ‘stock market speculation’) and a further nine under ‘Keynesian Cross’ (‘adjustments’, ‘decrease in taxes’, ‘dwindling in popularity of’, ‘economy in equilibrium’, ‘government purchases’, ‘planned expenditure’, ‘policy shifts and’, and ‘taxes’). In another module, Intermediate Macroeconomics, the course text was 2007’s Macroeconomics by Stephen Williamson. Solidly in the Real Business Cycle tradition even this book contains index references to ‘Keynesian business cycle theory’ (‘labor market in a sticky wage model’), eleven references under ‘Keynesian coordination failure model’,  and one each for ‘Keynesian transmission mechanism for monetary policy’, and ‘Keynesian unemployment’.

Besides, the point of university is that you do much of the study off your own bat. At the end of my first year I had got so fed up reading textbooks telling you what was in The General Theory that I went and read it myself. Quite honestly, it is difficult to believe that Chang actually has met “American students who have never heard of Keynes” and if he did they would seem to be uninquisitive, unrepresentative idiots who a change of syllabus is unlikely to help.

In another Guardian article Mahim Husnain and Rikin Parekh of the Manchester society write that “in the education we receive as economics students, there is little stress on how a market could fail”. If this is true then the curriculum at Manchester University is very different to mine. In a module on Intermediate Microeconomics  one of the textbooks we used was 2003’s Microeconomics by Robert S. Pindyck and Daniel L. Rubinfeld, the fourth and final part of which was called ‘Information, Market Failure, and the role of the Government’. We also used Hal R. Varian’s 2006 text Intermediate Microeconomics which included entire chapters on supposed sources of market failure such as ‘Monopoly’ and ‘Oligopoly’, ‘Public Goods’, ‘Externalities’, and ‘Asymmetric Information’.

Much of the microeconomics taught at universities is, in fact, based on notions of market failure and what the government can apparently do to remedy them, so much so in fact, that Joseph Stiglitz, George Akerlof, and Michael Spence won the Nobel prize in 2001 for their work on the subject. If you haven’t come across it either your university is letting you down or you’re not paying attention in class.

Michael Joffe, professor of economics at Imperial College, London, says “many reformers (have) called for economics courses to embrace the teachings of Marx and Keynes”. But heterodox economics should not simply mean any old rubbish. Some of it, like Marx with the ludicrous Labour Theory of Value as the keystone of his system, is heterodox for a very good reason.  And the idea that Keynes is or was particularly neglected and that universities are teaching that markets can never fail is simply untrue; he is an integral part of the orthodox mainstream.

Economists should always be testing their theories against new ideas and to that extent the recent interest in different approaches is to be welcomed. But we should be wary of people trying to pass off the useless (Marx) or the thoroughly familiar (Keynes) as something fresh and challenging.

This article originally appeared at The Cobden Centre

Output gaps and heterogeneity

What shape is the Short Run Aggregate Supply (SRAS) curve? The question might sound tediously esoteric but it is, in fact, central to current economic policy debate.

In the long run almost all economists agree that the supply curve is vertical. The quantities of factors of production (land, labour, capital) available at a given time are fixed and even combined in the most efficient way can yield only a given amount of output. In this long run analysis the only way to increase the supply of goods and services available, the essence of economic growth, is to shift the vertical supply curve to the right by either increasing the amount of productive factors, or increasing the efficiency of their combination (their Total Factor Productivity).

Some economists think this also applies in the short run. As a result they argue that any attempted expansion of demand via monetary or fiscal policy, shifting the demand curve to the right, will simply result in rising prices. Output and employment will be unaffected.

But does it actually apply in the short run? After all, we see many factors of production lying idle. Unemployment, at 7.7%, is higher than at any time between January 1997 and May 2009. 14.1% of shops were empty in September according to the Local Data Company, barely down from 14.2% in February. Here we are in the ‘output gap’, the difference between current output and what output would be if all those unemployed workers were put to work in all those empty shops.

Couldn’t monetary stimulus bring these unemployed workers and empty shops together to increase employment and output without causing inflation? Monetary expansion will not cause higher prices, on this thinking, because rather than bidding up the wages of workers already employed or rents of commercial premises already occupied, the idle ones will be employed instead. That is what Bank of England governor Mark Carney sees when saying that monetary stimulus will continue at least until unemployment falls to 7%. Isn’t this the economist’s hitherto mythical ‘free lunch’?

A problem with this approach is that it views the factors of production as largely homogenous. Every square foot of empty commercial property, whether boarded up corner shop or out-of-town retail unit, is lumped in with every JCB as ‘capital’. All unemployed workers, whether builders or estate agents, are aggregated as undifferentiated slack in the labour market. What this approach misses, as does much clumsy, aggregative, ‘modern’ macroeconomics, is heterogeneity.

As economist Benjamin Powell points out, “A tractor is not a hammer”. An economy experiencing a tractor boom may find itself with a glut of unemployed tractors when that boom busts. Hammers, on the other hand, would be relatively scarce. As a result the returns on employing each capital good, tractors or hammers, will differ.

Any monetary stimulus attempting to bring these tractors back into employment will not be confined to spending on tractors. Some, probably most, will be spent on hammers which are not currently idle and whose supply will not expand to accommodate this new ‘demand’ immediately. It will simply bid up hammer prices. And if hammer supply does expand, that expansion will be revealed as an unsustainable malinvestment when the monetary stimulus is withdrawn.

And, a tractor not being a hammer (capital goods being heterogeneous in other words), they are not substitutes. An increased demand for one from monetary stimulus need not result in a proportionate increase in demand for the other. Those idle tractors will remain idle as the hammer boom takes off.

Just as a tractor is not a hammer, Mesut Özil is not Miley Cyrus; labour is also heterogeneous. If the economy had overinvested in midfielders during a singing bubble and there were now too many to gain employment as such in a sustainable pattern of demand, any monetary stimulus designed to get these guys back to work would begin driving up the wages of relatively scarce twerking pop stars before a substantial number of those midfielders had found employment.

Those footballers, like the tractors, do not represent ‘slack’ waiting to be picked up by a few more dollars. They are just dead capital and unsuitable labour, the product of malinvestments.

The lesson is that there is no single Short Run Aggregate Supply curve for the ‘the economy’. In each example above, at a given point the SRAS curve for tractors and running backs was horizontal while those for hammers and pop stars were vertical. Attempts to drive the economy along one aggregated economy-wide curve towards full employment will hit choppy waters sooner than monetary policy makers, with their crude view of a few macro variables, think. They might find they have less room for manoeuvre than their models tell them.

This article originally appeared at The Cobden Centre

The real Iron Law of Wages

Lots of labour, little output

One of the oldest fallacies in economics is that the amount of work done should be reflected in the amount of pecuniary reward received for doing it. How can it be fair that someone who slaves away for hours slicing kebab meat in a kitchen on a sweltering day earns £6.19 per hour while someone who kicks a football around for a few hours a week gets £2,040 per hour?

In fact, the amount of work we do is not commensurate with how much we are paid. Nor should it be. In the late 18th century for every bit of effort the average Indian textile worker put in he or she was paid just one sixth of what a British textile worker was paid for the same amount of effort because the British worker, with their greater capital stock, produced six times as much with that given amount of effort. Whatever our gut reactions, what wages reflect is not the ‘effort’ of the worker but their output and the market’s and the employers subjective valuation of that output.

When deciding whether or not to hire, and at what wage, an employer will only employ that person if  they think doing so will add more to turnover than to costs and they will not pay that person more than he or she is expected to add to turnover. To pay more would mean that that the employer is paying to employ that worker. This is the real Iron Law of Wages.

If a landlady has to pay £100 per week to hire a barman she will hire him if she expects doing so to add more than £100 per week in revenue. If hiring that first barman adds £150 per week to turnover, and a second barman (because of diminishing returns to labour) adds £140 both will be hired. If hiring a sixth barman adds £100 in revenue and hiring a seventh barman adds £90, then the landlady will hire six barmen at £100 per week.

If, however, a minimum wage is introduced which raises the cost of hiring a worker to £115 per week the fifth and sixth barman are now being paid more than they generate in revenue, their marginal product, so they will be laid off. The first four barmen are £15 a week better off, five and six are looking at their P45s.

The lesson is that raising minimum wages, as the Conservatives are now rumoured to be considering, makes some people better off but they also make some people worse off.

Some will deny this and say that the mass job losses predicted when the minimum wage was introduced never materialised. But what about the jobs never created? Number seven in our example who was never employed lost a job just as surely as did barmen five and six when the minimum wage was raised. Indeed, many advocates of higher minimum wages implicitly admit this by not pushing for a much higher minimum. Doing so, they admit, would lead to unemployment. But they can never explain why, if the demand curve for labour is downward sloping at one point, it is not so at another.

The only way to raise wages is to raise the marginal productivity of labour. To make labour more productive we either need to train it better (sending one of our barmen on a cocktail course so he can entice a lager drinker to splash out on a Pina Colada) or give it more capital to work with as in the textile example (optics on spirits bottles as opposed to measuring cups).

Sadly there is reluctance in Britain to pursue either of these paths. Our education system has been slipping compared to those in other nations and our financial system, with its addiction to low interest rates and focus on consumption, is inimical to capital accumulation. If the government is worried about low pay it needs to get serious about these issues. They are fundamental questions and attempts to mollify their symptoms with minimum wages are a waste of time.

This article originally appeared at The Cobden Centre

The Laffer Curve and the limits of the State

Atlas shrugs

I’m mortified to have to pay 50%!” So said the phenomenally successful singer Adele in an interview with Q magazine. And why shouldn’t she be? Isn’t it unfair that a person can perform labour for which they get less of the reward than someone else who didn’t perform it? The right to work as you wish and dispose of the fruits of your labour as you wish are essential rights that differentiate free men and women from slaves. Agreeing with Adele seems a moral slam dunk.

Not if you write for or read the Guardian. They took Adele to task for criticising government spending on transport and schools elsewhere in her interview, remarks which are easily dealt with. But their rebuttal of Adele’s complaint about the 50% tax rate was bizarre; the Guardian simply said “The Beatles had to pay 95%”

This is true historically but the obvious response would be ‘So what?’ It’s worth remembering that the period when these penally high tax rates were in place wasn’t exactly a golden one for British economic policy making with the ‘stop – go’ spasms and sterling crises of the 1960’s giving way to the rampant inflation and economic mayhem of the 1970’s. High taxes are no better an idea now than they were then.

The reason high taxes were and remain the wrong policy prescription is a very obvious one; the more you tax something the less of that something there is. That is why governments pile taxes on cigarettes and alcohol, (they claim) they want there to be less smoking and drinking.

The problem the left had when it imposed high taxes before, and has now that it would do so again, is that while it accepts that this obvious and empirically proven proposition applies to fags or booze, it refuses to see it in action anywhere else. It was this economic blind spot which led Labour to campaign at the last election for a tax on jobs under the strange notion that it would not lead to fewer jobs being created.

Fundamentally, this problem stems from the left’s assumption that everyone is (or ought to be) just like them.  Because they are happy to be servants of the state, seeing it as some benign Rousseauian manifestation of the General Will, they are happy to hand large chunks of their pay packets over to it.

The rest of us, however, are slightly more sceptical of the obviously crazy notion that every single copper coin of government spending is virtuous of itself. Thus, when taxes on our earnings go up, instead of redoubling our efforts and congratulating ourselves for supplying yet more income for the state we tend to be a bit annoyed and wonder what the point of putting any extra effort in is when more than half of the reward for that extra effort will be taken from you. Your effort slackens. You reduce your labour or you go and do it somewhere else. With less labour going on, the state’s income from taxes on labour falls. We saw all this back in the high tax Keynesian heyday of the 1970’s and look where it got us. Taxes went up and The Rolling Stones rolled off to the south of France with their millions and watched on TV as Denis Healey went to the IMF in 1976 to ask for a loan to pay the government’s bills.

It was all rather gracefully explained by the Laffer Curve which took this obvious insight and formalised it. With a tax rate of 0% the government would obviously receive no revenue. But, Laffer argued, with a tax rate of 100% the government would also receive no revenue as all activity would grind to halt because of the disincentive effect of taxes which took all the reward of your labour.

This was, and remains, a direct challenge to the left wing notion that because all public spending is good there is no disincentive effect from higher taxes; that despite receiving less and less of the reward for their labour, people will continue to provide the same amount of taxable labour regardless. To a left winger there would be no Laffer Curve, simply a diagonal line sloping upwards from bottom left at a 45 degree angle.

There is a Laffer Curve shaped mountain of empirical evidence to support this basic contention. Yet the statists’ opposition to this economic truism has often been simply hysterical, even from noted economists. This is because they understand the implications of the Laffer Curve. It sets a cap of t*, whatever the precise numeric value may be, beyond which the state’s share of the economy cannot advance. At some point taxes will rise so high that they will start to decrease revenue, the limits of statism are reached. That is why people like Adele, Philip Green or, indeed, anyone who questions even taxes of over 50% is considered not just wrong but evil. Adele can take comfort that she has morality and economic fact on her side as well as talent.