Your humble narrator is in City AM today explaining why central bankers can’t grow real GDP so we shouldn’t expect them to.
Your humble narrator is in City AM today explaining why central bankers can’t grow real GDP so we shouldn’t expect them to.
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.
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.
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.
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”
“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”
“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.
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.
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.”
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.”
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 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.
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
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.
In this quarter’s Economic Affairs I have a review of Money, Blood and Revolution: How Darwin and the doctor of King Charles I could turn economics into a science by George Cooper. If you have access, you can find it here.
In this quarter’s Economic Affairs I have my first book review, of Positive Linking: How Networks Can Revolutionise the World by Paul Ormerod. If you have access, you can find it here.
No money down
It is famously said that a butterfly flapping its wings in Brazil can cause a hurricane on the Florida coast. But how did mortgage defaults in the United States lead to queues around the block outside banks in this country?
Back in 2001 the American economy was reeling under the double blow of the bursting of the dot com boom and the September 11th terrorist attacks. In order to keep the economy buoyant, the Federal Reserve cut interest rates 13 times between 2001 and June 2004 in an effort to boost consumption and prompt the US to spend its way out of the nascent recession. By December 2001 the Federal Funds rate was down to 1.75%.
Interest rates are simply the price of money. A 5% annual interest rate on a loan of £100 will mean that you will eventually pay back £105 if you pay it off at the end of the year. And, as interest rates (the price of money) fell, people suddenly found they could afford loans. These keen borrowers found eager lenders.
The lenders had a brand new way of working. Traditionally they could loan someone money to buy a house and they would have kept the house as collateral. Now, they sold the debt on the debt market to, let’s say, Third Party Inc. In essence, the mortgage repayments would now be going to Third Party Inc and, in the event of default, Third Party Inc would repossess the house and sell it in order to make back its initial outlay. These bundles were known, among other things, as Collateralised Debt Obligations (CDO’s).
But that wasn’t all. Third Party Inc could take this debt and package it with another one. The idea was that this would insure one with the other in the event that it ever turned sour. Risk spread was supposed to be risk lessened.
Sadly, these derivatives were less like steel rivets spreading the load through the structure of a building, and more like the cracks in a dam ready to burst. Back in 2003, Warren Buffet called them “financial weapons of mass destruction”. Nevertheless, the trade in these derivatives boomed as they were packaged and repackaged, sold and resold, and they shot through the global economy like shrapnel.
The insatiable appetite for more debt to be repackaged and resold led lenders to look to people with bad credit histories, who, with interest rates so low, could afford to take the debt on. This was the now infamous ‘sub prime’ market. And as new borrowers with cheap credit flocked into the market house prices boomed. In 2004-2005, five US states recorded house price rises of more than 25%.
But then the sub prime market dried up. Interest rates were now on the way up and borrowers were unable to keep up repayments. Defaults rocketed and lenders suddenly found themselves in possession of houses. The lenders tried to sell these homes to recoup the original loan but found that, with the cost of borrowing rising, new borrowers had been priced out of the market. This sudden rush of repossessed homes coming onto the market coupled with a reduction in potential buyers caused the value of the lenders assets to tumble. In parts of the US a house is cheaper than a new car.
Like a game of pass the parcel, the music had stopped and banks all over the world were anxiously unwrapping their CDO’s to see who was holding a portfolio of worthless bungalows in Florida or Michigan.
This was the credit crunch. Banks were no longer sure if the other banks were prime or sub prime and became reluctant to lend to each other. From August, when the squeeze began, the Interbank rate, the interest rate which banks charge each other, leapt by 75 points in four months. Money stopped flowing and credit dried up.
When the bottom was reached and banks sat, shocked and surrounded by torn parcel paper, the losses were posted. Merrill Lynch: $7.8 billion, JP Morgan: $1.3 billion, Citigroup: $9.8 billion, Morgan Stanley: $9.4 billion…
But how did the flapping butterfly, unable to meet its mortgage repayments or lend money to its fellow banks, lead to the hurricane which swept through Britain leaving desperate queues outside banks, a potential liability of £3000 for every British household and a nationalisation in its wake?
Traditionally people deposit money with banks who would then lend it out charging interest. Northern Rock had hit upon a different idea. Instead of limiting their lending to an amount backed by deposits, they funded their mortgage loans by borrowing on the money markets. For a while it worked and Northern Rock’s profits soared.
But when, in August, the credit market seized up, Northern Rock ran out of cash. In desperation, the bank went to the Bank of England on September 13th to ask for an emergency loan. With the credit market in a coma it looked as though other banks would soon be in the same situation. Their share prices began to fell, that of Alliance and Leicester providing a notable source of worry.
Were back at the creaking dam metaphor again. With a banking crisis in the offing the government piled in to prop up Northern Rock. But the law of unintended consequences came into play as Rock’s depositors took this government intervention as a sign that the bank was doomed. They began withdrawing their savings no matter how long they had to queue.
Thus, the government was called on to lend more and more. They desperately sought a buyer for the stricken bank which would guarantee repayment of the massive sums lent. However, due to the ongoing credit crunch, no buyer could afford to borrow the money to finance a takeover. The government, the taxpayer, you and me, were left holding the baby. By mid January the treasury had spent £55 billion to shore up Northern Rock. Compare this with the annual defence budget of £33 billion.
On February 17th the government gave up its forlorn search for a buyer who would take Northern Rock off its hands and nationalised it. The aim is to run the bank until a private sector buyer can be found. To do this, the bank will have to be running at a profit so as to attract buyers and this means that the government will be competing for market share with other banks. One wonders how shareholders in these other banks will feel now that they are subsidising a competitor since we all became shareholders in Northern Rock.
There is no telling how long this period of government ownership will last as a falling housing market makes mortgage lenders, such as the Rock, a bad investment. In the 1960’s and 1970’s the British government nationalised many struggling businesses in order to keep them going, such as Rolls Royce and even a brewery, but they often found themselves lumbered with them for the long term. Also, we now have the unpleasant prospect of the government, as owner of Northern Rock, having to evict home owners who fall behind with repayments.
What are the prospects in this grim panorama? In a situation like this, government can typically use either fiscal policy or monetary policy. In this instance, monetary policy would mean the lowering of interest rates with the hope of cutting the price of money and getting people borrowing and spending again. Fiscal policy would mean tax cuts with the aim of increasing people’s disposable income and prompting them to get back into the shops or estate agents.
The US has followed an aggressive fiscal policy. On February 13th the US Congress, with uncharacteristic speed, passed $168 billion worth of tax cuts and investment incentives, about 1% of GDP, in an effort to pump cash back into the economy.
This is not without risks. George W Bush inherited a budget which was in surplus to the tune of $236 billion but has seen this transform into a deficit of $286 billion. The US has got away with this profligacy thanks to the willingness of much of the rest of the world to hold dollars. But, as the US continues to splurge currency around the planet, these dollars are worth less and less. Soon, countries such as China and the Gulf states will begin to question whether they are content to hold onto an asset which is falling in value. The tax cuts are only likely to accelerate this process.
Gordon Brown and Alistair Darling may have even less room for manoeuvre. Despite his reputation for prudence, Gordon Brown has overseen a budget surplus of £14 billion in 2001 turn into a deficit of £43 billion in 2007. As demonstrated by the recent dispute over Police pay, the governments’ tight finances leave it with little room to cut taxes without pruning services further than already planned.
America and Britain have also gambled on an active monetary policy. America’s Federal Reserve has been on its biggest interest rate cutting spree in 25 years and rates have now fallen by 2.25% since the August crunch to just 3%. The Bank of England has gingerly followed suit with rates cut from 5.75% to 5.25% between August and February.
The problems with this are obvious. It was a glut of cheap money which started this whole process in the first place and we are right back to where we started. Besides, with the Fed cutting rates from what was already quite a low level, it has to be asked just how much more scope there is for further cuts. With inflation at a little over 2%, interest rates of 3% are barely positive as it is.
In Britain monetary policy runs into problems of inflation. As interest rates are cut more money flows into the economy. Yet, unless there is a corresponding increase in output, this money will be chasing relatively scarcer goods and inflation, or the rate at which prices rise, will increase.
The Treasury has long fiddled the figures on inflation by using the Consumer Price Index as a measure which leaves out spending on things, like mortgages and Council Tax, which have been rising fastest. Whereas CPI has inflation running at 2.1%, the broader Retail Price Index has it at 4%. A survey of British workers, which showed their expectations of inflation in the coming year to be 3.3%, suggests that the RPI might be nearer the mark and that the Chancellor has less room for manoeuvre than may be apparent.
But saviours may be ready to ride over the horizon, only they will be wearing Arab robes and Chinese sandals, not suits of armour. For decades the west, and the US in particular, have been spending more money than they have coming in. As a result countries all over the world have found themselves sat on vast reserves of foreign currency. Now deployed by governments as instruments of economic policy, they have become known as the sovereign wealth funds. Since August last year these funds, valued at around $2.9 trillion, have injected $69 billion into western banking.
Whether this is a good or a bad thing depends on how you feel about Globalisation. Though there is a certain irony in the rich world being bailed out by its developing neighbours, it does at least show that economic muscle is not as concentrated as it once was.
But while this welcome cash may be a good short term fix, it is not a long term proposition. The sovereign wealth funds are funded by savings, like the 40% of GDP which the Chinese have saved up. But, as these countries become more affluent, their people are going to want a more affluent lifestyle and this means they will have to save less. As the Chinese decide to eat more of the meat or wear more of the designer clothes their rising incomes can now buy them, the sources of the sovereign wealth funds riches will shrink. This bail out may well be a one off event.
Ultimately, whether it is monetary or fiscal policy or the unknown quantity of sovereign wealth funds, this is a problem caused by an excess of cheap money being solved with another dollop of cheap money. A line from Alice in Wonderland seems all too appropriate for this story; “That’s the reason they’re called lessons,’ the Gryphon remarked: ‘because they lessen from day to day’”