I stumbled across the website takeonit.com, where users can pose questions which can be answered by yes or no only. Although this does not seem to be made for economists, there are some really interesting questions like Does government spending help mitigate a recession? or Is the US Federal Reserve to blame for the 2008 financial crisis?. There is a frontpage for economics and one for macroeconomics.

Michael Hoel received the above honorary degree from our faculty on June 23rd 2009 (free letter soup included.) He is an early environmental economist, and this is what he looks like:

Irving Fisher presented his idea of 100% Money in 1935. Fisher understood that business cycles would be caused by fractional reserve banking. In good times, commercial banks create more credit, lending reserves ten times over (p. 36), while in bad times they are in dire need for liquidity. In the end, the government would step in and go deeply into debt, saving the banks. This would create booms and recessions, which could be avoided by using 100% money.

With the 100% system, banks have to hold reserves for all loans they hand out. This means that banks can lend out only the money they have but nothing more. Imagine a bank with $110. Under the 10% system, the bank can lend $100 and keeps $10 as a reserve in case the loan does not perform. Given that the lender returns the money to the banking system, some other bank will end up with the $100. It will loan out $90, keeping $10 as a reserve. This happens until 1100$ of loans are build on $110 of money. If, however, the people that deposited the money want to see it to make sure its still in the bank, all banks are bankrupt: the only money they can show is the original $110.

Fisher’s solution is to not allow commercial banks to create credit by requiring 100% reserves. A bank that loans out $100 has to place the money at the currency controller, either directly (physically) or indirectly (via an IOU). The borrower receives a check on the check department which he would deposit (p. 81). Banks cannot create any more credit. That role now belongs to the currency controller. The currency controller has to make sure that the unit of account would be stable. The purchasing power of the dollar should not change (too much) over time, so that expectations can be anchored. Sounds like inflation-targeting? It is. This time, without the financial market booms and busts, it might actually work.

Fisher’s 100% Money is a very interesting idea. Today, it should be understood that fractional reserve banking is part of the problem. Also, all institutions have been pro-cyclical: rating agencies, credit supply, Basel II and so on. So how should all this be regulated? At best, we will come up with second best solutions, since the real problem is endogenous to fractional reserve banking. Maybe abolishing it and replacing it with 100% Money is a good idea. Just moving away from the tiny reserves that we have now towards something bigger would be an improvement, but then why stop before we reach 100%? This will be the question to answer for policy makers.

Fractional reserve banking explained for the non-economist (I have watched only this episode and the next one – which I also recommend – and cannot guarantee for the quality of other episodes):

I posed a question for Xavier Sala-i-Martin today on the website of El Pais (me: Dirk, Oldenburg):

¿Como va a salir España de la crisis y quedarse en la zona euro si solamente queda la opción de bajar los sueldos – o existe otra manera?

Si. Existe otra manera. Aumentar la productividad para hacer que lo que cobra el trabajador sea rentable para el empresario que lo contrata.

The European monetary union prohibits adjustment of the exchange rate in order to change the competitive situation. Monetary policy is also not available, which could in theory be used in order to deflate. Changing the price level is out of the question anyways because of arbitrage. So, two possibilities are left for adjustment of international competitveness:

1. the nominal wage
2. productivity

I have asked Sala-i-Martin whether downward adjustment of Spanish wages would be the only way available, and he answers that productivity growth would be the way out. My next question would be: how can Spain’s productivity grow faster than, say, Germany’s in the next few years?

UPDATE 08/07/2009: I did some quick fact checking on Eurostat. The following graph shows labour productivity per hour worked. The index (100) is the average EU-15 value, Germany is the blue line, Spain is brown.

Remember: this is only productivity. Germany had falling real wages for the last 8 years or so while wages in Spain were growing (see graph from The Economist below). The gap is wider than it seems…

If Spain plans to export itself out of the crisis, the adjustment will take many, many years. The process could only be sped up if Germany’s wages go up (or it’s productivity falls), but that is not very likely to happen. However, some European macroeconomic coordination to shift the burden of adjustment might make sense.

Oligopol Oldenburg, 2009 team

According to our own accounting, we finished the season with 10 points and a 3-1-4 record. In the table as of today we are put in 4th position out of 9, but that is not right. Anyway, our team had 4 points last year, 10 points this year, and if I do a regression with the data that I have… Maybe next year we can beat Mankiw United.

Oldenburg, Faculty of Law and Economics

These banks have been installed here yesterday, three days after the Bundestag approved a bad bank plan.

The FAZ reports that politicians get angry about the German banks not fulfilling their roles by channeling credit to German firms. The bad banks law and the flood of liquidity recently provided by the ECB have led politicians to believe that recovery is around the corner. They are mistaken.

We are in a Great Depression. As I have remarked on this blog more than once, saving-investment imbalances are at the center of this problem. Still, policy makers do not understand the problems of the banks. They are over-indebted and to protect themselves from a bank run and non-performing loans in the near future, they have to stay liquid. This means they will invest any extra credit only into liquid assets. Long-term loans to companies are not liquid.

It’s not that this never happened before. Here is another excerpt from Irving Fisher’s 1935 classic (well, it should be!) 100% Money (p. 148-9):

The present system of ostensibly short term loans is especially disappointing in a depression. Recovery from a depression requires long capital loans, not short commercial loans. But the banks require the opposite. Hence the allegation of business that it can’t get loans, and, of banks, that they can’t make them.

Well, that sure does sound familiar. Funny, isn’t it?

.. is the title of the introduction of The Inside Job – The Looting of America’s Savings and Loans by Stephen Pizzo, Mary Fricker and Paul Muolo. A month ago Paul Krugman claimed that ‘Reagan did it’, and when you read the first few paragraphs you might understand why he thinks so:

President Ronald Reagan stepped through the tall French doors of the White House Oval Office into the bright sunlight of a lovely fall morning. Whispers and nudges rippled through the crowd, and a hush fell over the Rose Garden. A squad of Secret Service agents melted into the audience as Reagan, smiling broadly, strode across the lawn to the podium.

The president stood at ease for a moment and looked out over the assembled guests, beaming with pride and satisfaction. He had promised the American people that he would get government off their backs, that he would deregulate the private sector. Reagan had promised to remove government constraints on the accumulation of private wealth. On October 15, 1982, less than two years into his presidency, he had invited 200 people to witness the signing of one of his administration’s major pieces of deregulation legislation.

Reagan told the audience of savings and loan executives, bankers, members of Congress, and journalists that they were there to take a major step toward the deregulation of America’s financial institutions. He was about to sign the Garn-St Germain Act of 1982, which he said would cut savings and loans loose from the tight girdle of old-fashioned, restrictive federal regulations. For 50 years American families had relied on savings and loans to finance their homes, but outmoded regulations left over from the era of the Great Depression, Reagan believed, were preventing thrifts from competing in the complex, sophisticated financial marketplace of the 1980s. The Garn-St. Germain bill would fix all that, he promised.

At the conclusion of his remarks, and following enthusiastic applause, Reagan took his seat at a table surrounded by the bill’s proud political parents. He flashed a broad smile for the cameras and launched into the signing process. With each sweep of a souvenir pen, thrift regulations crumbled. It was an exhilarating moment for Ronald Reagan. The bill was “the most important legislation for financial institutions in 50 years,” he said. It would mean more housing, more jobs, and growth for the economy.

“All in all,” he beamed, “I think we’ve hit the jackpot.”

The speech of Ronald Reagan at the event is available online.

Deflation is a major threat for our economies. Though inflation has been falling for a long time, until now there has been almost no concern about deflation. This lack of regard is probably due to the macroeconomic theories that the mainstream has embraced. Money is not properly understood, and the role of banks in creating and destroying the money supply neither. Money is not only used for transactions, but also for saving. Irving Fisher in his book 100% money explains why banks contract the money supply in a depression. If he is right than Milton Friedman, who blamed the central bank for letting monetary supply, is wrong. Here is Fisher (p.78):

And the banks cannot help it. The public is quite wrong when, in the depression, they blame the individual bankers. It is the banking system – the 10% system – which is at fault. Under this system, the bankers cannot help destroying money when it should be created, namely in a depression; while in a boom they create money when it should be destroyed.

The HWWI has published a study on government debt. Here is what they say (p.6):

Neben den negativen fiskalischen Implikationen von Staatsschulden entstehen auch wesentliche realwirtschaftliche Folgen. So bedeutet die staatliche Kreditaufnahme, dass weniger Kredite für die Finanzierung von privaten Investitionen zur Verfügung stehen.

Apart from negative fiscal implications of government debt there are also consequences for the real economy. Expanding government debt means that there will be less credit to finance priavte investments.

Repeating a wrong argument doesn’t make it better. These people do not understand saving. There are two ways to save money: invest in government bonds or in private sector IOUs (corporate bonds, stocks, …). If people and banks (which hold their money) do not trust the private sector, the only other opportunity to invest is government bonds. If these are not on offer, people will be hoarding money either directly or the banks will hoard the money for them. This is exactly what is happening now.

On the same page, the authors reveal they do not understand debt either:

Neben den expliziten Staatsschulden belasten auch implizite Staatsschulden durch die Sozialversicherungen zukünftige Generationen. Die impliziten Staatsschulden entstehen, da die derzeitigen Beitragszahler in umlagefinanzierten Sozialversicherungen Ansprüche an zukünftige Zahlungen erwerben, denen keine Einnahmen in erforderlicher Höhe gegenüberstehen.

So, because of entitlements in the future that are not covered by any income there is additional implicit government debt. Of course we have a problem in that there will be fewer workers per retired person in the future. But implicit government debt? How can we understand something as debt today that might or might not develop in the future? This is plain silly. The pension system will be in trouble, but stating the problem clearly is a precondition for solving it. Again, there is complete misunderstanding about how the financial side and the real side of the economy fit together.