The WSJ in an article from May 23rd last year said the following:

Traders said the initial setback for the market came overnight from Federal Reserve Chairman Ben Bernanke, who said the central bank could reduce asset purchases in coming months if U.S. economic data improve.

That created fresh worries for the Japanese government-bond market, because the Fed’s asset purchases help keep down U.S. bond yields, and higher U.S. yields could also push up yields on Japanese bonds. The yield on the benchmark 10-year Japanese government bond climbed to 1.0% in morning trade, the highest since April 2012. It later dropped as the Bank of Japan moved into the market with bond purchases and other measures, and as investors switched away from stocks. The 10-year Japanese yield was down 0.04 percentage point at 0.845% in late Tokyo trading.

So, what has happened since then? Let us take a look at the yield of generic Japanese government bonds 10Y (graph and data from Bloomberg):


Well, government bond yields went up in May last year, but since then came down. It does not look like there is much action, and the usual predictions of Japanese interest rates going up very soon notwithstanding, I would say that the Japanese central bank has the situation well under control. The Fed already cut QE several times – it does not seem to have any effect on the Japenese treasury bond yield (10y) – which is not identical with saying that there is no effect. Whatever happened, bond yields have been stable and this is what Japanese authorities probably had in mind. The US dollar is a sovereign currency, and so is the Japanese yen.

Posted by: Dirk | April 2, 2014

Bagehot on ‘legal tender’

Walter Bagehot described the lender of last resort function of the Bank of England in his classic ‘Lombard Street: a description of the money market’, which is available online for free at Econlib. In a very important section in chapter 7 he writes:

I do not imagine that it would touch the Issue Department. I think that the public would be quite satisfied if they obtained bank-notes. Generally nothing is gained by holding the notes of a bank instead of depositing them at a bank. But in the Bank of England there is a great difference: their notes are legal tender. Whoever holds them can always pay his debts, and, except for foreign payments, he could want no more. The rush would be for bank-notes; those that could be obtained would be carried north, south, east, and west, and, as there would not be enough for all the country, the Banking Department would soon pay away all it had.

Nothing, therefore, can be more certain than that the Bank of England has in this respect no peculiar privilege; that it is simply in the position of a Bank keeping the Banking reserve of the country; that it must in time of panic do what all other similar banks must do; that in time of panic it must advance freely and vigorously to the public out of the reserve.

And with the Bank of England, as with other Banks in the same case, these advances, if they are to be made at all, should be made so as if possible to obtain the object for which they are made. The end is to stay the panic; and the advances should, if possible, stay the panic. And for this purpose there are two rules:—First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer. The news of this will spread in an instant through all the money market at a moment of terror; no one can say exactly who carries it, but in half an hour it will be carried on all sides, and will intensify the terror everywhere. No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the ‘unsound’ people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected. The great majority, the majority to be protected, are the ‘sound’ people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.

These two rules for the lender of last resort are very famous, but let me focus on the legal tender issue:

Generally nothing is gained by holding the notes of a bank instead of depositing them at a bank. But in the Bank of England there is a great difference: their notes are legal tender. Whoever holds them can always pay his debts, and, except for foreign payments, he could want no more.

This is interesting because Bagehot talks here about the demand for what we now call reserves. Reserves are deposits at the central bank held by other banks. These reserves can be changed into notes and coins, and in this forms households and firms can hold them. Bagehot then continues to say that these notes can always pay ‘debts [...] except for foreign payments’. I assume he means debts both public and private. Public debts are mostly taxes, but could also mean tariffs (Bagehot wrote in the 19th century). Private debts are probably bank loans and debt instruments like securities. Normally, we discharge both public and private debts through deposits, not through bank notes. (Have you ever repaid a bank loan in cash?) So, deposits are promises to deliver reserves at par, and when that promise looks rather shaky a bank run can occur.

What is interesting is that in Bagehot the demand for money (and implicitly, the demand for deposits) comes not from the fact that money and credit can be used to buy stuff, but that deposits and bank notes can be used to pay one’s debts. Whereas private debts can be at least theoretically fully repaid, the state can through the imposition of taxes generate perpetual debt. It seems that it is the government then which is the ‘creditor of last resort’, forcing households and businesses to accept money to pay their taxes. It might be argued that this is why the private sector also uses legal tender as the unit of accounts of its own debt contracts. Hopefully we will never have a real world experiment which either confirms or rejects this theory.

Finanzagentur GmbH, you might have guessed it, is the German finance agency, which is conducting the operations necessary to ensure that the German government does not run out of money. It is part of the German treasury. As investors have found out the soft way, euro zone bonds are not always riskfree. Greece restructured its debt, but only when most of its debt was offloaded by the private sector to the public sector and its institutions. Since I am looking into the mechanics of German government debt emission, I was a little bit surprised to find Finanzagentur writing the following:

Investors in German Government securities have at their disposal a range of risk-free, highly liquid securities with a straightforward and transparent  structure across the full yield curve. The safe haven status of the Bund is especially attractive to investors in times of crisis.

This is the first sentence in the first paragraph on the website after you have clicked on institutional investors. So, whatever the German government says about Draghi, the Finanzagentur has accepted that ‘whatever it takes’ means literally risk-free.

The schism between academia and central banks, banks and policy makers has just been increased by this publication of the Bank of England. It has been written by Michael McLeay, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate.

This article explains how the majority of money in the modern economy is created by commercial banks making loans.

There is an accompanying video that summarizes the creation of money in five minutes.

In a nutshell, it confirms the views of Wicksell (1898) and everybody that followed him in describing money as basically connected to credit: loans make deposits. So, Post-Keynesians and Modern Monetary Theory (MMT) get it right when they stress the importance of endogenous money. Those arguing that the monetary supply plays a role in this will not find their view represented in the documentation of the Bank of England. Of course, central banks are not academic institutions and their findings should not be believed without critical examination. The Bank of England is not the first to describe money creation by banks in these terms either. However, some central banks are still reluctant to discard the use of the money supply concept and instead use monetary aggregate. The Federal Reserve Bank writes:

Over some periods, measures of the money supply have exhibited fairly close relationships with important economic variables such as nominal gross domestic product (GDP) and the price level. Based partly on these relationships, some economists–Milton Friedman being the most famous example–have argued that the money supply provides important information about the near-term course for the economy and determines the level of prices and inflation in the long run. Central banks, including the Federal Reserve, have at times used measures of the money supply as an important guide in the conduct of monetary policy.

Anyway, I think the silence of mainstream economists when it comes to crisis resolution has something to do with their realization that the central bank cannot increase the money supply at will and hence they will not be able to stop deflation when it has started. The world is more complex, money and credit are intertwined and so are central bank and treasury, as Éric Tymoigne illustrates using historical episodes in recent US central banking in this new working paper.

The FT carries an article today by Takatoshi Ito, who chaired a panel of experts, on sovereign debt holdings of Japanese pension fonds:

How much of its assets should a public pension fund invest in bonds? Consider the question assuming that bond yields in developed economies remain low for a few more years, but are expected to rise, the economy is expected to go back to a growth path and the inflation rate is expected to rise from a deflationary level to a normal 2 per cent in a year or two.

Ito goes on to call this Finance 101. Here is his answer:

There is a widespread belief in Japan, shared by some in the GPIF, that government bonds are “safe” and stocks are risky, and that bonds are for pension funds and stocks for speculators.

Fifteen years of deflation and the 25-year decline of the Nikkei 225 index have reinforced this belief. There is insufficient consideration of the interest rate risk of long-dated bonds and the benefits of diversifying into a variety of asset classes.

The panel members unanimously agreed that the GPIF bond portfolio is exposed to too much risk from an expected rise in interest rates, a natural consequence of Prime Minister Shinzo Abe’s economic programme and Bank of Japan governor Haruhiko Kuroda’s 2 per cent inflation targeting.

I disagree with his view. First of all, the widespread belief that Japanese government bonds are safe is based on the fact that they are, well, safe! The way the monetary system works in Japan, the government can always approach the central bank and get fresh reserves in return for government bonds (either directly or indirectly). So the probability of default is zero, unlike in the euro area where the central bank does not directly finance the governments.

Now about the fact that when bond prices are very high, so that effective yields are basically zero, the yields can only go up, which means prices can only go down. We heard this for many years now. However, if you hold bonds that pay you zero interest and you hold them to maturity – which is something which a pension fund will probably do – then you will not have lost any money, although the valuation of the bond will have decreased after the interest rates rose (even though I cannot see any reason to do that in Japan, which is far, far away from an inflationary spiral). You just did not make more money than you could have made if – and that is a big if – the interest rates have started to rise. So, if pension funds won’t buy as many sovereign bonds as in the past, will interest rates in Japan go up? Not if the central bank controls the interest rate and buys up any excess sovereign bonds to keep it that way.

Posted by: Dirk | February 24, 2014

Iceland does not want to access EU and euro

Iceland last week officially withdrew its accession bid to the European Union. Joining the EU would have meant joining the euro, as the EU itself says:

Who can join and when?

All Member States of the European Union, except Denmark and the United Kingdom, are required to adopt the euro and join the euro area. To do this they must meet certain conditions known as ‘convergence criteria’.

The question is why they don’t want to join, and I think the answer is pretty straightforward. Here are the rates of unemployment for the countries in crisis inside the euro area:


And this is the unemployment rate for Iceland:

It is obvious that Iceland, which let its ‘too big to fail’ banks go bankrupt, has enjoyed a strong recovery while the euro zone members did not. Therefore, it is better to stay out of the euro zone, where in times of crises the political top (European Commission) forces countries to cut government spending, disproportionately putting the burden on workers, the unemployed and the young especially. While Iceland has 2% unemployment in sight, the Greek government celebrates a positive primary surplus while the Greek people face record unemployment. The European economy faces bleak prospects. Also last weak, the data revealed that German real wages have been falling again in 2013, as Reuters reports:

Real wages in Germany are likely to fall this year for the first time since the height of the financial crisis in 2009, the Federal Statistics Office said on Thursday, basing its prediction on data for the first nine months.

The decline could dampen hopes that domestic consumption will boost Europe’s biggest economy in the coming months as the traditionally export-driven powerhouse suffers from fragile demand from the euro zone and a slowdown in emerging markets.

Take a look at the macroeconomic identity: Y = C + I + G + NX. In Germany, the government does not want to stimulate and instead targets a zero. Consumption can’t rise if real incomes are falling. Net exports are unlikely to go up as the euro area is still weak and more exports to the rest of the world will be stopped by an appreciating euro. The last possibility is to engineer a real estate (or something else) bubble, but with real wages falling and the experiences in Spain and Ireland in fresh memory households will probably not opt for more debt.

It’s the economy, stupid. And economic management in the euro area is a mess. The only institution that worked has been the ECB (much more so under Draghi than under Trichet), but even the ECB can’t make governments spend more or let taxes go down. And don’t forget that the ECB has been a member of the troika and is responsible for the austerity policies that put Europe in a hole. Politically, the situation is probably going to get worse before it gets better, with European far-right parties set to gain momentum in the European elections later this year.

Posted by: Dirk | February 19, 2014

A not-so-friendly critical look at MMT?

Academic discussions are good. Since no (sub-)school of economics can claim to have the final truth – except DSGE modellers, of course, but they are not a school of economics but rather a church of mathematics – it is helpful to discuss issues in order to stress where the theoretical and practical differences are, and to advance insights into how the economy works. The rise of MMT in blogs and other new media has attracted attention from the Post-Keynesian camp, to which MMT ultimately belongs. Marc Lavoie started with a friendly critical look, then Thomas Palley added a critical look, to which Randall Wray and Èric Tymoigne responded here, to which some days ago Thomas Palley responded by a perhaps not-so-friendly paper here.

The discussion centers on Palley claiming that MMT says nothing new and is not different from Post-Keynesian economics. I am not aware that MMTers claimed otherwise. Here is a paragraph from an introductory blog post of what later became Randall Wray’s MMT primer:

In recent years an approach to macroeconomics has been developed that is called “modern money theory”. The components of the theory are not new, but the integration toward a coherent analysis is. My first attempt at a synthesis was in my 1998 book, Understanding Modern Money. That book traced the history of money as well as the history of thought undergirding the approach. It also presented the theory and examined both fiscal and monetary policy from the “modern money” point of view. Since that time, great strides have been made in applications of the theory to developing an understanding of the operational details involved. To put it simply, we have uncovered how money “works” in the modern economy. The findings have been reported in a large number of academic publications. In addition, the growth of the “blogosphere” has spread the ideas around the world. “Modern money theory” is now widely recognized as a more-or-less coherent alternative to conventional views. However, academic articles and short blogs do not provide the proper venue for a comprehensive introduction to the approach.

I think that Randall Wray is right. MMT’s ‘components are not new’, but the coherent analysis is. A case in point is Scott Fullwiler’s paper on modern central banking operations. I have not read anything else (Post-Keynesian or not) that is so good at explaining how these operations work in such a limited space of (digital) paper. However, when I talked to Post-Keynesians they apparently knew everything that was in the paper. So, to some extent I think this debate is superfluous. MMT differs from Post-Keynesian economics by method. While the latter has taken over the idea of modelling, MMT has not. I find this difference in methodology rather helpful. It means that you have different approaches to the same problem, and there is some use in that. Not all problems are best explained by a model, not all problems are best explained by balance sheets. Another part in Thomas Palley’s new paper that I find not helpful is that on counter-cyclical policy. He (2014) writes:

I confess I was stunned by the claim (T&W, 2013, p.44) that MMT rejects counter-cyclical fiscal policy – what T&W call “fine-tuning”. I had thought counter-cyclical fiscal policy was an essential element of the MMT argument, and that the recent recession and current stagnation called for large-scale money financed fiscal expenditures. Apparently, that is not the case.

That is a stark misrepresentation of what Wray and Tymoigne (2013) had written here:

MMT draws specific policy conclusions about fiscal, monetary and financial policy. In line with Keynes and Minsky, MMT recognizes that unemployment, arbitrary distribution of income, price instability and financial instability are central problems of market economies that require some government involvement for resolution. The nature of this involvement is, however, very different from the Bastard/IS-LM Keynesian approach that focuses on fine-tuning. That fine tuning takes the form of discretionary, temporary, and limited fiscal and monetary policies to deal with slumps and booms through proactive change in government spending, tax rate, and interest rate. This approach of government intervention aims at avoiding direct intervention to achieve the goal (e.g. hiring to achieve full employment, or price controls to achieve low inflation), but rather using indirect “tools” while letting market participants push the economy toward desired goals by tweaking their incentives.

MMT does not agree with this approach. The government should be directly involved–  continuously–over the cycle, by putting in place structural macroeconomic programs that directly manage the labor force, pricing mechanisms, and investment projects, and constantly monitoring financial developments. Because those programs would be permanent and structural, rather than discretionary and specific to one Administration, they would be isolated from the political cycle and political deliberations.

So, MMT does call for Thomas Palley’s ‘large-scale money financed fiscal expenditures’. Apart from these two issues there are some good discussions and clarifications on both sides, and it is interesting to see that Randall Wray and Èric Tymoigne have moved from recommending a flexible exchange rate regime at least partly to fixed.

Happy reading to those interested in modern monetary theory!

Posted by: Dirk | February 14, 2014

Wikipedia 1, professor 0

I am grading student papers (already) and it is interesting to see how students use information to write their papers. What I have often found is that students use Wikipedia, which has led to interesting ideas like the existence of a liquidity premium of 3%. The information came from Wikipedia (Germany), and since I cannot find it I hope someone deleted it. Now, in a new twist, I had a student using as a source the Bundeszentrale für politische Bildung (federal central for political education). This article by Hermann Sautter, who is a professor at the University of Göttingen whom I worked for as a student, says that the US proposal won the day at Bretton Woods whereas Wikipedia speaks of a compromise between US and UK. Those familiar with the matter would side with Hermann Sautter, since the Keynesian Bancor proposal clearly lost out and the White plan won. A new book by Benn Steil – The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order – seems to provide new evidence towards this interpretation. I haven’t read it, but this paragraph on the publisher’s website says it all:

Upending the conventional wisdom that Bretton Woods was the product of an amiable Anglo-American collaboration, Steil shows that it was in reality part of a much more ambitious geopolitical agenda hatched within President Franklin D. Roosevelt’s Treasury and aimed at eliminating Britain as an economic and political rival. At the heart of the drama were the antipodal characters of John Maynard Keynes, the renowned and revolutionary British economist, and Harry Dexter White, the dogged, self-made American technocrat. Bringing to bear new and striking archival evidence, Steil offers the most compelling portrait yet of the complex and controversial figure of White–the architect of the dollar’s privileged place in the Bretton Woods monetary system, who also, very privately, admired Soviet economic planning and engaged in clandestine communications with Soviet intelligence officials and agents over many years.

The disturbing thing is that the student sides with crowd wisdom and against the academic. While democracy is a nice thing to have, it is utterly wrong to say/think “what the majority believes must be right”. The way that students use the internet and the problem arising from an abundance of publications should be addressed more specifically. A course in methodology might be something to think about for the institutions of higher learning. Otherwise, the way social science is done might be changed towards the worse. I am sure other social sciences face the same problem. It is a question of culture: if in doubt, who do you turn to?

Posted by: Dirk | February 11, 2014

Höpner’s neo-classical view of the euro crisis

Martin Höpner is head of a research group at the MPIfG (Max-Planck Institut for society studies). The research group is titled ‘political economy of European integration’. I read a short article by him (here) that is based on a larger paper and was published with the foundation of the German labour unions. The abstract is available in English (oddly enough, neither website nor papers seem to be available in English – that is sub-MPI standard):

Euro member states possess very different wage bargaining regimes. This heterogeneity has shaped the diverging wage and price increases among European member states and has therefore contributed to the real exchange-rate distortions from which the euro-zone has suffered since the introduction of the common currency. This paper analyses nominal wage increases in twelve euro countries during the first ten euro years, 1999-2008, to demonstrate the above. Neither the European-wide export of German-style wage bargaining nor European-level wage coordination can be expected to solve the problem of heterogeneous wage pressures. It is therefore unlikely that the euro will function any better in the future than it has in the past.

When I read that I instantly though: neo-classical. The typical neo-classical starts with the labor market and develops everything else from there. Hence, it is differences in wage growth that caused the euro zone crisis. I agree. Next question: is this a cause or a symptom? I guess for him it is a cause, but for me it is a symptom. It is common knowledge that the German wages are set through coordination, and many Southern European wages are not. Is this, then, why wages have been growing so quickly in Spain from 1999-2007?

AMECO has some data on wages in construction (Nominal unit wage costs: building and construction; 2005=100):


The story here is that of construction workers in Spain earning rising wages until 2008 when the property bubble burst. Why did wages rise so fast and so high (relatively)? Well, people went crazy over real estate and lots of it was built. This leads to labour shortages and when something is scarce, its price goes up. Construction labour was scarce, so wages in that sector went up. Since you can work in construction without a lot of education, other sectors had to increase their wages to keep their workers from moving to the construction sector. That is where the rising wages in Spain are coming from. And that is why they are falling now. There is less demand for investment (read: housing), and hence wages are not rising. Austerity policies have something to do with why they are falling, but that is another discussion.

Of course, the fall in wages has macroeconomic consequences. Here is a look at some data from AMECO:

Gross wages and salaries: households and NPISH in billions of euros.

It seems that there is a break in Spain in 2008, because wages start falling afterwards. Was there a change in the wage regime? Did Spain take over the German system of coordinated wages? The answer is no. Instead, the real story happened on the capital market. Spanish households had increased their debts through to 2008, buying house financed with mortgages, then after prices started falling began repaying. Here is domestic credit to the private sector (in % of GDP, World Bank data):


Obviously, a lack of demand results since people preferred to repay debt to consumption. This, however, is a Keynesian demand story and incompatible with a neo-classical world view.

I find it quite astonishing that even now the crisis in Spain (and Ireland, which was also about real estate) still has not been understood by many colleagues. Maybe wage regimes have something to do with it, but how can you choose to completely ignore the role of capital markets? Spanish and Irish household debt increased over many years, and that development has not been caused by the labor market. So, a or perhaps the major explanation for the shift in the wage growth is the capital market, not labor market institutions.

However, a neoclassical can’t argue that. Savings are equal to investment, so the capital market is of no concern apart from the quality of the investment, which influence long-term growth. But this is about short-term depression, not long-term growth. If investment stays at low levels, than incomes will remain depressed longer.

If your theory says that whatever happens on the capital market, it should not have any effect on GDP or employment, and then you look at Spain 1999-2013, how can you not say: “wait a second, something is wrong here – the data don’t fit my theory!” There is still refusal on the neo-classical side of economists to engage in discussion with the other side. All the while, the other side looks at wages and goods and capital markets, too, so this refusal to engage in a contest of ideas is asymmetric.

Posted by: Dirk | February 10, 2014

Ayn Rand was almost right on money

I am reading some early Post-Keynesian literature for a research project. Marc Lavoie (1992, 439) writes:

Furthermore, according to Le Bourva, money enters the econonomic system through the activity of production rather than exchange. [...] This leads to a view of the economy based on the ‘total prefinancing’ of production …

In brief: producers want to produce, and to start production they need money. They don’t have money, or not enough, and hence they borrow money. With that money they pay for inputs, including labor, which sets into motion a monetary circuit.

Compare that to Ayn Rand’s writings, much favored by Alan Greenspan. This is an excerpt of Atlas Shrugged:

“So you think that money is the root of all evil?” said Francisco d’Anconia. “Have you ever asked what is the root of money? Money is a tool of exchange, which can’t exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears, or of the looters, who take it from you by force. Money is made possible only by the men who produce. Is this what you consider evil?

I see some confusion, because she talks about exchange. As a Russian emigré, she probably had no idea how the US monetary system worked (nor the Russian one). So, she would not know how money is ‘born’. Without this understanding how money is ‘born’ her whole monetary theory was nice and simple – too nice, and too simple to be true. Money is born as debt, when credit is given to government or the private sector (household and firms). This was also recognized by economists like Schumpeter, who belongs to the Austrian school. Rand is confused but with a little bit of XXI century help her sentence:

Money is a tool of exchange, which can’t exist unless there are goods produced and men able to produce them.

… could be changed to …

Money is a tool of debt, which can’t exist unless some entrepreneurs (public or private) borrow money so that there are goods produced and men able to produce them are paid with that money, which they can exchange against goods.

And that would have been correct. So, our economies are driven by those borrowing money. As the statistics of the European Central Bank show (table 2.3 on page S14), money has lately been created to a large extent by households borrowing to buy houses, not by businesses to build investment projects. And that is where the problem is in Europe. With falling house prices and expectations of continued falling house prices, why should people buy a house – by taking a mortgage – now? And so they don’t, and so there is less money created, and less production, and less exchange, …

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