Posted by: Dirk | October 1, 2014

Campaign Finance and Modern Monetary Theory

Over at Muckraker, Carillo, Gokhmark, Grey and Schweinberger wonder whether campaign finance should be financed from public coffers:

Once the public understands that the U.S. government cannot “go broke,” and thus most fears of federal budget deficits are irrational, the dream of fundamental CFR becomes much more viable. Public elections do not need to be financed by higher taxation, spending cuts, or greater indebtedness to China and our grandchildren – instead, they can be funded directly from the source of money itself: the U.S. Government. This insight, in our opinion, is ultimately the strongest argument in favor of public election funding, yet remains sorely overlooked by the CFR community.

I agree with this the application of this insight of understanding modern money. It is obviously not a good idea to institute one dollar – one vote in a democratic system. This idea belongs to the market: one dollar – one vote. For example, what determines the location, quality and prices of bakery’s in your neighborhood? If we let the market decided, you decide with your dollars what will be the outcome. This is not independent from the institutional structure (regulations in health, workplace safety, labour contracts, etc.), but nevertheless only those that spend dollars on the actual production have a say.

While markets work more or less well for many things, for some they don’t. That is why we have democracy, where the rule of thumb is, or used to be, one man – one vote. If we want to decide on, say, the minimum standards of food quality, then this should not be decided by lobbyists of big business, but rather by all the people. This ensures that the consumers get a bigger say. It would prevent business interests from creating institutions that benefit them to the harm of everybody else.

So what if big business has ‘all the money’? As the Muckraker article rightly points out, the US government cannot go broke. Therefore, if it wants – so, if people elect a government that wants – it can publicly finance the election campaigns. In most countries this is basically how it works. Probably most systems are hybrid in the sense that parties receive money from party members and donations, but also money from the government depending on the election results. For instance, in the Czech Republic all votes for parties that reach more than 1% translate into a €1,20 transfer for the party. In Germany, donations from people to parties are increased by €0.38 for every euro donated.

It is very important to understand money in order to make the right policy choices. Normally, I would think that universities should provide that understanding. From my own experience, I cannot see that happening. Academic economists are ignoring money creation and the mechanics of fiscal spending. You don’t think so? Consult your public economics, monetary economics or general economics textbook and see if you can answer the following questions (correctly):

  1. How does government spend?
  2. Is there any limit to government spending?
  3. How is money created (cash and reserves)?
  4. How are loans created (credit)?
  5. What is the connection between money and credit?
Posted by: Dirk | September 30, 2014

A universal desire for equal pay?

A recent research paper by Sorapop Kiatpongsan and Michael Norton investigates the difference between people’s perception, actual and ideal wage differentials of CEOs and other groups to unskilled workers (hat tip to HBR’s blog and Jia Lyng). It is quite impressive how far reality diverges from people’s perception. Here is one of the main graphs from the paper:

pay ratios

It is very interesting to see how pay ratios of CEOs to unskilled workers differ over the world. According to neoclassical theory, these difference can be explained in different ways:

  1. CEOs in Australia, Chile, South Korea, the US and other countries are much more productive than elsewhere and therefore the pay ratios reflect marginal productivity. This, however, would imply that Sweden’s and Norway’s managers must be pretty inefficient, even compensated for exchange rates. That is hard to believe, given that Scandinavian countries are relatively rich.
  2. Those countries which are relatively rich in capital will gain much more from good CEOs – hence their relatively high wages. Again, I find this implausible.
  3. The difference can be explained by market power of the CEOs in each country, but then the market should take care of it – where CEOs are relatively expensive they will be outsourced, replaced by machines or unskilled labour. For the case of the US that would mean that there are or will be less managers than elsewhere. Again, this is not helpful. That is not how it works.

A political economy explanation would be needed here to explain the power structure that has produced these results. In a 2006 paper by Gomez and Tsioumis, part of the explanation is the non-existence of unions:

We estimate the relation between union presence and executive compensation using a unique panel of executives in publicly listed US firms during the period 1992-2001. We find evidence that union presence is associated with lower levels of total executive compensation. We find this union effect to be primarily the result of substantially lower stock option awards, and to a lesser extent due to lower cash pay. Moreover, the negative relation between unionization and executive remuneration becomes larger at the higher end of the conditional distribution of executive remuneration.

Correlation is not causation, but it seems quite straightforward which way causality runs in this case. Neoclassical theory ignores institutions and focuses on markets exclusively. In some cases this makes sense, but here I would argue that the problem is mostly institutional.

I have been at the International Post-Keynesian conference in Kansas City last weekend – after a very pleasant vacation in Valencia, Spain – and the most impressive chart came from Pavlina Tcherneva:tcherneva
Whatever economists think they are doing, we should state the obvious facts:

1) The economic system provides income to different groups and the distribution of income during expansions changes over time.

2) Whatever causality is, since the early 1980s we have seen an increase in the share of income going to the top 10% (and top 1%, which Pavlina showed at the conference)

3) Despite all the talk that economics is not having any fundamental flaws, the outcome of today’s economy shows us that there is a need to address the problem(s) of distribution

4) The economic system as it is can hardly be called sustainable. Negative income growth for the lower 90% cannot continue to fall forever. We will see serious demand shortages and low growth when credit growth is not the driver of the economy.

Personally, I think that it is more important than ever to talk about change in economics. Even though the growth rate for the US economy has just be revised upwards, the distributional consequences of the recent economic policies should not be ignored.

Posted by: Dirk | September 3, 2014

Spanish unemployment goes up again

Reporting unemployment numbers is always a bit of a game. Cyclical variations mean that you can either show that unemployment goes up or down, you just need to pick the right moment in the cycle. At this point in the cycle, many Spanish summer jobs are over. School restarts, and people don’t go to the beach anymore in September (though not this September, as Mediterranean temperatures rise above 30 still.) So, unemployment goes up, as El Pais reports (have look at part time contracts – parciales – to see the story). This comes hardly a week after German chancellor Merkel visited Spanish president Rajoy. Deutsche Welle reports:

Visiting Chancellor Merkel also lauded the gradual Spanish turnaround, saying it was the result of “very challenging and difficult reforms” embarked upon by Rajoy’s government. Merkel said that “the foundations are now laid” for a more sustained improvement of the Spanish economy.

The crisis in Spain continues, and given the contractionary fiscal policy stance in the whole of the euro zone it remains to be seen how and when growth will revive. If everybody spends less, the demand will continue to be weak. This problem has been with the euro zone since 2010, when worries about the ability to repay its debt started in Greece. Spain will not see its unemployment rate return to normal until something is done to the aggregate demand problem. The market was supposed to heal itself, but since the crisis in Spain started in 2007 that has already taken 7 years and it doesn’t look like things are improving.

Reuters reports from the Jackson Hole conference of late August, writing that the Bank of Japan’s governor Kuroda has proposed to set benchmarks for wage negotiations:

Low long-term interest rates will likely not rise until the 2 percent target is reached, he said, adding that the BoJ’s 2 percent inflation target, once met, could serve as a benchmark for wage negotiations.

This is quite interesting, because it goes completely against neoclassical thought. This school of economics recommends that government stays out of the market in almost anything, and that higher (real) wages lead to more unemployment. Since neoclassical economics assumes that the inflation rate is determined by the stock of money supply, a rise in nominal wages would increase real wages and hence increase unemployment. Kuroda begs to differ, based on the view that the inflation rate is mostly determined by the change in the nominal wages. More inflation is good because it allows debtors to pay off debt more easily. If my wages are rising 2% a year rather than not at all, it is easier for me to repay any debt that I have contracted.

The comments by Draghi have already been reported in the press, but in case you want to see the ECB president speaking of demand problems again, here is the paragraph from the transcript:

Cyclical and structural factors

Cyclical factors have therefore certainly contributed to the rise in unemployment. And the economic situation in the euro area suggests they are still playing a role. The most recent GDP data confirm that the recovery in the euro area remains uniformly weak, with subdued wage growth even in non-stressed countries suggesting lacklustre demand. In these circumstances, it seems likely that uncertainty over the strength of the recovery is weighing on business investment and slowing the rate at which workers are being rehired.

I would add that it is not uncertainty over the strength of the recovery which is the problem, it is the certainty that in a situation of lack of demand that is the problem. Maybe Draghi agrees but can’t say that much. After all, his job depends on Merkel and the other heads of state, who constitute the European Council (Wikisource):

11.2. In accordance with the second subparagraph of Article 283(2) of the Treaty on the Functioning of the European Union, the President, the Vice-President and the other members of the Executive Board shall be appointed by the European Council, acting by a qualified majority, from among persons of recognised standing and professional experience in monetary or banking matters, on a recommendation from the Council after it has consulted the European Parliament and the Governing Council.

Nothing on this planet is ‘independent’, and the same goes for the ECB. The power is – at least to some extent – with politics, as it should be. Whether a central bank should be ‘independent’ at all is a different discussion.

Posted by: Dirk | August 26, 2014

Sparpolitik is actually Investitionspolitik

German blog Nachdenkseiten comments on the crisis of the French government by saying that the vocabulary needs to be rethought. The German Sparpolitik could be translated as policy of thrift. Whatever its name, in Europe it does not seem to work well as an economic policy. The self-equilibrating forces of the market seem not come to the rescue, and the cuts in government spending imposed on the European periphery largely translated into reductions of income and a subsequent rise in unemployment.

Let’s revisit the idea of Sparpolitik, which is the idea of a rise in savings being somehow good for the economy. Trichet, former president of the ECB, is on the record with this:

“It is an error to think that fiscal austerity is a threat to growth and job creation. At present, a major problem is the lack of confidence on the part of households, firms, savers and investors who feel that fiscal policies are not sound and sustainable”

But how do you increase the savings of an economy? I mean, in real life, not in some high theory macroeconomic model. Well, we have a set of identities, and it should not be that hard to find out how to increase savings of an economy. Let’s start by defining income (GDP) as consumption plus investment plus government spending:

Y = C + I + G

We omit foreign countries, because we don’t want to increase the savings of our economy so that the savings of some other economy comes down. So, we have income Y and now we need to define savings as income not spend by neither private sector (C) nor public sector (G):

S = Y – C – G

Obviously, the difference between the two equations is the omission of investment (I), but let’s not take that short cut now. In order to run a proper Sparpolitik, you would want to increase savings. That only works if income rises or government spending or consumption are reduced. There is a slight complication with the latter two: consumption and government spending feature in our equation (1). If these two segments of demand go down, than income will also go down and hence savings will not go up. The fall in consumption (C) or government spending (G) will be exactly matched by a fall in income (Y). So, the only road open to us leads through an increase in income Y. How is this going to happen?

Looking back at equation (1), we see that a rise in income could come about trough a rise in consumption, investment or government spending. Keeping in mind that equation (2) has Y-C and Y-G on the right sight respectively, an increase in consumption (C) or government spending (G) cannot lead to a rise in saving, since income (Y) rises simultaneously only with C and G.

Hence, there is only one way to increase the savings of a single national economy and that leads through an increase in investment! Only with an increase in investment would income rise in equation (1) and savings in equation (2), since investment is not part of the right hand side of equation (2)!

Sparpolitik is then not the proper name of any policy intended to raise savings – it should be called Investitionspolitik!

Why is investment not on the rise in the European Union? Interest rates are close to zero (or below), but still investment doesn’t seem to jump upwards. What can be done to increase private investment is to increase public investment. An increase in government spending shrinks public saving but increases private savings since the private sector will have more government bonds, which constitute income not spend. So, there is no rise in savings, but if as a result of this policy private investment will pick up then an expansionary private sector can drive investment and with it savings up.

This is just a small exercise in national income accounting. The two equations from above are identities, which means that they cannot be ‘wrong’. Either you define savings and income like we did above or we don’t. Since the Great Depression economists use these identities, and it should be crystal clear that there is no Sparpolitik without Investitionspolitik – actually, they are two sides of the same euro.

Posted by: Dirk | August 25, 2014

Banking is boring … in Japan

Bloomberg reports that banking is incredibly boring in Japan – apparently, the Citibank CEO’s salary is higher than the profits of its Japanese branch:

Citibank Japan Ltd.’s net income of 1.34 billion yen ($12.9 million) in the year ended March compared with CEO Michael Corbat’s total 2013 compensation of $14.5 million. The U.S. bank has begun approaching Japanese companies including the three biggest lenders, trust banks and regional lenders, a person familiar with the matter said this week.

Unprecedented monetary stimulus has cut the spread between lending rates and deposit rates at Mitsubishi UFJ Financial Group Inc. to a record low in the first quarter. Cash and deposits at the nation’s biggest bank and its two closest rivals piled to 82 trillion yen last quarter. Citigroup is considering a retreat from Japan after pulling back from retail banking in markets with low returns, including Spain, Greece and Turkey.

The difficulties to make money probably have something to do with the weak demand for loans in Japan. Obviously, banking is demand-led. You cannot supply borrowers if they don’t demand anything. For the last 20 years, the private sector has been reducing its liabilities. To make up for the shortfall in effective demand, government spent hundreds of billions of yen to keep the economy at somewhere close to full employment. Compared with what Spain and Greece are going through it has been a resounding policy achievement so far. However, government bonds are boring for bankers, especially if the central bank buys them up and clearly fixes the prices (which it does anyway, but it is more obvious now in Japan then ever). There does not seem to be any indication that this will change in the near future, especially not after the unsurprising big dent to GDP growth after the latest tax hike (Reuters).

The thing that isn’t boring can be done from without: exchange rate speculation. As Bloomberg reported last year:

George Soros made almost $1 billion since November from bets that the yen would tumble, according to a person close to the billionaire’s $24 billion family office.

The Japanese wager helped the firm return about 10 percent last year and 5 percent so far this year, said the person, who asked not to be named because the firm is private. The yen has weakened 17 percent versus the dollar since about the start of the fourth quarter, the worst performance over a similar period since 1985.

With no further weakening of the yen in sight, bankers and central bankers in Japan might as well enjoy a vacation or two. Probably it would be their first since ‘the crisis’ which started in 1991. They could try to think about a new concept to describe what has happened to Japan and discuss existing economic theories in order to solve the countries economic woes. One hint: another tax hike is not a good idea. Another hint: it is not a problem of social justice or the budget, it is a macroeconomic problem. Which some say started with Wicksell back in 1898.

Posted by: Dirk | August 4, 2014

There is no ‘great bond mispricing’ in the US.

FT Alphaville has a discussion government bond (treasury securities) prices:

The theory is that taper talk prompts dumb money to sell safety, and the smart money — which knows there’s no such thing as underpriced principal safety these days and that taper implies risk-off — to pile into safety at an even faster rate.

However, from a monetary theorist point of view there should be no discussion. The price of US treasury securities is not set by the free market, it is set by arbitrage. This graph from FRED2 shows you 1-Year constant treasury maturity minus federal funds rate:


The price of treasury securities is set – via arbitrage – by the short-term interest rate on the money market. The different maturities are connected via arbitrage, too. Bond prices and therefore effective yields are not set by central banks of emerging economies and the interactions of supply and demand. They are set by the Fed and by market makers ‘playing’ the yield curve. As long as the Fed’s interest rates are low, the price of US treasury securities will not go anywhere.

That does not mean that you cannot make money in the bond market, obviously. However, I’d argue that the closer the line of the graph above is to zero, the less money you can make. Sovereign Bond markets have been boring (while people shouted: “Hyperinflation”), are boring (“Debasement of the Dollar!”) and will be boring for some time (“The Great Bond Mispricing”). If you want action, look at ‘sovereign bonds’ denominated in foreign currency drafted under foreign law.

German Sunday paper FAS, which belongs to FAZ, has an article named “Hilfe, die Bank will mein Geld nicht” in today’s paper. The title translates to “Help, the bank doesn’t want my money”. The author seems to understand that low interest rates at the ECB are the major cause, but he doesn’t go further and asks why they are so low. Perhaps the German public is not ready yet for the admission that austerity has driven Europe’s economy into a hole, which even ultra-low interest rates can’t fix.

For the first time in the conservative press I see an intent to put forward “endogenous money”, as the author writes:

Zwar ist die verbreitete Vorstellung, Banken könnten nur dann Kredite ausleihen, wenn sie vorher gleichviel Geld bei den Sparern eingesammelt haben, ein populärer Irrtum. “Einlagen- und Kreditgeschäft einer Bank sind nicht unbedingt gekoppelt”, sagt der Bonner Ökonom Martin Hellwig. Banken können sich auf unterschiedliche Weise finanzieren: über Spareinlagen, aber auch über den Geldmarkt oder die Notenbank.

So, it is a popular myth that banks can only make loans after they have acquired savings to the same amount. “Deposit and Credit business of a bank are not necessarily connected”, says Bonn economist Martin Hellwig. Banks can finance in different ways: through savings deposits, but also through the money market or the central bank. I must say that I am amazed to read this. It is a first try to ‘get’ the endogeniety of money, which describes the fact that banks create loans and deposits from nothing. Also, Martin Hellwig is not the reference for endogenous money, and in his 2012 book with Anat Admati he definitely does not understand it:

Banks use both borrowed and unborrowed money to make their loans and other investments. Unborrowed money is the money that a bank has obtained from its owners if it is a private bank or from its shareholders if it is a corporation, along with any profits it has retained.

This is traditional loanable funds theory: bank borrow money to ‘make their loans and other investments’. It is good that Martin Hellwig has changed his opinion, I’m glad he did. However, this should be the start of a big rethink. If those people who held the loanable funds theory dear have been wrong, what about the people who have been right all along? Shouldn’t we be saying: “there was a contest in the discipline of economics to explain how money works, and one side succeeded?” After all, the stuff in the textbooks is still wrong. Olivier Blanchard’s book (2003 edition, but I am very sure it did not change) says:

  • High-powered money is the term used to reflect the fact that the overall supply of money depends in the end on the amount of central bank money (H), or monetary base.

Well, that is wrong. Banks don’t need reserves to make loans. Hence the overall money supply does not depend on central bank money. And economists wrote about it long ago. Here is an example from Knut Wicksell:


That seems to be right. When was this written? Well, in 1898. Yes eighteen-98! And Keynes in his early years was a ‘Wicksellian’, writing about the monetary circuit from a balance sheet perspective. Where does the money come from, where does it go, etc. If economics is a science, then it must be about a competition of ideas – which we might call theories if they are more complex – and regardless whether we like it or not, the winner should be made ‘mainstream’, by including this theory in all textbooks, and the runners-up should be put into boxes in textbooks (if they are interesting enough) and books on history of economic thought. After all, we can never be sure that we are right when it comes to social arrangements. Nevertheless, endogenous money is a theory that is able to fit with reality on a lot of things, whereas loanable funds doesn’t.

Loanable funds theory, for instance, assumes that the interest rate is set endogenously in the money/capital market. However, it is quite clear that the ECB, the Fed, the BoJ, the BoE and so on all set interest rates. Then, it can’t be determined in the market. Also, these central banks deny that they control the amount of reserves. Here is the ECB (my highlighting):

Standing facilities aim to provide and absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates. Two standing facilities, which are administered in a decentralised manner by the NCBs, areavailable to eligible counterparties on their own initiative.

Marginal lending facility

Counterparties can use the marginal lending facility to obtain overnight liquidity from the NCBs against eligible assets. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate.

Deposit facility

Counterparties can use the deposit facility to make overnight deposits with the NCBs. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate.

The marginal lending facility is open 30 minutes after the closing of the market. If banks borrow more reserves after markets closed, there is nobody at the ECB or its member central banks who could counter the increase in reserves.

I sincerely hope that in the coming months we will see a wider discussion of endogenous money as a description for how banks work. It will then become clear that repayment of loans destroys money in the form of deposits, and that this is what is holding the European periphery, nay, the whole euro zone back. If we as European consumers have less deposits in our bank accounts, how are we supposed to buy more stuff? If we don’t, then unemployment will stay above 10% in the euro zone and the slump continues. This is an unhealthy situation brought about by ‘the free market’, and if economic policy does not intervene then the weak economy will continue. What this means for European politics should be clear to everybody (article by Reuters):

French far-right leader Marine Le Pen would reach the final round of a presidential election if voters were to vote now, winning more votes than any mainstream party in the first round, a poll showed on Thursday.

The survey by pollster IFOP showed Le Pen winning 26 percent of all votes in round one of the two-round election, versus 17 percent for either President Francois Hollande or his more popular prime minister, Manuel Valls.

The next presidential election is in 2017.

The end of Europe as we know it is what it could mean.

In a NYT article, Laurence Kotlikoff gives us his account of economics as it used to be: a science to confuse the public about what a government can and can’t do:

HOUSEHOLDS can’t spend, on a continuing basis, more than they earn. Countries can’t either, at least not over the long run. But countries can certainly leave the bill for their current spending to the young and to future generations. Official borrowing is the old-fashioned way to do this: Sell Treasury bonds, and other securities, and spend the proceeds. But borrowing in broad daylight has a drawback: The more you do it, the more lenders worry about repayment, and the more interest they charge for their loans.

This might sound very logical, except that there is a problem: a government is not a household. Why not? Well, households don’t have an account at the central bank, as the US Treasury has. Households also cannot sell treasury (or household) bonds that are risk free, because if push comes to shove the central bank will buy these bonds on the secondary market to an extent that all actors on the primary market will engage in arbitrage. If banks buy treasury bonds (and bills and notes) directly from the government, and they know that they can turn around and sell them to the Federal Reserve Bank for a profit, then there should be no doubt about one thing: the US government cannot go bankrupt. Which household can say that?

Kotlikoff continues:

The fiscal gap — the difference between our government’s projected financial obligations and the present value of all projected future tax and other receipts — is, effectively, our nation’s credit card bill.

Right. If the US government spends more than its tax income in the future, then it is charged to ‘our nation’s credit card bill’ today. As I have described above, the US Terasury does not have to rely on bank loans or credit card companies to finance its expenditures (above taxes). Let’s jump to his conclusion:

What we confront is not just an economics problem. It’s a moral issue. Will we continue to hide most of the bills we are bequeathing our children? Or will we, at long last, systematically measure all the bills and set about reducing them?

That is utter nonsense. We will not bequeath any bill to our children. If government spends more than it collects in taxes, it issues treasury bonds. These treasury bonds are bequeathed to our children, too. Somebody will be quite rich, as there are quite a lot of government bonds outstanding. Inequality can be a problem, because the future tax payers transfer money to those that are holding the bonds. Conveniently, Kotlikoff overlooks this issue.

The framing used by Kotlikoff to talk about US government debt is misleading. It is based on false analogies, starting with the idea that government spends just like a household. One could argue for lower social security payments, but not on the basis that the US government can’t afford it.

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