Posted by: Dirk | October 27, 2014

Paul Krugman and monetary theory

Paul Krugman has voiced his view on monetary theory again in today’s column in the NY Times:

Some background: More than seven years have passed since the housing bubble burst, and ever since, America has been awash in savings — or more accurately, desired savings — with nowhere to go. Borrowing to buy homes has recovered a bit, but remains low. Corporations are earning huge profits, but are reluctant to invest in the face of weak consumer demand, so they’re accumulating cash or buying back their own stock. Banks are holding almost $2.7 trillion in excess reserves — funds they could lend out, but choose instead to leave idle.

And the mismatch between desired saving and the willingness to invest has kept the economy depressed. Remember, your spending is my income and my spending is your income, so if everyone tries to spend less at the same time, everyone’s income falls.

While I agree with the policy conclusions, I still cannot agree with the monetary economics, namely that:

  1. Savings finance investment (credit does!)
  2. banks can lend out reserves to the private sector (they cannot)

These points have been discussed before (here and here), and Krugman has not changed his opinion. Fair enough, apparently he was not persuaded to change his mind. So here we are, in 2014, with no public figure understanding how money and credit work in the real world. At least the British central bank, the Bank of England, understands it (there is a companion article which is good as well). Here is an excerpt:

Far more important for the creation of bank deposits is the act of making new loans by banks. When a bank makes a loan to one of its customers it simply credits the customer’s account with a higher deposit balance. At that instant, new money is created.

That means that you do not need savings to create a loan. Since the loan is enough to finance investment, there is no need to wait for savings to roll in order to be able to make loans. The workings of the actual monetary system are a bit more complicated – but not too much. (After all, both articles together are below 50 pages combined.) And then it says this:

So banks are allowed to hold a different type of IOU from the Bank of England, known as central bank reserves and shown in green in Figure 2. Bank of England reserves are just an electronic record of the amount owed by the central bank to each individual bank.

Note that it says ‘banks are allowed to hold a different type of IOU from the Bank of England, known as central bank reserves’, not ‘the private sector’ or ‘businesses’ or ‘everybody’. Since monetary theory is complicated stuff, I would like to see the debate on endogenous renewed. It is a, perhaps the, decisive issue for the Western world in the 21st century.

Posted by: Dirk | October 23, 2014

“Gentlemen … the national debt … is PAID.”

As some commentators here in Germany demand that the national debt has to be repaid, it should be interesting to look at instances when that has actually been achieved. I did not know of any until I stumbled upon the case of the US in 1835. NPR reports:

On Jan. 8, 1835, all the big political names in Washington gathered to celebrate what President Andrew Jackson had just accomplished. A senator rose to make the big announcement: “Gentlemen … the national debt … is PAID.”

That was the one time in U.S. history when the country was debt free. It lasted exactly one year.

By 1837, the country would be in panic and headed into a massive depression.

Not surprising, then-president Andrew Jackson oversaw weak government investment and was benefitted by a real estate bubble in the West, which meant that tax income was up. Nevertheless, there was no happy end, as NPR reports:

Jackson had already killed off the national bank (which he hated more than debt). So he couldn’t put the money there. He decided to divide the money among the states.

But, according to economic historian John Steele Gordon, the party didn’t last for long.

The state banks went a little crazy. They were printing massive amounts of money. The land bubble was out of control.

Andrew Jackson tried to slow everything down by requiring that all government land sales needed to be done with gold or silver. Bad idea.

“It was a huge crash, and the beginning of the longest depression in American history,” Gordon says. “It actually lasted six years before the economy began to grow again.”

During the depression, the government started borrowing money again.

There are modern discussions of why a government surplus is not a good idea, and one of them throwing his hat in was Alan Greenspan:

At zero debt, the continuing unified budget surpluses now projected under current law imply a major accumulation of private assets by the federal government. Such an accumulation would make the federal government a significant factor in our nation’s capital markets and would risk significant distortion in the allocation of capital to its most productive uses. Such a distortion could be quite costly, as it is our extraordinarily effective allocation process that has enabled such impressive increases in productivity and standards of living despite a relatively low domestic saving rate.


So to all those arguing that in good times government should accumulate net wealth – I think I have seen some papers supporting this idea – there are at least two problems: 1) Government starts to own private businesses and that cannot go on forever (and hence will stop) and 2) tax payments are made harder if government sucks out deposits from the banking system. This reminds me of a Shakespeare quote from Hamlet:

Though this be madness, yet there is method in’t.

I am writing a grant application which would allow me to teach a MOOC (massive open online course) on the bread & butter of (monetary) economics: how does the monetary system function? It is all quite basic stuff, but I am very much afraid that not many colleagues in Germany could explain to their students how money is created, how banks clear their accounts at the end of the day, how the government spends or how the fiscal is related to the monetary. I am glad to see that Thomas Piketty speaks out in favor of my view of economics: providing understanding of elementary economics before moving on (if one is so inclined) to mathematical models that are more abstract.

Reuters reports:

The IMF has now cut its current-year growth forecasts nine out of 12 times in the last three years as it consistently overestimated how quickly richer countries would be able to pull free from high debt and unemployment in the wake of the 2007-2009 global financial crisis.

It also lowered its expectations for longer-term potential growth, something its chief economist Olivier Blanchard called “the force from the future.”

“You have these forces from the past, the forces from the anticipated future … and I think that explains the sequence of revisions that we’ve had,” Blanchard said in an interview.

Well, of course, it is ‘the forces from the anticipated future’! That’s what’s holding back the economy. Now politicians only have to fight ‘the forces from the anticipated future’ and then we’re off to … Olivier Blanchard had better moments than this one. It all reeks of intellectual bankruptcy. There is only one institution that can be forced to spend when nobody else does, and that is the government. Like or not.

More government spending does not mean a bigger government, does not mean more public workers, does not mean redistribution from poor to rich. All of that is independent from the question how much the government spends, except size of the government. Also, tax cuts could also provide economic stimulus to the economies, leading to a widening government deficit just the same.

Today is Tag der Einheit (day of reunification), and while many positive things stand out, it should also be mentioned that in terms of macroeconomics it has been difficult for Germany’s east. Having joined a currency union with West Germany in 1990, unemployment was higher in the east than in the west from the start because of a ‘lack of competitiveness’. A large fiscal program (Solidarpakt) transferred about €100 billion to the eastern Bundesländer from 1995 until 2004 (plus taking over some debts), and still until 2019 there will be fiscal support. This year it amounts to about €6 billion. Nevertheless, the unemployment rate has never been close to that of Western Bundesländer, as this graph from Sozialpolitik Aktuell shows (unemployment in Eastern states – blue line – and Western states – black line, average = red line):


As things go in the euro zone, with member countries having joined a common currency but no fiscal mechanism in place, it should not be surprising to see high unemployment in many countries. The lesson of Eastern Germany seems to be that these countries should not expect their unemployment rates to return to normal. Also, they should expect emigration of the young and able, which is what happened to Eastern Bundesländer as well.

Posted by: Dirk | October 2, 2014

Martin Wolf on inequality

The FT’s Martin Wolf had a good piece named ‘Why inequality is such a drag on our economies‘, summing up the problem in the following way:

The costs to society of rising inequality go further. To my mind, the greatest costs are the erosion of the republican ideal of shared citizenship.

As the US Supreme Court seeks to bend the constitution to the will of plutocrats, the peril is to the politically egalitarian premises of the republic. Enormous divergences in wealth and power have hollowed out republics before now. They could well do so in our age.

This connects nicely to the post on campaign finance from yesterday, and it also connects to an Adam Smith quote:

Civil government, so far as it is instituted for the security of property, is in reality instituted for the defence of the rich against the poor, or of those who have some property against those who have none at all. (book 5, chapter 1)

The effects of quantitative easing have been extremely unequal, with the gains going almost exclusively to the wealthiest of our societies. Unemployment, however, has not been tackled with the same speed. Fiscal policy, which can raise demand for labor, has not been used, in Europe the opposite policy was chosen – austerity. Since even macroeconomic textbooks say that in times of weak demand, a fall in government spending leads to less income the problems of our day are not purely economic. They are political (campaign finance, the role of the press, …) and institutional (the euro, tax competition, tax avoidance, …) and perhaps also philosophical (Do you really think that managers deserve such a high income compared to, say, teachers).

As Martin Wolf wrote, the egalitarian premises of the republic are now being dismantled, and there has not been a discussion in the papers whether we want to allow that. Most of the erosion of civil rights took place under the war against terror. This is not without precedent. Actually, the Roman Empire began its end like that, as the NY Times reported in 2006:

IN the autumn of 68 B.C. the world’s only military superpower was dealt a profound psychological blow by a daring terrorist attack on its very heart. Rome’s port at Ostia was set on fire, the consular war fleet destroyed, and two prominent senators, together with their bodyguards and staff, kidnapped.

The incident, dramatic though it was, has not attracted much attention from modern historians. But history is mutable. An event that was merely a footnote five years ago has now, in our post-9/11 world, assumed a fresh and ominous significance. For in the panicky aftermath of the attack, the Roman people made decisions that set them on the path to the destruction of their Constitution, their democracy and their liberty. One cannot help wondering if history is repeating itself.

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.

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