Zoltan Jakab and Michael Kumhof have published a short article at VoxEU with the above title. This is the abstract:

… and here is the rest of the article.

I have published a review of Adair Turner’s “Economics After the Crisis: Objectives and Means” from 2012 at the Review of Political Economy (Volume 27, Issue 2, pages 247-250, 2015). The article is available online (for a fee, if you are not a member). A video in which Adair Turner explains the consequences of money-manager capitalism follows below.

This is one of the videos created by Eric Tymoigne’s students at L&C. Enjoy!

I have always thought that an inflation-targeting central bank is independent because it follows a clear goal: get inflation to fall in line with the target in the medium term. What I cannot understand is what ECB and Bundesbank are doing. The NYT reports:

The European Central Bank has called on governments in the eurozone to clear away bureaucracy that burdens businesses and loosen rules on hiring and firing workers. The goal: bring down chronically high unemployment rates.

Sorry? How is it possible that with no major changes in “bureaucracy” Spain has seen its unemployment rate rise from below 10% to before the crisis to 23% today? Or did the case for more labor market flexibility exist before the crisis? After all, the country with one of the least flexible labor markets is Germany, which has an unemployment rate of 4.7% according to the NYT. As far as I can see, Germany did not institute any major reforms of the labor market since the crisis broke out. Actually, the country just introduced a minimum wage of €8,50 this year – and it is still growing! Does the ECB have a mandate to issue these kinds of statements?

The same goes for the Bundesbank. Deutsche Welle, run by the German government, reports:

Germany’s central bank has expressed its dissatisfaction with the reform process in Greece. In its latest monthly report, it said Athens would not be able to avoid bankruptcy without changing its course in negotiations.

Once again, I wonder where this is coming from. Does the Greek central bank in its monthly reports express its dissatisfaction with the reform process in Germany? After all, the country (Germany) has a net export surplus of more than 8%, which is completely against the rules. The Bundesbank does not say anything about this in its monthly report. However, Bundesbank president Weidmann is presented on the homepage with an interview by Handelsblatt. Weidmann complains that the German central bank, if perceived to shift the boundaries of monetary policy, will find it harder to fulfill its mandate. If he is the president of Bundesbank (which he clearly he is), how is that compatible with the statement on Greece in its latest report? How does “dissatisfaction with the reform process in Greece” fit with an inflation target of a little below 2%?

The euro zone, I argue, is a disaster because of the separation of fiscal and monetary. The ECB bails out banks, not governments. This leads to blackmailing sovereign governments into reforms that they would never have undertaken because the people would never have voted for austerity. The way that Germany handles its newfound power is destructive, imposing poverty and stagnation on the periphery. Central banks – ECB and national central banks – have found a new, enlarged role for themselves. I wonder whether the public benefits from this change.

“Europe finally starts pumping markets with cash”, CNN Money titled in early March 2015 when the ECB announced its program of quantitative easing (QE). Other press outfits wrote similar lines (Telegraph, RT, Reuters, …) whereas some understood what was going on at the time (among others, the BBC). Since the actual implementation of QE started on March 9 2015, one would expect that the amount of money circulating in the euro zone would shoot up because of all this “printing money”. The ECB has just released the data that concerns March, and since it is stocks, that means end of March. So, did the amount of money (cash) in the eurozone increase significantly from February 2015 to March 2015? Here is the data:


The first graph shows a longer time period, the second a year. it is quite obvious that there was only a slight increase in currency in circulation. Growth of currency in circulation has been in line with the data of the last five years and does lead one to conclude that QE consists of printing money. What QE was supposed to do was to lower longer-term interest rates, but the yield curve went up, not down:


That might have something to do with expectations, as “the market” bought into treasury securities in advance, speculating on rising prices and falling yields (see ECB’s yield curve below). Personally, I doubt that the yields will move up significantly in the near future because the ECB can buy treasury securities in unlimited amounts. If it wants lower long-term yields, it can get them. Perhaps the flight from the euro has caused the rise in the yield curve. I do not buy into Bill Gross, who was wrong about the bond and stock market before, who says that the bond market will collapse (“short of a lifetime“).

Posted by: Dirk | May 19, 2015

Money – a legal, not an economic thing

I have recently read a paper by Christine Desan that is titled Money as a legal institution. The author argues that money is a legal thing, that it is defined by laws and that the law is changed in times of crisis. I very much agree with that. Economists have been so bad at understanding money because it is not their field of comparative advantage. Anthropologists have long doubted that money arose from “coincidence of wants”, and David Graebers 5,000 year history of debt has been read by so many economists that nobody can deny anymore that the story that modern textbooks tell us is wrong. Money is a legal entity. Bill Mitchell writes about money:

Please also note that the term ‘money’ is quite difficult to pin down given that it is a social construct with embedded power relationships. For us to understand the history of money requires us to also be sociologists and anthropologists among other things to penetrate the broader relationships that govern the use of a ‘thing’ which might be called money.

… to which scholars of the law should be added, and since Mitchell kept the door open with “among other things” he might agree with me. What does this mean, money as a legal institution? I suggest that economists should open up their minds (and textbooks) to a sort of microeconomics that is not rooted in mathematics but in precise descriptions of reality. Before building a map, one has to know the terrain. It is a weak excuse to model money as a veil that is not important when all we talk about as economists in these times of crises is – money!

Legal scholars have a lot to say about power, too. Who decides what money is? Who gets to create money? Who creates credit? What if there is a bank run? Where is the line between fiscal and monetary? What is the political economy of central banking, perhaps? There are many interesting subjects to be explored once the monetarist idea of money as something controlled directly by the central bank and then multiplied by the banks has been discarded. However, the tools to analyze these questions are not of the general equilibrium, rational agent, scarcity type of tools. Perhaps economics, which I think is very ignorant about other disciplines, has to focus more on core competences in order to reinvent itself. What these are is up to the young generation of economists.

Posted by: Dirk | May 4, 2015

The Way We Live Now

Anthony Trollope is a 19th century novelist who according to the New Yorker is “trending”. It is said that his novel “The Way We Live Now” is different from his other novels, but since it is the only book of Trollope that I’ve read I want to write a little bit about a passage that fascinated me (p. 227, Wordsworth Classics edition, free e-book available via Gutenberg):

“You think him honest – don’t you?” asked Lady Carbury. Mr Booker smiled and hesitated. “Of course, I mean honest as men can be in such very large transactions.”

“Perhaps that is the best way of putting it,” said Mr Booker.

“If a thing can be made great and beneficent, a boon to humanity, simply by creating a belief in it, does not a man become a benefactor to his race by creating that belief?”

“At the expense of varacity?” suggested Mr Booker.

“At the expense of anything?” rejoined Lady Carbury with energy. “One cannot measure such men by ordinary rule.”

“You would do evil to produce good?” asked Mr Booker.

“I do not call it doing evil. You have to destroy a thousand living creatures every time you drink a glass of water, but you do not think of that when you are athirst. You cannot send a ship to sea without endangering lives. You do send ships to sea though men perish yearly. You tell me this man may perhaps ruin hundreds, but then again he may create a new world in which millions will be rich and happy.”

“You are an excellent casuist, Lady Carbury.”

“I am an enthusiastic lover of beneficent audacity,” said Lady Carbury […]

This discussion foreshadows the macroeconomic discussions on the credit cycle. Is it beneficial, is it harmful? What is its net effect? How can we make sure that speculation driven by greed still benefits the public? Should capitalists be allowed to rule over their fellow men? Are they rather entrepreneurs than capitalists, working for the benefit of future generations?

One year later, William Stanley Jevons published his book Money and the Mechanism of Exchange. Chapter XX on “Book Credit and the Banking System” picks up the line of thought regarding credit booms and crises:

Considerable economy of the precious metals arises, as we have seen, from passing about pieces of paper representing gold coin, instead of the coin itself. But a far more potent source of economy is what we may call the Cheque and Clearing System, whereby debts are, not so much paid, as balanced off against each other. The germ of the method is to be found in the ordinary practice ofbook credit. If two firms have frequent transactions with each other, alternately buying and selling, it would be an absurd waste of money to settle each debt immediately it arose, when, in a few days, a corresponding debt might arise in the opposite direction. Accordingly, it is the common practice for firms having reciprocal transactions, to debit and credit each other in their books with the debt arising out of each transaction, and only to make a cash payment when the balance happens to become inconveniently great. An insurance broker is one who acts as a middleman between the owners of ships and the underwriters who insure them in shares. He has therefore to make many small payments to underwriters, for the premiums on policies, and at intervals has to receive back the indemnity for any insured vessel which has been lost. It is the common practice to avoid cash payments; the broker credits the underwriters with the premiums and debits him with losses, and only pays or receives the balance when large.

To represent the highly complex system of book credit which is organized by the bankers of a large kingdom, we shall have to employ a method of diagramatic notation. I will therefore remark that the simplest case or type of book-credit is represented by the formula

P —— Q.Each of the letters, P and Q, indicates a person or a firm, and the line indicates the existence of transactions between them. Only in special cases, however, will this direct balancing of accounts render the use of cash or of a more complex system unnecessary. Generally speaking, there will be a tendency for a surplus of goods to pass in one direction, so that money must pass in the opposite direction. The manufacturer sells to the wholesale dealer, the hatter sells to the retailer, and the retails retailer to the consumer. By the intervention of the banker, however, the transactions of many different individuals, or even of many branches of trade, are brought to a focus, and a large proportion of payments can be balanced off against each other.

Note the methodology of Jevons. He is interested in empirical observations and strives to explain first how credit works before any theory is brought forward. This is different today. Take Paul Krugman’s core-periphery model, for instance. It created the New Economic Geography, which is supposedly a theory that can explain (parts of ) industry location, stability of agglomerations and whatnot. However, it does not feature money. This is a most peculiar thing. The 1991 model by Krugman and later models do not feature equilibria where the current account is unbalanced because their are not financial assets that could balance the balance of payments. This is all the more surprising since Krugman also wrote extensively (and well) about financial crises. Krugman (1999, 9) writes:
“If there is a single statistic that captures the violence of the shock to Asia most dramatically, it is the reversal in the current account …”
If we assume that in good times (during the boom) there is no large demand for macroeconomists, then it would be logical that when looking at economic geography you allow for current account imbalances, isn’t it, so that when the crisis comes you can explain how current account deficits had been financed and how that finance is not forthcoming anymore (which os why the IMF comes in, usually). Think of Spain, Greece, the Baltics, etc.
I think that in order to deal with crisis old models and old habits have to be discarded. We need to describe reality in detail before we make maps. This then is not a call to suspend modeling, but a call to comprehend reality first before employing models. After all, it was the failure of our maps that led us to the way we live now. And it is not so hard to spot current account imbalances in the real world. They have been ignored because of an undue focus on models and their equilibrium assumptions. This is an intellectual failure that can be repaired.

As Positive Money reports, Iceland is considering “ending lending” – for banks:

Frosti Sigurjonsson, Member of the Parliament of Iceland and Chairman of the Committee for Economic Affairs and Trade, today published a report outlining the need for a fundamental reform of Iceland’s monetary system.

The report, commissioned by the Prime Minister, considers the extent to which Iceland’s history of economic instability has been driven by the ability of banks to ‘create money’ in the process of lending.

While there are a lot of uncertainties with this proposal, I think that it is a very good idea to think outside the box and consider all alternatives. The report, which can be downloaded via Positive Money, answers some very interesting questions in ways that are completely different from the standard macroeconomics textbooks (which might be a good thing!):

The gross demand for money is affected by various factors such as the size and growth rate of the real economy, and the financial sector. Demand for ISK is also affected by the fact that taxes can only be paid in ISK, thereby creating an underlying demand for ISK by taxpayers.

This is something I definitely agree with. This is also why I do not understand how the IMF can circulate a paper in which they predict hyperinflation should Greece return to a domestic currency. The state, via taxes, can set the demand, and this will have an influence on the exchange rate! Of course, it would not make sense for the Greek currency to be expensive, but if government would think that is the way forward they can tax Greek neo-drachmas away until only one is left – which surely would have more purchasing power than a euro.

Anyway, here is the real problem:

While banks have an incentive to create money, the costs of an overshooting money supply, in the form of inflation or bubbles, are borne by society in general. This separation of benefit and cost may explain why banks have not created an optimal amount of money for the economy

This has been discussed for centuries almost. Are we better of with credit bubbles and business cycles or are we better of without? Schumpeter’s creative destruction in his theory of economic development would be a good starting point, because money has real consequences!

Anyway, I recommend reading the report. A cursory reading has left me impressed, the analysis of the monetary system that we usually have is pretty good. I would disagree/have reservations on many issues, like this sentence: “This means that in order to create new money for a growing economy, households and businesses must go deeper in debt. ” Let us not forget that government can create money, too. They call this deficit spending, and we already have decades of experience. Not the Keynesian era, but the neo-liberal era, too! Government debt has exploded, pundits all over the world would tell you, and … government bond yields approach zero.

This is should give you something to think about.

Posted by: Dirk | April 29, 2015

Goodhart on pegged exchange rates

I am reading Charles Goodhart’s book Money, Information and Uncertainty in the second edition from 1989 to see what I could use in a course on global macroeconomics. Apart from the fact that it is out of date it contains a good mixture between empirical puzzles and theoretical explanations, often based on balance sheets and accounting. Here is a very interesting paragraph from page 435 which reminds one of the euro:

If the exchange rate is pegged it is not going to be doing this job [of achieving external balance]. If the authorities are not driven to abandon their internal objectives – and the whole idea was to prevent this happening – then an external imbalance will develop, and often grow over time, as the ‘equilibrium’ rate diverges from the pegged rate (e. g., under the influence of differing trend rates of inflation among the various countries). For a time such imbalances may, perhaps, be financed by acceptable fluctuations in reserve holdings or by relatively small variations in interest rates vis-à-vis other countries. There are, however, fairly narrow bounds to the extent that this is possible, particularly in support of a rate that appears to be overvalued. Reserves are limited and there can be difficulties in arranging large-scale international borrowing on acceptable terms. The main problem, however, is that such financing of itself does nothing to correct the imbalance caused by a divergence between the pegged and the ‘equilibrium’ exchange rate. At some point in time there will, therefore, be pressures on the authorities to correct the external imbalance by adjusting the exchange rate. It will generally be obvious under such conditions which way the exchange rate must move, if it moves at all: there is only a ‘one-way option’. This ‘one-way option encourages speculation against the pegged currency, and such speculation will cause large-scale flows of capital out of the country which is seen as a devaluation candidate into the country which is seen as a revaluation candidate. The volume of such flows was much increased, but not caused, by the development of an efficient, large-scale, international money market in the shape of the euro-dollar market.


One wishes that the creators of the euro would have read this text-book before the creation of the euro. The TARGET2 system has worked properly, but as mentioned by Goodhart “such financing of itself does nothing to correct the imbalance caused by a divergence between the pegged and the ‘equilibrium’ exchange rate”. The imbalance bothers not because it has to be financed – TARGET2 takes care of that – but because employment is low in those areas where the ‘equilibrium’ exchange rate is not correct.

We have two problems in the euro zone today:

  1. general lack of aggregate demand
  2. uneven geographic distribution of aggregate demand

Recent policy measures have not explicitly addressed #1 or #2 and often made things worse (fiscal brake, austerity, etc.), except for the QE which lowered the euro’s exchange rate and thus might increase foreign demand. Without a conversation centering on aggregate demand we will not be able to work out effective solutions, I’m afraid. More muddling through to come…

John Kay, who was at a panel on curriculum reform at the INET conference in Paris last week, published an article at the FT summarizing his findings:

There is alternative medicine, but most alternative medicine remains so because there is no evidence that it works. The medical profession is often resistant to innovation, especially innovation that challenges accepted wisdom — in the 19th century the Hungarian doctor Ignaz Semmelweis struggled for decades to persuade his colleagues that the best thing they could do for patients was wash their own hands.

More recently, much effort was required to gain acceptance of the discovery that many ulcers were caused by the Helicobacter pylori bacterium. But good doctors are, in the end, persuaded by what works for their patients, as they were in these cases. Good alternative medicine becomes orthodox.

This is a very interesting metaphor. Let me stay in his metaphor and expand on what the viewpoint of heterodox economists would be. Heterodox economists would turn this metaphor around and accuse the orthodox view as the “alternative medicine”. Why? Against all the wisdom of heterodox economics and the IS/LM model, somehow the mainstream came up with lots of ideas that can be considered failures by now, like expansionary austerity (a cut in spending leads to a rise in incomes), the confidence fairy, bond vigilantes, Ricardian equivalence, targeting the inflation rate exclusively with complete neglect of everything else (Taylor rule, inflation-targeting), the idea that an increase in reserves can lead directly to more lending to the private sector (QE), that more flexibility on labor markets would increase employment, that cutting wages would increase unemployment, that Chinese savings would cause US interest rates to fall, and the list goes on.

Whereas “alternative medicine” is often a placebo kind of science – no harm done – the contemporary strand of macroeconomics is more like the practice of bloodletting. Instead of fixing problems it creates new and bigger problems! Austerity in Europe – this includes the treatment of the Greek case of insolvency as one ofilliquidity – was what really cause the troubles in the euro zone. The spreads of government bonds really start to increase only after January 2010 when the Greek situation leads to the imposition of austerity policies. These policies where discretionary and are not included in the European laws. It was a deliberate choice of European politicians, based on mainstream economic thinking. However, as Albert Einstein said: “We cannot solve our problems with the same thinking we used when we created them.”

So, I agree with John Kay on his last sentence: “Good alternative medicine becomes orthodox.” It’s just that paradigm shifts take some time – obviously, it can take centuries to root out dogmatic beliefs!

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