Forecast verification as a way to hold macro-economics to account.

I’ve been struck by how weather forecasters face some of the same types of difficulties  that beset macroeconomics. Both have to rely on “natural experiments” (ie events) as a way to test whether they have an understanding of how the system works. In each case, the systems they work with are extremely complex and chaotic. Weather forecasters make a tremendous effort to continuously assess how well their forecasts perform. They recognize that such forecast verification is crucial for progress to be made. The verification process itself is not trivial. Often the most important predictions are knowing when there is a heightened risk of an extreme event such as a severe storm moving from the ocean over the land. It can be much more valuable to have better (though still probabilistic) awareness of possible extreme events than to have precision for normal weather. Weather forecasters fully recognize that; they use a variety of different types of modeling systems and wide variety of verification approaches. An analogy between weather forecasting and macroeconomic forecasting is not a novel idea and the BIS has made the analogy with severe storm prediction methods to call for more probabilistic forecasting to help spot risks of financial crisis.

There is great controversy over whether or not the 2008 global economic crisis was predicted by heterodox economists employing stock flow consistent models. The mainstream macroeconomists claim that such predictions of imminent crisis were continuously being issued by various mavericks and so (just as a stopped clock is right twice a day) harebrained doomsayers eventually got lucky. There is also controversy over whether macroeconomics is entangled with politics. Some economists profess that they are politically impartial scientific observers and technocrats whilst others say that they (perhaps unwittingly) are party to an inextricably political process. Margret Thatcher famously acknowledged that for her,

Economics are the method; the object is to change the heart and soul.

To my mind both these controversies need to be dealt with head on by a comprehensive and transparent program of continuous verification of macroeconomic approaches. It is not enough to have occasional ad hoc predictions leading to an unresolvable mess of anecdotes as to what approach does or doesn’t provide insight. It is also vital for the public to see how the economic policies being implemented are predicted to influence future outcomes. If an economic policy is being implemented and the widespread prediction is that it is going to greatly increase the risk of economic crisis or depression, then the public deserve to know. Comprehensive public forecasts would throw up an endless stream of material for journalists to discuss and for politicians and their economic advisers to be held to account over.

A verification system would work best if every macroeconomics program hoping for respectability continuously provided a standardized and wide-ranging set of predictions (including probabilistic assessments of tail risks) stretching for various time spans into the future (from weeks to many years) for a wide set of countries. It is crucial that every participant provided forecasts for the wide set of countries or otherwise the data would be too thin to spot whether any branch of macroeconomics had managed to develop predictive power. The predictions would be most valuable if they included metrics that had direct real importance. As well as financial measures such as  household income (and discretionary income level) level and wealth at each decile, inflation, GDP,government debt level and current account deficit; I think it would be useful to include unemployment, labor participation, energy use and child mortality rates.

I think much of the problem with macroeconomics stems from a misplaced reverence for microfounded mathematical models. It is great whenever a phenomenon can be successfully described mathematically but we need to face facts and accept when that is still beyond us. Many fields of science make progress without being at a stage where mathematical modelling can provide much insight. Some people make valiant attempts to mathematically model the development of embryos based on diffusion of proteins and such like. As yet however that approach hasn’t been what has driven the bulk of the advances that have been made in that field. The useful models have largely been crude flow diagrams that provide little more than an expected direction for an outcome. Nevertheless it is much much better to actually know whether something is likely to increase or decrease than to have a fancy model that gives you the wrong answer. What I’m calling for is for macroeconomists to simply do their best to predict what the economy will do. The methodology could be as crude as simply having a check list of “good” and “bad” economic policies. Let’s just see what predictive method works best. Bringing this back around to the comparison with weather forecasting, some of the current controversies in macroeconomics are more akin to arguments as to how gross geography influences climate. Some economists predicted that the fiscal regime in Latvia would cause a depression when others said it was a recipe for prosperity. That dichotomy of opinion is as extreme as if we still hadn’t established whether the weather was cooler near the poles or near the equator.

Economic policies conducted in various parts of the world over the years do seem (with hindsight) to have made profound transformations to how economies have developed. Consider how Singapore has transformed from the poverty it found itself in at independence to having widespread affluence. The financialization and crisis in Iceland was dramatic but the people there didn’t subsequently suffer the real poverty that for instance occurred in Russia in the 1990s. Perhaps the most shocking economic phenomenon has been the persistent extreme poverty of the world’s poorest two billion people. If the globalized capitalist economy is seen as an integrated system that we are all responsible for, then that is a shameful failure causing millions of avoidable deaths. If, in the developed world, we enact some facilitation for capital flight or agricultural tariff adjustment that led to forecasts for increased child mortality rates across Africa, then the public might recoil with a “not in my name” type protest. Comprehensive forecasts could help to expose such issues.

Macroeconomists often make pronouncements about the worthiness or otherwise of various policies such as monetary policies, tax structures, labor regulations or deficit levels. I simply want them to pin themselves down to making formal predictions as to the outcomes from the myriad of natural experiments that our world economy continuously provides us with as events unfold. Some macroeconomists might counter with the view that their subject is about deep theoretical insight rather than petty forecasting. My view is that such insight is as worthwhile as it is useful for informing a predictive understanding.

Related stuff on the web:

WWRP/WGNE Joint Working Group on Forecast Verification Research

Continually improving our forecasts -Met Office

Moving towards probability forecasting -Bank of International Settlements

Economics Education and Unlearning -Post-Crash Economics Society

Who Are These Economists, Anyway? -James K Galbraith 

What does it mean to have “predicted the crisis”? -Noah Smith

Simon Wren-Lewis Defends the Status Quo -Nick Edmonds

 Are macroeconomics methods politically biased?- Noah Smith

Can economists forecast recessions? Some evidence from the Great Recession- Hites Ahir and Prakash Loungani (link added 30May2014)

Macroeconomic model comparisons and forecast competitions -Wieland and Wolters (link added 20Oct2014)

On Macroeconomic Forecasting- Simon Wren-Lewis (link added 01Jan2015)

Forecast errors -Bank of England (link added 01Jan2015 ht Simon Wren-Lewis)

Could we replace petroleum with seaweed biofuels?

Recently, the small start up company Bio Architecture Lab, reported that they have developed a yeast strain that efficiently converted seaweed to ethanol biofuel. This significant advance in biotechnology achieved a place in the most prestigious scientific journal. Nevertheless, Bio Architecture Lab also announced that they had abandoned their commercial scale facility for producing seaweed biofuel. Looking into it, I have been struck by how the overriding challenges we face in terms of energy provision and climate change seem to be more the political economy issues. We seem to have an astonishing capacity to meet technical challenges  and an equally astonishing capacity to become held up by awkward political economy issues.

My recent post “Could this be a way to scrutinize climate science enough for the skeptics?“, was all about grappling with the controversy over whether or not our climate is at risk from fossil fuel use. This post here is about what it would entail to wean ourselves off fossil fuels. Mainstream political opinion professes respect for the warnings from climate scientists such as James Hansen who has told us,

Burning all fossil fuels, we conclude, would make most of the planet uninhabitable by humans, thus calling into question strategies that emphasize adaptation to climate change.

And yet in terms of what actually gets done, it is obvious that there is no meaningful attempt to avoid our accelerating consumption of fossil fuels. Since the Kyoto agreement was signed, fossil fuel consumption has continued to accelerate by 3% per year just has it has been doing since the 1950s. Continuing along this exponential trajectory would lead to cumulative  emissions of ten trillion tonnes of carbon in just over a century from now and for atmospheric carbon dioxide levels to be 8x the preindustrial level (as compared to the 40% increase seen to date). Known recoverable reserves of fossil fuels are enough to sustain that; the only thing that would prevent it from happening is if we choose to leave them in the ground.

The debate about what should or should not be done is encapsulated by Vaclav Klaus’s assertion that , “Freedom, not climate, is at risk”. In general I agree with Vaclav Klaus that we need to avoid interfering in each others’ lives as much as is compatible with overall well being. That however is always going to be a fraught balancing act with contentious value judgments at every point along the way. We need to first assess the arguments as to whether fossil fuels do genuinely pose a risk to the climate and then balance that assessment against the politics and practicalities of doing something about it.  Weighed up against the assessment of warnings about catastrophic climate change is an assessment of how catastrophic it would be to try and wean ourselves off fossil fuels. The leading climate skeptic campaigner Nigel Lawson sums this up when he expresses exasperation about climate change alarmists,

What was clear, however, was that they had no understanding of, or interest in, the massive human and economic costs involved in the policies they so glibly endorse.

Likewise, if Vaclav Klaus is to be believed, only a brutal, miserable, command economy system would leave the fossil fuels in the ground. A vibrant economy that makes the most of all of our individual talents and joys is supposedly inextricably linked to unimpeded consumption of fossil fuels. Is that really true?

Perhaps it helps to view the current debate about carbon dioxide in the light of the historical debates about sanitation. In the 1840s in England there was a heated controversy about provision of sewerage facilities. At the time it was considered by many to be an absurd imposition of central control to move away from simply having people cast their faeces into the street. Today we take effective sanitation for granted in the developed world and view inadequate sanitation as a mark of a failed state not as an exemplification of the laissez-faire ideal. Might we in the future view fossil fuel use as being as unnecessary and noxious as casting faeces into the street?

To my understanding, the crucial measure to effectively induce a transition away from fossil fuels would be a tariff charged on the basis of how much carbon dioxide would come from burning them. That would be what it would take to ensure that much of our fossil fuel reserves were left in the ground and that alternatives were instead brought into existence.  A fossil fuel tariff of that sort would be paid to the country where the fuels were extracted, charged at the point of extraction. That would encourage many countries to sign up to the system because it would provide a local source of revenue (at any rate until it induced adoption of alternative energy sources). If a country did not participate, then participating countries could apply an equivalent tariff on imports from that country based on the fossil fuels used in production.

The effectiveness of such a tariff mechanism has been demonstrated by how in the European Union we have been effectively coerced into producing and paying for beet sugar despite the fact that it costs twice as much as cane sugar. A near 100% tariff on sugar imports has ensured that European sugar production has been nurtured into existence whilst much more efficient cane fields in the Caribbean now lie fallow.

The owners of the fossil fuel reserves have already paid for them. Those owners would be dispossessed by an effective policy that caused the reserves to remain unused. Our current renewable energy policies only become explicable when viewed in the light of the political reluctance to render those fossil fuel assets worthless. Environmentally minded voters are placated with ineffectual “green washing” measures aimed to give the greatest political impact whilst avoiding any threat to the value of fossil fuel assets. The result is rooftop photo-voltaic panels in rain lashed northern England. Perhaps, in order to ensure that fossil fuels do actually get left in the ground, it will be politically necessary to compensate the owners of those fossil fuel reserves. Perhaps only then would we have a hope of introducing the necessary tariff system. If the move away from fossil fuel use became something of a free lunch for the owners of the fossil fuel assets, then perhaps the wind would be taken out of the sails of the climate change denial public relations campaign.

To my mind the key point is that effective measures to ensure a move away from fossil fuels need not entail the sort of command economy horror show that Vaclav Klaus warns us of. Once an effective tariff was in place, the stage would be set for self organizing human ingenuity to rise to the challenge of providing us with alternative energy. That brings us to the wider controversy of whether we do have the potential to provide enough energy without fossil fuels; whether we would indeed successfully rise to that challenge. In principle the energy is there for the taking; every hour the sun radiates more energy onto the earth than the entire human population uses in one whole year. Basically the challenge is how to tap into that abundant energy.

The full scope of the possibilities for renewable energy is too wide to be dealt with here. In this post I want to focus on liquid transportation fuels as an illustrative example that highlights wider issues. The vast bulk of global fossil fuel reserves are in the form of coal. In the past decade, most of the growth in fossil fuel use has been from coal. However the last century was all about oil. Oil provides an extremely convenient source of energy. Diesel for trucks and jet fuel for planes allows economic activity to blossom with a minimal need for infrastructure or political organisation. We have now burned our way through much of our easily recoverable reserves of oil. Exxon Mobil spends a hundred million dollars a day prospecting for new reserves but that is providing ever diminishing returns. A century ago it took one barrel of oil to find and extract a hundred barrels, it now takes thirty. Saudi Arabia still has substantial reserves but the Saudis carefully ration production so we are left relying on reserves elsewhere that are ever more expensive and hazardous to exploit. There has recently been a shift towards mining tar sands for conversion to oil. If environmental considerations do not hold sway, the next step will be large scale production of synthetic liquid fuels from coal. The way we respond to the immediate “peak oil” phenomenon can be seen as a forerunner for our overall approach towards renewable energy.

This brings us back to Bio Architecture Lab’s yeast that are able to efficiently convert seaweed into ethanol. This technology uses wild varieties of seaweed, grown in their native parts of the world on floating supports in the open sea. It requires no farmland nor freshwater and no addition of fertilizer nor pesticides. The byproducts can be used as animal feed and soil improvers. It addresses both climate change and food security issues. Depletion of soil has been described as the most frightening long term threat for humanity. Seaweed provides a way to return phosphates and potassium back from the oceans to our farmland. Whilst ethanol is not the ideal transportation fuel and it can’t be used as jet fuel, the technology to allow fermentation microbes to directly convert any form of carbohydrate (including alginates from seaweed) into diverse types of hydrocarbons is within our grasp. 

Nevertheless this promising technology has been met with a flurry of nay saying. The most damning allegation was that it would take more fuel to cultivate the seaweed  and convert it into fuel than the process produced. A detailed audit revealed that allegation to be unfounded and demonstrated an efficient net yield. The other key allegation was that it would be  impossible to conduct seaweed cultivation on a sufficiently large scale. Current oil consumption is five billion tonnes per year; it would take fifty billion tonnes (dry weight) of seaweed to provide that and that would require a cultivated area of one billion hectares (less than four percent of the ocean surface). Globally, there is over a billion hectares of arable land under cultivation. In the developed world, it takes minimal human effort to work that land. The vast bulk of the economy is left for other activities. Likewise, cultivating seaweed on that scale would be a significant source of jobs and economic activity but would nevertheless be very much a minority activity.

Much of the skepticism about seaweed cultivation has come from the mistaken idea that only the brown seaweeds used by Bio Architecture Lab are relevant for this process and that only certain parts of the oceans are suitable for cultivation of those seaweeds. What Bio Architecture Lab really demonstrated is that yeast can be readily developed to meet any fermentation challenge whatever the carbohydrate composition of the seaweed feed stock. Red seaweeds growing in tropical waters would need a different strain of yeast but the same principle could be applied to rapidly develop such yeast.

Why then has Bio Architecture Lab abandoned its commercial scale seaweed biofuel project? Presumably the financial backers of companies such as Bio Archictechture Lab and Seaweed Energy Solutions were banking on state mediated intervention (such as fossil fuel tariffs) to create an economic incentive for full scale adoption of the technology. That necessary intervention simply hasn’t materialized. Although those companies are small they attracted cutting edge expertise in biotechnology and offshore energy provision. Those people saw the potential of the project, nevertheless, it has recently been argued that there is little sense in converting high value seaweed into less valuable liquid fuel. That argument overlooks the fact that scaling up seaweed production to a market size that swamped all non-fuel demand for alginates would render it irrelevant that the alginate intermediate product is currently far more valuable than liquid fuel. The relevant way to appraise the economics is to view the cost as money spent to keep tar sands in the ground and to build human expertise in a renewable technology that could serve us for future generations.

The broad thrust of the concerns of skeptics such as Nigel Lawson, is that tariffs that increased the cost of fuel would hamstring the global economy. However one of the thorniest issues facing the global economy is unemployment and underemployment.  Advocates for tar sand extraction justify the environmental cost on the basis of what it can do for job creation, digging the stuff up and building the trucks to do so. On that basis, seaweed biofuels would be even “better”. If there is a problem with adopting seaweed biofuel technology, it is that it entails more labour than the fossil fuel alternatives. There is a political appetite for job creation; seaweed biofuels would provide job creation with a necessary purpose. What is more, many of the jobs created would be in coastal communities that are beset by loss of jobs in the fishing and shipbuilding industries.

Of course it is stupid to have wasteful activity just for the hell of it. Our economy does best when we all interact to provide each other with what we want as efficiently as possible. However if the worry is that renewable energy would act as a cost drag, there are other less easily justified cost drags that could be cut out. The EU common agricultural policy currently spends almost £50Bn per year as payments to farmers and landowners. In effect much of that ends up going to increased rents for farmland. Added to that, trade barriers prevent imports of many types of food that can be produced far more efficiently outside of Europe (I mentioned the example of sugar above). We also have a global financial system that has been built (by the global financial system itself) in such a way as to maximize the financial overhead borne by the real economy. In the USA alone, it has been estimated that over a trillion dollars a year could be saved if the financial sector was trimmed down towards functioning as a service for the real economy rather than gathering as much as possible for itself. I think much of the skepticism about renewable energy is actually founded on a naive belief that it would be a blemish in an otherwise pristine and perfectly optimized economic system. I see our current system as something of a mess with plenty of room for improvement and plenty of capacity to accommodate necessary measures such as leaving the fossil fuels in the ground.

Related previous posts:

Could this be a way to scrutinize climate science enough for the skeptics?

Sustainability of economic growth and debt.

To save the environment, target poverty.

Related stuff on the web:

Environmentalism poses a problem for libertarian ideology -Matt Bruenig

Assessing “Dangerous Climate Change”: Required Reduction of Carbon Emissions to Protect Young People, Future Generations and Nature -Hansen et al

Climate sensitivity, sea level and atmospheric carbon dioxide -Hansen, Stao, Russel and Kharecha

Statoil invests, partners with BAL in macroalgae: How big will big algae be? -biofuelsdigest

Efficient ethanol production from brown macroalgae sugars by a synthetic yeast platform -Enquist-Newman et al -Nature

Bad News: Scientists Make Cheap Gas From Coal -Wired

Marine macroalgae: an untapped resource for producing fuels and chemicals -Wei, Quarterman and Jin- Trends biotech

Large-scale carbon recycling via cultivation and biorefinery of seaweeds for production of biobased chamicals and fuels -ECN

Sea6 Energy

Sea6 Energy Biofuel from the oceans

Unlocking Seaweed’s Next-Gen Crude: Sugar -The New York Times

Seaweed biofuels: a green alternative that might just save the planet -Guardian

Bio Architecture Lab, EcoShift make waves with seaweed-based biofuels -biofuelsdigest

Bio Gives Up on Seaweed-to-Ethanol Effort in Chile -Bloomberg

NLACM leads to changing times at Bio Architechture Lab -biofuels digest

A skeptical look at seaweed ethanol -Alice Friedmann

Who benefits from farm subsidies: farmers or landowners? -CAP Reform.eu

The Beginning of the End of the Fossil Fuel Revolution: GMO_QtlyLetter_3Q14_full (added 22nov2014)

Let’s be constructive about currency and debt arrangements for an independent Scotland

I think the current rumpus about future Scottish currency arrangements serves to illustrate important general points about how national currencies can work for their people or fail to do so. Scotland is due to vote in a referendum on independence from the UK. Like many people in the UK, I have mixed Scottish and English ancestry and have family in both countries. I’ve lived in Scotland for a few years in the past but I consider myself English and I’m writing this as an English person. I have no objection to Scottish independence and I can see that it makes a certain amount of sense since people in Scotland so often vote differently from those in England and have a distinct national identity. On the whole small countries seem just as able to provide their citizens with an affluent lifestyle as do large countries. Basically I don’t mind either way if Scotland chooses to split from the UK or chooses to stay. However, if they choose to split, I’d like the split to leave all of us with a monetary and political arrangement conducive for continued prosperity and harmony.

Alex Salmond hopes to have a currency union between a future independent Scotland and the UK. I’m vehemently against my country being in a currency union with any other country -whether with the Euro or with some new sterling currency union between an independent Scotland and the remaining UK . The fact that the Euro currency union was broken by design was apparent as soon as the idea was proposed. As Wynne Godley wrote in 1992,

 It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates. As local authorities possess none of the instruments of macro-economic policy, their political choice is confined to relatively minor matters of emphasis – a bit more education here, a bit less infrastructure there. 

The ongoing Euro crisis has confirmed the foolishness of having monetary union without fiscal, banking and political union. Greece now has a staggering level of unemployment and relationships between previously friendly Eurozone countries have become fraught.

Within a country, if one region suffers a localized economic downturn, then that region will typically end up paying less in taxes whilst receiving more in terms of central government spending. That automatic fiscal stabilizer effect helps to prevent a downward spiral from taking place where a small downturn becomes amplified into a prolonged depression. Currency union without fiscal union exposes a country to just such a pointless and destructive feedback effect. The crucial problem for the eurozone is that deficit spending in each eurozone country is financed by selling national bonds BUT spending by say the Italian government can end up in the hands of people buying say German bonds or paying German taxes. That money is then not available to fund the Italian government. By contrast, spending by the UK government will circulate around until that money gets spent on buying UK government bonds or paying UK taxes. There is no other way for that money to leave the UK system. The exchange rate between the pound and other currencies may be at risk if the UK acts irresponsibly, but the UK government will never have any nominal funding difficulties so long as we keep a sovereign currency arrangement (I’ve summarized an overview of our monetary system on page 12 of this pdf). A currency union breaks our sovereign currency arrangement.

It is crucial to note the distinction between a currency union and a situation such as that of Montenegro or Ecuador where foreign currency is used as money.  The government and people of Montenegro use the Euro as money and the US dollar is used in the same way in Ecuador. Clearly Scotland could bizarrely choose to use the UK pound in a similar fashion but that is not what Alex Salmond is proposing. Alex Salmond is proposing a sterling currency union with a supranational central bank akin to the Euro currency union. Montenegro is not part of the Euro currency union and the European central bank provides no support for Montenegro. All of the Euros in Montenegro were aquired in exchange for goods and services sold to Eurozone citizens. In effect Montenegro’s arrangement has given the Eurozone a free lunch. The European Central Bank has belatedly provided some support for Spain and Italy, buying government bonds so as to keep yields and financing costs under control. Montenegro has no such backstop and Montenegro has no central bank with fiat currency capabilities. But any problems that Montenegro may encounter do not become the responsibility of the eurozone. By contrast, Alex Salmond’s proposal would radically change the monetary arrangements for the remaining UK. We would no longer have our own central bank beholden to us. The actions (or lack of actions) of the central bank would become a fraught source of unaccountable political  squabbling just as in the eurozone.

In my view if Scotland wants to become independent then it needs to adopt its own currency. Scotland is no smaller than some other successful developed countries that have their own currencies. Scotland  has a population of 5.3 million whilst New Zealand has 4.4 million; Norway 5 million; Singapore 5.3 million; Switzerland 8 million and Iceland only 320 thousand. Undoubtedly, Scotland could remain a prosperous country and a valued trading partner with its own currency. However we would then have the issue of how to apportion the current  outstanding UK sovereign debt. Alex Salmond has threatened to repudiate Scotland’s share of that debt if the UK refuses to enter into a currency union with Scotland. I think it is crucial that UK treasury debt does not degenerate into becoming a high yield mess such as happened with much of the Eurozone debt. This issue is too important for it to be used as a weapon for political brinkmanship between those wanting and those resisting Scottish independence. It would also be a disaster if Scotland had its own currency and yet also had a burden of sterling denominated (and so foreign currency) debt. That situation would be akin to how Haiti started off independence with a burden of debt to France. Foreign currency denominated debt has no place in responsible governance. When the UK stupidly took on US dollar denominated debt in 1976 it swiftly lead to the IMF crisis.

Just as currency converted when countries joined the Euro, bank accounts, bank reserves and debts in an independent Scotland could switch to being denominated in Scottish currency. Likewise Scotland’s share of the UK treasury debt could also switch to being denominated in Scottish currency. Obviously people who bought outstanding UK treasury debt did so on the understanding that it was sterling denominated. It would be well worth avoiding compromising the UK treasury debt market. However £375Bn of UK treasury debt is owned by the Bank of England as a consequence of the quantitative easing activity of recent years. That UK treasury debt on the Bank of England’s balance sheet has a counterpart in the form of bank reserves and those have a counterpart in the form of customer bank deposits. Upon Scottish independence, all of the bank reserves that switched from being sterling denominated to being denominated in Scottish currency could be mirrored by debt transferred from the Bank of England to a new Scottish central bank and switched into being denominated  in Scottish currency. There would nevertheless still be some remaining share of the debt to deal with. To my mind the best approach would be for new Scottish currency denominated debt to be issued and transferred to the UK government’s foreign currency reserves. So the UK government would keep more than its “fair share” of the UK treasury debt liabilities but it would be compensated with new Scottish treasury debt that would be serviced with interest payments payable in Scottish currency. Scotland would then have a robust sovereign monetary system allowing the Scottish government to facilitate an effective Scottish economy. It would also avoid leaving the remaining UK short-changed and ensure that Scotland provided us with a prosperous trading partner.

Related previous posts:

Political Consequences of Risk Free Financial Assets

Global Reserve Currency Status Matters

Related stuff on the web:

Scotland and a Currency Union -Open letter from UK Treasury Permanent Secretary Nick Macpherson

Alex Salmond Speech on Currency Union

The eurozone shambles has been the worst setback for European integration since the 1940s- Tim Congdon

Target2-Window on Eurozone Risk-JKH

Excluding Scotland from currency union is demeaning and insulting claims Alex Salmond -Telegraph

Scotland analysis: Assessment of a sterling currency union -UK treasury

Scotland’s Future -Scotreferendum.com

The Economics of Currency Unions -Mark Carney-Bank of England

Maastricht and All That -Wynne Godley 

The Russian Default – What Happened -Cullen Roche

ECB introduces unlimited bond-buying in boldest attempt yet to end euro crisis.-Guardian

Adding the Central Bank-Eric Tymoigne and L Randall Wray

Debt, Deficits and Modern Monetary Theory -Harvard Review interview with Bill Mitchell

UK’s Official Reserves -Bank of England

 Sterling devalued and the IMF loan -Cabinet Papers

Could this be a way to scrutinize climate science enough for the skeptics?

Scientists have warned that we are faced with a stark choice; either we leave almost all of our known reserves of fossil fuels in the ground unused or else we will catastrophically damage our climate by the greenhouse effect. Of course there is also an extremely effective campaign based on the conviction that the whole idea is simply a baseless pretext dreamed up by those with an anti- free-market  political agenda. Vaclav Klaus has the view that “Freedom, not climate, is at risk”. He states,

There are huge material (very pecuniary) and even bigger psychological incentives for politicians and their bureaucratic fellow-travellers to support environmentalism. It gives them power. This is exactly what they are searching for. It gives them power to organise, regulate, manipulate the rest of us. There is nothing altruistic in their environmentalist stances.

The manifesto of the “climate skeptic” campaign was laid out by Vaclav Klaus:

As a witness to today’s worldwide debate on climate change, I suggest the following:

■Small climate changes do not demand far-reaching restrictive measures

■Any suppression of freedom and democracy should be avoided

■Instead of organising people from above, let us allow everyone to live as he wants

■Let us resist the politicisation of science and oppose the term “scientific consensus”, which is always achieved only by a loud minority, never by a silent majority

■Instead of speaking about “the environment”, let us be attentive to it in our personal behaviour

■Let us be humble but confident in the spontaneous evolution of human society. Let us trust its rationality and not try to slow it down or divert it in any direction

■Let us not scare ourselves with catastrophic forecasts, or use them to defend and promote irrational interventions in human lives..

That “climate skeptic” campaign has demonstrably succeeded in derailing any effective attempt to move away from using fossil fuels.  If the climate scientists are to have any hope of seeing their warnings heeded, they will need to win over the skeptics or at least the large swathe of public opinion currently influenced by them.

By way of background, we need to consider the case the scientists have presented us with. The key evidence in support of the greenhouse effect is a combination of the geological record and the fact that atmospheric carbon dioxide (at the relevant concentrations) is significantly more transparent to incoming sun light than to infrared heat energy returning back out into space. That “climate forcing” effect from atmospheric carbon dioxide allows an estimate of the long term increase in the earth’s temperature that is expected for a given level of atmospheric carbon dioxide. In accord with those predictions, the geological record demonstrates that the climate shows the expected correlation with the level of atmospheric carbon dioxide, superimposed against the backdrop of the climate changes due to the known variations in the Earth’s orbit around the Sun. We have examples in the geological record of when the level of atmospheric carbon dioxide has been much higher than today -due for instance to plate tectonics causing volcanic activity to release carbon dioxide from carboniferous rocks. A major source of bickering is whether we have sufficient evidence for man made climate change to date. To my mind, that is entirely missing the point. The real argument that we should be having is not whether or not the slight change to the climate we have already seen is significant and man made but rather whether we expect burning of our remaining reserves of fossil fuels to cause a catastrophic effect.

It is to be expected that there will be a time lag between a sudden increase in atmospheric carbon dioxide and the subsequent global warming effect. This lag is akin to the fact that typically the warmest part of summer does not occur until several weeks after the solstice; the difference, in the case of climate change,being that the time lag is decades with the full effect perhaps stretching much further. It is critical to note that this is not a feedback effect that mitigates the effects of climate change over the long term, it is simply a time lag. Modeling such effects is iffy -the time lag depends on complex effects, as melting polar ice releases vast amounts of ice cold water into the ocean currents and the oceans absorb heat energy. Climate change skeptics are however extremely foolish if they view the fallibility of efforts to model that lag as somehow providing reassurance that we needn’t worry about climate change. It is merely a question of precisely when (rather than if) the warming effect is going to be realized.

How much climate change can we expect and how hard would it be to live with it? James Hansen and coworkers predicted that burning the currently known recoverable reserves of fossil fuels would increase atmospheric carbon dioxide levels to about eight times their current level  (as compared to the 40% increase above pre-industrial levels caused so far by fossil fuels). They point out that mammals have existed on Earth under equivalent conditions (during the Eocene) and that the expected temperature increase of about 20 degrees centigrade (on land, less over the sea) is far below the level that would cause evaporation of the the entire oceans, loss of all water out to space and a climate incompatible with life. Nevertheless, the turmoil of the predicted scenario should not  be underestimated. Whilst collapse and melting of all of the polar ice caps would be a very slow ongoing process, much of the currently populated world would become intolerably hot and incompatible with agriculture. There would need to be a mass exodus towards the polar regions. To my mind it is fanciful to imagine that such a scenario would not entail unprecidented strain on the political and economic system. It would be a triumph if we were able to cope with it and not suffer humanitarian disasters, not to mention a breakdown of the freedoms and property rights that Vaclav Klaus and like minded climate change skeptics are endeavoring to defend.

I do not believe that Vaclav Klaus is a nihilist nor an idiot.  My impression is that he and other prominent climate change skeptics would have a totally different opinion as to whether we should stop burning fossil fuels if they were not convinced that predictions such as those of James Hansen  are merely a mass delusion spurred on by the political opportunities they offer. As Vaclav Klaus puts it,

The scientists should help us and take into consideration the political effects of their scientific opinions. They have an obligation to declare their political and value assumptions and how much they have affected their selection and interpretation of scientific evidence

Before I recently started looking into all of this, I was completely flummoxed by the rejection of the scientific advice but I think I can now understand how this rejection has come about. The predictions of catastrophic climate change have been through the usual scientific scrutiny of peer review BUT the policy implications are gigantic. We have no option of a trial run; we only have one planet and if we believe the climate scientists we all need to turn our lives upside down. The business as usual, everyday best practice level of scientific scrutiny simply isn’t appropriate for what the climate scientists themselves describe as a fork in the road for the future of humanity. The climate scientists no doubt work very hard at scrutinizing each others’ work and so were dismayed that their peer-reviewed scientific work is not sufficiently trusted. That defensiveness is perceived very badly and the skeptics smell a rat. The response of the skeptics has been to take the most expedient action to clip the wings of any political influence the climate scientists may have had. That has entailed a PR campaign against the science rather than a scientific argument with the science. Opinions have become more inflamed and the debate ever less constructive.

To my mind what is needed by all sides is for a totally fresh set of people from a totally different background to meticulously reexamine the predictions for catastrophic climate change. The issue is not whether climate scientists are any less reliable than any other scientists; the issue is that in this case the stakes are so high that a totally extraordinary belt and braces level of assessment is needed. As a general rule, when assessing scientific findings, people working in the same scientific field are those most able to spot weaknesses that would simply be overlooked by outsiders. What is more, it would be an extremely arduous task to review some scientific work in an unfamiliar field, so people working in the same field are used by journal editors for scrutinizing scientific work. That peer review process however does little to allay the main concern of climate change skeptics.  Their concern is that the field of climate science as a whole has a political agenda or at the very least a worrying level of group think. We need a one-off rigorous investigation expressly designed to be entirely robust against any such danger.

I think it would be perfectly feasible to apply a process of “outsider review” as a second safety net for this extraordinary case. The expense and effort would be trivial considering the context. It would be vital to keep the focus very tightly on examining the veracity of the key underpinnings behind the predictions of catastrophic consequences from burning all known recoverable fossil fuel reserves. Perhaps the ideal starting point would be a “global all stars” paper submitted specifically for this purpose, by the climate science field, laying out their best evidence for such a prediction. The team of reviewers could be assembled by a search committee chaired by prominent climate change skeptics (eg perhaps the Koch brothers, Vaclav Klaus and Nigel Lawson). If that search committee had any sense (and I trust they would) they would recruit a team of people who -whilst perhaps being totally unfamiliar with climate science- nevertheless had the capability to get up to speed and do the necessary work over the course of a year of extremely intense full time work. Perhaps the team would be made up from geologists, physicists and chemists from the petrochemical and mining industries along with mathematicians and software engineers previously working in quantitative finance or whatever. By all means they could all be screened by the search committee as having political inclinations that garnered the trust of the skeptics. Salaries and compensation to employers for leaves of absence could be on a pay what it takes basis.

The plan would be to drill down and stress test every point of the argument, word by word, data point by data point. Hopefully it would be possible to provide the team with comprehensive supplementary data and perhaps even access to actual mud cores and ice cores. The computer climate models could be rebuilt from first principles. At the end of the exercise the team could make publicly available their point by point assessment of the science. Just as happens in the current scientific peer review process, the climate scientists could then rejoin with a rebuttal, either clarifying points of misunderstanding, conceding and correcting mistakes or making the case that the reviewers are plain wrong. Unlike the peer review process, this whole exchange would be fully publicly available.

By confronting and dealing with the politics of the science we would be able to get to the point of having a true scientific argument/consensus rather than a political wrangle/PR campaign. We could then focus the political debate on addressing the policy implications.

I don’t think this idea is fancifully naive. Nigel Lawson has already taken part in a face to face meeting with climate scientists organised by the Royal Society in an attempt to build bridges. He has stated that regrettably no progress came of it and that he was not told anything he hadn’t heard before. Nevertheless, the fact that the meeting took place at all demonstrates an encouraging level of good faith from both sides.

Related stuff on the web:

Assessing “Dangerous Climate Change”: Required Reduction of Carbon Emissions to Protect Young People, Future Generations and Nature -Hansen et al

Climate sensitivity, sea level and atmospheric carbon dioxide -Hansen, Stao, Russell and Kharecha

Patterns in Palaeontology: The Palaecene-Eocene Thermal Maximum -Phil Jardine

The 1970’s Global Cooling Compilation-looks much like today-WUWT

Peer review and ‘pal review’ in climate science -Pat Michaels- GWPF-Cato

Unburnable Carbon 2013: Wasted capital and stranded assets -carbon tracker

Global Warming’s Terrifying New Math -Bill McKibben- Rolling Stone

Policy Relevant Climate Issues in Context -Judith A Curry

Freedom, not climate, is at risk- Vaclav Klaus-FT

The eye of the storm , interview with James Hansen -NRCC

Nigel Lawson’s diary: My secret showdown with the Royal Society over global warming -Spectator

Why can’t the champion of climate change denile face the music?-George Monbiot-Guardian

Spectator’s new editor fails to tell a straight story -George Monbiot-Guardian

Accurate Answers to Professor Plimer’s 101 Climate Change Science Questions -Department of Climate Change and Energy Efficiency

On the Absorption and Radiation of Heat by Gases and Vapours, and on the Physical Connexion of Radiation, Absorption , and Conduction -John Tyndal 1861

Climate change controversies a simple guide -Royal Society

Utopias in the Anthropocene -Clive Hamilton

The Global Warming Policy Foundation website-“restoring balance and trust to the climate debate”

Koch Industries secretly funding the climate denial machine -Greenpeace

Cato Institute Global Warming website

Slamming the Climate Skeptic Scam -Jim Hoggan

Be persuasive. Be brave. Be arrested (if necessary) -Jerry Grantham-Nature

The Beginning of the End of the Fossil Fuel Revolution: GMO_QtlyLetter_3Q14_full (added 22nov2014)

 

Money demand that doesn’t raise interest rates

The standard narrative is that money serves three functions:

• Medium of exchange
• Unit of account
• Store of value

Central banks have the mandate of ensuring that these functions all work smoothly so as to best serve the economy. When they don’t, problems with the monetary system can snarl up the real economy. For instance, if there is an insufficient supply of money to meet the demand for medium of exchange, then interest rates will spike up. The most familiar role of the central bank is in providing more base money so as to avoid crises of that type. Where things become murkier is when there is a deflationary slow down with great demand for money as a store of value. That situation is profoundly different and in such circumstances, interest rates can fall to zero. Should we expect the central bank to be able to deal with a situation of that type? In the 1930s that economic condition was prevalent.  Something similar reappeared in Japan twenty years ago and now has spread across much of the developed world.

Market monetarists such as Scott Sumner make the case that lack of nominal economic growth is always down to unmet demand for money and it is vital that the central bank meets any such demand whether it is driven by a requirement for medium of exchange or by a desire to hold money as a store of value. However, a key distinction between demand for money as a medium of exchange and demand as a store of value is that monetary base can be a limiting factor for the medium of exchange role. Whenever banks settle up the net payment transactions that have occured between customers of one bank and  another, base money is the only form of money they can use. The amount of base money required for that purpose is very small in terms of the total value of financial assets in the economy but nonetheless vital. By contrast there is nothing special about base money when it comes to providing the store of value role. Any other form of risk free broad money will serve that role just as well. Asset holders seeking to hold wealth as money will readily exchange other assets for base money but they will just as readily hold wealth in the form of broad money such as short term, risk free, debt securities. That is why interest rates are at the zero-bound; that after all is what it means for interest rates to be at the zero-bound.

So if the central bank takes it upon itself to conduct quantitative easing (QE) to appreciably alter the supply of money applicable for the store of value role, it has a massively larger job on its hands. Furthermore, broad money is readily constructed outside the central bank by the commercial financial system. To some extent, the increase in the money supply from QE gets offset by the shadow banking system reducing its output of broad money because demand for broad money is being met by QE.

I think the most crucial issue to examine is whether unmet demand for money as a store of value is actually what is impeding the economy and if so, what that implies.  In an idealized system, financial intermediation would match those who had savings with those who had need of finance for ventures that would subsequently pay a return. A problem arises when financial savings have instead built up on the basis of lending to fund unaffordable consumption, house price inflation and financial speculation. Servicing such debts has been based indirectly on further credit expansion providing the necessary  flow of funds. When much of the wealth in an economy is based on such a shaky foundation, asset holders seek money as a store of value rather than risk being caught up in a collapse in asset values.

Some economists such as Bill Mitchell advocate massive government deficit spending as a way to extricate ourselves from this situation. That could provide a flow of funds to enable debtors to service their debt burden and could provide ample risk free government debt securities as a way for savers to hold wealth. What actually seems to be being done is a toned down version of that approach. Just enough deficit spending is reluctantly being eked out to keep debts serviced and asset prices aloft. In the USA, QE is being used to purchase mortgage backed securities and in the UK the government is backstopping mortgage lending. This provides support for asset holders who don’t trust that asset prices won’t collapse. Meanwhile debtors are weighed down with debt servicing costs and unemployment squanders much potential that we instead permanently loose. The tragedy is that this scenario could persist pretty much indefinitely or even get worse over time.

As bad as our current situation is, I have grave doubts about the longer term consequences of taking the Bill Mitchell massive deficit route. My view is that the best option could be to ensure that money circulates through the system by replacing all current taxes with a tax on gross asset values and paying everyone a citizens’ dividend.

Related previous posts:

Does QE increase the preference for cash as a way to store wealth?

Monetary policy, the 1930s and now.

Sustainability of economic growth and debt.

Is it unjust to tax assets.

Bail out the customers not the banks.

Fiscal autopilot.

Rich people could benefit if everyone else were also rich.

Political Consequences of risk free financial assets.

Related stuff on the web:

Money creation in the modern economy -Bank of England (link added 19March2014 ht JKH)

The Myth of Japan’s Failure -E. Fingleton -NewYorkTimes

The Supply and Demand for Safe Assets -Gary Gorton, Guillermo Ordonez

Capitalism for the masses- Ashwin Parameswaran

The Road to Debt Deflation, Debt Peonage, and Neofeudalism -Michael Hudson

Depression is a Choice -Interfluidity

Debt and Demand -JW Mason

Does QE increase the preference for cash as a way to store wealth?

“we are able to catch a first glimpse of the way in which changes in the quantity of money work their way into the economic system. If, however, we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip. For whilst an increase in the quantity of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money; and whilst a decline in the rate of interest may be expected, cet. par., to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of interest; and whilst an increase in the volume of investment may be expected, cet. par., to increase employment, this may not happen if the propensity to consume is falling off. ” J.M.Keynes 1936

This is my second post about quantitative easing (QE). This subject may seem arcane but I think it is crucial to the general theme of this blog. As I discussed in that previous post, QE is being held out as a painless solution for a stagnant economy. As such, any other policies to sort out our economy get put to one side in favour of giving QE more of a chance. Meanwhile QE seems to have somewhat mysterious effects on asset prices and those impact on inequality and capital flows between countries and so effect us all.

I think it is important to make a clear distinction between simply using QE to bring risk free interest rates down and using excess QE, above and beyond that, in an attempt to satiate any preference the public may have to hold wealth in the form of zero yielding cash rather than as other asset classes such as stocks or bonds. In WWII and its immediate aftermath, the US and UK governments both used QE to peg low interest rates for both short term and longer term government bonds so as to facilitate massive deficit spending. That is a straightforward policy and keeping such low interest rates could be a permanent arrangement much as it has been in Japan for the past couple of decades. However we now have QE being used not so much to facilitate government spending but as an alternative to that as a way to try and stimulate the economy.

In my previous post I tried to rationalize the effects of further QE (once risk free interest rates were at the lower bound) in terms of how it could place a ceiling, for a period, on the extent to which the central bank could subsequently raise interest rates. Nick Edmonds has expressed skepticism as to whether such a constraint would actually come to bear on a central bank that wished to hike interest rates. His point is that, one way or another, a fix would be found.

Nick Edmonds models QE  in terms of how purchases of assets such as government bonds (by the central bank, from the public) induce price changes in all other asset classes, domestic and foreign, as the public rebalances  holdings of those various asset classes. This also tallies with how the Bank of England explains QE effects. To me this raises the crucial issue of why “the public” chooses to exchange other liquid assets for cash* even when cash is a zero yielding asset and the assets they sell do have an appreciable yield. In principle in the simplest model, a liquid asset with ANY yield would be preferable to zero yielding cash that was in excess of what was needed as a medium of exchange. Such a view however overlooks the crucial attribute of cash as the ideal stable store of value over the short and medium term  (1). Perhaps the clearest description I have seen for this is from an interview with Warren Buffett’s biographer Alice Schroeder:-

“”He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.” It is a pretty fundamental insight. Because once an investor looks at cash as an option – in essence, the price of being able to scoop up a bargain when it becomes available – it is less tempting to be bothered by the fact that in the short term, it earns almost nothing. Suddenly, an investor’s asset allocation decisions are not simply between earning nothing in cash and earning something in bonds or stocks. The key question becomes: How much can the cash earn if I have it when I need it to buy other assets that are cheap, versus the upfront cost of holding it? “There’s a perception that Buffett just likes cash and lets cash build up, but that optionality is actually pretty mathematically based, even if he does the math in his head, which he almost always does,””

Asset managers selling assets to the central bank obviously must value the cash they receive just as much as the assets they sell. This undermines the popular narrative about QE causing a “hot potato effect” as asset managers try to offload zero yielding cash. More generally whenever anyone sells an asset to anyone, it is because they value that amount of cash as much as that asset. That, after all, is what sets the market price for assets. So every asset is valued as that amount of “call option …with no expiration date… on every asset class, with no strike price” to use Alice Schroeder’s description of cash in its asset class guise.

Every asset also has its price set by what it itself is likely to earn. Peters and Adamou make the case that asset prices and price volatility find levels at which borrowing money to purchase more of an asset won’t increase gains. Buying more of an asset using borrowed money will amplify any short term gains but also any losses whenever the asset price falls and those losses will outweigh the increased gains overall. This stems from the phenomenon of “volatility decay”. A 25% fall in price requires a 33% rise to get back even,whilst a 50% fall requires a 100% rise. This effect would cap any durable upward repricing of assets unless price volatility also reduced and/or earnings increased.

Obviously, just as cash can be used to “scoop up a bargain when it becomes available“, so any other liquid asset can potentially be sold to fund such a purchase. The asset manager’s ideal would be to have holdings of diverse asset classes that had prices that could be relied upon to move in opposite directions such that bargains in one asset class could be bought when the other asset holdings had boosted available funds. The asset value of cash relies on the unreliability of such negative correlations between the price movements of various assets. I suppose this is making the same general point as J.M.Keynes’s statement :-

“It might be thought that, in the same way, an individual, who believed that the prospective yield of investments will be below what the market is expecting, will have a sufficient reason for holding liquid cash. But this is not the case. He has a sufficient reason for holding cash or debts in preference to equities; but the purchase of debts will be a preferable alternative to holding cash, unless he also believes that the future rate of interest will prove to be higher than the market is supposing.” In this context J.M.Keynes means future interest rates on long term debt or in other words, bond prices.

Of course cash doesn’t simply serve as an asset class; its value is also anchored in the real economy in terms of how much goods and services it can buy. Cash in the hands of asset managers has little influence on the prices of real economy goods and services. Asset managers simply work to transport value through time and use wealth to gather more wealth by buying and selling securities. The cash they control is restricted to that use and so does not generally take part in bidding for goods and services.

So basically the financial system is dealt exogenous constraints from the real economy. Cash has its real economy value and the firms and property underlying assets can only supply asset holders with gains limited by real economic activity. The financial system then juggles that around amongst itself. For everything to still tally up, the extra cash held by the public due to QE must shift the return characteristics of the market to justify the continued exchange of yielding assets for yet more cash. The Peters and Adamou study indicates that increasing levels of cash are unlikely to durably push up asset values. Those selling assets to the central bank also clearly have that perception or presumably they wouldn’t sell. It seems to me that something has to give and perhaps the most likely effect is to synchronize the price movements of the various asset classes. Perhaps that unfolding scenario is the only reason why the public continues to choose to part with assets in exchange for zero yielding cash.

All the cash provided by QE has to be held by someone at all times as with all other issued securities until they are withdrawn. Prior to all of the QE, an upward revaluation of say mining stocks might have entailed a sell off of say long term treasury bonds so as to provide the funds. The last participant to sell his treasury bonds would not have got much money for them and would not have been able to buy many shares of the mining stocks. By contrast, in a post-QE world, the mining stocks could be bid up by buyers who did not need to sell off anything else because they had ample cash reserves to draw upon. Consequently all assets now can be bid up in unison and likewise they can all fall in unison. The more that effect takes hold, the more valuable cash becomes as an asset class. In June 2013 there was a modest drop in asset prices that nevertheless was widely remarked upon because it seemed perfectly synchronized across all major asset classes; all classes of stocks, bonds and commodities, across the globe, seemed to suddenly revalue downwards in terms of the US dollar or Sterling.

Its worth asking whether this is a problem or not. If asset managers now hold more cash and need to hold more cash, then perhaps that is a fairly neutral non-effect. However, at the very least, it makes me very much doubt that we can sort out our economic problems simply by doing more QE.  To me the main downside to QE looks to be a further dislocation between the financial system and the real economy. In an ideal world, asset markets would serve the real economy by coordinating allocation of real resources towards where they could best serve the real economy. I worry that QE might only serve to make asset markets yet more stochastic, disruptive and capricious in their effects on the real economy. Perhaps the starvation that came for many people as a result of the seemingly stochastic spikes in grain prices in 2008 should serve as a warning of the potential real damage irrational financial markets can cause.

notes:

*I’m using “cash” here in the sense of any “cash equivalent” such as risk free bank deposits, very short term treasury bills, and, for banks, bank reserves.

(1) I think Keynes was alluding this when he described the “liquidity-preference due to the speculative motive”. For me however, Keynes’s terminology is unfortunate because this is all about the price stability of cash, not the fact that cash can readily be exchanged for other assets as the adjective “liquidity” is often used to mean.

Related Previous Posts:

Monetary policy, the 1930s and now

Larry Summers at least sees the problem

Related stuff on the web:

Money creation in the modern economy -Bank of England (link added 19march2014 ht JKH)

For Warren Buffett, the cash option is priceless -The Globe and Mail

Chapter 13. The General Theory of the Rate of Interest -J.M.Keynes 1936

Stochastic Market Efficiency -Ole Peters and Alexander Adamou

The Case Against Monetary Stimulus via Asset Purchases -Ashwin Parameswaran

What the *&%! Just Happened -Ben Inker -GMO

Leash the Dogma -John P. Hussman

Investing Like the Harvard and Yale Endowment Funds -Frontier

A Value Investor’s Perspective on Tail Risk Protection: An Ode to the Joy of Cash -James Montier -GMO

Thanks to Dan Kervick and Mark A Sadowski for prompting my thoughts about QE with their astute comments on Steve R Waldman’s Interfluidity blog (obviously if this post is stupid, that’s not their fault 🙂 ).

Global reserve currency status matters

Paul Krugman concluded a recent post with,  “The bottom line is that while saying “the international role of the dollar” sounds very sophisticated and important, the more you know about all this the less you care. This is simply not a big deal.”

Steve R Waldman has also previously posted somewhat skeptically about the significance of “US dollar hegemony”. This has come as a bit of a shock to me. I had fully taken on board the widely made case that the global economy is severely hampered due a national currency (the USD) also serving as the international reserve currency. I previously posted an attempt to explore ways in which this problem might be addressed. Should we instead be reassured that there isn’t any problem after all?

Just to be absolutely clear, there IS agreement that the USA could thrive without the USD being the global reserve currency -that isn’t the issue. I would totally understand if Paul Krugman were simply saying that it is no bad thing that China has arranged bilateral currency swap agreements with twenty other countries and that the USA should not intervene if oil producing nations agree payment in currencies other than the USD. My shock is that Paul Krugman dismisses the whole issue as inconsequential. I worry that complacency has come from the knowledge that our current system has been brought about by good-natured people -it is not the work of evil conspirators. I think it is vital to recognize that dreadful macroeconomic consequences can result without anyone having any malign intent. Once we take that on board, we will have a better chance of honestly appraising how things really are and that could help in avoiding tragic future mistakes.

Michael Hudson’s view is that, because the USD serves as the international currency for global trade, nations and companies need prices to have some semblance of price stability as denominated in USD or else they will not be able to compete in international markets. In Michael Hudson’s account, a sobering consequence of this is that other countries end up inadvertently funding the gigantic US military budget. The USA can have military bases across the world and the monetary authorities of other nations have to mop up that spending to avoid their own exporting industries becoming bankrupted. If monetary authorities across the world did not accumulate US treasury bonds as fast as the US military spent, then the USD would drop in value. If a factory is built or a mine is dug, then the flow of USD received from exports needs to be able to cover the cost of the initial investment and of wage contracts denominated in local currency. So long as the USD is used as the unit of account for global trade, this effect manifests even when the exports do not directly involve the USA and are between countries that have their own different currencies.

Rather than emphasizing the military, Greenwald and Stiglitz emphasize the accumulation of USD reserves for use as a buffer stock by monetary authorities seeking to moderate currency exchange rate fluctuations. By this account, much of the accumulated reserves of US treasuries are not wholly a “waste product” of efforts to counter the effects of runaway US current account deficits. Rather a significant stock is needed for use in crises when the local currency falls in value relative to the USD. Although the USA has run pronounced, sustained, current account deficits, the movements of currency exchange rates are far from smoothly in one direction. In times of financial panic, there is a flight to safety to the USD. In the 2008 crisis there was a dramatic fall in many emerging market currency values relative to the USD even though the crisis largely originated in the US housing market. In such circumstances, reserves can be drawn down to temporarily support the value of the local currency. As economies of developing nations grow, so the demand for these buffer stocks expands. Accordingly, even if the USA were to decide to radically scale back its overseas military spending, there would still be an awkward issue. Basically the USA, the worlds richest country receives real goods and services from far needier populations in return for electronic ledger entries -which is what the stock of US treasury bonds really amounts to.

A persuasive case can be made that the best policy can be to ride out exchange rate volatility without intervening. The calamitous  1997 Asian Financial Crisis actually prompted many countries to BOTH let exchange rates float considerably more freely than they had in the past BUT ALSO to amass much larger reserves of US treasuries for when intervention really was desperately needed. -A belt and  braces approach for ensuring some semblance of national financial security. Such reserves need to be held as US treasuries rather than as some other currency because the significant exchange rate is that between the local currency and the unit of account for global trade. Imagine if a monetary authority had amassed reserves in the form of Australian Government Bonds rather than US treasuries. During the 2008 crisis, the AUD/USD shifted from 0.97 to 0.61 and so for the purposes of intervening to support the value of the local currency, AUD reserves would have fallen short just when they were needed. Furthermore, by their very nature, currency exchange rate interventions by monetary authorities are huge, market moving, trades. Selling off reserves of US treasuries during such a crisis intervention can act to depress the value of the USD, which helps towards the intervention. Contrast that with the consequence of the price impact of selling off reserves that were in some other currency.

To me a particularly incongruous passage in Paul Krugman’s post was: “There is no evidence that America is able to borrow dramatically more cheaply because of the dollar’s role (and anyway more foreign borrowing is not necessarily a good thing.) You often hear claims that we’ve only been able to run persistent trade deficits because of the special role of the dollar; this is just false, since other countries like Britain and Australia have been able to do the same thing. What is true is that the large holdings of US currency outside the United States — largely in the form of $100 bills, held for obvious reasons — represent, in effect, a roughly $500 billion zero-interest loan to America. That’s nice, but even in normal times it’s only worth around $20 billion a year, or roughly 0.15 percent of GDP.”

First off, Paul Krugman’s emphasis of paper money rather than holdings of US treasuries seems utterly bizarre. That $500B held as paper money by foreigners is dwarfed by the $5.7T (ie more than eleven times as much)  held by foreigners as US treasuries. I also struggle to see how this can be viewed as “a loan”. To my mind, a meaningful use of the word “loan” is for when a debt is to be repaid. What we are talking about here are stocks of US treasuries that are perpetually rolled over along with any interest that accrues. In reality, foreign holdings of US treasuries have conferred $5.7T worth of real goods and services to the USA as a pure seigniorage profit.

What of Paul Krugman’s counter examples of the UK and Australia? The UK has gone all out in tapping into another equally profound and damaging distortion in the global financial system by becoming a piggy bank for the world’s elite. I had a go examining that phenomenon in the post  “Isn’t a financialized economy the goose that lays our golden eggs?”. In fact an analogy between the way that capital flows are enticed into UK asset markets and US dollar hegemony has led to Michael Goldfarb describing London real estate as a “global reserve currency”. The USA already partakes avidly in  similarly enticing capital flows into US asset markets. That gravy train can only be spread so far and the US is a much larger economy to try and distort than the UK economy.

The Australian balance of trade has been in persistent deficit as Australian households have racked up more and more mortgage debt over a very long time period. Australia has a relatively small population and a lot of mineral wealth. That mineral wealth, together with the immigration restrictions that ensure exceptional high pay for mine workers, underpin the ability of Australian households to service those debts.

In trying to understand all of this, I found it helpful to try and imagine the consequences if some other country were to try to unproductively splurge with their own currency across the world on a scale comparable to the overseas US military bases. Let us imagine that after reading Paul Krugman’s blog, such a country decided to set up lavishly appointed cultural outreach bases in every city on earth. It would entail employing tens of thousands of interpreters, and bidding for building materials and local contractors to build the bases. Perhaps a  million staff would live abroad to conduct the business of the bases, doing dance displays and such like, with it all being paid for out of the, now colossal, cultural outreach budget. My guess is that if an attempt was made to pay for all of that using Indonesian rupiah, Swedish krona, Japanese yen, Brazilian real or any other currency that was not the currency used for global trade, then the consequence would be a fully fledged slide in the currency value to the point where it became worthless and so the grandiose project had to be abandoned. The other countries couldn’t care less if all of their currencies appreciated dramatically relative to the Indonesian rupiah or Swedish krona. They would see no cause for intervening in the currency markets and no exorbitant privilege would be granted.

Edited on 28dec2013: expanded and amended the paragraph about Australia

Related previous posts:

Globalization, Triffin’s dilemma and demurrage crypto currency.

Isn’t a financialized economy the goose that lays our golden eggs?

Related stuff on the web:

A Modest Proposal for International Monetary Reform – Greenwald and Stiglitz

Reserve Accumulation and International Monetary Stability -IMF

De-Dollarization: Dismantling America’s Financial-Military Empire -Michael Hudson

Godwin and the Greenback -Paul Krugman

Does it matter what currency oil is priced in? -Steve R Waldman (2007)

Dollar Hegemony -Steve R Waldman (2006)

Petroldollar warfare -wiki

Larry Summers at least sees the problem

Larry Summers gave an IMF speech on Nov 8th where he acknowledged that since the 2008 crisis, the USA has had a “jobless recovery” and that the economy is still floundering well below potential. I’m glad that he is drawing attention to all of that. What I disagree with is his suggestion that we need encouragement of asset bubbles as a way to cope with this reality.

It is as well to note exactly what Larry Summers said:

“Then, conventional macroeconomic thinking leaves us in a very serious problem; because we all seem to agree that, whereas you can keep the Federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever — but the underlying problem may be there forever. It’s much more difficult to say, well, we only needed deficits during the short interval of the crisis if aggregate demand, if equilibrium interest rates, can’t be achieved given the prevailing rate of inflation.

And most of what would be done under the auspices — if this view is at all correct — would be done under the aegis of preventing a future crisis would be counterproductive, because it would in one way or other raise the cost of financial intermediation, and therefore operate to lower the equilibrium interest rate that was necessary. Now this may all be madness, and I may not have this right at all; but it does seem to me that four years after the successful combating of crisis, with really no evidence of growth that is restoring equilibrium, one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing and inflated asset prices than there was before. So my lesson from this crisis is — and my overarching lesson, which I have to say I think the world has under-internalized — is that it is not over until it is over; and that is surely not right now, and cannot be judged relative to the extent of financial panic; and that we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back below their potential.”

Throughout this blog I’ve being trying to explore ideas for a reconstruction of our economic system  both to address exactly the “secular stagnation” issue that Larry Summers recognizes AND avoid asset bubble induced financial crises. To me the key is to replace the current tax system with a tax on gross assets.

Furthermore I suspect that asset bubbles actually worsen the underlying root cause of secular stagnation. Over the long term, the only way that bubbles offer relief is by forcing fiscal stimulus in the form of bailouts to clear up the mess after the bubble bursts. As the bubble builds, the private sector appears to be creating prosperity by itself. Once the burst happens, the damage could more than make up for that except government deficits induced by bailouts mitigate the crunch. It may be politically more acceptable to have such “disaster relief” than to have everyday fiscal stimulus but it is exceptionally regressive and wasteful. The private sector becomes distorted into becoming a bailout harvesting machine.

It might be argued that bubbles act as a sort of asset tax in that they cause wealth to be moved out of safety and splurged on malinvestments -creating jobs in the process. People become employed building ghost estates of unwanted houses or making patent applications for pretend biotech innovations or whatever. However I suspect that the people who predominantly get fleeced by such bubbles are minor savers saving for retirement. Retirees who’s pension savings went towards buying insanely overvalued pets.com stock in 2000 are now cutting back consumption as a consequence of having lost those savings. The major players  profited not only at the expense of the real economy but also at the expense of all those “dumb money” savers who bought high and sold low. In that way bubbles actually worsen the wealth inequality that is at the root of the whole problem.

Related stuff on the web:

No, Larry Summers, We Don’t Need More Bubbles -Clive Crook, Bloomberg

Secular Stagnation, Progress in Economics -JW Mason (link added 27nov2013)

The Onion Revealed As Mystery Source Of Larry Summers’ And Paul Krugman’s Economic Insight -ZeroHedge

Secular Stagnation, Coalmines, Bubbles, and Larry Summers -Paul Krugman

The Economy almost certainly needs Bubbles -Michael Sankowski

Why Do the Rich Save So Much -Christopher Carrol

Innovation, Stagnation and Unemployment -Ashwin Parameswaran (link added  30nov2013)

Tapping the Brakes: Are Less Active Markets Safer and Better for the Economy -Stiglitz (link added 21April2014)

appendix (this is an excerpt from the pdf that I started this blog off with)

A zero interest rate policy does not reduce the financial overhead

It is sometimes celebrated that the current ultra-low interest rate regime supposedly reduces the “unearned increment” taken by “rentiers”. Some politicians effuse about the exceptionally low “cost of capital” enabled by the current financial climate. Interest free credit for the financial system means boundless financial leverage. Financial leverage powers the ability of the finance industry to feed off of financial instability and also creates and amplifies such instability.

The current zero-interest rate policy was brought about in Japan to save the Japanese banks after their stock market and real estate price collapse of 1990 and then in the USA and UK after the global asset bubble burst in 2008. Reducing interest rates tends to boost asset prices. Ultra-low interest rates also enable banks to “earn their way out of insolvency” by conducting interest rate arbitrage especially across national boundaries to regions with much higher interest rates. In fact just such a “carry trade” between Japan and the rest of the world provided some of the impetus for the bubble in the lead up to 2008. The impact of zero interest rates runs much deeper than such effects however. Understanding how interest free credit benefits the finance industry requires an understanding of how financial markets extract cash flows via price volatility. Potentially a fluctuating price can be harvested to provide a cash flow. If a security maintains roughly the same price over the long term then that means any 20% drop in price eventually being matched by a 25% rise (4/5×5/4=1), any 50% drop being matched by a 100% rise (1/2×2=1) and any 90% drop being matched by a 1000% rise (1/10×10=1). Obviously, simply holding such a security would provide no benefit as the price would simply bob up and down with no overall gain. However a 50% drop from $100 is a $50 loss whilst a 100% gain from $100 is a $100 gain. The fluctuations in the price are geometric but money is money. The fact that financial holdings can be bought and sold allows that geometric to linear inconsistency to be harvested. Simply periodically rebalancing such a holding against a holding of cash would extract financial gains. Rebalancing across a portfolio of securities with independently fluctuating prices optimises that process.

Rebalancing between financial holdings bids up the prices of whatever is cheap and bids down the prices of whatever is expensive. Such trading moderates the price fluctuations that it depends upon. However, such ‘liquidity providing’ speculation is accompanied by extensive ‘liquidity taking’ speculation that amplifies price fluctuations. If a trader envisions that prices are due to rise (or fall) then she can take advantage of such anticipated price changes.  In an idealised market where no participant had ‘an edge’ such ‘liquidity taking’ speculation would not make sense -the market as a whole would have already priced in any predictable price movement. However in the real world, market-moving levels of finance are controlled by traders who do have ‘an edge’ over the market as a whole. Liquidity panics occur when traders risk losing everything due to the market moving against their leveraged positions. Consequently, increases in the volume of trading activity typically increase rather than decrease price volatility.

Security trading is a zero sum game. For every participant who buys low and sells high someone else has to have sold to them and bought from them. Certain financial securities are firmly linked to the real economy. Commodity futures set the prices for essentials such as crude oil, grains and industrial metals. Producers and processors of such commodities have real world considerations when they decide whether to sell or buy. The real economy provides the “chump” who ends up buying high or selling low so as to provide the trading gains for financiers. Previously, the borrowing cost for the funds used for trading limited such financial extraction. Interest free credit removes that constraint.

The dream of “popular capitalism” was for everyone to own stocks and align with capitalistic interests to benefit from corporate profitability and efficiency. Various government schemes endeavoured to induce households to buy stocks. However a shift in the capital structure of many companies allows much of the potential benefits to slip past “mom and pop” type stock holders. In principle, the stock market provides a mechanism for distributing corporate profits amongst the shareholders. However, companies can decide to take on debt such that much of the cash flow services the debt instead of going to profits. Low interest rates favour such corporate leverage. Corporate debt is encouraged by the current severe taxes on corporate profits. Debt servicing costs are fixed ahead of time whilst the corporate cash flow varies according to the varying fortunes of the company. Once a fixed block of cash flow is pledged to creditors, any variation becomes proportionately much more dramatic for the remaining profits. The consequence is amplified share price volatility. Management payment in the form of stock options especially encourages a capital structure orientated towards inducing share price volatility.

A highly indebted company needs to nimbly keep the debt burden serviceable by either paying off debt if tough times are envisioned or expanding the debt and buying back stock when times are good. In effect the company itself acts as “the chump” using profits for share buybacks and aquisitions -bidding up oscillations in its own share price. Those shareholders who know what they are doing are able to harvest that volatility by buying and selling at opportune times. The benefits entirely pass by the other shareholders who simply hold the stock as the price bobs up and down. All of the gains pass on through to be captured by those who trade astutely. Some shareholdings last for less than a second in an effort to harvest wiggles in the price on a microsecond timescale.

When financial leverage goes wrong, the assets bought on credit may fall in value to become worth less than the money owed. Historically, bankruptcy laws were extremely harsh on debtors and so financial leverage was feared. Without limited liability laws, company owners were personally on the hook for every debt. Nowadays, however, debts can be taken on such that there is an amplification of any gain (which is pocketed) or an amplification of any loss (which becomes un-payable and so is apologized for). The bank bailouts since 2008 have taken this asymmetry to another dimension. The government stepped in and said that it would pay for all of the losses so that none would be suffered by the creditors (predominately also banks and financial institutions in a reciprocal web of lending). Richard Bookstaber summarised the strategy ,

“Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.”

Currently, high finance is an extremely complex business. It requires a colossal technological and human effort. The most advanced and expensive computers are dedicated to high frequency trading (HFT). The best and brightest are educated at elite universities to prepare them for the intense battle of mathematical genius that financial trading has become.  Traders pay exorbitant rents so as to have their computers next to those of the major exchanges to avoid even the slightest time delay. A private fibre optic cable has been laid directly between New York and Chicago so as to gain a microsecond advantage for comparisons between the futures and stock markets. It is easy to become beguiled by the sheer complexity and effort of it all. People marvel at superlative feats of human endeavour and the financial markets are the Great Pyramids of our time. That is not to say that it is not counter-productive and essentially moronic.

The vast sums skimmed off from the economy by the vastly expensive finance system could mostly be avoided if money used for financial leverage had a cost such as would be the case under an asset tax system. The useful functions of price discovery and exchange would be better served by pedestrianized financial markets in which all participants interacted on a level playing field. Advanced computers would be rendered pointless if transactions were conducted with a time resolution of minutes rather than microseconds. Such a time buffer would end the vastly expensive arms race in computer technology between elite traders. The current ultra-low-latency trading environment often provides a perfectly continuous price variation down to a microsecond resolution. That much applauded attribute is only of any relevance for ultra-low-latency traders in their quest to out manoeuvre other participants. Whilst advanced technology normally creates such (superfluous) pricing precision it occasionally runs amok creating gross mispricing events such as the “flash crash” of May 2010 and the Knight Capital fiasco of August 2012. A genuinely efficient financial market is one that allows prices to be formed that genuinely reflect supply and demand and does so at minimal cost. Excessive opportunities to “make money” from trading are an indication of a dysfunctional market. However, the current market structure is entirely a concoction for just that purpose. The failure of current financial markets to serve their original purpose is apparent from withdrawals.  Farmers are now making less use of futures to hedge their prospective crop yields. There has been a transfer of stock ownership from households and pension funds to financial institutions.

Monetary policy, the 1930s and now

The US Great Depression of the 1930s still ignites heated controversy, with divergent views as to what was going wrong and how it could have been avoided. Uncanny parallels with some current economic woes emphasise that this is more than just a historical curiosity.

The Great Depression was a very striking phenomenon – a previously thriving economy that had provided the American people with the opportunity to make full use of their talents and the nation’s resources, instead floundered. Although all of the necessary manpower and resources were still immediately to hand, they were left idle and great suffering resulted from the unemployment and lost production. This malaise continued until the start of WWII when the economy was transformed by the massive demand for war equipment with consequent full employment and widespread prosperity.

This 1933 quote from Marriner Eccles exemplifies the underconsumptionist view of what was going on,

“It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they can not save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying. It is for the interests of the well to do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.”

Today, instead, the mainstream view is that the Great Depression could have best been avoided by deployment of monetary policy. Monetary policy has the fantastic attribute that almost everyone finds it politically palatable. It simply involves the central bank making purchases from willing counterparties. If it really can do the trick, then that is fabulous. For just that reason, politicians have been bowled over and have widely abdicated much responsibility for unemployment and price stability over to the central bankers who conduct monetary policy. The problem though is that if monetary policy is incapable of rectifying the problem, then relying on it becomes a dangerous delusion.

According to the monetarist view, the 1930s Great Depression was all down to the phenomenon of monetary deflation. Prices fell but debt burdens and wage contracts were still in place that had been negotiated when prices were higher. Such debts and wage costs  could not be met from the reduced revenue as prices fell. In reaction to that, firms cut costs and directed revenue towards paying down debts. Defaults and bankruptcies caused lenders to become ever more wary of extending credit even to those still seeking it. Unemployment, and the fear of it, reduced consumer spending. That all caused a lack of demand and so further price falls and a destructive deflationary spiral was set off. Proponents of monetary policy claim that it has ample capacity to ward off any such episode.

Such monetary policy consists of central bank purchases of financial assets in exchange for freshly created base money (aka central bank liabilities). If there is a tight shortage of base money (such as was the case in the 1920s and then again in the 1980s) then relieving that shortage can dramatically lower interest rates and so encourage credit expansion throughout the economy. However in the 1930s (as now) there was a glut of monetary base such that interest rates were at the zero lower bound. In fact, Treasury bill rates were actually negative when the Great Depression was at its worst. Prices fell not because there was a shortage of base money overall but because the money was not being used. This was recognised at that time as shown by another 1933 quote from Marriner Eccles,

“In 1929 the high level of prices was supported by a corresponding velocity of credit. The last Federal Reserve Bulletin gives an illuminating picture of this relationship as shown by figures of all member banks. From 1923 to 1925 the turnover of deposits fluctuated from 26 to 32 times per year. From the autumn of 1925 to 1929 the turnover rose to 45 times per year. In 1930, with deposits still increasing, the turnover declined at the year end to 26 times. During the last quarter of 1932 the turnover dropped to 16 times per year. Note that from the high price level of 1929 to the low level of the present this turnover has declined from 45 to 16, or 64 per cent.  I repeat there is plenty of money today to bring about a restoration of prices, but the chief trouble is that it is in the wrong place; it is concentrated in the larger financial centers of the country, the creditor sections, leaving a great portion of the back country, or the debtor sections, drained dry and making it appear that there is a great shortage of money and that it is, therefore, necessary for the Government to print more. This maldistribution of our money supply is the result of the relationship between debtor and creditor sections – just the same as the relation between this as a creditor nation and another nation as a debtor nation – and the development of our industries into vast systems concentrated in the larger centers. During the period of the depression the creditor sections have acted on our system like a great suction pump, drawing a large portion of the available income and deposits in payment of interest, debts, insurance and dividends as well as in the transfer of balances by the larger corporations normally carried throughout the country. The maladjustment referred to must be corrected before there can be the necessary velocity of money. I see no way of correcting this situation except through Government action.”

Nevertheless there is still today a popular view that even when interest rates are essentially zero, further increasing the monetary base nevertheless increases prices. It has to be stressed that this is not about conferring purchasing power to people or institutions who lack it (conferring such benefits would be fiscal policy and not monetary policy). This is about exchanging base money for other liquid financial assets (such as government debt securities) that are worth as much as is being paid for them by the central bank and that can be effortlessly exchanged for money within the private sector anyway. The idea is that somehow the overall quantity of monetary base causes all prices to adjust so as to regain some natural ratio between the monetary value of available goods and services and the quantity of monetary base. Central banks don’t themselves make such a claim but some of the most ardent advocates for monetary policy do. Scott Sumner is perhaps the most strident purveyor of that view.

Scott Sumner acknowledges that the immediate effect of boosting the monetary base is to reduce its “velocity” (the frequency with which each dollar is used). However the claim is that this lack of a short term effect on prices nevertheless projects into a robust effect over the long term. I struggle to comprehend how this short term to long term transformation is supposed to take place. The (hand waving) explanation is that it entails “inflation expectations”. The idea is that for instance employers will keep staff employed, even when the wage bill is too high, in the anticipation that prices will rise enough such that sales and so revenue will cover staff costs. Consequently such high staff costs are actually paid (perhaps funded using extra debt) and the anticipated inflation becomes realised.  So apparently, once interest rates are at the zero lower bound, increases in the monetary base have a purely propaganda role-they supposedly work because they are believed to work. It is claimed that the observed lack of pronounced inflationary impetus from quantitative easing (QE) in Japan, USA and UK is because QE is supposedly expected to be reversed. It is claimed that if people believed QE were permanent, then prices would rise via this “expectations” mechanism.  By that reasoning, this alleged “inflation expectations” mechanism could equally be conducted via some sort of inflationary rain dance. I suspect the fly in the ointment is that people aren’t so gullible and, even when they are, they often are constrained by immediate considerations such as bankruptcy and becoming unemployed.

My view is that QE instead acts to make it harder for the central bank to raise interest rates in the future. The more QE we have, the less likely it is that we have an interest rate rise in the next few years. Currently the Federal Reserve pays interest on reserves so as to prevent interest rates falling below 0.25%. The funds to pay for this come from the interest received by the Federal Reserve on the assets in its own portfolio. Thus the interest paid on reserves cannot exceed the interest received from the assets exchanged for the reserves in the first place. Previous episodes where interest rates have been set high have necessarily relied on a scarcity of monetary base such that banks had to bid against each other to obtain it. From where we are today, such scarcity could be brought about only after the current excess stock had been vastly diminished by government budget surpluses or rendered insignificant by inflation and economic growth. The price impact of any attempt to sell off the Fed’s portfolio of longer maturity assets would thwart any attempt to use such sales to gather back enough of the excess monetary base to induce a scarcity.

A receding risk of future significant interest rate rises does constitute an genuine and rational “expectations” channel BUT it is all about interest rate expectations and not inflation expectations. People may be more willing both to take on more debt and to lend when assured that rates are not going to rise. Central banks have recently offered “forward guidance” saying that they are not going to raise rates for the next year or so. Perhaps QE serves as a demonstrable “bridge burning” exercise that adds considerable heft to such forward guidance. The central bank puts itself into a position where it no longer has any capability to significantly raise interest rates even if it were to want to.

I am not convinced however whether even the certainty of zero-interest rates for decades is really enough to cure an economic depression. To me it looks more like a palliative measure that kicks the can down the road allowing the current imbalances to be perpetuated for a bit longer so debt burdens are serviced rather than defaulting. Debt burdens may be maintained but there is only so much revenue that can be passed through as debt interest if those payments don’t somehow circulate back around from the creditors to the debtors. Expectations of zero interest rates won’t induce such circulation.

Perhaps some of the rationale for the belief in the monetary base setting prices stems from ideas of how the gold standard led to long term price stability. During the gold standard period both in the USA and the UK, prices oscillated but over the long term, inflations were matched by deflations. Subsequently, since leaving the gold standard there has been a steady overall inflation. However the gold standard had its effect by forcing monetary tightening that foreshortened boom periods.  When credit expansion and increased economic activity outgrew the capacity of the monetary base provided by the stock of monetary gold, a tight money recession would lead to debt write downs, fire sales of assets and inventory and a consequent resetting of prices such that the monetary base was once again sufficient. Note that there is a clear mechanism by which insufficient monetary base curtails nominal growth and price rises BUT that is totally different from imagining that adding more monetary base will raise prices when the current stock of monetary base is more than sufficient and yet prices are suppressed due to other constraints.

As mentioned above, in the Great Depression there was a glut of monetary base and interest rates were at the zero bound. The trade surplus between the USA and Europe and the WWI debts that Europe was saddled with had caused a massive transfer of gold from Europe to the USA. That together with the newly created Federal Reserve system, allowed the 1920s boom period to extend for longer than was typical under the gold standard system. Credit growth continued for longer. Eventually debt fueled consumption and speculation could no longer be sustained as funds failed to recirculate from creditors back to debtors and the crash and depression ensued. Perhaps the Great Depression was a manifestation of the more extensive polarisation between debtors and creditors that had built up due to the extended 1920s boom on top of all of the accumulations from the industrial and agricultural developments of the previous century.

Another key assertion from Scott Sumner is that hyperinflations demonstrate that, “Monetary stimulus can make NGDP grow as fast as you like, as we saw in Zimbabwe”. I think it is very misleading to describe such currency slide hyperinflations as being driven by central bank balance sheet expansion. They are typically the result of futile attempts to service unpayable foreign currency denominated debt burdens and in the worst cases also have involved massive supply shocks from loss of production due to political conflict. If bizarrely such a scenario were chosen on purpose, it would not be in the central bank’s power to induce it. The Treasury would need to take on such foreign currency denominated debt and the security services would need to damage productive capacity so as to induce a supply shock. The central bank obviously takes part by way of supplying the ballooning monetary base BUT that is entirely different from claiming that central bank balance sheet expansion provides sufficient cause.

There is however one clear example of monetary policy successfully raising prices during the Great Depression. In 1934 the exchange rate between the US dollar and gold was reset from $20.67 per ounce to $35. That did reset the prices of imports since at that time gold was the unit of account for international trade. It has to be stressed however that after that point in the Great Depression, the fixed  $35 per ounce gold peg acted to limit appreciation of the dollar. If the dollar had been a free floating currency, the price of gold would have fallen in dollar terms as evidenced by the considerable inflows of gold sold to the US Treasury in exchange for dollars. I guess in principle the monetary authorities could have made a commitment to continuously devalue the US dollar against gold by say 10% per year every year. That would obviously have had the primary effect of simply inducing an  impetus to hoard gold. At the time US citizens were prohibited from owning gold so it might instead have acted to induce holding of foreign currency or other stores of value such as other metals, diamonds, art work or land. It would undoubtedly have also instigated a worsening of the international trade disputes and barriers that already bedevilled the period. Perhaps it would have brought forward abandonment of the gold standard by all of the other countries and so rendered the policy impotent. What I am not convinced it could have done is to have shifted spending towards employing and providing for the American people.

I think the crux of this debate revolves around the attempt to shoe horn four contrasting economic conditions of prosperity, inflation, deflation and “tight money” into an overly simplistic model where prosperity is conflated with inflation and deflation is conflated with “tight money”. A simplistic view that sees a straight axis of inflation/prosperity to deflation/“tight money” leads to policy designed to remedy the “tight money” condition being deployed even when there is deflation in the hope that it will be inflationary in the hope that that will cause a shift towards prosperity. In reality many factors need to be in place for prosperity to prevail. Prosperity requires a financial system that supports the wide population in making full use of their talents and property so as to provide whatever is wanted by anyone. It requires a delicate balancing act where financial power is sufficiently distributed to the most competent and yet needs to include the whole of the population such that no one’s potential contribution or needs are left out. Throughout the 1980s and 1990s, many “third world” countries exhibited stalled economic development with mass unemployment and underemployment in conjunction with inflation due to sliding currency values. Wealth polarization with economic exclusion of much of the population and political cronyism will ensure an economic depression irrespective of the inflation level. Tackling those issues is beyond the scope of monetary policy.

Related previous posts

Fiscal autopilot

Bail out the customers not the banks.

Rich people could benefit if everyone else were also rich.

Political Consequences of risk free financial assets

Sustainability of economic growth and debt

direct economic democracy (pdf)

Related stuff on the web:

U.S. Monetary Policy & Financial Markets – Ann-Marie Meulendyke, Federal Reserve (ht Mark A Sadowski)

Testimony of Marriner Eccles at Investigation of Economic Problems 1933

Leash the Dogma -John P. Hussman

Quantitative Easing: Entrance and Exit Strategies- Alan S. Blinder

The United Kingdoms’s quatitative easing policy: design, operation and impact -Joyce, Tong and Woods, Bank of England

Deflation: Making Sure “It” Doesn’t Happen Here -Ben S. Bernanke

The Macroeconomic of the Great Depression: A comparative approach -Ben S. Bernanke

Why (and when) interest-on-reserves matters… -Interfluidity

Some Peculiar Dynamics with Long Term Money Neutrality -Nick Edmonds

1682 days and all’s well -JP Koning

Rates or quantities or both -JP Koning

The Case Against Monetary Stimulus Via Asset Purchases -Ashwin Parameswaran (link added 30nov2013)

A non-monetary explanation for inflation -Matt Busigin (link added 27dec2013)

Money creation in the modern economy-Bank of England (link added 19march2014 ht JKH)

How to sort out the UK energy market

In the UK there is currently a political rumpus about our over-priced electricity and gas supply. It would be hard to imagine a more broken by design market structure than the energy market our politicians have concocted for us. And yet the price freezing “remedies” proposed by the Labour Party opposition seem even worse (see the Californian example).  I think we do however have realistic options for structuring the market in a way that ensures genuine price competition to provide consumers with a better deal and allow energy companies to invest appropriately to ensure future supply.

In the UK we have a system where  companies compete to supply electricity and gas over shared supply grids. Consumers each choose which electricity generator and gas supplier to pay. The consumers use the electricity and gas from the common transmission pool and the suppliers get paid to contribute the electricity and gas used by “their” consumers. Obviously the only consideration for the consumer is cost since the electricity and gas is all the same and is taken from a common pool. In principle every consumer would choose the same cheapest supplier if costs were transparent- BUT costs are not transparent. The dysfunctional set up ensures that companies actually compete on the basis of bamboozling consumers. A  bewildering and constantly changing array of different tariffs (that combine or separate gas and electricity supply and charge various amounts for different quantities) ensures that consumers typically inadvertently choose more expensive suppliers. Rather than investing in efficient energy generation, the suppliers are induced to invest in marketing campaigns to increase brand awareness and loyalty in consumers. This sorry mess is overseen by the regulators Ofgem who supposedly ensure a correct “balance” between “fairness” to consumers and profitability for the suppliers.

The system was designed following a goofy blind faith that consumer choice and competition, however construed,  would inevitably provide a good system. Stepping back we can see that in this instance consumer choice is a mute concept. What is needed is pure, pared-down, price competition. The way to ensure that is by directly linking retail prices to wholesale prices established by uniform-price auction. Uniform-price auctions are known as the most competitive way to set energy prices (the uniform-price auction method may also be familiar to you as the way US Treasury debt is issued). In such auctions, npower say could place a bid at £x to supply 10 GW of electricity whilst E.ON might bid at £y for 20 GW etc. The cheapest bids would be filled first until the entire market had been portioned up. Consequently companies that bid too high a price would end up not getting the market share they sought. The same price would be paid to all of the successful bidders and the price would be set by the bid at the margin that only got partially filled. Auctions could cover a series of time frames such that some of the market was sold just covering the next hour, some the next day, some the next two years, next ten years or whatever. As much of the market as possible would be covered by the long term contracts so as to keep overall prices more stable and to facilitate the financing of any necessary new capacity.  All consumers would pay the same as each other per unit of power at any given time. Collection of payment from the consumers would be conducted centrally much as energy transmission is today; it would be a service provided to the energy suppliers by a separate company.

Retail prices would be constantly fluctuating much as retail prices for say diesel constantly fluctuate today. The current price would need to be made public on a continuous basis. It would be an amalgamation of the various long term and short term prices covering that moment.  For the vast majority of consumers, exposure to the raw cost would get them the cheapest power for each billing period. However, just as some transportation companies today use financial hedging to avoid variations in their fuel costs, consumers with special circumstances (such as commercial consumers with cash flow issues) could pay finance companies to provide a swap to a fixed rate that was known in advance.

We would then have a system where market share went to those companies that were able to provide power the cheapest rather than to those companies with the catchiest TV adverts and most charming/aggressive telephone sales teams. Currently new entrants to the market are thwarted by the dominant brand awareness garnered by the “big six” energy companies. Under the system I’m proposing no advantage whatsoever would be gained by having a brand that was a household name. Suppliers could then focus on ensuring efficient supply rather than marketing and none of our energy bills would end up going towards TV adverts, sports sponsorship and door to door or telephone sales pestering.

Electricity markets are notoriously vulnerable to manipulation. This vulnerability arises because electricity can not be stored; demand is exceedingly price insensitive in the short term and creating extra generation capacity is relatively slow. Consequently if a market participant commands even a seemingly modest share of the market, the phenomenon can arise where withdrawing generation capacity during periods of peak demand increases profits because the remaining capacity becomes so much more profitable as prices spike up. Regulators need to be exceedingly vigilant to make sure that no company or coordinating group controls more than a few percent of the market. It is vital to recognize that such market fragility may remain latent until precipitated by a crisis as occurred in California in 2001. There is no place for complacency.

Another key consideration is how to ensure that appropriate electricity generating technologies are used to meet environmental and energy security concerns. Perhaps renewable energy could be given precedence over fossil fuel energy such that all provided renewable energy was bought and fossil fuel generated electricity just made up the (large) shortfall in capacity. The auction could directly set the price for the fossil fuel generated electricity whilst the renewable energy was paid for at a fixed premium above that auction price. The need for renewable energy  and energy conservation (which I personally fully recognize) is anyway a somewhat separate debate from this.

Related stuff on the web:

Uniform-Price Auctions in Electricity Markets -Crampton and Stoft

Energy bills: Where does my money go -BBC

Understanding energy prices -Ofgem

The energy market explained- Energy UK

Electricity Market Reform: policy overview -Department of Energy and Climate Change

The Retail Market Review – Findings and initial proposals – Ofgem

Our dividend obsession -SSE

The California Electricity Crisis: Causes and Policy Options -Christopher Weare

MPs to quiz energy chiefs on price hikes -Express

Revealed: How Big Six energy firms conceal their profits -Independent (link added 09Nov2013)