Archives for posts with tag: asset tax

The standard narrative is that money serves three functions:

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

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.

Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist. –Kenneth E. Boulding

Our world today seems full of contradictions. We seemingly need to work longer hours to secure our jobs when there aren’t enough jobs to go around. It appears necessary to bombard us with advertising to persuade us to buy stuff we don’t really want because that is the only way to ensure enough employment for people to afford what they need. Apparently much of this is in aid of economic growth and economic growth is important because without it we won’t be able to service our debt burden.

It is easy to come to the conclusion that debt and economic growth are at the root of our problems and so we should eliminate both. There is a campaign organisation advocating just that – the “Center for the Advancement of the Steady State Economy” (CASSE). Nevertheless, it is also easy to dream up imaginary fables where both debt and economic growth are entirely beneficial:

Imagine an economy where people relied on camel herding to provide food and fire wood for power. They had intermittent famines whenever droughts occurred and spent all day every day scouring the desert for fire wood, water and camel forage. Life was hard and getting harder due to desertification from camel overgrazing and tree loss.

To avoid the looming crisis they constructed solar powered desalination plants to provide fresh water from the sea and grew seaweed on floating farms to convert into aviation fuel, plastic materials and animal fodder. The waste from the seaweed was used as a soil improver and so plenty of camels could be kept on good pasture for use as family pets and recreational riding. Solar powered, robot staffed, factories provided everything everyone wanted. The land that had been overgrazed recovered and wild animals that had been rare became numerous again. Materials were recycled and the cornucopia of consumer goods and capital equipment entirely came from organizing existing materials using human ingenuity and renewable energy.

All the economic development was funded using debts drawn up between the people. The revenue from providing goods and services to each other provided an ample revenue stream for all the debts to be serviced. Everyone was both a creditor and a debtor. People used the revenue from their debt holdings to help pay their debts to each other. There was initially a debate as to whether to use a monetary system based on bills of exchange drawn up between the populace or whether to allow banks. It was decided that banks would add convenience and fortunately the excess interest charged by banks got spent back into the economy by the bank workers and owners. There initially was nothing much in the way of government but it was decided that so long as government workers spent what was received in taxes back into the economy, a mixed public sector private sector economy might be conducive to overall prosperity.

There was no inflation either of consumer prices or of assets. The price of a camel stayed exactly the same as did the prices of the buildings that predated the economic transition. However whilst previously the camels and few permanent buildings constituted essentially all of the asset stock in the economy; they became a tiny proportion of a vastly wealthier economy with masses of incredibly valuable high tech capital equipment. The stock of debt grew in proportion to the size of the economy; as the economy grew so did the revenue streams available to service the debts with. There seemed no end in sight to the economic growth. People owned more and more sophisticated machines that enabled them to do less and less drudgery. At no point was economic growth sort after as a way to service the debts. It was simply a by-product of people doing things better. If for whatever reason economic growth had stalled, the debts would have remained serviceable because all of the repayments were spent – returning the means of payment back to the debtors.

I think it is instructive to unpick how this imaginary scenario diverges from our real life situation that has led people to found the “Center for the Advancement of the Steady State Economy”. I think it boils down to the imaginary situation being based on money and debt being entirely used to direct current investment and consumption (I’m not using the word “investment” in its financial meaning as exchange of money for another asset but rather in its economic meaning as spending on new machinery etc.). In the imaginary situation the money and debt are simply a form of communication that enables people to organize and rearrange the resources they have. They are analogous to the pheromones used by insect colonies that enable a colony of insects to work together in harmony for the greater good of each other. My impression is that our real life problems stem from money and debt being instead used to concentrate power and control rather than to direct activity. Often money is lent not so as to obtain a revenue stream to spend on goods and services produced from the investment; but rather so as to gather more wealth to keep as an insurance in case in future there is competition for scarce resources.

It is perfectly rational to want to insure against an uncertain future. The problem is that collectively our ability to provide for each other depends on our real productive capacity not our paper wealth. If bees or ants saved up their pheromones, instead of using them to direct each other for gathering nectar, the colony would collapse. When the hive was in disrepair with no stocks of honey, it would be too late and the amassed stock of pheromones would be seen for the foolishness it was.  It is exactly the same with money and debt for us. I think we need to think rationally about the glitch in the nature of finance that enables claims to be accumulated without an accompanying ability to honour those claims. When we talk about debt being unsustainable, what we are really meaning is that the debt has become disconnected from the real economy and money is being used to gather money rather than to build productive capacity. I think replacing our current tax system with a tax on assets could ensure that all wealth remains continuously grounded in the productive capacity required both to pay such a tax and so prevent that potential glitch in the nature of finance.

We also need to be extremely wary of exhortations for economic growth where what is actually meant is growth of debt disconnected from productive capacity. That is simply a demand for increased wealth inequality. Debts based on lending to fund consumption to paper over inequalities have to be recognised as reckless lending that provides no basis for real wealth and need to be left to default with no backstop for the creditors. It is wealth inequality that leads to disconnected debt being the most financially prudent form of saving. In my opinion, tackling wealth inequality is crucial if we are to have a sustainable prosperous economy.

The “Center for the Advancement of the Steady State Economy (CASSE)” have a “myth and reality” section. Two of the “myths” they refute are “We can grow the economy continuously because we can decouple growth from resource use and waste production” and “technological progress will allow unlimited economic growth”. Refuting those “myths” seems to me to be saying that people will stop learning from experience. I don’t believe that that would be desirable. I think it is vital never to conflate environmental conservation with eschewing knowledge and technology. A blind grasping for economic growth for the sake of sustaining non-productive debts may be leading us to neglect environmental concerns but in principle efforts directed at protecting our environment may actually lead to economic growth. Goods might become exquisitely designed with a view towards reuse and recycling. Potentially materials could just be remoulded again and again with no waste and no natural resource consumption. Humans have been doing exactly that with gold and gemstones for thousands of years. We will simply need to treat other mineral resources in the same way.

The sun provides our planet with an immense power source that renders the “thermodynamic” objections posed by CASSE complete nonsense. Do CASSE believe that evolution by natural selection will cease? Isn’t evolution simply a honing of the fitness of living things -the natural world’s equivalent of economic growth? I don’t consider that there is any more reason to evoke a “thermodynamic” objection to economic growth than there is against evolution. Of course humans are perfectly capable of screwing up and making each other’s lives miserable. The history of Easter Island illustrates that perfectly. That is very different from saying that we can’t behave differently.

Also see posts:

Rich people could benefit if everyone else were also rich

Chance, luck, risk and economic democracy

Related stuff on the web:

Is sustainable growth an oxymoron -John Fullerton

Growth isn’t possible- nef

The End of Growth Wouldn’t Be the End of Capitalism -The Atlantic

On the Road to Zero Growth -Jeremy Grantham

Murphy’s Law? or, Follies of a Finite Physicist- Noah Smith

I think the greatest threat to our environment is human poverty. This may seem counter-intuitive since in general each rich person consumes and pollutes far more than each poor person. It has been estimated that it would take five Earths to provide all seven billion of us with a current US lifestyle. An astonishingly low environmental impact is achieved by the poorest . On the face of it, if everyone managed to lift themselves out of poverty, increases in pollution and environmental degradation might be expected to cause an environmental calamity. However if having all seven billion of us living an affluent lifestyle poses an environmental challenge, a more serious environmental challenge is posed by having ten billion people sharing the planet even if two billion of those don’t pollute or degrade the environment much due to poverty. To my mind population growth is the crucial environmental issue and population growth comes from poverty.

Hans Rosling makes a very compelling case that the poorest two billion people are the source of global population growth. People from utterly different cultures all over the world on average have large families when child mortality rates are high and small families when they are low. Over the past few decades there has not been an explosion in the number of poor people because thankfully many poor people do manage to escape poverty. But enough remain poor to maintain a steady source of global population growth. The poorest two billion people today are just as poor as the poorest two billion a few decades ago and just as likely to see their children die and just as likely to have large families. Poor people  are the progenitors of the increased future population of better off people who eat meat, drive cars and water their lawns. If you believe that the world can only support a limited number of affluent people then the answer is to ensure that everyone is affluent.

Obviously if each of us who has the good fortune to be comfortably well off chooses to consume in a way that minimises environmental problems; then that is great. We can spend our money on say dance classes for our children rather than new hardwood flooring or whatever –reduce, reuse, recycle. Environmental concerns do also feed into politics though. Many people want the political system to steer other people towards behaviour that protects the environment.  I think it is crucial that people living in the rich world channel the politics of environmental concern towards ameliorating the extent to which the rich world impoverishes the world’s poorest. I don’t think policy makers in the rich world intentionally impoverish the world’s poorest. It comes as a by-product of efforts to ensure prosperity in the rich world or to protect special interest groups in the rich world. Agricultural tariffs and subsidies are a classic example. They lead to what otherwise would be uneconomic intensification of agriculture in the developed world so as to dump food at a loss in the poor world. There is consequent destitution of people who could otherwise be involved in commercial agriculture in the developing world both for local consumption and for export. In the 1800s the case was successfully made that repealing the English “corn laws” would benefit almost everyone with the exception of those wanting increased rents and mortgages from English farmland. I think the same arguments hold today.

In the USA in particular there is much popular support for protectionist tariffs and subsidies*. The USA is such a large country that it can cope relatively well even if global trade gets shut down. I think it is crucial that we unpick the motivation behind such protectionist views. Much of it seems to stem from the conflict between “labour” and “capital”. The owning class has the most to gain from globalization. The owning class can own whichever companies are most profitable where ever they are based. They can lend money to whoever in the world provides the highest return. Workers on the other hand lose bargaining power. Jobs become outsourced to where ever in the world has the lowest wages for a given level of competency. As I see it the answer is to ensure that everyone belongs to the owning class. Replacing all current taxes with an asset tax and paying a citizens’ dividend would have that effect. If the increased profits that came from offshoring jobs went to everyone rather than just a select owning class then much of the current resentment would evaporate.

What the world needs are advances in efficiency and technology. We need to be able to do more with less. To my mind it makes much more sense for people to be freed up to push new technologies in the developed world. A compelling case can be made that developing countries benefit from “learning by doing”. If a basic manufacturing process can be done well in a developing country then it makes sense for it to be done there, providing jobs there. Hopefully the experience gained will raise capabilities so that all of the world can be at the forefront.  People like working not simply because they want money but because they find it satisfying to create and provide, to master skills and innovate. To truly satisfy that motivation, people need to be doing work where they are really making a difference for the better. The duplication and waste that comes from trade barriers runs counter to that.

Even more than trade barriers, I think policies aimed at encouraging capital flows from the developing world to the developed world have been the overriding influence on world poverty. I’ve examined this in the previous post “Isn’t a financialized economy the goose that lays our golden eggs”. People in the UK are not callously minded towards people in the developing world. I’m sure that the decimation of the real value of the median wage across the developing world that occurred during the 1980-2000 “great moderation” period is not connected in most people’s minds  with the apparently miraculous affordability for global commodities that came in that period for those in the developed world. Ignorance is no excuse though. We need to get real and face up to the consequences of the policies we vote for. Making the UK a perfect piggy bank for capital flight from developing countries does far more damage than can be put right by some charitable donations.

It is striking that the popular sympathy for protectionism as a way to “keep jobs here” is at odds with nurturing capital flight from poorer countries as a way to gain prosperity by sleight of hand. If money were staying in poor countries, causing those countries to develop a prosperous economy of their own, then that would raise wages there. That would avoid the issue of jobs being offshored from the rich world to lower wage countries. Furthermore if the whole world were prosperous, then countries that are currently poor would become potential importers of products made by workers here.

The cost of natural resources does however increase if the whole world can afford them. If what we really want are more jobs in the rich world, then perhaps we should be more sanguine about that. There are lots of potential job opportunities in renewable energy and recycling. To my mind it makes no sense to at the same time put up trade barriers so as to “keep jobs at home” and yet entice capital flight so that we can get all the world’s natural resources and put off the day when we need to recycle and use renewables.

*As an aside, I think protectionism also is a very bad idea because it provides a compelling motivation for imperialism. In the absence of world trade, a country needs to have a large internal market and that means that countries need to be as large as possible.

see also posts:

We choose for renewable energy to make no financial sense.

Rich people could benefit if everyone else were also rich.

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:

People and the planet -Royal Society

Stop blaming the poor. Its the wally yatchers who are burning the planet – George Monbiot

populationmatters.org

The mother of invention – Interfluidity

A system of governance needs to follow widely held principles of justice and “fairness” if it is to have any hope of being happily adopted. It is equally true that views as to what constitutes justice and “fairness” change dramatically between different eras and places. We currently have a cottage industry of economists and “think tanks” funded to persuade us all that handing over everything to their funding sources (largely the finance industry) constitutes the ultimate manifestation of liberty and freedom.

Perhaps one of the most startling examples I’ve seen of shifting viewpoints is an 1807 election poster from the campaign to abolish British participation in the slave trade. Bizarrely the abolitionists gave prominence to the point that the slave trade was advocated  for and conducted by self-made entrepreneurs whilst abolition had the supposed superiority of being backed by the landed aristocracy. From a modern perspective the inhumanity of the slave trade is ample argument itself and we now consider being a self-made entrepreneur to be a reason for pride whilst inherited aristocratic wealth is a shameful political liability. I was similarly struck by how the recent tearful resignation of the UK’s first police youth commissioner was forced as much by revelations of homophobic tweets as by her boasts about drugs. Only a generation ago homophobia was the respectable standard view point.

My views put forward in this blog are simply what seems fair to me now. I totally appreciate that most people will take a different view. I’m just trying to explain how I’ve come to the conclusions I have. This blog is largely based around the idea that our economy could be transformed for the better by replacing the entire current tax system with an asset tax (see bottom of this post for details). This idea typically does not go down well. A lot of the objections raised revolve around issues of “fairness” and so “fairness” is the focus of this post.

A major role for the state is enforcing property law; that enables property owners to benefit from the property they own as well as creating an orderly and prosperous economy for everyone. To a large extent the financial benefits from that state service accrue to each citizen in proportion to how much property she or he owns. Warren Buffett gains billions of dollars each year from the $53Bn worth of assets he owns. All of that is entirely dependent on the state enforcing law and order. The many people who don’t own anything much gain far less from that state enforcement. To me it seems fair that tax should therefore be paid in proportion to how much we each own. Even if we own something that does not provide an income, unrealized capital gains typically build in relation to the overall economy.  A valuable painting will increase in value each year due to increases in other forms of wealth providing potential purchasers with the means to bid more for it if it were sold. All the while that increasing value for the painting will be entirely dependent on the extremely costly maintenance of law and order by the state. Unrealized capital gains account for a large proportion of wealth increases.

A widely held view is that simply owning something has no economic impact and so should not be taxed. A painting or an unused plot of land may be rapidly increasing in value but that is merely a potential benefit for the owner if and when it is sold. As such, so it is argued, tax should only be paid if and when the asset is sold. This blog largely boils down to a refutation of that view. As I see it the critical factor is possession of financial power. The mainstream view would make more sense to me IF there was an overriding economic bottleneck due to insufficient potential for productive capacity in the economy. If all possible machines had been made and were whirring away 24/7, all production was sold without diversion of resources towards marketing and there was no involuntary unemployment –THEN a good case could be made that holding wealth simply meant deferring consumption – letting a limited supply pass on to other people; so it would seem unfair to constantly tax those assets. In the real world, that economic condition was actually approached during WWII. In peace time however, there is a HUGE gulf between what gets done and what could get done.

Most potential productive capacity is kept constantly untapped because there isn’t sufficient demand for it. Having the financial power to choose whether or not potential productive capacity is kept untapped or is made use of –that to me is the critical economic responsibility distributed amongst us all. Obviously productive capacity can be expanded tremendously by technological and organisational improvements BUT financial power is something totally different from that. What I am referring to is economic influence relative to everyone else. Clearly if productive capacity (or wished for leisure) is untapped and so goes to waste (or gets used wisely or unwisely) that is a consequence of people’s choices. Wealth amounts to having command over whether other people do sensible stuff, do stupid stuff or are left sitting on the side lines. That isn’t a power someone who acquires wealth necessarily wants or has any means of sensibly executing but nevertheless that is what it is. An asset tax is a tax on that responsibility to ensure that it is fully appreciated, wisely used and doesn’t just passively accumulate as money gathers more money.

In my view an asset tax is simply causing wealth to reflect the reality that every unused hour of machine time or human labour is permanently lost. To me a fair financial system is a financial system that mirrors reality such that doing best by money reflects what would be best if money were not considered.

Economists in the Modern Monetary Theory (MMT) tradition contest the idea that stocks of government debt (which constitute much wealth and underpin more) have much bearing on the economy. As MMT believers attest, extra resources are mobilised only if and when such stocks get drawn down and spent and in practice they  simply build up decade after decade (except for rare occasions when the entire monetary system is replaced). MMT economists such as Bill Mitchell claim that as the public fails to spend enough; government deficits can seamlessly remedy any consequent deficit in aggregate demand. The idea is that as humans we (or at least some of us) want to safely squirrel away purchasing power. It doesn’t matter what level of productive capacity there is relative to all those claims because in aggregate we will always want to squirrel away wealth more than we will want to invest or consume. Supposedly the best approach is to accept and accommodate that squirreling instinct by simply printing off government debt as fast as it gets squirreled away regardless of whether that results in a stock of paper wealth that amounts to a greater and greater multiple of everything real there is to buy.

That MMT approach is in my view extremely misguided. It might work if we were amnesic squirrels but we aren’t. Large accumulations of wealth accrue to those who have been most focussed in accumulating them. Guardians of such wealth do look at their account statements and take great consideration of what purchasing capacity they represent. A large stock of saved up government debt securities warrants a major effort and expense in political lobbying to maximise its value. Maximising the value of that paper wealth massively distorts the economy and the political process (see post Political consequences of risk free financial assets). From what I can see government deficits merely offer a short term palliative whilst the underlying issue of the distribution of financial power gets more out of hand. The distinction between the MMT and economic democracy views on taxation can be summed up as MMT viewing the proper role of taxation to be moderating consumer price inflation whilst economic democracy views the proper role of taxation to be ensuring dispersed financial power. The MMT view of taxation is actually somewhat aligned to the “Reaganomics” of Art Laffer since reducing the tax burden on the wealthy can actually reduce inflation by enticing inward capital flows (for a while anyway).

Another objection to asset taxes is that owning an asset does not necessarily mean that someone has funds immediately to hand to pay an on-going tax with. This issue could be particularly acute in the case of an elderly person living in a large house in an expensive district. They could be asset rich but income poor. In the case of personal residences, I’d be in favour of allowing an asset tax to be paid for by transferring partial ownership of the residence over to the state in lieu of the tax. The proportion of the house that was state owned would then be rented by the resident. Potentially the entire value of the house could become state owned whilst the resident kept uninterrupted occupation for their entire life. Of course the resident would be free to alternatively enter into a private equity release scheme to convert their home equity into liquid funds as many people now do. Overall I think an asset tax would actually help people to own their own homes because it would cause houses to be cheaper.

Another particular thorny issue is with small individually owned businesses. Such enterprises account for a large part of the economy of most countries. I’m not convinced that it would actually be much of a problem if much of the intangible value of such businesses slipped past taxation. If taxation were due on the sellable value of tangible assets of the business such as buildings, inventory and equipment and on debt taken on, then that would probably account for enough. If the value were disputed, then I think it would be reasonable to have a public auction of the assets where the current owner would not need to stump up the purchase price but would simply bid on the basis of what taxable value she was willing to pay the tax on.

Appendix -detail of the suggested asset tax (this is an excerpt from the pdf that I started this blog off with)

The most crucial reform would be to abolish all current taxes and replace the current tax burden with a single tax applied equally to all gross assets. Very roughly, the UK population has gross assets of about £10T. This amounts to about £160k per person but obviously is very unevenly distributed. Total annual government spending is currently about £700B or £11k per person, which is about 7% of that asset value per year.  In addition to such assets owned by households, other financial assets and liabilities are owed between financial institutions. For instance, if two banks each owe each other £100B, then that £200B of gross assets will net out and so not be overtly apparent as an asset for households owning shares of those banks. There is about £10T of such debt between UK financial institutions. There are also cross holdings of financial derivatives. The proposed gross asset tax would apply to assets before any such netting out.

A key purpose of the asset tax would be to ensure that paper assets are not concocted unless they can pay their way. Presumably a gross asset tax would lead to financial sector deleveraging (eg by loan write-downs) and that would reset the tax base to a lower level. The true purpose of taxation, however, is not to “raise revenue” but rather to maintain the true value of money. The aim is to re-align the economy towards providing true utility and away from monetary schenanigans.

The UK economy is integrated with the global economy. Assets in the UK are owned by foreigners and UK citizens and institutions own foreign assets. Multinational companies have operations in the UK and in other countries. That allows a beneficial global pooling of expertise. This situation nevertheless creates complexity for the current tax system and would also be a challenge for an asset tax system.

GBP cash and government bonds would need to have the asset tax deducted at source. Crucially the asset tax would have to apply to GBP financial assets owned by foreigners as well as those owned domestically. A key purpose of the asset tax is to avoid long term sink holes for net financial flows. Hoarding of GBP financial assets by foreigners is just such a distortion. Discouraging such foreign use of GBP financial assets as a store of value would allow exchange rates to properly reflect and correct trade imbalances.  Holdings of any other sort of debt security by UK citizens would also need to be subject to the asset tax.

Real estate on UK territory would need to be directly subject to an asset tax whoever owned it. You cannot hide real estate and so direct taxation of real estate would provide an entirely inescapable core for the asset tax. Even foreign owned UK real estate would need to be taxed. If foreign owners were able to avoid paying, then all UK real estate would simply become foreign owned. If someone owned a £200k house with a £150k mortgage, that homeowner would still need to be liable for the full tax on the £200k asset. To a large extent such leveraged ownership amounts to a duplication of financial wealth (both the house and the mortgage are assets). Taxing the gross asset value is appropriate since a doubling of house prices would benefit the homeowner in proportion to the gross asset value irrespective of the mortgage.

Entirely overseas assets owned by UK citizens would be taxed at the level of the owner. So if a UK citizen owned £10k worth of shares in say a Brazilian mining company (or foreign currency or foreign real estate), then that citizen would pay the tax based on that value. Entirely UK based companies would be taxed at the company level.  So shareholders of an entirely UK based company would not pay any asset tax directly on that shareholding. As already stated, any UK real estate or GBP owned by that company would be taxed directly. The remaining value of the company would be taxed on the basis of the market capitalization plus debt liability with a deduction for any real estate holdings (that already would have been taxed). Including debt in the corporate asset tax liability means that a UK citizen would be (indirectly) paying more asset tax when holding shares of an indebted UK company than of an indebted foreign company. However since the foreign company would be paying the foreign country’s corporation taxes, there would probably be no overall tax advantage for ownership of foreign versus UK company shares.

A multinational company with operations in the UK would pay UK tax at the company level based on those UK operations. A real risk would be companies playing the system and so making use of the lack of corporation, sales and income taxes here whilst minimising asset tax liability here. As already stated, any UK real estate or GBP owned by that company would be taxed directly. Harder to pin down would be the tax liability from, for instance, having a large research and development program in the UK. Possibly the best approach would be to divide the tax liability on the basis of the proportion of cash flow attributable to the UK operations. So if a company had 25% of its cash flow from UK operations, then the asset tax due would be based on 25% of the corporate debt owed plus total company market capitalization with the tax already paid on UK real estate deducted. UK shareholders of multinational companies would have to pay the tax for the remaining “foreign” portion of the company that was not taxed at the company level.

Currently the UK hosts banks that hold colossal webs of financial derivatives. London provides a global centre of expertise for such activity and has a buccaneering, free-wheeling regulatory system that facilitates innovative financial engineering. Of the $707T USD notional value of outstanding financial derivatives held worldwide, $417T come from London. To put that in context, global GDP is about $70T USD. An asset tax system would be incompatible with hosting such activity. Obviously such derivative contracts could never hope to earn enough to pay an asset tax imposed on their notional value. Those banks would need to relocate to other countries and cease UK operations. In terms of loss of well-paid jobs it would be painful. Goldman Sachs is an archetypal example of such an institution. They hold $44T USD of financial derivatives. They have 5500 London based employees and pay each employee an average of £336k per year. To some extent having firms such as Goldman Sachs in London can be seen as a pure gain for the UK economy. The US government has spent tens of billions of dollars bailing them out, they extract money from the entire global economy and yet a good portion of what they extract and get bailed out with goes to UK based employees. Such considerations, however, have a corrosive, warping effect on governance of the economy. The role of our monetary system should be to facilitate the activity that everyone would want if money were not a consideration. A monetary system designed so as to facilitate gaming of the system is a bottomless pit leading towards ultimate system failure. Another consideration is whether such firms actually constitute a “brain drain”. People currently employed as elite financial engineers would presumably also be doing complex, ground-breaking, work if they were otherwise engaged.

Currently trivial asset classes such as collectables would also need to be covered. Doing so would ensure that they did not become significant speculative stores of value. Legal ownership of anything would be dependent on being up to date with the asset tax.

Trusts are currently used to hold assets for collective pension saving schemes, charitable endowments, and some households and institutions.  Assets held under trusts under UK jurisdiction could be subject to the same asset tax as if they were held directly by a UK citizen. So taxation would be at the level of the trust and administered by the trustee. Ownership of UK assets by foreign trusts could be subject to the same taxation as ownership by a foreign citizen. UK citizens owning shares in a foreign investment trust could pay tax just as if they were shares in an entirely foreign company. That would lead to tax inefficiency for foreigners owning shares in UK trusts and for UK citizens owning foreign trusts that held UK assets but minimal economic disruption would result. A UK citizen transferring assets out of UK jurisdiction by transferring them over to an offshore trust could be subject to a one off “expatriation of assets” tax of say 50%.

Regulatory restrictions on land use etc would reduce the asset value and so the tax liability. If some land was a nature reserve with a public right of access, then it would have a minimal asset value and so the tax would be affordable for community groups, ancestral owners etc. Asset prices would reset to being whatever people who wanted to own an asset were willing to support through exposing themselves to the tax. For “consumer assets” such as houses, cars, paintings, leisure boats etc that price would be a function of what people felt able to afford as personal consumption. For “working assets” such as company shares, debt securities, farmland or commercial property, the price would set to a level where yield justified the asset tax exposure.

Currently, asset values are assessed for inheritance tax purposes. The same process would need to be applied universally for an asset tax system. It would be burdensome, however the same is true for the current myriad of different taxes that it would replace. If someone disputed the valuation set for taxation, then they could put the asset up for auction. If they could buy it back for a lower price, then that would be the taxable value.

People often choose to live and work in different countries at different times of their lives. It is important not to impede mobility but also important not to induce counterproductive tax avoidance migrations. That provides a challenge for taxation systems. The USA, for instance, currently has a complex expatriation tax system and taxation is based on US citizenship not simply US residency. Under an asset tax system, tourists and short term (eg two month) working visitors could be tax exempt. Perhaps foreign citizens resident long term in the UK could be largely subject to the same tax system as UK citizens whilst they were resident here. Any assets already owned before the UK residency could be tax exempt. An exemption on the asset tax could also extend up to the value of the citizens’ dividend (which they would not receive). Upon leaving the UK, a foreign citizen could choose to either continue to pay the asset tax, for any assets obtained whilst resident, or to pay a one off exit charge (much like current US expatriation taxes) of say 50%. UK citizens would need to be subject to the asset tax irrespective of where they lived. However, UK citizens living abroad could be exempt from the asset tax up to the value of the citizens’ dividend (which they would not receive). A UK citizen choosing to revoke citizenship could choose either to continue paying the asset tax on the assets they had obtained up to that point or to pay an exit charge of say 50%.

Related stuff on the web:

To Reduce Inequality, Tax Wealth, Not Income -New York Times

The Conservative Case for a 3% Annual wealth Tax -Ronald McKinnon

Want a Flat Tax? I got a flat tax for you -Steve Roth

A Theory of Commodity, Income and Capital Taxation -Michal Kalecki 1937

Tax on wealth is true to Tory principles -FT

Goldman’s Top Economist Explains The Worlds’s Most Important Chart -Business Insider

Briefly Revisting S=I+(S-I) -JKH

Now they want to tax jewellery: New Lib Dem wealth plan to target ALL assets – including buy-to-let homes -Daily Mail

The Three Ways ‘Old Money’ Holds on to its Riches -James Rickards

Modern Monetary Theory Means We Shouldn’t Have A Progressive Tax System – Forbes (link added 23May2013)

On the Phenomenon of Bullshit Jobs -David Graeber (link added 22Aug2013)

Taxing Times -IMF (link added 12Oct2013)

MMT stabilization policy -some comments and critiques -Interfluidity (link added 24Nov2013)

We all know the Samuel Goldwyn quote, “the harder I work the luckier I get”; as a personal maxim it has some considerable advantages over, “what will be, will be.” Capitalism revolves around the idea that control amasses to those who have done well. To some extent that ensures that the economy is governed by the competent. However it would be irresponsible and delusional to deny that the effects of personal effort are overlaid on a canvas of stochastic dumb luck. Serendipity is the backdrop to many a success and many losers are potential future winners. If we want our economy to best provide for all of us and make best use of every ones‘ talents, then we need to face up to this randomness.

Ole Peters has posted a fantastic video lecture about the nature of chance (bear with him past the grasshopper stuff). He describes a simple game where a coin flip decides whether the player gains 50% or loses 40%. Clearly winning  gains more than losing loses BUT a subsequent win does not make up for a preceding loss and a subsequent loss loses more than was gained by a preceding win (1.5×0.6=0.9<1); that is the “magic” of compounding.  This simple set up means that a large enough population of players will, in aggregate, steadily gain from playing the game but all of the winnings will randomly accrue to an ever smaller minority of players whilst almost everyone loses almost everything. Ole Peters points out that from an individual’s perspective playing such a game appears highly unattractive. A critical point to emphasize is that it is just as unattractive for a winner to continue with the game as it is for anyone else. A winning or losing streak does not influence the future. A rational winner would choose to stop and keep the winnings.  If wins and losses are pooled and rebalanced across many players, then the game becomes universally attractive.

Perhaps this simple game has more similarity to real life than we care to admit. Starting an enterprise entails financial risks and from an individual’s perspective the financially prudent course of action is typically to hold back. However, if we do that, nothing gets done and we are all poorer.  Perhaps much of the regulatory and legal framework of our financial system is an attempt to entice participation in the perils of enterprise risk so as to add to the overall greater good of society. Whatever lies behind how our financial system has come to be the way it is; I think it has lost its way. Limited liability and bankruptcy laws protect owners from the full financial consequences of bankruptcy. Winnings are kept but losses can be transferred to creditors. Ultimately the state subsidises credit provision to socialise losses whilst leaving profits with owners. This would all be very well if the only sort of risk being subsidised were true enterprise risk from potentially productive endeavours. We all need people to be making valiant attempts to create the next technological breakthrough or provide services in a more effective manner or whatever. The problem is that blindly subsidising financial credit and risk also encourages concoction of synthetic financial risk through use of financial leverage*.

The incredibly complicated to manage and idiosyncratic world of creative innovation or micro-enterprise is not an easy zone to park a vast fortune into. A vast fortune can however prosper very well in circumstances where enterprise risk is avoided and instead exposure is taken to the stochastic fluctuations of global asset and commodity prices. Then economies of scale favour the biggest players –it becomes more affordable to have market beating ultra-low-latency trading systems and to employ the best of the best to develop and operate them. Wealth deployed in that way however is not providing for the future; it is merely gathering money from other people in a zero sum redistribution towards the richest. Unfortunately leveraged speculation also exacerbates price volatility and that can have tragic real world consequences such as the starvation that occurred from the 2009 spike in grain prices.

In principle financial intermediation might be hoped to distribute risk and so create a situation where enterprise risk is readily taken on. The problem is that true enterprise risk is massively dependent on the details of what is being done. That is something that can only be assessed and managed by those intimately involved in each specific project. It is utterly unsuited for pooling across the whole economy. Large corporations have a tendency to only engage in cutting edge developments after it becomes clear that the most risky, initial stages are in the bag. When broader pools of funding for investment are available, it is all too often the case that genuine attempts at innovation become displaced by those cynically attempting to tap into a gravy train. There are plenty of ghastly anecdotes from the 1990’s tech bubble. One scientist told me about how a financier in the 1990’s tried to persuade him to start a biotech company. The financier was triumphantly boasting that none of the many companies he had started had any prospect of commercial viability and all investors had been conned. Even within large companies, it is very hard to keep cutting edge innovation on an effective focussed footing. All too often projects flounder in a way that wouldn’t happen if those involved all saw the project as theirs rather than the companies.

The mainstream view seems to be that innovation would best be fostered by facilitating concentration of wealth. I wonder whether the opposite might not be true. A universal citizens’ dividend could provide a necessary small measure of financial freedom that would help anyone who fancied to have a go at developing some innovation perhaps together with other like-minded people. The history of the 19th century industrial revolution is full of examples of very small groups of individuals tinkering away and making ground-breaking technological advances. Jean-Pierre Garnier then head of GSK has stated that, “The basic philosophy for modern R&D should be to morph big into small in recognition of the fact that critical mass in fundamental research is the size of one human brain.” To my mind that is an argument for ensuring that much financial power is also at the scale of each and every human. The key thing is that people having a go at developing an innovation whilst being partly supported by a citizens’ dividend would have a lot of skin in the game. Their time and money would be theirs and so they would be so much less likely to simply “go through the motions” in the way they might if they were simply following orders.

I also think the same principle applies to provision of everyday goods and services and not just to cutting edge innovations.  In some circumstances it may be most efficient to supply say groceries through a huge supermarket chain but there are also certain efficiencies in having a dispersed small scale system. Currently, holders of outdoor market stalls selling food may be displaced by a supermarket not because they are less efficient or convenient but simply because a supermarket chain is more suitable for accommodating large scale impersonal financial investment. It might be argued that bank lending provides finance to small scale enterprises such as market stalls. However as Ole Peters so clearly demonstrates in his lecture, an enterprise financed in that way becomes dramatically more risky. The repayments are fixed but the revenue stream is subject to the variances of real life. That is why in the UK and USA the (relatively predictable and secured) purchase of pre-existing housing stock accounts for 80% of bank lending and banks are so wary of business lending. An asset tax and citizens’ dividend system might cause the economy to be conducted at whatever scale was most effective rather than having the current bias towards ever greater scale (this pdf describes such a possible economic arrangement).

*This subject is explored in further detail in the section “A zero interest rate policy does not reduce the financial overhead” on page 18 of this pdf.

Related material on the web:

Opaque and stinky logorrhea- Interfluidity and the many many links therein

We Love Banks – Monetary Realism

Cutting Edge Capital Raising for Small Business – katovich (I added this link 11May 2013)

VC for the people -Interfluidity (link added 17April2014)

There are impassioned campaigns for replacing our current system of banking with various proposed alternatives termed “full reserve banking”.  Typically the aims of these proposals are to stabilize the banking system AND to prevent private banks from controlling the supply of money. This post is about how the first aim seems realistic and wise but the second concern is something perhaps much better addressed by other means.

This discussion needs to start from a clear understanding of what banks are (I’ve attempted a background overview of our monetary system on page 13 of this pdf). I also want to make the case that this is all about “maturity transformation”. Imagine lending without maturity transformation: Adele and Beyonce are neighbours who each own their own homes. Adele also has £100000 as paper cash in her mattress. Adele decides to sell her house to Beyonce and then live as a tenant, paying rent to Beyonce. Beyonce goes to a loan company to get a loan to buy Adele’s house with. The loan company grants a £100000, ten year, interest only, mortgage to Beyonce. Beyonce has to pay 4% (ie £4000) every year to the loan company and then after ten years pay back the £100000. The loan company funds the loan by selling a £100000 bond to Adele in return for the £100000 paper cash Adele had in her mattress. When Beyonce buys Adele’s house she pays Adele £100000 and Adele puts that as paper cash in her mattress. Adele receives 3% (ie £3000) interest each year from the bond and also gets the £100000 principle back at the end of the ten years. Adele is also an employee and shareholder of the loan company and the loan to Beyonce adds to Adele’s annual pay and dividends by £1000. Adele pays £4000 rent a year to Beyonce. At the end of the ten years Adele hopes to buy her house back with the £100000. The entire ten year long process simply uses Adele’s starting money and circulates it about leaving things at the end just as they started. During the period of the loan however there is extra asset in the system in the form of the bond owned by Adele. This is a corollary of the debt owed by Beyonce. This process is NOT bank lending. The loan company would not need a banking license to do this.

Imagine the loan company instead decides to fund the ten year loan to Beyonce by selling a one year bond to Adele. The loan company hopes that after the first year, it will be able to sell another one year bond to Adele or someone else and use the money from selling the second bond to pay the principle on the first. In that way, ten successive one year bonds fund the ten year loan. Under this scenario, the extra asset in the system is in the form of a one year bond rather than a ten year bond. Adele now has £100000 of paper cash in her mattress but also knows that she is due to receive £100000 in a year’s time. The loan company needs to find a buyer for each successive bond. This necessity to find a buyer is termed “liquidity risk”.  Nevertheless the loan company still would not need a banking license to do this.

In the third scenario the loan company decides to fund the loan by rolling over successive one week bonds. Adele now has £100000 in her mattress and also knows that by the end of the week she has another £100000 coming. For most practical purposes Adele has £200000. Nevertheless the loan company still would not need a banking license to do this.

In the final scenario, the loan is funded by a continuous succession of instantaneously maturing bonds. Now the loan company has become a bank and the loan is funded by bank deposits.  What we know as bank deposits are in effect a continuous succession of instantaneously maturing bonds. Whilst the bank deposit is with the bank, it is funding the bank’s loans. Adele would now have £100000 of paper cash in her mattress and £100000 in the bank. She would have £200000.

Note however that in practice banks typically would not have a large book of ten year loans funded over the entire ten year period by bank deposits. Banks avoid undue liquidity risk by reducing the extent of “maturity transformation” by ensuring much of the funding is in the form of longer term bonds or fixed term savings accounts. The bank constantly needs to fund the outstanding loans either by bank deposits or such longer term liabilities.

Of course we use bank deposits as the medium of exchange for most payments (see page 15 of this pdf for an overview of the payment and settlement process). Paper cash is much less significant. So the debt from bank loans is the predominant form of money in our economy. It seems to me that banks currently provide two completely separable functions. One is the payments system; that could potentially be a “full reserve system” just like PayPal; the other is the lending system. Where we run into trouble is that we mix them up. We have a system where the payments system uses the debt from lending as the medium of exchange. That entails all of the hazards of maturity transformation and liquidity risks. It means that the payment system (a vital utility for the entire economy) is held hostage by the lending system. That creates a slippery slope towards bailing out an irresponsible lending system so as to keep the payment system intact.

If the payment system was just by something such as PayPal and the lending system were separate; THEN it wouldn’t matter if systemic credit defaults led to defaults on the bonds sold to fund loans. That would not impact on the vital role of the payment system. It would simply be irresponsible lenders getting what they had coming to them.

Lending could potentially be by loan companies that did no maturity transformation and simply sold bonds with the same maturity profile as the loans made. Retail savers could hold savings in the form of ETFs that were made up of thousands of such bonds (just like existing bond ETFs). Customers could sell their ETF holding whenever they needed to draw down savings.

I think it is worth remembering that half of all the credit provided in the USA is already by shadow banks (ie lenders that don’t hold deposits) and we already have a non-bank payment system in the form of paypal. Transition from our current system to a system without maturity transformation need not be at all disruptive. There is already a vast stock of excess bank reserves in the UK banking system (the same is true in the USA and Japan). If banks were to now match the maturity profile of their liabilities to their existing loan book, then that would entail selling of bonds. Those bond sales would drain the bank deposits and so replace much of the current stock of bank deposits with bonds. The remaining bank deposits automatically would be those entirely matched by bank reserves. At that point full reserve banking would have been achieved. In effect the banks would have simply been converted into being the functional equivalents of PayPal together with a loan company that could be separated off as a distinct institution. A bank run would be an accounting impossibility for the payment system. Even if all of the customers withdrew all of their money, the payment system would suffer no liquidity stress. Obviously such accounts would purely be provided as a service. The payment system would no longer have any reason to seek account holders custom except so as to charge a service charge. That seems no great problem to me. Mobile telephone services are provided efficiently and providers of that service charge their customers. The payment system could similarly be such a mundane, low cost, utility. We now indirectly pay banks to administer the payment system. We would simply be paying for it in a more direct manner.

If people wanted to receive interest on their savings, then they could hold their savings in the form of a bond ETF. Various bond ETFs could be offered each with a different maturity profile. An ETF with bonds of less than one year duration would have minimal price fluctuations. An ETF with bonds of over 15 years’ duration would have considerable price fluctuations. In either case however any given saver could sell their holding on the market, at any time, with a click of the mouse, just as with current ETFs. The demand from savers to hold such interest bearing bonds would be what set lending rates. A key aspect of what I’m proposing is that there would be a regulatory ban on maturity transformation. Loans of each time to maturity would be made available at the price the debt was actually sell-able for. I consider maturity maturation to not only be a key cause of instability but also to be a distorting source of mis-pricing that causes more robust equity financing to be displaced by fragile debt financing.

It is important to contrast this proposal with maturity matched peer to peer lending systems such as Zopa and Funding Circle. Zopa and Funding Circle simply offer savers a stake in aggregated maturity matched loans without any shielding from losses due to defaults. Zopa and Funding Circle simply administer the system and do not bear the credit risk. I’m proposing that loan companies would have to themselves hold capital that would stand first in line to take losses in the case of defaults. If losses were so great that a loan company had insufficient capital, then the bonds sold would convert to shares in the loan company until the loan company were adequately capitalised. Loan companies would also have to keep any loans made on the books until they matured or were written down. It would thus be the responsibility of the loan company to assess the credit risk of the borrowers.

This proposed system is starkly different from currently prominent “full reserve banking” ideas. The key difference is that it makes no attempt to prevent debt from taking on “money-like” characteristics. Savers would presumably view their holdings of my proposed ETFs as being “money” they had available and would act accordingly. This “money-like” quality would be especially true because the loan companies would be well capitalized, would not be subject to liquidity risk and (because they kept loans on their books) would be cautious about credit risk.

The reason why most “full reserve banking” proponents wish to prevent debt from taking on “money-like” characteristics is because they consider that only the state ought to have the role of deciding a country’s money supply. They consider it unfortunate that commercial provision of credit confers that power to private companies. The “positive money” campaign hopes that debt would be prevented from slipping into being “money-like” by insisting that it is held as fixed term saving accounts. The intention is that savers would then not be able to access their savings for several years and so would consider such accounts as being money that they were due to receive rather than being money they actually hold. In practice I don’t believe it would work. People who needed access to money in the interim would simply take out a shorter term loan knowing that they would be able to pay it off when their savings account matured. Credit providers would also take account of what savings accounts would be borrowers held. On a more general note, I think any such attempt at placing inconvenient obstacles would fail to erase the “money-like” properties of debt. I consider that the government does have an important role to play in controlling the supply of credit but I consider that the tool to use is price. Furthermore the way to put a price constraint on credit formation is to replace existing taxes with a tax on all gross assets (this tax idea is detailed in this pdf).

The “full reserve banking” proposal of Benes and Kumhof takes the approach of insisting that all debt from lending is transferred to government ownership so as to eliminate “debt as money” altogether. The government then becomes the entity behind decisions as to who is lent money. The country as a whole pays the consequence if debts default. Perhaps more worryingly, the political system becomes embroiled in the minutiae of the entire economy. To me it seems a recipe for cronyism and gross inefficiency.

Edited 29April2013, added: I also want to make the case that this is all about “maturity transformation”. Imagine lending without maturity transformation (In response to Ralph Musgrave’s comment)

Related stuff on the web:

Toward a run-free financial system -John H Colhrane (ht Nick Edmonds) (link added 30April2014)

100% Reserve Banking-The History -House of Debt (link added 30April2014)

 

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

‘Loans create deposits’- in context

What is a bank loan- interfluidity

What is money and how is it created- Bank of England (see page 377)

Hitch-hiker’s guide to monetary infrastructure -FT

Positive Money

Banking in the Abstract -The ‘Chicago Plan’ -Monetary Realism

Proposals for the Banking System- Warren Mosler

Bagehot was a shadow banker

More on M-pesa and e-money -FT

When safe assets return -FT (link added 26May2013 ht Mike Sankowski)

Endogenous Money and “Out of Thin Air” Money – Nick Edmonds (link added 14July2013)

Repeat after me: banks cannot and do not “lend out” reserves -Standard and Poors (link added 15Aug2013 ht Mike Sankowski)

Comercial Banks as Creators of “Money” – James Tobin 1963 (link added 20Aug2013 ht Ramanan)

Banks, Non-banks and the Medium of Exchange – Nick Edmonds (link added 06Sep2013)

Financing Investment In A World Without Maturity Transformation -Ashwin Parameswaran (link added 30nov2013)

In the 1960s and ‘70s, the US and UK economies gyrated along what became described as the political business cycle or partisan business cycle. The idea was that before each election, looser fiscal and monetary policy caused a surge of expansion that was then curtailed after the election so as to keep a lid on inflation. Alternatively alternate governments of differing hue would alternately focus on controlling inflation or on expansion. Our current political wariness of fiscal policy and over-reliance on monetary policy dictated by unelected central bankers is a sorry legacy born from that experience. Currently fiscal policy is typically only deployed in an automatic way. If we are in a boom period, then tax revenue tends to increase because more taxable economic activity takes place whilst in slumps, welfare payments tend to increase and tax revenues drop. These counter-cyclical effects are termed the “ automatic stabilisers”. I consider many of the economic policies of recent decades to have been deeply misguided. However, I’m wondering whether an entirely automatic, non-reactive, form of fiscal automatic stabilisers could be consistent with economic democracy.

Economic democracy is a movement hoping for a reformed economic structure. I’ve tried to make the case that the best way to achieve economic democracy might be to replace all current taxes with a tax on gross assets and to replace all means tested benefits with a citizens’ dividend. People advocating for a broadly similar argument have made the case for using a variable blend of different types of taxes and transfer payments to fine tune fiscal policy so as to supposedly steer along an optimal macro-economic course. This post is an argument in favour of instead setting up an automatically self-correcting fiscal framework and then leaving things to take their course.

Imagine that a gross asset tax was set at say 5% per year, all other taxes were abolished and a citizens’ dividend was paid at say £7000 to all citizens of all ages. No active attempt was subsequently made to balance the budget or provide fiscal stimulus or to moderate inflation. The government just left the economy to it and concentrated purely on doing stuff that only the government was well placed to do (such as policing, maintaining infrastructure etc), endeavouring to provide such government services for the best value with no regard to job creation or such like. If a consequence was that government spending outpaced taxation, then the increased stock of government issued money would soon provide a larger source of revenue for the asset tax (the details about the proposed tax are in this pdf). If asset values increased greatly due to economic growth (or bubbles) such that taxation was greater than government spending, then the asset tax demands would cause asset price deflation so increasing the real value of the citizens’ dividend to the point where it stayed proportional to the expanded economy. Government employees could have pay scales proportional to the fixed citizens’ dividend. If everyone became lazy and just lived off the citizens’ dividend, then supply shortfalls would soon push up consumer prices to the point where it was easy to make lots of money by working and harder to live off the citizens’ dividend. It would be a self-correcting system. The key point is that the government has unlimited ability to maintain the nominal size of the citizens’ dividend, the pay of government employees and the asset tax. The government also has the unlimited capacity to electronically “print” the money to pay for it and to automatically electronically deduct the asset tax from that money.

The great advantage of such an automatic system is that it does not obscure price signals and allows firms to plan long term on the basis of how they predict the economy is going to be based on a long term fixed system rather than the fickle whims of political expediency. It provides no scope for gaming the system around reactive government interventions because there aren’t any. The only way to make money is by providing customers with what they want to pay for. Speculators would know that a credit fuelled asset bubble would never become a “new normal” because the consequent asset tax would bring everything down to earth. Conversely investors could see that genuinely useful new productive capacity would provide earnings that could not be matched by speculative asset bubbles.

Monetary policy would be permanently set to “maximum looseness” with a zero interest treasury rate (as it has been in Japan for many years) and no issuance of anything but the shortest term treasury debt. However the gross asset tax would cause credit to be something that required careful consideration by those taking it on.

Deflation is the great fear of current economic planners and much of current economic planning is focused on ensuring that it never occurs. Much of that fear is because currently deflation would encourage money hoarding and because our economy is so indebted that deflation would cause a severe debt crisis. A gross asset tax would cause money hoarding to be much less attractive and would favour equity financing over debt financing. We do currently have spectacular levels of deflation in the prices of certain high technology products such as computers and DNA sequencing and that is celebrated rather than being seen as a problem. In an economy with minimal debt, deflation need not be at all distorting; it can be simply providing accurate price information leading to rational economic planning by the real economy. If the economy was growing strongly such that all prices were deflating in the way that the cost of computing has, then great.

Related stuff on the web (I added this link on 11May2013):

Monetary policy for the 21st century- Interfluidity

It is now 70 years since Michal Kalecki wrote the seminal “Political Aspects of Full Employment”. It is quite simply the clearest and most insightful essay I have ever read. Even if you don’t read anything else about economics or politics or the human condition, read it! And it is short. Now that is out of the way, this post is going to be an attack on the main thesis of that essay.

Michal Kalecki’s aspiration was for the economy to provide well for us all with  minimal imposition on anyone. That aspiration is shared by pretty much everyone despite extremely diverse political persuasions and equally diverse conceptions of how to achieve it. There is no longer much debate that Michal Kalecki was misguided in his “plan A” as to how to achieve it. He favoured a socialist command economy and  “Political Aspects of Full Employment” is merely his “plan B” capitalist alternative. Long after writing “Political Aspects of Full Employment” Michal Kalecki actually moved back to Poland to participate in being a socialist central planner. He resigned in frustration with the realities of socialism – enough said.

Michal Kalecki’s “Political Aspects of Full Employment” instead is all about how a capitalist economy apparently could in principle always be administered such that there was never any unemployment much as there was no unemployment in WWII Britain when and where the essay was written. He describes how in order to fight WWII an immense increase in production was mobilised using government deficit spending without any difficulty whatsoever in funding it all. Where the essay gets really interesting is where he unpicks why such a system is generally only politically acceptable during times of war or under a Fascist regime (he noted that the Nazis had full employment policies as soon as they took power). He saw Fascism as something to be avoided by peaceful democratic countries beating them at their own game and extending war time deficit spending policies into peacetime. He also made astonishingly prophetic warnings about the troubles that might result. He predicted the industrial unrest of the 1970s, the subsequent moderation of full employment policies and the secular decline in interest rates of the “great moderation”. In my opinion however Michal Kalecki failed to spot a crucial flaw in the system and that glitch is increasingly smothering our economy now.

Michal Kalecki wrote:

If full employment is maintained by government spending financed by borrowing, the national debt will continuously increase.  This need not, however, involve any disturbances in output and employment, if interest on the debt is financed by an annual capital tax.  The current income, after payment of capital tax, of some capitalists will be lower and of some higher than if the national debt had not increased, but their aggregate income will remain unaltered and their aggregate consumption will not be likely to change significantly.  Further, the inducement to invest in fixed capital is not affected by a capital tax because it is paid on any type of wealth.  Whether an amount is held in cash or government securities or invested in building a factory, the same capital tax is paid on it and thus the comparative advantage is unchanged.  And if investment is financed by loans it is clearly not affected by a capital tax because if does not mean an increase in wealth of the investing entrepreneur.  Thus neither capitalist consumption nor investment is affected by the rise in the national debt if interest on it is financed by an annual capital tax.”

Note that Michal Kalecki is not saying that government spending needs to be matched by taxation. He is saying that merely the interest due on the debt needs to be. Clearly he believed that although an asset tax sufficient to pay the interest would not impede the economy (for the reasons he gives), an asset tax sufficient to balance the budget would or else would be politically unacceptable. Presumably he envisioned that endless increases in the productivity of the economy would allow the interest payments for the ever larger debt to stay as a proportionately modest burden and so require an equally proportionately modest asset tax. The only change over time would be the stock of government debt securities held by investors.

My argument is that that stock of government debt securities causes behavioural changes that derail the system. They are risk free financial assets (1). They enable people to save for the future and be certain of being able to draw down the full nominal amount irrespective of how the economy has performed in the interim. If it were not for such risk free financial assets, the only way to provide for the future financially would be to provide for it in terms of maintaining enough productive capacity to meet that future claim. As such, risk free financial assets disconnect finance from reality. Owners of the risk free financial assets become a constituency who own wealth that as it increases does nothing to increase or even maintain real world capacity to honour that financial claim. So long as the government exists*, the debt will be paid even if the economy is mired in depression.

Currently government securities are issued both as conventional bonds and as inflation protected index linked bonds and of course as cash. Such assets are most valuable when assets that depend on a productive economy are doing worst. In the case of long dated bonds, such as the 50year gilts and 50year index linked gilts we have in the UK, even the prospect of the economy taking a nose dive causes a surge in their market value. In a deflationary depression 50year conventional gilts will make you a fortune whilst a stagflationary depression will do the same for holders of 50year index linked gilts. Both asset classes plummet in price whenever an economic recovery seems likely. I’m not claiming that some cabal of evil geniuses is conspiring to derail the economy on purpose in order to enrich themselves. I’m simply saying that people with power and influence have a safety net that detaches their financial interests from the real economy. If it were not for risk free financial assets then everyone would be painfully aware that in order to preserve any of their wealth the economy would need to be productive. As it stands many people are frankly complacent. They have the view that we ought to ensure an economic recovery so long as doing so doesn’t risk impairing their personal fortune. It is a distant abstract “wouldn’t it be nice” hope rather than a desperate imperative.  The consequent fall in economic output causes shortages that are suffered by those without the risk free financial assets. In many cases the political force comes from people who do not follow bond prices directly and don’t give the matter much detailed thought; they simply are reassured by professional asset managers that their pensions and savings are well taken care of. They probably genuinely believe that the problem is the fault of those who are suffering its consequences.

Ironically it is those who own the most extensive personal safety net of risk free financial assets who are now behind the political force to ensure that further deficits are brought to a halt even though such expansion is our current way of holding off economic depression. That is an inbuilt characteristic of the system. In my view that is the design flaw that has led us to where we are now. The hope that government debt would not increase relative to economic output has been undone by the behavioural changes induced by holding that debt. The only solution that I can see is to adopt an economic policy that eliminates involuntary unemployment and yet does not increase the stock of risk free financial assets and so does not build up a constituency that is opposed to full employment.

As Michal Kalecki described, replacing all other taxes with a generalised asset tax frees economic activity from taxation. He clearly expounded that such a tax could meet interest repayment obligations however large without impeding the economy. Perhaps we need to face up to the thorny possibility of using such a tax to balance the budget over the business cycle. I’ve explored such a tax system in more detail in https://directeconomicdemocracy.files.wordpress.com/2013/01/direct-economic-democracy8.pdf

1, This discussion only applies to countries with monetary sovereignty (such as the USA, UK, Japan, Brazil, Canada, Australia, etc). Countries that are in the Eurozone do not have monetary sovereignty. Of course many citizens of Eurozone countries own the government securities of foreign countries that do have monetary sovereignty and so hold a safety net in that way. That is partly why the prices of US treasury bonds increase so much whenever the Euro crisis takes a turn for the worse. See page 14 of this pdf for a discussion of the Euro and monetary sovereignty.

* Of course continued existence of the state is a prerequisite for risk free financial assets to maintain their value. The Nazi government securities were all voided after WWII. Holders of government securities are a constituency that has an interest in maintaining the government and perhaps that is a motivation behind surplus countries such as Singapore issuing government debt securities.

Related material on the web:

http://www.interfluidity.com/v2/3212.html      Depression is a choice – Interfluidity

http://www.interfluidity.com/v2/3451.html     Michal Kalecki on the Great Moderation -Interfluidity

http://bilbo.economicoutlook.net/blog/?p=11127       Bill Mitchell on Michal Kalecki The Political Aspects of Full Employment

http://en.wikipedia.org/wiki/Micha%C5%82_Kalecki     Michal Kalecki wiki page

Crises of Capitalism and Social Democracy John Bellamy Foster Interviewed by Bill Blackwater (I added this link on 29May2013)

Phony Fear Factor – Paul Krugman (added 12Aug2013)

Peter Cooper on Kalecki’s Political Aspects of Full Employment (added 20Aug2013)

 MMT stabilization policy – some comments & critiques -Interfluidity (link added 24Nov2013)

Direct economic democracy

please click on the above link to view PDF