Money demand that doesn’t raise interest rates

The standard narrative is that money serves three functions:

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

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

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

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

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

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

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

Related previous posts:

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

Monetary policy, the 1930s and now.

Sustainability of economic growth and debt.

Is it unjust to tax assets.

Bail out the customers not the banks.

Fiscal autopilot.

Rich people could benefit if everyone else were also rich.

Political Consequences of risk free financial assets.

Related stuff on the web:

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

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

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

Capitalism for the masses- Ashwin Parameswaran

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

Depression is a Choice -Interfluidity

Debt and Demand -JW Mason

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

notes:

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

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

Related Previous Posts:

Monetary policy, the 1930s and now

Larry Summers at least sees the problem

Related stuff on the web:

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

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

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

Stochastic Market Efficiency -Ole Peters and Alexander Adamou

The Case Against Monetary Stimulus via Asset Purchases -Ashwin Parameswaran

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

Leash the Dogma -John P. Hussman

Investing Like the Harvard and Yale Endowment Funds -Frontier

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

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

Larry Summers at least sees the problem

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

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

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

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

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

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

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

Related stuff on the web:

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

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

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

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

The Economy almost certainly needs Bubbles -Michael Sankowski

Why Do the Rich Save So Much -Christopher Carrol

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

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

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

A zero interest rate policy does not reduce the financial overhead

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

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

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

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

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

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

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

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

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

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

Demographics, migration and fiscal sustainability.

The UK Office for Budget Responsibility (OBR) has made a pronouncement that we need to have mass migration into the UK as a way to reduce future government debt to GDP ratios. They claim that the “dependency ratio” between people of working age and retirees will become “unsustainable” as the baby boomer generation retires unless millions of migrants of working age join the UK workforce. This pronouncement has been hailed for supposedly dashing aside xenophobic objections to mass immigration with impeccable economic logic.

Immigration is an extremely thorny issue. I think we have a responsibility to really examine those issues rather than blustering with glib “economic arguments”. The OBR “economic argument” for migration seems to me to be entirely fatuous. It is not as if there is any shortage of unemployed or underemployed people in the UK who would willingly do the work required to care well for our aging population. Increases in mechanisation mean that our real needs can be met with less man-power. That potentially leaves plenty of people free to provide nursing care etc. The whole OBR argument is about finance and not about real resources such as human labour, buildings or equipment.

The OBR argument is entirely based on the presumption that taxes are levied on employment. Thus, so their argument goes, when a demographic bulge leaves fewer people of working age, tax revenue falls and government indebtedness tips over into unsustainability where interest repayments cause a snowballing debt crisis. There are two bogus assumptions at the heart of this argument:

-Firstly taxes need not necessarily be levied on employment. Imagine if the government relied instead on inheritance tax – then tax revenue would INCREASE as the baby boomers reached their twilight years. I’ve argued that the most sustainable form of taxation would be an asset tax. Revenue from such an asset tax would not be swung about by demographic shifts in the “dependency ratio”.

-Secondly deficit spending to fund elder care during a “demographic bulge” certainly need not precipitate a debt crisis. Currently, as fast as deficit spending adds to the UK’s stock of government debt, that debt is purchased by the Bank of England under the various QE programs. Consequently the increased interest payments by the UK treasury simply get passed back to the UK treasury from the Bank of England. There is no prospect of a snowballing of interest payment obligations. There are issues about the political consequences of endless deficit spending but it is simply not true that spanning a demographic bulge with deficits would precipitate a government debt crisis.

We need to be very wary of the extent to which “economic arguments” about demographics are not really about providing sufficient supply of needed goods and services but instead about asset prices. An increasing population gives asset prices a Ponzi effect impetus. For those currently in the “owning class”, the increasing scarcity that comes from an increasing population inflates their financial power. By contrast a shrinking population would mean that land, natural resources and capital equipment became less scarce. That would benefit those wanting to buy into ownership and those saving for future pensions but diminish the relative financial power of the current owners. I think it is very misguided to aim for asset price inflation as a target for economic policy but sadly that seems to be what is behind standard economic advice.

That gets us back to the thorny real issues around migration. It is vital to draw a distinction between on the one hand the entirely beneficial phenomenon of people working abroad as a way to exchange expertise and on the other hand mass net migration driven by macroeconomic forces. Furthermore my skepticism about the merits of mass migration is not due to any issue with multiculturalism. I view the multicultural character of the UK as a positive attribute to be celebrated. I’m struck by how the serious sectarian conflict that we do have within the UK is in Northern Ireland and is between people who share a local ancestry going back centuries. And let’s be clear that conflict is about tribalism not religion. Also in the last century the UK suffered the crippling effects of social class divisions. That is a sectarian division concocted out of thin air without a whiff of ethnic pretext. Sectarian conflict is an ever present peril that every society and individual has a responsibility to continuously dispel irrespective of how seemingly homogeneous or diverse their community is.

The libertarian ideal is that everyone should be free to live and work wherever they fancy and government has no place imposing restrictions on migration. Many migrants do experience culture shock in their adoptive country. This is starkly illustrated by the fact that a personal or family history of migration is an important risk factor for schizophrenia. Libertarians argue that any difficulties with living in a foreign culture are a private matter to be weighed up by each individual in deciding whether or not to migrate. Obviously some individuals have family or personal reasons for moving to a new country. To me however the reality of mass economic migration seems very murky. Clearly imposing restrictions on whether people LEAVE a country is a hallmark of desperate “prison states” such as the former East Germany. It also seems shocking to hear of restrictions on where individuals are allowed to live within their own countries. I would be appalled to have our government dictating which part of the UK I was allowed to live in.  However I worry that it would be calamitous to eliminate immigration restrictions.

The plight of indentured labourers working in Dubai starkly illustrates the potential cruel reality of economic migration. Desperate, illiterate, people in countries such as Pakistan, India and Bangladesh get bamboozled into taking on un-repayable debts to pay for passage to Dubai where they work and live in appalling conditions. Their situation amounts to effective slavery – about as far from a Libertarian ideal as is conceivable. Clearly this is an extreme example but it underlines a wider phenomenon of migrant workers being in a less assertive position to ensure that they receive a fair level of pay.

Much economic migration appears somewhat deranged. Migration is inevitably towards where the money is rather than where there really is a genuine greater need for work. Recruitment of migrants to meet “labour shortages” often appears to actually be a symptom of a deeper conflict over what share gets taken by workers as wages rather than accruing to employers as profits. Perhaps it would be much better if that key issue was instead dealt with head on by facilitating employee ownership such as with the John Lewis partnership.

In the 1950s mass migration to the UK was encouraged supposedly to meet a labour shortage. At the same time labour unions endeavoured to safeguard jobs and wage levels by insisting on ineffective working practices and over-manning. Unions tried to ensure that labour was scarce and valued; migration was a way to undermine that artificially exacerbated scarcity. Ironically migration was away from countries that had a vastly greater real need for work that the UK did. The West Indies, Bangladesh and Pakistan had a real need for infrastructure development, water and power supplies etc. etc. Arguments that the West Indies had an excess population as a legacy of the declining sugar industry don’t make sense to me. People anywhere have the potential to themselves be the engine of economic vitality and job creation if only allowed the necessary economic environment. Singapore after all supposedly has had a multi-decade labour shortage and yet Singapore is also a tropical island with no source of employment prospects other than those created by its own population.

The more recent mass migration from Poland to Western Europe seems to me no less deranged. Poland seemed in great need of skilled, motivated, Polish people to re-build their nation after decades of communist era floundering. Instead the 2004-2008 housing bubble in Western Europe provided such a lucrative draw, that engineers and school teachers left Poland to take unskilled labouring jobs, constructing ghost estates in Ireland and never to be used shopping centres in the UK. Perhaps if it hadn’t have been for an endless supply of migrant labour, labour shortages might have brought sanity to the housing bubble. The proceeds of the bubble might also have been distributed in a less inequitable fashion if labour shortages had pushed up construction workers’ wages.

The reality is that if all people were free to migrate around the world willy-nilly then, all too often, we would end up having to do so in an entirely wasteful and pointless fashion. Momentum chasing “hot money” flows from country to country in a largely stochastic fashion at the whim of automated trading algorithms driving the gyrations of the financial markets. Families would end up having to up-root and follow the money, further fuelling such bubbles and busts.

When considering the UK situation it is helpful to make a comparison with the extreme cases of Singapore and Japan. Both those countries have a more dramatic demographic issue than the UK does. Japan seems to be successfully ensuring that the dramatically aging Japanese population is very well looked after with no recourse to mass immigration into Japan. As elsewhere, there is no genuine constraint of labour shortage in Japan. Singapore on the other hand is fully embracing the mass immigration option. That is despite Singapore being on a tiny, densely populated, island.

Singapore has the peculiar characteristic that over a third of the people living there are not actually Singaporean citizens. Such guest workers have to leave as and when the job market dictates and in many cases their families are not permitted to live with them in Singapore. The Singapore government has set its sights on both increasing permanent immigration to increase the number of full Singaporean citizens and also increasing the ratio of guest workers to Singaporean citizens. They have set the ideal that Singaporean citizens should be predominantly managers whilst less senior jobs should be taken by guest workers. This is simply a starker and more forthright example of the mind-set also exhibited by our last “New Labour” government here in the UK. Then we were told that mass net immigration into the UK ensured career opportunities for existing UK citizens as managers of all of the new immigrants.  Personally I think this reflects a misguided view that undervalues front line workers. To my mind it is better to cherish and properly reward all required work.

See previous post:

Isn’t a financialized economy the goose that lays our golden eggs? -Rather than saying that people should migrate to where money is flowing, shouldn’t we instead stop fostering capital flight from the poor world (where the money is genuinely needed) to asset bubbles in the rich world?

Related stuff elsewhere on the web:

A rely to”Direct Economic Democracy” – Paul Crider, Open Borders (added 09Aug2013)

Fiscal Sustainability Report July 2013 – Office for Budget Responsibility

A Sustainable Population for a Dynamic Singapore

Charlie Rose: Jeremy Grantham on Our Debt Solution -Bloomberg video

Migration Matters Trust

Open Borders (added 31July2013)

Japanese nurses blocking skilled help from overseas -Japan Times

Nursing Leadership in a Rapidly Aging Society: Implications of “The Future of Nursing” Report in Japan -Nursing Research and Practice

Sunder Katwala on immigration from the West Indies -BBC

Economics and Emigration: Trillion-Dollar Bills on the Sidewalk? -Michael A. Clemens (added 31July2013)

If People Could Immigrate Anywhere, Would Poverty Be Eliminated? -Atlantic (added 01July2013)

North of the Border – Krugman NYT (added 02Aug2013)

Fiscal autopilot

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

Political Consequences of risk free financial assets

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)