The supercooperators

In a previous post I argued that economic growth was compelling evidence that human society has become increasingly cooperative. This is because economic growth depends on commerce, which involves specialising in activities that we are good at and then exchanging the products of that activity with others who specialise in what they are good at. I chose commerce as an example of cooperation because many see it as exemplifying the selfish aspects of human behaviour and rail against it. In doing so they miss out on the bigger picture. Commerce implies cooperation. Global trade implies global cooperation.

There is plenty of other evidence that human cooperation is increasing and is now greater than ever, despite occasional set backs. I provide two more examples.

One example is the extent to which countries adopt support systems for their vulnerable members. This includes support for the disabled, social housing, unemployment benefits, healthcare, and pensions. This support has increased steadily to the extent that it is considered unacceptable for countries to not provide such systems. There is of course considerable debate about these welfare provisions but this debate is mostly about how they should be provided, to what extent they are being abuses by certain segments of society, and how much money should be spent on them. There is very little if any support for abolishing these systems. 

Another example is the extent to which over time people voluntarily organise themselves on ever increasing scales. This is exemplified by the spread of the nation states ruled by the consent of its people, and the increase in supranational organisations, where nation states voluntarily cooperate. This culminated in the creation of the United Nations and numerous other sister organisations. The Europe Community represents perhaps the 'next level' of this cooperation as joining countries sacrifice considerable freedom of action by agreeing to adopt rules agreed to by all members. 

The good guys are winning

One of the most striking, and under-appreciated features of humans is their facility for cooperation and altruism. It is under-appreciated because we are constantly exasperated by news of problems which seem to illustrate a propensity to NOT cooperate and instead act selfishly. This can lead to pessimism and apathy, which is damaging. 

To counter this pessimism we need to remind ourselves constantly of two things. Firstly, that the vast majority of humans on the planet are good people like us, who want to do the right thing. Secondly, that despite what seems like a blizzard of examples of human cruelty and selfishness, the basic direction of travel is ever-increasing cooperating and ever-increasing improvement in the way we treat our fellow human beings and the planet as a whole. The 'good guys' are winning and, despite losses along the way, they will almost certainly win in the long run.

Why do I think we are winning? How can I claim this in the face of all the evidence of the harm that humans do to each other and to other species? 

One reason is that our treatment of each other has continued to improve and is now better than it has ever been. The evidence for this is overwhelming. Cruel behaviour that was previously common and widely tolerated has become much less common and in some case has been eliminated. For example slavery, torture, racial discrimination, violence towards children, the death penalty, public executions. Of course bad things still happen, and there are periods where there is a big increase in this behaviour, notably during war, but the direction of travel is very clear. For those still skeptical I recommend Steven Pinker's book The better angels of our nature, which documents the remarkable decline in violence in human society. 

A second reason is that the level of cooperation amongst humans has also continued to increase, despite occasional setbacks. What is the evidence for this? The most compelling evidence is economic growth, which has, despite setbacks such as the global financial crisis, continued across the world. Increases in economic activity can only happen when there is an increase in productivity and this comes about through the twin processes of specialisation and exchange. Specialisation means that we  as individuals do what we are best at rather than doing everything. Take, for example, farmers who produce all they consume, but for whatever reason are much better at producing wheat. Because they are good at it they can produce more using fewer resources and in less time than others. However if they were to concentrater on wheat production they would produce more than they need and not produce other foods that they need to survive. However if other farmers agree to produce these other products and exchange them for the surplus wheat the problem is resolved, and everyone is better off. This process requires people to make complex arrangements with, and become very reliant on, each other. It implies considerable trust since those not producing essential items, such as food, could starve if those producing them fail to supply them. Since specialisation and exchange require and therefore represent cooperation, and are essential for increases in productivity, it follows that sustained growth in economic output can only come about through increases in cooperation. The fact that economic output is higher than ever is strong evidence that cooperation amongst humans has never been greater than it is now. 

Of course many types of economic activity are harmful in some way and so could be considered evidence of increasing selfishness. However this is compensated for by activity that is beneficial. Furthermore, as we learn how to mitigate these harmful effects, the proportion of activity that is harmful is continually decreasing. 

Creating money

An economy needs money. The question is how to provide it in amounts that are sufficient to allow optimal amounts of economic growth. Too little limits growth. Too much can result in inflation. 

How is money created? Most people think that it is created exclusively by the central bank. This is not the case. The central bank only creates base money, which consists of the electronic money in the reserve accounts at the central bank held by commercial banks and all physical cash (notes and coins). When commercial banks order cash from the central bank their reserve accounts are debited, and vica versa.

How is the amount of base money controlled? In principle any govertment with its own currency it can simply create it by adding numbers to reserve accounts. However in most modern economies there are self-imposed rules in place to prevent governments from creating money. The reasoning behind this seems to be that politicians (and voters) cannot be trusted to do this responsibly. Instead this power is given to a central bank. Of course central banks are created and ultimately controlled by governments (and thus the people) so this is a somewhat artificial excercise. Nevertheless in normal times only central banks can create base money. 

Although the amount of base money is tightly controlled it represents only a small fraction of the money circulating in the economy - currently under 5% of the broad money supply in the UK. So who creates the rest of the money? Commercial, privately owned banks. 

Yes that is correct. Most of the spendable money that we absolutely depend on is created by private banks. When private banks make a loan to a customer they usually just add numbers to that customers bank account, creating 'bank money'. At the same time they get the customer to sign a debt or mortgage contract which compels them to repay the loan by a certain date and also pay interest. The money is created out of nothing together with a matching debt contract. This does not mean that all money that is lent by banks is newly created. But it does mean that banks do not need to wait for customers to deposit money with them before they make loans. Most people are surprised and disbelieving when they are told that banks are able to create money out of nothing. Ask any central bankers and they will acknowledge this as a simple fact. The best evidence for this is that there is vastly more money in private bank accounts (bank money) than the amount of base money created by central banks. It must have come from somewhere!

There is a notion that private banks are limited as to how much money they can lend by having to keep a certain fraction of money in their reserve accounts, and this is termed fractional reserve banking. In fact this is not a real limit as there is no longer any reserve requirement in many countries (such as the UK), and in countries with reserve requirements (eg USA) banks can always borrow additional reserves from the central banks. Banks lend first and then obtain the reserves later. The central banks will always provide the reserves because failure to do so would undermine the financial system. 

Bank lending is legally limited by a requirement to meet a 'capital adequacy ratio', but this is nothing to do with reserves so is not limited by base money. All it means is that banks need to have assets that exceed their liabilities by a certain amount. Incredibly, this amount, also called equity, is only around 3-4% of assets. Any businessman will tell you that having equity of 4% is incredibly risky because if your assets decrease by 4% (through defaults or decreases in asset prices) you will be insolvent. Equity buffers of 20-30% are more typical of businesses. Bizarrely, given their importance, banks are allowed to operate with dangerously low equity buffers. Banks can expand total lending by simply retaining profits. With current rules retaining profits of £1 billion enables them to create a £25 billion of new money through lending. Their only real constraint on lending is being able to find customers wiling to borrow and their judgment as to whether they will be paid back.

The fact that most spendable money in the economy is created by private banks when they make loans had important consequences. All such loans are matched by an equivalent debt, so no NET new money is created. When loan are repaid the money is 'destroyed'. When the private sector reduces its debt levels by paying back its existing loans and taking out fewer new ones the overall money supply shrinks, which depresses the economy. That is why governments and central banks are desperately trying to encourage more credit creation by banks.

To counter the contraction in the money supply that economies are experiencing because of the reduction in bank credit creation, central banks are increasing the dramatically amount of base money by quantitative easing or QE.  This involves central banks purchasing various assets from the private sector, typically government bonds.

Some people are concerned that this increase in base money will result in inflation. This always seemed unlikely given that the level of total bank money was and still is actually shrinking, despite QE. What is odd is that the same people that are worried about this increase in base money were unperturbed by the far greater increase in the broad money supply in the 20 years before 2008. Indeed the money supply tripled in the UK and USA in the 10 years leading up to 2008, with almost all of this increase being accounted for by commercial bank created money. This did not result in consumer price inflation, but it was responsible for asset price inflation, especially property prices. 

To conclude, the rules that are in place to prevent governments from creating money have had the curious and underappreciated effect of placing most of the responsibility for money creation in the hands of private banks. In effect we rent our money from banks. In my view this was a mistake and one of the underlying cause of the global financial crisis (GFC). This crisis was a result of excessive credit creation by private banks which governments had enabled by loosening regulations governing banking. Many of these regulations had been introduced after the financial crash that precipitated in the Great Depression, which was also ultimately caused by a bank-created credit bubble. The reason why the GFC did not result in another depression is almost certainly because this time central banks flooded the financial system with enough base money to prevent banks collapsing. Unfortunately, however, this extra base money may not be enough, on its own, to restore growth. The reason for this will be discussed in the next post. 

A revealing comment

The debate about the notorious Rogoff/Reinhart spreadsheet has taken an interesting turn. Recall that they argued strongly that high government debt is a bad thing as it depresses growth, and they provided evidence in the form of an analysis of the relationship between government debt and growth since the war. They claimed that the evidence shows that once debt gets above 90% of GDP growth slows sharply to zero. This was the evidence used by numerous politicians and commentators to justify imposing austerity on economies that were struggling economically.

It turns out, thanks to investigations by a graduate student, that their evidence was wrong, the result of a spreadsheet error and dubious selection of data. They have come back strongly, arguing, firstly, that the data still shows a relationship, albeit a weak one, and secondly, that they always acknowledged that austerity was not the whole answer. Then they go on to point out, as an illustration, that one of them has argued for policies that increase inflation to 5-6% to reduce the burden of debt.

This is a revealing comment because it shows that they do not know what they are talking about. I say this because anyone who understands how fiat currency systems work knows that the only risk posed by government deficit spending is inflation. There is no risk of government default or insolvency. The government (which includes its central bank) cannot run out of money. To think so is ridiculous. In fact they are the only agency that can create the base money required to pay taxes, and there is no intrinsic limit to much they can create. It follows that they cannot go insolvent. Period.

It is true that there are self-imposed rules on government spending which give the appearance that it is limited by revenues. These rules have one primary purpose: to prevent the sort of excessive money creation that could cause inflation. Taxes are required to control private sector demand, not to raise money for government spending. Economist who really understand the monetary system know this but believe that it is important to run fiscal policy as though tax revenues fund spending because this provides the discipline needed to constrain excessive growth in government spending. It also makes it easier to justify spending cuts or spending restraint if one can claim that there is just not enough money, that the government is 'broke'. For a sovereign government that creates its own currency this is always a lie. The only intellectually honest reason for restraining or reducing government spending in a fiat currency system is to prevent or reduce inflation.

The fact that Reinhart and Rogoff raise concerns about the dangers of government deficit spending and then suggest that a solution to the problem of debt is to create inflation reveals that they are not actually worried about deficit spending causing inflation. Instead they are worried about the possibility that the growing debt will become a problem for the US government because they might have trouble raising the funding, similar to what has happened to Eurozone countries, and indeed numerous other countries who have defaulted on their debts.

Unfortunately they don't seem to recognise the CRUCIAL difference between governments who have debts in their own currency, that they issue, and governments with debts in currency that they do not create. The latter include Eurozone governments and all governments who borrow in foreign currencies.  Countries with their own currencies, like the USA, UK and Japan, are never revenue constrained and so cannot be forced to default on debts in their own currency. Not only can these countries not default, they can also control the interest rates that they pay on their debt. So there is no danger of them being forced to pay crippling interest rates on their debt. These facts are demonstrated by the very low rates payable on government debt in such countries, despite high deficits and increasing debt levels.

It follows that for the vast majority of countries deficit spending and government debts do not pose a solvency or funding problem. There is a risk that large deficit will lead to inflation, but this is only likely to be a problem if the economy is running at full capacity. In this case the extra demand from government could cause prices to rise. This is not likely when the economy has plenty of spare capacity which is the case when there is high unemployment. There might be a risk but it is only a small risk, and it is easily dealt with by cutting the deficit if inflation picks up.

The discussion above should make it clear that Rogoff and Reinhart are seriously mistaken. It makes no sense to oppose deficit spending when the only real risk of deficit spending is inflation and recommend instead intentionally inducing inflation. Why oppose a policy (deficit spending) that has a small risk of inducing inflation and favour instead a policy of actually inducing inflation? Assuming that they are not being deceptive, they appear to believe that the US government could have serious trouble 'funding' their spending, revealing ignorance if how their own monetary system operates. This is something one might expect from many people as it sounds like common sense. But surely academics who study government debt should know better?

Who should be tightening their belts - banks.

After the global financial crisis there has been much talk of the need to tighten our belts. Most is hypocritical as it is used to justify cutting other peoples income or benefits. It is also misguided because the paradox of thrift tells us that it if we all cut spending everyone's income decreases by the same amount and we all just become poorer as a result. However there is one group of people who definitively should be tightening their belts, namely bankers. The current financial mess is the result of banks becoming insolvent because of excessive, risky lending. Banks, unlike any other business entities, operate with incredibly low levels of equity*, at around 2-3%. This means that a tiny (i.e. 4%) drop in the value of their assets (e.g. a small number of defaults on mortgages) can make them insolvent, at which stage taxpayers usually have to step in to rescue them to avert contagion, imposing a large costs on the rest of the economy.

It makes no sense at all for such systemically important parts of the economy to operate with far thinner equity cushions than other businesses. If anything they should be higher. So you would have hoped that bankers would be required to increase their equity cushion to a more reasonable thickness such as 20-30% of assets, which is what most businesses and individuals use. They can easily do this by simply retaining their considerable profits. But banks have strenuously resisted such an adjustment and instead banks executives have distributed these profits out to themselves in the form of very high salaries and obscene bonuses. As a result their equity cushions are still very thin and they remain at higher risk of collapse, which will require an expensive rescue. This is completely insane. How can we allow them to get away with such extraordinarily antisocial behaviour so soon after they almost destroyed our economies?

[*equity is difference between your debts and your assets, usually expressed as percentage of assets. Assets of £100 and debts of £97 mean equity of £3 or 3%. Equity allows businesses to absorb losses without becoming insolvent, acting as a cushion. The thicker they are the more robust the businesses are to shocks like a customer defaulting on it debts]

An important speech proposing a major change in macroeconomic thinking and policy

A few days ago Adair Turner, former chair of the Financial Services Authority, made a bold speech in which he made a number of points already made in many of my previous posts about the causes and ways of tackling the global financial crisis. For example, he stated that:
-the global financial crisis was the result of an unsustainable increase in the private sector debt to GDP ratio driven by excessive bank lending, which was mistakenly ignored by mainstream economists and policymakers, who claimed it did not matter. This inflated asset prices bubbles which inevitably burst, causing financial mayhem.
-the subsequent recession is a result of the fact that the private sector are deleveraging, and that government deficits are required to enable this deleveraging. Trying to cut them is therefore seriously misguided and counterproductive.
-deficit spending is healthy when there is a deficiency in demand and should be encouraged as a way of regulating aggregate demand
-efforts to restore growth by increase bank lending are unlikely to succeed and are potentially hazardous as they recreate the problem that cause the financial crisis in the first place.
-banks need to be much more tightly regulated and should have much higher capital and reserve requirements. He makes the important points that all these lessons were learnt following the great depression, but have been forgotten.

Interestingly, he argues that government deficits are financed directly by central banks creating money - also called helicopter money. The reason he advocates this is that deficit spending financed by government borrowing results in a growing government debt. He thinks this is a bad thing because it will have a psychological impact on the private sector. They will worry about the fact that the resulting debts will eventually need to be repaid, and that this will require higher taxes, which will cause people to save now, depressing demand. This is called Ricardian equivalence. A solution to this psychological problem is to explain that government debt just represents net private sector savings, which is a benefit not a burden, and there is no reason why these savings need to be decreased in future. Provided that the government has its own currency and central bank it can set the interest rate on this debt and cannot default on it. In fact it is the safest place for the private sector to keep savings. Government debt serves a useful purpose as a safe asset for banks and investors such as pension funds.

The real difference between deficit spending financed by the central bank and deficit spending accompanied by issuing government debt is that instead of the extra money created by the deficit being kept in non-interest bearing reserve accounts at the central bank it is moved into interest bearing savings accounts at the central bank.

The effects of the bank levy - forcing the non-bank private sector into insolvency

There has been some comment that the bank levy of depositors in Cyprus might, if it does not cause to much contagion, be tried again when, as is inevitable, more banks need to be rescued. This idea makes no macroeconomic sense at all and is incredibly unfair. What it also reveals is a huge logical flaw in the thinking behind austerity.

The bank levy is a default on debt owed by banks to the non-bank private sector. Since it has no effect on debt levels held by the non-bank private sector it improves the solvency of banks by making the rest of the private sector less solvent. This will naturally result a decrease in spending, as attempts are made to increase saving to restore solvency.

What is curious is that the rationale for cutting the government deficit rather than allowing it to remain high with support from central banks is that deficit spending will result in inflation which will effectively reduce the real value of savings. The difference of course is that inflation causes the relative value of debts (which do not increase with inflation) to decrease, improving solvency, so it makes much more sense economically to risk some inflation by deficit spending than to impose huge losses and force large parts of the private sector into insolvency.

Of course not the whole private sector will suffer. Banks will escape by having their debts reduced so that they can be restored to health. Does that not seem just a little unfair?