Rediscovering the obvious

A book by Richard C. Koo immodestly entitled 'The Holy Grail of Macroeconomics: lessons from Japan's Great Recession' is a good example of how mainstream economists are rediscovering what those outside the mainstream having been saying for years.

In this case the obvious is that when the private sector (households and businesses) are heavily in debt and their income drops they try to repay their debt rather than borrow more. The main contribution from this book is to provide empirical evidence for this by looking at actual behaviour during the Great Depression in the USA and the Great Recession in Japan. He shows that during these periods companies and household were reluctant to borrow and instead tried to reduce their debt or 'repair their balance sheet'. When the aggregate private sector does this demand remains depressed, resulting in what he call a 'balance sheet recessions'. He points out that this contradicts mainstream economic thinking, which is revealing about how wrong this thinking is.

The current stagnation across the developed world is exactly this kind of balance sheet recession. Aggregate private sector debt reached record levels just before the onset of the crisis and remains very high.

The practical importance of this is that during balance sheet recessions policies that try to stimulate growth by encouraging more borrowing are doomed to fail. Yet these are the main policies that have been promoted by mainstream economists today. They are not working and so central banks are coming up with ever more desperate measures to stimulate borrowing, such as quantitative easing. Banks are being accused of failing to lend when the real problem is the absence of any desire to borrow. Why should businesses take out loans to expand their businesses when demand is stagnant and there is excess capacity?

The experience in Japan, where 15 years of unprecedented loose monetary policy has failed to stimulate growth, is compelling evidence that this policy won't work. Japan has only managed to grow by remaining a net exporter.

So what is his solution? His big idea is that during balance sheet recessions fiscal stimulus is needed. He calls it the Holy Grail of Macroeconomics because it reconciles monetarism and Keynesianism, which have long been at odds.

Surely this is just common sense? As Wynne Godley and, more recently, proponents of Modern Monetary Theory have been saying for many years, the simple accounting dictates that the aggregate private sector can accumulate net financial assets and thus 'repair its balance sheet' only if the the government sector spends more into the economy than it removes through taxes. The government is the only possible source of net financial assets for the private sector. This is no theory. It is simple reality. Or should be to anyone who understands the monetary system and the constraints of sectoral balances as shown by Godley.

However mainstream economist do not understand sectoral balances. Instead of recognising that it is an absolute NECESSITY for government to run deficits in order to enable the private sector to save they argue that the government should borrow the private sectors savings and spend them. This sound like something that is optional and therefore open to challenge. It also sounds like a call to get the government to expand relative to the private sector. Since many people are, with good reason, skeptical about governments expanding, this line of argument is unconvincing.

The way to explain the need for deficit spending is that government should not remove all the money that they spend into the economy through taxes. Instead they should reduce taxes, thereby enabling the private sector to deleverage quickly while maintaining demand. It is not about expanding the government. Instead it should be about enabling saving, reducing private sector debt, and repairing balance sheets.

Conversely cutting the deficit by decreasing spending and increasing taxes PREVENTS the private sector from saving. Since they have no choice but to try to save they simply cut spending further, resulting in a deeper recession. This is why austerity has been such a dismal failure wherever it has been tried. When you understand the problem it is fairly obvious that it is almost exactly the wrong thing to do.

Those who worry that excessive government borrowing could lead to default should be reassured that in countries with their own currencies government can never default as they create the currency. There may be a risk of inflation, but there is no risk of default.

Worrying about the wrong debt

Those who worry about debt and think it is a major problem are correct. Unfortunately they often confuse two types of debt, namely, private sector debt and government debt. These debts are entirely different. They are best considered as opposites. Government debt is, in fact, private sector savings, and vica versa. Indeed the only way that that the private sector as a whole can accumulate net financial assets is by the government sector spending more into the economy than they remove through taxation, i.e. by running a deficit.

Sound confusing? Think of it this way. The government has a legal monopoly on creating debt-free money. It creates this money by spending. If the private sector AS A WHOLE is trying to accumulate money (i.e. save) this can only come from the government spending. When government's tax they are removing money from the private sector. The annual difference between taxation and spending (the deficit) represents the amount of money created each year by the government. To repeat, government debt represents the total amount of debt-free money that the government has created. It is also exactly equal to the net financial wealth of the private sector.

The big macroeconomic change over the past 40 years has been the rise in private sector debt relative to income. This has risen to over 300% of GDP in many countries. This change was simply ignored by mainstream economists and policymakers. The usual justification was that private sector debt was matched my private sector credit so net private sector debt was zero. This is odd since it is obvious that there is a limit to how much debt can be carried by anyone which is set by their income. As debt rises relative to income an ever greater proportion of income has to be spent on servicing the debt.

The financial collapse was a result of defaulting on this debt, which created panic in the financial sector, which froze up the payment system. This induced a deep global recession which prompted the aggregate private sector cutting its spending and increasing its saving. This is entirely appropriate but it has depressed growth, since growth requires spending, and when spending is diverted to savings, growth is depressed. Governments stepped in to prevent collapse. This resulted in a big increase in deficits and government debt, which had been at record low levels in most countries before the financial crisis.

Remember that the aggregate private sector can only save if the government sector runs a deficit. Government deficits will continue to remain high precisely because the private sector is desperately trying to save by reducing its spending, which depresses growth and thus government tax revenue.

When understood this way it should be clear that attempts by the government to cut the deficit prevents the private sector from saving at their desired level. Does this austerity seem sensible when private sector debt is still at record high levels? Of course not. In fact it is counterproductive because, by depressing growth and increasing unemployment, austerity increases the private sector's desire to save. When you see your income go down and everyone else's is dropping, does it make sense to borrow more money?

Of course many will argue that, despite the damaging effect austerity has on the economy it is necessary to reduce the deficit because if we don't the government would have to pay very high interest rates to borrow money. This is an understandable mistake to make given what we have seen in the Eurozone. The difference is that Eurozone governments do not issue their own currency. They have to borrow it, and they do not control the interest rates for borrowing. This is unusual. Normally governments issue their own currency and they can set interest rates at whatever level they choose. Because of this they can never be forced to default on their own debt. That is why interest rates on government borrowing are so low in the US, the UK and Japan. There is no shortage of people keen to buy government debt even at low interest rates. Why? Because we are all still worried about the banking system, and when governments issue the currency then their debt is the safest place to store savings.

Instead of worrying about government debt policymakers should be focusing on accommodating the private sector's desire to save by increasing their deficits. Probably the best way to do this is to cut taxes, especially regressive taxes such as VAT and National Insurance. This would provide an immediate boost to demand. The deficit should be kept high until there are signs that the economy is running at full capacity. The clearest evidence of would be an increase in inflation. When this happens the deficit should be cut. If unemployment is till high then this suggests that there are structural constraints causing bottlenecks to economic growth. That is the time to focus on structural reforms to increase efficiency and eliminate bottlenecks. It should be clear from where inflation is greatest where those bottlenecks are.

Instead what the government is doing now is:
-aggressively trying to cut the deficit, when demand is already low
-trying to encourage private sector borrowing, when private sector debt is too high
-wasting time and money on structural reform without there being any evidence for structural problems.

The scale of their ignorance and incompetence is breathtaking.

Are we preparing the way for a new Hitler in Europe?

The strong preference of Germany for 'sound money', which was a major factor in the design of the Eurozone monetary system, may be based on a tragic misunderstanding of it's own history. Many Germans seem to believe that the hyperinflation during the Weimar Republic was somehow to blame for the shift of Germany to the right, which culminated in the disaster of the Third Reich and WWII. In fact there is no direct connection between hyperinflation and Hitler's rise to power. The sequence of causes and events was as follows.

1. The German government, saddled with huge reparation demands imposed by the rest of Europe, which it could not afford, printed money in order to devalue them (they were denominated in German currency). This succeeded but wiped out the cash savings of the German middle class. Economic growth began to recover but then slowed as governments around the world introduced 'sound money' (essentially a reintroduction of the gold standard) at the same time as balancing budgets. A new government was duly elected.

2. This government attempted to introduce sound money policies in the face of economic headwinds by cutting government expenditure and increasing interest rates. The result was a severe recession and mass unemployment. Hitler, campaigning on populist xenophobic and racist ideas that allocated the blame for this crisis on other groups (mostly Slavs and Jews) soon rose to power by popular vote.

3. Once in power he dramatically increased government spending (and the deficit) in order to rearm the country. This classical demand stimulus restored vigorous economic growth and living conditions improved rapidly. His popularity rose and his hold on power became unbreakable. The rest is well-known.

What lessons are there from this? Austerity and sound money policies do not work in a recession and when the money supply is contracting. Stubbornly pursuing them in a democracy will hand power to anyone who is prepared to abandon them. We must just hope that the politicians who eventually do what is obviously necessary to restore economic growth in Europe are not extremists. It would be tragic if the same mistake was made within living memory due to a misunderstanding of history.

Intellectual paralysis

It was painful to watch the budget speech, but even more painful to watch Ed Ball's response to it. George Osborne had to paint a picture of a stagnating economy which will not grow significantly for the foreseeable future. This was widely predicted by those relatively few commentators who understand how our monetary system works. As they also predicted, the stagnation has been accompanied by continued deficits and ever rising debts. So what was his solution? Continue with the austerity. There is no alternative. Why? Because if the government shows any signs of reducing its commitment to fiscal 'responsibility', and cutting the deficit, the markets will punish it by refusing to lend the money the government needs to finance this deficit. The credit rating agencies will downgrade the UK's credit rating and the interest rate that the government has to pay for for its 'borrowing' will rise, increasing the 'burden' on taxpayers. the government may even find itself unable to borrow and have to go grovelling to the IMF for loans, which will impose even tougher conditions than his austerity measures.

This is, of course, complete nonsense. Government with a sovereign fiat currency and floating exchange rates have no need to 'borrow' in order to spend. They create money when they spend. Borrowing is a self-imposed requirement that simply provides the private sector with somewhere very secure to earn interest on their savings. The government and its central bank can set these interest rates at any level they want to. [This does not apply to countries that do not issue their own currency such as those in the Eurozone.]

What was most painful about watching this was that the opposition, because they have the same mistaken understanding of the monetary system as the government, were unable to offer any coherent criticism. Ed Balls was reduced to accusing the government of failing to cut the deficit, which actually supported the Chancellor's previously mistaken austerity policy and his continuation of that policy. No wonder he looked flustered and confused. His head was grappling with a contradiction so large that it induced intellectual paralysis.

The tragedy of the current economic crisis is that across the world all policymakers are operating under the same mistaken understanding of how modern monetary systems operate. Most importantly, they operate under the same view that governments must not run deficits and should try to run surpluses, believing this to be prudent. In fact this is a very dangerous. In modern fiat currency systems the governments are the only source of debt-free money. When they spend they are adding this money into the economy. When they tax they are removing it. They need to spend more than they tax (i.e. run a deficit) in order to add debt-free money into the economy. This additional money is needed to satisfy the private-sector's desire to save. Without it the economy would shrink every year by an amount exactly equal to net private sector savings, as this 'hoarding' of money removes it from circulation, reducing demand. Running a budget surplus reduces private sectors savings. Government ’debt' represents net savings of the private sector. Reducing this debt will reduce their savings. At a time when private sector debt levels are still at very high levels this seems bizarre.

There are compelling historical demonstrations of the dangers of government surpluses. For example, there is the fact that every depression in the USA in the past 230 years, and there have been six of them, was preceded by many years of government budget surpluses. Conversely, on every single occasion that the US federal government has tried to reduce its 'debt' substantially by running multi-year surpluses this has been followed by a financial collapse and a depression. When you appreciate that by running budget surpluses the government is effectively confiscating private sector savings it is not surprising that surpluses are so damaging. Logic and experience are clear. When the government is the supplier the currency deficits are necessary and surpluses are reckless.

Taxes can encourage working

We keep hearing that taxes destroy the motivation to work. I am not aware of any evidence that supports this. In fact countries with high taxes (northern Europe and Japan) have some of the hardest working people, whereas countries with low taxes (eg Monaco and other tax havens) seem to be filled with people who do very little work at all!

In fact there is evidence that taxes have been used effectively to encourage people to work. This was the case when European countries colonised less developed lands and wanted to employ the native people to work on their farms or in their houses, factories and mines. They were understandably reluctant to do these jobs because, being subsistence farmers, they had no need for the wages. This problem was resolved by colonist by imposing a poll tax or hut tax on them, payable in the same currency that was paid to workers. Since payment of these taxes was enforced by threat of punishment it was now necessary to acquire the currency. This motivated them to work for wages. Taxation therefore encouraged working by creating a demand for currency needed to pay the taxes.

The simplest way for a new currency to be introduced and have it accepted is to impose a tax payable in the currency, or allow existing tax obligations to be settled using the new currency. It has been suggested in Greece, for example, that the Greek government start paying wages using government IOU's which would be accepted as payment for taxes. This is an ingenious solution to the key problem facing Greece and other Eurozone countries which is a severe shortage of currency in circulation.

If one considers that taxation is a debt imposed by the government, a good case can be made that the real value of any modern currency ultimately derives from the fact that it can be used to repay debt obligations. These could be debts to private banks or debts to the government (taxes). As long as there are debts payable in a currency, and payment is enforced, there will be demand for that currency.

A Family Analogy (Part 3)

This is the third post in a series in which I describe how a family would operate if it was similar to a modern economy, with the parents as government (and central bank) and the children and grandchildren as the private sector. Hopefully it will be self-evident from the first two posts in this series that in order for the amount of trade between children (and their descendants) to increase the number of circulating coupons needs to increase as well. In other words economic growth requires growth in the number of coupons (i.e. money) in circulation. The question is how to provide these coupons in the required amounts?

There are two ways of accommodating this need for more coupons. One way is for parents to provided additional coupons by spending more than they remove through taxation - i.e. deficit spending. The second way is for children acting as banks to make loans. In the former case the coupons are debt free and no interest is paid on them. In the latter case all the new money is accompanied by a debt and there is a requirement to pay interest. In other words the coupons are rented from children acting as private banks, with the interest payment being equivalent to rent.

IT MAKES SENSE TO CREATE MONEY IN TWO WAYS: DEFICIT SPENDING AND PRIVATE CREDIT CREATION
Looked at this way it is not obvious why creating coupons by deficit spending is necessarily worse than allowing them to be created through lending. Indeed it is better in some ways as it avoids excessive debt and the corresponding growth in the number of children who make their living as rent-seekers (who grow wealthy at the expense of other children by renting them they coupons they need for economic activity). There is a risk of inflation if deficit spending is excessive but there is no reason why this cannot be contained by the parents simply by reducing the number of coupons created or increasing the number removed through taxation.

It would seem sensible to use both mechanisms of coupon creation together, and in moderation. Deficit spending to gradually increase the amount of debt free coupons, with strict controls to prevent inflation. Bank lending to provide the flexibility needed for productive investment wherever the opportunity arises, with strict controls on the overall level of debt so that it remains at sustainable levels.

THE IDEOLOGY BEHIND BALANCED BUDGETS
Given the above why has it become conventional wisdom that in the real economy money creation by deficit spending is entirely bad whereas money creation by credit creation is good?

As far as I can tell the reason is largely ideological and deeply cynical. It is based on the notion that governments and the general public cannot be trusted with the knowledge that government spending is not constrained by revenues. It is feared that once they realise this they will not be able to resist the temptation to spend ever more and tax ever less, even this results in inflation. So in order to maintain political pressure to moderate spending it is better if parents (politicians) and children (voters) believe that deficit spending is dangerous. This is achieved by maintaining the myth that parents need to get the coupons that they spend by taxation and borrow the difference from the children. Once this is believed then it is relatively easy to convince children that it is bad for parents to deficit spend just as it is bad for the children themselves to live beyond their means. It is also possible to persuade them that the parents are forced to cut the deficit by fear of not being able to borrow coupons in future except at very high rates, which the children would have to pay through higher taxes. Which could result in default and economic collapse.

If you have followed my explanation of how things actually work you will see this is a plainly ridiculous falsehood. Since the parents (governments and central banks) create coupons (money) they can never run out of it. They have no need to borrow it but if they do, to comply with self-imposed accounting rules, they can keep the interest rate at whatever level they want. Deficit spending provides the children with more coupons which accommodates increase economic activity and enables them to accumulate savings. It is particularly needed if children are trying to reduce excessive debt levels. This is because as they pay their debts this eliminates bank-created coupons from the economy. Exactly the same common sense applies to the real economy.

Whatever merit there were was maintaining the myth of the need for governments to finance their spending and 'balance their budget', I think experience over the past 5 years has demonstrated that this approach is neither prudent nor sustainable. It was was indirectly responsible for excessive credit creation because it forced central banks to make borrowing money ever cheaper as they had no other means of stimulating growth. It also required ever looser financial controls on borrowing to accommodate ever higher debt levels. The end result was an asset price bubble and a relentless, unsustainable growth in private sector debt relative to income, until the bubble burst in 2007.

Unfortunately entire generations of our leaders and the public at large have been so heavily brainwashed for so long that they do not understand how our monetary system really operates, don't really understand why there was a financial crisis, and have no clue as to how to restore economic growth. This will be one of those example of where thinking changes with funerals as the old guard simply cannot change their world view.

Government 'debt' represents private sector savings

The UK government has a savings organisation called National Savings & Investments (NS&I) which is popular because it is the only place where savings of large amounts are 100% secure. This is explicitly stated on their website:

"Your money is safe with NS&I. We’re backed by HM Treasury, so all the money you invest is 100% secure. Always."

Note that this is the same Treasury that sells government bonds. It follows that government bonds must also be 100% secure. Those who imply that there is any risk of default by the government if it 'borrows' too much money by selling bonds are either wrong or the NS&I are lying.

In recent years when the NS&I has announced that it is issuing savings certificates (i.e. takes deposits) demand for them has been huge and they and they have been 'sold-out' within a few weeks. This reflects the huge demand there is at the moment for a secure place to deposit savings. It also explains why the Treasury has no problems selling government bonds even though interest rates earned for buyers is at record low levels. Having seen runs on a bank (Northern Rock) and realizing that bank deposits are only insured up to a certain level (currently £85,000), sensible people prefer to deposit their money in government-backed institutions. This is a reminder that government debt represents very safe savings accounts for the private sector.

While there is disagreement about the significance and risks of current level of government debt, I think most people now accept that private sector debt is too high. It exceeds 300% of GDP in the UK, which is far higher than it has ever been. It follows that it is necessary for this debt to be reduced, by saving.

It is an cast-iron accounting fact that when the private (or non-government) sector as a whole is trying to save money (accumulate net financial assets) the only possible source of these savings is the government sector. There is nowhere else for net financial assets to come from. To meet this desire and need to save the government sector (which includes the central bank) must introduce more money into the economy. That means that either the government must run a deficit by cutting taxes and/or increasing spending, or the central bank must issue debt-free money directly into the economy. Given the instinctive opposition that there is to government deficit spending, and the many self-imposed rules designed to restrict it, many knowledgable central bankers are beginning to consider the latter option. They could do this by crediting every citizen with a certain amount of money. This is also known as 'helicopter money' using a colourful phrase coined by Ben Bernanke.

This way of introducing money into the economy is very different from quantitative easing. With quantitative easing the central bank creates money and uses it to purchase an asset, such as government bonds or mortgages. The private sector receives the money but hands over an asset of the same financial value (the bonds or mortgages) to the government in return. There is no change in the net financial position of the private sector. With 'helicopter money' the central bank creates the money and GIVES it to the private sector, without receiving any asset in return. As a result private sector has increased its net financial assets (and reduced is overall debt levels).

Just as government debt just represents private sector savings, deposit at NS&I represent government debt owed to the depositors, and savings deposits at banks represent bank debt owed to depositors.

Euro fallacies

Many in the Eurozone are deeply frustrated that their diligent and rigorous attempts to cut government deficits and debt are not leading to restoration of growth and market confidence. They have taken to lashing out at the markets for being unfair and irrational. It is they that are being irrational. They hold two beliefs very dear to their hearts which dominate their thinking. First, that governments must aim to balance their budgets and keep debts low. Second, that it is the failure to do so that is the primary cause of the problems in Greece, Italy and Spain.

The first proposal is irrational because it fails to appreciate the important role that money creation by the issuer of a fiat currency plays in economic growth. Puts simply, only government deficit spending introduces debt free money into a currency zone, enabling the aggregated private sector to save. A system which does not permit deficit spending backed by the central bank creates a shortage of net financial assets. The only source of money in such an economy is commercial bank lending which is necessarily accompanied by debt creation. Any system in which private sector debt must increase to accommodate growth while net financial assets stay the same will eventually collapse.

The second argument is irrational because it should be obvious to any reasonable observer that increased government deficits were a consequence rather than a cause of the global financial crisis. Spain and Ireland are clear examples of this. Furthermore, efforts to cut these deficits and debts have made the situation worse in all the countries were it has been tried, including Greece, Spain, Italy, Ireland, and Portugal. How can one explain this if the deficits were the cause of the problem?

These deeply irrational ideas are based on economic thinking which has been thoroughly discredited several times in history, most notably during and after the Great Depression. They were resurrected after stagflation in the 1970's when poor analysis blamed the combination of inflation and high unemployment on excessive government spending. In fact they were the inevitable result of the huge increases in energy prices of up to 20 fold.

Here is a thought experiment. Imagine what an increase in oil prices to $1500 would do today. It would induce a combination of inflation and recession, which would continue until other prices had increased relative to energy prices, at which stage inflation would stop and growth would recover. That is exactly what happened in the 1980s.

Unfortunately monetarism and neoclassical economics wrongly took the credit for the recovery from stagflation and saw their influence restored, despite being thoroughly discredited by history. Control of the money supply was returned to commercial banks. This set the scene for the slow expansion of the giant credit bubble, it's bursting that resulted in the global financial crisis, and the Eurocrisis.

Hopefully these events will kill off these bad economic ideas forever. This may require a new generation of economists and politicians not subjected to brainwashing by neoclassical dogma. Change may require many funerals.

A Family Analogy (part 2)

This is a continuation of my attempt to explain the monetary system by describing how a (somewhat unusual) family would operate if it was similar to a country, with its parents issuing their own currency. To recap, the parents buy services from the children by issuing coupons which they can, in principle, create in any amount, and require tax to be paid in the same coupons, both to create demand for the coupons and to prevent too many coupons circulating amongst the children, which could cause inflation. The coupons are used by the children to trade amongst each other, enabling them to specialise in what they do best and/or enjoy most. The availability of coupons would limit the overall amount of trade possible, particularly if some of the children choose to save coupons instead of spending them immediately.

In this post I am going to explain how the banking system fits into the monetary system.

IF THE PARENTS BALANCE THEIR BUDGET ECONOMIC GROWTH IS RESTRICTED BECAUSE THERE IS INSUFFICIENT MONEY
Imagine the parents (the government) introduced a principle that they would always remove through taxes the same amount of coupons as they create through spending - i.e. they would 'balance their budget'. There is no fundamental need for this but it is nevertheless a widespread belief that this is a 'good thing'. Because this fixes the number of coupons in circulation it places a restriction on the amount of trade possible amongst the children. Much of the time they will be unable to buy from each other because they lack money. This situation is further aggravated by the fact that some children will choose to save their money rather that spend it, thus further reducing the money supply. Thus a shortage of money can prevent economic activity and reduce overall well-being.

BANKING HELPS TO MAINTAIN ECONOMIC ACTIVITY BY ENABLING SAVINGS TO BE BORROWED
At some stage one child, who has accumulated coupons through saving, has the idea of lending these to other children at interest. After a while he runs out of coupons and so starts to borrow surplus coupons from other children by offering to pay them interest. As long as this interest is lower than the interest he charges borrowers he can make a profit. The child is acting as a bank of sorts by intermediating between savers and borrowers.  While this helps because coupons that had been hoarded are now being spent, economic activity is still artificially limited by the total number of coupons in circulation. As long as the parents 'balance their budget' economic growth is restricted by a shortage of coupons.

CREDIT CREATION BY BANKS ENABLES THE MONEY SUPPLY TO GROW
To make transactions more convenient the child acting as the bank develops a computer spreadsheet where he keeps track of all the deposits he has taken and all the loans he has made. He offers a service whereby instead of borrowers coming to him to get the coupons to spend, them spending them to purchase from sellers, and the sellers coming to the bank to deposit the coupons, he allows electronic transaction via his website, much like we spend and receive money today through electronic payments. When there is a transaction he just moves money around on his spreadsheet. This is far more convenient than dealing with physical coupons.

A major advantage of this new system, apart from convenience, is that the bank no longer needs actual coupons to lend money. This can be done by just marking up the balance of the borrower's account on their spreadsheet (and keeping a record of the loan). This means the bank can greatly increase the amount it lends and therefore increase its interest income. Since loans create deposits which can be spent by the borrowers this greatly increases the amount of money available for transactions, provided that they are all electronic. This is essentially how banks create most of our money supply.

CENTRAL BANKS PROVIDE THE CASH NEEDED BY BANKS AND MEDIATE PAYMENTS BETWEEN BANKS
Once this system is in place and most financial transactions are electronic it makes sense for the parents to issue coupons electronically. To do this the parents create a spreadsheet with an account for the bank. This is the bank's 'reserve account'. Now when parents spend by, for example, paying one of the children for washing the dishes, they mark up the child's bank's reserve account on their spreadsheet by the payment amount, and that bank then marks up the child's account on its own spreadsheet by the same amount. No coupons need to be issue. What if the child wanted some physical coupons? The parents provides the bank with coupons as and when children need it. When the coupons are issued to the bank the parents debit the bank's reserve account by the number of coupons issued. The parents are now acting as central bank. Only central banks issue coupons and create reserves. Reserves are money on their spreadsheet, which are interchangeable with coupons.

One of the other children, seeing the success of the bank, starts up a second bank. They also need to have an account on the parent's spreadsheet (a reserve account) to receive electronic payments. When a child A who keeps it money at bank A makes a payment to a child B with an account at the bank B the parents can settle the payment by transferring amounts between these banks' reserve accounts on its spreadsheet. They debit bank A's account and credit bank B's account. The parents, like a central bank, now settle payments between different banks by transfers between their reserve account. Now you understand what central bank reserves are and how the payments system works.


BANK LENDING BY CREDIT CREATION EXPANDS THE MONEY SUPPLY AND DEBT AT THE SAME TIME
Since bank loans create electronic money the supply of money increases with the amount of lending. This provides a mechanism for the amount of money available to children to increase independently of the amount of coupons introduced into the economy by the parents. Even if the parents introduce NO new coupons the economy can grow the money supply and thus economic activity can increase. The key difference is that money created by bank lending is always accompanied by an equal debt. Because interest has to be paid on this debt there is a limit as to how high this debt can go relative to the level of economic activity. If it is too high the debt will be too expensive to service. This is analogous to  limiting the size of one's mortgage relative to one's salary.

EXCESSIVE CREDIT CREATION BY BANKS CAUSED THE GLOBAL FINANCIAL CRISIS
We are now in the position to understand the causes of the current financial crisis, and the possible solution. It is very tempting for the child acting as bank to increase the amount of loans it makes as that increases its revenue (interest payments). Its main consideration when making the loans is whether the borrower will be able to meet the interest payments and pay the capital back. To reduce the risk they would usually only lend large amounts if the loan was backed ('secured') by an asset such as a house, which could be repossessed if repayments were not made. When asset prices go up banks are more willing to make loans to purchase them as they are confident they will get their money back. The problem is that this increases the amount of money available to purchase assets causing prices to go up further. This is a self-perpetuating cycle called an asset price bubble which all credit-based banking systems are prone to. As the bubble inflates the amount of debt increases along with the amount of bank money and asset prices. In the decade preceding 2007 bank-created money and private sector debt increase far more rapidly (~10% pa) that the rate of economic growth (~3% pa). Private sector debt approached 450% of GDP, far higher than ever before in history. Clearly this cannot continue forever and, as always happens eventually with such bubbles, it burst when asset prices stopped increasing and started to fall. When this happens the debt starts to be repaid more quickly than new loans are extended. Since repayment eliminates both the money and the debt the money supply contract, causing a decrease in the overall level of economic activity. This decrease in economic activity causes more distress as those with loans have difficulty paying the interest on them as their incomes drop or they lose their jobs. The banker is now much less likely to lend money because asset prices and economic activity is dropping.

During this process the spending by the parents may have been maintained but their tax revenues, if they are based on sales and income taxes, will decrease along with sales and income. The budget is therefore no longer balanced - there is now a 'deficit'. It is important to note that this increase in the 'deficit' is the inevitable result of economic contraction and has NOTHING to do with 'loose spending' by the parents.

Economic activity is low because the children are trying to repay their debts and the banks are reluctant to lend, causing the money supply to shrink. As a result many of the children are inactive and getting hungry.

DEFICIT SPENDING IS NEEDED TO INCREASE DEMAND AND ENABLE THE NON-GOVERNMENT SECTOR TO REDUCE ITS DEBTS
How do we resolve the problem? If you have understood the above you will realise that origin of the problem is in excessive credit creation by the banks and that the obvious solution is for the parents to increase their spending into the economy and/or reduce taxation rates so that more money enters the economy, demand increases, and those that are un- or under-employed can get back to work. Of course this will further increase the 'deficit' and the 'government debt' but this is irrelevant since the deficit is simply a measure of net spending and the debt just represents the net financial assets of the children as a result of deficit spending. Once the economy is recovering and functioning at full capacity the amount of spending can be reduced and/or the level of taxation increase to prevent demand exceeding supply, which could cause inflation.

Instead what is being advocated is policies to increase bank lending/private borrowing while parents/government cut their spending and increase taxes in an attempt to reduce the deficit and stop the 'government debt' increasing. If you have followed my explanation so far it should be obvious that this approach, cutting spending and/or increasing taxation to reduce the 'deficit', will only make things worse. It is precisely the wrong thing to do. Indeed, as expected, wherever this austerity based approach has been tried it has made things much worse.

What is amazing is that despite this evidence so many people, many highly educated, still cling to the belief that the primary problem is the government deficit and debt, and that tackling that is urgently needed. This is arguably the most tragic example of collective blindness and/or stupidity that the world has ever known. It is a problem that is remarkably easy to solve, but you have to understand the problem in the first place. Unfortunately those that do are outside the economic mainstream and have to deal with two generations of economic brainwashing.

In the next post I will explain how the parents can set up rules make it appear that they have to obtain  the coupons that they spend from the children through taxes and borrowing. Similar self-imposed and easily-changed rules are in place in all countries. This has created the confusion which supports the dangerous myth that it is important for governments to 'balance their budget' and keep their 'debt' levels low.

Lets hope for deadlock

Arguably the single most important question in the US presidential election is who is most likely to 'successfully' cut the deficit. I think Obama is because he will allow most tax cuts to expire to protect spending programmes, pushing the USA over the rightly-feared fiscal cliff. I believe Romney will maintain or even cut taxes and instead try to cut spending by cutting welfare spending. These cuts will be blocked by Democrats in the senate, who will insist instead on more cuts to defence and 'corporate welfare' spending. Compromise is unlikely and so the deficit will soar, which is exactly what is needed.

So it may be better for the US (and global) economy if Romney wins. It will be miserable for poor Americans and immigrants, and it won't be good for liberals, scientists, academics etc., but cutting the deficit will be disastrous for just about everyone as it will drag the US and the rest of the world into a deep recession with no end in site.

A Family Analogy

We tend to think about the economy as we do about our households or businesses. Commentators, politicians and even some economists do this, so it is not surprising that ordinary people do as well. Using this analogy it seems logical that governments must balance their budgets and avoid deficits and debt.

However, governments are nothing like households or businesses. One way to appreciate this is to imagine that a family is the economy and the parents are the government. Now imagine that the family run a self-sufficient farm in which their only employees are family members - who they are committed to providing for. Can you think of any circumstances in which it would make sense for some healthy and willing members of the family to not do any work at all on the farm ? Or for previously productive parts of the farm to be left idle and neglected when there are members of the family that want to work on it and they could produce something that would improve the family's well being? Of course not. Not using the family's full productive capacity to increase their well-being makes no sense. Yet we accept this in the case of our economy. Why? Because, unlike our family we have introduced money into the economy, and the misguided way that we operate our monetary system forces us to accept involuntary unemployment and underused capacity.

What is it about the way we use money that does this, and can we change it? The key problem is that we treat money as a commodity and artificially restrict its supply to maintain its value (which is the same as preventing inflation). Until 1971 this restriction was imposed by fixing the amount of money to a precious commodity which was limited, such as gold. When the gold standard was abandoned because of the damaging effects it had on economic growth and global trade most countries adopted fiat currencies with floating exchange rates. This made it possible to deal with money in a way that allowed full employment and use of all productive capacity. Unfortunately this opportunity has not yet been taken up. It has been prevented by a set of self-imposed restraints that have been adopted by almost all countries. These restraints mean that we think and act as though we are still on the gold standard with fixed exchange rates.

SPENDING CREATES MONEY, TAX ELIMINATES IT
To explain how a fiat currency system works lets return to the analogy of the family. Assume that parents decide to introduce money into the family economy which they issue as coupons. To get the coupons accepted they require their children to pay a monthly charge or tax payable only with those coupons. Because they need to pay the tax the children will work to earn coupons. Since the parents make the coupons at no cost they can employ all the children. And if they were being rational they would, since this would increase the total output of the family. It is important to appreciate that taxes are not needed to collect coupons to pay the children. Parents can create coupons at will so can pay their children even if they collect no coupons through taxes.

TAXES CREATE DEMAND FOR THE CURRENCY AND HELP CONTROL INFLATION
So why have taxes? For two reasons. Firstly because they create demand for the coupons or currency and give them value. Since taxes are compulsory and the family can enforce payment this creates a demand for the currency. Fiat currencies are backed by the state. Since the coupons have value they will be used for trade between the children. They could even employ each other. This trade will result in prices being set.

If the number of coupons increases more rapidly than the available items to be traded prices will increase - inflation. Prevention of inflation is the second reason for taxation. By removing coupons that parents have spent into the economy they restrict demand and reduce inflationary pressures.

GROWTH REQUIRES DEFICITS
Now imagine that the number of children and grandchildren increase over time and because of innovation they become more productive as well. This necessitates and increase in the number of coupons in line with an increase in the amount of economic activity. One way to do this is for parents to always spend more coupons than they remove through taxation. In other words to run a 'budget deficit'.

SAVING REQUIRES DEFICITS
Imagine that the family economy did not grow at all in terms of number or productivity. However some children decided to save some of their coupons by hoarding them under their bed. This saving is clearly only possible if the parents take back fewer coupons by taxing than they issue by spending. Thus the children, analogous to the 'non-government' sector, can only save if the parents, analogous to the 'government' sector run a budget deficit. And their net savings must equal exactly the parental 'deficit'.

'GOVERNMENT DEBT'
Now imagine that the parents decided that they would offer to look after the coupons that children had previously saved under their beds and pay interest on them as well. Since these extra 'saved' coupons arise from the 'deficit' these coupons stored by the parents are formally equivalent to the government 'debt'. Clearly it is absurd to think of this 'debt', which is just the accumulated savings of the children, as a burden on the children. It is also ridiculous to think that parents could default on this 'debt'. How could they when they can make and issue coupons at no cost? This parental (or government) 'debt' is really just a very safe savings account for the children (or non-government sector).

In this post I have tried to create an accurate analogy between economies and families to explain the role of government spending, taxation and debt in economy. The key concept is the notion that government are the sole suppliers of money and can never run out of it. It makes sense for them to use it to maximise employment and productive output, and they can do this by adjusting the deficit. Increasing it when there is unemployment and recession and decreasing it when there is inflation.

In the next post I will introduce bank lending into the analogy as this is needed to explain the origins of the current financial crisis.

QE and low interest rates depress demand

As noted in previous posts QE does little to stimulate demand because it just increases the reserves banks hold in their accounts at central banks. Central bank electronic reserves cannot and do not leave the central bank. There is a mistaken notion that increasing reserves enables commercial banks to lend more. In fact there is little correlation between reserves and bank lending. Increasing reserves has had no effect on the amount of money in the wider economy. Indeed this has decreased as reserved have increased dramatically. The only good QE does is that it props up certain asset prices and reduces some interest rates. In doing so it helps to delay insolvency and defaults.

Less well known is the fact that the reduction in interest rates induced by QE acts to reduce demand by reducing net private sector interest income. When central banks purchase securities paying high interest rates this interest income is effectively diverted from the previous owners (the private sector) to the central banks who pass this income to governments. Thus QE is effectively a tax that reduces government deficits.

Since these deficits inject demand and net financial assets into economies, enabling the private sector to reduce its debts, QE reduces demand. Not exactly helpful!

The myth of default

Paul Krugman and Larry Summers are two mainstream economists, from the neoclassical school, who are arguing strongly for governments to maintain spending and avoid tax increases rather than cut deficits. In this they are absolutely correct.

Unfortunately they are not getting much traction. The main reason for this is that their reasoning has one gigantic hole in it which makes it unconvincing. The key question is what happens when the deficit and debts gets so large that markets take fright and refuse to 'lend' to the government except at very high interest rates? People have seen what has happened in Ireland, Greece, Portugal, Italy and Spain and they worry that unless their government cuts the deficit the same think could happen in their country. Many commentators warn of the same issue. They warn that 'the bond vigilantes' will suddenly turn on spendthrift governments, demanding very high interest rates which make debts much harder to bear.

There is a simple, reassuring answer to this concern. It can't happen in countries that, unlike the Eurozone, have their own currencies, borrow in that currency, and have floating exchange rates. This includes the UK, USA, Japan etc. These countries have no real need to 'fund' their expenditure as they can create money in unlimited amounts. Anyone who says otherwise is wrong. Of course there are risks associated with excessive money creation, namely inflation and devaluation of the said currency. However there is essentially no risk of default.

Because Krugman and Summers have the conventional mistaken view that governments need to borrow to fund deficits they are unable to make the clear argument that deficit spending when there is deficient demand is absolutely without risk. Instead they make woolly, unconvincing arguments about how government spending will kick start growth which will increase tax revenues enabling government debt to be paid back. This strategy sounds pretty risky to most people, like doubling down when gambling. When things are bad people don't want to take risks. What is needed is an explanation which demonstrates that deficit spending when there is deficient demand carries no risk. It is austerity that is incredibly reckless.

Private sector debt is the problem

I find it puzzling that discussions on debt invariably focus on government debt. However a casual glance at the data shows that government debt was not particularly high before the financial crisis, except in Japan. What was very high was NON-government (i.e. private sector) debt.

Private sector debt has risen dramatically since World War II, as shown in the following data from the USA. In contrast, government debt has actually fallen.

The figures for the UK and most other developed countries are similar. Falling or stable government debt and rapidly rising private sector debt.

It is widely accepted now that the global financial crisis was the result of a bursting asset price bubble, which had been inflated by excessive credit creation by banks.

Given this analysis, what is needed is that the private sector deleverage (pay off their debt) by borrowing less and saving more.

Since the money for saving by the private sector can only come from the public sector (there is no other source of money), deleveraging REQUIRES the public sector to run a deficit i.e. spend more into the economy than they collect back through taxes.

This is what has been happening since October 2008, and is the primary reason for the large government deficits across the developed world. To repeat, these government deficits are REQUIRED in order for the private sector to pay off its excessive debts.

Unfortunately the knee-jerk response to rising public sector deficits has been to sound the alarm and advocate cuts in in spending and increases in taxes. These deficit hawks argue that deficits must be reduced or the government could find itself unable to finance its spending. What is happening in the Eurozone is cited as evidence to support this view.

There are several errors in this thinking.

The first error is the notion that governments with sovereign currencies and floating exchange rates need to raise money through taxes in order to spend it. This has not been the case since 1971 when the gold standard was abandoned. Since then governments with their own sovereign currency have had no need to finance their own spending. They spend by marking up numbers in bank accounts. Admittedly they do still give the appearance of 'financing' spending, by removing through taxes much of what they added by spending and appearing to 'balance the books'. However this is a self-imposed accounting exercise designed to restrain government spending by coupling it with taxation, which is seldom popular.

The second error is to assume that if the amount 'raised' through taxes is less than the amount spent then the difference has to be borrowed from the 'markets'. Clearly if the government spends by simply adding numbers to spreadsheets it has no fundamental need to borrow money. Once again this is a self-imposed rule designed to provide 'discipline' on governments. Government bonds are really just savings accounts for the private sector. Government debt equals private sector savings. Increases in government debt represent an increase in private sector net financial assets. When the private sector is so heavily indebted it is surely a good thing for them to accumulate savings in the form of government debt.

The final error is to assume that if the private sector don't want to purchase government bonds it will increase the costs of financing and the government could default on it debts. This is clearly absurd. How can a government with a sovereign currency with the ability to create its currency ever run out of its own money? That is like saying that a cricket scorer can run out of points, or a pocket calculator can run out of numbers. 

Events in Europe have confused many because they seem to reinforce the view that government debts can result in default. However countries in the Eurozone do not have their own sovereign currency. It is only the ECB which has the power to create debt-free money. Eurozone countries and their central banks have signed away this privilege, permanently. They are thus at the mercy of the markets. In contrast most countries still have their own currencies which they control and issue. They can never therefore be forced to default on debts in their own currency.

Helicopter money and a debt jubilee

One other way to resolve the global financial crisis that has been advocated by some economists is for central banks to create money and simply give it to people. Everyone gets exactly the same amount. This is sometimes referred to as helicopter money. Steve Keen has proposed a clever variant; recipients first have to use helicopter money to pay off any debts they have. They can only spend what is left over. He calls this a debt jubilee.

The main advantage of this approach is that it will reduce aggregate private sector debt levels very quickly without penalising creditors. It would also be thoroughly fair and democratic. The main danger is that it might, if it is overdone, result in inflation. However, provided it was done carefully and quickly stopped at the first sign of inflation this is easily avoided.

Cuts in VAT have a similar effect but there is a political difference. Tax cuts increase government deficits which scares many people into opposing them. Helicopter drops of central bank created money neatly sidestep this obstacle.

What does QE really do?

It is important to appreciate that quantitative easing is unlikely to restore growth because it does not remove the main obstacle to growth, which is excessive private sector debt.

With QE the central bank simply creates electronic money and uses it to purchase securities (a fancy word for debt) from the private sector. Does this reduce private sector debt? No it does not. All it does is change whom the debt is owed to. What central banks are doing is purchasing debt from creditors in the private sector. The creditors position is unchanged. They have simply converted one asset (a loan or security paying interest) into another (cash paying no interest). The debtor still has the debt and still has to make interest payments.

Hopefully you will appreciate from this explanation that it is inconceivable that QE would be inflationary in the sense of increasing consumer price inflation.

It can, however, give a boost to asset prices for the simple reason that it means that a whole lot of private sector agents will be seeking to invest the cash they have from the sale of interest-earning securities to the central bank into other assets such as stocks, securities, or housing. That is why stock markets and other asset markets rally after QE. It is not because QE stimulates growth.

Why have my blog posts reduced in number?

Mainly because I no longer feel frustrated by what I see and read about the global financial crisis. It was that frustration which drove me to write the blog as a way of working off steam.

Why am I no longer frustrated?

Because what I believe to be a misunderstanding of, and incorrect response to, the global financial crisis is gradually being corrected. Conventional wisdom is shifting in the right direction and more appropriate measures are being introduced.

The ECB has finally accepted a role as the lender of last resort, willing to use its power to created unlimited money to prevent a collapse of the euro. They have allowed national central banks to fund unlimited transfers of Euros into creditor countries and they have pledged unlimited support for government debt. This was unexpected as I thought Germany would veto it. Merkel has shown that she is pragmatic and sensible.

There has also been a shift in mainstream opinion. For example in a post in January I criticised Martin Wolf, the Chief Economist at the Financial Times for arguing that ways must be found to reduce private sector saving in order to allow governments to reduce their deficits. Recall that private and government sectors balances must add up to zero, so changed in the one have to be matched by the opposite changes in the other. He correctly noted that the reason for collapse in growth following the global financial crisis was that the private sector drastically reduced spending and increased saving. This resulted in a massive increase in government deficits. His mistake was the lazy assumption that such government deficits are problem and need to be reduced. This lead him to conclude that ways must be found to stop the private sector from paying off its debts. I felt that this was seriously mistaken.

In a more recent column and 5 subsequent blog posts starting with this one his analysis has evolved.  Here are parts two, three, four and five. These blogs are worth reading because of the wealth of data they include to bolster his typically clear reasoning.

In short, he accepts that:

• aggregate private sector debt rose too fast in the previous 20-30 years, primarily as a result of irresponsible credit creation by banks,
• this excessive money creation by banks inflated an asset price bubble,
• the inevitable collapse of this bubble precipitated the global financial crisis,
• the drop in growth was primarily the result of a collapse in private sector demand as the private sector switched very rapidly from net borrowing to net saving
• this change, and the bank bailouts, resulted in an explosion in government deficits and debt
• these deficits were essential preventing a Depression
• recovery continues to be slow because the private sector is still paying of these huge debts accumulated in the previous 20 years,
• this deleveraging is necessary,
• this deleveraging requires that government deficits stay high until private sector debts stabilise at lower levels.
• these deficits and the debt can be safely ignored until normal growth resumes and inflation picks up.
• Other ways of reducing excessive aggregate private sector debt, such as inducing inflation or mass default, are dangerous and replete with moral hazard. Is it fair to punish creditors such as pensioners for the sins of debtors?

This analysis is exactly in line with the views posted on this blog. However, my blog (understandably) has almost no influence. Martin Wolf, on the other hand, is highly respected and very influential. 

A German economist acknowledges their contribution to the crisis

In a post earlier this year I made the case that German efforts to suppress wage growth within Germany and achieve high net exports did severe damage to the Eurozone by essentially sucking up euros from fellow eurozone members. This is pure beggar-thy-neighbour mercentalism and in the past would have been considered an act of aggression because of the damage it does to net importers. They were left defenceless by EU rules that implicitly encouraged this behaviour by preventing any of the usual defenses against mercantilism from being deployed. When, eventually and inevitably, the surpluses became too great to be ignored it was the deficit countries that were required to do the adjusting, even though it is well known from history that this is effectively impossible without devaluation.

I received some criticism for making this point. I am pleased to see that a German economist has frankly admitted that their policy was indeed mistaken and that it is Germany that as a surplus country they should be doing most of the adjusting by increasing wages, boosting demand and recycling their surpluses.

The tragedy is that all this was known and understood 70 years ago, but the current generation of economists have become so infatuated with their beautiful but absurdly unrealistic macroeconomic models that they rewrote history and ignored reality so that they could justify continuing to use them.

The IMF see the light

It is heartening that the IMF seems to recognise the flaws in our current monetary system and is proposing radical change.

The proposal is full reserve banking, which is gathering increasing support elsewhere, as described in a previous post.

This takes away from private banks the role of creating our money supply. Instead, all money would be issued by the reserve bank and held in commercial banks' reserve bank accounts. This would eliminate, at a stroke, bank runs and the need for taxpayers to bail out banks in future. It would also massively reduce debt since money creation would no longer be accompanied by debt creation.

The only people that would 'suffer' are bankers, as they would lose their richly rewarded and much abused right to create money. They would only be able to intermediate between savers and borrowers. Banks would then actually work like the average person, and at least one nobel prize winning economist, mistakenly thinks they work.

Political discord may save the Euro

Readers of my blog will be well aware of the fact that I view the central problem afflicting the global economy at the moment as excessive private debt, which was allowed to grow to unprecedented levels before the global financial crisis because mainstream economists did not think it was a matter for concern. The collapse of this debt bubble is causing severe stress as the private sector desperately tries to repay its debts. Simple accounting dictates that the private sector as a whole cannot accumulate savings unless the public sector runs a deficit (i.e. spends more into the economy than it removes through taxes). That is why it is important for governments with over indebted private sectors, like the USA and the UK to run large public sector deficits. Unfortunately conventional wisdom suggest, completely incorrectly, that government deficit and debt, like private deficits/debt, are bad things and should be avoided. In fact in countries with their own currency government deficits and debt are simply private sector savings. I pointed out in a previous post that political discord in the the US congress has meant that it has been impossible for politicians to do what conventional wisdom dictates, which is to decrease the US deficit. As a result the deficit stays large, which is the reason that America, unlike the UK or Europe, has not entered a double-dip recession and is forging ahead, already surpassing its size before the financial crisis. Long may US politician do the right thing by acting foolishly!

Something similar is happening in Europe. The fundamental problem in the Eurozone is that the Eurozone public sector as a whole (i.e. all government collectively) cannot run a deficit because the ECB is forbidden from purchasing government securities or otherwise supporting deficit spending. In effect Eurozone governments are like other members of the private sector, currency users, and therefore cannot easily add net financial assets to the Euro by deficit spending. This makes it difficult for the aggregate private sector to save and to pay off its debts. There is therefore, in my view, a fundamental need for a radical policy change in which the ECB, like central banks elsewhere, provides the funds needed to support deficit spending, and, in doing so, add net financial assets to the Eurozone system.

Up until now this type of solution has not been in prospect. Instead most of the measures that have been proposed to 'save' the Euro have involved persuading existing savers to provide further loans to debtors. Savers are understandably reluctant to do this as they are worried that they won't get all their money back, which the Greek experience suggests is almost certainly correct. It has turned into a zero-sum game. So no agreement has been reached and these measures have stalled.

This is actually helpful because these are measures, which just redistribute aggregate private sector debt without reducing it, won't work. Furthermore, this impasse is forcing the ECB to resort to what it considers radical, last-ditch measures to save the Euro, namely providing the funds to support fiscal expansion by, for example, purchasing government securities. If they don't do this Spain and Italy will not be able to obtain funding, will default, and the Euro will collapse. The ECB has made it crystal clear in recent weeks that they won't let this happen, and it seems as though they now have the political support from all Eurozone countries, including Germany, for this. This means they will create money to buy government bonds, and thereby introduce net financial assets into the Eurozone system, supporting deficit spending and enabling the private sector to save and pay off its debts.

In short, political stalemate is leading to the correct policy. Like America, this is an example of how the failure of politicians to agree on a way of implementing a gravely mistaken policy, has resulted in the correct policy being implemented! Call it the wisdom of crowds....

Light at the end of the tunnel?

Now that the ECB have finally said they will support government deficit spending (by buying sovereign debt) and eurozone politicians, including Germany's, seem united in support of this, it seems meltdown is likely to be avoided. However, unless there is a massive fiscal stimulus of the sort seen during World War II the best outcome can hope for is a prolonged period of stagnation, as in Japan.

Demand leakages require deficit spending

In a simple economy, with no government and no foreign trade, economic activity (the GDP) can only remain at a stable level if everyone spends all their income.

Why?

Because if they don't spend all their income but instead save some then they deprive other parties of income. These other parties then have to cut down on their purchases. The original sellers will experience a reducing in sales and therefore receive less income. To be succinct: if you represent the entire economy your spending today is your income tomorrow. Cut spending and you cut your income.

Understanding this basic principle is so important that I will illustrate it with an example. Imagine that the economy consist only of two people, one producing food (the food guy) and the other drink (the drink guy). Imagine that they have 1 dollar between them, which is 'the money supply'. To start things off the drinks guy has the dollar and he uses it to purchase food from the food guy, which enable the food guy to use this dollar to purchase drink. With this income the drink guy can once again buy food. This purchasing cycle can continue indefinitely with economic activity at a stable, constant rate.

Now imagine the drinks guy decides he would like a few days off occasionally. This is only possible if he saves some of his income from selling drinks to spend on food on his days off, when he won't receive any income because he won't be selling drinks.

In order to save he decides not to spend his entire 1 dollar income on food. Instead he spends only 75 cents and saves 25 cents. But this means that the food guy only earns 75 cents so he can only buy 75 cents worth of drinks the next day. The drinks guy is disappointed that his sales (and therefore income) have dropped from $1/day to 75p/day but decides to still save 25 cents of this and spends 50 cents on drink. However the next day he finds he only sells 50 cents worth of food (because that is all the drinks guys has received in income). He realises he can't save any of this so now he spends 50 cents. Now he and the drinks guy continue trading but at only half the level - 50 cents/day. Economic activity has dropped by 50% simply because one of the parties has decided save some of his income.

This propensity of individuals and companies to save is a form of demand leakage. Another source of demand leakage is net imports - where some of our spending is diverted outside our economy. Demand leakages WILL cause economic activity to contract unless the missing demand is replaced.

Government tax policies actually promote demand leakage by making contributions to pensions tax deductible. This provides a strong incentive to make pension contributions from your income (i.e. save) instead of spending. Apart from suppressing demand these tax incentives for saving channel huge amounts of money into the financial sector.

There are three possible sources of demand to fill the gap caused by demand leakage.

1. From outside the country - increasing exports to other countries. This is easier said than done. Moreover, not every country can be a net exporter. Not until we find markets on other planets.

2. From credit expansion by bank lending. This has been the main source of demand compensating for demand leakages in the past 4 decades. It has resulting in excessive private sector debt and an asset price bubble, the collapse of which precipitated the current crisis. Now this debt has to be paid off. Clearly credit expansion can no longer be relied on to plug a demand leakage. Instead there is a powerful desire to save which is likely to last until private sector debt are at sustainable levels.

3. From the government sector. Demand leakages can be filled by deficit spending. This is when the government sector spends more into the the economy than it extract through taxes. Spending injects demand and taxation subtracts it. That is why tax cuts are a powerful economic stimulus.

Unless countries are net exporters, like Germany, deficit spending is required just to maintain economic activity at a steady state (i.e. no growth). In the absence of net exports the level of deficit spending needs to match the level of net private savings (savings - investment) just to prevent the economy from shrinking. If a country is net importer the budget deficit needs to equal net imports plus net private sector savings just to prevent a recession.

This is another illustration of how deficit spending is usually essential in an economy, since most economies have demand leakages as the private sector tries to save.

Silent ECB intervention

A curious thing has been happening in the Eurozone, first noticed by Warren Mosler. Despite massive amount of money leaving Greek and Spanish banks in the past 3-4 weeks no bank has had liquidity problems and these Government have made all their payments on time and in full. The likely explanation for this is  that the European Central Bank (ECB) is providing effectively unlimited liquidity to the national central banks, governments and commercial banks. In other words the ECB is acting as lender of last resort. What is striking is that this has been happening on the quiet. There have been no announcements. This is a huge shift in policy since it means the ECB is now injecting net financial assets into the  Eurozone. This means that the Eurozone solvency crisis described in my previous post is being countered by ECB intervention. The fact that there has been no objection to this from Germany suggest that there has been a dramatic change of view. Presumably because when they recognised that they faced two equally unacceptable options they decided to relent and allow the ECB to stretch its rules. It is interesting that they have decided to keep quiet about this policy change. Instead Merkel et al have been making the same noises about Greece sticking to its commitments and the need for fiscal integration before Eurobonds can be considered. There may be a careful political game going on where noises are being made to reassure the German public that their money is not going to be squandered through fiscal transfers, whilst the ECB is being allowed to use its money creating powers to fully support the Eurozone. AT LAST!

Provided this is allowed to continue we can all breathe a sigh of relief. Financial armageddon will be avoided.

Mosler dates this change to an intervention approximately 5 weeks ago when Trichet, the outgoing ECB head, floated the notion of ECB-backed fiscal authority.

Germany seems trapped.....but there is a way out

Germany faces an awful choice. It has done everything by the book. It's citizens work hard, accept modest wage increases, and avoid excessive debt. It's government likewise limits its borrowing. It is highly competitive and is a world-class exporter. But now everything is going pear-shaped and they can see no way out. One by one Eurozone governments are going bust, requiring bailouts or threatening to default. Germany has tried to solve the problem by agreeing to lend money to these countries provided that they implement austerity measures and 'structural reform'. But this approach has not worked. Wherever implemented it has aggravated the debt problem. Now that Spain has succumbed and required a (disguised) bailout, Italy is next, and then the game will be up, as its huge debts will take Germany down with it. Everyone is clamouring for Germany to put all its financial and economic might behind the entire Eurozone. But that would mean placing German citizen's hard one savings at risk - something that they are understandably reluctant to do. Yet if they don't help and countries default, the resulting financial contagion could destroy the Euro and the EU. Germany is deeply committed to the EU and is desperate to prevent this happening. It certainly does not want to be blamed for destroying the EU.

Looked at this way, which is the perspective of most Germans, there seems to be no way out. But there is. What is required is for Germany to understand what the real problem is. When they do the solution will be obvious.

There has been much discussion about the need for fiscal and banking union to solve the problem. In short it is argued that a monetary union such as the Eurozone can only work if the Eurozone developed a structure similar to the USA. I would argue that this is not only unrealistic, at least within a time scale needed to prevent collapse of the Eurozone, it would NOT solve the key problem which underlies the current crisis. Conversely, addressing this problem will both resolve the crisis and provide the time needed to move towards full integration.

So what is this problem? Essentially, it is that the Eurozone is becoming insolvent, if it is not so already. This process is accelerating and has reached the stage that it is irreversible unless there is massive intervention by the ECB to inject net financial assets into the banking system through support of deficit spending, something which is blocked by Eurozone rules.

The problem arose because of a serious flaw in the design of the Eurozone. Its critical feature is that it is forbidden for the ECB to act in a way that enables increases in the money supply through deficit spending. As a result the only mechanism by which the money supply can grow is through credit creation by commercial banks. This was OK during the boom years because banks created money (too) freely, supported by (and resulting in) asset price inflation in several Eurozone countries. As noted in previous posts, the problem with growth fuelled by commercial bank lending is that it is accompanied by ever-increasing debt since all new money is matched by an equal amount of associated debt. Under this system economic growth across the Eurozone REQUIRES increasing private sector debt

The rules meant that, even with economic growth, it is impossible for the Eurozone as a whole to accumulate net financial assets. Some within the Eurozone can accumulate net assets but only if others become more indebted. Individual and businesses can accumulate profits but only if others borrow more to provide the source of these profits. Similarly countries that are net exporters within the Eurozone can stay in the black, but only at the expense of the net importer countries.

Another way of describing credit creation is that banks create money and equal amounts of debt. The money accumulates in the net exporter countries while the importers retain the debt. Such a system cannot continue for ever. Eventually the debts will become too great. And this has come to pass.

So what is to be done? The core of the problem is that a system which relies exclusively on commercial bank lending is vulnerable to financial collapse. As soon as growth stall and and confidence drops people stop borrowing and start saving and paying down their debts. This cause a drop in the money supply and demand and asset prices (which back up much of the debt). This leads to a recession which leads to further drops in confidence and reductions in spending and asset prices. A downward spiral continues until there is complete collapse. Even if those with the money step in to stand behind the debts of the indebted the problem is not solved. The entire system becomes insolvent.

It is critical to understand that what is happening is contraction of the money supply. Bank-created loans are paid paid off the money is eliminated. Economic activity, which depends on money, is thereby reduced. The only way to break this downward spiral is to introduce counter this contraction by introducing net financial assets into the economy through increases in government spending and/or decreases in taxes. In other words government must spend more into the economy than they extract through taxes - the essence of deficit spending. This must be supported by the ECB either through provision of debt free money to government's, or through them purchasing government bonds.

This will restore demand and thus growth and reduce unemployment. Most importantly, it will finally allow the aggregate private sector to save and pay off its huge debts. Everyone will be better off and the Euro would be saved.

Germany will see the drawback of this approach as being two fold. First the risk of inflation if money creation is excessive. Second, the moral hazard of providing both profligate governments with 'free money'. Regarding inflation I would argue that the risk is minimal and it would not be difficult to reduce any inflation by simply reversing the policy and tightening monetary policy. Regarding moral hazard I would argue that the approach that should be used is for the ECB to provide debt free money to Eurozone countries on a per capita basis. That would mean that everyone benefits to the same extent.

Importantly this will enable Germans to keep their hard earned savings while preserving the EU.

I believe that Germans (and other Eurozone citizens) would embrace this solution if it was offered to them. The tragedy is that it is not even being offered to them. ECB-supported deficit spending is not even on the agenda. That reflects the dreadful state of macroeconomic theory, for which academic economist are largely to blame.

Guardian letter

The Guardian printed a letter today that I wrote in response to Larry Elliot's comment yesterday. It is disappointing that the chief economics editor of a liberal newspaper is spouting the nonsense that the underlying problem is international current account imbalances and that the solution is improving competitiveness in importer countries to enable them to become net exporters. Firstly, it is impossible for all countries to become net exporters unless we discover another planet with willing importers. Trying to do so will lead to trade competition between countries in which some countries can only benefit at the expense of others. It becomes a zero sum game which increases conflict and reduces cooperation. Secondly, it misses the real problem which is excessive private sector debt. This was the inevitable consequence of us relying for the past 40+ years on increases in commercial bank lending to provide our money supply and gradually removing all control on credit creation. That resulted, as it always will, in asset price bubbles which always burst, eventually. This is exactly what caused the Great Depression. The solution to this problem is crystal clear. The private sector must be allowed to reduce its debts. Instead what policymakers are trying desperately to do is get them to renew their borrowing spree. This is utterly ridiculous and cannot succeed. The private sector are not idiots. The ONLY way for the aggregate private sector to save is for the public sector to spend more into the economy than it takes back out through taxes. That is a straightforward accounting reality as the private sector and public sector balances MUST add up to zero. In other words we NEED deficit spending. This is what allowed robust recovery following the Great Depression. Provided this is supported by central banks this can continue indefinitely. There is no risk of default. The only limiting factor is inflation but this is readily controlled by reducing the deficit or switching to a surplus and/or increasing the base interest rate.

How do banks create money?

One of the root causes of the global financial crisis is that mainstream economists do not understand how banks work. Like most people they believe that banks act as convenient financial intermediaries, receiving deposits from savers and lending this money onto others. While this seems intuitively sensible it is wrong. When banks extend credit they simply increase the borrowers current account balance by the loan amount. They do not "get" this money from anywhere. It is literally created out of thin air. Instead of deposits being required for loans, loans actually create bank deposits.

This can be a difficult concept to grasp so here is an analogy to help explain it. Imagine that the landlord at your local pub allows you to buy drinks and food on credit, i.e. run up a tab. Now imagine that he extends credit to you before you spend it. To do this he tells you that you have £10 to spend in his pub which you have to repay at a future date. This is equivalent to having £10 in your 'account' with him. Imagine that he allows you to use this credit to pay £5 to another of his customers, who also has a tab or 'account'. To make the payment the landlord decreases your 'account' by £5 and increase the other customer's 'account' by the same amount. Of course the £10 loan has to be paid eventually but meanwhile you are able to use the credit that this loan created as money. The landlord is now acting like a bank. Indeed, anyone can make these types of arrangements and so act as a bank of sort. All that is needed is a reliable and mutually acceptable way of keeping track of these debt obligations or IOUs, which usually achieved by recording them in writing. There is evidence that these obligations or IOUs were the first form of money and recording them was one of the first uses of writing.

The main difference between all of us and a bank is that the £10 of credit that banks create when making a loan can be spent almost anywhere and converted into cash, whereas the £10 credit that the landlord extends to you can only be spent in the pub or transferred to another person to spend in the same pub. Why is bank money accepted everywhere? The short answer is possession of a banking license. The long answer requires an explanation of the payment clearing system that only licensed banks can use. If you spend money loaned to you and thus created by a bank the money is transferred through this payment system. All licensed banks have accounts at the central bank called reserve accounts. Payments between parties are settled by transfers between these reserve accounts. For example, if I use my debit card to pay for a meal at a restaurant the money is transferred as follows. My bank reduces my current account balance by the amount of the payment. It simultaneously transfers the same amount from its account at the reserve bank to the restaurant's bank's reserve bank account. The restaurant's bank then increases the amount in the restaurant's bank account, less any charges.

Instead of making a transfer between reserve bank accounts for every individual payment the Bank of England keeps a record of all gross transactions between all banks over a 24 hr period and only transfers the net amounts. Transfer between any two banks will occur in both directions and will mostly cancel each other out. It is only necessary to transfer the difference between these amounts - the net amount - between the two bank reserve accounts, which will be a tiny fraction of the gross transactions.

Central banks can create reserves in unlimited amounts and so can and will always ensure that interbank payments will clear. They will also convert bank reserves into cash. This enables customers to convert the money created by banks into cash.

In summary, the central bank provides a clearance system which ensures that bank money can be used to make any payment and convertible into cash.

So when banks make a loan to you they create spendable money out of nothing. In return you acquire a debt of the same value, which you have to pay interest on.

Almost all new money is created this way. At the moment 97% of the money supply in the UK is this kind of bank money. As a result, increases in the supply of money are accompanied by equivalent increases in the amount of debt, on which interest is paid. In effect, we rent our money supply from commercial banks.

Importantly, banks have few constraints on how much new money they can create by extending loans. The main factor that determines whether they extend a loan is whether the person that they are lending the money to can pay back them back and meet the interest payments. That is why they prefer to make loans towards the purchase of an asset such as a house, which can be held as security in case the borrower defaults. Even this limit can be removed if banks can sell the loan onto someone else. This is known as debt securitisation.

Most economists unfamiliar with the intricate details of the payments system think that central banks control the amount of bank lending by, for example, changing the amount of reserves held by banks and/or by requiring banks to holding a minimum amount of reserves that is a certain fraction of their deposits. The reality is that most central banks either do not have this requirement (eg Canada) or allow commercial banks to increase their reserves after they have created the new deposits, by borrowing either from other banks who have surplus reserves or from the central bank itself. Banks create money first and acquire the necessary reserves later, and these reserves are always available. At worst they have to be borrowed from the central bank at the base rate set by central banks.

There is another constraint on lending which is called the Capital Adequacy Ratio (CAR). This is a requirement for the banks to ensure that their assets (e.g. loans) exceed their liabilities (e.g. bank deposits) by a certain minimum margin. However, the CAR does not act as a restraint as long as banks make a profit. If the CAR is 5% then retained profits of £5 billion enable a bank to make £95 billion of new loans.

In conclusion, commercial banks create almost all new money, through credit creation. We rent our money supply from banks. This explains why economic growth has been been accompanied by huge, unsustainable increases in private sector debt and asset price bubbles, why the global financial crisis was inevitable, why the recovery has been so weak, and what needs to be done to restore growth and reduce private sector debt. The failure of mainstream economists to understand the role of banks explains their failure to predict the GFC, and their inability to come up with effective solutions.