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.