The supercooperators

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

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

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

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

The good guys are winning

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

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

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

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

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

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

Creating money

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

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

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

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

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

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

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

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

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

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

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

A revealing comment

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

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

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

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

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

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

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

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

Who should be tightening their belts - banks.

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

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

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

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

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

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

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

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

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

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

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

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

The student debt bubble

As noted in previous posts growth for the past 40 years has relied on the private sector taking on debt in ever larger amount. This reached record levels before the global financial crisis, and attempts to pay down this debt are responsible for the protracted recession. That is why central banks are desperately trying to convince the private sector to start borrowing again.

While this has not succeeded, there is one group that have increased their borrowing rapidly since the global financial crisis, and that is students. In both the USA and the UK student debt is surging fast. In the USA and the UK this was a result of a rapid increase in University fees and government underwriting of loans to pay for them.

Students are building up debts that they can never repay. Like all bubbles this will end in tears. Already there are signs that this new credit bubble is about to burst in the USA.

Public debt is no more of a burden on your children than a large bank balance.

Those worried about government debt often claim that it is an unfair burden on future generations who will have to pay it back. This is completely wrong. Government debt is a liability to the private sector. It is a claim against government by the private sector. That means it is a private sector ASSET. This is similar to bank deposits. These are a liability of the bank to us, the depositors. It would be accurate to call customer deposits in banks bank debt in the same way that we call government liabilities to us government debt. Similarly, just as we consider this 'bank debt', i.e. the deposits that we have in the bank, to be our assets that we can pass on to our children, government debt represents private sector assets that we can spend in future. Clearly it makes no sense to call this a burden on our children.

The main difference between private sector deposits in banks (bank debt) and government debt (private sector deposits held by the government) is that government debt it far more secure since a government cannot go bankrupt.

Some may argue that government debt eventually has to be repaid and that will require higher taxes in future, which will be a burden on future generations. However there is no reason why a government should ever have to pay back all its debts. Individual debts have to be paid when they come due but total debt need never be reduced. This is similar to banks who have to pay out customers all the time but don't have to reduce the overall level of deposits they hold. These can increase indefinitely.

The only reason that taxes need to go up or government spending needs to drop is to reduce demand if the economy is overheating and inflation is picking up. It is hardly a burden to have to cope with such rapid growth that these measures become necessary. What is absurd is to cut spending and increase taxes when there is no growth and there is unemployment and excess capacity. It just damages the economy further, as has been demonstrated so clearly in Eurozone countries and the UK.

Why are central bankers suggesting negative interest rates?

The central bank is trying to stimulate the economy by encouraging banks to lend money and people and businesses to borrow money. Lowering the base interest rate almost to zero has not worked. Quantitative easing has not worked despite increasing dramatically the amount of money commercial bank have in their reserve accounts at the central bank.

So, in desperation, some have suggested that they try negative interest rate. By this they mean that banks would have to pay interest on the money they keep in their reserve accounts at the Bank of England.

The rational given for this is that it will encourage banks to lend these reserves instead of 'hoarding' them. This reveals a misunderstanding of reserve banking. Bank cannot easily lend this money, except to each other, as reserves can only move between reserve accounts, and only banks and the government have reserve accounts. The only way that reserves can actually leave the bank of England is after conversion into notes and coins. This is unlikely to be much of a stimulus given that they notes and coins form such a small proportion of the money supply. Banks would probably choose just to hang onto the notes in any case since at least they don't pay interest on them. It would be good times for potential bank robbers as mountains of cash accumulated in bank vaults.

Another way that banks can get rid of reserved and so avoid negative interest rates is to buy assets from the government/central bank which is pays with using reserves. This is like reverse quantitative easing so would presumably be resisted by central banks. It does however suggest a mechanism of reversing quantitative easing which could be useful in future.

Rather than increasing demand, what negative interest rate would do is act as another tax, further reducing demand. I have already pointed out that quantitative easing, where the central bank buys interest bearing securities from the private sector, is effectively tax because it diverts interest income from the private sector (who previously own the securities) to the government/central bank, the new owners of the securities. A negative interest rate on reserves has the same effect since (private) banks would be paying interest to the central bank which then remits it to the government, as it does all its profits. Not so clever.

Reality (2): the nature of money

In this post I continue to discuss elements of macroeconomics that are beyond dispute. One of these is our monetary system. While this is complicated it was designed by humans so should be readily understood. What is remarkable is that not only do very few ordinary people understand the monetary system, most of those working in or writing about the financial sector do not appear to fully understand it. This is a consequence of the highly misleading fact way that it is taught at University and described by economists.

The first important fact to appreciate is that most of the electronic money that is used by the private sector is created by private banks, NOT by the central bank or government. This money, which experts call bank money, is created when a bank makes a loan. When it does this it adds a number to your bank account using a computer. At the same time it gets you to sign a contract requiring you to pay that money back by some future date. When this loan is paid back the money disappears. This is analogous to how matter is created out of nothing but has a counterpart anti-matter. When the two come together nothing remains.

Central banks also create electronic money but this money, called bank reserves, is present at far lower amounts than commercial bank money. The relationship between central bank reserves and bank money is not well understood. Central bank reserves never actually leave the central bank account system. Instead they move between those who have accounts at the central bank, namely the government and licensed banks. Their primary role is to settle payments between private banks, and between the government and private banks.

When customers with accounts at the same bank exchange money all that happens is their accounts recording their bank money go up and down accordingly. No central bank reserves are involved. However when customers with accounts at different banks exchange money then the banks transfer central bank reserves between their respective accounts at the central bank to effect these payments. In essence banks have reserves to enable them to settle payments between their respective customers. They also use reserves when they issue notes and coins to customers. When they obtain cash from the central bank their reserve account is marked down by that amount, and vica versa.

Only central banks can create bank reserves, and they can do this unlimited amounts. The amount of money in reserve accounts bears little relationship to the amount of spendable money in the economy. Some central banks require banks to hold a minimum amount of reserves, equivalent for example to 10% of the value of bank deposits that they hold. Students are usually taught that this requirement enables the central bank to indirectly control the total amount of money in the economy just by changing the amount of reserves. This is wrong. In practice central banks always lend banks whatever reserves they need to meet these reserve requirements (if they exist) or to make payments between each other. They do this because failure to do so would cause the payment system and hence the economy to collapse. What central banks do try to control is the interest that banks have to pay to borrow more reserves. When a bank makes a loan of BANK money it is possible that, if that money is transferred to a customer at another bank it will need to borrow reserves to settle the transaction. Therefore the interest rate that banks set for that loan will be influenced by and always be higher than the interest rate that it would have to pay to borrow reserves.

The fact that almost all the money that is spent in the economy is bank money created by banks out of nothing when they make loans has important implications.

1. We effectively rent most of our money from private banks.
2. The amount of money circulating in the economy is determined by the balance between the rate that banks make new loans and the rate that old loans are repaid. If people take out fewer loans or increase the rate at which they repay existing loans then the money supply shrinks which reduces economic activity. This is why the government has been trying so hard to persuade people to take out more loans.
3. Increasing the amount of central bank reserves does increase the amount of money in the economy but changes in bank lending have much bigger effect on the amount of money. Since 2008 central banks have been increasing reserves by huge amounts but this has barely compensated for the reduction in the amount of bank money as people stop taking out new loans and continue to pay back existing ones.
4. As the economy grows the level of private debt grows since all bank money created to support growth has a corresponding debt. In fact in the past 40 years the level of private debt has grown much faster than the growth in economies. It should be obvious that it is not sustainable for private sector debt to grow faster than the economy as measured by GDP because the interest costs of this debt are paid for out of total income or GDP. Nevertheless policymakers allowed this to happen, and only a tiny handful of economists pointed out the fact that this would end in tears. By 2007 this debt level reached over 300% of GDP before, as predicted by economists outside the mainstream, the credit bubble collapsed.
5. Growth collapsed largely because the private sector switched from increasing their borrowing year by year, which they had done for up to 40 years non-stop, to paying down their debts. Unfortunately because of the fact that most money is created through bank lending, this resulted in a decrease in the money supply and has suppressed economic growth. That is why government are desperately trying to reverse this and encourage borrowing.
6. Given this scenario described above, and the fact that private sector debt levels are still so high, it seems foolish to try to restore growth by encouraging the private sector to once again increase its debt levels, especially when economies are shrinking because of cuts in government spending.

The problem of net exporters

One of the main sources of imbalances in the world economy are the countries who aggressively pursue a policy of becoming and remaining net exporters. These include countries such as Germany and China.

With floating exchange rates net exporting will eventually lead to an appreciation in the exchange rate, which by changing relative costs of exports and imports will reduce the surplus. Sometimes countries determined to remain net exporters try to prevent exchange rate appreciation by keeping the money that they received in payment for their goods in the importing countries. That is a self-defeating policy since it means that people in exporting countries are working hard to producing goods, sending them off to other countries, and receiving no real benefit in return other than a financial claim. All they have is some money in the importing country, but what use is that? It would make more sense for them to get something in return from those countries, such as imports of goods. In modern fiat currency systems exports are only of any real benefit if the proceeds are use to purchase imports. Countries that are net exporters are working hard and exporting the benefits.

If net exports are a cost, why do so many countries pursue net export policies? The short answer is the IMF. This organisation was set up to help countries that were temporarily short of the foreign currency reserves they need to purchase essential imports or pay back loans. When countries have run into problem in the past the IMF has lent them money under very strict conditions, which include a requirement that government sacrifice control over the budgets and impose austerity on their economies. Bitter experience of the hardship and humiliation that this resulted in has meant that many countries are determined to avoid ever having to seek help from the IMF ever again by building up large foreign exchange reserves. This is best achieved by being a net exporter and not repatriating earning from imports, building up large foreign currency reserves.

Other countries like to be net exporters because they believe it is prudent for both the private sector and the government sector to be in surplus, and this is only possible if they are net exporters. Germany is good example of this. Germany works very hard at maintaining its net exports by suppressing wage increase amongst its workers which keeps imports down by suppressing domestic consumption. Ironically it is the German people that stand to lose the most from this policy of aggressive net exporting since they are effectively creating things that other countries are using in return for a financial claim which will become worth less or even worthless as their currency appreciates or the importers default on these debt. Not so clever.

Reality (1): Money has to come from somewhere and go somewhere

There is much that is debatable in macroeconomics but some facts are beyond dispute. One such fact is that the flows of money between three different sectors of any economy with a given currency have to add up to zero. Understanding this and its implications is incredibly important.

These sectors are the domestic government sector, the domestic private sector, and the external sector or 'rest of the world'. The reason that the balance of these sectors must add up to zero is simply that there is nowhere else for the money to go. If any one sector has a surplus then at least one of the two sectors must have a deficit.

We often hear references to the balances of two of these sectors, namely the government sector and the external sector. When people discuss the government deficit or surplus they are referring to the difference between the amount of money flowing out of the public sector (through spending) and the amount flowing in (through tax revenue). Government debt is just the sum of the accumulated past annual deficits (minuses surpluses).

When people discuss current account deficit or surplus with the external sector they are referring to the difference between the money received from exports or remittances and money spent on purchasing imports. Saying there is a current account deficit is equivalent to saying that the external sector has a surplus.

What is seldom, if ever, explicitly discussed is the financial balance of the third sector, which is the domestic private sector, comprising individuals, households, and companies. This can obviously also have a surplus or deficit.

As noted a key fact is that financial flows between the three sectors will always balance each other.

What this means is that if a country is a net importer (i.e. the external sector has a surplus) then at least one of the other two sectors must run a deficit. Either the government must have a budget deficit or the private sector has to run a deficit.

Since it is widely felt that it is bad for the government to run a deficit and accumulate debts, when there is a government deficit policymakers frantically try to reduce it by increasing taxes or cutting government spending. The problem with this is that, because of the sectors must balance, this forces the private sector to run a deficit.

This is potentially dangerous. It is not sustainable for the private sector to run deficits as it will eventually lead to insolvency and financial collapse.

This contrasts with government deficits, which are sustainable indefinitely in modern economies since the state issues its own currency and, unlike the private sector, can never run out of it. That is the defining feature of modern fiat currency systems. Indeed it seems logical that if the government creates money then it needs to run a deficit as this is the only way for the private sector as a whole to accumulate money (i.e. save).

Unfortunately there is widespread belief that public sector deficits are not sustainable and have to be eliminated. That is simply not the case. Indeed most governments run deficits most years. Surpluses are rare. On the rare occasions when the US government has tried to run surpluses for several years they have always precipitated financial collapse of the private sector and depressions. It is repeated public sector SURPLUSES that are not sustainable, as this forces the private sector to run repeated deficits.

The only way that they government sector can avoid deficits and the private sector simultaneously run surpluses is for the country to be a net exporter. In other words for the government and the private sector to have surpluses the external sector has to run a large deficit. The problem with that approach is that not all countries can be net exporters. Globally exports and imports have to balance to zero as, until we connect with alien life, there is nowhere else for exports to go! So if some countries are net exporters that forces other countries to be net importers. Because many countries (e.g. China, Germany, Koreas, and until recently Japan) actually have policies committing themselves to being net exporters this forces other countries to be net importers. Most large developed countries (Germany excepted) are net importers. It follows that in these countries, which include the USA and the UK, it is necessary essay for governments to run deficits to match the external sector surplus. If they don't they will be forcing their domestic private sector into deficit.

In summary, the requirement for money flows between sectors to balance means that in countries that are net importers governments need to run deficits in order to ensure that the domestic private sector does not become insolvent.

The student loan scam

The government has pulled of a huge scam which screws the young in order to to ensure that their own generation does not have to face higher taxes or cuts in benefits.

The scam works as follows. The government lends money to students to pay their fees and maintenance and then collects payment in the form of increased taxes. Because repayment is only required when earnings rise above a threshold level, and the outstanding loan amount is cancelled after 29 years, there is a perception that the terms of the loan are very favourable. This is not the case. The key fact is that the interest payable on the loan is set at 3% above the retail price index or inflation rate. The current inflation rate is 3.6% so the interest rate would be 6.6%.

The huge cost of these loans can be determined by using the government's own student finance website (www.studentfinance.direct.gov.uk).

Students doing a standard 3 year degree who borrows the whole fee of £9000 pa as well as £3750 pa for living expenses will owe £38,000 when they graduate. If they earn the average graduate starting salary of £25,000 they will end up paying a total of £103,000 before the loan is paid off.

Medical students who take out the full loan for fees and maintenance for their 6 year degree will owe £100,000 when they graduate. If they have the average doctors starting salary of £35,000 they and will eventually pay £255,000.

These are huge sums. There is little chance of escaping payment as they are charged through income tax. Graduates with loans effectively pay a 9% higher income tax rate for most of their working lives.

One wonders how long it will take for graduates to realise that the only way to escape payment is to emigrate? If the system stays in place it could lead to emigration of graduate in huge numbers, doing enormous damage to the UK economy, and leaving the elderly who introduced these charges to protect their own pensions to fend for themselves. Perhaps then they will appreciate that the money is useless when there is no one left to actually do the work. And it will serve the misers right.

Why it would not matter if no one wanted to 'fund the deficit' by buying government bonds.

Let us consider the mechanics of government spending and borrowing. In a fiat currency system when governments spend numbers are added to recipient bank reserve accounts at the central bank. The money in reserve accounts earns little if any interest. When governments sell bonds what happens is that money in reserve accounts is moved into special interest-bearing accounts. If no-one wants to buy the bonds the money simply stays in the reserve accounts, earning no interest. Does this mean that the government is broke or will default? Of course not. In fact they are better off as they don't have to pay any interest. Government bonds are a benefit to the public and a cost to the government. The requirement to sell bonds is not needed to fund spending. Typically it is needed to execute monetary policy, as it enable central banks to target interest rates that banks pay to lend reserves to each other. When there are excessive reserves in the banking system and base rate is very low, as is the case now, there is no longer a need to sell bonds to execute monetary policy. If the economy recovers and starts growing rapidly, and it is felt necessary to reduce reserves then there are other ways of doing it that don't require the sale of new government bonds. The central bank could sell some of the bonds that it has purchased through the quantitative easing programme. The government could reduce the deficit or even run a surplus by increasing taxes and reducing spending. In fact this will happen anyway as the economy grows since tax revenues would rise and welfare payments such as unemployment benefits etc would fall.

If there is no need to worry about about our government being able to borrow to finance spending why is there so much anxiety expressed about the deficit? It is all down to mythology. There is a self-imposed rule that governments sell bonds equal to the value of the deficit, which gives the appearance that governments are financing the deficit. To implement this rule government have an notional account at the central bank. When tax payments are made this account is marked up by that amount. Similarly, when bonds are sold the account is also marked up. When governments make payments this account is marked down. Finally this account is not meant to fall below zero. These are all rules that the government imposes on itself to support the myth that government spending needs to be funded by taxes and borrowing. They can easily be bypassed or changed as the government enforces them. The myth is sustained because of the view of those who know better that the public and political leaders need to have a 'fear of bankruptcy' in order to convince them to raise or pay unpopular taxes and to restrain their impulse to spend excessively. It is analogous to the idea that religious belief in heaven and hell are needed to encourage virtuous behaviour. Myths can have tragic side effects. Suicide bombing is one example. The entirely unnecessary waste and misery induced by misconceived fiscal austerity is another.

Reconciling MMT with New Keynesianism

Simon Wren-Lewis's recent post and work that he cites provides a fascinating insight into how modern monetary theory (MMT) and mainstream neo-classical views on the effect of government deficits can be reconciled.

According to MMT government debt represents accumulated net private sector financial assets and, since government's create the money and can never default, the level thereof should not be considered as a constraint. It represents the private sector's desired level of net savings. It never needs to be repaid, and even if it did, it could easily be repaid as the government/central bank could just issue the money. MMT regards the only constraint of deficit spending to be demand-led inflation. The deficit should be reduced if inflation rises above an agreed target. It should be used a second tool of monetary policy, in addition to interest rates, to hit inflation targets.

The neo-classical view, based on the notion of rational expectations, is that the debt has to be paid off and so a rational consumer will view this government debt as a future tax liability and adjust their behaviour accordingly. In other words they would not consider the debt to be a net financial asset. Simon Wren-Lewis discusses the implication of using 'printed money', which he refers to as outside money, instead of government debt to fund the deficit. Would this have a beneficial wealth-enhancing effect now that this debt did not need to be paid of by future higher taxes? He cites work suggesting that it would, but then argues that it may not if the authorities had an inflation target, as the printed money would be expected to expand the monetary base and inflate prices. He argues that, in order to hit the inflation target the authorities may increase taxes to contract the monetary base, neutralising the wealth effect of outside money.

The problem with this argument is that it assumes that the authorities to act in a way that conforms to the neoclassical view, and that this will be anticipated by the the rational consumer. How realistic is this? The authorities would surely not contract the monetary base under circumstances he cites (a liquidity trap) to counter inflation. First, the liquidity trap arises because there is a recession that the authorities will be trying to counter by loosening monetary and fiscal policy. Why would they raise taxes and contract the monetary base? The whole point of QE is to increase the monetary base. Second, the usual way to decrease the monetary base is by the authorities issuing securities (e.g. government debt), or reverse QE. Why would they not do this instead of increasing taxes? Third, the monetary base has a very weak, if any, relationship with the broad money. Look at the data. This is what you would expect if you understood how broad money is created, by bank lending, which is not reserve constrained.

The MMT view is that the rational consumer, if they really understood the monetary system, should and would consider government deficit spending to be financed by 'outside money'. In reality when government spend they introduce new (outside) money increasing the monetary base. Taxes remove most of this new money in order to ensure that demand is not excessive. Current self-imposed rules require that the difference or ’deficit' is borrowed back by issuing government debt certificates. In reality all this involves is them moving the money from reserve accounts at the central bank to interest bearing accounts at the central bank. In some countries this 'reserve drain' is necessary in order for central banks to hit their overnight interest rate target. The key point is that this government debt really represents government backed savings accounts for the 'outside money' that has already been introduced, much like National Savings Certificates in the UK.

So government debt actually is 'outside money' and represents net financial assets of the private sector. There is no need for it to be fully repaid and so no reason to expect tax increases just to pay this debt. A truly rational agent would not expect tax increases unless growth was so vigorous that it resulted in inflation, which would be associated with full employment and an economy functioning at full capacity. A rational agent would expect such growth to result in a reduction in the deficit (as tax revenue increase and welfare spending drops) and a reduction in debt/GDP ratio as GDP increases, and historical experience backs this up.

Time to be honest

A modern economy is incredibly complicated, and there is a lot that we do not fully understand. That is one of the reasons why making predictions is so difficult, and why there will always be plenty to argue about.

However, there are some complex things that we can understand because they were engineered by humans. There are no big controversies about how cars or smartphones work.

One example of a human-engineered system that we should understand is our monetary system. So why is there so much confusion and debate about it? I argue in this post that it is because the conventional description of how money works is intentionally misleading.

It is possible for anyone with an internet connection and sufficient time and determination to figure out the truth. But most people don't have the time and are not sufficiently interested in the topic. Others have found that, when they do manage to understand, it is very difficult to convince others. Why? Partly because it requires a counterintuitive conceptual leap, and partly because it requires people to ignore what they read in and hear from other trusted sources.

The key conceptual leap is to appreciate that money has to come from somewhere, and in modern fiat currency systems that somewhere is the government, which has monopoly power to create the sovereign currency*. Most governments have handed some of the authority for money creation to a central bank. However, for all practical purposes the central bank can be considered to be part of the government.

[*the Eurozone is different]

So how does this money get to us? In almost all cases by government spending. The action of spending introduces money into the economy for the first time. In practical terms when a government Department wants to pay, for example, a company for providing it with something, someone sits at a computer and types numbers to mark up the value in accounts that all banks have at the central bank. You could call it printing money but 'typing money' is more accurate.

If governments were very small relative to the size of the economy they could do this without any problem. However, when they get as large as they are now, they would be introducing a huge amount of new money into the economy each year, and this would cause inflation because the added demand for goods and services would exceed the capacity of the economy to supply them.

It is for this reason that taxation is necessary. It removes spending power from the non-government sector to ensure that overall demand does not exceed supply and cause inflation.

The sequence of events is important. First the government spends, introducing new money. Then it taxes to remove money. Creating the money is necessary before it can be removed. Removing it is not needed until it has been created. Governments must spend the money into the economy before it can be removed by taxation.

This simple reality of how money is created by spending and removed by taxation has two very important implications.

First, since the government does not need tax revenues to fund its own spending, or any other current or future obligations, it can never be forced to default on any of these obligations. It may choose to do this because of self-imposed rules, but this will be a choice made, ultimately, by the electorate. An analogy is a cricket scorer. They can never run out of points because they create them.

Second, there is no need to remove through taxation all the money introduced through government spending. In fact there are good reasons for wanting taxation to remove less money than introduced through spending. The main one is that it enables the non-government (private) sector to accumulate savings (net financial assets). If taxation always removed all the money the government spent then it would be impossible for the private sector to accumulate savings in the form of government money. When the government removes by taxes more than it spends, it is confiscating savings from the private sector.

Now you can see why the way that we talk about government taxation providing revenue to fund spending is misleading, and potentially dangerous. By implying that tax revenues need to be raised to fund government spending, and calling the annual shortfall a deficit, and the cumulative shortfall government debt, we give the impression that it is imprudent and unsustainable for government spending to exceed tax revenues. And we wrongly imply that it would be a good thing for the government to confiscate private sector savings, and that it is a bad thing for the private sector to accumulate savings. Surely this is wrong?

To repeat, a government deficit represents a private sector surplus, and government debt represents cumulative private sector saving. When understood this way it should be clear why it is potentially dangerous for the government to run a fiscal surplus and eliminate its debts, as this prevents private sector saving. It is only justified when the economy is operating at full capacity or there is demand-driven inflation. In fact whenever the US government has tried hard to run surpluses to reduce its debt this has ALWAYS followed by financial collapse and depressions. Coincidence?

So why we stick to an incorrect description of government spending and taxation?

Many people just accept the views of experts as it makes intuitive sense. We know from personal experience that we need to earn money before we spend it. So why do the experts not correct this misunderstanding. Some have admitted that the conventional (taxes fund spending) explanation is necessary to provide the 'discipline' needed to prevent excessive government spending. They reason that, if politicians and voters believe that increased government spending has to be funded by taxes, this provides a built in constraint on excessive public spending, since taxes are deeply unpopular. If they realised that this was not the case it might be difficult, in a democracy, to control government spending.

So the fundamental reason for maintaining the fiction is that the public cannot be trusted with this knowledge. Is this ethical?

Leaving aside the ethics, another problem is that when people make decisions based on a misunderstanding, the consequences can be devastating. In fact one could make the case that the global financial crisis, and the six depressions that preceded this in US history were the direct result of operating our monetary system based on this misunderstanding.

Isn't it time for the truth?

What the words on you pound note actually mean

Ever wondered why x pound notes have the statement 'I promise to pay the bearer the sum of x pounds'?

If this statement makes no sense to you or seems ridiculous then it is because you do not understand modern money.

To understand it you need to understand what the essence of modern fiat money is, and what gives it value. Fiat money gets its value from the fact that it can be used to pay taxes owed to the government.

There are two sorts of money that are issued in all modern economies. First there is government money or state money, also called base money. Only the government or central bank (which is part of the government) can create this sort of money. Government money exists in two interchangeable forms: as central bank reserves, which are just numbers on a spreadsheet, and as physical cash (notes and coins). When notes and coins are issued central bank reserve accounts are marked down by the same amount. When the central bank or government receive cash they mark up the appropriate reserve account. The central bank reserves plus all the physical cash equals the monetary base. So physical cash is simply an easily transferable and anonymous form of government or state or base money.

The second form of money is commercial bank money. This is created by commercial banks and only exists in electronic form. 97% of the money that is available to the public to spend is this form of money. Commercial banks can create this money whenever they want and they do this whenever they make a loan. They simply increase the numbers in the bank account of the borrower by the amount of the loan. In return they get a debt from the borrower, which they mark as an asset, and they receive interest payment. Effectively they are renting the money to the borrower. It is important to recognise that bank money has no official status in that it cannot be used to make official payments to the government, such as paying taxes.

When you write a cheque to pay your tax bill to the government, on receipt of this cheque, goes to your bank and requires that your bank pay it that exact amount using government or state money. Banks can do this either using money in their reserve account at the central bank or by using physical cash.

It is because physical cash, unlike commercial bank money, can be used to pay taxes owed to the government that it says what it does on the notes. If you or anyone else produces these notes the government has to accept them as payments of tax owed to them or, if you are a bank, it has to credit your reserve account with that amount. You can't do this with commercial bank money.

So currency notes can be considered as transferable government IOUs that can be used to pay taxes or settle any other obligations to the government. If you are a bank and have a reserve account at the central bank they will credit your central bank reserve account by the same amount.

If this makes sense to you then you understand more about modern money than 99% of people, including most economists.