Bubbling Up...1/15/13

1) The State We’re In by David Glasner @ Uneasy Money (emphasis added)

it’s interesting to note that, despite his Marshallian (anti-Walrasian) proclivities, it was Friedman himself who started modern macroeconomics down the fruitless path it has been following for the last 40 years when he introduced the concept of the natural rate of unemployment in his famous 1968 AEA Presidential lecture on the role of monetary policy. Friedman defined the natural rate of unemployment as:

"the level [of unemployment] that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the costs of gathering information about job vacancies, and labor availabilities, the costs of mobility, and so on."

Aside from the peculiar verb choice in describing the solution of an unknown variable contained in a system of equations, what is noteworthy about his definition is that Friedman was explicitly adopting a conception of an intertemporal general equilibrium as the unique and stable solution of that system of equations, and, whether he intended to or not, appeared to be suggesting that such a concept was operationally useful as a policy benchmark. Thus, despite Friedman’s own deep skepticism about the usefulness and relevance of general-equilibrium analysis, Friedman, for whatever reasons, chose to present his natural-rate argument in the language (however stilted on his part) of the Walrasian general-equilibrium theory for which he had little use and even less sympathy.

Inspired by the powerful policy conclusions that followed from the natural-rate hypothesis, Friedman’s direct and indirect followers, most notably Robert Lucas, used that analysis to transform macroeconomics, reducing macroeconomics to the manipulation of a simplified intertemporal general-equilibrium system. Under the assumption that all economic agents could correctly forecast all future prices (aka rational expectations), all agents could be viewed as intertemporal optimizers, any observed unemployment reflecting the optimizing choices of individuals to consume leisure or to engage in non-market production.

Woj’s Thoughts - I had to read this section of Glasner’s fantastic post twice because its conclusion is so striking given the particular economist involved. Although I was aware Friedman’s work played a large role in the neoclassical synthesis, it remains strange to think that someone so opposed to government intervention would set forth a policy benchmark by which future economists would determine intervention is necessary.

2) Buchanan: Seeing With New Eyes, by Garett Jones @ EconLog

Buchanan saw Arrow's Theorem as a solution to a problem raised by America's founders: how can democracies avoid the tyranny of the majority? Well here's one way, Buchanan said: Just let democracy behave normally. As long as people are diverse enough in their views for Arrow's assumptions to hold, then the factions holding power will change relatively often. His words:

"Would not a guaranteed rotation of outcomes be preferable, enabling the members of the minority in one round of voting to come back in subsequent rounds and ascend to majority membership?"

Where other economists--including myself--had seen Arrow's Theorem as an indictment of democracy, as a reducing the scope for democratic utopianism, Buchanan saw an argument that democracy might not be quite so dangerous after all.

Woj’s Thoughts - Although I did not have the opportunity to meet James Buchanan, as a student of economics and member of the George Mason community, I’m saddened by his recent passing. This past semester I became more formally introduced to his work through his book Cost and Choice. The many remembrances, including the one above, have shed even more light on the multitude and magnitude of his achievements throughout his life. I look forward to learning far more about the ways in which Buchanan separated himself from average economists in the years ahead.

3) Burn This Into Your Brain…. by Cullen Roche @ Pragmatic Capitalism

I really like this quote from the NY Fed:

“Most commonly used measures of the broad money supply include both currency and certain types of bank deposits, which in effect represent money created by banks when they make loans, but not reserves. These broad money measures tend to be more directly relevant for economic activity and inflation.” (emphasis added)

Woj’s Thoughts - The NY Fed recognizes that “inside” money is relevant for economic activity and inflation. How come mainstream economics doesn't?

Bubbling Up...1/3/13

1) Fluffing off a Trillion Dollars. And a Third Thing by The Arthurian @ The New Arthurian Economics

The deficit isn't a result of spending. It is a result of policy: of fighting inflation, and encouraging growth. The deficit is a result of these two policies, done in a very bad way for a very long time.

Policymakers pushed down the quantity of money in circulation to fight inflation:

Graph #1: Money in the Spending Stream per Dollar's Worth of Output

At the same time, they encouraged growth, spending, and the use of credit:

Graph #2: Total Credit Market Debt Owed per Dollar in the Spending Stream

The honest and honorable goals of fighting inflation and encouraging growth turned us into a nation with no money and inexplicable debt. That is why the economy refuses to grow. That is why tax revenue is down and "slump-related expenses" are up.

And that is why we have trillion-dollar deficits.

Woj’s Thoughts - Hard to argue with Art’s take on the matter. I might add that encouraging growth through private credit creation has also led to more wealth accumulation through capital gains. Subsequent policies that largely excluded capital gains from taxation exacerbated the above trends and can probably help explain a significant portion of wealth inequality witnessed today.

2) Why economics is rubbish, episode 324. by Sell on News @ MacroBusiness

It is an especially extreme example of scientism. It leads to a sort of homogenous nonsense. As the historian of science Stanley Jaki commented, such confusions are deadly to science itself. “By assigning unlimited relevance and competence to the scientific method, scientism rules out precisely that test. By setting quantitative exactitude as the only and supreme test of truth, scientism robs of meaning the world of qualities and values. By the same stroke it makes science meaningless as well. He then quotes GK Chesterton:

“Science, which means exactitude, has become the mother of inexactitude. This kind of vagueness in the primary phenomena of the study is an absolutely final blow to anything in the nature of science. man can construct science with very few instruments .. a man might measure heaven and earth with a reed, but not a growing reed.”

That latter point is crucial. The metrics used to “measure” economic and financial behaviour are growing reeds, they do not stand still. They grow in the minds of those who use them, used for trading strategies, to formulate polices, for the basis of consumer sentiment. Even if the quasi-scientific economic abstractions worked, they would not work.

3) yen dynamics by Warren Mosler @ The Center of the Universe

So it may be the case that Japan is in the process of resuming it’s traditional dollar and euro buying, which can move the currency to whatever level it desires. Which is probably back to north of 100 to the dollar?

Lastly, there is a record yen short position being reported. While this could mean it’s getting over sold and subject to a rally, it could also mean insiders have been tipped off to this policy shift and will profit immensely.

Caveat: If all the noises around the coming election and weak yen policy result only in an increase in the inflation target and ‘unlimited qe’ involving only yen financial assets, that policy will only serve to make the yen stronger and a wicked short covering scramble will follow.

Nothing short of buying fx, directly or indirectly, will do the trick.

Woj’s Thoughts - In a recent post on the re-election of Prime Minister Abe, I mentioned that the likely outcome was merely stepped up monetary policy tied to relatively restrictive fiscal policy. There has been no mention yet of direct fx purchases (that I’m aware of). If I’m correct that Japan will limit itself to NGDP targeting through unlimited QE, than investors should be wary of severe Yen strengthening in the not too distant future.

Private Debt and Modern Cost-Push Inflation

The Arthurian rekindles consideration of Cost-Push Inflation: An Issue Resolved, or Simply Dismissed?:

At The Everyday Economist some months back, Josh Hendrickson captured my attention with his Nominal Income and the Great Moderation. In that post, Hendrickson introduced a forthcoming paper and said:

As I argue in the paper, during the Great Inflation period of the 1970s, members of the FOMC regularly asserted that the process of inflation determination had changed. Relying on public statements and personal diary entries from Arthur Burns, I demonstrate that there is little evidence that the Federal Reserve was less concerned with inflation during the 1970s. Rather, the view of Burns and others was that inflation was largely a cost-push phenomenon. Burns thought that incomes policies were necessary to restore price stability and stated that “monetary and fiscal tools are inadequate for dealing with sources of price inflation that are plaguing us now.”

The shift in policy, beginning with Paul Volcker, was an explicit attempt to stabilize inflation expectations and this was done deliberately at first through monetary targeting and ultimately through the stabilization of nominal income growth. Gone were notions of cost-push versus demand-pull inflation.

I can see a natural progression there: from the thought that "incomes policies were necessary" to policies for "the stabilization of nominal income growth." Incomes policies means wage-and-price controls. The method is crude, but the objective of wage and price controls is precisely "the stabilization of nominal income growth."

Beside the point. What concerns me is "the view of Burns and others was that inflation was largely a cost-push phenomenon." That, and the apparent fact that this issue of cost-push was never resolved. It was simply dismissed.

As with many aspects of science, there is an inherent desire to find one all-encompassing explanation for macroeconomic phenomenon. Maybe it’s naivete, or pragmatism, but there seems little reason to expect one simple reason behind inherently complex phenomena. Returning to inflation, maybe a simple primary cause exists at certain periods of time and in certain locations, but throughout history there may very well be numerous causes.

Approaching the question of inflation from a Keynesian perspective, it seems obvious that demand-led inflation is plausible. Individual’s desire for goods can clearly shift faster than the economy’s ability to produce new output. Similarly, from a Monetarist perspective, one can easily envision an excess supply of money causing a decline in its value that represents an increase in the price level. Or, as Nick Rowe suggests, maybe monopoly power causes inflation.

While all of the above views likely have their time and place, a way to reconcile cost-push inflation with today’s circumstances may not exist within mainstream models. In The Bubble and Beyond, by non-mainstream economist Michael Hudson, a case is made whereby rising interest expenses on debt could generate cost-push inflation. Over the past 30 years, there has been a massive increase in the amount of private debt both at the household and corporate levels. The reliance on debt funding involves interest expenses that push up the cost of production. Since interest expenses can rise at compounding rates, the impact on the overall cost structure becomes larger over time. These effects on inflation may help to explain persistent inflation throughout the recent crisis despite the significant drop in aggregate demand and broad measures of money.

The cost-push inflation of an earlier era may be gone, but the phenomena may still be with us today. The dismissal of private debt and interest expenses from macro models may be the reason the issue of cost-push inflation was “simply dismissed.”   

Reducing the Debt-per-Dollar Ratio: A Long Road Ahead

Last week, in response to a post by Scott Sumner, I argued that Debt Surges Don't Cause Recessions...Excessive Aggregate Amounts Do. A recent post from Pragmatic Capitalism, Failing to Connect the Boom to the Bust, offers the following chart to support the importance of credit expansions in understanding business cycles:

Commenting on the post from Pragmatic Capitalism, The Arthurian comes to a similar conclusion:

During the boom you get lots of credit expansion, so total debt goes up a lot. During the bust you get little credit expansion, and total debt goes up only a little. But total debt goes up, either way. (Until the crisis, of course. And that's why there eventually is a crisis.)

There ya go: When credit expansion declines, you have recession. When total debt declines, you have depression. There's a definition for you.

Don't worry, it's not set in stone. It's not fate. It's just stupidity. We *insist* on using credit for growth. We *insist* on using credit for everything. We *insist* on using bank-issued “inside money” as our primary form of money. Change that, and we change the world forever.

Always keep in mind the ratio between inside money and outside money.

Some people want to go back to gold. Some people want 100% reserve. I just want to reduce the debt-per-dollar ratio to a workable level, and keep it there. The same system we knew and loved for 60 years, only not so extreme.

Clearly in agreement with the conclusion, I decided to explore the italicized statement above. Earlier in the post, The Arthurian said:

you can get a feel for the ratio between inside money and outside money, by looking at a picture of debt per dollar of circulating money. Or at debt per dollar of base money.

Since the graphs at those links were a bit out of date, here are the updated versions:

Debt-per-Dollar of Circulating Money

Debt-per-Dollar of Base Money

Both charts depict the persistent rise in debt-per-dollar from the 1950’s until the late 2000’s. Although the decline is pronounced in the past few years using either metric, the degree to which the ratio has retraced its 60 year rise is markedly different. Choosing the appropriate measure is therefore necessary if we are going to implement The Arthurian’s plan “to reduce the debt-per-dollar ratio to a workable level.”

Since both graphs use the same measure of total debt, the stark difference in rate of decline is clearly due to changes in circulating money (M1) versus base money (MB), shown in the following chart:
Digging a bit deeper, the sharp rise in base money over the past few years is largely attributable to an increase in excess reserves:This chart, which is incredibly important for our discussion, suggests that the rise in excess reserves is the primary driver between the diverging rates of decline in the two measures of debt-per-dollar. Why is this important? The increase in excess reserves, engineered by the Federal Reserve, is primarily just an asset swap with private financial institutions. Since the Federal Reserve is purchasing US Treasuries and agency-MBS (liabilities of the US government), the economic sector which is really witnessing a decline in its debt-per-dollar is the US government.

Deconstructing the argument one more time, this graph again shows total credit market debt owed, now also separated out by the federal government and the private sector (blue line):
For nearly 60 years, private debt growth (credit expansion) continued unabated both in nominal terms and relative to federal debt. Although this provided a tailwind for economic growth, the legacy of accumulated debt is burdensome interest costs. While spending by the federal government is unconstrained by income, due to monetary sovereignty, the private sector is not so fortunate. When accrued interest costs (debt) become large enough, an economic shock (either exogenous or endogenous) may cause the private sector to increase savings and/or debt repayment and thereby decrease consumption and investment. If these actions are pursued in the aggregate, a “paradox of thrift” debt-deflation can take hold. In the US, this has been partially offset by the rapid rise in federal debt, but not fully given the exorbitant relative size of private sector debt.
Since private sector debt expansion and contraction has been a primary driver of the economy for at least 60 years, the debt-per-dollar ratio that best depicts the private sector should be the desired metric for policy reduction and stabilization. As shown above, the decline in debt-per-dollar of base money largely reflects an increase in excess reserves that does little to reduce the private sector debt burden. This last chart, however, displays private sector debt-per-dollar of circulating money:
Having decreased sharply since the onset of the Great Recession, this ratio remains at heightened levels only last witnessed at the beginning of the new millennium. We may still have a long way to go but reducing this debt-per-dollar ratio to a reasonable level will be worth it.

The Necessity of Private Banking

Yesterday, Rodger Malcolm Mitchell offered a second part to his view that private banking should be ended. He begins by accurately acknowledging the difficulty in writing and enforcing sufficient regulation, along with the bankers’ success in using the government system to bolster profits. The apparent impossibility of eradicating rent-seeking from bankers leads Mitchell to conclude:

When private individuals control vast amounts of money, and when they are compensated according to their control of this money, even the saints among us would be tempted. Bottom line, private banking is, and always has been, crooked, the bigger the bank, the greater the temptation, the more crooked.

In banking, the profit motive corrupts. And combining the profit motive with short-termism corrupts absolutely. Always has; always will.

All banks should be federally owned.

Although I agree that the profit motive “corrupts” (though not absolutely), it dawns on me that this view can easily be extended to the entire private sector and holds a strong parallel in the public sector if one alters profits with power. All individuals, at some point, are tempted to work the system in their favor. Banking, whether done through the private or public sector, will therefore always be subject to some level of corruption.

Apart from the reasoning on corruption, there are two other discrepancies I brought up in the comments. First, removing the profit motive from banking effectively eliminates the market (price system) for credit/lending. Government agents will therefore have full discretion over who receives a loan, as well as the size and price, without an incentive to determine the borrower's ability to repay. As many economists in the Austrian tradition have previously explained, without knowledge from a market (i.e. prices), the allocation of resources will be highly inefficient.

Second, Mitchell’s usage of the term “money” to include credit obscures an important distinction between money and credit. Kurt Schuler of Free Banking recently addressed this confusion:

Money in the narrow sense is the monetary base, which, at least from the standpoint of the domestic monetary system, is a pure asset and not somebody's IOU. Payment with the monetary base extinguishes IOUs.…“Money” in the looser, broader sense includes IOUs, particularly those issued by banks, that are readily convertible at 1:1 into the monetary base.

Private banks are the majority supplier of credit (IOUs)*, which acts as a money-like instrument. The Arthurian explains the significant difference:

The cost of interest is an "extra" cost, a largely unnecessary cost in our economy. Yes of course we need to use credit. But we don't need to use credit for everything. But we do. So, we have this extra cost to deal with, the factor cost of money. And it creates cost-push conditions. And cost-push conditions cause inflation. Inflation, or decline.

Further, the added interest cost transfers wealth from borrowers to lenders. This increasing reliance on credit in the past three decades, supported and subsidized by government, is largely behind the enormous rise of profits in the financial sector and current economic struggles. Considering the public support for use of credit, making banks publicly owned is unlikely to address this issue.
I entirely agree that the financial sector is a source of corruption and prime example of problems with rent-seeking. However, turning over the role of banking to the government will not reduce corruption or the country’s reliance on credit and will be significantly more inefficient.


*Ralph Musgrave, who also got involved with comments on Mitchell’s post followed up with a post of his own seeking clarity on the proportion of the money supply (broad version) created by private banks. Presumably, since loans create deposits:

to get at the proportion of money created by central bank it strikes me we need take physical cash add total deposits and subtract total loans.

This site gives the deposit to loan ratio of U.S. FDIC insured banks as 79%. (loans are $7.28 trillion while total deposits are $9.22 trillion).

From that I deduce that about 20% of money in the U.S. is central bank created.

Markets are 'natural' and money is important

Brenda Rosser discusses the assumption that markets are ‘natural’ using David Graeber’s recent book, Debt: The First 5,000 Years, as a guide. The basic gist of Graeber’s selected quotes appears to be that government policy and money are necessary to enable functioning markets. This is mentioned in contrast to the presumed view of economists which

have come to see the very question of the presence or absence of money as not especially important, since money is just a commodity, chosen to facilitate exchange, and which we use to measure the value of other commodities.

While this may be true of most mainstream economists, I have previously highlighted the fallacy of monetary neutrality and the need to incorporate money into economic models.

Stemming from Graeber’s text, Brenda concludes that

Money brings markets into being.  Not the other way around, as most economists would have it.

While I don't disagree that governments set rules for the market or that money is important to market transactions, I think it is a stretch to suggest that governments or money is necessary for markets to exist. Surely there have been periods throughout history, where prior to governments or money, people exchanged goods or services. In fact, it is unlikely that governments or money would have come into being unless individuals had previously learned to exchange ideas, goods and services. Given that markets can/do exist naturally, it would still be a mistake to assume this minimizes or nullifies the role of government policy and money. It is in combination with government policy and money, that markets will almost certainly prove most abundant and beneficial.

Cullen Roche - Misunderstanding Banking is Helping Bankrupt an Entire Society

What is Wall Street’s job?  Wall Street’s job is simple.  It is to increase earnings for their shareholders.  It is not to provide jobs for the private sector.  It is not to make sure the US economy is running smoothly.  It is not to make sure you feel good about your day to day life.  It is to generate a profit for its owners.  This is the essence of private banking.  To generate a profit.  But banks play a unique role in our capitalist system.  I’ve explained before that banks are not the engine of capitalism.  They are simply the oil in the machine.  As the oil in our machine, banks must be functioning smoothly in order for the machine as a whole to be functioning smoothly.  So when big banks do bad things that threaten their well-being parts of the system begin to malfunction.  And sometimes when these mistakes are big enough the contagion leads to the entire machine malfunctioning and requiring a major repair (hello 2008!).

But make no mistake, your local bank is not your best friend or a public purpose serving charity.  For instance, when a bank extends a mortgage (a word literally meaning “death security pledge” from the latin root “mortuus” for death and germanic “security pledge”) they are not doing you some charitable service to help you buy your home.  They are rating your credit risk and evaluating you as a potential profit engine for their shareholders.  That might not be the most pleasant way to think about it, but it is what it is.  A bank is not a charity.  It does not really care if your mortgage results in jobs or happiness for you.  Of course, it would be great if this did because that might result in more future business, but the bank does not need these things from you in order to generate a profit.  It really just wants to manage its risks in a way that helps to generate a profit for their shareholders without excessive risk.  Obviously, the debtor finds the mortgage advantageous, but don’t confuse this service for charity work.  It’s just good old fashioned profit seeking and offering a service where one is needed (in this case, the debtor being able to obtain money they could not otherwise currently obtain).

Read it at Pragmatic Capitalism
Misunderstanding Banking is Helping Bankrupt an Entire Society
By Cullen Roche

Cullen remains one of my primary go-to sources for a clear, objective view of our monetary system. While this post is strong in many facets, it appears to downplay the role of government in the current environment. Deposit guarantees, creditor bailouts and tax laws are just a few of the ways in which government alters the price of credit. These actions, which impact the decisions of both banks and consumers, may unintentionally exacerbate the normal boom/bust cycle.

Mike ‘Mish’ Shedlock - Monopoly Money vs. Bernanke Money, is there a Difference?

If massive inflation was coming 10-year treasury rates would not be yielding a record low 1.60% and consumers would certainly not be deleveraging!

Might massive inflation be coming down the road?

Certainly, but it will take a change in attitude by consumers and banks or massively reckless policies by Congress.

Interestingly, Congressional policies are indeed "massively reckless" just not reckless enough yet. The emphasis is on "yet". I will not be a deflationista forever, but I remain one for now.

Read it at Mish’s Global Economic Trend Analysis
Monopoly Money vs. Bernanke Money, is there a Difference?
By Mike ‘Mish’ Shedlock

Mish argues that the Fed’s ability to generate inflation in practice is quite different from their theoretical ability. I couldn’t agree more.

Cost-Push vs. Demand-Pull Inflation: Monetary and Fiscal Policy Continue to Attack the Wrong Problem

What we spend, matters. If we spend money, there's no associated interest cost and we don't have to pay the money back. If we spend credit, we have the cost of interest to deal with. And the repayment of principal.

Our economic policies took money out of circulation and encouraged the reliance on credit. "What we spend" became more costly. The factor cost of money increased.

A factor cost is something like wages or profit, or something that competes with wages and profit. The cost of interest is a factor cost that competes with wages and profit.

The cost of interest is an "extra" cost, a largely unnecessary cost in our economy. Yes of course we need to use credit. But we don't need to use credit for everything. But we do. So, we have this extra cost to deal with, the factor cost of money. And it creates cost-push conditions. And cost-push conditions cause inflation. Inflation, or decline.

Read it at The New Arthurian Economics
The Cost-Push Economy
The Arthurian

An old post but a beauty. The difference between demand-pull and cost-push inflation is incredibly important for determining the correct policy response and has been largely misunderstood for several decades. Reliance of money-like instruments (credit) has dramatically changed the balance of “What we spend” and thereby altered the source of inflation. This change may also help explain why, since the 1980’s, The Economy Needs a Bubble! Until this distinction is better and more widely understood, monetary and fiscal policy may continue to attack the wrong problem.

The New Arthurian - Andrew Haldane: Financial arms races

The Federal Reserve seems to think that a dollar of credit-in-use is just as good as a dollar of money in circulation. It isn't just as good. It's better (for the lender) and worse (for the borrower) because of the cost of interest that applies to credit but not to money.

Better for the lender and worse for the borrower. Doesn't that explain the growth of finance? Doesn't it explain the laggard performance of the economy?

We need to take income out of the non-productive sector and put income into the productive sector again, where it was when our economy was good.

Read it at The New Arthurian
Andrew Haldane: Financial arms races
By The Arthurian

If you haven’t Haldane yet, you should read some his work immediately. He is the Executive Director of Financial Stability at the Bank of England and a brilliant writer, especially on matters of banking. Attempting to solve this problem, The Arthurian also provides policy recommendations and addresses those suggested by Andrew Haldane.  

Ann Pettifor - "credit creates economic activity"

The fact is, and it has been so since 1694, when a borrower approaches a bank for a loan, the funds for the loan are not in the bank. They are created when, after assessing risk, a bank clerk enters the loan amount into a ledger, demands collateral; sets the rate of interest on the loan and after agreement has been reached, transfers the funds – as ‘bank money’ – from the bank’s account to the borrower’s account. This loan creates a deposit in the borrower’s account. Loans create deposits. Credit creates money.

It gets better: credit creates economic activity. This is why I consider the creation of a sound banking and credit system to be a great civilizational advance. In countries without sound banking and credit systems, it is very hard to kick-start and sustain economic activity, through investment and job creation.

It’s because we have a sophisticated monetary system and a well-developed (if badly regulated) banking system – that we can afford to tackle climate change.

There is no shortage of money. There may be a shortage of skills; of regulation; of commodities; of land; of water and atmosphere – but there need never be a shortage of money.

Read it at Debtonation
Ann Pettifor: speech notes for presentation to the Just Banking Conference, Edinburgh, 20th April, 2012
By Ann Pettifor
(h/t Tom Hickey at Mike Norman Economics)

Brilliant piece focusing on private credit creation and the enormous overhang of private debt that continues to depress economic growth. Sadly, the five tools for recovery do not appear politically feasible in the current state. Of those tools, however, I strongly favor a re-structuring of the banking sector that recognizes insolvency combined with a debt jubilee for households.

Changing Our Basic Assumptions of Monetary Policy

It remains true that if there is inflation because there is too much spending-money, then the quantity of spending-money should be reduced. That is not true, however, if there is inflation because there is too much credit-use.

And it remains true that credit-use is good for growth when there is little credit-use. But when credit-use is already excessive, when debt is already excessive, increased credit-use is not likely to be an effective way to boost growth.

Even before policy can change, our basic assumptions must change.

Read it at the New Arthurian Economics
Something's Missing
By The Arthurian


Focusing solely on base money creation has led many individuals to incorrect predictions about inflation over the past several years. The amount of credit outstanding is a large multiple of spending money currently in the system (and of base money). Declining credit use has been a major deflationary force during the past few years and excessive debt continues to pose significant risks for future economic growth. Meanwhile, government policies continue to encourage increasing credit-use, not recognizing the futility of these actions in solving a crisis caused by excessive credit. The Arthurian is spot on in expressing that our assumptions about monetary policy must change before any lasting resolutions can begin.

Points of Public Interest

1. Money, credit and inflation - Sean Corrigan explains the difference between money and credit, highlighting the different nature of banks and individuals in creating credit. An often forgotten aspect of our current monetary system is that individual banks can create credit (which can turn into money) irrespective of Fed or Treasury policy. This unique ability generates the potential for inflationary and deflationary forces in the money supply outside of the federal government’s control.
2. Death by Wealth Tax - Richard Epstein argues against the proposal for a wealth tax on assets.
3. Trials and Errors: Why Science Is Failing Us - Jonah Lehrer details some failings in medicine stemming from the incorrect, basic “assumption—that understanding a system’s constituent parts means we also understand the causes within the system.” As Lehrer notes, centuries ago David Hume recognized a human desire to view the appearance of causation as an actual fact, rather than “fiction that helps us make sense of facts.” (HT: Russ Roberts)
4. Debt, Deficits, and Modern Monetary Theory - Bill Mitchell, a founding member of Modern Monetary Theory (MMT), outlines the difference between MMT and mainstream economics. These differing conceptions about public debts and very important to the public policy battles in the news today. (HT: Neil Wilson)
5. Peter Boettke on Austrian Economics - “Austrians want to talk about things like dispersed knowledge, heterogeneity, uncertainty – not just risk, but real uncertainty – and institutions, how institutions arise to allow us to cope with our ignorance and our uncertainty and to ameliorate the frictions that exist in the world.” Peter Boettke discusses contributions of Austrian economics and five books to read on the subject.

Why QE2 Failed, Part 1

Following last week’s severe volatility and steep drops, equity markets have regained their footing this week. Renewed confidence in the economic outlook has come despite continued weakness in economic data as evidenced by a 30-year low in U.S. consumer confidence, deteriorating manufacturing reports and nearly stalled growth in Germany, as well as the rest of the Eurozone. Some of the confidence may stem from expectations that Eurobonds are becoming a more realistic option, providing support for the Euro. Other investors appear to be holding out hope that Fed Chairman Bernanke will hint at QE3 during the forthcoming economic conference at Jackson Hole. Having previously highlighted aspects of zero percent interest rates and monetary illusions, the operations of quantitative easing can be further explained. Understanding this process will help explain why QE2 failed to have a noticeable impact on the economy or create sustained inflation.

As I noted in Monetary Illusions, as long as individuals maintain confidence in a bank’s solvency, banks can grant credit through fiduciary media that is uncovered by current capital. A bank’s ability to provide loans is therefore never constrained by the amount of capital. Loan creation, however, is constrained by price and demand. To recognize the effects of QE it is important to consider the impact on price, demand and the quantity of “money” within the economy. Before looking into the Fed’s actions, further consideration of non-central banks is necessary.

An obvious function of banks is holding deposits and making loans. A less obvious observation is that most credit is granted without the backing of money. Although this credit is treated equivalent to money, for our purposes it will be considered money substitutes. During normal economic periods, the demand for credit vastly exceeds the money held by banks. Seeking to earn interest income, banks provide loans through fiduciary media to customers. The interest rate (price) on the loan corresponds to market interest rates and the perceived credit risk, or potential of the loan not being repaid.

When banks grant credit uncovered by money, customers simply promise to repay the loan plus interest in the future. Based on this action, the total base money (money and money substitutes) is actually increased. The extra funds are free to circulate through the economy. Since the supply of “money” has expanded, holding the number of goods in the economy constant, the price of goods initially rises. Also, because one person’s spending is another person’s income, total income temporarily rises. In theory this process could continue indefinitely, if production of goods doesn’t exceed growth in base money and confidence in the banking system is maintained. Unfortunately, maintaining this balance has proved elusive throughout history.

At this point it should be clear that banks have the ability to create “money” (money substitutes) out of thin air. Many people seem to believe that the Fed is undertaking this process through quantitative easing. Yet there is a very distinct difference between QE and granting credit through fiduciary media. As stated earlier, when banks provide credit through fiduciary media, consumers only promise repayment in the future. No current assets are exchanged for the loan. During QE it’s true that the Fed created new reserves separate from any capital. The crucial difference is that the reserves were exchanged for another current asset, Treasury notes. Although the Fed’s balance sheet expanded, this process in no different than normal open market operations used to control short-term interest rates and the supply of base money. As for banks involved in the process, their balance sheets were not expanded, but rather the composition of assets was changed.

Many economists and investors have focused on charts that display monetary growth including banks’ excess reserves. Using this definition of “money” has led many individuals to believe that QE will create high inflation as more money chases the same number of goods. This assumption misses the critical point that bank lending is not constrained by reserves. Net financial assets in the real economy (excluding the Fed) remain unchanged. Since no base money has been added to the real economy, the long-run exchange value also holds steady.

These concepts are certainly clear to the Federal Reserve Board, so an interesting question is, why would the Fed perform QE? As stated by the Fed, a primary goal was to reduce interest rates. Through QE2, the Fed swapped short-term reserves for longer-term Treasury notes. This process reduced the number of Treasury notes freely traded in the economy, lessening the amount of effectively risk-free securities. With the demand for risk-free securities expected to remain relatively constant, reducing the supply drives up prices and lowers interest rates.

The Fed also intended to generate a positive wealth effect through QE2. This expectation stemmed from the belief that the remaining supply of risk-free securities would not satisfy demand. Funds resulting from this excess demand would be invested in slightly riskier securities rather than simply held in cash. By increasing demand for riskier securities, asset prices would be pushed higher. Ultimately, increasing paper wealth should reduce the desire to save and increase spending.

Despite the Fed’s best efforts, unintended consequences of their policy resulted in failure on the first goal and only temporary success on the latter. Due to a common misconception that the Fed was “printing money, “ inflation expectations rose. Fear of losses in real purchasing power countered the reduction of Treasury note supply and potential decrease in interest rates. These fears, coupled with increasing asset prices, spurred demand for hard commodities rather than finished goods that might require subsequent increases in production. The resulting commodity inflation actually reduced aggregate demand for finished goods, creating a drag on the economy.



At the onset of QE2, the solvency of banks was not in question. Rather than removing illiquid securities from the economy, the Fed exchanged one liquid asset for another. Without altering net financial assets in the system, the main goal was to reduce real interest rates, convincing individuals to increase loan and aggregate demand. Misunderstanding of the monetary system, by much of the public, created outcomes far less stimulative than hoped. Future risks to the system have also been heightened by continued intervention. Had policy makers looked beyond neoclassical economics and considered the impact of private sector debt burdens, it’s hard to envision QE2 having been practiced. A future post will delve further into these unresolved issues. For now, I hope readers will recognize the non-inflationary impacts of QE and invest wisely on any further mention of the Fed continuing these policies.