Are Government Bonds Just Another Form of Money?

Most mainstream economists would argue they are not. They would say  cash and bonds are not economic equivalents.  They would argue that issued money wasn’t debt but issued bonds were. A common counter argument would run as follows:

“This idea  falls apart at the local gas station…  you can’t go shopping, bar-hopping, or on vacation to Miami with a bunch of T-bills and not notice the difference compared to cash…therefore, they are NOT ECONOMIC SUBSTITUTES. Let’s be very clear here: nominal financial *value* DOES NOT EQUAL purchasing power.”

I’ve quoted here from an on-line discussion I’ve just had on this same topic.

The argument on whether bonds are, or can be considered to be money, has perhaps to be considered on several levels. Of course if we need to pay a £9 grocery bill a (genuine) £10 note will be very acceptable  to the cashier. A £10 bond, were it to exist in paper form wouldn’t be. Neither of us would know exactly what it was worth at the time. If it was close to maturity it could well be worth something close to £10 but if not, it might not be enough to cover the £9 bill. That’s the only difficulty.

The acceptability argument, though, would also fail €500 notes in Europe. They aren’t easy to spend! No-one wants them.  Does that mean they aren’t cash or even money? The best way to get rid of them is to take them into a bank where you have an account and pay them in. The cashier will probably take a note of the serial number in case there is any problem. In that respect a €500 note is no more useful than a paper bond. We’d be able to pay that into our bank account too.

To answer the question we need to consider what money is and why it has a value. To fit in with the concept of financial sector balances, money has to be classed as a liability or a debt to the issuer and an asset to the holder.

So, if we have a closed system of say 100 currency users and their ‘government’ issues 10 currency units to each, the government then has a fiancial debt/liability of 1000 currency units and the users have total assets of 1000 currency units.

The users later switch half their assets to bonds. Say they each buy, at auction, 5 cu of bonds from their government (on the promise that they will be worth, say, 10 cu at some future time) their total assets are still 1000 cu as they can trade the bonds for exactly what they paid for them between each other or even sell them back to the government, if it should have a policy of QE!

The government still has total liabilities of 1000 cu. The fact that it created new IOUs (bonds) and swapped them for its previously issued IOUs (Cash) is of little signficance. If the effective interest rate on those bonds is zero, then zero significance.

The commonly held view that cash and bonds are somehow fundamentally different probably is a hangover from gold standard days. If the government had a policy of backing its cash IOUs but not its bond IOUs with gold,  it would make some significant difference. If gold held in bank reserves by government was counted as a financial asset, then issued money wouldn’t represent any net debt, providing it was always on a strict 1:1 basis.

Of course it is arguable that gold is just a commodity like all the other commodities owned by the government and shouldn’t be counted. But if the mindset is that MONEY=GOLD it’s possible to see the logic of the alternative argument.

Germans don’t understand how currency unions need to function.

The economic clash between Greece and Germany is invariably portrayed as a clash of cultures. The majority of Germans resent what they see, and are assured by those who should know better, as a bailing out, at their expense, of those in the southern peripheral European countries who appear to be unable to manage their economic affairs as well as they can.

      

That seems a perfectly commonsensical point of view but raw ‘common sense’, as always, in economics cannot be relied upon to be the best guide. Our common sense is invariably derived from our own micro-economic experience. The principle that it is better to be in surplus than deficit, for example, works fine for us as individuals in the micro world, but taking a wider view, that commonsensical notion is inconsistent with the basic accounting principle that for every asset there has to be a debt. For every surplus there has to be a deficit. Not everyone can be in surplus and not everyone can be in deficit.

So we need to correct our ‘commonsense’. Physicists, like Angela Merkel who therefore can have no excuse,  are used to doing exactly that. They know that their commonsense viewpoints of the world will only take them so far. It fails completely after that. Anyone who has studied Maxwell’s equations, Quantum Mechanics or Einstein’s Relativity knows that these subjects can make your brain hurt! After a while, we have to come to the conclusion that it is better to try to understand via the mathematics of it all rather than understand completely.

It is nowhere near as bad in economics,  but still just a little lateral thought is required. The easiest way to understand what needs to happen in the single currency eurozone, is to make a comparison with what already does happen in a successful currency union.

Let’s take a look at how it all works in the USA. The United States has, as we all know,  a common currency but also  a Federal Government to conduct macroeconomic policy, and transfer surpluses from the wealthy parts of the US to the poorer parts. It transfers surpluses. It does not arrange loans, except perhaps for special projects. If it did, the wealthier parts of the USA would end up as massive creditors. The poorer parts would end up as massive debtors. There would be clashes between New Jersey, the wealthiest state, and Mississippi the poorest.  I had to look this up , by the way. I suspected that Mississippi might be the poorest but I had no idea which was the wealthiest. I had thought maybe California. That’s as it should be. It should not be like it is in the Eurozone where the wealthy states never tire of letting everyone else know who is paying the bills.

So, imagine New Jersey  providing big loans to an impoverished Mississippi, dictating that it implement  privatisation of public assets at knock down prices and drastic cuts to state spending, pensions, its education service etc to be able to repay those loans.  The Mississipians and the New Jerseyites would be saying exactly the same things about each other as the Germans and Greeks are saying now!

So, just as any transfer of funds between New Jersey and Mississippi has to be just that, ie a transfer and not a loan,  so too it needs to be between Germany and Greece in the Eurozone.

The German taxpayers may well not like that idea. It certainly would not have been properly explained to them just what they were letting themselves in for when the Euro was created. No politician in any of the Eurozone countries would have dared make that explanation! It would have been career suicide. There were economists around who did their best to explain it all but they weren’t listened too.

It is too late for that now, but the reality of what has been created, in their name now needs to be recognised and understood by all. Some rethinking is in order. That has to start with the Germans,  then the Dutch and then everyone else too. The sooner the better.

The Euro could work so why doesn’t it?

Arguably, it did work reasonably well for the first few years of its public existence from 2002 onwards, but now, unarguably, it does not. Recession and high levels of unemployment is the norm, not just in the peripheral countries of Spain, Greece, Portugal, Ireland, Poland, etc but increasingly in the original group of six too. Italy and France are both experiencing double digit levels of unemployment; and the problem is now spreading to Germany itself, as its export markets in the Eurozone start to dry up. The high levels of unemployment in the peripheral regions of the Eurozone naturally leads to increased levels of migration to other areas of the EU which are performing better. Whatever we feel should be the case, our observations tell us that this is causing social and political problems too, especially in the UK, which we would be foolish to ignore.

There are many theories offered to explain the origins of the problem. The stated opinion of German right wing politicians and their ordo-liberal economic supporters is that there is nothing wrong with the Euro. If they can manage perfectly well with the Euro then so should everyone else. If they, like Germany would only just get close to balancing their budgets then all would be well.

See for example:

http://www.theguardian.com/business/2014/aug/20/angela-merkel-scolds-italy-france-eurozone-faltering-growth

Furthermore, there tends to be a lot of finger pointing in the German circles directed particularly, but not exclusively, towards Greece. The criticisms generally include a past reliance on an oversized pubic sector, an inefficient system of tax collection, a past over-reliance on ‘money printing’ to fund government spending leading to higher than desirable levels of inflation and even systemic corruption. They probably do have a something of a point, no countries are ‘perfect’ not even Germany; but are the German right missing the point completely? From an understanding of just basic economics we can clearly see they are.

The fundamental problem is none of the above. There is also a widely accepted, but not necessarily correct, argument that countries need their own currency, which should be allowed to vary to allow countries to devalue or revalue their way out of economic trouble. That certainly would help but neither is it the core problem. Rather it is a problem of financial transfers, albeit an easily solved one, that is to be expected whenever two or more countries decide to share a common currency; one or more of which are large net exporters and one or more of which are large net importers. There is nothing wrong with wanting to be a net exporter, if that is what countries want to do. Of course, for every net exporter there has to be a net importer willing to buy those exports. So, we firstly have to disabuse ourselves of the idea that the net exporters, like Germany, the Netherlands, Austria, Switzerland (even though the Swiss are not in the EU) are somehow more virtuous than the USA and the UK (in the EU but not the EZ) who are net importers.

It makes sense, all round, to allow countries to choose whether to be net exporters or net importers. The alternative would mean clashes over trade, the imposition of high tariff barriers, and currency wars. It is no exaggeration to say that these clashes can lead, and have led in previous eras, to real wars too. No-one wants to see any re-occurrence of that.

How does it work when a net importer and a net exporter trade together using their own and, therefore, different currencies? Assuming that the two countries have the same trade pattern with each other as they do globally, there is an inevitable imbalance when it comes to the net importer being able to pay in its own currency. There is always going to be a ‘glut’ of that currency on the market, which if left alone would cause the currency to depreciate. That country would then be able to afford fewer imports, its exports would look more competitive, and so its trade would naturally move into balance. Neither country wants that, so the importer issues bonds which are obligingly bought by the exporter using the excess of the importer’s currency. The importer then re-issues the money obtained from the sale of those bonds into its economy by government deficit spending. In other words, the supplier lends money to its customer to be able to continue to be a good customer. The central bank of the exporter then stores the purchased bonds and just creates, or ‘prints’, extra amounts of its own currency to satisfy the need of its internal exporting companies to be paid in that currency.

So, despite  all German assertions to the contrary, the policy of the Bundesbank has never been solely the minimisation of inflation. The Bundesbank was quite willing to ‘print’ as many DMs as was considered necessary to hold down its value to maintain the sales of German exports. An artificially lower exchange rate also translates into higher prices in German shops and so contributes to a higher level of inflation than may be the case otherwise.
This kind of arrangement can continue indefinitely. Of course, as the currencies are separate, they can vary over time in value in relation to each other, but, providing that inflation rates in the two countries are approximately the same, they do not need to. In principle they could be fixed, providing the exporter and importer co-operate to equalise their monetary transfers by the necessary issuance and purchase of government securities.

Therefore, if this arrangement can work with fixed exchange rates, it must be able to work with the same currency too. The process is simply same one, as before, of the exporting country lending back its surplus to the importing country so that it can continue to be a good customer. As the currencies are the same there does not have to be any bonds involved, it just needs money to be lent back, but there can be a transfer via bonds if that is mutually preferred. Money and bonds are just different forms of government IOUs in any case.

In the case of the Eurozone these would be the so-called Eurobonds which are widely being discussed, but adamantly opposed by German ordo-liberals. I fail to understand why. These are essentially the same people who were happy to lend their customers money when their currencies were different, so why do they have a problem now they are the same?

Ordo-liberals compound their mistake of not wanting to lend back the surpluses of the exporting countries in the EZ to the importing countries, by insisting that the importers should not borrow from anywhere else either. It may make sense for an exporter to have a balanced budget, but not an importer. The importer needs to sell securities and   deficit spend the money received back into its economy. That deficit could be 3% of GDP, the Euro limit, but equally it could be higher. It makes no sense to even try to impose arbitrary limits on government deficits, which are also affected by the desire of populations to save financially. The deficits can, and should be, varied, as need be, to ensure the consistency of levels of inflation in different EZ economies. So a possible strategy for the ECB would be to set an inflation target of something like 3% for every EZ economy and issue Euros either via the process of quantitative easing if the exporting countries were unwilling to recycle their surpluses, or the encouragement of bond issuance or even straight lending of euros if they were, or a mixture of both.

3% inflation may be too high, even if only for a limited time, for many in the more prosperous regions of the EZ to contemplate, and they have said so in no uncertain terms. See for example:
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/11211973/Mario-Draghis-efforts-to-save-EMU-have-hit-the-Berlin-Wall.html
However, the alternative is to leave things as they are. It will only be a matter of time before France is ruled by their National Front. Greece ruled by Syriza, Spain by Podemos,   Ireland by Sinn Fein, the UK by UKIP. There will be an upsurge in support for new Eurosceptic movements emanating from both the extremes of left and right as the EZ economies, including the now prosperous ones,  go from bad to worse to disaster. It is hard to see how that could be any preferable than paying a small price by way of an acceptance of slightly higher inflation, and the issuance of as many Euros and Eurobonds as are required to fix the problem right now.

PS Another similar view
http://www.3spoken.co.uk/2014/02/its-exporters-stupid.html

The Japanese own their own debt so they don’t have a problem. Right?

Wrong.  Even though those of us who argue that National Debts are not quite the huge monsters of popular neo-liberal supposition often point to Japan.  Japan manages to function very effectively with a debt to GDP ratio which is over 200%,  and more than double the US and UK’s national debt ratios.

All debts and deficits are caused by people, organisations, and countries wishing to save ££, $$ or Yen or whatever. If money issued by the US, UK or Japanese governments ends up being held by the central banks of the big exporters, or by their own citizens,  and who don’t wish to spend it, then these countries have to be in debt in accounting terms.

The only solution, if indeed there is a problem of debts owned by foreign countries, is to go back to countries imposing tariff barriers to protect their trade zones and prevent the build up of these kinds of financial imbalances. That caused wars in the past and would again in the future. It isn’t a good option.

It is usually pointed out by supporters of the neo-liberal orthodoxy that Japan manages to have such a high state debt by also having lots of savers who lend the money to the government. It is, therefore, not external debt and so is a lesser problem  True, Japan usually has a trade surplus and “pays its way” abroad.

However, internal debt can be more destabilising than external debt. If Japanese savers get spooked about a potential inflation they would all start over-spending simultaneously which could set off the problem they most fear. It would be politically very difficult for the Japanese government to control that by applying taxes on its own citizens. So whereas the debt isn’t at all a direct problem for the Japanese Government, the ownership of too many financial assets by the Japanese population could give them one.

On the other hand, if their debt were owned by a foreign country, say in the form of Japanese treasury bonds, it would be somewhat different. All that country could do , if it wanted to spend its Japanese Yen, would be to give large orders for real goods and services to Japanese industrial companies. It would boost Japanese exports tremendously. That too could be inflationary, but the situation would be more manageable. The Japanese government would be able to negotiate with its foreign creditors to spend at an agreed rate. As a last resort it could even impose a tax on its own exports.

That’s essentially the position the USA is in with regard to its Chinese creditors. If there is really a problem with debts,  it is China who has the bigger one than the USA. Japan has a bigger problem too. Not so much because it has a larger debt but because it is, rather than isn’t, largely owned by its own citizens.

When Joe says he wants a surplus, he means for government but a deficit for everyone else!

The Australian public have just been told that: The ‘Age of Entitlement’ is over, we have been living beyond our means, we can’t afford to spend more than we earn, we are leaving an unsustainable debt burden for the next generation. Think of a neo-liberal falsehood and the chances are Joe Hockey will have used it in yesterday’s  budget speech. Most of all, we are told “we” need to move to balance the budget and achieve a surplus. Note that Joe means a surplus for government and a deficit for everyone else!

If the governments take more out of the economy than they spend back in, as they would by the definition of a surplus, and at the same time individuals and companies within that economy wish to save some of the money they earn, and if there is a drain of money from the economy to pay for net imports, then isn’t that a recipe for crashing the economy, Greek style?

There won’t even be any ‘improvement’ in the deficit. Joe knows that. All sensible economists know that depressing the economy will make it higher not lower. Tax revenues will simply fall by an equal or greater amount than the cuts he has made, as the economy spirals downwards. If he genuinely wants to reduce the deficit, if that is what is really important to him, he needs to press the fiscal accelerator pedal, not puts his foot on the brake. That way the economy grows, the tax take rises, people are more confident to spend and invest more, and as unemployment falls, workers start to pay tax rather than receive welfare benefits. If Joe hasn’t abolished those completely!

Edit: Further reading
http://bilbo.economicoutlook.net/blog/?p=27823

Muddled Thinking Watch #5: “Increase taxes to balance the budget, the revenue well is not dry” Greg Jericho. The Guardian.

http://www.theguardian.com/business/grogonomics/2014/apr/08/increase-taxes-to-balance-the-budget-the-revenue-well-is-not-dry

“With government expenditure set to jump, we need to think about how to pay for it”

It’s not always the neo-liberals who get it wrong. Greg Jericho understands full well that austerity economics is bad news for the economy generally, and has previously written:

http://www.theguardian.com/business/grogonomics/2014/feb/27/australia-needs-austerity-like-hole-head

The point that Greg seems not to comprehend is that an argument for balanced budgets, in an importing nation like Australia, is also an argument for austerity economics. It would perhaps be just about possible to argue that if the budget were balanced by the imposition of a wealth tax and other high taxes on the high earners and wealthy then the degree of austerity would be slight but no, Greg Jericho makes statements like:

” I’ve been making the case that the budget isn’t just about cutting expenditure, it’s also about raising revenue.”

Greg might want to think about making the case that the budget should be about neither. It should be primarily about ensuring that the Australian economy is working close to its maximum capacity, and that everyone who wants a job is able to find one,  but without generating too much inflation in the process. That’s the economics. Greg also might want to consider if the collection of a pile of its own IOUs through the taxation system can actually be considered Government “revenue”.

In any case if  government expenditure does jump that will nearly all come back as a tax take or be saved in bank accounts. The only possible danger is inflation. Nothing else. That looks a very remote prospect at present.

There is the secondary consideration of the social effect of how taxes are levied and spending is conducted. If we want people to consume less alcohol for example then we tax it more. If we want to reduce the income and wealth differences in society we have a greater degree of graduated tax on incomes, a lesser dependence on regressive taxes like GST, and possibly add in a wealth tax too.  We spend more on public education and the public health sector and remove any tax loopholes, or anomalies,  which allow the private sector to benefit. Conversely, if we want to bring about a greater degree of inequality, we do the opposite. These are political questions.

It is important to separate the economics from the politics. IMO.  Or at least try to!

 

Want to make your business card worth something? Easy. Start a protection racket!

An interesting experiment is take out a bank note from your wallet or purse and ask your friends and family , “Why does this piece of paper have value?” You’ll get a range of answers. Some people may think “gold”. They will be completely wrong. There was a time when they would have been right. Once you could demand a fixed weight in gold in exchange for a pound or a dollar, but those days are long gone. Some may say “ Because you can buy things with it” — an answer that only begs the question! “Faith” will be another possible answer. Everyone will accept it because everyone else will!

There is the “because it is legal tender” argument. But, do we all do what we are supposed to purely because the law may require it? Do drug dealers happily accept cash, in dollars or pounds, for their wares because they are concerned to comply with legal requirements?

There must be another reason.

Suppose I wanted to establish my own currency. I’d start with a collection of business cards or even old Christmas cards, and write on the back of each one, 1 Martin, 5 Martins , 10 Martins etc. How would I ensure they were worth anything?. I could promise everyone that each ‘Martin’ would be redeemable for $1 or £1. If I was sufficiently well regarded in the neighbourhood then that would work, up to a point. That’s exactly what some countries do. They peg their currencies to another currency, usually the US$ or the Euro. These currencies work on the basis of an IOU.  However, if confidence is insufficient in the ability of that country to maintain the peg then speculators move in to try to make a killing by forcing its value down. It can be a dangerous game to play as many countries have found to their cost. If I can’t redeem the IOU at what I promise then technically I’m in default.

So what else could I do? Legally not much. But, if I were unscrupulously, not to say criminally, inclined, I could start a protection racket. I’d tell all my neighbours there was a problem with gangs of hooligans who came into the area at night to break windows and damage cars etc. I’d offer to protect everyone but the cost would be a signed business card of 5 Martins or however much I considered each person and household could afford. They would want to know how to acquire my signed business cards and I’d suggest they could paint my house, mow my lawn or clean my car or whatever. My signed business cards would acquire a value to me. I’d get work done for nothing! People from out of the area, who weren’t covered by any offer of protection would also work for me to acquire the Martins and either sell them to those who were in need of protection, or exchange them for an agreed value of goods and services. My business cards would be just like money. I’d be have to issue just enough Martins to enable my neighbours to acquire the cards at not too great a cost but not too many that they started to lose their value!

Martins would have an exchange rate! I would naturally keep an eye on what that was and use fiscal policies to control its value. My business card would still be an IOU but this time it would be a much vaguer IOU. There would be no guarantee that a ‘Martin’ would be worth anything other than 10% of 10 Martins.

Whereas everyone else would think of Martins as money, to me, as an issuer they would be useful but I wouldn’t view them in the same light as users of Martins. There would be no point in saving them up, for example, just in case I was short of them at some time in the future. I’d always be in debt in the sense that I’d always have issued more Martins than get returned to me. Would I have to balance my budget and only spend, in Martins, what I received in Martins? No of course not!

If I were arrested and thrown into jail then my cards would be instantly worthless. If another racketeer took over my patch he might, to establish some form of ‘customer relationship’, offer to redeem some of them but he would not have to.

My neighbours will be pleased to know that protection racketeer isn’t exactly my choice of profession. I’m not confident I’d be able to frighten people sufficiently to keep their mouths shut!   But governments aren’t similarly constrained. They send us tax bills so we can pay for their protection from all sort of threats, both real and imagined. If we don’t pay we don’t get our windows and cars damaged but we do run the risk of being jailed! Libertarians probably like the idea that Governments run legalised protection rackets. Liberals and Socialists less so but that’s essentially the way things are. It is the power of the State which gives the $$ and ££ their value.

So whereas Bob will take a £5 note or a $5 bill in payment from Ann because Bob knows that Col will take it from him, it cannot be an infinite chain. The chain is possible because at the end of it, Zoe has a tax bill to pay. It maybe a TV licence or car registration, and she needs that £5 note to help pay it.

If a government ceases to exist, for any reason, as happened when East Germany dissolved itself in 1989, its currency becomes worthless. There’s no need to pay the protection money, sorry taxes, any longer! The new racketeers, sorry the new unified German Government, weren’t completely heartless though. They did offer to exchange Ostmarks for Deutschmarks up to a certain value!

Thoughts on the Euro

The Euro is an exceptional case, a dangerous experiment of a currency divorced from individual nations themselves. The Euro is a foreign currency to all its users -except, some may say, Germany which has insisted right from the start that the Euro should be, to all intents and purposes, a continuation of the DM.

All 18 governments that use the Euro are users not issuers of the currency. They have all scrapped their sovereign currencies. They now lack the powers that a sovereign issuer has. Japan, the United States, the U.K., Canada, Australia, are sovereign issuers. Governments that adopted the Euro must borrow the currency. They must pay whatever the bond vigilantes require. They can run out of money. And they lack the policy space of a sovereign issuer.

For a member of the Eurozone, such as Italy the relationship between the government and the currency is different from the UK’s relation to the pound. Italy does not issue the currency that it uses. A country giving up control of the currency effectively gives up its own independence. Italy has becomes a State like Georgia is the sense that Georgia is a State of the USA. Except that the Eurozone doesn’t have anything like the financial infrastructure, which exists in the USA, and which is needed to equalise the imbalances between the richer and poorer parts of the currency zone and make a common currency work.

The problem with the Euro is that it cannot be created as needed. The governments must go out and get Euros from someone else. The Eurozone countries have sacrificed their ability to conduct sensible economic policy, and the effects are clearer now than ever. Spain and Greece have unemployment rates of over 25%. Youth unemployment is over 50%. Unemployment is high everywhere. France has unemployment measured in double gigures. 1 in 4 of their young people are without work. The Eurozone as a whole is an economic disaster area.

But  the Europeans can’t say they weren’t warned. In 1997 Wynne Godley wrote:

“The danger then is that the budgetary restraint to which governments are individually committed will impart a dis-inflationary bias that locks Europe as a whole into a depression it is powerless to lift.”

The UK thankfully learned from its own experience the pitfalls of tying its own currency to another currency with its ill fated attempt to shadow the DM in the 90s. That ended in the debacle of Black Wednesday. But better a debacle than a disaster. At least the pound still existed, at the time, and could be freed. Greece and Spain don’t have their Drachma or Peseta any more. Just how they can free themselves from their predicament isn’t easy to see.

If you talk to most Germans , or read articles in the German media, you’ll notice a lot of finger pointing towards, particularly, the Greeks.  Their argument is basically one of ‘Look, we manage perfectly well with the Euro. If you sorted out your deficiencies then you could manage too’!

To decide if this is realistic we need to look  at the three sector balances for any country:

Public Sector Balance +Private Sector Balance + Rest of World Balance = 0

Germany runs a balance of trade surplus with the Rest of the World. Therefore the last term is negative.
The Private Sector save, in true German style, for their pensions etc. Therefore the second term is positive.
So the Government can comfortably run a closed to balanced budget without causing a deflationary effect on their economy.

It’s a lot different for Greece or Spain.
Their balance of trade is poor. Therefore the last term is positive.
There are still many who wish to save (people do when times are bad) so the second term is positive too.
The EU requires countries to minimise their deficit. So the periphery have to try to balance their budgets. The first term has to be close to zero.

So yes,  theoretically there is a lot that could be done to gather in more taxes from the rich in Greece. That could be done, of course. But fundamentally the German argument is nothing more than saying that if all countries had a balance of payments surplus then everyone could be like Germany!  The Germans are supposed to be smart and modern. Can’t they see the lack of logic?

The dictat of the EU is effectively one of trying to suspend the rules of basic arithmetic. The more Governments of the periphery countries try to achieve the impossible the more their economies spiral downwards in search of a ‘zero solution’ to the equation.

What can be done? Forcibly stop Greeks and Spaniards saving? Import controls within the Euro region? That would work but there are obvious problems! But, the first step is to at least recognise the reason for the problem. It’s pretty obvious but I don’t see any indications that the penny has dropped. German politicians, mainstream European economists, the IMF and many others are locked into a neo-liberal mindset.

They are like old fashioned doctors who prescribe the bleeding of a patient . When that doesn’t work they prescribe more bleeding. Then more and more until the patient dies! Afterwards they all agree that bleeding was the right course of action but they probably should have prescribed it earlier and in greater amounts! Is this supposed to be the 21st century?

Keeping it Simple

Many academics, and economists are no exception, rate difficulty of understanding as a virtue in itself . A look at any modern economics journal confirms this. A incomprehensible argument can bring a lot of academic kudos! The problem, though, is that when an argument appears incomprehensible, it often means the person making it doesn’t understand it either and it therefore may well turn out to be quite wrong.  I’ve seen one blog which compares economics to Quantum mechanics! Which is a load of b******s IMO!

We can often get a good insight into what is wrong with the real economy by looking at a very simple economy. For example, suppose we look at the case of a baby sitting circle which has been set up by parents of small children. They set up a club, elect a club council and issue everyone with two tokens. Straightway we can observe that the council are going to be in ‘debt’ to the number of tokens they have issued. That’s no big deal is it?

If every parent  both sits, and is sat for, regularly then the system should work very well. Those doing the sitting are paid one token. Those who are sat for have to pay one token.

But, say, after a time some parents start to like the idea of accumulating tokens which they keep in the proverbial cookie jar at home.. For whatever reason, they do more sitting than they need to cover their spending.  Maybe they are planning to have lots more children at some time in the future and they think these tokens will come in handy. Or maybe they just have a squirrel – like mentality. Who knows?

Inevitably, the number of active tokens in the club diminishes. Parents notice that there just don’t seem to be many tokens around any more. Parents still need baby sitting and other parents are willing to do the sitting but there are no tokens around to to pay for the service. Invitations to social events have to be declined because of that! So the members petition the club council to issue more tokens. Of course those with the biggest store of tokens don’t care for this idea. They say the members of the club have to learn within their means. They say its wrong for the council to issue more tokens and go even further into debt. They’ll warn that issuing more tokens is just a sure fire road to hyperinflation. They’ll ask if members of the club really want to have to pay with a wheel barrow full of tokens for just one night out!

Can commercial banks create money out of thin air? (2)

Since my first posting on this topic it has occurred to me that each bank behaves exactly like a government with a fixed rate currency to support. That was the situation with most countries up until the 1970’s when national currencies were fixed against the US$. In the UK I remember the rates were around  $2.40 to £1.00 in the final days of a fixed exchange rate.

The UK government could print, or create, as many £ as it liked but it had to have a sufficiently good financial base to support that rate. If the reserves dropped too low then the currency speculators would take positions against the pound bringing it under downward pressure.

How does that work with a bank? Well for a start we know that the neo-classical multiplier  doesn’t fit the observable facts so we can forget all reference to that theory. There are those who claim that banks can create their own money without limit. That seems to be going much too far in the opposite direction. If they could really do that they could grow without limit, and never ever fail or fall into bankruptcy.

What could be a better theory? If I look in my bank account I can see, say $2000. but are they really dinky-di Australian dollars?  Sure I can put my card into the ATM and out do pop the genuine article. But what about the rest? I would argue these Commonwealth Bank IOUs  are actually Commonwealth Bank Australian dollars – which can be considered a sub-currency. The Commonwealth Bank can create, in theory, as many of these as they like, by keystoke. However they can’t overdo it. They can’t create CBA_A$ without limit. They do have to maintain the confidence of the market that they are have enough reserves to maintain their peg to the Australian dollar. So, the more they lend, the more reserves (or capital base) they need to do this.

Of course it’s the same story with all the other Australian banks. There are ANZ_A$ , Westpac_A$ etc. Providing all these banks are in good financial shape,  there is no effective difference between their IOUs or sub-currencies and and the Reserve Bank of Australia issued currency. But if any of these banks ever fell into difficulty that link could be broken and some deposit holders could find they lose part of their savings.

This theory is consistent with the observation that QE doesn’t work in the way intended. Once the bank has decided what reserves it needs it doesn’t make any difference whether they are in bonds or cash. It won’t change the bank’s lending practice.

I haven’t seen anyone else make this observation so it is possible there is a flaw in the theory. Any comments either for or against are welcome.

********************

The previous posting on this subject generated quite a bit of heat. The line I’m advocating didn’t go down well with those who were of the opinion that commercial bank lending goes much further.   That is a pity because I would say they, like the proponents of MMT, are motivated to have a better functioning economy, and do advocate full reserve banking as a key policy towards this end.

I’m not sure that FRB is necessary but, if it is, then it should only be done with a a full understanding of the issues involved. Goodwill isn’t enough.  Changing things and hoping for the best isn’t ever going to work. The basic theory needs to be right.
I’d make the same argument to people like Russell Brandt who argue for revolutionary change. OK, so we have a revolution, and then what?