Want to reduce your deficit, Mr Osborne? Stop your boys burning those £50 notes* !

* Or at least ask them to tell you about it!

The Oxford University based Bullingdon club has attracted controversy of late, in large part  due to certain unsavoury practices  indulged in by its young, privileged, elitist but poorly behaved members. Their current initiation ceremony is reported to include the burning of a  £50 note in front of a beggar or homeless person.

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Former members of the club are now a well ensconced part of the UK political establishment. These include the current Prime Minister Mr David Cameron (In photo, second from the left standing) , the Chancellor of the Exchequer Mr George Osborne, and the Mayor of London Mr Boris Johnson (far right sitting)

A key source of worry for our worthy politicians is the UK’s government budget deficit which now runs at approximately 4% of GDP. This is the gap between what the government spends into the economy and what it receives back in taxation.  The budget deficit is often referenced in support of their argument that we are all “living beyond our means”,  that our “credit card is maxed out”, and that cutbacks in spending  and increases in taxes are unfortunately necessary to “cut our coat according to our cloth” etc etc.

So in this context, we might ask just what macroeconomic impact the burning of our currency might have? It is course illegal to deface or destroy currency. Why should that be?

It does have an effect. If these wealthy young men had chosen to give £50 to a homeless person that money would no doubt have been quickly spent. It would have been a stimulus to the economy.  The destruction of £50 has the opposite effect. It is exactly the same as if we had handed that £50 note over to the government in taxation, where the government routinely puts old notes through the shredder.  If Mr Osborne knows of specific instances where currency has been deliberately destroyed he is quite entitled to count that as voluntary taxation. His deficit would be reduced commensurately.

As he can’t know just what happens to our currency he has to assume it still exists and that it is just being saved somewhere. The net effect is still the same. To keep the economy functioning,  at full capacity,  any money which has been taken out of circulation either by its destruction or because it is being stored in a safe or bank account has to be respent back into the economy by government on our behalf. It’s neither here nor there  whether the budget is in deficit or in surplus.

We don’t need to know how much is being burnt and how much is just being stored. If any government overdoes the spending, relative to the levels of taxation, we’ll have too much inflation, but if it underdoes it , like now, we’ll have deflation and high levels of unemployment and underemployment.

Is Government Spending Already by PQE?

We can think that all spending by government is already by the creation of new money, which is the general understanding of PQE (otherwise known as  Overt Monetary Financing of Government), using the concept that money is an IOU of a sovereign currency issuing government.

So, just as you or I have no use for our own IOUs, we tear them up when we get them back, neither has government. All money collected  in the form of taxation or in bond sales is simply shredded. Destroyed -either physically or digitally. When govt spends, it does so by issuing new IOUs. ie Issuing new money.

So what is the point of taxation? It’s to prevent high inflation as has already been mentioned in previous posts.

And the point of selling gilts (bonds)? It is to set longer term interest rates. Generally speaking: The more that are sold by auction, the lower their price, and the higher their yield. The higher their yield the higher are longer term interest rates.

If Government wants lower interest rates in the longer term it should sell fewer gilts, yet still create as many new IOUs, as many new ££, as it needs for spending purposes. Its spending decisions have to be such that they won’t produce too much inflation, of course,  which would require the raising of taxes. The balance between spending and taxation remains the subject of political debate as always.

A better idea might be to stop selling gilts completely and allow savers, ie the hitherto bond purchasers, to put their money on account with the BoE ( which is best considered as part of Treasury) and set the interest rate payable just as a high street bank would set the interest to us on our longer term savings. Short term interest rates are already set this way so the concept, and practice, just needs to be extended to include all savings. The interest rate would probably be higher for a longer deposit period, again as we might expect from our own bank.

And what about the exchange rate?

If the government offers lower interest rates the £ might be expected to fall, and higher rates will probably cause it to rise. If we stay with the idea of selling gilts, and stick with the concept that PQE  is somehow different,  we can say there will be less need for the government to ‘borrow’  and therefore less need to pay out interest.

This will have the same effect on the exchange rate as directly reducing interest rates.  It is just looking at the process from a different perspective.

PQE, as is conventionally understood, could be part of the government’s exchange rate strategy. That is if it wants one, and that could be the subject of another discussion! If it wants a lower pound, it does more PQE. A higher £ means less PQE. It depends on what sort of trade deficit we want to run. If we are happy to run a high deficit, and there is no reason why we shouldn’t, we can keep the pound high, but if we want to reduce it we will need a lower £.

How to win and lose elections. (2)

There’s been a lot of navel gazing in British Labour circles recently about what went wrong last week and what needs to be done to prevent a re-occurrence next time. Presumably in about five years time. The arguments are pretty much along the same lines as the last time that Labour suffered an unexpected election defeat. Naturally, those on the right want to move more to the right. Those on the left want to move more to the left. Those in the middle think a new personality might do the trick.

Who’s right? Let’s just stand back and look at the numbers. According to my calculations the Tories received about 24% support from the electorate in the 7th May 2015 UK elections. Labour about 20% support. That’s including those who didn’t vote. So to win government, next time, Labour need to get at least another 5%. If they are positive, and were prepared to really go for it, they could aim for another 10%. If they achieved that they’d be back big-time.

So what’s the best way to do that? Let’s leave the politics out of it as much as possible and just think in pragmatic terms. Do they try to persuade nearly half, or a quarter if we allow for the same reduction in the Tory vote, of those who voted Tory this time to switch sides? I could be wrong, but I don’t think that’s ever going to work. I know a good few Tories and I can’t think of a single one who would ever vote Labour, even if the Labour Party were offering the most Tory of policies and had a picture of Maggie Thatcher on the front cover of their next manifesto. Of course, if the party did that they would jeopardise their own core vote. That’s never a good idea.

I’d say the same would be true in the USA too. Both the Democrats and Republicans would expect only limited success if either moved towards the other politically. Probably it wouldn’t be enough to make a real difference. It could well be counterproductive and would naturally give more justification to those who were disillusioned with the lack of political choices that were on offer. They’d choose to do other things, rather than becoming involved in the election and would be less likely to make the effort to vote. This argument probably wouldn’t apply to Australia which has compulsory voting – the Aussies are quite unusual in that respect.

Alternatively, Labour could aim for the 56% who didn’t vote for either them or the Tories. This, again, would include those who didn’t vote at all. Labour wouldn’t persuade them all, that’s for sure. But, they’d just need to sway 1 in every 5 and they’d be home and dry.

This is an implied conclusion which, I have to acknowledge, will be more appealing to the left than the right. But, I’d argue it’s the reality too. The left would argue that by being true to their historic principles, and offering a message of hope rather than despair to working people they would have a better chance of winning. They’d argue the need to have a distinctive message which wouldn’t allow anyone on the doorstep to say “but you’re all the same”.

I’d add that the party, as a whole, needs to make a start on the explanation of how the economy really works which is not at all how most people think it works. Once more people have that understanding it will become apparent what the real choices are from both a left and a right perspective.

“Why, sometimes I’ve believed as many as six impossible things before breakfast.” (or what’s so hard about MMT)

Guest Post by John Armour

Last week Australia’s Prime Minister, Tony Abbott, said; “we are now borrowing to pay the interest on the money we’ve borrowed.” He added that if this didn’t stop we were “stuffed.”

This must make Abbott lead contender for the title of “The Stupidest Man in Australia.” His only serious challengers would be the Treasurer, Joe Hockey, and sidekick Mathias Cormann, who say equally dumb things on a daily basis.

Behind Abbott, Hockey and Cormann, one could reasonably nominate every member of the Press Gallery, the journalists (supposedly our best) who cover the important political issues of the day for the MSM, for the runner-up awards.

Last weekend, on the ABC’s “Insiders” program, four of the nation’s top journalists nodded sagely as one of them expounded on the necessity for “fiscal consolidation,” an oxymoron.

To those well versed in the mechanics of our monetary system it must seem as if our politicians and the press corps live in a parallel universe where black is white and water flows uphill.

Only in the blogosphere does one learn about the reality. Why is this so?

The answer seems to be that non-mainstream academic economists like Bill Mitchell decided to try using the internet to reach a wider audience, to describe how our monetary system really works, and bust a few myths, in the hope that the insights of MMT would then trickle up to policy makers and cut the rug from under the Neo-Liberal experiment.

One would have to say they have been spectacularly successful, but only up to a point.

Despite an enthusiastic lay following that seems to be growing exponentially, the advancement of MMT seems to have hit a wall when it comes to getting around the gatekeepers of the Neo-Liberal madhouse, the economists and financial and political journalists, who write for the MSM.

Keynes said the problem is not in understanding new ideas, but in getting rid of the old ones.

That’s certainly true, but MMT is just so damned confronting to deeply embedded “self-evident” truths. The instincts and “common sense” of Keynes’ “practical men” are of no help. MMT is counter-intuitive.

Proponents of MMT generally can’t understand why people don’t “get” MMT as it seems so obvious.  They may have forgotten however, that at their critical point of ‘enlightenment’ they had to jump a number of conceptual barriers to get to the other side.

In my experience, these are the six (seemingly) “impossible things” you have to believe (before or after meals, it doesn’t matter) to have any hope of ‘getting’ MMT.  Once you believe these “impossible things” however, the getting of wisdom follows quickly and logically.

The order of priority is based on my experience of the degree of ‘jaw dropped-ness’ as I’ve sought to explain to friends, family, and household pets.

(1) Taxes don’t fund anything

(2) The government doesn’t borrow from anybody to finance its spending

(3) The government’s fiscal balance (deficit) is the non-government sector’s surplus.

(4) The government creates currency by fiat (‘out of thin air’)

(5) Bond issuance is  not borrowing.

(6) Banks lend without reserves constraints imposed by the central bank.

They are of course not “impossible things” but the absolute reality of the sovereign fiat monetary system we actually operate under.

I could’ve added a few more but I needed just six to fit my literary allusion (“Through the Looking Glass”).

Warren Mosler’s great little book “Seven Deadly Innocent Frauds of Economic Policy” covers all these points in detail as does Frank E. Newman’s “Six Myths that Hold Back America.”

Money, Government Bonds, and Quantitative Easing

Quantitative Easing is considered, by many, to be a euphemism for printing money. Is there just possibly a germ of truth in that statement? Why is it done?What exactly does it mean?

In normal times, central banks try to increase the amount of lending and activity in the economy  by cutting interest rates which encourages people to spend, not save. However, when interest rates are close to zero and can go no lower, another  option for a central bank is to lend money into the economy, by which they usually mean the commercial banks, directly. That is  supposed to be the motivation for quantitative easing (QE).

The way the central bank does this is by buying assets – usually government bonds – using money it has simply created “out of thin air” .The institutions selling those bonds , either commercial banks or other financial institutions, will then have extra money in their accounts, so boosting the money supply. That is the mainstream theory

It was used first by  in Japan to help it out of a period of deflation following an asset bubble collapse in the 1990s.

Let us just go through the steps of what happens when a government issues, say, $1 billion of new bonds and then re-purchases them. That in a nutshell is QE – although usually just the last step is considered. A government issues (prints!) the bonds. They are sold for $1 billion at auction. The government can then claim, somewhat dubiously as we will see, their $1 billion is real and hasn’t been printed. The financial institutions have their bonds. The government decides to buy them back. There would be no point in using the original $1 billion so
Government prints another $1 billion. The government gets back the bonds. As they are an IOU all they can do is tear them up. The financial institutions then have back their $1 billion, plus no doubt a little extra to keep them
sweet, so there’s no net change as far as they are concerned. The bonds no longer exist and all that is apparent is the government, somewhat to their embarrassment, have funded their deficit by printing money after all!

But is all what it seems?

Let’s start from the beginning with our understanding of what money is. Nearly all modern money is fiat based. It is not backed by anything tangible like Gold or silver. It isn’t pegged to any foreign currency and can be worth more or less against other currencies one day than the next. It has a value because of the power of governments to impose taxation and insist on payment in that currency.

All money is printed. Or, it is an electronic version of that. So the term ‘printed’ can mean either one or the other. Look in your wallet and you’ll possible have a $100 dollars or so of printed government money. They are just IOUs. You’ll maybe have a thousand dollars or so in your bank account. They are just electronic government IOUs. Basically they are the same thing.

So what is a bond? Anyone can issue a bond which is just an IOU with interest included. If the issuer sells a bond, there will be a promise to pay a certain amount at some future date. Depending on the credit worthiness of the issuer and the prevailing, and anticipated future,level of interest rates at the time, the bond will have some value which is less than the face value of the bond.For instance, I could issue a ten year bond for $200 and maybe expect to sell it for $100. That would give my creditors approximately a 7% return on their investment. That bond would be trade able during its lifetime and at some intermediate point will have a value of $150.

Governments too issue bonds. The more credit worthy the government, the less risk of their defaulting on their commitment and so the higher price they can expect to receive on issue. These are usually decided by a process of auction. When governments are in full control of their own sovereign currencies there is zero risk of involuntary default. There isn’t zero risk of inflation though, and so the issue price will probably still be less than the face value of the bond. Although there have been instances of that not being the case. It is possible to have negative interest rates. In that case investors are effectively paying a fee for someone else to look after their money.

Government bonds are still known as ‘Gilt-edged securities’ in the UK. At one time they were printed pieces of paper with golden edges. On some bonds, coupons were attached which could be handed in for the payment of interest.
The term coupon is still used for payment of interest on a bond.

The conventional wisdom is that it would be highly irresponsible for Governments to finance their budget deficits by printing money. It is not considered acceptable for Governments to spend new money into existence. There is a different argument when it comes to lending money into existence. That’s different of course! We may come back to how commercial banks by arrangement with reserve banks can create money ‘out of thin air’ in a later posting.

That argument does, of course, depend on whether bonds are not just another form of money. If we look at one piece of paper which is a bond, we have to ask if it is really different from another piece which is in the form of a banknote. One will have an interest rate associated with it but what if that interest rate is very low as would be the case presently? What if that interest rate were so close to zero that it hardly mattered? In that case it can be seen there is no functional difference between a bond and a banknote.If one is printed money then they are both printed money. The level of interest is just a detail.

Quantitative easing, the buying of bonds, and other securities by Government, is just an exchange of one form of money for another. Its all done in bank accounts in reality. There are probably no pieces of paper involved. A customer of a central bank has money in bonds when it is in one type of bank account. The process of QE means shifting out the money to another account which is currency based. The process will tend to reduce the level of interest rates but if they are near zero to start with, probably not by much. The overall effect on the economy will be small. Especially when the financial institutions choose to sit on their assets, rather than lend them out,  as they previously decided to do. Contrary to initial fears QE has not led to runaway inflation in countries where it is being used.

Yes, printing money has occurred: it happened when the bonds were first issued, which is considered quite normal, not when they are being re-bought.

More on why fiat currencies have a value.

I received an email about my “Fairy Story”  making the point  that most currencies did start off as commodity currencies and later switched to being fiat currencies.

So here is another take on how that has come about:

Imagine a large prison camp with many prisoners. The authorities have  issued tokens to be used as a currency. One token is  equal to a packet of cigarettes. The authorities promise to redeem those tokens for a packet of cigarettes and so the prisoners are able to use those tokens as a currency. For every token they take in, and for every packet of cigarettes they pay out, they in turn pay out that token in the form of wages for jobs the prisoners may do in the kitchens or the prison gardens. That’s like the Gold Standard of course.

Then one day one of the people in the prison authority comes up with a bright idea to eliminate the need for them to pay out any cigarettes.

How is that done?

The answer is that they impose a poll tax of one token per week from each prisoner. Or just from some prisoners. They have to pay in one token. There are severe penalties for non-compliance. The authorities have to give the prisoners a way of earning those tokens so they offer them a job in the prison gardens or the kitchens, as previously,  so they can earn them. Even the prisoners who aren’t liable to pay can still work and trade their tokens if they want to.
That’s the way it works – I think.

So, the government pays out the tokens in the form of wages to its employees and contractors first and then receives them back in the form of taxes later.

The “conventional wisdom” is that it’s the other way around. Governments can only spend, unless they borrow the difference,  what they receive in taxation!  I don’t think so!