Thursday, January 29, 2009

Errors Galore

It's kind of cool living through this economic period, when it is patently clear that no one has any idea what is going on. Here is a comedy of errors to enjoy.

1) Eugene Fama -- was inline for a Nobel Prize before he before he began blogging.
Again, here is my argument in three sentences.

1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the same funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

Are any of these statements incorrect?
Krugman says 2 is incorrect, and calls Fama pitiful.

Krugman, of course, is also pitiful because 1. is wrong too. But I don't have a spot in the NYTimes.

2) Jeffrey Sachs -- has an FT column, which is not that great, Nobel Prize status unknown to me. Still wrong though:
The most obvious problem with the stimulus package is that it has been turned into a fiscal piñata – with a mad scramble for candy on the floor. We seem all too eager to rectify a generation of a nation saving too little by saving even less – this time through expanding government borrowing
Government does not need to borrow to spend. Government deficit enables private savings. Therefore, to balance increased private savings, you must increase the Federal deficit. The Government can issue debt, if it wants, or it can just sit on the deficit.

3) Me! Check out the comments thread beneath the very charitable post by the indomitable Interfluidity. JKH, who does not blog but comments up a storm, and I are almost at the heart of whether a combined Government/Central Bank entity needs to borrow to spend, or not. It is clear to me that currency, whether debt or notes, is just monopoly money with an army backing it up, but JKH has a flurry of balance sheet entries, open market operations, and other highly complex jujitsu to prove me wrong. We've seen where highly complex financial jujitsu has gotten us lately so I'm feeling good, but we'll see.

Wednesday, January 28, 2009

What is an Animal Spirit when it's at home?

Robert Shiller has an OK article on "animal spirits" and talks about the importance of "trust".
But lost in the economics textbooks, and all but lost in the thousands of pages of the technical economics literature, is this other message of Keynes regarding why the economy fluctuates as much as it does. Animal spirits offer an explanation for why we get into recessions in the first place -- for why the economy fluctuates as it does. It also gives some hints regarding what we need to do now to get out of the current crisis.... A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others. In talking about animal spirits, Keynes sought to convey the message that swings in confidence are not always logical.
I wish when people spoke about "animal spirits" and "trust" they would explicitly talk about what these things actually are, and how they can be quantified. Warren Mosler clearly lays out what the key quantification is:
A drop in ‘animal spirits’ is also known as an increase in ’savings desires’ which reduces aggregate demand as private borrowing wanes.

Any drop in demand, however, can be readily addressed with some combination of lower Federal taxes or spending increases, and the longer ‘animal spirits’ remained subdued the longer our taxes can be kept down. This is well worth considering before we jump to the conclusion that we want to restore the financial sector and lending in general.
Banking is inherently pro-cyclical. Giving money to banks during a declining economy will not stimulate that economy, although it does transfer assets from people who have them now to banks, or more particularly, bank equity holders and especially debt holders.

Low 'animal spirits' mean that people want to save, not spend or go into debt. Given that the US consumer has been spending an unsustainable 107% of their income over the past few years, this is not surprising. Open any NYTimes dated 2004-2006 and you'll see story after story with serious economists, like Paul Krugman, saying that the US Consumer must stop spending and start saving. Given that incomes have been stagnant, this new demand for saving (an exogenous demand shock, if you prefer) has come from transactions -- spending and investing. It will continue until the household balance sheets have been delevered. The demand for delevering is being complicated by increased unemployment, which makes it both harder to save and also increases the demand for (precautionary) saving as insurance.

But remember -- 30% of household income is taken away by taxation. It would be easier for the Government to help households save by taking away and uncreating less of their money. The point of taxation is not spending -- Government can print money and does not need to tax to spend -- the point is to uncreate money and thus reduce aggregate demand, and prevent inflation. In a deflationary environment, taxes are counter productive. Worse, when Paul Krugman and the NYTimes/Obama team dismiss tax cuts because "people will save the money", they miss the entire dynamic behind 'animal spirits', 'deflation', and our current situation.

Tuesday, January 27, 2009

Too slow? No problem!

Paul Krugman acknowledges that his/Obama's stimulus plan is too slow.
Every economics textbook — mine too! — warns that stimulus based on public spending has a habit of peaking much too late, and therefore ends up being counterproductive... It’s not a problem if some or even most of the stimulus arrives after the official recession, as determined by the NBER, is over.
So, how long should fiscal stimulus continue?
The reason we’re talking about fiscal policy is the fact that monetary policy is up against the zero lower bound. Stimulus will still be valuable as long as we’re still up against that bound — which is likely to be the case for a long time.
Just so we're all clear, Japan has been up against the zero bound not for about 20 years.

Increasing the Federal Deficit so that it meets the private sector's desire to net save, and thus support aggregate demand, is at the heart of any fiscal stimulus plan. Krugman, and pretty much every other economist, does not understand how the Federal deficit is required to fund the private sector's demand to keep cash in their bank account.

Krugman's argument is that, since increasing G by an inadequate amount, slowly, is going to keep unemployment high (and not meet the private sector's demand to save) it doesn't matter if G happens late. The circularity of this is obvious and ridiculous. If the Government enacted a faster, payroll tax driven stimulus, then households would have repaired their balance sheets faster, and unemployment would fall sooner.

Monetary policy has an indirect effect on the economy (as we can see now) so it's always somewhat ineffective at controlling the economy. The very ineffectualness of Krugman's stimulus is also his excuse for why it doesn't matter if it doesn't kick in until 2010/11. The fact that people are losing their jobs now seems not to register.

NYTimes 1, Chicago 0

Paul Krugman is ably taking U Chicago behind the tool shed and thrashing them. I had an email exchange with Prof Cochrane yesterday where I tried to gently point out the error of his ways, but to no avail. Drinking down a tall glass of FAIL may to tolerable if you have tenure, but it still cannot taste that great. I'm sure Fama, Cochrane, and the rest of U Chicago are not enjoying all the egg on their face, so I'll try once again to show them a way out of their conundrum.

The Issue

Essentially, Cochrane and Fama both assert that savings = investment (+ capital account), and so say that any Government stimulus will crowd out private investment. Here's the derivation (by identity) to get you S = I

Y = C + I + G

National savings can be thought of as the amount of remaining money that is not consumed, or spent by government. In a simple model of a closed economy, anything that is not spent is assumed to be invested:

NationalSavings = Y − C − G = I

If you think that banks make (investment) loans based on their deposits, then it's reasonable to assume that all money not spent (ie. saved) is invested. But banks do not take deposits and loan them out. In fact, banks make loans first and then those loans become deposits. Remember -- loans create deposits, deposits do not "enable" loans.

Loans create deposits

Banks, by way of their Federal charter, can expand both sides of their balance sheet at will, subject to capital requirements. This money is created ex-nihilo, but always nets out to zero in the private sector, as each (private) asset that a bank creates must be matched by a (private) liability. Government can create money outside of the system, but banks always need to net out and balance the balance sheet.

People believe that fractional reserve banking, in some weird way, has banks taking deposits, multiplying it (through what seems like a strange and fraudulent process), and then making a larger quantity of loans. In fact, banks make whatever loans they think make sense from a credit perspective, and then borrow the money they need from the interbank market to meet their reserve requirements. If the banking sector as a whole is net short of deposits, it can borrow the extra money it needs from the Fed. If you think this is a weird and pointless regulation you are correct. Canada, for example, has no reserve requirements and yet seems to have a banking sector. The quantity banks can loan out is constrained by capital requirements and credit assessments.

Facts on the ground

If a description of how banks actually work doesn't shatter your belief that savings = investment, consider Reality. From about 2000-2006, American savings went negative, yet banks loaned out huge amounts of money (made huge investments). In fact, they came up with all kinds of clever ways to skirt capital requirements so they could make even more investments. If savings = investments, and savings fall, how can investments rise? By the same token, from 2006 to now, the private sector has actually delevered, saved, but banks aren't making any loans (investments). What's up with that?

More Facts on the ground

Anyone who thought they were saving by putting money in the S&P500 has had a rude wakeup call. They were not saving, they were investing, and now 40% of that money is gone. I don't think they will confuse saving with investing in the near future.

So, what is savings?

A better way to think of savings is to think of it as what's left after taxes, consumption, and investment.

Y = C + I + G

Net Private Savings = Y - C - I - T = G - T

Austrians will howl that it is unreasonable to define savings as a residual, there should be a term S for active savings, but people have to save in currency, and in a fiat, floating fx, non-convertible world, currency is not a store of value. Fiat currency trades bankruptcy risk for inflation risk, and fiat currency is all that's sitting in bank accounts. So the Austrians are right, there should be some way to actively save, but they are wrong, because fiat currency in a bank is not it.

You split out savings from investment and you get Net Private Savings = Government spending - Taxes, also known as the deficit. So, the Government runs a deficit (spends more than it taxes) in order for the private sector to have the extra money it needs, after consumption, investment, and paying those taxes, to net save. This idea totally blew my mind when I first encountered it, but it actually makes total sense.

So, if you acknowledge that savings does not equal investment, then you see that Government deficit enables private savings. This is the OPPOSITE of all the Chicago guys who argue that the Government deficit REDUCES national savings. Government is a currency issuer, why does it need to save? Does a bowling alley need to hoard the points it awards for strikes and spares? Everyone acknowledges that the Fed can print money, but few people actually think about what that means.

The way out for Chicago

Once Chicago makes its peace with the role the Federal deficit plays in the economy (funds private savings) then they way out for them is clear and easy. The private sector went from an unsustainable borrowing binge that is over, and now it wants to save. Those savings can only come from two sources: 1)fewer private sector transactions, and 2)larger government deficit. Right now we're getting both, as aggregate demand falls, generating unemployment, and lower tax receipts and higher unemployment claims increase the deficit. We want less unemployment, so that means we want to increase the deficit in a way that funds the private sector's demand to net save.

The Federal deficit is G - T.

Obama, Krugman, and the New York Times wants to increase G as fiscal stimulus. But G will be stimulated too slowly, will be allocated incorrectly, and cannot be reduced. The overshooting will (eventually) cause inflation.

Reducing T is a faster, broader, less distortionary, and more reversible mechanism to increase the deficit. Paul Krugman says that tax cuts are not stimulative because people will save some of the money. But the whole reason aggregate demand is falling is because people want to save some of the money! People saving money is the entire point of the whole exercise. The private sector, after being told for years it should save more, is finally doing just that, and it's being beat up for it! If the higher deficit funds private saving (which it will), that increases the money available for investment and consumption. If you want to increase investment and consumption, then reduce T some more. Repeat as necessary until you get enough aggregate demand, without too much inflation. Done.

Chicago needs to recognize that a higher deficit is required to fund private savings, which is what's going on right now. It then needs to argue to implement this via a payroll tax holiday. It should attack the Krugman/Obama/NYTimes strategy as being unstimulative -- because it's too slow, and impossible to turn off once it gets started. Long term investment is fine, but that should be separate from a stimulus package.

Both sides are deficit nazis, and want the deficit to be smaller (one would do it through lower G, the other through higher T). Neither sees the role the deficit plays in funding private sector savings. Given that Keynes himself acknowledges higher G is too slow for real stimulative effect, you need to argue for lower T, and understand enough about monetary mechanics to point out that having people save is the point. The spending and investment will come once the demand to save has been met.

Friday, January 23, 2009

You must be Brave or Foolish to go against UChicago econ

I've studied with all of the profs in this excellent U Chicago panel, particularly Kevin Murphy, who I believe is the smartest man at the school. And that's *really* saying something, as the place is silly with Nobel Prize winners.

And yet, and yet, I'm going to go against them. Foolish or brave? You be the judge.

First Huizinga: His major point is that this recession, so far, is not awful compared to previous recessions, so calls of a new Depression are overdone. I think it's difficult comparing this recession to past ones without also comparing how heroic Government actions have been to keep things from getting worse. I don't know if the 57, 74, or 81 recessions included bailing out the banking system, the shadow financial system, insurance companies, car companies, and more, but if things are not so bad right now it must, in part, be because a huge chunk of the private sector is now existing on the Fed's largess.

His identity

National Savings = I + Current Account

arguing that Government action will crowd out private investment is not being interpreted correctly.

You begin with

Y = C + I + G

And you claim that anything that is not spent is saved and you split saving up into public and private. This is how you get S = I

But, a more accurate use of the identity is to have private savings as the residual after private consumption, taxes, and investment

Y - C - I - T = G - T

Private savings = Federal deficit

This distinction between savings NOT being investment is critical, and is clearly the dynamic we see now, where banks are sitting on cash and not making loans (and private equity is similarly sitting on the sideline). A change in demand of cash is at the heart of the crises, and eliding it by using the wrong identity begs the critical question!

Next, Kevin Murphy.

I loved the model he used for evaluating fiscal stimulus:
• Let G = increase in government spending
• 1-α= value of a dollar of government spending (α measures the inefficiency of government)
• Let fequal the fraction of the output produced using “idle” resources
• Let λbe the relative value of “idle” resources
• Let d be the deadweight cost per dollar of revenue from the taxation required to pay for the spending

Love it!

But, the deadweight cost per dollar of revenue for taxation required to pay for the spending is *wrong*. Government does not need to tax in order to spend. The dollar is a fiat currency, not some "store of value" and as such the Government can spend more by changing entries in a spreadsheet, and not increase taxes. The result is a larger deficit, but a larger Federal deficit is exactly what we need to support aggregate demand as the private sector (net) deleverages.

Finally, Robert Lucas. Lucas at least includes price and velocity -- thank you for that! -- but again misses the key element:

MV = Py

Given that V is going to zero (as people demand more savings) you need to increase M by a large amount so y can stay where it given that P is fixed. In the long term, P will fall and we will return to the 10 cent hamburger, but in practice the US is simply not going to be allowed to enter a 1930s style protracted and deep deflation.

The obvious solution at this point would be to talk about how we can increase M rapidly, in a way that is equally rapid to reverse! The obvious candidate, and it would be obvious to Keynes if he was alive today, would be a payroll tax holiday. It would avoid all the fiscal problems that all three economists mention, while still handling the money supply in a way that gets us to a rebalanced economy without having to do things the hard way and increase the deficit through unemployment.

But, sadly, in U Chicago fashion we get stuck at "Government spending is bad" and don't take the next step on how to fiscally stimulate in a way that would actually work in the short term, and be better for the economy in the medium and long term also. There is a reason none of these three guys are on the NYTimes Op Ed page.

Friday, January 16, 2009

God Forbid we help households pay down their debt

Great unintentional blooper from Princeton's Uwe Reinhardt
Noneconomists may ask, of course, exactly how a $1 cut in taxes would translate itself into a $3 increase in G.D.P. at a time when traumatized households, whose wealth has been eroded, might use any new tax savings merely to pay down debt or rebuild their wealth through added savings, rather than spend it, and when businesses unable to sell their output even from existing capacity might hesitate to invest such tax savings in more capacity.

But never mind this fine point.
The point is obviously too fine for Uwe. The private sector's desire to increase net savings is a normal action following years of unsustainable net dissavings. Household debt ratios were at an all time high, and sooner or later they had to revert to mean -- no mystery here!

A tax cut would help households pay down their debt faster. Increasing the deficit to help households pay down their debt is non-inflationary, as savings do not contribute to inflation. They do not contribute to GNP either, but helping households save through lower taxes means they won't try to do it through lower spending and investing, which is exactly what's happening now.

And besides, if households save some, just give them more. It's not complicated

Instead, Reinhardt has some bizarro fantasy where state construction contractors being really really busy in 2010 and 2011 is going to help unemployed investment bankers and real estate agents in 2009. With households as indebted as before.

But never mind this fine point.

Thursday, January 15, 2009

Rewording Keynesianism

Let's try to reword Keynes' classic General Theory equation in terms that underlies the "points, not gold" reality behind fiat currency.

The identity reads:

GNP = C + I + G + [CAS]

Gross National Product = Consumer Spending + Private Investment + Government Spending + [Current Account Surplus]

Subtract taxes from both sides and you get:

Gross National Product - Consumer Spending - Private Investment - Taxes = [Government Spending - Taxes] + [Current Account Surplus]

OK, let's put this into words that explicitly track money creation, transfer, and destruction.

(The total sum of all monetary transactions in the economy) - (transfers of money between private parties in exchange for real goods and services) - (transfers of money between private parties in exchange for promises of future money) - (transfer of money out of the private sector and into the Government) = (creation of new money by the Government which it transfers to the private sector) - (destruction of money) + (foreign inflows of money in exchange for outflows of goods)

So, the residual left over after all transfers in the private sector, and taxes, equals the Government deficit, plus foreign inflows of money.

Or, the (net) money the Government creates (out of nothing, because it can; through spending, because it must) equals the private desire to (net) save, plus the foreign desire to (net) save.

The Government creates money and transfers it to the private sector by spending. The private sector transfers the money amongst itself (spending, investment) and puts the rest in the bank. If the private sector wants to put more money in the bank, that money can either come at the expense of transactions, or it can come from the Government simply running a larger deficit, and thus creating additional money for the private sector. So long as the private sector uses this money to save, it's creation is not inflationary and will not show up in the CPI. Inflation is caused by too many dollars chasing too few goods, and dollars under the mattress are not chasing anything.

To be added: the role of Prices, Banks, Taxes, Interest Rates, and the Yield Curve.

Tuesday, January 13, 2009

Modern day Keynes

David Henderson makes a simple point about why infrastructure spending is a bad way to get Keynesian stimulus in 2009 (as opposed to 1909):
What is particularly ironic in this discussion of idle resources is that it is the pro-stimulus Keynesians who ought to be very fastidious in their recommendations for government spending projects. After all, if the whole point is to draw down resources that have been thrown out of work, then care should be taken to tailor the stimulus package for the resources in question. Is it really the case, for example, that bridges and roads require labor and other inputs in the same proportions as housing construction and finance? Does the construction of a new sewer system require the services of investment bankers and roof layers in such combinations that local government spending can perfectly offset the bursting of the housing bubble?

A little price theory, realizing, for example, that not all workers are perfect substitutes, would have gone a long way here.

...What we know is that three sectors that need to shrink are housing, autos, and financial services. And guess what sectors the government is subsidizing.
In the 1930s, there was no infrastructure to speak of, Federal taxes were low, and labor was generally undifferentiated. In 2008, the US has lots of infrastructure, Federal taxes are high, and labor is highly specialized. If Keynes was alive in 2009, he would say that the Government should increase the deficit [G - T] by reducing Federal T(axes) -- ideally via a payroll tax holiday--and not by increasing G.

By contrast, Arnold gets it right, but gets it wrong:
" Facts are facts. The US has already proved it can raise over $1.5 trillion in a single year [in Treasury borrowing]"

That is a the sort of statement that could come back and haunt someone. It is along the lines of the guy jumping out of a building from the 10th floor, passing the third floor and saying, "It's all fine so far."
The US Government does not need to borrow to increase money supply. It can print money. So, the US can print $1.5T, $15T, or $150T without any problem or limit. Talking about the US Government "raising dollars" is nonsensical--who are they "raising dollars" from given that they are the sole supplier of dollars, and they have an infinite supply!?

The "multiplier" is a totally different matter, and Arnold is right to say that the multiplier will fall, and fall quickly as spending goes up.

Monday, January 12, 2009

Why tax?

Everyone agrees, more or less, that the Federal Government has the power to print money. That's what fiat money means by definition. Since the Federal Government can print it's own money, in whatever quantity it chooses, have you ever wondered why it taxes at all? In fact, if you chose to mail in your 2009 taxes in crisp Federal Reserve Notes, the Government would take that paper money and shred it.

The Federal Government does not need taxes in order to spend. At the Federal level, because the Fed is a currency issuer, the sole purpose of taxes is to extinguish money, reduce aggregate supply, and therefore limit inflation to a tolerable level.

At the State and City level, where the local government authorities are currency users just like the rest of us, this is not true. San Francisco has to tax if San Francisco wants to spend. But this is not true for US Gov.

Since Federal taxation is about extinguishing money, not raising revenue, then efficient taxation may be the wrong approach. Efficient taxation looks to tax so that the Government raises as much money as possible but distorts behavior, which reduces growth and creates waste, to a minimal degree. Maybe the goal, at the Federal level,should solely be behavior modification. After all, if Federal taxes are important to extinguish money, then they should target money in circulation, as savings are effectively extinguished--taken out of the money supply--anyway. Money in circulation is money that people are acting on.

Friday, January 09, 2009

Fama & French on Debt Overhang

I recommend this piece by U Chicago's Fama and French on what debt overhang is, and what different kinds of bailouts mean. In particular, it shows how taking a balance sheet approach is critical to understanding this financial crises.
A severe fall in the market value of a financial institution's assets raises the risk and lowers the market value of its debt, as well as its equity. Bringing in new equity capital produces an equal (dollar for dollar) increase in the market value of assets. This lowers the risk and raises the market value of the institution's debt. As a result, part of the new equity capital shows up not as equity but as a transfer to debt holders. (This is the debt overhang problem.) Who pays for the transfer? Not the new private stockholders. They will not invest unless they get stock with market value at least equal to the funds they provide. This means the transfer of wealth to the old debt holders must come from the old stockholders. They pay via the dilution of their ownership share (and the drop in the share price) caused by bringing in new equity. (The stockholders, of course, hate this transfer to debt holders.)

If the market value of the old stock before the equity issue is low, it may be insufficient to cover the transfer of wealth to debt holders that new equity capital produces. As a result, the market value of a stock issue would be less than the funds provided, and the financial institution's attempt to issue equity to meet its capital requirement will fail.

If the Treasury steps in when the private market refuses to provide equity capital to a financial institution, we are in subsidy land. Again, the subsidy arises because a large part of the equity injection by the government does not end up as government (taxpayer) equity but rather goes to prop up the financial institution's debt holders.
The key here is that, so long as the debt holders are first in line to claim the firm's assets, any infusion of capital will pay them, and not recapitalize the bank. Banks cannot be recapitalized until the debt overhang is written off. Undercapitalized banks do not make loans.

Wednesday, January 07, 2009

Rogoff on the Recession

I recommend this nice interview of Ken Rogoff when he talks about the recession, and what is and is not understood by academic macroeconomists. Some key passages:
Region: You start, I believe, with England's default on debt in the Middle Ages and work up to the current period. What can you tell us about the regularities that you found over those eight centuries and the lessons or forecasts that might provide for our current situation?

Rogoff: One thing that we find certainly is that virtually every country experiences serial default on external debt when going through the emerging-market stage of development. They default not just once but many times on external debt.

Another thing we find, less surprisingly, is that the same thing is true, more or less, for high inflation. It's a matter of degree, and countries that were emerging markets in 1700 didn't have the technology that those in 2000 did, but to the best of their abilities, they did the same thing. (By technology, I mean that before the printing press became widely used in the mid-1800s, governments had to resort to clipping coins, using inferior metals and otherwise debasing the currency to achieve inflation.)
I wonder where Iceland would sit in this analysis? Also, to what degree are developed countries immune from default because developed central banks help them out? The Fed's lending line to the EU is quite different from the line it opened to Mexico.
Region: And the long-term growth consequences of that additional debt?

Rogoff: Fortunately, adding a trillion dollars in debt is quite manageable for the United States. Of course, it is not a fun way to spend money, bailing out the financial system. We'd rather spend it on health, education, infrastructure or the environment. (That is, if the expenditures are well crafted and packaged with policy changes and structural improvements.) The fact is that for all the railing against the Bush deficits, the United States grew decently until recently, so that our debt/GDP burden is still modest by European or Japanese standards.

The rising debt burden will have some effect on growth. But I'm more concerned about what happens to our financial sector at the end of this, what's left of it. I just don't know what's going to emerge after the political system works it over. I hope that we do not throw out the baby with the bathwater. If we rebuild a very statist and inefficient financial sector—as I fear we will—it's hard to imagine that growth won't suffer for years.
Whether or not the US Fed deficit adding $1T depends entirely on how much the private sector wants to net save. $1T would be too small, too big, or just right. If it's too small, then we'll see unemployment continue to grow the deficit through falling taxes and rising unemployment claims until it's just right. If it's too big, we'll see inflation in CPI. I am also surprised to Rogoff is concerned about the efficiency of the financial sector. Throwing the baby out with the bathwater is a good idea if it's Rosemary's baby.
We have to rethink banking. Suppose you were putting your money in a bank, and it's being insured up to a large amount by the government. Suppose then the bank is taking the money and putting it at the Federal Reserve and getting interest on it. This arrangement begs the question of what the bank exists for. Should the bank just be charging for markup services on checking? If the government is ultimately going to be the one providing liquidity services, should the whole structure be different than it is now?
He's getting close to a key issue. Under FDIC insurance, individuals are lending directly to the Federal Government. Banks borrow from the Federal Government to make loans, and the tie between their deposit base and the amount they can lend is strictly legal. Different countries have very different limits on fractional reserve limits, and they are all equally pointless. Ken Rogoff is a super smart guy, but I don't think he sees the banking system as it actually is, since its de facto operation is so different from the explanation that they give of it in classrooms. The whole structure should be different from how it is now.

Tuesday, January 06, 2009

Predictions for 2009

The year has only just begun, but I think we've seen enough hints of how the Obama administration will act to make some predictions for 2009. I'll check in again in 2010 to see how I did.

1. Deflation, and not inflation, will continue to be a problem in 2009

The Obama fiscal stimulus plan is, unfortunately, pathetic. I don't know what other word to use for a stimulus that only gives $500 to individuals. It will also be slow to roll out. The upshot is that we won't see anything announced until March, and things will continue to deteriorate into the summer. The usual suspects will be back at the trough by the end of the year. Net, in 2009, CPI will remain stagnant or continue to fall.

2. Unemployment will reach double digits in the US

See above.

3. Europe will do ever worse

I expect to see the euro continue to weaken against the US$. As poorly as fiscal policy is managed here, it is worse across the pond.

4. GM and Chrysler will get their second slug of the bailout under Obama

Their "restructuring plans" will be accepted as adequate, and they will get additional funding from the Government. I do not expect either company to materially change in 2009. They are zombies, but there is no one around to shoot them (twice) in the head.

5. Citibank will not go bankrupt

See above.

6. Oil will remain under $60 a barrel

Since global aggregate demand destruction will continue under weak American and European leadership, expect demand for commodities to remain weak. Cuts by Saudi may help a little, but oil will remain sedate.

7. There will be another sharp fall in equity markets

Equity markets will end the year another ~10% down. People will realize things are not getting better, which will trigger another round of selling.

8. Obama will raise taxes in mid 2009, to disastrous consequences

Just like FDR, Obama will start to worry about the deficit and move to raise taxes midyear. That, of course, will reduce aggregate demand further, and so make the economic situation worse

9. The Fed will maintain ZIRP through the year

Just like Japan, expect interest rates to remain on the floor

10. The Dubai real estate bubble will pop

A combination of falling equities and low oil prices will cause financier Abu Dhabi to reign in lending. That, combined with falling aggregate demand, will reverse momentum in Dubai real estate, and the bubble will pop there too.

Sadly, a grim 2009. I hope that I'm wrong in all of these predictions.

Monday, January 05, 2009

No Stimulus for You!

Stimulus Nazi Paul Krugman is unhappy that Barak Obama might implement some of it through tax cuts
Is Obama relying too much on tax cuts?
I don’t know yet. But news reports this morning certainly raise questions.

Let’s lay out the basics here. Other things equal, public investment is a much better way to provide economic stimulus than tax cuts, for two reasons. First, if the government spends money, that money is spent, helping support demand, whereas tax cuts may be largely saved. So public investment offers more bang for the buck. Second, public investment leaves something of value behind when the stimulus is over.
No Paul. Individuals in the US are overindebted, and will not spend or borrow more until they have paid down their current debts. They may save some of their stimulus, but they will spend some too. If you want them to spend even more, stimulate even more. You can run a payroll tax holiday for as long as you need.

Also, the statist chauvinism of Paul's second assertion is remarkable. A bridge to nowhere is less valuable than an individual paying down their debt, or getting something they value, like healthcare, education, training, improving their house, etc. etc.

I also love the phrase "shovel ready". Shovels have certainly been busy lately.

The delay issues Krugman states, along with the inflexibility of fiscal policy to be ratcheted up and down, are fatal for his "bigger G" stimulus. By the time his Government spending is triggered, unemployment will already have increased the deficit to where it needs to be through lower PX, C, I, and T. Bigger G will overshoot, triggering inflation, so those who managed to hang on to their jobs will see their savings eroded.

Sunday, January 04, 2009

Private Savings is the Federal Deficit

Jesse has a very nice post explaining the different kinds of money, and I recommend people read it. However, (s)he ends on an error, which I was prey to until recently also.
Are credit cards or loans Money? No,those are all forms of borrowing something that is not yours that you promise to return with conditions. You are receiving money that was not yours.

Credit Is Not Money.

Credit, or debt, is the 'potential' for money, a way of receiving it.

Whether water is held in a canteen, a well, a cistern, or a private lake, it is still water and it is yours if you own it. So too money is still money if it is yours, no matter under what conditions you hold it or save it for your use.

The cloud of credit, or debt depending on your perspective, is the potential for money as it is defined in our economy. It is a source of money. At a given point in time, you either have the money as your property or you do not.

But the source is not the money itself, and the source can be different and can change over time. In our society borrowing is so common and so technologically convenient that there is little difference in most people's mind between credit and money.
I used to believe the same thing, but I was wrong. Money is not a store of value. Credit is money. It is more useful to think of money as "points" than anything with intrinsic worth, and credit is points in an asset column, and debts are points in a liability column, but the points themselves, those are money and they are money no matter which column they go in.

I tried to explain this on Marginal Revolution, but they banned me from the comments there. Both Brad DeLong and Tyler Cowen ban people they do not agree with in their comments. I prefer Greg Mankiw's approach, which is not to allow comments at all. It's honest, and it avoids echo chambers.

I recommend spending time at Mosler Economics which is really difficult to get into, but really changed my perspective on this stuff. I don't agree with everything, but the "points" mental model for money is much more accurate to reality than the "store of value/gold" model we instinctively carry in our heads.

Here's a pure derivation:

The real (inflation-adjusted) national income, Y, is defined as
Y = G + X – M + PX + I

G = Govt' spending
X = exports + foreign transfers + property income
M = imports
PX = Private spending
I = Private investment (note, I left this out by mistake the first time. Sorry!)

Subtract T from each side, where T is taxes and government transfers we get

Y – T – PX - I = [G – T] + [X – M]

Private Net Savings = [G – T] + [X – M]

Private Net Savings is GNP - taxes - private spending (PNS is private disposable income less taxes less private spending on consumption less private investment).

So, by identity, PNS equals the Federal deficit (G-T) + the current account surplus (X-M). The current account surplus is the $ value of exports minus the $ value of imports. The US runs a large current account deficit ($ value of imports >> $ value of exports) which is, contrary to popular opinion, a *good* thing. Swapping real goods and services for shiny baubles is always a good trade for those receiving the real goods and services. So, as [X-M] is negative, and we would prefer to keep it good, the [G-T] must grow to support higher demand for PNS. The alternative would be for [X-M] to switch and become positive (US starts exporting, stops importing) which means we are now trading real stuff for foreigners shiny baubles. That day may still
come, but there is no need to hasten it.

Arguments against the above:

1. It just ain't so

It is so. This is all true and straightforward as accounting identities.

2. You can't just define savings as a residual, what you have left over to make the national income equations balance!

Yes you can. Brad DeLong answers that Walras' Law says you can. My response is that there is no such thing as "active savings" because no vehicle exists that is an actual store of value over time. So people may think they are "actively saving" but in fact all they are doing is increasing the residual left over after everything else, which will drive by the Federal deficit or current account surplus by identity. Sucks to be you.

3. It's not fair that there is one set of rules for currency issuers and another set for currency users.

Fairness does not come into it, the same way fairness does not come into discussions of whether a referee should follow the same rules as the players. The job of a ref is to be a good ref. The job of the players is to play the game. Both have different roles, and both should strive to do a good job in their role. Arguing that refs should pick a team and try to score baskets too blocks the discussion of what makes a good ref, and does not display good understanding of how the Federal banking system actually works.

4. This is just a static model, tells us nothing about how booms and busts happen, or how to run an economy.

Totally true. And incredibly important to remember.

4a. You are wrong about imports being good and exports being bad.

Quite possibly, and there is a good argument for this. Nevertheless, the US is largely a closed economy and I end up ignoring the capital account term below.

5. It just makes no sense. This would then lay the fault of our current depression on surpluses run under Clinton/Rubin in the 90s!

Yes. This blows my mind also.

It helps a little, but not much, to take a balance sheet perspective on the world. When we think about our own household balance sheets, we add up our liabilities (debts) and our assets (checking account etc.) and hope that our assets are greater than our liabilities. If all of our liabilities vanished with a stroke of a pen, then we'd be happy because all we would have is pluses. This would be wrong -- balance sheets always have to balance, and assets always have to equal liabilities. Personal equity sits under the liabilities column.

When it's pointed out to gold bugs that the Fed can print money at will, they like to analogize it to the Fed having a monopoly on an infinite gold mine. This is almost true, but misses one important detail -- the Fed needs to account for each ounce of gold that leaves the mine, not because it is in any danger of running out, but because it wants to keep its books in balance and not pump out too much gold. Counting how much gold is out there in circulation is done via an entry called the "Federal deficit" (G-T). The term is misleading because it makes you think that the Government is somehow in debt, and you worry about whether it will be able to pay everyone back. This is wrong, the Fed can print money, and therefore everyone can get paid.

Let's Ignore the current account (imports/exports) for now, and imagine a God like currency creator, with a celestial t-table.

In the beginning, there was nothing.

And then God said, let there be credit and debit of $100. And it was so.

And then God lent that credit to Man, who now has a debit of $100 to the Government, and a credit of $100 in his bank account. The Government has $100 debit (which he created originally) and a $100 credit (in accounts receivable) to the man. The $100 in the Government's debit column -- also know as the Federal deficit -- equals the amount of money in the man's bank account, also known as Private Savings. The Federal deficit must always equal net private savings.

The picture is complicated a little by banks, because banks act as intermediaries between the Fiat God and lowly Man. Banks can borrow from the Fed, and lend to Man in FDIC insured accounts, which as equivalent to Man borrowing directly from the Fed because the credit risk Man takes on by putting his money in these accounts is the credit risk of the Government, not the bank. Banks can create debt too, in the same way as the Fed, except they borrow from the Fed directly and lend out to Man. When banks stop doing this, then bank debt creation stops and the Fed needs to step in an increase the Federal deficit if it wants to keep aggregate money supply from contracting. This should be the goal of any stimulus.

On the left hand side of the equation, Y – T – PX, PX is falling. To keep the same size, Y has to fall too. Alternatively, you could increase G on the right hand side, or reduce T on both sides to support a larger PX. If you do nothing, that T will fall the hard way, though people losing income which reduced income tax, and so bring the equation into balance that way, but this requires a large increase in unemployment just to support the desire for higher net private savings and that just seems stupid.

So there you have the ugly and stupid math behind recession economics. The demand for net private savings goes up, probably for very good reasons, and the Federal Deficit MUST INCREASE to meet this demand for net private savings. It can increase in two ways: higher government spending, or lower taxes, or both.

Taxes can go down in two ways. People can lose their jobs so they stop having income to tax. Or the government can just cut taxes. Given that it's better to have people employed than not, this seems like a no brainer to me.

If the deficit goes too large, then there is more money available for net private savings than is required, and this extra money is not saved, it's spent. Too many dollars chasing too few goods creates inflation, and that is bad also. It's important to note that money in bank accounts does not contribute to inflation, although it can if everyone decides they no longer want money in the bank.

The problem with increasing G is that it's proven impossible to decrease it again when the times comes, while T bounces up and down like a yo-yo. Big Government advocates, like Paul Krugman, support larger G no matter what the consequences. Increasing G is slow. "Shovel ready" projects cannot be implicated as quickly, or at the scale, of a payroll tax holiday, and are essentially impossible to shut down. Larger G also slows the long run productive capacity of the country, as, by definition, Government is after things other than sheer efficiency and productivity.

So, a larger G solution will 1) increase the deficit by reducing T the hard way -- driving up unemployment, and 2) will then start to increase the deficit in a way that cannot be stopped after the deficit has already reached its new, optimum size, driving up inflation. This inflicts large economic costs on current workers (who will lose their jobs), future workers (who are now in an economy with lower productive capacity) and current and future savers (who will see the value of their "savings" be inflated away).

Whenever you hear anyone say there should be a fiscal stimulus, ask them why it wouldn't be better implemented as an immediate payroll tax holiday, to be ended once CPI picks up, instead of paying government contractors to build bridges to nowhere beginning next summer.

Saturday, January 03, 2009

How valuable is liquidity?

I enjoyed this though provoking post from Angry Bear (who I usually do not agree with):
I don't think that "market liquidity" is a good thing.

A sudden decline in the liquidity of assets can create problems as firms can't unwind leveraged positions without extreme market disruption. If the assets had always been illiquid, those leveraged positions would never exist. I think that would be a good thing.

Now there is a class of arguments that rational investors will take highly leveraged positions to profit from asset miss pricing and that this is socially desirable as they will drive asset prices towards their fundamental values. It is hard find these arguments convincing given the enormous increase in asset price volatility which has accompanied the enormous increase in gross long positions and gross short positions not to mention the huge increase in trading volume. My sense is that the average super smart highly trained trader is driving asset prices away from fundamentals. Thus I think honestly reported legal trading strategies are, on average, worsening the quality of the signals financial markets send to the real economy.
There is a specific sense in which the value of liquidity is overrated, or rather inverted, it becomes a toxic compound that degrade the financial sector as a whole, and that is when trading is structured in such a way that it can produce bank runs. In the Diamond-Dybvig model, long term assets financed by rolling over short term liabilities have two stable prices, one where you can roll over the liabilities, and one where you cannot. In practice, the state where you can roll over short term liabilities is unstable, once these assets fall, they cannot get back up.

You might be able to make an argument that the benefit you get from financing long term assets by rolling over short term liabilities is so great, that even if there is occasional disruption, the net benefit still makes the activity worthwhile. But given that the banking system has already lost more money than it ever made, and there are trillions that still need to be spent, the Empirics suggest that there is no net benefit, only net costs. In this spirit, Angry Bear and I have found common ground -- match the maturities of assets to liabilities and eliminate bank runs from the system once and for all.

Friday, January 02, 2009


Beautiful, wonderfully implemented, incredibly useful feature on Google maps. I've wanted this so many times when planning trips. Fantastic!