Monday, 15 August 2016

MMT vs the bond market

Why do governments borrow from the bond market? Is there a better way for governments to finance their deficits than this? If so, what economic factors should determine where governments need to look for finance? These are questions that I have been asking myself over the past few months and years, but I seem to be in a minority. Certainly most mainstream economists don't seem to be that bothered, but I think they should be because it is becoming pretty obvious that the old ways don't work any more.

This week the Bank of England cut interestrates to 0.25% and embarked on a new wad of quantitative easing (QE) in a bid to head off recession. Now I pointed out a few years ago that lowering interest rates to near zero will have practically no effect on stimulating extra demand for credit and so will not create new demand via increased consumer spending in the real economy either. Only a fiscal stimulus will do that but this government has set itself against doing anything that remotely resembles Keynesian interventionism. But as I pointed out last time, even governments that are supposed to believe in Keynesian economics have consistently failed to apply sufficiently large fiscal stimuli during major recessions.

Yes they increase welfare spending, but only because unemployment has increased and that has forced their hand. Meanwhile, they compensate by cutting spending in other areas to try and minimise total borrowing. These cuts often further increase unemployment and lower GDP. This leads to the austerity that we have been familiar with over the last eight years, and while welfare spending has still increased, it has often been undertaken grudgingly and parsimoniously. Consequently, while government spending increases, it does not increase fast enough to reverse the effects of the recession. The result is the recession is longer and deeper than it needed to be and chancellors like George Osborne continuously miss their deficit targets.

So while the government may claim that their actions are Keynesian because they are increasing spending and borrowing in the recession, their actions cannot in any way be considered to be within the spirit of Keynesianism because they make no attempt to restore the economy to full employment or maximum output. But this failure to adhere to Keynesian orthodoxy is not totally ideological. As I pointed out previously, the last Labour government was almost as obsessed with deficit reduction post-2008 as the Tories have been. What drives this fiscal trepidation is fear and loathing about debt. In the aftermath of the 2007 crash the worry was all about debt to GDP ratios and sovereign default. We were bombarded with threats to our credit rating from the very credit agencies that partially created the financial crisis in the first place. We were told that if we borrowed too much we would end up like Greece. But all this was bogus economic scaremongering for two reasons.

Firstly, unlike Greece we had control of our own currency, and secondly all our debt was denominated in our own currency. No developed country has ever defaulted on its sovereign debt when that debt has been denominated in its own currency. But there is another more important point that needs to be appreciated when it comes to sovereign debt. Who you borrow from matters just as much as, if not more than, how much you borrow.

To see this consider these two examples. Greece currently has a debt to gdp ratio of 180%. As a result most economists consider Greece to be essentially bankrupt and incapable of paying back what it owns. Most expect it to default sooner or later. Japan on the other hand has an even higher debt to gdp ratio of 230% but no-one expects Japan to go bust. Why?

The answer is because Greece owes virtually all its debt to foreign creditors (ECB, IMF, German and French banks) in a currency that it cannot print, cannot control, and cannot devalue. Even if Greece left the euro its new currency would devalue and its economy shrink relative to its economic competitors, but its debt would not. So its debt to gdp ratio would skyrocket even further.

Japan's debt on the other hand is owned mainly by its own citizens and domestic banks and corporations and is also denominated in its own currency. The Japanese government can never fail to repay its debts because it can always raise taxes on the people it owes money to in order to pay them the money it owes them. As a result it can never run out of money and the money it pays out in interest and maturity repayments never leaves the Japanese economy. The only risk to the Japanese government is loss of confidence by the public in the government and a rush to liquidate the bonds they hold, but this can be avoided in two ways. Either the government can impose fixed maturity dates on the bonds or savings, or it can borrow from itself in the form of its central bank (like QE). This latter mechanism is the essence of what is known as modern monetary theory or MMT, which I will discuss further in a future post, and what this and previous posts are intended to provide the justification for.

What this shows is that when it comes to national debt, borrowing from within your own currency area is more sustainable than borrowing from outside it. In short, countries that borrow internally instead of externally from the bond market can never go bust. This is one major reason why countries should shun the bond market, but there are other good reasons as well.

Every time a government borrows from overseas it is adding to the current account deficit. The UK gilts created are in effect exchanged for foreign currency which can then be used to purchase additional goods from overseas. This happens without an equal amount of production having taken place inside the UK and then exported. Alternatively, the foreign currency is first converted to sterling in order to buy the gilts, thereby leading to a strengthening of sterling on the currency markets. Neither of these effects is desirable.

So what is clear is that conventional methods of government borrowing come with a significant sting in the tail, and yet as QE has shown, these stings are often unnecessary and could be avoided. So why does most of the mainstream economic community not appear to get this? Why don't they recognise that there might be better ways for governments to finance their deficits and to run the economy?

Well one reason that they continue to use the bond market is perhaps because that is what they have always done. In the times before fiat currency and free flows of capital governments needed to physically borrow other people's money in order to spend it. Money creation was not possible. But I think there is a deeper problem. Economists don't think like physicists. A physicist will always tackle a problem by simplifying it to its core. This means first considering a closed system problem and then looking at system leakage as a perturbation to that initial system. Economics on the other hand seems obsessed with open systems, globalisation and free trade.

What I think MMT could do is allow a government to more effectively internalise its economy and protect its currency. It could enable it to borrow unlimited funds (from its own central bank) in a recession in order to enact a proper Keynesian response to a financial crisis. This in turn could be used to fund investment, job creation or helicopter money which would be far more effective than cutting interest rates to zero or providing QE for banks. The result could be much greater macroeconomic control and shorter and shallower recessions.

Thursday, 11 August 2016

Who is afraid of the bond market? The paradox of Keynesianism

One of the added benefits of Brexit is that it has finally forced the government to kill off George Osborne's tenure at No. 11 Downing Street and thus abandon his insane attempts to balance the country's finances through austerity. But it would nevertheless be unfair to blame George Osborne entirely for the austerity of the last six years. Why? Because he was only doing what most mainstream economists and the opposition Labour Party were telling him to do, only doing it better.

The problem is this. Cast your mind back to the 2010 general election and remind yourself of the options that were available to the electorate. In essence there were only two: Osborne with his austerity-max, and the Labour Party with its austerity-lite. Neither were very appealing, but more pertinently, neither had any basis in macroeconomic theory, or more specifically in that part we consider as pure Keynesianism.

According to Keynes, the appropriate fiscal response of a government in a recession is to cut taxes and increase spending. The aim is to increase aggregate demand in the economy to compensate for the fall that has induced the recession thereby helping to rebuild confidence and restore output to pre-recession levels. Unfortunately there is a problem with this plan: nobody seems to have the necessary bottle to carry it out. This is because the plan as it is conventionally implemented contains a fundamental flaw. That flaw is debt.

In a recession incomes and employment levels fall and hence so too do tax revenues. In contrast unemployment levels rise and so consequently does social security spending. As a result the government budget deficit grows more negative and the national debt increases. And the bigger the recession, the bigger the deficit and so the bigger the borrowing requirement will be. Now in theory this shouldn't matter because a government that prints its own currency can never run out of money, but in practice it does matter because economists and the financial markets obsess about debt to GDP ratios and sovereign default, and driving this fear are the IMF, the bond market and the credit agencies.

The consequence of this is that in a recession when Keynesian theory demands that governments borrow whatever is necessary to get the economy moving again and operating back near full capacity, the bond market is urging caution and threatening to restrict credit. So in 2010 even though UK gilt yields were at historic lows and government borrowing was dirt cheap, all the talk was about reducing borrowing as quickly as possible to prevent market bond rates rising and our credit rating falling. Yet paradoxically, before the crash when the economy was booming and the government should have been discouraged from borrowing, there was no such alarm in the markets about UK debt and borrowing was positively encouraged.

This is the paradox of current Keynesian economics. When your economy is in a deep recession and Keynes says "borrow borrow borrow", the bond market wants to do the opposite. Yet when the economy is booming and Keynes says governments need to operate a surplus, the bond market is quite happy to lend you anything you want. Just ask Gordon Brown.

So in 2010 instead of both main political parties promising to cut taxes, raise welfare payments and increase investment as Keynesian theory demands, both political parties promised to do the opposite, but by slightly different amounts (obviously) in order to at least maintain a pretence of economic and political pluralism. All of this should therefore make economists think seriously and critically about what they really understand by Keynesian policies and how they can implement them because what this clearly demonstrates is that the current paradigm that they adhere to just isn't working. Not only that, it can NEVER work.

Fortunately there is a solution. That solution is Modern Monetary Theory or MMT. (To be continued...)

Wednesday, 29 June 2016

Does migration reduce inequality?

In his defence of the EU the Oxford economist Simon Wren-Lewis recently made a number of interesting claims that directly relate to the general debate on the benefits, or otherwise, of immigration, globalisation and free trade. One that stands out is this in response to Kate Hoey's claim that migration has been used to suppress the wages of the low paid:

"She seems to be arguing that free movement in the EU is a means of keeping down the wages of the low paid. The first point to make is if labour mobility keeps wages down in the destination country, it should increase wages and/or reduce unemployment in the country the migrant came from. As migrants move from lower to higher wage countries, then migration tends to equalise incomes. This should normally count as a plus from a left wing perspective."

Well it is certainly true that migration reduces unemployment in the country of origin. It is also true that migrants tend to repatriate a portion of their earnings to their country of origin and so help to  increase its GDP per capita and thus increase its overall prosperity. In theory this should help to close the gap in inequality between rich countries and poor ones, and thereby "equalise incomes".
 One could also then argue that once the poorer countries have attained a sufficient level of income, they will also be able to trade with richer countries as equals, in effect increasing the size of the market accessible to firms in both countries. This is the essence of current globalisation policy and is one reason for the EU's policy of continued expansion. It is therefore certainly true that it could be claimed to be "a plus from a left wing perspective" in that it raises living standards and reduces inequality in the poorer country. As such it probably does the same globally as well. The problem is that it doesn't do so in the richer country.

In the richer country most of the immigration will be into low paid jobs, and much of the earned income that results will leave the country. This will have two negative effects on aggregate demand in the rich country. Firstly, it will force down wages of the low paid through increased competition; secondly, the additional economic activity that results from the immigrant workers will be exported and so will not be used to stimulate extra demand (a multiplier effect) to replace that lost through job losses and earnings reductions of the existing low paid workers. On top of that the population will have increased so GDP per capita will be reduced.

Now it is probably true that once the economies of the two countries have equalised both countries will benefit fully and equally from the larger market available to them.  The question, though, is how long will this take? As Keynes famously put it, "In the long run we are all dead." The point he was making when he said it was that time is not infinite and people are not immortal. After a recession or depression the economy will inevitably recover eventually. The argument of classical economists is that, if the economy is going to recover anyway, then it doesn't need any government intervention to help it along. The argument Keynes was making was that ordinary people can't wait that long and therefore the recovery needs to be brought about as soon as possible through active interventionism, rather than arriving at some unspecified later date because of passive liberalism. That same statement can also be applied to the effect of immigration on the poor in developed countries. How long must they wait for the benefits of migration to bear fruit? Until after they are all dead?

The reality is migration is just another manifestation of globalisation policy and both have been exploited and abused to suppress wages in developed countries because that is how western governments have managed to deliver economies that simultaneously have low inflation and low interest rates. That is why living standards in most developed countries have stagnated for the bottom 50% over the last 30 years. In which case I would argue that Kate Hoey is correct in her viewpoint and Professor Wren-Lewis is wrong. Moreover, I would argue that an economic policy is only beneficial and equitable if those that sacrifice the most in the short term also benefit the most in the long term. That after all is one reason why most on the left reject austerity. But if migration hurts the poor in the UK and benefits the rich, how is this "a plus from a left wing perspective"? And of course the adverse side effect of all this of course is massive wage inequality in the rich countries, excess savings by the rich, low investment and asset price booms. Ultimately that is why we are in the mess we are in now.

But the above is not the only point of contention I find with the views of Professor Wren-Lewis. In the same blog post he then went on to say:

"Migrants tend to be young, healthy and working. They provide more in terms of resources than they take out by using public services. I remember having a conversation about this with someone who lived in Spain. He said if anyone should be angry about free movement it is Spain, in having to take lots [of] non-productive British pensioners who will be a burden on Spain’s health service."

This argument also contains a number of major flaws in its reasoning. Firstly, it neglects to take into account the fact that most of the UK pensioners that have moved to Spain have done so on large pensions. These pensions are paid out in the UK by insurance companies and the government but spent in Spain. Therefore not only does this constitute a massive export of capital from this country, it also leads to an equally massive loss of both consumption and taxation in the UK. This loss of government revenue far exceeds any burden those pensioners would place on the NHS if they were to return to the UK. The UK therefore loses from this arrangement and Spain gains.

Secondly, the argument fails to take account of my previous point, that migrants tend to repatriate a large portion of their earnings to their country of origin. As a result any increase in economic activity that results from the immigrant workers will be exported and so will not be used to generate extra demand in the UK. In short there will be no multiplier effect that would create additional jobs to compensate for the immediate effects of immigration.

What this shows is that it is not just inward migration that can hurt the UK economy, but also outward migration. Both have negative effects on our budget deficit and our trade deficit. And as I have argued previously, both therefore represent an existential threat to the solvency of the national government and therefore ultimately to the democracy of the UK, because if a Labour government cannot fund its programmes, then there can be no Labour government. In short we end up like Greece.

But if you still think unlimited immigration is a good thing then consider this from Social Democracy for the 21st Century:

"Corbyn is also delusional if he thinks effective Keynesian fiscal policy will be possible in Britain with an open border policy, for the more prosperous a country becomes, the more it will simply become a magnet for mass immigration from Europe, which in the process will defeat the whole purpose of fiscal policies to create full employment."

In other words full employment is impossible if you have an open borders policy. And what is the point of a Labour Party that doesn't believe in full employment?