Monthly Archives: June 2016

Bloomberg Interviews Mervyn King Post EU Referendum

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Tom Keene and Francine Lacqua of Bloomberg interview Mervyn King post the Brexit vote. What I liked about the interview is that King says explicitly that the UK politicians exaggerated the impact of the leave vote. In another interview to BBC, he said explicitly that the UK Treasury exaggerated. He also criticizes the assumptions people made when putting out the numbers.

Mervyn-King-Bloomberg-Interview

click picture to open the video on Bloomberg’s site

When Tom Keene asks him what he says as a “card carrying member of the UK elite” on what people think of common people, Mervyn King says that the UK political class has lost touch with them and has alienated them and were not allowed to discuss certain issues.

This is not a lefty or a socialist saying all this, this is Mervyn King. This goes on to prove that the UK left is clueless about economic impacts of their own ideas. There was hardly any noise against the remain camp.

Even heterodox economists supported remain!

He even says the fall in the pound is not a cause for concern as it can do good for UK trade. Which is a good point. What matters is expectations of the exchange rate more than the exchange rate itself for alarm and now expectations have stabilized.

Bank Lending Causes Growth?

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Of course it does. If banks restrict their lending, it has an effect on aggregate expenditure as producers will postpone their plans and consumers might spend less. If banks increase their animal spirits, and lend more, producers and consumers borrow more with effect on aggregate demand and output.

But is growth only caused by bank lending?

In a recent article on Brexit, Richard Werner says:

I have been trained in international and monetary economics at the London School of Economics and have a doctorate from the University of Oxford in economics. I have studied such issues for several decades. I have also recently tested, using advanced quantitative techniques, the question of the size of impact on GDP from entry to or exit from the EU or the eurozone. The conclusion is that this makes no difference to economic growth, and everyone who claims the opposite is not guided by the facts. The reason is that economic growth and national income are almost entirely determined by a factor that is decided at home, namely the amount of bank credit created for productive purposes.

But this logic is carrying the logic in my first paragraph too much. Causality is a complicated issue. Banks don’t lend without thinking anything about its customer. Werner even claims that he has confirmed it with causality tests. But these tests have their own fallacies such as post hoc ergo propter hoc.

Let’s take a specific example. Suppose, I make a robot which does all household stuff for you, such as cooking food, washing your clothes and ironing them and keeping them back in your wardrobe. Basically any household stuff. Suppose I also make it difficult for anyone to replicate or copy it. My product – the robot – will sell like hot cakes all over the world, if the pricing works out cheap. The sales of my firm will benefit employees and stock holders and it will greatly benefit India, where I reside. Banks will lend me of course but it’s clear that the causality of the rise of output is more my innovation and not bank lending. More generally one can ask other questions: how was I successful in innovating? Perhaps my education was subsidized and I did most of my research was carried out in a university before I corporatized the idea.  Or maybe I paid employees a lot which made them productive.

There can be various other reasons, such as a fiscal expansion causing a rise in domestic demand and output, leading banks to lend more when they spot the trend and are confident of their lending. In that case, you could say that fiscal policy caused growth.

Post Brexit, two important things can be identified – which have already been talked about such as by the UK Treasury or NIESR. They are UK trade with the EU and migration. Migration is a complicated subject. If the UK regulates low skill migration, wages can rise and will contribute positively to aggregate demand. Allowing high skill migration to continue can keep UK firms competitive in international markets. Trade tariffs have to be renegotiated with the EU. UK politicians can ignore the message of the referendum result and reduce tariffs or, they can raise tariffs. A lot depends on how the political climate evolves. Just saying growth depends on bank lending implies that these trade and migration policies have no impact, which is completely wrong.

tl;dr summary: causality is a complicated subject.

UK Poorer?

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The commentary after the EU Referendum has moved into a consensus from economists claiming that “Brexit” will make the UK poorer. So we hear it from Paul Krugman:

Yes, Brexit will make Britain poorer

Krugman’s thoughts are also echoed by Simon-Wren Lewis. First SWL claims that:

Calculating the size of this effect is an exercise in trade economics not macroeconomics

I don’t understand this. Calculation is both an exercise in trade economics and macroeconomics. So in stock-flow consistent models of the open economy, you see such a thing. It’s both macroeconomics and trade. Trade is automatically incorporated in a macroeconomic model.

This is not just a minor point in semantics. In stock-flow-consistent models, one cannot avoid some parts and talk of the rest. One is forced to incorporate trade, not just in goods and services but also financial assets. Something which models which SWL uses isn’t sophisticated enough to handle.

Moving on, SWL claims that the UK’s exit from the EU makes the UK poorer. He says:

This decline in trade leads to a loss in productivity which makes UK citizens poorer over the medium term. It also means that the real value of sterling has to fall to make up for the fall in net exports. Other things being equal, this fall in sterling will happen immediately, as indeed it already has. This will make people poorer immediately, because imported goods cost more. But here the macroeconomics gets complicated. The hit to trade from leaving the single market will evolve gradually, but the fall in sterling is immediate. (The reason is something economists call UIP.) That means that trading firms might get a short term competitiveness boost, even though this will evaporate in the medium term. This may or may not be enough to compensate for the short term impact of rising prices on consumption spending.

Unfortunately that is not all that happens in the short term. Uncertainty about future arrangements will hold back investment, and it may also add to the depreciation in sterling. For this and other reasons the short term impact on aggregate demand is likely to be negative, although measuring its size is difficult. We then need to think about whether the MPC will raise or cut interest rates. The National Institute’s analysis is very readable on all this.

[underlying: mine]

So the claim that it will make the UK poorer. In effect, SWL’s model is telling him that real GDP will fall as well as real wealth as well fall in real household expenditure. There are several ways in which it happens. Productivity falls. Fall in productivity leads to a less than rapid increase in production. Consumer prices rising means lower real expenditure and so on.

Now, in Kaldorian story the causalities in the real story of actual economic dynamics are almost reverse than the ones presented above. Faced will less free trade, the UK government is less constrained to expand domestic demand and output. It can protect its manufacturing industry. Rising production leads to rising productivity, reverse of what is implied by SWL’s model. True, imported goods will be costlier, but it also reduces import penetration which allows domestic demand to be expanded and hence output and hence real national income and household income so that consumers are more than compensated for imports being made more expensive.

Of course, all this depends on whether the UK government reduces austerity and expands domestic demand. But some effects can be seen, although uncertain. This is because the foreign trade multiplier is improving and the fiscal policy multiplier improves, even if the fiscal stance is not changed. Higher wages if immigration is controlled also provides a boost to demand.

At any rate, the important point in this post is that the remain campaign’s economics is a model which is completely erroneous about causalities and how economies work.

Wynne Godley On The EU

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In the previous post, I highlighted Nicholas Kaldor’s view on the EU. I want to quote Wynne Godley’s views as well. Wynne Godley was highly influenced by Nicholas Kaldor so it is not surprising his views were similar.

In an article Wynne Godley Asks If Britain Will Have To Withdraw From Europe, written for London Review Of Books, written in October 1979, Godley writes:

The implications for Britain of EEC membership are rapidly becoming so perversely disadvantageous that either a major change in existing arrangements must be made or we shall have, somehow, to withdraw.

I strongly support the idea of Britain’s membership of the Common Market for political and cultural reasons. I would also support co-ordinated economic policies which were mutually advantageous to all the member countries. But this is not what we have got at the moment.

…

So we are all to be losers. The taxpayer through the Budget contribution, the consumer through higher food prices, the farmer through costs rising more than selling prices, and the manufacturer through rapidly rising import penetration.

…

… And if we may also take into account the dynamic effects, our balance of payments would be better by several thousand million pounds than it is at present. This would by itself have had a favourable effect on real national income and output, but, more important, it would have enabled the Government to pursue a less restrictive fiscal and monetary policy. According to preliminary estimates, the real national income could have been at least 10 per cent higher than at present and the rate of price inflation several points lower than if we had never joined the EEC.

The UK Should Leave The EU

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It’s the United Kingdom European Union membership referendum tomorrow. In my opinion, the UK should leave the EU.

When discussing the Euro Area, it is emphasized frequently that Euro Area governments do not have the power to make expenditures by making drafts at the central bank as argued by Wynne Godley in 1992:

It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates.

The Euro Area was formed because Europeans wanted to come together and create a union which is big and powerful enough to be not affected by financial markets. The original intent was right but soon the whole idea came to be influenced by neoliberalism. The thing which was hugely missing (“the incredible lacuna” in Wynne Godley’s words in the above cited article) was the absence of central government of the Euro Area itself, which will have the power to collect taxes from Euro Area economic units and make expenditures. After some years of boom, the Euro Area found itself in crisis and could not deal with it well because there was no central government and fiscal policy to the rescue. The European Central Bank tried to save the monetary union but isn’t as powerful enough as a central government. More importantly, the Euro Area was brought into existence with the idea of free trade. Not only was power taken away from relatively economically weaker nations such as Greece but free trade was imposed by bringing their producers compete in the common market. In summary, there were two reasons why some Euro Area nations suffered.

  1. The monetary arrangement
  2. The common market.

Typically the former is emphasized more than the latter. Perhaps the reason is simple. It is easier to explain the former than the latter. In my experience, the latter is more difficult for people to understand and appreciate. Very few have emphasized it. Few exceptions are: Nicholas Kaldor, Wynne Godley.

Because economic growth is “balance of payments constrained”, free trade is devastating. The Euro Area could have had free trade if it had a central government which keeps imbalances in check because of fiscal transfers and regional policies.

Which brings us to the European Union itself and Britain’s membership. Although the UK government neither didn’t surrendered its sovereignty to make drafts at the central bank nor irrevocably fix the exchange rate in 1999, the nations’ producers still compete in the common market. It is better off leaving the European Union and have powers to impose tariffs on imports. Free trade is destructive to trade and one needs a lot of protection – at least the power of the optionality to impose such things any time a nation needs.

It was surpising to see less heterodox noise on this.

Nicholas Kaldor wrote a lot on this in the 1970s before the United Kingdom European Communities membership referendum in 1975. In his Collected Economics Essays, Volume 7, Nicky wrote (Introduction, page xxvi, October 1977) :

The final section of this volume, Part III, reproduces papers written in the course of the “Great Debate” on the question of British Membership of the Common Market in 1970 and 1971, and includes as a postscript a lecture on Free Trade written in 1977. As this debate came to an end when Britain entered the market, a decision which was later confirmed in popular referendum with a 2:1 majority, the reproduction of these papers may strike as otiose and serving little purpose other than somewhat ignoble one of self-vindication in the eyes of future historians. However, if the long-run effects of our membership turn out to be as disastrous as I feared they would be in 1971—and nothing that has happened has caused me to change my views—I think it is of the utmost importance that the true arguments against membership should be accessible to successive generations of students, the more so since the political debate continues to be dominated by issues (such as our effects of membership on the cost of food, on our agriculture, or the net budgetary cost of membership) which I regard as secondary and which could be brushed aside if the long-run effects on Britain’s manufacturing industry and on our capacity to provide employment were favourable.

…

[page xxviii] … the last essay of this volume, “The Nemesis of Free Trade”, which recounts the arguments in the great debate on Free Trade and Protection conducted at the beginning of this century between Herbert Asquith and Joseph Chamberlain. The points made on both sides seem to have lost none of their freshness or relevance in the intervening years. What has changed is our freedom to act. In 1905 we were free to decide whether to continue with the policy of free imports or to protect our industries. In 1977 the choice is no longer open to us, except at a political cost of withdrawing from the Common Market, an act which few people would contemplate seriously so soon after accession.

But after so many years, here is the chance to undo all this and withdraw from the EU. The UK should leave the EU.

We Don’t Need No Helicopters … Hey! Economists! Leave Fiscal Policy Alone

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A lot has been written on helicopter money recently. Most of them bad with a few exceptions such as one by JKH.

In my opinion, the main reason economists come up with stories such as “helicopter money” etc. is that it is difficult in standard economic theory to introduce money.

Few quotes from Mervyn King’s book The End of Alchemy: Money, Banking, and the Future of the Global Economy:

But my experience at the Bank also revealed the inadequacies of the ‘models’ – whether verbal descriptions or mathematical equations  – used by economists to explain swings in total spending and production. In particular such models say nothing about the importance of money and banks and the panoply of financial markets that feature prominently in newspapers and on our television screens. Is there a fundamental weakness in the intellectual economic framework underpinning contemporary thinking? [p 7]

For over two centuries, economists have struggled to provide a rigorous theoretical basis for the role of money, and have largely failed. It is a striking fact that as as economics has become more and more sophisticated, it has had less and less to say about money… As the emininent Cambridge economist, and late Professor Frank Hahn, wrote: ‘the most serious challenge that the existence of money poses to the theorist is this: the best developed model of the economy cannot find room for it’.

Why is modern economics unable to explain why money exists? It is the result of a particular view of competitive markets. Adam Smith’s ‘invisible hand’ …

… Money has no place in an economy with the grand auction. [pp 78-80]

But the ex-Bank of England governor perhaps never worked with stock flow consistent models. The advantage of these models is that what money is and how it is created is central to the question of how economies work. The framework used in stock flow consistent models is not new exactly. What’s new in stock-flow consistent models is the behavioural analysis on top of the existing framework the system of national accounts and flow of funds. As Morris Copeland, who formulated the flow of funds accounts of the U.S. economy said:

The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.

I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.

– Morris Copeland, Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]

So what do we mean by helicopter money and it is really needed or useful? For that we need to go into a bit into some behavioural equations in stock-flow consistent models. One way is to use a somewhat simplified notation from Tobin’s nobel prize lecture Money and Finance in the Macroeconomic Process. In Tobin’s analysis, the government’s fiscal deficit is financed by high-powered money and government bonds:

G – T = ΔH + ΔB

ΔH = γH·(G – T)

ΔB = γB·(G – T)

 γH + γB = 1

0 ≤  γH, γB  ≤ 1

So the deficit is financed by “high-powered money” (H) and government bonds (B) in proportion γH and γB

Now it is important to go into a bit of technicalities. Prior to 2008, central banks implemented monetary policy by a corridor system. After 2008, when the financial system needed to be rescued and later when central banks started the large scale asset purchase program (“QE”), central banks shifted to a floor system.

Although economics textbooks keep claiming that the central bank “controls the money supply”, in reality they are just setting interest rates.

In the corridor system, there are three important rates:

  1. The deposit rate: The rate at which central banks pay interest on banks’ deposits (reserves) with them,
  2. The target rate: The rate which the central bank is targeting, and is typically the rate at which banks borrow from each other, overnight, at the end of the day.
  3. The lending rate: The rate at which the central bank will lend to banks overnight.

There are many complications but the above is for simplicity. Typically the target rate is mid-way between the lower (deposit rate) and the higher (lending rate).

In the floor system, the government and the central bank cannot set the overnight at the target rate if the central bank doesn’t supply as much reserves as demanded by banks. Else the interest rate will fall to the deposit rate or rise to the lending rate. In a system with a “reserve-requirement”, banks will need an amount of reserves deposited at the central bank equal to a fraction of deposits of non-banks at banks.

So,

H = ρ·M

where M is deposits of non-banks at banks and ρ is the reserve requirement. In stock-flow consistent models, M is endogenous and cannot be set by the central bank. Hence H is also endogenous.

In the floor system, the target rate is the rate at which the central bank pays interest on deposits. Hence the name “floor”. There are some additional complications for the Eurosystem, but let’s not go into that and work in this simplification.

In the floor system, the central bank and the government can decide the proportions in which deficit is financed between high powered money  and government bonds. However since deposits are endogenous the relation between high powered money and deposits no longer holds.

In short,

In a corridor system, γH and γB are endogenous, M is endogenous and H = ρ·M. In a floor system, γH and γB can be made exogenous, M is endogenous and H ≠ ρ·M. M is not controlled by the central bank or the government in either cases and is determined by asset allocation decisions of the non-bank sector.

Of course, the government deficit G – T itself is endogenous and we should treat the government expenditure G and the tax-rates θ as exogenous not the deficit itself.

So we can give some meaning to “helicopter money”. It’s when the central bank is implementing monetary policy by a floor system and γH and γB are exogenous.

But this doesn’t end there. there are people such as Ben Bernanke who have even proposed that the central bank credit government’s account with some amount and let it spend. So this introduces a new variable and let’s call it Gcb.

So we have a corridor system with variables G and θ versus a floor system with variables G’, G’cb, θ,  γ’H and γ’B

The question then is how is the latter more superior. Surely the output or GDP of an economy is different in the two cases. However people constantly arguing the case for “helicopter money” are in the illusion that the latter case is somewhat superior. Why for example isn’t the vanilla case of a corridor system with higher government expenditure worse than “helicopter money”.

Also it effectively reduces to a fiscal expansion combined with a large scale asset purchase program of the central bank (“QE”). I described QE’s effect here. Roughly it works by a wealth effect on output with some effect on investment via asset allocation.

To summarize, the effect on output by these crazy ways can be achieved by a higher fiscal expansion. There’s hardly a need to bring in helicopters. Some defenders say that it is faster but that just sounds like an excuse to not educate policymakers.