Arguing with Zombies (part 2)

April 7, 2021

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Many of Paul Krugman’s essays deal with the need to combat economic recession by basing public policy on sound economic ideas. Here is where the zombie ideas that “should have been killed by contrary evidence” do the most mischief. Occasionally his arguments get a little technical, but overall he does a good job of explaining his ideas in pretty plain English, and he puts warning labels on his more “wonkish” essays. One essay—his discussion of the determinants of interest rates—sent me scurrying to his macroeconomics textbook for a more thorough explanation.

Interest rates and monetary policy

The most technical essay in the collection describes the “IS-LM” economic model, where IS stands for the relationship between investment and savings, and LM stands for the relationship between liquidity preference and money supply. It is a macroeconomic model describing relationships among some of the most important variables in the economy.

In Krugman’s formulation, the IS-LM model is a way of reconciling two different views of how interest rates are determined. Interest rates are, of course, crucial to the workings of a capitalist economy because interest is the price of financial capital. Businesses pay interest when they borrow money to finance business expansion, and so do consumers when they finance major expenditures. Both views of interest rates rest on the laws of supply and demand as applied to money. We start with the idea that the price of anything varies directly with the quantity demanded and inversely with the quantity demanded. Low prices increase the quantity demanded and discourage the quantity supplied, while high prices do the opposite. In theory, the price mechanism brings supply and demand into balance, making transactions acceptable to both parties.

How does this apply to the interest rate, which is the price of money? The two approaches focus on different forms of money. The first view of how interest rates are determined is the “loanable funds” approach. It says that interest rates are determined by the supply of savings and the demand to use those savings for investment spending. The interest rate has to balance the desire of savers to earn a high return against the desire of borrowers to obtain funds at a reasonable cost. In this context, think of the borrower as a company borrowing to finance business expansion.

The second view of how interest rates are determined is the “liquidity preference” approach. It focuses on the supply and demand of “money”, meaning liquid forms of money like the cash in your wallet or your checking account, which is earning little or no interest. Here we have something of a riddle. How can the interest rate be the price of money for money that earns no interest? In this case, the interest rate is the opportunity cost of money, the price you pay for keeping money in cash instead of loaning it out at interest. The higher the interest rate, the higher the cost of liquidity and the lower the demand for liquidity. In this approach, the supply of money is a simpler concept, since it is just the money placed in circulation by the central bank, which controls the national money supply. The balancing of supply and demand in the money market is not just a matter of reconciling the wishes of buyers and sellers, or of lenders and borrowers. It is a matter of reconciling the conflicting desires of anyone with income—the desire for both money to spend and money to lend. Too much liquidity and spending, and interest rates must rise to attract more money into lending. When the desire to save and lend is very high, interest rates can fall, bringing down the opportunity cost of liquidity.

Can the two approaches be reconciled? Yes, because interest rates balance supply and demand in both the loanable funds market and the money market, the two being interconnected. Suppose the Federal Reserve deliberately increases the money supply—we won’t worry about exactly how—in order to stimulate the economy. That lowers interest rates, encouraging businesses to borrow for expansion. That in turn increases production and national income, which increases the supply of loanable funds when people save some of the increased income. Krugman’s Macroeconomics (with co-author Robin Wells) says, “As a result, the new equilibrium rate in the loanable funds market matches the new equilibrium interest rate in the money market….” The two approaches are focusing on different sides of one adjustment process.

To return to Arguing with Zombies, The IS-LM model synthesizes both approaches by relating both markets to the Gross Domestic Product. The balancing of investment and savings in the loanable funds market implies a negative (inverse) relationship between interest rates and GDP. Low interest rates encourage businesses to borrow for investment, and investment spending contributes to GDP. This can also be looked at the other way around, since high GDP means high incomes, and high incomes provide the supply of savings for investment, which holds interest rates down. This negative relationship between interest rate and GDP is described by the downwardly-sloping IS curve on a graph plotting interest rate on the vertical axis and GDP on the horizontal axis.

However, the balancing of supply and demand in the money market implies a positive (direct) relationship between interest rate and GDP. A growing economy with higher GDP increases the demand for money to spend rather than save, especially if wages and prices are rising. That tends to push interest rates up. That is represented graphically by an upwardly-sloping LM curve, based on the dynamics of liquidity preference and money supply. Put the IS and LM curves on the same graph, and “the point where the curves cross determines both G.D.P. and the interest rate, and at that point both loanable funds and liquidity preferences are valid.”

The IS-LM model is useful for understanding the effects of monetary policy. If the Federal Reserve increases the money supply, that tends to reduce interest rates, stimulating the economy by encouraging borrowing for investment. As long as prices are “sticky”—that is, they react slowly to the increased spending—the IS effect can predominate, and the economy can move to a new equilibrium at higher GDP. But when and if prices rise, the increasing demand for money may force interest rates back up (and eventually GDP back down). Monetary policy can have a stimulating effect, but mostly in the short run.

The analysis does get very technical, but it’s important because it supports some of Krugman’s main conclusions. One is that more than one relatively stable point of equilibrium is possible. Another is that a particular equilibrium does not always represent the most desirable state of affairs, such as full employment with inflation under control. Nations can and do make political choices that affect economic outcomes, for better or for worse. An economy can remain in a less than ideal state for a long time, if the wrong political choices are made.

When an economy is in recession, most economists support an expansionary monetary policy, and some advocate it to the exclusion of fiscal policy (deficit spending by government). However, Krugman emphasizes the limitations of monetary policy in his many discussions of the 2007-2009 recession and the economy’s long recovery. For one thing, the benefits of monetary policy tend to be short-term, easily undone by longer-term rebalancing, as described above. And monetary policy becomes ineffective or even counterproductive once interest rates fall to near zero, as they did during the 1930s, after the 2008 financial crisis, and again in 2020. Then the economy may fall into a “liquidity trap,” where people are hoarding cash because they have no financial incentive to lend. If things reach that point, it’s a sign that economic demand is really depressed. Companies are reluctant to borrow for expansion not because interest rates are too high, but because they don’t see a good market for more of their product. What the economy needs is not looser monetary policy, but aggressive fiscal policy—especially more government spending.

Fiscal policy

Many people, including many political leaders, make the mistake of describing an economy as if it were an individual household, always benefiting from spending no more than it receives in income. Statements like, “People are having to tighten their belts, so the government should tighten its belt too” epitomize that kind of thinking. But in the economy as a whole, everyone cannot run a budget surplus at once; my surplus is someone else’s deficit, and my spending provides someone else’s income. If everyone tries to cut spending at the same time, they just reduce overall production and income. Government is a big player in the economy, and it can help the economy by increasing spending when others are cutting theirs.

Economists have found relationships between GDP, unemployment, and government fiscal policy. Okun’s law states that unemployment varies inversely with GDP. A reasonable rule of thumb is that GDP must go up at least 2% to reduce unemployment by 1%. In our $21 trillion economy—I am updating the number from Krugman’s book—that would mean increasing GDP by $420 billion for each 1% desired drop in unemployment. Fortunately, government spending has a multiplier effect, which Mark Zandi has estimated at 1.5. That means that a mere $280 billion increase in spending should increase GDP by $420 billion and reduce unemployment by 1%.

What about tax cuts? Estimates of their stimulus effects vary, but most estimates put the multiplier at no more than 1.0. In general, a tax cut will stimulate the economy less than a spending increase of the same size, especially if it puts more money into the hands of people who are sitting on cash already. Krugman argues that the Obama stimulus package was less effective than it could have been because it relied too much on tax cuts in order to win conservative votes. It was an economic success anyway, reversing the downslide and saving millions of jobs. Yet Republicans turned it into a political liability for Democrats by declaring it a failure and blaming it for the sluggishness of the economic recovery. That set the stage for Donald Trump, who described the economy as a disaster and proposed even more tax cuts as the solution.

As I noted in the last post, Krugman calls the Trump tax cuts “the biggest tax scam in history.” He says that the “core of the bill is a huge redistribution of income from lower- and middle-income families to corporations and business owners.” He sees it as a continuation of standard Republican policy of cutting taxes mainly for the rich, and then using the fear of excessive government debt as an excuse to cut spending on the social safety net. But more to the point of fiscal policy, he describes the Trump tax cut as a “fizzle” because it didn’t produce the promised boom in investment. Corporations did not use very much of their tax cut to add jobs and productive capacity. What was holding them back was not a shortage of capital, but a lack of market demand for their products.

Krugman wrote the essays in this book before President Biden proposed his $1.9 trillion Covid Relief plan. He has written about it elsewhere, however, such as here. If the estimate based on Okun’s law is at all correct, and it takes only a $280 billion stimulus to reduce unemployment by 1%, we can understand why some economists regard $1.9 trillion as stimulus overkill. Unemployment is currently around 6%, and economists doubt that we can get it down below a “natural” level of 4 or 5% without risking runaway inflation. Krugman acknowledges the “good-faith criticism coming from people who actually have some idea what they are talking about, as opposed to the cynical, know-nothing obstructionism that has become the Republican norm.” Nevertheless, he defends the plan, for two reasons. First, he compares it to fighting a war, when a country just has to spend what it takes now, and worry about the costs later. World War II spending brought us high taxes and inflation, but it also won the war, ended the Depression, and sparked the postwar economic boom. Second, he thinks that the plan’s price tag may exaggerate its actual stimulus, since a lot of the cash benefits will probably be saved by households and state or local governments rather than spent or invested.

The price of debt

How much of a problem are budget deficits and the rising national debt for the future economy? Krugman steers a middle course between minimizing and exaggerating their effects. He reserves some of his harshest criticism for politicians who do both, minimizing their own deficits and attacking those incurred by the other party.

First, the good news. The rate of interest on government debt is normally lower than the growth rate of the economy. That means that even if debt is rising in absolute dollar terms, it can shrink as a percentage of GDP. If the government runs a deficit when interest rates are especially low, and if deficit spending stimulates economic growth, the country can come out ahead. This is exactly what happened to the debt accumulated by the end of World War II. “When and how did we pay it off? The answer is that we never did. Yet…despite rising dollar debt, by 1970 growth and inflation had reduced the debt to an easily handled share of G.D.P.” Krugman calls this “melting the snowball.”

Some economists warn that deficit spending can undermine growth by raising consumption but lowering investment. All that government borrowing siphons off resources that could have been used for private investment. But that argument is least relevant in times of recession, when companies aren’t investing enough anyway, and a boost in consumption is what the economy needs to get it moving. When the economy is running at full capacity, government has to be more careful about borrowing too much.

Krugman acknowledges that debt can become too large under unusual circumstances. He uses an example where the national debt is 300 percent of GDP, and the interest rate is 1.5 percent above the economic growth rate. Then in order to keep the debt-to-GDP ratio from spiraling out of control, the government would have to run an annual surplus of at least 4.5 percent of GDP. That would require politically difficult tax increases or benefit cuts. Right now the debt-to-GDP ratio is about 130% of GDP. Reinhart and Rogoff argued that anything over 90% is a big problem, but other economists have been unable to verify that conclusion.

Finally, Krugman distinguishes among different kinds of expenditures proposed by progressives. First are expenditures that can truly be regarded as public investments, such as infrastructure improvements. He is least worried about paying for them because they should boost future productivity enough to pay for themselves in economic growth and higher tax revenues. “If you can raise funds cheaply and apply them to high-return projects, you should go ahead and borrow.” His second category includes projects where “the sums are small enough that the revenue involved could be raised by fairly narrow-gauge taxes,” like the taxes imposed to pay for Obamacare. These too are easily justified as fiscally responsible. His third category is a “major system overhaul,” such as replacing all private health insurance with Medicare. That type of expenditure could not be undertaken without convincing the public that the gains in universal access and efficiency are worth the additional taxes.

Notice that Biden’s infrastructure proposal, although very costly, falls into Krugman’s first category, the kind of expenditure we shouldn’t worry about paying for. But Biden does propose to pay for it, by reversing some of the tax cuts on corporations and the wealthy. No doubt, opponents will try to argue that such tax increases hurt the economy more than infrastructure spending helps it, but they will not have the evidence on their side. Krugman is especially upset that we have let infrastructure spending fall to historically low levels, when it is one of the best investments a society can make.

Continued

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MMT 5: Monetary Operations

July 7, 2018

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This is the fifth in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.

What is money?

In modern economies, money is not a thing, but “a unit of account in which we keep track of debits and credits.” The sovereign state specifies the accounting unit, in our case the dollar, when it issues a currency. It has value not because it is backed by anything tangible, but mainly because the state accepts it as payment for people’s tax liabilities. That forces people to keep records in dollars for any transactions with tax implications. Once people are using the currency to track their transactions, it transcends anything physical. Money includes the paper dollars in your wallet, but it also includes all the accounting entries that record exchanges and show that someone has a dollar-denominated claim on someone else.

The dollar no longer has any fixed value. Since 1971, when the U.S. went off the gold standard, the value of the dollar has fluctuated according to its supply and demand in global financial markets.

According to Modern Monetary Theory, the creation of money is driven primarily by the demand for loans. When Meili extended credit to Thelma to buy stuff at her yard sale (see the previous post), the loan became a financial asset for Meili and a liability for Thelma, whether recorded in an I.O.U., a ledger, or in their respective memories. That kind of personal loan is at the bottom layer of the “pyramid of liabilities” that constitutes the monetary system. At a higher level, when a bank makes a business loan, it creates the money by crediting the business’s checking account. It also records the account balance as a liability for the bank, since it represents the bank’s obligation to accept checks drawn on the account. The loan itself is an asset for the bank, but a liability for the business, since the business is obligated to repay it.

Bank reserves

But doesn’t the bank have to have the money sitting in its vault before it can loan it out? No it doesn’t. It only has to have a small fraction of it in cash reserves, and most of those are held not in its vault but in an account with the central bank, in our case the Federal Reserve. The local bank doesn’t need much cash on hand on any given day, since it has deposits and loan payments coming in as well as withdrawals going out.

Modern Monetary Theory does not accept the notion that the reserves put a limit on the bank’s ability to lend, so that loan activity is limited by the existing supply of money. Banks respond to an increased demand for loans by finding the additional money they need to keep in reserve, whether by selling assets or borrowing from other banks or from the Federal Reserve. They make a profit by borrowing money at an “interbank” rate of interest and then charging their customers a somewhat higher rate.

The Federal Reserve stands at the top of the “pyramid of liabilities.” It is the “monopoly supplier of reserves.” Its operations accommodate the demand for money to lend, but only within limits because of the Fed’s responsibility to control inflation.

Inflation and interest rates

The Federal Reserve tries to control inflation by setting a target for the interest rate on interbank loans. Since the banks mark up this rate to make a profit when they lend to customers, this rate also affects interest rates for mortgages, business loans, and so forth. The Fed’s aim is to set rates high enough to discourage borrowing and spending when prices are rising too fast, and low enough to encourage borrowing and spending when inflation is low and the economy is growing too slowly. The Fed keeps a constant watch on actual interbank borrowing to see if the rates on interbank loans are deviating from the target. That happens because of fluctuations in the reserves held by the banks.

When banks are short of reserves, the shortage may drive the interbank rate up. (Banks are willing to pay more to borrow, or they can charge more to lend.) The Federal Reserve can alleviate the shortage by injecting cash into the system with purchases of bonds or other assets from banks. When an excess of reserves drives the interbank rate below the Fed’s target, it can drain reserves from the system by selling bonds or other assets to banks.

Treasury spending and lending

When the U.S. Treasury spends money authorized by the federal budget, it also creates money for the economy, for example by crediting the account of a building contractor. When it taxes, it removes money from the economy. When it spends more than it taxes, the excess money increases disposable income and boosts aggregate demand.

Deficit spending can be a source of inflation, however, by pushing up the market demand for goods and services without adding to the supply, especially if the economy is already running near capacity. The government spending went to produce a public good, such as a new highway, but it didn’t add to the supply of consumer goods that people can buy. By issuing Treasury bonds, the Treasury drains excess cash from the system and replaces it with I.O.U.s. People who buy the bonds are saving rather than spending.

Notice that I did not say that the government had to issue bonds in order to borrow the money before it could spend it, like a consumer using a credit card. In principle, the sovereign state has the power to create money when it spends without draining that money back out again through taxation or bond sales. Selling bonds is mainly a prudent measure to ward off inflation. For that reason, Modern Monetary Theory considers it a part of monetary policy more than fiscal policy, which is concerned more with taxing and spending.

The Federal Reserve does not buy Treasury bonds directly from the Treasury, but it can buy and sell them on the secondary market. Those buys and sells are an important way of adjusting bank reserves, as described above. Although the Federal Reserve has a degree of independence from the Treasury, in practice they work together to control inflation.

A tight monetary policy keeps interest rates high enough to discourage too much borrowing and spending. Experience has shown that it can be effective in controlling inflation. The downside is that it can slow economic growth and keep the economy running below capacity. The holy grail for economists would be a set of government policies that would promote both full employment and low inflation. Modern Monetary Theory tries to develop such a policy.

Continued

 

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Postcapitalism (part 4)

May 18, 2016

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The last part of Paul Mason’s Postcapitalism discusses how the transition out of capitalism might unfold, with special attention to the role of the state in facilitating change.

To review, Mason expects information technology to liberate people from the capitalist market economy. We will be liberated as workers because fewer hours of paid work will be required to produce the necessities of life. We will be liberated as consumers because goods and services will be more abundant and less expensive. We will be able to devote more of our time to voluntary activity and sharing.

A rough road

If this sounds too rosy and idealistic, readers should take a close look at Chapter 2, “Long Waves, Short Memories,” and Chapter 9, “The Rational Case for Panic.” Mason does not expect a smooth, leisurely and pleasant transition beyond capitalism, but something more tumultuous. As the historical material in the book makes clear, the history of capitalism is not just a story of steady progress through technological innovation and rising productivity. It is a story of periodic crises as the profitability of existing industries wanes and capital has to find new opportunities elsewhere. The transition now underway is especially difficult because it calls into question the viability of capitalism itself. As production becomes more knowledge-based, the means of production become harder to own and maintain as sources of private profit. Since the 1970s, capitalists have been counteracting the tendency for profits to fall by holding wages down in the developed countries and exploiting the cheap labor of poorer countries, but at the cost of increasing inequality and social resistance.

To make matters worse, new environmental and demographic conditions are delivering “external shocks” to the economic system. The prime example is climate change, a problem that Mason does not believe the market can solve on its own. When the price of fossil fuels goes up, energy companies take that as a signal “that it’s a good idea to invest in new and more expensive ways of finding carbon.” When the price goes down, consumers conclude that they can drive more or buy less fuel-efficient vehicles. However the market fluctuates, the price does not factor in the externalities, the true costs of environmental impacts on the global economy.

Another shock is the “demographic timebomb,” the addition of another two billion people to the planet by mid-century, most of them in poorer countries. In the richer countries, falling birth rates and rising longevity are creating rapidly aging populations. With fewer working-age people to support more retirees, workers are under pressure to generate enough wealth to save for their own long retirement as well as contribute to the support of today’s retirees through payroll taxes. Demographic change puts additional stress on the economy in several ways: requiring the financial system to deliver high investment returns for retirement accounts, increasing the demands on public spending for the elderly, and increasing the flow of migrants from rapidly growing poor countries to slower growing but aging rich countries.

The world cannot afford a leisurely transformation to the postcapitalist economy Mason foresees. The world needs a rapid deployment of new technologies to produce as much as we can, but do it in a cleaner, greener way that mitigates environmental damage. The potential benefits are enormous, but the task of getting from here to there is daunting.

“Project Zero”

Because of the urgency of the situation, Mason believes that a spontaneous process of increasing information-based activity is not enough. The process needs to become a conscious project, based on the insight that “a new route beyond capitalism has opened up, based on promoting and nurturing non-market production and exchange, and driven by information technology.” He calls it “Project Zero” because “its aims are a zero-carbon energy system; the production of machines, products and services with zero marginal costs; and the reduction of necessary labour time as close as possible to zero.”

The state has a special role to play in Project Zero because only the state is “centralized, strategic and fast” enough to address the urgent problems. However, Mason rejects the old socialist idea of a centrally planned economy, arguing that a centralized bureaucracy cannot respond to new data fast enough to keep up with the pace of change in the information society. Recall the earlier point that the key agent of change will be the educated and networked individual, which implies a high degree of decentralization.

Limits on private capital

So what can the state do to facilitate the transition to postcapitalism? First, it can curb private economic power in industries where it has become a danger to the public good. The energy industry would be one, as the discussion of the climate issue illustrates. The state should actively discourage fossil fuel production and encourage cleaner sources of energy. Mason also sees a much larger role of government in the financial industry. One proposal sure to provoke controversy is that the state take control of the central bank in order to implement a monetary policy that helps debtors more than creditors. That would be a looser monetary policy that keeps interest rates low but allows the inflation rate to be somewhat higher. Over time, that erodes the real value of debt, in contrast to a strict monetary policy that protects wealthy lenders by placing primary emphasis on fighting inflation. Since government itself is a large debtor, that would help governments recover from the fiscal crisis resulting from demands for both low taxes on capital and high spending on social programs to assist struggling wage-earners.

Mason would also reorganize the banking system to make it less profit-driven, by encouraging non-profit banks, credit unions, peer-to-peer lenders, and “a comprehensive state-owned provider of financial services.” He would regulate the remaining profit-oriented banking to curb wasteful speculation and encourage its proper role of efficiently allocating capital to productive activities.

In the economy as a whole, the state would act to insure that what profits remain would be a reward for entrepreneurship, and not just a “rent” based on ownership. Creators of new knowledge would get the rewards of intellectual property rights, but those rights would be short-lived to encourage the flow of knowledge and the continued incentive for further innovation.

Liberating workers

Another thing the state can do is strengthen the legal rights and protections of workers to give them more bargaining power in their relationship with capital. This will indirectly encourage the fuller application of new technologies that can produce economic abundance. “If we legally empowered the workforces of global corporations with strong employment rights, their owners would be forced to promote high-wage, high-growth, high-technology models, instead of the opposite.” Owners would try to make each worker as productive as possible if they could no longer profit from paying such low wages.

An obvious objection is that higher wages and productivity would have the downside of less employment. But for Mason, less employment in capitalist workplaces where owners profit by overworking and/or underpaying workers is ultimately a good thing. Ideally, workers would be better paid for the hours they worked, but also have the option of working fewer hours. They could then experience the decline of paid employment as a liberation, not an involuntary displacement.

The other side of the transformation of work is the increasing opportunities for work outside of traditional profit-centered firms, such as in non-profits and co-ops. Mason recommend that the state “reshape the tax system to reward the creation of non-profits and collaborative production.”

Liberating consumers

The replacement of millions of workers by automated systems is unlikely to be experienced as a good thing unless it has benefits for people as consumers, not just as workers. Here the state can facilitate the transition by providing a basic income to all households, to support those who are voluntarily or involuntarily outside the system of paid employment. That can improve the safety net for those who are displaced by new technologies. It also “gives people a chance to build positions in the non-market economy” by subsidizing participation in volunteer work, co-ops and adult learning opportunities. Market work would still be rewarding as long as minimum wages were higher than the basic income.

In the long run, the abundance of things made available by hi-tech production methods would bring the monetary cost of living down and reduce consumers’ dependency on earned income. People could rely more heavily on non-market forms of sharing, since they would have more time for unpaid but socially useful activity. As the income tax base became smaller, government’s ability to pay a basic income would decline, but so would people’s need for one.

Can democracy survive the transition?

Just about every one of Mason’s political suggestions goes against conservative thinking, which sees the free market as the creator of wealth and the limited state as its supporter. In the conservative view, the state should tax and regulate capital as little as possible, protect wealth against inflation with tight monetary policy, and keep people dependent on paid employment by providing only the most meager welfare benefits. Mason ends his book by warning that if the democratic state tries to facilitate a transition beyond capitalism, the economic elite may decide that preserving capitalism is more important than preserving the democratic state!

How long will it take before the culture of the Western elite swings toward emulating Putin and Xi Jinping? On some campuses, you can already hear it: “China shows capitalism works better without democracy” has become a standard talking point. The self-belief of the 1 per cent is in danger of ebbing away, to be replaced by a pure and undisguised oligarchy.”

We can already see the beginnings of an alliance between right-wing autocrats and blue-collar workers fearful of losing their jobs, especially in doomed occupations like coal mining or pipeline construction. If such alliances succeed in taking over the governments of developed countries such as the United States, then things could get pretty ugly in the next few decades.

In the last great transition of capitalism, in the early twentieth century, authoritarian politics had to be defeated before the democratic state could help create a broader-based prosperity. (Third-world peoples and racial minorities remained excluded however.) We should not be surprised if the same turns out to be true of the twenty-first century, as we struggle to create a more inclusive and sustainable prosperity.

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