Category Archives: Currencies

People who reject free lunches are fools: Liquidity trap – part II

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Fiscal and monetary policy in a liquidity trap – part II

By Martin Wolf

Output is produced by work.
Work is a cost, not a benefit.
It is in that sense that there is no free lunch.

Might fiscal expansion be a free lunch? This is the question addressed in a thought-provoking paper “Fiscal Policy in a Depressed Economy”, March 2012, by Brad DeLong and Larry Summers, the most important conclusion of which is obvious, but largely ignored: the impact of fiscal expansion depends on the context. *

In normal times, with resources close to being fully utilised, the multiplier will end up very close to zero; in unusual times, such as the present, it could be large enough and the economic benefits of such expansion significant enough to pay for itself.

‘Paying for itself’ implies there is some real benefit to a lower deficit outcome vs a higher deficit outcome. With the govt deficit equal to the net financial assets of the non govt sectors, ‘Paying for itself’ implies there is a real benefit to the non govt sectors have fewer net financial assets.

In a liquidity trap fiscal retrenchment is penny wise, pound foolish.

I would say it’s penny foolish as well, as it directly reduces net financial assets of the non govt sectors with no economic or financial benefit to either the govt sector or the non govt sectors.

Indeed, relying on monetary policy alone is the foolish policy: if it worked, which it probably will not, it does so largely by expanding stretched private balance sheets even further.

Agreed.

As the authors note: “This paper examines the impact of fiscal policy in the context of a protracted period of high unemployment and output short of potential like that suffered by the United States and many other countries in recent years. We argue that, while the conventional wisdom rejecting discretionary fiscal policy is appropriate in normal times, discretionary fiscal policy where there is room to pursue it has a major role.”

There are three reasons for this.

1. First, the absence of supply constraints means that the multiplier is likely to be large.

Why is a large multiplier beneficial?

A smaller multiplier means the fiscal adjustment can be that much larger.

That is, the tax cuts and/or spending increases (depending on political preference) can be that much larger with smaller multipliers.

It is likely to be made even bigger by the fact that fiscal expansion may well raise expected inflation and so lower the real rate of interest, when the nominal rate is close to zero.

However the ‘real rate of interest’ is defined. Most would think CPI, which means the likes of tobacco taxes move the needle quite a bit.

And with the MMT understanding that the currency itself is in fact a simple public monopoly, and that any monopolist is necessarily ‘price setter’, the ‘real rate of interest’ concept doesn’t have a lot of relevance.

2. Second, even moderate hysteresis effects of such fiscal expansion, via increases in the likely level of future output, have big effects on the future debt burden.

Back to the errant notion of a public sector debt in its currency of issue being a ‘burden’.

3. Finally, today’s ultra-low real interest rates at both the short and long end of the curve, suggest that monetary policy is relatively ineffective, on its own.

Most central bank studies show monetary policy is always relatively ineffective.

The argument is set out in a simple example. “Imagine a demand-constrained economy where the fiscal multiplier is 1.5, and the real interest rate on long-term government debt is 1 per cent. Finally, assume that a $1 increase in GDP increased tax revenues and reduces spending by $0.33. Assume that the government is able to undertake a transitory increase in government spending, and then service the resulting debt in perpetuity, without any impact on risk-premia.

“Then the impact effect of an incremental $1.00 of spending is to raise the debt stock by $0.50. The annual debt service needed on this $0.50 to keep the real debt constant is $0.005. If reducing the size of the current downturn in production by $1.50 avoids a 1 per cent as large fall in future potential output – avoids a fall in future potential output of $0.0015 – then the incremental $1.00 of spending now augments future tax-period revenues by $0.005. And the fiscal expansion is self-financing.”

This is a very powerful result.

Yes, it tells you that the ‘automatic fiscal stabilizers’ must be minded lest the expansion reduce the govt deficit and, by identity, reduce the net financial assets of the non govt sectors to the point of aborting the economic recovery. Which, in fact, is how most expansion cycles end.

For the non govt sectors, net financial assets are the equity that supports the credit structure.

So when a recovery driven by a private sector credit expansion (which is how most are driven), causes tax liabilities to increase and transfer payments to decrease (aka automatic fiscal stabilizers)- reducing the govt deficit and by identity reducing the growth of private sector net financial assets- private sector/non govt leverage increases to the point where it’s unsustainable and it all goes bad again.

It rests on the three features of the present situation: high multipliers; low real interest rates; and the plausibility of hysteresis effects.

A table in the paper (Table 2.2) shows that at anything close to current real interest rates fiscal expansion is certain to pay for itself even with zero multiplier and hysteresis effects: it is a “no-brainer”.

And, if allowed to play out as I just described, the falling govt deficit will also abort the expansion.

Why is this? It is because the long-term real interest rate paid by the government is below even the most pessimistic view of the future growth rate of the economy. As I have argued on previous occasions, the US (and UK) bond markets are screaming: borrow.

The bond markets are screaming ‘the govt. Will never get its act together and cause the conditions for the central bank to raise rates.’

Of course, that is not an argument for infinite borrowing, since that would certainly raise the real interest rate substantially!

Infinite borrowing implies infinite govt spending.

Govt spending is a political decision involving the political choice of the ‘right amount’ of real goods and services to be moved from private to public domain.

Yet, more surprisingly, the expansion would continue to pay for itself even if the real interest rate were to rise far above the prospective growth rate, provided there were significantly positive multiplier and hysteresis effects.

I’d say it this way:
Providing increasing private sector leverage and credit expansion continues to offset declines in govt deficit spending.

Let us take an example: suppose the multiplier were one and the hysteresis effect were 0.1 – that is to say, the permanent loss of output were to be one tenth of the loss of output today. Then the real interest rate at which the government could obtain positive effects on its finances from additional stimulus would be as high as 7.4 per cent.

Thus, state the authors, “in a depressed economy with a moderate multiplier, small hysteresis effects, and interest rates in the historical range, temporary fiscal expansion does not materially affect the overall long-run budget picture.” Investors should not worry about it. Indeed, they should worry far more about the fiscal impact of prolonged recessions.

They shouldn’t worry about the fiscal impact in any case. The public sector deficit/debt is nothing more than the net financial assets of the non govt sectors. And these net financial assets necessarily sit as balances in the central bank, as either clearing balances (reserves) or as balances in securities accounts (treasury securities). And ‘debt management’ is nothing more than the shifting of balances between these accounts.

(and there are no grandchildren involved!)
(and all assuming floating exchange rate policy)

Are such numbers implausible? The answer is: not at all.

Multipliers above one are quite plausible in a depressed economy, though not in normal circumstances. This is particularly true when real interest rates are more likely to fall, than rise, as a result of expansion.

The ‘multipliers’ are nothing more than the flip side of the aggregate ‘savings desires’ of the non govt sectors. And the largest determinant of these savings desires is the degree of credit expansion/leverage.

Similarly, we know that recessions cause long-term economic costs. They lower investment dramatically: in the US, the investment rate fell by about 4 per cent of gross domestic product in the wake of the crisis. Businesses are unwilling to invest, not because of some mystical loss of confidence, but because there is no demand.

Again, we know that high unemployment has a permanent impact on workers, both young and old. The US, in particular, seems to have slipped into European levels of separation from the labour force: that is to say, the unemployment rate is quite low, given the sharp fall in the rate of employment. Workers have given up. This is a social catastrophe in a country in which work is effectively the only form of welfare for people of working age.

Not to mention the lost real output which over the last decade has to be far higher than the total combined real losses from all the wars in history.

Indeed, we can see hysteresis effects at work in the way in which forecasters, including official forecasters, mark down potential output in line with actual output: a self-fulfilling prophecy if ever there was one. This procedure has been particularly marked in the UK, where the Office for Budget Responsibility has more or less eliminated the notion that the UK is in a recession. Yet such effects are not God-given; they are man-chosen. They are the product of fundamentally misguided policies.

This is an important paper. It challenges complacent “do-nothingism” of policymakers, let alone the “austerians” who dominate policy almost everywhere. Policy-makers have allowed a huge financial crisis to impose a permanent blight on economies, with devastating social effects. It makes one wonder why the Obama administration, in which prof Summers was an influential adviser, did not do more, or at least argue for more, as many outsiders argued.

The private sector needs to deleverage.

It’s no coincidence that with a relatively constant trade deficit, private sector net savings, as measured by net financial $ assets, has increased by about the amount of the US budget deficit.

In other words, the $trillion+ federal deficits have added that much to domestic income and savings, thereby reducing private sector leverage.

However, as evidenced by the gaping output gap, for today’s credit conditions, it’s been not nearly enough.

The government can help by holding up the economy. It should do so. People who reject free lunches are fools.

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Fiscal and monetary policy in a liquidity trap

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Not bad, but let’s take it up to the next level.

Comments below:

Fiscal and monetary policy in a liquidity trap

By Martin Wolf

With floating fx, it’s always a ‘liquidity trap’ in that adding liquidity to a system necessarily not liquidity constrained is moot.

Part 1

What is the correct approach to fiscal and monetary policy when an economy is depressed and the central bank’s rate of interest is close to zero? Does the independence of the central bank make it more difficult to reach the right decisions? These are two enormously important questions raised by current circumstances in the US, the eurozone, Japan and the UK.

With floating fx, it’s always about a fiscal adjustment, directly or indirectly.

Broadly speaking, I can identify three macroeconomic viewpoints on these questions:
1. The first is the pre-1930 belief in balanced budgets and the gold standard (or some other form of a-political money).

Yes, actual fixed fx policy, where the monetary system is continuously liquidity constrained by design.

2. The second is the religion of balanced budgets and managed money, with Milton Friedman’s monetarism at the rules-governed end of the spectrum and independent inflation-targeting central banks at the discretionary end.

Yes, the application of fixed fx logic to a floating fx regime.

3. The third demands a return to Keynesian ways of thinking, with “modern monetary theory” (in which monetary policy and central banks are permanently subservient to fiscal policy) at one end of the policy spectrum, and temporary resort to active fiscal policy at the other.

MMT recognizes the difference in monetary dynamics between fixed and floating fx regimes.

In this note, I do not intend to address the first view, though I recognise that it has substantial influence, particularly in the Republican Party. I also do not intend to address Friedman’s monetarism, which has lost purchase on contemporary policy-makers, largely because of the views that the demand for money is unstable and the nature of money ill-defined. Finally, I intend to ignore “modern monetary theory” which would require a lengthy analysis of its own.

This leaves us with the respectable contemporary view that the best way to respond to contemporary conditions is via fiscal consolidation and aggressive monetary policy, and the somewhat less respectable view that aggressive fiscal policy is essential when official interest rates are close to zero.

Two new papers bring light from the second of these perspectives. One is co-authored by Paul McCulley, former managing director of Pimco and inventor of the terms “Minsky moment” and “shadow banking”, and Zoltan Pozsar, formerly at the Federal Reserve Bank of New York and now a visiting scholar at the International Monetary Fund.* The other is co-authored by J. Bradford DeLong of the university of California at Berkeley, and Lawrence Summers, former US treasury secretary and currently at Harvard university. **

Unfortunately, and fully understood, is the imperative for you to select from ‘celebrity’ writers regardless of the quality of the content.

The paper co-authored by Mr McCulley and Mr Pozsar puts the case for aggressive fiscal policy. The US, they argue, is in a “liquidity trap”: even with official interest rates near zero, the incentive for extra borrowing, lending and spending in the private sector is inadequate.

An output gap is the evidence that total spending- public plus private- is inadequate. And yes, that can be remedied by an increase in private sector borrowing to spend, and/or a fiscal adjustment by the public sector towards a larger deficit via either an increase in spending and/or tax cut, depending on one’s politics.

The explanation for this exceptional state of affairs is that during the credit boom and asset-price bubble that preceded the crisis, large swathes of the private sector became over-indebted. Once asset prices fell, erstwhile borrowers were forced to reduce their debts. Financial institutions were also unwilling to lend. They needed to strengthen their balance sheets. But they also confronted a shortage of willing and creditworthy borrowers.

Yes, for any reason if private sector spending falls short of full employment levels, a fiscal adjustment can do the trick.

This raises an interesting question:

Is it ‘better’, for example, to facilitate the increase in spending through a private sector credit expansion, or through a tax cut that allows private sector spending to increase via increased income, or through a government spending increase?

The answer is entirely political. The output gap can be closed with any/some/all of those options.

In such circumstances, negative real interest rates are necessary, but contractionary economic conditions rule that out.

I see negative nominal rates as a tax that will reduce income and net financial assets of the non govt sectors, even as it may increase some private sector credit expansion. And the reduction of income and net financial assets works to reduce the credit worthiness of the non govt sectors reducing their ability to borrow to spend.

Instead, there is a danger of what the great American economist, Irving Fisher called “debt deflation”: falling prices raise the real burden of debt, making the economic contraction worse.

Yes, though he wrote in the context of fixed fx policy, where that tends to happen as well, though under somewhat different circumstances and different sets of forces.

A less extreme (and so more general) version of the idea is “balance-sheet recession”, coined by Richard Koo of Nomura. That is what Japan had to manage in the 1990s.

With floating fx they are all balance sheet recessions. There is no other type of recession.

This is how the McCulley-Pozsar paper makes the point: “deleveraging is a beast of burden that capitalism cannot bear alone. At the macroeconomic level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction . . . by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.

Correct, in the context of today’s floating fx. With fixed fx that option carries the risk of rising rates for the govt and default/devaluation.

“Fiscal austerity does not work in a liquidity trap and makes as much sense as putting an anorexic on a diet. Yet ‘diets’ are the very prescriptions that fiscal ‘austerians’ have imposed (or plan to impose) in the US, UK and eurozone. Austerians fail to realise, however, that everyone cannot save at the same time and that, in liquidity traps, the paradox of thrift and depression are fellow travellers that are functionally intertwined.”

Agreed for floating fx. Fixed fx is another story, where forced deflation via austerity does make the maths work, though most often at an impossible social cost.

Confronted by this line of argument, austerians (a term coined by Rob Parenteau, a research associate at the Levy Economics Institute of Bard College), make three arguments:

1. additional borrowing will add heavily to future debt and so be an unreasonable burden on future generations;
2. increased borrowing will crowd out private borrowing;
3. bond investors will stop buying and push yields up.

Which does happen with fixed fx policy.

In a liquidity trap, none of these arguments hold.

With floating fx, none of these hold in any scenario.

Experience over the last four years (not to mention Japan’s experience over the past 20 years) has demonstrated that governments operating with a (floating) currency do not suffer a constraint on their borrowing. The reason is that the private sector does not wish to borrow, but wants to cut its debt, instead. There is no crowding out.

Right, because floating fx regimes are by design not liquidity constrained.

Moreover, adjustment falls on the currency, not on the long-term rate of interest.

Right, and again, unlike fixed fx.

In the case of the US, foreigners also want to lend, partly in support of their mercantilist economic policies.

Actually, they want to accumulate dollar denominated financial assets, which we call lending.

Note that both reserve balances at the Fed and securities account balances at the Fed (treasury securities) are simply dollar deposits at the Fed.

Alas, argue Mr McCulley and Mr Pozsar, “held back by concerns borne out of these orthodoxies, . . . governments are not spending with passionate purpose. They are victims of intellectual paralysis borne out of inertia of dogma . . . As a result, their acting responsibly, relative to orthodoxy, and going forth with austerity may drag economies down the vortex of deflation and depression.”

Right. Orthodoxy happens to be acting as if one was operating under a fixed fx regime even though it’s in fact a floating fx regime.

Finally, they note, “the importance of fiscal expansion and the impotence of conventional monetary policy measures in a liquidity trap have profound implications for the conduct of central banks. This is because in a liquidity trap, the fat-tail risk of inflation is replaced by the fat-tail risk of deflation.”

The risk of excess aggregate demand is replaced by the risk of inadequate aggregate demand.

And the case can be made that lower rates reduce aggregate demand via the interest income channels, as the govt is a net payer of interest.

In this situation, we do not need independent central banks that offset – and so punish – fiscally irresponsible governments. We need central banks that finance – and so encourage – economically responsible (though “fiscally irresponsible”) governments.

Not the way I would say it but understood.

When private sector credit growth is constrained, monetisation of public debt is not inflationary.

While I understand the point, note that ‘monetisation’ is a fixed fx term not directly applicable to floating fx in this context.

Indeed, it would be rather good if it were inflationary, since that would mean a stronger recovery, which would demand swift reversal of the unorthodox policy mix.

The conclusion of the McCulley-Pozsar paper is, in brief, that aggressive fiscal policy does work in the unusual circumstances of a liquidity trap, particularly if combined with monetisation. But conventional wisdom blocks full use of the unorthodox tool kit. Historically, political pressure has destroyed such resistance. Political pressure drove the UK off gold in 1931. But it also brought Hitler to power in Germany in 1933. The eurozone should take note.

Remarkably, in the circumstances of a liquidity trap, enlarged fiscal deficits are likely to reduce future levels of privately held public debt rather than raise them.

As if that aspect matters?

The view that fiscal deficits might provide such a free lunch is the core argument of the paper by DeLong and Summers, to which I will turn in a second post.

Free lunch entirely misses the point.

Why does the size the balances in Fed securities accounts matter as suggested, with floating fx policy?

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Yen Drops Versus Peers as Tankan Fuels Easing Speculation

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Right!
Lower rates!
More QE!

Be patient, monetary policy works with a lag
It’s only been 20 years
Hyper inflation is just around the corner…

Yen Drops Versus Peers as Tankan Fuels Easing Speculation

April 2 (Bloomberg) — The yen weakened versus all of its major peers after a Bank of Japan (8301) report showed that sentiment failed to improve at the nation’s largest companies, stoking prospects the central bank will boost monetary stimulus.

The Japanese currency slid against the dollar and euro as signs that manufacturing is improving in the U.S. and China, the world’s two biggest economies, undermined demand for haven assets. The euro remained higher after a quarterly gain versus the greenback as European governments called for a bigger global financial emergency fund after engineering a firewall to fight the region’s debt crisis.

“The worse-than-expected Tankan survey seems to be fueling talk that the BOJ will ease policy further,” Lee Wai Tuck, a currency strategist at Forecast Pte in Singapore, said about the central bank’s quarterly sentiment survey. “This is probably leading to selling of the yen.”

The yen lost 0.4 percent to 83.18 per dollar as as of 10:19 a.m. in Tokyo. It slid 0.4 percent to 110.97 per euro. Europe’s 17-nation currency was little changed at $1.3341 after rising 3 percent versus the greenback in the three months ended March 31.

The Tankan index for Japan’s largest manufacturers was unchanged last quarter from minus 4 in December, the BOJ said today in Tokyo. That was less than the median estimate of minus 1 in a Bloomberg News survey of economists. A negative number means pessimists outnumber optimists.

BOJ Meetings

BOJ policy board members are scheduled to meet April 9-10 and April 27 this month. The central bank held off from expanding asset purchases at its meeting in March as it monitored improvements in the economy. In February, it expanded bond purchases by 10 trillion yen ($120 billion) and set a 1 percent inflation goal in February.

The Institute for Supply Management’s factory index for the U.S. probably rose to 53 last month from 52.4 in February, according to the median estimate of economists surveyed by Bloomberg before the figures are released today.

An index of Chinese manufacturing climbed to 53.1 last month, the highest since March 2011, the logistics federation and the National Bureau of Statistics said yesterday. The measure has a pattern of rising each March.

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Japan to purchase 65 billion yuan in China government debt

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Part of the general move of the current govt to exit deflation via weakening the yen, as previously discussed. Look for Japan to be increasing total fx reserves, and in multiple currencies. The only thing that might stop them is being called on it by the US Treasury secretary.

Japan to purchase 65 billion yuan in China government debt

By Stanley White

March 13 (Reuters) — Japan said on Tuesday it had received approval from China’s government to purchase 65 billion yuan ($10.3 billion) in Chinese government debt in a move that can help Japan diversify its reserves away from the dollar and strengthen economic ties between the two Asian countries.

The timing of purchases hasn’t been set yet as Japan still needs to make some administrative preparations, but Japan is likely to start with a small amount and then increase purchases, Japan’s Finance Minister Jun Azumi said.

Japan will also consider the impact on financial markets when it decides the timing of its purchases, Azumi said.

China said on Monday it would continue its purchases of Japanese government debt but would reduce purchases when the yen is rising as China and Japan, holders of the largest and second-largest currency reserves, look to limit exposure to the dollar.

“We feel this is an appropriate amount when considering our mutual goal of strengthening economic cooperation between Japan and China,” Azumi told reporters.

Japan and China agreed at a summit in December to facilitate trade between the yen and the yuan as part of a broader push to strengthen economic cooperation.Japan said on Tuesday it had received approval from China’s government to purchase 65 billion yuan ($10.3 billion) in Chinese government debt in a move that can help Japan diversify its reserves away from the dollar and strengthen economic ties between the two Asian countries.

The timing of purchases hasn’t been set yet as Japan still needs to make some administrative preparations, but Japan is likely to start with a small amount and then increase purchases, Japan’s Finance Minister Jun Azumi said.

Japan will also consider the impact on financial markets when it decides the timing of its purchases, Azumi said.

China said on Monday it would continue its purchases of Japanese government debt but would reduce purchases when the yen is rising as China and Japan, holders of the largest and second-largest currency reserves, look to limit exposure to the dollar.

“We feel this is an appropriate amount when considering our mutual goal of strengthening economic cooperation between Japan and China,” Azumi told reporters.

Japan and China agreed at a summit in December to facilitate trade between the yen and the yuan as part of a broader push to strengthen economic cooperation.

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GEI article is up

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Eurozone: How to Drive an Economy in Reverse

By Warren Mosler

February 27 — The situation in Greece brings me back to the conclusion that merely resolving solvency issues in the Eurozone doesn’t fix the economy. Solvency must not be an issue, but if there is negative growth, solvency math simply doesn’t work for any of the Euro members.

Without growth in the Eurozone the resolution (for now) of the Greek crisis will simply result in the focus moving on to one of the next weaker sisters. As this happens the risk remains that other countries in trouble will ask for haircuts on their debt (similar to Greece) as part of their rescue. And that could trigger a general, global, catastrophic financial meltdown.

Follow up:
Monetary and Fiscal Expansion are Needed

My first order proposal remains an ECB distribution on a per capita basis to the euro member nations of maybe 10% of euro zone GDP per year to put the solvency issue behind them. Along with relaxed budget rules, maybe allowing deficits up to 6% of GDP annually, further supported by the ECB funding a transition job at a non disruptive wage to facilitate the transition from unemployment to private sector employment. I might also recommend deficits be increased by suspending VAT as a way to increase aggregate demand and lower prices at the same time.

Alternatively, the ECB could simply guarantee all national government debt and rely on the growth and stability pact for fiscal discipline, which would probably require enhanced authorities.

And rather than trying to bring Greece’s deficit down to current target levels, they could instead relax the growth and stability pact limits to something closer to full employment levels. And, again, I’d look into suspending VAT to both increase aggregate demand and lower prices.

Strong Euro First

However, all policies seem to be ‘strong euro’ first. And the ‘success’ of the euro continues to be gauged by its ‘strength’.

The haircuts on the Greek bonds are functionally a tax that removes that many net euro financial assets. Call it an ‘austerity’ measure extending forced austerity to investors.

Other member nations will likely hold off on turning towards that same tax until after Greece is a ‘done deal’ as early noises could work to undermine the Greek arrangements, and take the ‘investor tax’ off the table.

Like most other currencies, the euro has ‘built in’ demand leakages that fall under the general category of ‘savings desires’. These include the demand to hold actual cash, contributions to tax advantaged pension contributions, contributions to individual retirement accounts, insurance and other corporate ‘reserves’, foreign central bank accumulations of euro denominated financial assets, along with all the unspent interest and earnings compounding.

Offsetting all of that unspent income (private savings) is, historically, the expansion of debt, where agents spend more than their income. This includes borrowing for business and consumer purchases, which includes borrowing to buy cars and houses. In other words, net savings of financial assets are increased by the demand leakages and decreased by credit expansion. And, in general, most of the variation is due to changes in the credit expansion component.

Austerity in the euro zone consists of public spending cuts and tax hikes, which have both directly slowed the economies and increased net savings desires, as the austerity measures have also reduced private sector desires to borrow to spend. This combination results in a decline in sales, which translates into fewer jobs and reduced private sector income. Which further translates into reduced tax collections and increased public sector transfer payments, as the austerity measures designed to reduce public sector debt instead serve to increase it.

Now adding to that is this latest tax on investors in Greek debt, and if the propensity to spend any of the lost funds of those holders was greater than zero, aggregate demand will see an additional decline, with public sector debt climbing that much higher as well.

All of this serves to make the euro ‘harder to get’ and further support the value of the euro, which serves to keep a lid on the net export channel. The ‘answer’ to the export dilemma would be to have the ECB, for example, buy dollars as Germany used to do with the mark, and as China and Japan have done to support their exporters. But ideologically this is off the table in the euro zone, as they believe in a strong euro, and in any case they don’t want to build dollar reserves and give the appearance that the dollar is ‘backing’ the euro.

Three Reverse Thrusters in Use

This works to move all the euro member nation deficits higher as the ‘sustainability math’ of all deteriorate as well, increasing the odds of the ‘investor tax’ expanding to the other member nations – and that continues the negative feedback loop.

Given the demand leakages of the institutional structure, as a point of logic, prosperity can only come from some combination of increased net exports, a private sector credit expansion, or a public sector credit expansion.

And right now it looks like they are still going backwards on all three. And with the transmission in reverse, pressing the accelerator harder only makes you go backwards that much faster.

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More on Greece and the euro

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As previously discussed, all policies seem to be ‘strong euro’ first.

And the ‘success’ of the euro continues to be gauged by its ‘strength’.

The haircuts on the Greek bonds are functionally a tax that removes that many net euro financial assets. Call it an ‘austerity’ measure extending forced austerity to investors.

Other member nations will likely hold off on turning towards that same tax until after Greece is a ‘done deal’ as early noises could work to undermine the Greek arrangements, and take the ‘investor tax’ off the table.

Like most other currencies, the euro has ‘built in’ demand leakages that fall under the general category of ‘savings desires’. These include the demand to hold actual cash, contributions to tax advantaged pension contributions, contributions to individual retirement accounts, insurance and other corporate ‘reserves’, foreign central bank accumulations euro denominated financial assets, along with all the unspent interest and earnings compounding.

Offsetting all of that unspent income is, historically, the expansion of debt, where agents spend more than their income. This includes borrowing for business and consumer purchases, which includes borrowing to buy cars and houses. In other words, net savings of financial assets are increased by the demand leakages and decreased by credit expansion. And, in general, most of the variation is due to changes in the credit expansion component.

Austerity in the euro zone consists of public spending cuts and tax hikes, which have both directly slowed the economies and increased net savings desires, as the austerity measures have also reduced private sector desires to borrow to spend. This combination results in a decline in sales, which translates into fewer jobs and reduced private sector income. Which further translates into reduced tax collections and increased public sector transfer payments, as the austerity measures designed to reduce public sector debt instead serve to increase it.

Now adding to that is this latest tax on investors in Greek debt, and if the propensity to spend any of the lost funds of those holders was greater than 0, aggregate demand will see an additional decline, with public sector debt climbing that much higher as well.

All of which serves to make the euro ‘harder to get’ and further support the value of the euro, which serves to keep a lid on the net export channel. The ‘answer’ to the export dilemma would be to have the ECB, for example, buy dollars as Germany used to do with the mark, and as China and Japan have done to support their exporters. But ideologically this is off the table in the euro zone, as they believe in a strong euro, and in any case they don’t want to build dollar reserves and give the appearance that the dollar is ‘backing’ the euro.

And all of which works to move all the euro member nation deficits higher as the ‘sustainability math’ of all deteriorate as well, increasing the odds of the ‘investor tax’ expanding to the other member nations that continues the negative feedback loop.

Given the demand leakages of the institutional structure, as a point of logic prosperity can only come from some combination of increased net exports, a private sector credit expansion, or a public sector credit expansion.

And right now it looks like they are still going backwards on all three.

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Greece

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Comes back to the idea that resolving solvency issues in the euro zone doesn’t fix the economy.

And with negative growth the solvency math doesn’t work for any of the euro members.

And what’s with the ECB threatening to back away on liquidity support for the banking system?

So looks to me like the Greek resolution is not the end of the solvency issues, but that the focus simply moves on to the next weaker sister.

And, as previously discussed, the risk remains elevated that if Greece gets to haircut its obligations and gets funding, others will ask for the same, triggering a general, global, catastrophic financial meltdown.

My first order proposal remains an ECB distribution on a per capita basis to the euro member nations of maybe 10% of euro zone GDP per year to put the solvency issue behind them. Along with relaxed budget rules, maybe allowing deficits up to 6% of GDP annually, further supported by the ECB funding a transition job at a non disruptive wage to facilitate the transition from unemployment to private sector employment. I might also recommend deficits be increased by suspending VAT as a way to increase aggregate demand and lower prices at the same time.

Alternatively, the ECB could simply guarantee all national govt debt and rely on the growth and stability pact for fiscal discipline, which would probably require enhanced authorities.

And rather than trying to bring Greece’s deficit down to current target levels, they could instead relax the growth and stability pact limits to something closer to full employment levels. And, again, I’d look into suspending VAT to both increase aggregate demand and lower prices.

Meanwhile, elsewhere in today’s world news:

The likes of Ford adding to pension funds makes the point of the increasing and ongoing demand leakages putting a damper on GDP.

And oil prices have now crept up enough to materially cut into aggregate demand as well.

Nor are banks adding to capital to meet expanding demand for credit, which remains anemic.

Headlines:

Data Suggests Euro Zone May Slide Back Into Recession
German Manufacturing Slows as New Export Orders Fall
China’s Factory Activity Shrinks for Fourth Month
ECB Preparing to Close Liquidity Floodgates
Ford Pours $3.8 Billion Into Pension Plan
Oil Could Turn to Headwind as Dow Flirts With 13,000
UBS to Issue More Loss-Absorbing Capital
Iran ‘Winning’ on Oil Sanctions: Top Trader
Greek Bailout Puts Focus Back on Credit Default Swaps
Iran Fuels Oil-Price Rally—And Prices Could Keep Rising

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Stephanie Kelton’s response to WaPo MMT article

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It was very nice to see Dylan Matthews, who is a young journalist and not an economist, recognize the growing influence of MMT. The piece does get a number of things wrong (perhaps inevitably, given the sheer volume of work we have produced over the last 10-15 years). We’ll be working to clear things up on our various websites (including: new economic perspectives and via our Twitter feed @deficitowl). We hope readers will not jump to erroneous conclusions about MMT. We have gotten a great deal right over the years (the S&P downgrade, the Eurozone debt crisis, QE, US interest rates, inflation, etc.). While the Austrians screamed, “Zimbabwe”, we explained that QE is nothing but an asset swap and that idle reserves — whatever their magnitude — will not “chase” any goods. And while “Keynesians” worried about the impact that large deficits would have on US interest rates, we calmly explained the flaws in the loanable funds framework and insisted that rates would remain low as long as the Fed was committed to low rates (as the Bank of Japan has shown for decades). And while Nobel laureates, like Robert Mundell, were espousing the virtues of a common currency in Europe, we warned that the new design would put bond markets in charge of government policies. At some point, being right should actually count for something.

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