Category Archives: Currencies

Wray- the currency as a public monopoly

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Good to see this- been suggesting it for quite a while.

Working Paper No. 658, March 2011

Keynes after 75 Years: Rethinking Money as a Public Monopoly

L. Randall Wray

Economists and government policymakers fail to recognize that money is a public monopoly. The result of this misunderstanding is unemployment and inflation, says Senior Scholar L. Randall Wray. The best way to operate a money monopoly is to set the “price” and let the “quantity” float, as exemplified by Hyman P. Minsky’s universal employer-of-last-resort program.

Understanding how a monopoly money works would advance public policy formation a great deal, says Wray. And since banks are given the power to issue government money, failure to constrain what they purchase fuels speculative bubbles that are ultimately followed by a crash. The real debate should be over the proper role of government—how it should use the monetary system to achieve the public purpose.

ABSTRACT:
In this paper I first provide an overview of alternative approaches to money, contrasting the orthodox approach, in which money is neutral, at least in the long run; and the MarxVeblen-Keynes approach, or the monetary theory of production. I then focus in more detail on two main categories: the orthodox approach that views money as an efficiency enhancing innovation of markets, and the Chartalist approach that defines money as a creature of the state. As the state’s “creature,” money should be seen as a public monopoly. I then move on to the implications of viewing money as a public monopoly and link that view back to Keynes, arguing that extending Keynes along these lines would bring his theory up to date.

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Dean Baker: Krugman Is Wrong: The United States Could Not End Up Like Greece

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Krugman Is Wrong: The United States Could Not End Up Like Greece

By Dean Baker

March 25 — It does not happen often, but it does happen; I have to disagree with Paul Krugman this morning. In an otherwise excellent column criticizing the drive to austerity in the United States and elsewhere, Krugman comments:

“But couldn’t America still end up like Greece? Yes, of course. If investors decide that we’re a banana republic whose politicians can’t or won’t come to grips with long-term problems, they will indeed stop buying our debt.”

Actually this is not right for the simple reason that the United States has its own currency. This is important because even in the worst case scenario, where the deficit in United States spirals out of control, the crisis would not take the form of the crisis in Greece.

Yes, precisely!

Greece is like the state of Ohio. If Ohio has to borrow, it has no choice but to persuade investors to buy its debt. Unless Greece leaves the euro (an option that it probably should be considering, at least to improve its bargaining position), it must pay the rate of interest demanded by private investors or meet the conditions imposed by the European Union/IMF as part of a bailout.

However, because the United States has its own currency it would always have the option to buy its own debt. The Federal Reserve Board could in principle buy an unlimited amount of debt simply by printing more money. This could lead to a serious problem with inflation, but it would not put us in the Greek situation of having to go hat in hand before the bond vigilantes.

This is also true under current institutional arrangements.

However, with regards to inflation, for all practical purposes the fed purchasing us treasury securities vs selling them to the public is inconsequential.

This distinction is important for two reasons. First, the public should be aware that the Fed makes many of the most important political decisions affecting the economy. For example, if the Fed refused to buy the government’s debt even though interest rates had soared, this would be a very important political decision on the Fed’s part to deliberately leave the country at the mercy of the bond market vigilantes. This could be argued as good economic policy, but it is important that the public realize that such a decision would be deliberate policy, not an unalterable economic fact.

True! And, again, for all practical purposes the decision is inconsequential with regards to inflation.

The other reason why the specifics are important is because it provides a clearer framing of the nature of the potential problem created by the debt. The deficit hawks want us to believe that we could lose the confidence of private investors at any moment, therefore we cannot delay making the big cuts to Social Security and Medicare they are demanding. However if we have a clear view of the mechanisms involved, it is easy to see that there is zero truth to the deficit hawks’ story.

Agreed!

Suppose that the bond market vigilantes went wild tomorrow and demanded a 10 percent interest rate on 10-year Treasury bonds, even as there was no change in the fundamentals of the U.S. economy. In this situation, the Fed could simply step in and buy whatever bonds were needed to finance the budget deficit.

Correct.

And this would result in additional member bank reserve balances at the Fed, with the Fed voting on what interest is paid on those balances.

Does anyone believe that this would lead to inflation in the current economic situation? If so, then we should probably have the Fed step in and buy huge amounts of debt even if the bond market vigilantes don’t go on the warpath because the economy would benefit enormously from a somewhat higher rate of inflation. This would reduce the real interest rate that firms and individuals pay to borrow and also alleviate the debt burden faced by tens of millions of homeowners following the collapse of the housing bubble.

However not to forget that the Fed purchases also reduce interest income earned by the economy, as evidenced by the Fed’s ‘profits’ it turns over to the treasury.

The other part of the story is that the dollar would likely fall in this scenario. The deficit hawks warn us of a plunging dollar as part of their nightmare scenario. In fact, if we ever want to get more balanced trade and stop the borrowing from China that the deficit hawks complain about, then we need the dollar to fall. This is the mechanism for adjusting trade imbalances in a system of floating exchange rates. The United States borrows from China because of our trade deficit, not our budget deficit.

True, but with qualifications.

China didn’t start out with any dollars. They get their dollars by selling things to us. When they sell things to us and get paid they get a credit balance in what’s called their reserve account at the Fed.

What we then call borrowing from China- China buying US treasury securities- is nothing more than China shifting its dollar balances from its Fed reserve account to its Fed securities account.

And paying back China is nothing more than shifting balances from their securities account at the Fed to their reserve account at the Fed.

Which account China keeps its balances in is of no further economic consequence,

And poses no funding risk or debt burden to our grandchildren.

Nor does it follow that the US is in any way dependent on China for funding.

Nor is balanced per se trade desirable, as imports are real economic benefits and exports real economic costs.

This also puts the deficit hawks’ nightmare story in a clearer perspective. Ostensibly, the Obama administration has been pleading with China’s government to raise the value of its currency by 15 to 20 percent against the dollar. Can anyone believe that China would suddenly let the yuan rise by 40 percent, 50 percent, or even 60 percent against the dollar? Will the euro rise to be equal to 2 or even 3 dollars per euro?

And, with imports as real economic benefits and exports as real economic costs, in my humble opinion, the Obama administration is negotiating counter to our best interests.

Also, inflation is a continuous change in the value of the currency, and not a ‘one time’ shift which is generally what happens when currencies adjust.

This story is absurd on its face. The U.S. market for imports from these countries would vanish and our exports would suddenly be hyper-competitive in their home markets. As long as we maintain a reasonably healthy industrial base (yes, we still have one), our trading partners have more to fear from a free fall of the dollar than we do. In short, this another case of an empty water pistol pointed at our head.

The deficit hawks want to scare us with Greece in order to push their agenda of cutting Social Security, Medicare and other programs that benefit the poor and middle class. This is part of their larger agenda for upward redistribution of income.

We should be careful to not give their story one iota of credibility more than it deserves. By implying that the United States could ever be Greece, Krugman commits this sin.

Agreed!

Addendum: In response to the Krugman post, which I am not sure is intended as a response to me, I have no quarrel with the idea that large deficits could lead to a serious problem with inflation at a point where the economy is closer to full employment. My point is that the problem with the U.S. would be inflation, not high interest rates, unless the Fed were to decide to allow interest rates to rise as an alternative to higher inflation.

Agreed!

Nor would today’s size deficits necessarily mean inflation should we somehow get to full employment.

It all depends on the ‘demand leakages’ at the time.

This point is important because the deficit hawk story of the bond market vigilantes is irrelevant in either case. In the first case, where we have inflation because we are running large deficits when the economy is already at full employment, the problem is an economy that is running at above full employment levels of output. The bond market vigilantes are obviously irrelevant in this picture.

In the second case, where the Fed allows the bond market vigilantes to jack up interest rates even though the economy is below full employment, the problem is the Fed, not the bond market vigilantes.

We have to keep our eyes on the ball. The deficit hawks pushing the bond market vigilante story are making things up, as Sarah Pallin would say, their arguments do not deserve to be treated seriously.

Agreed.

They should be unceremoniously refutiated!

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Japan update

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Looks to me they are at least as afraid of becoming the next Greece as they are afraid of nuclear contamination.

I have seen no statements about ‘spending what it takes’ to secure the safety of the world’s population and to rebuild their nation.

The prime minister isn’t saying that, probably because of his concerns about finance.
He probably believes that Japan is dependent on lenders and may be at a tipping point with a 200% debt to gdp level.
He likely believes that with one false move the government’s ability to spend could be cut off.

In fact, they have been floating trial balloons about this being the right time for a new consumption tax to pay for any rebuilding.

In fact, and ironically, the actual risks of a major yen spending initiative that did substantially increase their deficit spending is not solvency but inflation. A massive rebuilding effort would have a good chance of raising the measured inflation rate a few points, and send the currency lower as well.

Both of which they have been desperately trying to accomplish, largely with ‘monetary policy’ that has yet to restore aggregate demand to full employment levels and promote real growth after nearly two decades of near 0 rates and massive QE initiatives.

And I still don’t see how any of this makes the yen stronger.
The repatriation story is nonsense, so if that’s what’s been driving prices watch for a sharp reversal.

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Libya Libya Libya

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Here’s my take.

As before, all the world actually cares about is the price of oil.

And the internal struggle will wind down with someone controlling the oil.

And whoever gets control of the oil wants the oil for only one reason- to sell it.

In a land of haves and have nots (at all levels), and no understanding of fiscal balance, it’s all about having the oil to sell.

So that means prices go back to where the Saudis want them to be.

My guess, and all anyone can do is guess, is Brent at maybe 100 which puts WTI maybe just under 90 until the glut issues are sorted out.

If this happens, seems-

The long oil long trades reverse.
Food prices back off some.
The view of the economy goes from half empty to half full.
The dollar gets a lot stronger.
Energy related stocks lose, others win.
But a stronger dollar may dampen prospects for US stocks.
Bonds move with stocks.
Attention shifts back to China, Europe, UK, and US fiscal policies, which are all in tightening mode.

And happy birthday to my brother Seth who turns 60 today! He just posted some old family pictures on facebook.

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WSJ Euro Symposium- Eichengreen, Sinn, Feldstein, Solbes, Hanke

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The utter lack of understanding of monetary operations is telling.

None recognize the significance of the fiscal hierarchy move that shifted the euro member nations from currency issuer to currency users, making them much like US states in that regard.

None recognize the difference between deficits at the ‘currency issuer’ level and deficits at the ‘currency user’ level.

None recognize that the problem is a shortage of aggregate demand, that is not caused by a lack of available bank credit, and that ‘fixing the banks’ changes nothing in that regard.

None recognize that the liability side of banking is not the place for market discipline and that the ECB is the only source of credible deposit insurance.

None recognize that the ECB is in the role of currency issuer and is the only entity that is not revenue constrained.

None recognized the role of fiscal balance in offsetting the ‘savings desires’ that cause unemployment and the output gap in general.

None have proposed a means of allowing govt deficits that can be sustained at full employment levels.

None have recognized that the forces at work have resulted in the ECB has assuming the role of dictating permissible ‘terms and conditions’ for its funding that has become mandatory for the survival of the currency union. This includes the ECB dictating fiscal policy for the member nations.

This list could go on forever.

The text is below.

I couldn’t read it all and don’t suggest you read it either.

WSJ: The Future of the Euro: A Symposium

Fix the Banks, Fix the Currency
By Barry Eichengreen

For the euro to grow into a happy and healthy adult, many things must happen. Most importantly, Europe needs to fix its banking system. Many European banks, starting with Germany’s, are dangerously over-leveraged, undercapitalized, and exposed to Greek, Irish and Portuguese debt. Rigorous stress tests followed by capital injections are the most important step that governments can take to secure the euro’s place.

Since European leaders seem fixated on what to do after Greece’s rescue package runs out in 2013—often, it appears, to the neglect of more immediate problems—they should also contemplate transferring responsibility for supervising their banks from the national level to the newly created European Banking Authority. The mistaken belief that a single currency is compatible with separate national bank regulators is, at the most basic level, why Europe is in the fix it’s in.

Indeed, Europe’s budget deficits are largely a result of the continent’s festering banking crisis. Greece may be an exception, but it’s clearly of a kind. The whole euro area would benefit from stronger discipline on borrowers and lenders. However, it is fantastical to think that this can be achieved by imposing Germanic debt ceilings Continent-wide. Germany’s fiscal rules work because of Germany’s history. The idea that they can be mechanically transplanted to other countries is a historical thinking at its worst.

The only discipline guaranteed to prevent fiscal excesses is market discipline. Reckless borrowers and lenders must be made to pay for their actions. Governments with unsustainable debts should be forced to restructure them, damage to their sovereign creditworthiness or not. The banks that lent to them should similarly suffer consequences, as should the bondholders who provided those banks with funds.

But whether Europe can afford to let market discipline work comes back to the condition of its banks. Only if banks are adequately capitalized can they take losses without collapsing the financial system. Only if they are adequately capitalized can the European Central Bank refuse to buy more Greek, Irish and Portuguese bonds, and only then will the EU be able to say “no more bailouts.”

And once this experience with market discipline is burned into Europe’s collective consciousness, it will be correspondingly less likely that borrowers and lenders will again succumb to similar excesses.

In other words, European governments need to “put the risk back where it belongs, namely in the hands of the bondholders.” Those are not my words. They are from the mouth of Bundesbank President Axel Weber speaking in Dusseldorf on Feb. 21. But while President Weber is right about the principle, he is wrong to think this can wait until 2013.

Mr. Eichengreen is a professor at the University of California, Berkeley. His book, “Exorbitant Privilege: The Rise and Fall of the Dollar,” (Oxford University Press) was published in the U.K. last month.

Survival Isn’t Guaranteed
By Hans-Werner Sinn

In my opinion the euro should survive. Though its members are too many and too disparate, the monetary union must be maintained, largely with its current number of states, for the benefit of political stability. The euro also offers measurable economic benefits, among them substantial reductions in transaction costs and exchange risks, which are prerequisites for exploiting the benefits of free trade.

Whether the euro will survive is another matter. This very much depends on whether European countries implement political and private debt constraints that effectively limit capital flows. The trade imbalances from which the euro zone is currently suffering have resulted from excessive capital flows brought about by interest-rate convergence and the apparent elimination of investment risks after the currency conversion was announced some 15 years ago. While huge capital exports brought a slump to Germany, the countries at the euro zone’s southern and western peripheries overheated, with the bust and boom resulting in current-account surpluses and deficits respectively.

Automatic sanctions for excessive public borrowing, and a reform of the Basel system that forces banks to hold equity capital if they invest in government bonds, are among the political constraints necessary for the euro to survive. But much more important are private constraints.

After years of negligence, private markets have recently started to impose more rigid debt constraints on overheated euro economies. So the brakes kicked in eventually, but much too abruptly, triggering Europe’s sovereign debt crisis. What Europe needs is a crisis mechanism that is able to activate markets earlier and allow for a fine-tuning of the brakes they impose on capital flows; in sum, a crisis mechanism that helps to prevent a crisis in the first place and mitigates it when it occurs.

Such a system has recently been proposed by the European Economic Advisory Group at the Center for Economic Studies and the Ifo Institute for Economic Research (CESifo). The plan’s essential feature is a three-stage rescue mechanism that distinguishes between a liquidity crisis, impending insolvency, and full insolvency, and offers specific measures in each of these stages. The system places the most emphasis on a piecemeal debt-conversion procedure that contemplates haircuts in the second of these stages, which could help to avoid full insolvency by acting as an early warning signal for investors and debtors alike.

The system would allow Germany to gradually appreciate in real terms by living through a boom that generates higher wages and prices and thus reduces the country’s competitiveness, while cooling down the overheated economies of the south such that the resulting wage and price moderation would improve their competitiveness. European trade imbalances would gradually reduce.

If Europe, on the other hand, moves to a system of community bonds, where national debts are jointly guaranteed by all countries, then excessive capital flows would persist, and so would trade imbalances. The countries at Europe’s southern and western peripheries would abstain from necessary real depreciation, and Germany would not appreciate, with the result that trade imbalances would continue with ever-increasing foreign debt and asset positions respectively. In the end, Germans would own half of Europe. I do not dare to imagine the political tensions that would bring about. The death of the euro would be the least of our worries.

Mr. Sinn is president of Germany’s Ifo Institute for Economic Research and the CESifo Group.

David Gothard

Still an Economic Mistake
By Martin Feldstein

I continue to believe that the creation of the euro was an economic mistake. It was clear from the start that imposing a single monetary policy and a fixed exchange rate on a heterogeneous group of countries would cause higher unemployment and persistent trade imbalances. In addition, the combination of a single currency and independent national budgets inevitably produced the massive fiscal deficits that occurred in Greece and other countries. And the sharp drop in interest rates in several countries when the euro was launched caused the excessive private and public borrowing that eventually created the current banking and sovereign-debt crises in Spain, Ireland and elsewhere.

But history cannot be reversed. Despite these problems, the euro will continue to exist for the foreseeable future. It will continue even though that will require large fiscal transfers from Germany and other core nations to those euro-zone countries with large debts and chronic trade deficits.

One reason for the euro’s likely survival is purely political. The political elites who support the euro believe it gives the euro zone a prominent role in international affairs that the individual member countries would otherwise not have. Many of those supporters also hope that the euro zone will evolve into a federal state with greater political power.

There is also an economic reason that the euro will survive. While hard-working German voters may resent the transfer of their tax money to other countries that enjoy earlier retirement and shorter workweeks, the German business community supports paying taxes to preserve the euro because it recognizes that German businesses benefit from the fixed exchange rate that prevents other euro-zone countries from competing with Germany by devaluing their currencies.

The euro will not only survive but will likely continue to increase in value relative to the dollar as sovereign-wealth funds and other major investors shift an increasing share of their portfolios to euros from dollars.

Those investors had been quietly diversifying their investment funds to euros before the crisis began in Greece. They stopped temporarily because of uncertainty about the future of the currency. But they eventually came to recognize that the problems of the peripheral countries were not a problem for the euro and should be reflected in country-specific interest rates rather than in the euro’s value. The result was a rising euro and a renewed shift of portfolio balances to euros from dollars. As that process continues, the relative value of the euro will continue to rise.

Mr. Feldstein, chairman of the U.S. Council of Economic Advisers under President Reagan, is a professor of economics at Harvard University.

A Decade of Success
By Pedro Solbes

After 10 years with the euro, the economic crisis and its consequences in some countries of the euro zone have reopened the debate about the suitability of a single currency in the absence of a high level of political integration.

But the euro has been a great joint success, which has allowed for a long period of growth and price stability in Europe. It has had a different impact in each country, but its benefits have been seen across the board. The euro has permitted more coordinated action in Europe and has prevented competitive devaluations. This has been key not only for the euro zone, but also for the rest of Europe and even for the global economy. Without the euro, we would have witnessed an increase in protectionism, which would in turn have aggravated the impact of the crisis in Europe and elsewhere.

Would it have been easier to reach consensus in the G-20 without the euro zone? Would it have been easier to respond to the challenges and difficulties faced by the international financial system? Would there have been greater cash-flow access? The answer to all these questions is no. It could be argued that a fluctuating exchange rate could have limited the impact of the crisis in some countries. However, would the crisis have been avoided without correcting the fundamental problems in each country and subsequent generalized competitive devaluations? The absence of an exchange rate may have aggravated the problems that existed before the crisis. But have these been better tackled outside the euro? Some observers have affirmed that behavior outside the euro zone has not been any better.

Quite a few countries of the euro zone already faced significant risks before the crisis, both real (real-estate bubble, public and/or private debt) and financial (inadequate risk management or excessive dependence on external funding). In addition, in some cases, uncoordinated fiscal and monetary policies in the euro zone could have helped generate the problem. Experience shows that the Maastricht architecture designed to manage the euro zone has been lacking. Focusing economic-policy coordination in the fiscal arena, coupled with a somewhat lax implementation of norms, has not been enough. Leaving the task of correcting imbalances in the hands of euro member states has not worked. The crisis has brought to the fore the lack of a mechanism to help troubled countries before their problems end up affecting the entire euro zone.

As is often the case with the European construction process, the problem resides not only in diagnosing the problem. There is an urgent need for clear and quick solutions, backed by the political will to comply with what has been agreed, something not always easy to achieve when dealing with 27 different countries.

Even though it has not been adopted by all EU member states, the euro is today, as German chancellor Angela Merkel has recently expressed, an inherent element of the European integration process. The euro is here to stay and the real challenge is how to make it more efficient.

Mr. Solbes is chairman of the Executive Committee of FRIDE and former Spanish minister of economy.

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Gross misrepresentations

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My comments following Bill Gross’s comments:

I don’t know if the U.S. has reached a desperate point, but it is employing instruments and vehicles and policies that smack of desperation.

He fails to see the function of federal taxes is to regulate aggregate demand, and not to raise revenue per se.

We are not looking at a default here, but at years of accelerating inflation, which basically robs investors and labor of their real wages and earnings.

Apart from the possibility that he’s wrong, and that there will be no accelerating deflation, inflation per se does not make a nation poorer, and does not necessarily reduce real wages and earnings. In fact, real wages could very well be made to increase during an inflationary period. It’s all about policy responses and institutional structure. And as for investors, some will do well and some will do poorly, which most don’t consider an injustice.

We are looking at a currency that almost certainly will depreciate relative to other, stronger currencies in developing countries that have lower levels of debt and higher growth potential.

Maybe and maybe not on both scores.

The dollar may not depreciate.

And lower levels of public debt and higher growth potential do not necessarily mean a currency will appreciate.

For example, Japan has had perhaps the least growth potential and one of the strongest currencies for quite a while, and China has had a policy of keeping its currency weak which has been credited with fostering high growth, etc.

And, on the short end of the yield curve, we are looking at creditors receiving negative real interest rates for a long, long time. That, in effect, is a default.

No, it’s a policy option.

A default is a promise broken.

And there is no national promise by any nation to provide a real return to savers at the short end of the curve.

Ultimately creditors and investors are at the behest of a central bank and policymakers that will rob them of their money.

That’s a serious and groundless accusation of motivation of the Fed.
Robbing implies dishonesty and involuntary confiscation.

However no one is forced by the Fed or anyone else to hold dollars in money market accounts, investors buy securities with known nominal interest rates, and for all practical purposes investors know much the same information regarding inflation as the Fed does.

So when William Gross uses the word ‘rob’ he’s implying the Fed is deliberately publishing false inflation forecasts to trick investors into buying US govt securities at rates lower than if they knew the Fed’s actual inflation forecasts.

I suggest an immediate apology is in order for this groundless, inappropriate, and insulting remark.

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Thoughts on the fx swap lines data releases

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>   
>   (email exchange)
>   
>    On Thu, Dec 2, 2010 at 3:51 AM, Mike wrote:
>   
>   It seems it was around 7 trillion notional. Do you know the durations?
>   

No, haven’t read any details. I recall they were relative short but were extended maybe more than once.

>   
>   If they didn’t act would the entire fx market have come to a halt.
>   

Libor setting would have been higher for as long as the BBA kept the weaker banks in the basket.

>   
>   Given that this lending is unsecured, what happens if a foreign central bank doesn’t pay?
>   

The lender has no recourse and takes a loss.

>   
>   Are there any constraints on this lending?
>   

Just political. A nation can lend, spend, or toss down a rat hole any amount of it’s own currency it wants.

>   
>   Finally, would clearing all fx swaps have prevented the fx “run” if the fed had
>   backstopped the clearinghouses?
>   

Not sure which ‘run’ you are referring to?

But getting short a currency, spot or forward, means you are borrowing it, directly or indirectly, and none of the currencies in question are ever ‘quantity constrained’. What triggered the swap lines was the desire of the Fed to get libor settings lowered.

The large dollar borrowing funded by the Fed swap lines was done because foreign banks with presumed credit issues were bidding up libor and driving up the libor settings which was driving up home mortgage and other rate settings in the US. The Fed brought the rates down by facilitating lending at lower rates to those weaker credits via the ECB and other CB’s. (That would have been my last choice on how to get those US rates down, but that’s another story.)

Does this help?

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Time for England to complete the conquest of Ireland

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The UK conquest of Ireland began in 1169.

It’s time to finish the job.

All they have to do is offer the following:

Ireland converts all its public debt to sterling.

The UK Treasury takes over the responsibility for all of Ireland’s existing public debt.

(Ireland gets a clean start with no Irish govt. debt and not interest payments)

Ireland taxes and spends in sterling only and has a balanced budget requirement.

Ireland can borrow only for capital expenditures.

The UK Treasury guarantees all existing insured euro bank deposits in Irish banks.

Only sterling deposits are insured for new deposits.

Ireland runs a mirror tax code to the UK and keeps all of its tax revenues.

The UK agrees to fund Ireland’s with a pro rata/per capita share of any UK deficit spending.

St. Patrick’s Day is declared a UK national holiday and everyone over 21 gets a beer voucher.

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European Debt/GDP ratios – the core issue

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Review:

Financially, the euro zone member nations have put themselves in the position of the US States.

Their spending is revenue constrained. They must tax or borrow to fund their spending.

The ECB is in the position of the Fed. They are not revenue constrained. Operationally, they spend by changing numbers on their own spread sheet.

Applicable history:

The US economy’s annual federal deficits of over 8% of gdp, Japan’s somewhere near there, and the euro zone is right up there as well.

And they are still far too restrictive as evidenced by the unemployment rates and excess capacity in general.

So why does the world require high levels of deficit spending to achieve fiscal neutrality?

It’s the deadly innocent fraud, ‘We need savings to have money for investment’ as outlined in non technical language in my book.

The problem is that no one of political consequence understands that monetary savings is nothing more than the accounting record of investment.

And, therefore, it’s investment that ’causes’ savings.

Not only don’t we need savings to fund investment, there is no such thing.

But all believe we do. And they also believe we need more investment to drive the economy (another misconception of causations, but that’s another story for another post).

So the US, Japan, and the euro zone has set up extensive savings incentives, which, for all practical purposes, function as taxes, serving to remove aggregate demand (spending power). These include tax advantaged pension funds, insurance and other corporate reserves, etc.

This means someone has to spend more than their income or the output doesn’t get sold, and it’s business that goes into debt funding unsold inventory. Unsold inventory kicks in a downward spiral, with business cutting back, jobs and incomes lost, lower sales, etc. until there is sufficient spending in excess of incomes to stabilize things.

This spending more than income has inevitably comes from automatic fiscal stabilizers- falling revenues and increased transfer payments due to the slowdown- that automatically cause govt to spend more than its income.

And so here we are:

The stabilization at the current output gap has largely come from the govt deficit going up due to the automatic stabilizers, though with a bit of help from proactive govt fiscal adjustments.

Note that low interest rates, both near 0 short term rates and lower long rates helped down a bit by QE, have not done much to cause consumers and businesses to spend more than their incomes- borrow to spend- and support GDP through the credit expansion channel.

I’ve always explained why that always happened by pointing to the interest income channels. Lower rates shift income from savers to borrowers, and the economy is a net saver. So, overall, lower rates reduce interest income for the economy. The lower rates also tend to shift interest income from savers to banks, as net interest margins for lenders seem to widen as rates fall. Think of the economy as going to the bank for a loan. Interest rates are a bit lower which helps, but the economy’s income is down. Which is more important? All the bankers I’ve ever met will tell you the lower income is the more powerful influence.

Additionally, banks and other lenders are necessarily pro cyclical. During a slowdown with falling collateral values and falling incomes it’s only prudent to be more cautious. Banks do strive to make loans only to those who can pay them back, and investors do strive to make investments that will provide positive returns.

The only sector that can act counter cyclically without regard to its own ability to fund expenditures is the govt that issues the currency.

So what’s been happening over the last few decades?

The need for govt to tax less than it spends (spend more than its income) has been growing as income going to the likes of pension funds and corporate reserves has been growing beyond the ability of the private sector to expand its credit driven spending.

And most recently it’s taken extraordinary circumstances to drive private credit expansion sufficiently for full employment conditions.

For example, In the late 90’s it took the dot com boom with the funding of impossible business plans to bring unemployment briefly below 4%, until that credit expansion became unsustainable and collapsed, with a major assist from the automatic fiscal stabilizers acting to increase govt revenues and cut spending to the point of a large, financial equity draining budget surplus.

And then, after rate cuts did nothing, and the slowdown had caused the automatic fiscal stabilizers had driven the federal budget into deficit, the large Bush proactive fiscal adjustment in 2003 further increased the federal deficit and the economy began to modestly improve. Again, this got a big assist from an ill fated private sector credit expansion- the sub prime fraud- which again resulted in sufficient spending beyond incomes to bring unemployment down to more acceptable levels, though again all to briefly.

My point is that the ‘demand leakages’ from tax advantaged savings incentives have grown to the point where taxes need to be lot lower relative to govt spending than anyone seems to understand.

And so the only way we get anywhere near a good economy is with a dot com boom or a sub prime fraud boom.

Never with sound, proactive policy.

Especially now.

For the US and Japan, the door is open for taxes to be that much lower for a given size govt. Unfortunately, however, the politicians and mainstream economists believe otherwise.

They believe the federal deficits are too large, posing risks they can’t specifically articulate when pressed, though they are rarely pressed by the media who believe same.

The euro zone, however has that and much larger issues as well.

The problem is the deficits from the automatic stabilizers are at the member nation level, and therefore they do result in member nation insolvency.

In other words, the demand leakages (pension fund contributions, etc.) require offsetting deficit spending that’s beyond the capabilities of the national govts to deficit spend.

The only possible answer (as I’ve discussed in previous writings, and gotten ridiculed for on CNBC) is for the ECB to directly or indirectly ‘write the check’ as has been happening with the ECB buying of member nation debt in the secondary markets.

But this is done only ‘kicking and screaming’ and not as a matter of understanding that this is a matter of sound fiscal policy.

So while the ECB’s buying is ongoing, so are the noises to somehow ‘exit’ this policy.

I don’t think there is an exit to this policy without replacing it with some other avenue for the required ECB check writing, including my continuing alternative proposals for ECB distributions, etc.

The other, non ECB funding proposals could buy some time but ultimately don’t work. Bringing in the IMF is particularly curious, as the IMF’s euros come from the euro members themselves, as do the euro from the other funding schemes. All that the core member nations funding the periphery does is amplify the solvency issues of the core, which are just as much in ponzi (dependent on further borrowing to pay off debt) as all the rest.

So what we are seeing in the euro zone is a continued muddling through with banks and govts in trouble, deposit insurance and member govts kept credible only by the ECB continuing to support funding of both banks and the national govts, and a highly deflationary policy of ECB imposed ‘fiscal responsibility’ that’s keeping a lid on real economic growth.

The system will not collapse as long as the ECB keeps supporting it, and as they have taken control of national govt finances with their imposed ‘terms and conditions’ they are also responsible for the outcomes.

This means the ECB is unlikely to pull support because doing so would be punishing itself for the outcomes of its own imposed policies.

Is the euro going up or down?

Many cross currents, as is often the case. My conviction is low at the moment, but that could change with events.

The euro policies continue to be deflationary, as ECB purchases are not yet funding expanded member nation spending. But this will happen when the austerity measures cause deficits to rise rather than fall. But for now the ECB imposed terms and conditions are keeping a lid on national govt spending.

The US is going through its own deflationary process, as fiscal is tightening slowly with the modest GDP growth. Also the mistaken presumption that QE is somehow inflationary and weakens the currency has resulted in selling of the dollar for the wrong reasons, which seems to be reversing.

China is dealing with its internal inflation which can reverse capital flows and result in a reduction of buying both dollars and euro. It can also lead to lower demand for commodities and lower prices, which probably helps the dollar more than the euro. And a slowing China can mean reduced imports from Germany which would hurt the euro some.

Japan is the only nation looking at fiscal expansion, however modest. It’s also sold yen to buy dollars, which helps the dollar more than the euro.

The UK seems to be tightening fiscal more rapidly than even the euro zone or the US, helping sterling to over perform medium term.

All considered, looks to me like dollar strength vs most currencies, perhaps less so vs the euro than vs the yen or commodity currencies. But again, not much conviction at the moment, beyond liking short UK cds vs long Germany cds….

Happy turkey!

(Next year in Istanbul, to see where it all started…)

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