Tag Archives: monetary policy

supply, demand, and prices do not really exist

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This statement by James Galbraith makes my head spin a bit.

Just as Einstein had erased Euclid’s axiom of parallels, Keynes’s General Theory had long since obliterated the supply curves for labor and saving, thereby eliminating the supposed markets for labor and capital.

It followed that the prices of production were set by costs (mostly labor costs and interest rates), while quantities were determined by effective demand. Markets were not treated as if they were magical. It was obvious that most resources and components did not move under the influence of an invisible hand. Rather, they moved according to contracts between companies on terms set by negotiation, as had been the case for more than a hundred years. Technology was managed by organizations – mostly by large corporations – in what was sometimes called “the new industrial state.”

Project Syndicate

This is in a review of a book arguing that prices are really important. It’s a bit disturbing to me to think that there might not be a consensus among economists about how the economy actually works. We ordinary people can grasp theories like prices equilibrating supply and demand, and even how interest rates are related to the money supply and inflation, if we try really hard. But we assume the experts understand this stuff on a much deeper level, and that it is fundamentally science. If our understanding of civilization turns out to be based on pseudoscience, we might be in trouble.

modern monetary models

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These two posts have a long explanation of monetary theory in general, and modern monetary theory in particular. It’s a little over my head, although I like challenging myself to try to understand it. It is a very abstract system to try to understand. I think that if you can understand monetary policy, you might have a chance to understand what money actually is. And if enough people understand it, they might stop believing in it and the world might end.

Basically, as I understand it, the government prints money (i.e., borrows money from itself) and spends it, usually more than it takes back in taxes, and this creates a surplus in the private sector. It can control the money supply by changing the amount it borrows and spends, or by changing the tax rate. I think what people find scary about “modern monetary theory” is that it suggests money doesn’t have to be taken seriously and any needed amount can just be printed any time. This is why politicians generally have not been given the keys to the printing press.

I have a metaphor in my mind of the real economy as a machine with pistons and gears turning. The fuel for the machine is maybe human effort and ideas (and some actual fuel). But the gears will grind without grease, so you have to lube it up. Not enough and the system will shut down violently. Adding extra will not make the machine turn faster, but it will not do any serious harm other than maybe a gunky mess someone has to clean up. Better to use a little too much lube than not enough. The lube for the economic machine is money.

There were a few other interesting things in the articles that I didn’t know or hadn’t thought about recently. It refers to the late Wynne Godley at Cambridge University as the “father of stock-flow consistent modeling”. I think a few people in a few different disciplines might claim that mantle, but that is the neat thing about system theory, it’s interdisciplinary. There is a certain irony if anyone is into it and doesn’t realize it is interdisciplinary.

There is a free(?) system dynamics system called Minsky, something like Stella but tailored specifically to finance and economics. Matlab also has a sort of stock-flow simulation module call Simulink that I hadn’t heard of. I am still waiting for that system dynamics R package.

The Minsky model also made me think of the late Jay Forrester, who advocated for a long time for stock-flow modeling in economics.

Traditional mainstream academic economics, by trying to be a science, has failed to answer major questions about real- life economic behavior. Economics should become a systems profession, such as management, engineering, and medicine. By closely observing the structures and policies in business and government, simulation models can be constructed to answer questions about business cycles, causes of major depressions, inflation, monetary policy, and the validity of descriptive economic theories. A system dynamics model, as a general theory of economic behavior, now endogenously generates business cycles, Kuznets cycles, the economic long wave, and growth. A model is a theory of the behavior that it generates. The economic model provides the theory, thus far missing from economics, for the Great Depression of the 1930s and how such episodes can recur 50–70 years apart. Simpler system dynamics models can become the vehicle for a relevant and exciting pre-college economics education.

Jay Forrester, quoted in a blog called Viewpoints that Matter (including the blogger’s viewpoint, presumably)

Imagine if the average high school graduate really had an intuitive understanding of how important systems like the economy are structured and why they function the way they do as a result. The world might be a different place.

I’ve been working on one more metaphor for awhile. Maybe the real economy is like a tightrope, and the financial economy is like a safety net stretched above a concrete floor. If we use too much food, water, energy, saturate the atmosphere and ocean with our waste, etc. we will fall off the rope. Hitting the concrete floor would be a failure of the real economy like starvation or freezing to death. The safety net would be a spike in prices for food or energy that slows down the economy short of (most people, right away) actually dying of exposure. The fall would still be very painful and you might break bones or even your neck if you fall just the wrong way. What about something like nuclear proliferation or all the ice in Antarctica suddenly melting? I don’t know, maybe dry rot in the old net that we are failing to do anything about. No price signal is going to save us from those.

the next recession

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The next U.S. recession could be a rough one, according to Harvard economist Martin Feldstein. The argument is that the Federal Reserve will continue to raise short term interest but very gradually, not leaving itself a lot of room to lower them when a recession hits. At the same time, due to the pro-cyclical tax cuts, the government will not be able to increase deficit spending by a lot because it will not be able to afford the increased interest payments. And third, low unemployment seems to be causing inflation.

It would not be surprising if the rate on ten-year Treasury bonds rises to 5% or more over the next few years. With an inflation rate of 3%, the real yield will be back to a normal historic level of over 2%.

This normalization of the ten-year interest rate could cause the P/E ratio to return to its historical benchmark. A decline of that magnitude, from its current level of 40% above the historic average, would cause household wealth to shrink by about $8 trillion. The historic relationship between household wealth and consumer spending implies that the annual level of household consumption would decline by about 1.5% of GDP. That fall in household demand, and the induced decline in business investment, would push the US economy into recession.

If you have an enormous nest egg, a 2% real return on bonds doesn’t sound all that terrible. For the rest of us relying on stocks to help us build that nest egg (those of us lucky enough to have a little extra income to save, that is), this doesn’t seem like good news.

Modern Monetary Theory

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The Intercept has a long article on Modern Monetary Theory.

In a nutshell: MMT proponents believe that the government can safely spend far more money than it currently does, and increasing the federal deficit is not a bad thing in and of itself — a public deficit is also a private-sector surplus, after all.

While typically we hear rhetoric that our political leaders must first “find” money through new taxes or budget cuts in order to pay for new programs, MMT proponents say that’s a fundamental misunderstanding of how money works. In so-called fiat currency systems (meaning societies in which money isn’t backed by physically valuable commodities like gold or silver) governments literally create the money and tax it later to control for inflation and keep it in demand.

Inflation is still a risk, MMT advocates say, but it’s a much more remote risk than mainstream economists let on, and it’s one that can be addressed down the line if it arises, without so much pre-emptive austerity.

They also talk about the idea of a federal jobs guarantee.

I just had a few college economics courses, but the idea seems risky. By expanding the money supply so drastically, I thought you risked hyper-inflation and a devaluing of your currency relative to others. Of course the U.S. can push it further than other countries, but there still must be a breaking point. But the idea of some kind of counter-cyclical automatic investment in infrastructure, education, training, and research is appealing to me. This could kick in if unemployment hits a certain level, growth falls below a certain level, or some combination of the two. Then during stronger economic times, the government steps back and lets the private sector take the lead. I think it would have to be some kind of formula or else the politicians will ruin it.

the sinking dollar

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Barry Eichengreen points out that while the differential between growth and interest rates between the U.S. and most other countries should have predicted a stronger dollar in 2017, it actually fell by 8% and is still falling so far in 2018. Explaining exchange rate changes after the fact is a lot like explaining stock market changes after the fact – they are easy to rationalize after the fact, but if anyone really knew how to predict them accurately, that person would be a trillionaire. Somewhat humorously, Mr. Eichengreen links to an article that gives 17 possible reasons (with links to sources for many of them), which is essentially the same as giving none.

Finally he says the most likely explanation is just uncertainty. Foreign investors just don’t know where the U.S. and its economy are headed, or that it will continue to be the rock solid safe haven it has been for the past 50 years. This sounds about right to me. Foreigners have been willing to stuff U.S. dollars under their mattresses for 50 years, in the last couple decades with low or even no returns, and some may have decided it is time to diversify.

Don’t end the Fed?

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some candidates for Federal Reserve chairman are being mentioned, and the good news is that all appear to have some central banking experience, and none are actually against central banking or espousing weird conspiracy theories!

https://www.project-syndicate.org/commentary/next-fed-chair-yellen-successor-by-jeffrey-frankel-2017-10

https://www.project-syndicate.org/commentary/trump-fed-appointments-by-eswar-prasad-2017-10

do we want a strong or weak dollar

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This Economist article tries to explain whether a stronger or weaker dollar is better. The answer is both or possibly neither. A strong dollar makes imported stuff at the store cheaper for consumers, but it lowers the demand for exports and makes it hard for those same consumers to get well-paying jobs making stuff to export. It encourages trade deficits (more imports than exports) for this reason. Because it holds down wages for the working and middle classes, it makes income inequality worse. All other things being equal, the value of the currency should fall relative to foreign currencies in this situation until things are in balance again. This doesn’t happen to the U.S. dollar because it is the world’s reserve currency, meaning other countries are always willing to buy it – people consider it a safe investment even if it is paying very little interest. So this is one thing that is holding our interest rates artificially low. The author concludes that being the only reserve currency is actually not in the country’s long-term interests.

An overvalued currency and persistent trade deficits are fine for America’s consumers, but painful for its producers. The reserve accumulation of the past two decades has gone hand-in-hand with a soaring current-account deficit in America. Imports have grown faster than exports; new jobs in exporting industries have not appeared in numbers great enough to absorb workers displaced by increased foreign competition. Tariffs cannot fix this problem. The current-account gap is a product of underlying financial flows, and taxing imports will simply cause the dollar to rise in an offsetting fashion.

America’s privilege also increases inequality, since lost jobs in factories hurt workers while outsize investment performance benefits richer Americans with big portfolios. Because the rich are less inclined to spend an extra dollar than the typical worker, this shift in resources creates weakness in American demand—and sluggish economic growth—except when consumer debt rises as the rich lend their purchasing power to the rest.

Chalk the headaches generated by low interest rates up to the dollar standard, too. Some economists reckon they reflect global appetite outstripping the supply of the safe assets America is uniquely equipped to provide—dollar-denominated government bonds. As the price of safe bonds rises, rates on those bonds fall close to zero, leaving central banks with ever less room to stimulate their economies when they run into trouble.

One thing I know from painful experience is that when you live abroad, a falling dollar can hurt, because I was getting paid in U.S. dollars and had to pay my rent in Singapore dollars. So my rent was going up every month in U.S. dollar terms, and also going up every year in Singapore dollar terms. Ouch. Well, the life experience gained had a certain value I suppose. That was one of the only times lately that the U.S. dollar has been falling relative to Asian currencies, so I am just unlucky.

inflation

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The Economist says inflation could be on the verge of a comeback.

Some economists reckon a sustained rise in inflation is overdue. Most of the rich world is out of recession, emerging markets seem to have put the worst of their commodity bust behind them, and in a few places, like America, low unemployment has at last given way to accelerating wage growth. It is possible, some suppose, that the weak growth and sustained disinflation of the past half-decade has blinded markets and policy-makers to the potential for a sharp swing in the other direction, toward uncomfortably high inflation.

The rest of the article goes on to poo-poo the idea that inflation may be on the verge of a comeback. But we’ll see.

Joseph Stiglitz on the Euro

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Joseph Stiglitz has written a new book about the Euro. Here’s an interview in the New York Times.

It is difficult to overstate the economic trauma Europe has suffered in recent years — veritable depressions in Greece and Spain, alarming levels of unemployment across much of the continent. You place much of the blame on the euro. What happened?

The euro was an attempt to advance the economic integration of Europe by having the countries of the eurozone share a common currency. They looked across the Atlantic and they said: “The United States, big economy, very successful, single currency. We should imitate.”

But they didn’t have the political integration. They didn’t have the conditions that would make a single currency work. The creation of the euro is the single most important explanation for the extraordinarily poor performance of the eurozone economies since the crisis of 2008…

You conclude that the best-case scenario from here is to reform and save the euro. But absent that, you contend that it is better to just scrap it as a failed experiment. What needs to happen to make the euro viable?

A banking union with deposit insurance. Something like a euro bond. An E.C.B. that doesn’t just focus on inflation — you want it to focus on employment. A tax policy that deals with the inequalities. And you have to get rid of limits on government deficits.

If I understand this correctly, he is suggesting that the problem is that the Euro is not issued by a true central bank, but instead by individual countries with varying levels of wealth and power.

I was debating with a friend the other day about whether the average citizen is capable of understanding current events and issues well enough to support good policies. I think the average human being certainly has the raw intelligence to do so, but even the well educated mostly have not been provided with the mental tools they would need to understand the complexity of the world around us. Central banking is a good example of something an intelligent human being is capable of understanding, but almost none do. I never learned anything about it in elementary or high school. I learned some basic concepts about the money supply and interest rates in college economics courses, but I didn’t really get it the first time around. Part of it is that algebraic equations are just not the right way to introduce big picture concepts to most people including me (and I was doing just fine in engineering school at the time). Simulations or even physical models would work better to gain an intuitive understanding, backed up by symbolic algebra and calculus later.

I’m not really suggesting that the answer is to turn over public policy to the economists. They understand the theory behind the central banking system, sure, but they may neglect the larger social and environmental context it is embedded in, may neglect to consider complex, dynamic, nonlinear behavior that does not fit neatly into their elegant steady-state algebraic theories, and are often terrible at communication with decision makers and the public. We need experts and respect for experts, but we also need a broad base of intuitive understanding of systems among politicians, bureaucrats, and the public. It could be done.