Monthly Archives: August 2009

The Endogenous Money Approach

Posted on August 17, 2009 by | 3 comments
By L. Randall Wray [via CFEPS]

In Neoclassical theory, money is really added as an after thought to a model that is based on a barter paradigm. In the long run, at least, money is neutral, playing no role except to determine unimportant nominal prices. Money is taken to be an exogenous variable-whose quantity is determined either by the supply of a scarce commodity (for example, gold), or by the government in the case of a “fiat” money. In the money and banking textbooks, the central bank controls the money supply through its provision of required reserves, to which a deposit multiplier is applied to determine the quantity of privately-supplied bank deposits.

The evolving Post Keynesian endogenous approach to money offers a clear alternative to the orthodox, neoclassical approach. With regard to monetary theory, early Post Keynesian work emphasized the role played by uncertainty and was generally most concerned with money hoards held to reduce “disquietude”, rather than with money “on the wing” (the relation between money and spending). However, Post Keynesians always recognized the important role played by money in the “monetary theory of production” that Keynes adopted from Marx. Circuit theory, mostly developed in France, provided a nice counterpoint to early Post Keynesian preoccupation with money hoards, focusing on the role money plays in financing spending. The next major development came in the 1970s, with Basil Moore’s horizontalism (somewhat anticipated by Kaldor), which emphasized that central banks cannot control bank reserves in a discretionary manner. Reserves must be “horizontal”, supplied on demand at the overnight bank rate (or fed funds rate) administered by the central bank. This also turns the textbook deposit multiplier on its head as causation must run from loans to deposits and then to reserves.

This led directly to development of the “endogenous money” approach that was already apparent in the Circuit literature. When the demand for loans increases, banks normally make more loans and create more banking deposits, without worrying about the quantity of reserves on hand. Privately created credit money can thus be thought of as a horizontal “leveraging” of reserves (or, better, High Powered Money), although there is no fixed leverage ratio. In recent years, some Post Keynesians have returned to Keynes’s Treatise and the State Theory of Money advanced by Knapp and adopted by Keynes therein. Rather than imagining a barter economy that discovers a lubricating medium of exchange, this neo-Chartalist approach emphasizes the role played by the state in designating the unit of account, and in naming exactly what thing answers to that description. Taxes (or any other monetary obligations imposed by authorities) then generate a demand for that money thing. In this way, Post Keynesians need not fall into the “free market” approach of orthodoxy, which imagines some pre-existing monetized utopia free from the evil hands of government. The neo-Chartalist approach also leads quite nicely to Abba Lerner’s functional finance approach, which refuses to make a fine separation of fiscal from monetary policy. Money, government spending, and taxes are thus intricately interrelated. This approach rejects Mundell’s “optimal currency area” as well as the monetary approach to the balance of payments. It is not possible to separate fiscal policy from currency sovereignty-which explains why the “one nation, one currency” rule is so rarely violated, and when it is violated it typically leads to disaster (as in the current case of Argentina, and-perhaps-in the future case of the European Union!).

Like Keynes, Post Keynesians have long emphasized that unemployment in capitalist economies has to do with the fact that these are monetary economies. Keynes had argued that the “fetish” for liquidity (the desire to hoard) causes unemployment because it keeps the relevant interest rates at too high a level to permit sufficient investment to raise aggregate demand to the full employment level. While it would appear that monetary policy could eliminate unemployment either by reducing overnight interest rates, or by expanding the quantity of reserves, neither avenue will actually work. When liquidity preference is high, there may be no rate of interest that will induce investment in illiquid capital-and even if the overnight interest rate falls, this does not mean that the long term rate will. Further, as the horizontalists make clear, the central bank cannot simply increase reserves in a discretionary manner as this would only result in excess reserve holdings and push the overnight interest rate to zero without actually increasing the money supply. Indeed, when liquidity preference is high, the demand for, as well as the supply of, loans collapses. Hence, there is no way for the central bank to simply “increase the supply of money” to raise aggregate demand. This is why those who adopt the endogenous money approach reject ISLM-type analysis in which the authorities can eliminate recession simply by expanding the money supply and shifting the LM curve out.

Furthermore, unlike orthodox economists, Post Keynesians reject a simple NAIRU or Phillips Curve trade-off according to which some unemployment must be accepted as “natural” or as the cost of fighting inflation. Earlier, some Post Keynesians had argued for “incomes policy” as an alternative way of fighting inflation, however, that rarely proved to be politically feasible. Lately, at least some Post Keynesians have argued that not only is the inflation-unemployment “trade-off” unnecessary, but that full employment can be a complement to enhanced price stability. This is accomplished through creation of a “buffer stock” of labor, according to which the government offers to hire anyone ready, willing, and able to work at some pre-announced and fixed wage. The size of the buffer stock moves counter-cyclically, such that government spending on the program will act as an “automatic stabilizer”. At the same time, the fixed wage and benefit package helps to moderate fluctuation of “market” wages. Finally, it is emphasized that the “functional finance” approach to money and fiscal policy advanced by Lerner explains why any nation that operates with a sovereign currency will be able to “afford” full employment. In this way, it is recognized that while unemployment exists only in monetary economies, unemployment does not have to be tolerated even in monetary economies. When aggregate demand is low, fiscal policy-not monetary policy-can raise demand and provide the needed jobs. The problem is not that money is “neutral”, but that when demand is low, the private sector will not create money endogenously, hence, the government must expand the supply of HPM through fiscal policy. If a deficit results, this will increase reserves held by the banking system, which must be drained through sale of government bonds in order to prevent a situation of excess reserve holdings from pushing overnight interest rates to zero. Therefore, bond sales by the treasury are seen as an “interest rate maintenance operation” and not as a “borrowing” operation. Indeed, no sovereign issuer of the currency needs to borrow its own currency from its population in order to spend.

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FOR FURTHER READING

Brunner, Karl. 1968. “The Role of Money and Monetary Policy”, Federal Reserve Bank of St. Louis Review, vol 50, no. 7, July, p. 9.

Cook, R.M. 1958. “Speculation on the Origins of Coinage”, Historia, 7, pp. 257-62.

Davidson, Paul. Money and the Real World, London, Macmillan, 1978.

Deleplace, Ghislain and Edward J. Nell, editors. Money in Motion: the Post Keynesian and Circulation Approaches, New York, St. Martin’s Press, Inc., 1996.

Dow, Alexander and Schiela C. Dow 1989. “Endogenous Money Creation and Idle Balances”, in Pheby, John, ed, New Directions in Post Keynesian Economics, Aldershot, Edward Elgar, p. 147.

Friedman, Milton. 1969. The Optimal Quantity of Money and Other Essays, Aldine, Chicago.

Grierson, Philip (1979), Dark Age Numismatics, Variorum Reprints, London.

—–. 1977. The Origins of Money, London: Athlone Press.

Hahn, F. 1983. Money and Inflation, Cambridge, MA: MIT Press.

Innes, A. M. 1913, “What is Money?“, Banking Law Journal, May p. 377-408.

Kaldor, N. The Scourge of Monetarism, London, Oxford University Press, 1985.

Keynes, John Maynard. The General Theory, New York, Harcourt-Brace-Jovanovich, 1964.

—–. A Treatise on Money: Volume 1: The Pure Theory of Money, New York, Harcourt-Brace-Jovanovich, 1976 [1930].

Knapp, Georg Friedrich. The State Theory of Money, Clifton, Augustus M. Kelley 1973 [1924].

Lerner, Abba P. “Money as a Creature of the State”, American Economic Review, vol. 37, no. 2, May 1947, pp. 312-317.

Marx, Karl. Capital, Volume III, Chicago, Charles H. Kerr and Company, 1909.

Moore, Basil. Horizontalists and Verticalists: The Macroeconomics of Credit Money, Cambridge, Cambridge University Press, 1988.

Mosler, Warren, Soft Currency Economics, third edition, 1995.

Parguez, Alain.1996. “Beyond Scarcity: A Reappraisal of the Theory of the Monetary Circuit”, in E. nell and G. Deleplace (eds) Money in Motion: The Post-Keynesian and Circulation Approaches, London: Macmillan.

Rousseas, Stephen. Post Keynesian Monetary Economics, Armonk, New York, M.E. Sharpe, 1986.

Wray, L. Randall. Understanding Modern Money: The Key to Full Employment and Price Stability, Edward Elgar: Cheltenham, 1998.

—–. Money and Credit in Capitalist Economies: The Endogenous Money Approach, Aldershot, Edward Elgar, 1990.

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Financial Instability

Posted on August 15, 2009 by | 1 comment
By L. Randall Wray [via CFEPS]

Economists have long been concerned with the economic fluctuations that occur more-or-less regularly in all capitalist economies. (Sherman 1991; Wolfson 1994) To be sure, there are different kinds of economic fluctuations—ranging from the Kitchin cycle (tied to inventory swings and lasting on average 39 months) to the Juglar cycle (lasting about seven or eight years and linked to investment in plant and equipment) to the Kuznets cycle of twenty years (associated with demographic changes) and finally to the Kondratieff long wave cycles attributed to major innovations (electrification, the automobile). (Kindleberger 1989) Financial factors might play only a small role in some of these fluctuations. Generally, economists studying financial instability have tended to focus on periodic financial crises that frequently coincide with the peak of the common business cycle, although financial crises (especially in recent years) can occur at other times during the cycle. Furthermore, an economy might be financially unstable but manage to avoid a financial crisis. It is best to think of financial instability as a tendency rather than as a specific event, although the typical financial crisis might be the result of unstable financial processes generated over the course of a business cycle expansion. In this essay, we will be concerned primarily with economic instability that has at its roots a financial cause, with less interest in either economic fluctuation that is largely independent of finance or in isolated financial crises that do not spill over to the economy as a whole.


A variety of explanations of the causes of financial instability have been offered. One possible cause could be a speculative “mania” in which a large number of investors develop unrealistic expectations of profits to be made, borrowing heavily to finance purchases of assets and driving their prices to absurd levels. Eventually, the mania ends, prices collapse, and bankruptcies follow. (Kindleberger 1989) The tulip mania of 1634, the South Sea bubble in 1719, or the Dot-com boom of the late 1990s might be cited as examples of speculative manias. Speculative booms often develop, and are fueled by, fraudulent schemes. Recent examples of financial crises in which fraud played a large role include the collapse of the Albanian national pension system (1990s) as well as the American Savings and Loan fiasco (1980s). (Mayer 1990) Other explanations have tended to focus on a sudden interruption of the supply of money or credit that prevents borrowing and forces spending to decline, precipitating a cyclical downturn. The modern monetarist approach attributes financial instability and crises to policy errors by central banks. According to monetarist doctrine, when the central bank supplies too many reserves, the money supply expands too quickly, fueling a spending boom. If the central bank then over-reacts to the inflation this is believed to generate, it reduces the money supply and causes spending to collapse. (Friedman 1982) Others advance a “credit crunch” thesis according to which lenders (mostly banks) suddenly reduce the supply of loans to borrowers—either because the lenders reach some sort of institutional constraint or because the central bank adopts restrictive monetary policy (as in the monetarist story). (Wojnilower 1980; Wolfson 1994) Finally, one could add exchange rate instability and foreign indebtedness as a precipitating cause of economic instability, especially in developing nations since the breakup of the Bretton Woods system. (Huerta 1998)

Other analyses have identified processes inherent to the operation of capitalist economies. (Magdoff and Sweezy 1987) In other words, rather than looking to fundamentally irrational manias or to “exogenous shocks” emanating from monetary authorities, these approaches attribute causation to internal or endogenous factors. Karl Marx had claimed that the “anarchy of production” that is an inevitable characteristic of an unplanned economy in which decisions are made by numerous individuals in pursuit of profit is subject to “disproportionalities” of production such that some of the produced goods cannot be sold at a price high enough to realize expected profits. Key to his explanation was the recognition that production always begins with money, some of which is borrowed, used to purchase labor and the instruments of production in order to produce commodities for sale. If, however, some of the commodities cannot be sold at a sufficiently high price, loans cannot be repaid and bankruptcies occur. Creditors then may also be forced into bankruptcy when their debtors default because the creditors, themselves, will have outstanding debts they cannot service. In this way, a snowball of defaults spreads throughout the economy generating a panic as holders of financial assets begin to worry about the soundness of their investments. Rather than waiting for debtors to default, holders of financial assets attempt to “liquidate” (sell) assets to obtain cash and other safer assets. This high demand for “liquidity” (cash and marketable assets expected to hold nominal value) causes prices of all less liquid assets to collapse, and at the same time generates reluctance to spend as all try to hoard money. Thus, the financial crisis occurs in conjunction with a collapse of aggregate demand. (Sherman 1991; Marx 1990, 1991, 1992)

Some of the elements of Marx’s analysis were adopted by Irving Fisher in his “debt deflation” theory of the Great Depression, as well as by John Maynard Keynes in his General Theory. While Fisher devised a theory of special conditions in which markets would not be equilibrating, in Keynes’s theory these were general conditions operating in monetary economies. Briefly, Fisher attributed the severity of the Great Depression to the collapse of asset prices and the ensuing financial crisis that resulted from an avalanche of defaults. (Fisher 1933; also Galbraith 1972) Adopting Marx’s notion that capitalist production begins with money on the expectation of ending with more money later, Keynes developed a general theory of the determination of equilibrium output and employment that explicitly incorporated expectations. (Keynes 1964) He concluded there are no automatic, self-righting forces operating in capitalist economies that would move them toward full employment of resources. Indeed, he described destabilizing “whirlwinds” of optimism and pessimism, in striking contrast to the Smithian notion of an “invisible hand” that would guide markets toward stable equilibrium. Also, like Marx, Keynes identified what he called the “fetish” for liquidity as a primary destabilizing force that erects barriers to the achievement of full employment. Most relevantly, rising liquidity preference lowers the demand for capital assets, which leads to lower production of investment goods and thus falling income and employment through the multiplier effect.

Hyman Minsky, arguably the foremost twentieth century theorist on the topic of financial instability, extended Keynes’s analysis with two primary contributions. (Minsky 1975, 1986) First, Minsky developed what he labeled “a financial theory of investment and an investment theory of the cycle”, attempting to join the approaches of those who emphasized financial factors and those who emphasized real factors as causes of the cycle by noting that the two are joined in a firm’s balance sheet. (Papadimitriou and Wray 1998) As in Keynes’s approach, fluctuations of investment drive the business cycle. However, Minsky explicitly examined investment finance in a modern capitalist economy, arguing that each economic unit takes positions in assets (including, but not restricted to, real physical assets) that are expected to generate income flows by issuing liabilities that commit the unit to debt service payment flows. Because the future income flows cannot be known with certainty (while the schedule of debt payments is more-or-less known), each economic unit operates with margins of safety, collateral, net worth, and a portfolio of safe, liquid assets to be drawn upon if the future should turn out to be worse than expected. The margins of safety, in turn, are established by custom, experience, and rough rules of thumb. If things go at least as well as expected, these margins of safety will prove in retrospect to have been larger than what was required, leading to revisions of operating rules. Thus, a “run of good times” in which income flows are more than ample to meet contracted payment commitments will lead to reductions of margins of safety. Minsky developed a classification scheme for balance sheet positions that adopted increasingly smaller margins of safety: hedge (expected income flows sufficient to meet principal and interest payments), speculative (near-term expected income flows only sufficient to pay interest), and Ponzi (expected income flows not even sufficient to pay interest, hence, funds would have to be borrowed merely to pay interest).

This leads directly to Minsky’s second contribution, the financial instability hypothesis. Over time, the economy naturally evolves from one with a “robust” financial structure in which hedge positions dominate, toward a “fragile” financial structure dominated by speculative and even Ponzi positions. This transition occurs over the course of an expansion as increasingly risky positions are validated by the booming economy that renders the built-in margins of error superfluous—encouraging adoption of riskier positions. Eventually, either financing costs rise or income comes in below expectations, leading to defaults on payment commitments. As in the Marx-Fisher analyses, bankruptcies snowball through the economy. This reduces spending and raises planned margins of safety. The recession proceeds until balance sheets are “simplified” through defaults and conservative financial practices that reduce debt leverage ratios.

Central to Minsky’s exposition is his recognition that development of the “big bank” (central bank) and the “big government” (government spending large relative to GDP) helps to moderate cyclical fluctuation. The central bank helps to attenuate defaults and bankruptcies by acting as a lender of last resort; countercyclical budget deficits and surpluses help to stabilize income flows. The problem, according to Minsky, is that successful stabilization through the big bank and the big government creates moral hazard problems because economic units will build into their expectations the supposition that intervention will prevent “it” (another great depression) from happening again. Thus, risk-taking is rewarded and systemic fragility grows through time, increasing the frequency and severity of financial crises even as depression is avoided. While there may be no ultimate solution, Minsky believed that informed and evolving regulation and supervision of financial markets is a necessary complement to big bank and big government intervention. Like Keynes, Minsky dismissed the belief that reliance upon an invisible hand would eliminate financial instability, indeed, he was convinced that an unregulated, small government capitalist economy would be prone to great depressions and the sort of debt deflation process analyzed by Irving Fisher.

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REFERENCES

Fisher, I. (1933), ‘The Debt-Deflation Theory of Great Depressions’, Econometrica, 1, October: pp. 337-57.

Friedman, M. (1982), Capitalism and Freedom, Chicago and London: The University of Chicago Press.

Galbraith, J. (1972), The Great Crash, Boston: Houghton-Mifflin.

Keynes, J. (1964), The General Theory of Employment, Interest, and Money, New York and London: Harcourt Brace Jovanovich.

Kindleberger, C. (1989) Manias, Panics, and Crashes: A history of financial crises, New York: Basic Books, Inc.

Huerta, A. (1998), La Globalizacion, Causa de la Crisis Asiatica Y Mexicana, Mexico: Editorial Diana.

Magdoff, H. and P. Sweezy. (1987) Stagnation and the Financial Explosion, New york: Monthly Review Press.

Marx, K. (1990), Capital: Volume 1, London: Penguin Classics.

—–. (1991), Capital: Volume 3, London: Penguin Classics.

—–. (1992), Capital: Volume 2, London: Penguin Classics.

Mayer, M. (1990), The Greatest-Ever Bank Robbery: the collapse of the savings and loan industry, New York: Charles Scribner’s Sons.

Minsky, H. (1975), John Maynard Keynes, New York: Columbia University Press.

—–. (1986), Stabilizing an Unstable Economy, New Haven and London; Yale University Press.

Papadimitriou, D. and L.R. Wray (1998), ‘The Economic Contributions of Hyman Minsky: varieties of capitalism and institutional reform‘, Review of Political Economy 10, No. 2, pp. 199-225.

Sherman, H. (1991), The Business Cycle: Growth and crisis under capitalism, Princeton, New Jersey: Princeton University Press.

Wojnilower, A. (1980), ‘The Central Role of Credit Crunches in Recent Financial History’, Brookings Papers on #Economic Activity, No. 2: 277-326.

Wolfson, M. (1994), Financial Crises: Understanding the postwar U.S. experience, Armonk, New York and London: M.E. Sharpe.

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A Primer on Government Surpluses

Posted on August 15, 2009 by | 6 comments
What is a federal government surplus?

When the federal government’s revenue exceeds its spending over the course of a year, it is running a budget surplus and outstanding Treasury securities will be reduced by the same amount over the year. In 1999, the federal government’s surplus was $99 billion and it is projected to grow to $142 billion for fiscal year 2000. This means that US taxpayers will pay $142 billion more in taxes this year than the government spends. More concretely, taxpayers will write checks to the Internal Revenue Service in the amount of $1.914 trillion, while the US Treasury will write checks received by Americans in the amount of only $1.772 trillion—a difference of $142 billion. The only way that taxpayers can write checks to the IRS that exceed the amount of checks received from the Treasury is to surrender $142 billion of Treasury securities to the government. In other words, running a surplus necessarily means that the Treasury is reducing nominal wealth of the non-government sector. This is why federal budget surpluses reduce outstanding Treasury debt and non-government sector net nominal worth.


What is the long-term effect of running perpetual government surpluses?

On current projections, the federal government will run surpluses over this decade that will total more than $2.9 trillion, leading to an equivalent reduction of non-government sector net nominal wealth—of $2.9 trillion. This wipes out almost 80% all of the publicly-held US Treasury debt, including that now held by foreigners. No one can accurately predict how the economy will react to such an unprecedented reduction of its nominal wealth—especially when the most liquid assets will be removed from private portfolios. However, throughout our history, the US has experienced exactly six periods of substantial reduction of federal government debt, achieved through persistent budget surpluses, and each of those periods ended in one of our nation’s six depressions. Our last period of substantial surpluses occurred between 1920 and 1930, when Treasury debt was reduced by 36%; the Great Depression began in 1929. For a more recent example, Japan began to run government surpluses in 1987, which reduced non-governmental nominal wealth and generated a deep recession that has already lasted a decade. Note, however, that neither the US in the 1920s nor Japan in the late 1980s came close to draining $2.9 trillion worth of wealth from the economy, even after adjusting for higher prices today.

Doesn’t a budget surplus allow us to save for the future?

Those who believe that a surplus can be “saved” for the future, or “used” to finance tax cuts or spending increases simply do not understand the nature of a surplus. Does anyone really believe that we can “save for the future” by burning $3 trillion worth of private sector wealth? During any period, the government can always choose to spend more (or less), in which case the surplus over the period may be lower (or higher); similarly, it can increase (decrease) taxes and thereby may increase (decrease) the surplus. But, as Gertrude Stein said, “there is no there there”-a surplus exists only as a deduction from private sector income. The negative household saving that some commentators are finally noticing is merely the accountant’s flip-side to the budget surplus. A government surplus necessarily reduces private sector savings and cannot be “saved for the future”.

How do budget surpluses impact non-government sector financial balances?

There is another, less transparent, impact of government surpluses on the non-government sector. At the level of the economy as a whole, when one sector spends more than its income, another necessarily spends less for the simple reason that in the aggregate, total spending equals total income. Let us, then, disaggregate the economy into three sectors to determine the implications of government surpluses for the other sectors. First, we can consolidate all levels of government into a public (or, government) sector, and likewise consolidate households and firms into a domestic, non-government (or, private) sector. For completion, we must add a foreign (“rest-of-the-world”) sector. At the aggregate level, the spending of all three sectors combined must equal the income received by the three sectors. It is clear that if the public sector is spending less than its income—that is, it is running a surplus—this must imply that at least one other sector is spending more than its income (in other words, is running a deficit). Mathematically, the sum of the balances of the three sectors must equal zero. It is convenient for our purposes to write this as:

{Public Sector Surplus} + {Foreign Sector Surplus} = {Private Sector Deficit},

which merely moves the private sector balance to the right-hand-side and reverses the sign (in other words, writes the balance as a deficit rather than a surplus, since a negative surplus is the same thing as a deficit).

Because the US has been running a balance of payments deficit in recent years, this means that the foreign sector is in surplus (the rest-of-the-world receives more US dollars than it spends). A few years ago, our public sector ran a sufficiently large deficit to more than offset the foreign sector surplus, so that our domestic non-government sector was able to run surpluses. However, in the past two years, the US public sector’s balance has turned toward surplus. When combined with our balance of payments deficit (or foreign sector surplus), this means that the domestic private sector’s balance (that is, its savings) has turned sharply negative—toward large and growing deficits. The non-government sector deficit is now approximately equal to 5.5 percent of GDP—far and away the largest private sector deficit the US has seen in the post-war period.

Will the federal government really run surpluses for the next decade?

It is very difficult to take seriously any analyses that begin with the projection that our government will run surpluses for the next decade. Part of our skepticism comes from the inherent difficulty in making projections. More importantly, it is difficult to believe that our economy can continue to grow robustly as the government sucks disposable income and wealth from the private sector by running surpluses. When the economy slows, the surplus will eventually disappear—automatically—as unemployment compensation rises and tax revenue falls due to the slowdown. As the government spends more and taxes less, the surplus will vanish.

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The Federal Reserve: History, Procedures and Policy

Posted on August 13, 2009 by | 2 comments

By L. Randall Wray [via CFEPS]

History of the Fed
The Federal Reserve Act of 1913 created the Fed ‘to furnish an elastic currency, to afford the means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes’. For many years, the guiding principle of the Fed was the ‘Real Bills Doctrine’ under which the Fed ‘rediscounted’ eligible paper (lending reserves to banks) to facilitate trade. During WWI, the Fed purchased Treasury debt as interest-earning assets, although it was not noticed until the 1920s that this added bank reserves, supporting a multiple expansion of deposits–the ‘deposit multiplier’. In 1924 the Fed first attempted to operate countercyclically, loosening policy in recession to increase bank lending. However, bond purchases did not increase reserves because banks retired loans at the discount window–the first of many times that the Fed learned it could not ‘push on a string’: reserves, loans, and the money supply are demand determined and cannot be increased directly through monetary policy. Symmetrically, analysts found that bond sales merely forced banks to the discount window to replace lost reserves. Hence, the Fed could not control bank lending through attempts to control reserves.

Interpretations of the Fed’s policy during the 1930s range from the Monetarist claim that the Fed reduced the money supply, causing the financial crisis and Great Depression, to the more common belief that the Fed’s inaction made things worse. Actually, the Fed intervened immediately, buying $125 million of Treasury securities on the day of the stock market crash– nearly doubling Fed holdings in one day. The New York Fed also opened its discount window to New York banks that were helping correspondent banks. During the early months of the crisis, the Fed continued to meet currency demand and used open market operations to stabilize interest rates. However, by autumn 1931 gold outflows increased, leading the Fed to raise discount rates to protect gold reserves. The money supply (and reserves) was shrinking not because of Fed policy, but because banks could not find worthy borrowers. In truth, there was little that monetary policy could do; recovery would require fiscal stimulus, which finally came with the New Deal and WWII.

WWII generated huge fiscal deficits, and the Fed agreed in 1942 to peg the Treasury bill rate at 3/8 of 1 per cent. The long-term legacy was a large debt stock, enabling the Fed to use bond purchases rather than discount window borrowing to provide reserves. After the war, the Fed was concerned with potential inflation. In 1947 the Treasury agreed to loosen reins on the Fed, which promptly raised interest rates. The Fed continued to lobby for greater freedom to pursue activist monetary policy, resulting in the 1951 Accord, which abandoned the commitment to maintain low government interest costs. Although not announced explicitly, the Fed clearly targeted interest rates for the next three decades to implement countercyclical policy.

In October 1979, Chairman Paul Volcker, announced a major change: the Fed would use the growth rate of M1 as its target, abandoning interest rates. In practice, the Fed calculated total reserves consistent with its money target, then subtracted borrowed reserves to obtain a non-borrowed reserve target to control money growth. However, if the Fed did not provide sufficient non-borrowed reserves, banks would simply turn to the discount window, causing borrowed reserves to rise (and, in turn, cause the Fed to miss its total reserve target). Because required reserves are always calculated with a lag, the Fed could not refuse to provide needed reserves at the discount window. Thus the Fed found reserves could not be controlled. Further, the rate of growth of M1 actually exploded beyond targets in spite of persistently tight monetary policy, demonstrating the Fed could not hit money targets, either. The attempt to target reserves effectively ended in 1982 (after a very deep recession); the attempt to hit M1 growth targets was abandoned in 1986; and the attempt to target growth of broader money aggregates finally came to an official end in 1993.

Current Policy

Since the early 1990s, the Fed has formulated a new operating procedure that is loosely based on the new monetary consensus—the orthodox approach to monetary theory and policy. The Fed’s policy today is based on five key principles:

1. transparency;
2 gradualism;
3. activism;
4. inflation as the only official goal, but the Fed actually targets distribution;
5. neutral rate as the policy instrument to achieve these goals.

Briefly, over the past decade the Fed has increased “transparency”, telegraphing its moves well in advance and announcing interest rate targets. It also follows a course of gradualism–small adjustments of interest rates (usually 25 to 50 basis points) over several years to achieve ultimate targets. Ironically, by telegraphing its intentions long in advance, and by using a series of small interest rate adjustments, the Fed creates expectations of continued rate hikes (or declines) that it feels compelled to make—for otherwise it can jolt markets—even if economic circumstances change.

These developments have occurred during a long-term trend toward policy activism, contrasting markedly with Milton Friedman’s famous call for rules rather than discretion. The policy instrument used by the Fed is something called a “neutral rate” that varies across countries and through time—an interest rate that is supposed to be consistent with stable GDP growth at full capacity. The neutral rate cannot be recognized until achieved, so it cannot be announced in advance—which is somewhat in conflict with the adoption of transparency. In consequence, the Fed must frequently and actively adjust the fed funds rate hoping to find the neutral rate. But, as Friedman long ago warned, an activist policy has just as much chance of destabilizing the economy as it does to stabilize the economy—matters are made worse when activist policy is guided by invisible neutral rates and fickle market expectations that are fueled by the Fed’s own public musings.

Finally, the Fed claims that its chief concern is inflation. Actually the Fed does target asset prices and income shares, and it shows a strong bias against labor and wages. It will allow strong economic growth and even rising prices, so long as employment remains sluggish and wages do not rise. When, however, the Fed fears that wages might rise, it raises interest rates. Further, there is evidence from transcripts of secret Fed deliberations that it does pay attention to asset prices. Indeed, one of the reasons for rate hikes in 1994 was a desire to “prick” the equity market’s “bubble”. It is probable that rate hikes at the beginning of 2000 were designed to slow the growth of stock prices; and rate hikes that began in 2004 may have been geared to slow real estate speculation.

Chairman Greenspan has been credited with masterful management of monetary policy through the Clinton-era “goldilocks” boom of the 1990s, the recession at the end of the decade, and the economic recovery after 2001. Still, critics note a number of missteps: Greenspan said the stock market was “irrationally exuberant” as early as 1994 (six years before it peaked) and various attempts by the Fed to cool it failed; after stocks crashed in 2000, Greenspan denied it is possible to identify asset price bubbles; the Fed frequently forecast inflationary pressures that never arrived; and sometimes (including summer of 2004) appeared to raise rates when labor markets were weak, while in other cases it seemed to wait too long to lower rates in recession.

Central Banking Today

By their own admission, most central banks now operate with an interest rate target. To hit a non-zero target, the Fed adds or drains reserves to ensure that banks have the amount of reserves desired (or required in nations like the US with official reserve requirements). Reserves are added through discount window loans, purchases of government bonds, and purchases of gold, foreign currencies, or private sector financial assets. To drain reserves, the central bank reverses these actions. It is actually quite easy to determine whether the banking system faces excess or deficient reserves: the overnight rate moves away from target, triggering an offsetting reserve add or drain by the central bank. Central banks also supervise banks and other financial institutions, engage in lender of last resort activities (a bank in financial difficulty may not be able to borrow reserves in the private lending market even if aggregate reserves are sufficient), and occasionally adopt credit controls, usually on a temporary basis. We will ignore these types of activities as of secondary interest.

When the operating procedure is laid bare, it is obvious that views about controlling reserves, or sterilization of international capital flows, or central bank “financing” of treasury deficits by “printing money” are incorrect. If international payments flows or domestic fiscal actions create excess reserves, the central bank has no choice but to drain the excess–or the overnight rate falls toward zero. On the other hand, if international payments flows or domestic fiscal actions leave banks with insufficient reserves, overnight rates rise above target. For this reason, the quantity of reserves is never discretionary.

Likewise, the view that a central bank might choose to “print money” to finance a budget deficit is flawed. In practice, modern sovereign governments spend by crediting bank accounts and tax by debiting them. Clearing with the government takes place using reserves, that is, on the accounts of the central bank. Deficits lead to net credits of reserves; if excessive, they are drained through bond sales. These activities are coordinated with the Treasury, which issues new bonds in step (whether before or after is not material) with deficit spending. This is because the central bank would run out of bonds to sell. In countries in which the central bank pays interest on reserves, bond sales are unnecessary because interest-paying reserves serve the same purpose—that is, to ensure the overnight interest rate cannot fall below the target. The important point is that central bank operations are not discretionary, but are required to hit interest rate targets.

In sum, the Fed and other central banks of countries with sovereign currencies have complete policy discretion regarding the overnight interest rate. This does not mean that they do not take into account possible impacts of their target on inflation, unemployment, the trade balance, or the exchange rate. Further, central banks often react to budget deficits by raising the overnight interest rate target. These policy actions are discretionary. But what is not discretionary is the quantity of reserves in a system such as that adopted by the US—where banks do not earn interest on reserves. This is because a shortage causes the interest rate to rise above target; an excess causes it to fall. The Fed is forced to defend its target by intervening—adding or draining reserves. A country like Canada that pays interest on positive reserve holdings (and charges interest on reserve lending) need not drain “excess” reserves—because they are not really excessive. Indeed, there is no real distinction between reserves that pay interest or treasury bills that pay interest—both serve the same purpose of maintaining a positive overnight interest rate, so there is no reason to sell bills to banks to “drain excess reserves” in such countries.

We conclude that central banking policy really boils down to interest rate setting and that calls for controlling reserves or the money supply are misguided. However, it is far from clear that interest rates matter much, especially when transparency and gradualism eliminate the element of surprise. Thus, the view that monetary policy can “fine-tune” the economy is probably in error.

References:

Friedman, Milton. 1969. The Optimal Quantity of Money and Other Essays. Chicago: Aldine.

Wray, L. Randall. Understanding Modern Money: The Key to Full Employment and Price Stability, Edward Elgar Publishing, 1998.

—-. The Fed and the New Monetary Consensus: The Case for Rate Hikes, Part Two Levy Policy Brief No. 80, 2004 December 2004

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How to Implement True, Full Employment

Posted on August 12, 2009 by | 5 comments

By L. Randall Wray

We will briefly describe a program that would generate true, full employment, price stability, and currency stability. We will show that this program can be adopted in any nation that issues its own currency. Our presentation consists of three sections. First, we briefly examine a pilot program at the University of Missouri—Kansas City (UMKC). This provides the basis for the analysis in the second section of the functioning of a national monetary system. Finally, we show how this knowledge can be used to construct a public service program (PSE) that guarantees true, full employment with price and currency stability.

The Buckaroo Program

In the United States, there is a growing movement on college campuses to increase student involvement in their communities, particularly through what is known as “service-learning” in which students participate in community service activities organized by local community groups. It should become obvious that a modern monetary economy that adopts the full employment program described here will operate much like our community service hours program.

We have chosen to design our program as a “monetary” system, creating paper notes, “buckaroos” (after the UMKC mascot, a kangaroo), with the inscription “this note represents one hour of community service by a UMKC student”, and denominated as “one roo hour”. Each student is required to pay B25 to the UMKC “Treasury” each semester. Approved community service providers (state and local government offices, university offices, public school districts, and not-for-profit agencies) submit bids for student service hours to the Treasury, which “awards” special drawing rights (SDRs) to the providers so long as basic health, safety, and liability standards are met. The providers then draw on their SDRs as needed pay students B1 per hour worked. This is equivalent to “spending” by the UMKC treasury. Students then pay their taxes with buckaroos, retiring Treasury liabilities.

Several implications are immediately obvious. First, the UMKC treasury cannot collect any buckaroo taxes until it has spent some buckaroos. Second, the Treasury cannot collect more buckaroos in payment of taxes than it has previously spent. This means that the “best” the Treasury can hope for is a “balanced budget”. Actually, it is almost certain that the Treasury will run a deficit as some buckaroos are “lost in the wash” or hoarded for future years. While it is possible that the Treasury could run a surplus in future years, this would be limited by the quantity of previously hoarded buckaroos that could be used to pay taxes. Third, and most important, it should be obvious that the Treasury faces no “financial constraints” on its ability to spend buckaroos. Indeed, the quantity of buckaroos provided is “market demand determined”, by the students who desire to work to obtain buckaroos and by the providers who need student labor. Furthermore, it should be obvious that the Treasury’s spending doesn’t depend on its tax receipts. To drive the point home, we can assume that the Treasury always burns every buckaroo received in payment of taxes. In other words, the Treasury does not impose taxes in order to ensure that buckaroos flow into its coffers, but rather to ensure that student labor flows into community service. More generally, the Treasury’s budget balance or imbalance doesn’t provide any useful information to UMKC regarding the program’s success or failure. A Treasury deficit, surplus, or balance provides useless accounting data.

Note that each student has to obtain a sufficient number of buckaroos to meet her tax liability. Obviously, an individual might choose to earn, say, B35 in one semester, holding B10 as a hoard after paying the B25 tax for that semester. The hoards, of course, are by definition equal to the Treasury’s deficit. UMKC has decided to encourage “thrift” by selling interest-earning buckaroo “bonds”, purchased by students with excess buckaroo hoards. This is usually described as government “borrowing”, thought to be necessitated by government deficits. Note however, that the Treasury does not “need” to borrow its own buckaroos in order to deficit spend—no matter how high the deficit, the Treasury can always issue new buckaroos. Indeed, the Treasury can only “borrow” buckaroos that it has already spent, in fact, that it has “deficit spent”. Finally, note that the Treasury can pay any interest rate it wishes, because it does not “need” to “borrow” from students. For this reason, Treasury bonds should be seen as an “interest rate maintenance account” designed to keep the base rate at the Treasury’s target interest rate. Without such an account, the “natural base interest rate” is zero for buckaroo hoards created through deficit spending. Note that no matter how much the Treasury spends the base rate would never rise above zero unless the Treasury offers positive interest rates; in other words, Treasury deficits do not place any pressure on interest rates.

What determines the value of buckaroos? From the perspective of the student, the “cost” of a buckaroo is the hour of labor that must be provided; from the perspective of the community service provider, a buckaroo buys an hour of student labor. So, on average, the buckaroo is worth an hour of labor—more specifically, an hour of average student labor. Note that we can determine the value of the buckaroo without reference to the quantity of buckaroos issued by the Treasury. Whether the Treasury spends a hundred thousand buckaroos a year, or a million a year, the value is determined by what students must do to obtain them.

The Treasury’s deficit each semester is equal to the “extra” demand for buckaroos coming from students; indeed, it is the “extra” demand that determines the size of the Treasury’s deficit. We might call this “net saving” of buckaroos, and it is equal—by definition—to the Treasury’s deficit over the same period. What if the Treasury decided it did not want to run deficits, and so proposed to limit the total number of buckaroos spent in order to balance the budget? In this case, it is almost certain that some students would be unable to meet their tax liability. Unlucky, procrastinating students would find it impossible to find a community service job, thus would find themselves “unemployed” and would be forced to borrow, beg, or steal buckaroos to meet their tax liabilities. Of course, any objective analysis would find the source of the unemployment in the Treasury’s policy, and not in the characteristics of the unemployed. Unemployment at the aggregate level is caused by insufficient Treasury spending.

Some of thisanalysis applies directly to our economic system as it actually operates, while some of it would apply to the operation of our system if it were to adopt a full employment program. Let us examine the operation of a modern money system.

Modern Monetary Systems

In all modern economies, money is a creature of the State. The State defines money as that which it accepts at public pay offices (mainly, in payment of taxes). Taxes create a demand for money, and government spending provides the supply, just as our buckaroo tax creates a demand for buckaroos, while spending by the Treasury provides the supply. The government does not “need” the public’s money in order to spend; rather, the public needs the government’s money in order to pay taxes. This means that the government can buy whatever is for sale in terms of its money merely by providing it.

Because the public will normally wish to hold some extra money, the government will normally have to spend more than it taxes; in other words, the normal requirement is for a government deficit, just as the UMKC Treasury always runs a deficit. Government deficits do not require “borrowing” by the government (bond sales), rather, the government provides bonds to allow the public to hold interest-bearing alternatives to non-interest-bearing government money. Further, markets cannot dictate to government the interest rate it must pay on its debt, rather, the government determines the interest rate it will pay as an alternative to non-interest-earning government money. This stands conventional analysis on its head: fiscal policy is the primary determinant of the quantity of money issued, while monetary policy primarily has to do with maintaining positive interest rates through bond sales—at the interest rate the government chooses.

In summary, governments issue money to buy what they need; they tax to generate a demand for that money; and then they accept the same money in payment of the tax. If a deficit results, that just lets the population hoard some of the money. If the government wants to, it can let the population trade the money for interest earning bonds, but the government never needs to borrow its own money from the public.

This does not mean that the deficit cannot be too big, that is, inflationary; it can also be too small, that is deflationary. When the deficit is too small, unemployment results (just as it results at UMKC when the Treasury’s spending of buckaroos is too small). The fear, of course, is that government deficits might generate inflation before full employment can be reached. In the next section we describe a proposal that can achieve full employment while actually enhancing price stability.

Public Service Employment and Full Employment with Price and Currency Stability

Very generally, the idea behind our proposal is that the national government provides funding for a program that guarantees a job offer for anyone who is ready, willing and able to work. We call this the Public Service Employment program, or PSE. What is the PSE program? What do we want to get out of it?

1. It should offer a job to anyone who is ready, willing and able to work; regardless of race or gender, regardless of education, regardless of work experience; regardless of immigration status; regardless of the performance of the economy. Just listing those conditions makes it clear why private firms cannot possibly offer an infinitely elastic demand for labor. The government must play a role. At a minimum, the national government must provide the wages and benefits for the program, although this does not actually mean that PSE must be a government-run program.


2. We want PSE to hire off the bottom. It is an employment safety net. We do not want it to compete with the private sector or even with non-PSE employment in the public sector. It is not a program that operates by “priming the pump”, that is, by raising aggregate demand. Trying to get to full employment simply by priming the pump with military spending could generate inflation. That is because military Keynesianism hires off the top. But by definition, PSE hires off the bottom; it is a bufferstock policy—and like any bufferstock program, it must stabilize the price of the bufferstock—in this case, wages at the bottom.

3. We want full employment, but with loose labor markets. This is virtually guaranteed if PSE hires off the bottom. With PSE, labor markets are loose because there is always a pool of labor available to be hired out of PSE and into private firms. Right now, loose labor markets can only be maintained by keeping people out of work—the old reserve army of the unemployed approach.

4. We want the PSE compensation package to provide a decent standard of living even as it helps to maintain wage and price stability. We have suggested that the wage ought to be set at $6.25/hr in the USA to start. A package of benefits could include healthcare, childcare, sick leave, vacations, and contributions to Social Security so that years spent in PSE would count toward retirement.
5. We want PSE experience to prepare workers for post-PSE work—whether in the private sector or in government. Thus, PSE workers should learn useful work habits and skills. Training and retraining will be an important component of every PSE job.

6. Finally, we want PSE workers to do something useful. For the U.S.A. we have proposed that they focus on provision of public services, however, a developing nation may have much greater need for public infrastructure; for roads, public utilities, health services, education. PSE workers should do something useful, but they should not do things that are already being done, and especially should not compete with the private sector.

These six features pretty well determine what a PSE program ought to look like. This still leaves a lot of issues to be examined. Who should administer the program? Who should do the hiring and supervision of workers? Who should decide exactly what workers will do? There are different models consistent with this general framework, and different nations might take different approaches. Elsewhere (Wray 1998, 1999) I have discussed the outlines of a program designed specifically for the USA. Very briefly, I suggest that given political realities in the USA, it is best to decentralize the program as much as possible. State and local governments, school districts, and non-profit organizations would be allowed to hire as many PSE workers as they could supervise. The federal government would provide the basic wage and benefit package, while the hiring agencies would provide supervision and capital required by workers (some federal subsidy of these expenses might be allowed). All created jobs would be expected to increase employability of the PSE workers (by providing training, experience, work records); PSE employers would compete for PSE workers, helping to achieve this goal. No PSE employer would be allowed to use PSE workers to substitute for existing employees (representatives of labor should sit on all administrative boards that make hiring decisions). Payments by the federal government would be made directly to PSE workers (using, for example, Social Security numbers) to reduce potential for fraud.

Note that some countries might choose a much higher level of centralization. In other words, program decentralization is dictated purely by pragmatic and political considerations. The only essential feature is that funding must come from the national government, that is, from the issuer of the currency.

Before concluding, let us quickly address some general questions. First, many people wonder about the cost—can we afford full employment? To answer this, we must distinguish between real costs and financial expenditures. Unemployment has a real cost—the output that is lost when some of the labor force is involuntarily unemployed, the burdens placed on workers who must produce output to be consumed by the unemployed, the suffering of the unemployed, and social ills generated by unemployment and poverty. From this perspective, providing jobs for the unemployed will reduce real costs and generate net real benefits for society. Indeed, it is best to argue that society cannot afford unemployment, rather than to suppose that it cannot afford employment!

On the other hand, most people are probably concerned with the financial cost of full employment, or, more specifically, with the impact on the government’s budget. How will the government pay for the program? It will write checks just as it does for any other program. (See Wray 1998.) This is why it is so important to understand how the modern money system works. Any nation that issues its own currency can financially afford to hire the unemployed. A deficit will result only if the population desires to save in the form of government-issued money. In other words, just as in UMKC’s buckaroo program, the size of the deficit will be “market demand” determined by the population’s desired net saving.

Economists usually fear that providing jobs to people who want to work will cause inflation. Thus, it is necessary to explain how our proposed program will actually contribute to wage stability, promoting price stability. The key is that our program is designed to operate like a “buffer stock” program, in which the buffer stock commodity is sold when there is upward pressure on its price, or bought when there are deflationary pressures. Our proposal is to use labor as the buffer stock commodity, and as is the case with any buffer stock commodity, the program will stabilize the commodity’s price. The government’s spending on the program is based on a “fixed price/floating quantity” model, hence, cannot contribute to inflation.

Note that the government’s spending on the full employment program will fluctuate countercyclically. When the private sector reduces spending, it lays-off workers who then flow into the bufferstock pool, working in the full employment program. This automatically increases total government spending, but not prices because the wage paid is fixed. As the quantity of workers hired at the fixed wage rises, this results in a budget deficit. On the other hand, when the private sector expands, it pulls workers out of the bufferstock pool, shrinking government spending and thus reducing deficits. This is a powerful automatic stabilizer that operates to ensure the government’s spending is at just the right level to maintain full employment without generating inflation.

REFERENCES

Wray, L. Randall. 1998. Understanding Modern Money: the key to full employment and price stability, Cheltenham: Edward Elgar.

—–. 1999. “Public Service Employment—Assured Jobs Program: further considerations“, Journal of Economic Issues, Vol. 33, no. 2, pp. 483-490.

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Social Security: Truth or Useful Fictions?

Posted on August 11, 2009 by | 4 comments

By L. Randall Wray [via CFEPS]

I. SOCIAL SECURITY IS AN ASSURANCE , NOT A PENSION PLAN

Social Security is an intergenerational assurance plan. Working generations agree to take care of retirees, dependents, survivors, and persons with disabilities. Currently, spouses, children, or parents of eligible workers make up more than a quarter of beneficiaries on OASDI. A large proportion will always be people without “normal” work histories who could not have made sufficient contributions to entitle them to a decent pension. Still, as a society, we have decided they should receive benefits.

Further, the program is not means tested. One need only meet statutory requirements to receive benefits. Indeed, as the Bush Commission’s Report emphasizes, the Supreme Court has twice ruled Social Security does not make intergenerational promises to the dead, but, rather, only to their survivors. The Bush Commission sees that as a weakness; I see it as a strength.

II. TRUST FUNDS DO NOT INCREASE GOVERNMENT’S ABILITY TO MEET COMMITMENTS (Advance Funding is a Fiction)

The Greenspan Commission tried to change Social Security from paygo to advance funding in 1983. But that is impossible; it just demonstrated a misunderstanding of accounting. The existence of a Trust Fund does not in any way, shape, or form enhance government’s ability to meet Social Security commitments. This point is difficult to get across.

The Social Security Trust Fund is one of Uncle Sam’s cookie jars. He also has a defense cookie jar, a corporate welfare cookie jar, etc. (See Figure 1.) We count taxes as Uncle Sam’s income, and he can pretend he stuffs the various cookie jars with those tax receipts — the payroll tax goes into the Social Security cookie jar, and he pretends it pays for Social Security spending. Maybe he pretends capital gains taxes go into the corporate welfare cookie jar. And so on. That is all internal accounting.

Figure 1: Federal Government Internal Accounts

Say Uncle Sam spends more on corporate welfare than he pretends to have in that cookie jar. But he pretends the Social Security cookie jar is overflowing with tax receipts because he runs a huge surplus there. (See Figure 2.) So Uncle Sam writes some IOUs from the corporate welfare cookie jar to the Social Security cookie jar to remind himself. Over time, the Social Security cookie jar accumulates Trillions of dollars of IOUs from Uncle Sam’s other cookie jars.

Figure 2: Trust Fund

That is just the government owing itself, and has no effect on the external accounts. (See Figure 3.) The total spent on Social Security, corporate welfare, transportation and so on equals its total spending for the year. The total it collects from taxes, including payroll taxes, capital gains taxes, gas taxes, and so on, equals its total income for the year. If government spends more than its income, that is called deficit spending. If it spends less, it runs a budget surplus. The cookie jar IOUs cannot change that in any way.

Figure 3: Federal Government External Accounts

Note I’m not saying there is anything wrong with the Treasury Securities held by the Trust Fund-Social Security can count them as an asset. But they will not in any way change the external accounting in 2017 or 2027 or 2041 — when the government’s overall spending will be less than, equal to, or greater than its overall tax receipts. (See Figure 4.) When Social Security begins to run a deficit, the existence of the Trust Fund will not reduce the amount of Treasury Securities sold to the nongovernment sector.

Indeed, comparison of Figure 4a with 4b demonstrates that the external accounts are not changed by existence of a Trust Fund-the implications for the government are the same.

Figure 4a: Social Security Runs $10 Billion Deficit, With Rest of Federal Government Budget in Balance, WITH TRUST FUND

Figure 4b: Social Security Runs $10 Billion Deficit, With Rest of Federal Government Budget in Balance, WITHOUT TRUST FUND

III. TRUST FUNDS DO NOT PROVIDE POLITICAL PROTECTION (Proof: They Fuel Privatization Scams)

Many economists realize that from the perspective of Uncle Sam, the Trust Fund is just an internal accounting construction. But I’ve had top economic advisors of both Democrats and Unions tell me while that is true, the Trust Fund provides political protection. That is clearly false. It is only because Social Security runs surpluses accumulated in a Trust Fund that we have all these privatizat ion scams. Do you really believe Wall Street fund managers would have any interest in Social Security if it ran deficits?

IV. SOCIAL SECURITY CANNOT FACE A FINANCIAL CONSTRAINT (Except One Imposed By Congress)

Social Security is unusual because unlike most other government programs, we pretend a specific tax finances it. That makes it easy to mentally match payroll tax revenues and benefit payments, and to calculate whether the 75 year actuarial balance is positive or negative. No one knows or car es whether the defense program runs actuarial deficits — because we don’t pretend that a particular tax pays for defense. In reality, Social Security benefits are paid in exactly the same way that the government spends on anything else-by crediting somebody’s bank account. Social Security cannot be any more financially constrained than any other government program. Only Congress can establish a financial constraint.

V. SOCIAL SECURITY DOES NOT APPEAR TO FACE REAL CONSTRAINTS, (America Can Afford 7% of GDP for Social Security)

Today OASDI benefits equal 4.5% of GDP; that grows to 7% over the next 75 years. Does anyone doubt that we will be able to afford to devote 7% of our nation’s output to provide a social safety net for retirees, survivors, and disabled persons? That leaves 93% of GDP for everything else. We have easily achieved larger shifts of GDP in the past without lowering living standards of the working generations. I cannot imagine a future so horrible that we won’t be able support OASDI in real terms.

VI. PRIVATIZATION IS NOT NEEDED, NOR CAN IT HELP TO PROVIDE FOR FUTURE BENEFICIARIES (Any Future Problems Are Not Financial; Financial Fixes Cannot Help)

Future beneficiaries cannot eat stocks or bonds, and we can’t dig holes today to bury Winnebagos for future retirees. Whatever beneficiaries consume in 2050 will have to be produced for the most part in 2050. Financial Fixes cannot change that. Whether the stock market outperforms Treasury bonds is irrelevant. Whether future retirees have amassed $100,000 in personal accounts is irrelevant. All that matters is future productive capacity plus a method of distributing a portion of output to the elderly in 2050.

To accomplish that, all we have to do is credit the bank accounts of the elderly in 2050, and then let the market work its wonders. I am frankly shocked that the Cato Institute refuses to trust the market, backing what amounts to tax credits for playing in equity markets.

VII. PERSONAL ACCOUNTS ARE FINE, BUT ARE NOT RELEVANT TO DISCUSSION OF SOCIAL SECURITY (A Targeted $40 Billion Give-Away is Probably a Good Idea!)

I also find it ironic that the Bush Commission wants to increase government spending by $40 billion a year to give money away to encourage the poor to save. Hey, let’s give them $80 billion a year. I’d prefer that the poor spend it, but if they want to sock it away in personal accounts, that’s fine by me. But, please, let’s provide Big Brotherly advice that they keep it out of Telecom stocks. And leave Social Security out of it!

VIII. SOCIAL SECURITY IS, ALWAYS HAS BEEN, ALWAYS WILL BE, SUBJECT TO CONGRESSIONAL GOODWILL (Maintained At the Ballot Box)

Only Congress can decide who deserves support, and what level of support. Only Congress can decide how much of GDP ought to be devoted to support of the elderly. That’s Democracy and I’m willing to live with it. The Bush Commission says this generates insecurity, but I expect the elderly will continue to use the ballot box to hold the feet of Politicians to the fire of Social Security.

IX. HONESTY IS THE BEST POLICY (Convenient Fictions About Finances Cannot Help)

In spite of all the complex financial fictions, the truth is simple. In 2041, Social Security’s beneficiaries will have to rely on the working population, just as they do today. No financial scams can change that. Trust funds, actuarial balances, privatization, and relative rates of return don’t change it. There ain’t no crisis; there ain’t no urgency. We’ve got two generations to increase our capacity to produce.

X. TOWARD A PROGRESSIVE REFORM (Stop Taxing Work!)

In 1960 it might have made some kind of twisted logic to levy a tax on payrolls and to pretend this paid for Social Security benefits. There were few benefits to be paid, but lots of payrolls to tax, so the tax rate was low. Today, and increasingly in the future, there are more benefits to pay relative to taxable payrolls. In just a few years, only 1/3 of National Income will be subject to the payroll tax- hence ever-higher payroll tax rates will be required to maintain the delusion.

Let’s stop pretending. Payroll taxes simply discourage work-which is as perverse as policy can get. We need people to work to provide all the goods and services the elderly need. Abolish the payroll tax, abolish the Trust Fund, abolish actuarial gaps, and let’s recognize that Social Security is an intergenerational assurance program.

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Teaching the Fallacy of Composition: The Federal Budget Deficit

Posted on August 10, 2009 by | 32 comments
SUMMARY: One of the most important concepts to be taught in economics is the notion of the fallacy of composition: what might be true for individuals is probably not true for society as a whole. The most common example is the paradox of thrift: while an individual can save more by reducing spending (on consumption), society can save more only by spending more (for example, on investment). Another useful and very topical example involves the federal government’s budget deficit. Politicians and the media often argue that the government must balance its books, just like a household. If a household were to continually spend more than its income, it would eventually face insolvency; it is thus claimed that government is in a similar situation. However, careful examination of macroeconomic relations will show that this analogy is incorrect, and that it would lead to improper budgetary policy. This example can drive home the fallacy of composition.

One of the most important concepts we teach in economics, and most importantly in macroeconomics, is the notion of the fallacy of composition.

Students and others who haven’t been exposed to macroeconomics naturally extrapolate from their own individual situation to society and the economy as a whole.

This often leads to the problem of the fallacy of composition. Of course, that isn’t just restricted to economics. While a few people could exit the doors of a crowded movie theatre, all of us could not.

The macroeconomics example of the fallacy of composition most often used is the paradox of thrift. Any individual can increase her saving by reducing her spending—on consumption goods. So long as her decision does not affect her income—and there is no reason to assume that it would—she ends up with less consumption and more saving.

The example I always use involves Mary who usually eats a hamburger at Macdonald’s every day. She decides to forego one hamburger per week, to accumulate savings. Of course, so long as she sticks to her plan, she will add to her savings (and financial wealth) every week.

The question is this: what if everyone did the same thing as Mary—would the reduction of the consumption of hamburgers raise aggregate (national) saving (and financial wealth)?

The answer is that it will not. Why not? Because Macdonald’s will not sell as many hamburgers, it will begin to lay-off workers and reduce its orders for bread, meat, catsup, pickles, and so on.

All those workers who lose their jobs will have lower incomes, and will have to reduce their own saving. You can use the notion of the multiplier to show that this process comes to a stop when the lower saving by all those who lost their jobs equals the higher saving of all those who cut their hamburger consumption. At the aggregate level, there is no accumulation of savings (financial wealth).

Of course that is a simple and even silly example. But the underlying explanation is that when we look at the individual’s increase of saving, we can safely ignore any macro effects because they are so small that they have only an infinitely small impact on the economy as a whole.

But if everyone tries to increase saving, we cannot ignore the effects of lower spending on the economy as a whole. That is the point that has to be driven home.

We can then again return to the notion of the multiplier, and show that the way to increase aggregate saving is by increasing spending, specifically, nonconsumption spending—spending on investment, spending by government, or spending by foreigners on our exports.

I don’t want to go into that particular example any further. Another example that is less frequently used concerns unemployment.

The view shared by most of my undergraduate students is that unemployment is caused by laziness or lack of training. The argument they often use is that “I can get a job, therefore all the unemployed could get jobs if only they tried harder, or got better education and training”.

The way I go about demonstrating that fallacy is a dogs and bones example. Say we have 10 dogs and we bury 9 bones in the backyard. We send the dogs out to find bones. At least one dog will come back without a bone.

We decide that the problem is lack of training. We put that dog through rigorous training in the latest bone finding techniques. We bury 9 bones and send the 10 dogs out again. The trained dog ends up with a bone, but some other dog comes back without a bone (empty-mouthed, so to speak).

The problem, of course, is that there are not enough bones and jobs to go around. It is certainly true that a well-trained and highly motivated jobseeker can usually find a job. But that is no evidence that aggregate unemployment is caused by laziness or lack of training.

We could also go into the common belief that minimum wages cause unemployment. It is at least partly true that for an individual firm, higher wages reduce the number of workers hired. But we cannot extrapolate that to the economy as a whole. Higher wages mean higher income and thus higher consumption spending, which induces firms to employ more labor. So the truth is that economic theory does not tell us that raising minimum wages will lead to more unemployment, indeed, theory tells us it can go the other way—raising the minimum wage could increase employment.

Again, the reason we can reach the wrong conclusion in all of these cases when we aggregate up from the micro level to the macro is because we ignore the impacts that behavior of individuals or firms has on other individuals or firms. That can be OK for the case of the individual firm or household, but is almost certainly incorrect for firms and households taken as a whole.

Let me move on to a more important fallacy of composition. We hear politicians and the media arguing that the current federal budget deficit is unsustainable. I have heard numerous politicians refer to their own household situation: if my household continually spent more than its income year after year, it would go bankrupt. Hence, the federal government is on a path to insolvency, and by implication, the budget deficit is bankrupting the nation.

That is another type of fallacy of composition. It ignores the impact that the budget deficit has on other sectors of the economy. Let me go through this in some detail, as it is more complicated than the other examples.

We can divide the economy into 3 sectors. Let’s keep this as simple as possible: there is a private sector that includes both households and firms. There is a government sector that includes both the federal government as well as all levels of state and local governments. And there is a foreign sector that includes imports and exports; (in the simplest model, we can summarize that as net exports—the difference between imports and exports—although to be entirely accurate, we use the current account balance as the measure of the impact of the foreign sector on the balance of income and spending).

At the aggregate level, the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income).

Historically the US private sector spends less than its income—that is it runs a surplus. Another way of saying that is that the private sector saves. In the past, on average the private sector spent about 97 cents for every dollar of income.

Historically, the US on average ran a balanced current account—our imports were just about equal to our exports. (As discussed below, that has changed in recent years, so that today the US runs a huge current account deficit.)

Now, if the foreign sector is balanced and the private sector runs a surplus, this means by identity that the government sector runs a deficit. And, in fact, historically the government sector taken as a whole averaged a deficit: it spent about $1.03 for every dollar of national income.

Note that that budget deficit exactly offsets the private sector’s surplus—which was about 3 cents of every dollar of income. In fact, if we have a balanced foreign sector, there is no way for the private sector as a whole to save unless the government runs a deficit. Without a government deficit, there would be no private saving. Sure, one individual can spend less than her income, but another would have to spend more than his income.

While it is commonly believed that continual budget deficits will bankrupt the nation, in reality, those budget deficits are the only way that our private sector can save and accumulate net financial wealth.

Budget deficits represent private sector savings. Or another way of putting it: every time the government runs a deficit and issues a bond, adding to the financial wealth of the private sector. (Technically, the sum of the private sector surpluses equal the sum of the government sector deficits, which equals the outstanding government debt—so long as the foreign sector is balanced.)

Of course, the opposite would also be true. Assume we have a balanced foreign sector and that the government runs a surplus—meaning its tax revenues are greater than government spending. By identity this means the private sector is spending more than its income, in other words, it is deficit spending. The deficit spending means it is going into debt, and at the aggregate level it is reducing its net financial wealth.

At the same time, the government budget surplus means the government is reducing its debt. Effectively what happens is that the private sector returns government bonds to the government for retirement—the reduction of private sector wealth equals the government reduction of debt.

Now let us return to the Clinton years when the federal government was running the biggest budget surpluses the government has ever run. Everyone thought this was great because it meant that the government’s outstanding debt was being reduced. Clinton even went on TV and predicted that the budget surpluses would last for at least 15 years and that every dollar of government debt would be retired.

Everyone celebrated this accomplishment, and claimed the budget surplus was great for the economy.

In the middle of 2000, I wrote a contrary opinion (“Implications of a budget surplus at mid-year 2000, CFEPS Policy Note 2000/1). I made several arguments. First, I pointed out that the budget surplus meant by identity that the private sector was running a deficit. Households and firms were going ever farther into debt, and they were losing their net wealth of government bonds.

Second, I argued that this would eventually cause a recession because the private sector would become too indebted and thus would cut back spending. In fact, the economy went into recession within half a year.

Third, I argued that the budget surpluses would not last 15 years, as Clinton claimed. Indeed, I expected they would not last more than a couple of years. In fact, the budget turned around to large and growing deficits almost immediately as soon as the economy went into recession.

And of course we still have large budget deficits. No one talks any more about achieving budget surpluses this decade; almost everyone agrees that we will not see budget surpluses again in our lifetimes—if ever.

The question is whether the US government can run deficits forever. The answer is emphatically “yes”, and that it had better do so. If you look back to 1776, the federal budget has run a continuous deficit except for 7 short periods. The first 6 of those were followed by depressions—the last time was in 1929 which was followed by the Great Depression. The one exception was the Clinton budget surplus, which was followed (so far) only by a recession.

Why is that? By identity, budget surpluses suck income and wealth out of the private sector. This causes private spending to fall, leading to downsizing and unemployment. The only way around that is to run a trade or current account surplus.

The problem is that it is hard to see how the US can do that—in fact, our current account deficit is now rising toward 7% of GDP. All things equal, that means our budget deficit has to be even larger to allow our private sector to save. Given our current account balance, the budget deficit would have to reach 9% of GDP to allow our private sector to have a surplus of 2% of GDP.

I don’t want to give the impression that government deficits are always good, or that the bigger the deficit, the better. The point I am making is that we have to recognize the macro relations among the sectors.

If we say that a government deficit is burdening our future children with debt, we are ignoring the fact that this is offset by their saving and accumulation of financial wealth in the form of government debt. It is hard to see why households would be better off if they did not have that wealth.

If we say that the government can run budget surpluses for 15 years, what we are ignoring is that this means the private sector will have to run deficits for 15 years—going into debt that totals trillions of dollars in order to allow the government to retire its debt. Again it is hard to see why households would be better off if they owed more debt, just so that the government would owe them less.

There are other differences between the federal government and an individual household. The government is the issuer of our currency, while households are users of the currency. That makes a big difference, and one explored in many other CFEPS publications. However, the purpose of this particular note is to explain why we cannot aggregate up from the individual household situation to the economy as a whole. The US government’s situation is not in any way similar to that of a household because its deficit spending is exactly offset by private sector surpluses; its debt creates equivalent net financial wealth for the private sector.

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The Great American Bank Robbery

Posted on August 8, 2009 by | 2 comments

http://p.castfire.com/8Fi1I/video/129363/129363_2009-07-22-233157.flv

(From UCLA’s Hammer Forum) — William K. Black, the former litigation director of the Federal Home Loan Bank Board who investigated the Savings and Loan disaster of the 1980s, discusses the latest scandal in which a single bank, IndyMac, lost more money than was lost during the entire Savings and Loan crisis. He will examine the political failure behind this economic disaster, in which not only massive fraud has taken place, but a vast transfer of wealth from the poor and middle class continues as the federal government bails out the seemingly reckless, if not the criminal. Black teaches economics and law at the University of Missouri, Kansas City and is the author of The Best Way to Rob a Bank Is to Own One. (Run Time: 1 hour, 38 min.)

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Leakages and Potential Growth

Posted on August 6, 2009 by | 1 comment
In his book, Leakages, Treval Powers makes the outrageous claim that without leakages, the US economy could grow at a sustained rate of 13% annually. According to his calculations (based on empirical evidence), normal leakages of 7.4% reduce the rate of growth to 5.6%, leaving the economy operating at only 92.6% of its capacity. Periodic restrictive policy by the Federal Reserve adds another layer of leakages, which can reduce growth to zero, causing the economy to operate at only 87% of potential.

Ironically, the Fed imposes tight policy because it wrongly believes that inflationary pressures result from excessive demand, even though the economy chronically operates well below capacity. Indeed, Powers argues that the greater the leakages, the higher the price level, hence, when the Fed tightens it actually puts upward pressure on prices. In his view, the economy has not been supply constrained, at least in the postwar era, so there has been no reason to fight inflation by constraining demand.

All of this goes against the conventional wisdom. Powers might be dismissed as a crank, as someone who simply does not understand economics. While I do find most of his analysis of monetary policy somewhat confusing, I agree with the general conclusions. What I will do in this note is to concur on two main points:


1. the US economy suffers from chronic inadequate demand, and has rarely been subject to any significant supply constraints—whether of productive capacity or of labor;

2. and leakages have been the cause of the demand constraints

Thus, I also agree with the policy conclusions of Powers: Fed policy can be seen as a string of mistakes guided by a fundamentally flawed view that causes the Fed to tighten policy exactly when it should be loosened. Inflation in the US does not result from excessive aggregate demand and, indeed, our worst bouts with inflation have come during periods of above-normal slack.

However, I do not believe that Fed policy normally has a huge impact on the economy, and for that we should be eternally grateful given how misguided it has been. This is the major disagreement I would have with Powers and other critics of the Fed. I could go even further and argue that we really do not know whether restrictive policy by the Fed actually reduces aggregate demand—and whether lower interest rates stimulate demand—but that would take us too far afield.

Fiscal policy is the primary way in which government impacts the economy, and, unfortunately, it has become increasingly misguided in ways that many do not understand—especially during the Bush dynasty era in which populists, leftists, and the Democratic party have wrongly advocated a return to what they call fiscal responsibility. Thus, rather than focusing on monetary policy failings as the cause of demand slack, I highlight the role played by fiscal policy.

Let me begin with my argument that the US economy, as well as the economies of all the other major nations, have suffered from demand constrained growth. Figure 1 compares the per capita inflation-adjusted GDP growth of the major developed nations—indexed to 100 in 1970. Note the relatively rapid growth of Japan.

Per capita (inflation adjusted) GDP growth can be attributed by identity to growth of the employment rate (workers divided by population) plus growth of productivity per worker. Figure 2 shows employment rate growth by nation. Note that only the US and Canada had much growth of the employment rate. The long term trend in these two countries is rising as more women come into the labor force. There are also obvious cyclical trends—especially in Canada—when employment rates can actually fall off due to unemployment. Employment rates actually fell in France on a long-term trend, while they were more or less stable in the other nations.

I attribute the low growth of employment rates to slow growth of aggregate demand; that is, if aggregate demand does not grow at a clip sufficiently above productivity growth, then employment rate growth must (identically) suffer. Indeed, growth in Japan and Europe has not been high enough to increase employment rates—so they have come up with all these schemes to increase vacations, lower retirement ages, and share work (France’s experiment with mandated work week reductions is the most glaring example).

Figure 3 shows productivity growth. Recall that the sum of growth of the employment rate plus growth of productivity equals total per capita GDP growth. Japan, Italy and France had the best productivity growth—these are all nations that had no employment growth. Note that the US is at the bottom here. In the US our employment rate grows fairly strongly (for a number of reasons: population growth, immigration, and women entering the labor force) but given low growth of GDP, our productivity suffers. Figure 4 shows that our growth is just about evenly divided between employment growth and productivity growth.

These two figures shed light on a three-decades long controversy over productivity growth in the US. All during the 1970s and 1980s there was this hysteria about low productivity growth that was supposed to be the cause of low GDP growth. This is a supply side argument and led to all the policy measures, like tax cuts for the rich and other schemes to raise saving, to try to stimulate productivity through induced investment. In fact, the low productivity falls out of an identity; if the US grows at only 3% and if our employment rate grows at 2% it is mathematically impossible for productivity to grow at anything other than 1%.

Figure 5 shows a hypothetical trade-off for the US, Europe and Japan. In other words, for the US to have productivity growth as high as that of Japan or Europe—or as high as we had during the so-called new economy boom under Clinton–we must grow above 4 or 5% per year. This is something we rarely achieve for very long—for reasons I’ll get to in a second. During the Clinton boom there was all this nonsense about information technology that had suddenly made it possible to grow at such rates precisely because productivity was supposed to be able to grow fast. In reality, the fast growth of the Clinton years could have been achieved at any time, if only demand had been that robust.

That brings me to my second main point—the leakages that constrain demand, resulting in chronic underperformance. We can think of the economy as being composed of 3 sectors: a domestic private sector, a government sector, and a foreign sector. If one of these spends more than its income, at least one of the others must spend less than its income because for the economy as a whole, total spending must equal total receipts or income. So while there is no reason why any one sector has to run a balanced budget, the system as a whole must. In practice, the private sector traditionally runs a surplus—spending less than its income. This is how it accumulates net financial wealth. For the US this has averaged about 2-3% of GDP, but it does vary considerably over the cycle. That is a leakage that must be matched by an injection.

Before Reagan we essentially had a balanced foreign sector—we ran trade surpluses or deficits, but they were small. After Reagan, we ran growing trade deficits, so that today they run about 5% of GDP. That is another leakage.

Finally, our government sector taken as a whole almost always runs a budget deficit. This has reached to around 5% under Reagan and both Bushes. That is the injection that offsets the private and foreign sector leakages. With a traditional private sector surplus of 3% and a more or less balanced trade account, the “normal” budget deficit needed to be about 3% during the early Reagan years. In robust expansions, before the Clinton years, the domestic private sector occasionally ran small and short lived deficits—an injection that allowed a trade deficit to open up, and reduced the government budget deficit. See Figure 6.

Until the Clinton expansion, the private deficits never exceeded about 1% of GDP and never lasted more than 18 months. However, since 1996 the private sector has been in deficit every year, and that deficit climbed to more than 6% of GDP at the peak of the boom. This actually drove the budget into surplus of about 2.5% of GDP. With the trade deficit at about 4% of GDP, the private sector deficit was the sum of those—almost 6.5%. While everyone thought the Clinton budget surplus was a great achievement, they never realized that by identity it meant that the private sector had to spend more than its income, so that rather than accumulating financial wealth it was running up debt.

Let me link this back to the leakages discussed by Powers. The trade deficit represents a leakage of demand from the US economy to foreign production. There is nothing necessarily bad about this, so long as we have another source of demand for US output, such as a federal budget that is biased to run an equal and offsetting deficit. Private sector net saving (that is, running a surplus) is also a leakage. As discussed above, that was typically 2-3% in the past. If we add in the trade deficit that we have today (5% of GDP), that gives us a total “normal” leakage out of aggregate demand of 7 or 8%–about equal to the estimates of Powers.

This leakage has to be made up by an injection from the third sector, the government. The only way to sustain a leakage of 7-8% is for the overall government to run a deficit of that size. Since state and local governments have to balance their budgets, and on average actually run surpluses, it is up to the federal government to run deficits. The federal budget deficit is largely non-discretionary over a business cycle, and at least over the shorter run we can take the trade balance as also outside the scope of policy.

The driving force of the cycle, then, is the private sector leakages. When the private sector has a strong desire to save, it tries to reduce its spending below its income. Domestic firms cut production, and imports might fall too. The economy cycles downward into a recession as demand falls and unemployment rises. Tax revenues fall and some kinds of social spending (such as unemployment compensation) rise. The budget deficit increases more-or-less automatically. That is where we are today, with Bush budget deficits rising to 5% of GDP and, soon, beyond. They will probably need to reach 8% before we get a sustained recovery.

In sum, we experienced something highly unusual during the Clinton expansion because the private sector was willing to spend far more than its income; the normal private sector leakages turned into very large injections. The economy grew quickly and tax revenues literally exploded. State governments and the federal government experienced record surpluses. These surpluses represented a leakage that brought the expansion to a relatively sudden halt. What we have now is a federal budget that is biased to run surpluses except when growth is very far below potential. This means is that the “normal” private sector balance now must be a large deficit in order for the economy to grow robustly.

Rather than the government sector being a source of injections that allow the leakages that represent private sector savings, we now have the private sector dissaving in order to allow the foreign and government sector leakages. This sets up a highly unstable situation because private debt ratios rise quickly and a greater percentage of income goes to service those debts. While I said at the beginning that Fed policy normally doesn’t matter much, in a highly indebted economy, rising interest rates can increase debt problems very quickly—setting off bankruptcies that can snowball into a 1930s-style debt deflation. A far more sensible policy would be to reverse course and lower interest rates, then keep them low.

At the same time, the federal government should take advantage of slack demand and abundant labor by increasing its spending on domestic programs. Robust economic growth fueled by federal deficits is the best way to reduce over-indebtedness. It is hard to say what to do (if anything) about euphoric stock or real estate markets that could be stoked by renewed growth. But the Fed’s sledgehammer approach of jacking up interest rates does not work. We will probably need selective credit controls to constrain financial speculation, if such is desired.

In conclusion, I agree with Powers that growth in the postwar period has mostly been demand constrained, due to leakages. If demand were to grow at 7% or even 10% on a sustained basis, I see no reason to believe that supply could not keep pace. This is all the more true in today’s global economy with massive quantities of underutilized resources all over the world, and with the rest of the world desires to accumulate dollar-denominated financial assets. This requires that they sell output to the US—which is just the counterpart to our trade deficit leakage. In real terms, a trade deficit means we can enjoy higher living standards without placing pressure on our own nation’s productive capacity. While it is hard to project maximum sustainable growth rates, there can be little doubt that our economy chronically operates far below feasible rates. The best policy would be to push up demand, allow growth rates to rise, and try to test those frontiers.

Reference:

Treval C. Powers, Leakage: The bleeding of the American economy, Benchmark Publications, Inc, New Canaan, Connecticut, 1996.

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Social Security: Another Case of Innocent Fraud?

Posted on August 5, 2009 by | 1 comment
By Warren Mosler* and Mathew Forstater**

In his recent book, The Economics of Innocent Fraud, John Kenneth Galbraith surveys a number of false beliefs that are being perpetuated among the American people about how our society operates: innocent (and sometimes not-so-innocent) frauds. There is perhaps no greater fraud being committed presently—and none in which the stakes are so high—as the fraud being perpetrated regarding government insolvency and Social Security. President Bush uses the word “bankruptcy” continuously. And the opposition agrees there is a solvency issue, questioning only what to do about it.

Fortunately, there is a powerful voice on our side that takes exception to the notion of government insolvency, and that is none other than the Chairman of the Federal Reserve. The following is from a transcript of a recent interview with Fed Chairman Alan Greenspan:

RYAN… do you believe that personal retirement accounts can help us achieve solvency for the system and make those future retiree benefits more secure?

GREENSPAN: Well, I wouldn’t say that the pay-as-you-go benefits are insecure, in the sense that there’s nothing to prevent the federal government from creating as much money as it wants and paying it to somebody. The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase. (emphasis added)

For a long time we have been saying there is no solvency issue (see C-FEPS Policy Note 99/02 and the other papers cited in the bibliography at the end of this report). Now with the support of the Fed Chairman, maybe we can gain some traction.

Let us briefly review, operationally, government spending and taxing. When government spends it credits member bank accounts. For example, imagine you turn on your computer, log in to your bank account, and see a balance of $1,000 while waiting for your $1,000 Social Security payment to hit. Suddenly the $1,000 changes to $2,000. What did the government do to make that payment? It did not hammer a gold coin into a wire connected to your account. It did not somehow take someone’s taxes and give them to you. All it did was change a number on a computer screen. This process is operationally independent of, and not operationally constrained by, tax collections or borrowing.

That is what Chairman Greenspan was telling us: constraints on government payment can only be self-imposed.

And what happens when government taxes? If your computer showed a $2,000 balance, and you sent a check for $1,000 to the government for your tax payment, your balance would soon change to $1,000. That is all—the government changed your number downward. It did not “get” anything from you. Nothing jumped out of the government computer into a box to be spent later. Yes, they “account” for it by putting information in an account they may call a “trust fund,” but this is “accounting”—after the fact record-keeping—and has no operational impact on government’s ability to later credit any account (i.e., spend!).

Ever wonder what happens if you pay your taxes in actual cash? The government shreds it. What if you lend to the government via buying its bonds with actual cash? Yes, the government shreds the cash. Obviously, the government doesn’t actually need your “funds” per se for further operational purpose.

Put another way, Congress ALWAYS can decide to make Social Security payments, previous taxing or spending not withstanding, and, operationally, the Fed can ALWAYS process whatever payments Congress makes. This process is not revenue constrained. Operationally, collecting taxes or borrowing has no operational connection to spending. Solvency is not an issue. Involuntary government bankruptcy has no application whatsoever! Yet “everyone” agrees—in all innocence—that there is a solvency problem, and that it is just a matter of when. Everyone, that is, except us and Chairman Greenspan, and hopefully now you, the reader, as well!

So if solvency is a non-issue, what are the issues? Inflation, for one. Perhaps future spending will drive up future prices. Fine! How much? What are the projections? No one has even attempted this exercise. Well, it is about time they did, so decisions can be made on the relevant facts.

The other issue is how much GDP we want seniors to consume. If we want them to consume more, we can award them larger checks, and vice versa. And we can do this in any year. Yes, it is that simple. It is purely a political question and not one of “finance.”

If we do want seniors to participate in the future profitability of corporate America, one option (currently not on the table) is to simply index their future Social Security checks to the stock market or any other indicator we select—such as worker productivity or inflation, whatever that might mean.

Remember, the government imposes a 30% corporate income tax, which is at least as good as owning 30% of all the equity, and has at least that same present value. If the government wants to take a larger or smaller bite from corporate profits, all it has to do is alter that tax—it has the direct pipe. After all, equity is nothing more than a share of corporate profits. Indexation would give the same results as private accounts, without all the transactional expense and disruption.

Now on to the alleged “deficit issue” of the private accounts plan. The answer first—it’s a non-issue. Note that the obligation to pay Social Security benefits is functionally very much the same as having a government bond outstanding—it is a government promise to make future payments. So when the plan is enacted the reduction of future government payments is substantially “offset” by future government payments via the new bonds issued. And the funds to buy those new bonds come (indirectly) from the reductions in the Social Security tax payments—to the penny. The process is circular. Think of it this way. You get a $100 reduction of your Social Security tax payment. You buy $100 of equities. The person who sold the equities to you has your $100 and buys the new government bonds. The government has new bonds outstanding to him or her, but reduced Social Security obligations to you with a present value of about $100. Bottom line: not much has changed. One person has used his or her $100 Social Security tax savings to buy equities and has given up about $100 worth of future Social Security benefits (some might argue how much more or less than $100 is given up, but the point remains). The other person sold the equity and used that $100 to buy the new government bonds. Again, very little has changed at the macro level. Close analysis of the “pieces” reveals this program is nothing but a “wheel spin.”

Never has so much been said by so many about a non-issue. It is a clear case of “innocent fraud.” And what has been left out? Back to Chairman Greenspan’s interview—what are we doing about increasing future output? Certainly nothing in the proposed private account plan. So if we are going to take real action, that is the area of attack. Make sure we do what we can to make the real investments necessary for tomorrow’s needs, and the first place to start for very long term real gains is education. Our kids will need the smarts when the time comes to deal with the problems at hand.

Bibliography

Galbraith, John Kenneth, 2004, The Economics of Innocent Fraud: Truth for Our Time, Boston: Houghton Mifflin.

Wray, L. Randall, 1999, “Subway Tokens and Social Security,” C-FEPS Policy Note 99/02, Kansas City, MO: Center for Full Employment and Price Stability, January, (http://www.cfeps.org/pubs/pn/pn9902.html).

Wray, L. Randall, 2000, “Social Security: Long-Term Financing and Reform,” C-FEPS Working Paper No. 11, Kansas City, MO: Center for Full Employment and Price Stability, August, (http://www.cfeps.org/pubs/wp/wp11.html).

Wray, L. Randall and Stephanie Bell, 2000, “Financial Aspects of the Social Security ‘Problem’,” C-FEPS Working Paper No. 5, Kansas City, MO: Center for Full Employment and Price Stability, January, (http://www.cfeps.org/pubs/wp/wp5.html).

——————————————————————————–

[*] Associate Fellow, Cambridge University Centre for Economic and Public Policy;
Distinguished Research Associate, Center for Full Employment and Price Stability

[**] Associate Professor and Director, Center for Full Employment and Price Stability, University of Missouri-Kansas City

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