Sumner engages the crystal ball

Marcus Nunes brings up an old Sumner post. Old Sumner (from 27 May 2009) says interest rates a few years in the future will be either still near zero, or else they will have gone up to maybe 3.75%. Sumner says:

If I looked into the ball and saw 0.25% fed funds rates in 2011, I would have a sickening feeling—like I’d been punched in the solar plexus. Krugman would be right, we’d be another Japan.

In contrast a 3.75% fed funds rate would put a big smile on my face, as it would indicate nominal GDP growth had bounced back strongly. It would have been a V-shaped recovery.

In my view, promising year after year of near zero rates is like promising year after year of sub-par nominal growth.

I get his point. Policy is promising to keep rates low until economic pressures indicate that higher rates are called for. So if rates are still low in the future, it means higher rates are not needed. Sumner would rather they print even more money than they are printing, enough to push nominal GDP up enough that the economic pressures indicate higher rates are called for. Something like that.

Okay? Now, a question: What are the economic pressures that indicate higher interest rates are called for?

Inflation. That's it, really. People borrowing too much and spending too much, creating upward pressures on prices, leading to inflation.

Oh, and since we know that "inflation is always and everywhere a monetary phenomenon", we know that it was all the money created by all the borrowing that allowed all the spending, that caused the upward pressure on prices. We know that much.

Okay, and our plan is to push interest rates up enough to make people borrow a little less, so that there is less upward pressure on prices. That's the plan. Milton Friedman's plan, and Scott Sumner's plan, and maybe Bill Mitchell's plan.

But look what happened in the time between the zero rates and the 3.75% rates: Spending picked up. Spending picked up because the quantity of money increased, because of the growth of lending. So there is more money in the economy, more credit-money, the money created by lending. And there is more interest cost in the economy because of this increased lending.

By the time policymakers notice inflation is picking up, there is already too much of that money in the economy. Must be, right? I mean, if there is already inflation.

So what the policymakers do then is, they slow the further increase of money by raising interest rates. Or, in Bill Mitchell's case, by raising taxes. Now that's interesting, because Mitchell actually takes some money out of the private economy. (Presumably, the government sits on it instead of spending it, so the money stays out of the economy until inflation abates.)

But the other guys don't take money out of the economy. They leave all the money in the economy, even though it was causing inflation, and they raise interest rates. So they don't fix the problem that was making prices go up. Instead they aggravate the problem by increasing the cost of borrowing.

And if they don't do things exactly right, if they slow the growth of money a bit too much, then they create a recession. A "hard landing". We still have our increased interest costs to deal with, and we still have our increased debt to repay. But now we have fewer jobs and fewer people working.

If we do it Mitchell's way, taxing more instead of raising interest rates, then we have less money. But we still have our increased interest costs to deal with, and we still have our increased debt to repay. Mitchell slows growth, too. And he would have to raise interest rates, or people would just borrow the money they need.

I have a different way to fight inflation. I want to fight inflation by getting people to pay back the money they borrowed, faster. My plan is to accelerate the repayment of debt. If we do it my way, we don't aggravate the problem by raising interest rates. If we do it my way we address the problem directly, by reducing the quantity of money created by lending. So we no longer have our increased debt to repay, because we repaid it as a way to fight inflation.

We also reduce the interest we have to pay, which helps to lower costs. But we don't raise interest rates, so we don't choke off new borrowing and we don't kill off growth.

The Last Catfish

On Sunday I wrote

Salmon's view is that for GDP to keep growing on the path established by Potential GDP, total debt has to keep rising like [it] was rising before the Great Recession. But that is only true if we insist on using credit for growth -- or, really, for everything. And that is a plan which cannot succeed.

We need a better plan.

Sometimes we start out using credit for growth, and end up using credit for everything. That's what happened between 1947 and 2007.

Using credit for everything costs too much. That's how we got in trouble.

All told, before the Great Recession we had about $3.50 of debt for every dollar's worth of GDP. In a good year we might get 5% GDP growth, five cents on the dollar. So we had $3.50 of debt for every 5 cents of economic growth.

$3.50 credit-in-use for every 5 cents of growth. Obviously we were not using credit only for growth. We were using credit for everything. That's how we got in trouble.


Using credit for growth works well when the accumulation of debt is not large. It works less and less well as the accumulation grows. Ultimately, the accumulation of debt grows so large that the economy can no longer function normally. That's when people start noticing there is a problem.

By that point, of course, we're not just using credit for growth. We're using credit for everything.

All we need is to pay off debt a little faster -- a little faster than we have in the past. This is accelerated repayment of debt, and it will reduce total debt, reduce the cost of that debt, and reduce the economy's inflationary urge besides.

The money created by taking on debt is destroyed when debt is repaid. Repayment of debt is deflationary. We could use it to fight inflation, if we need to. That's what we should have done in the 1970s.

If people are paying down debt faster, we might be creating a deflationary trend. We would want to adjust for that possibility, to keep prices stable. This is where the Fed comes in. The Fed can monetize some government debt, to put money enough into circulation to keep prices stable.

When the economy grows, we need more money. Not more credit. So we use credit for growth, and the economy grows, and we pay down our debt, and the Federal Reserve increases the quantity of money to compensate. That way, we don't have to use credit for everything.

It's not complicated. The confusion arises because people think printing money causes inflation. People think the Fed causes inflation. But private credit use is the culprit.

So here is the plan: We use credit for growth, just as always, but then we pay off our debt a little faster, and the Fed compensates for that by monetizing enough to keep the quantity of money growing in proportion to the economy.

The next year, the economy is N% bigger, the quantity of circulating money is N% bigger, and total debt is N% bigger or less.

In our case the debt number must be less, until balance is restored to our money.


So the plan is to use credit for growth, and then stop using that credit by paying off the debt. This will keep private debt small -- something we all seem to want for ourselves -- and it will keep private credit creation from interfering with Federal Reserve policy decisions regarding the appropriate quantity of money. The Fed will be better able to control inflation.

The use of credit does us a great service: It allows the real economy to expand. But once the economy has grown, the credit that drove it does us no good. It remains only as the cost of accumulating debt. The plan is to limit that accumulation so it does no harm.

To do it, we must pay down private debt. But paying down debt puts downward pressure on prices. So the Fed must step in to keep prices stable.

Later, when we've worked down the accumulation of debt to a low level, we might even think about restoring the value of the dollar by allowing some of that deflation to occur.


Accelerated repayment of debt is the key. But it won't happen by itself. We need incentives to make it happen. Tax incentives.

Right now we have the tax deduction for mortgage interest paid. People think of it as something that helps us afford to buy a home. And it is. But it also encourages the accumulation of debt.

Congress apparently keeps getting closer to eliminating the tax deduction for mortgage interest. They should have done that in the 1960s when the economy was still good. But no, they want to do it now, after the financial crisis, when the world has fallen apart.

It's bound to happen sooner or later. And we should give it up, you know, because it contributes to the accumulation of debt. But we shouldn't give it up easily. We should demand something in exchange.

We should expect Congress to replace the tax deduction for interest paid, replace it with a tax credit to help us make extra payments on our debts. We could get exactly the same dollar-value of benefit that we get from the mortgage interest tax deduction, or more. But the effect of the new policy would be to help us pay down our debt, instead of helping us accumulate more.

A Scenario for Mark

Over at Illusion of Prosperity, Stagflationary Mark looks at Real Total Debt vs Real GDP.

Mark's graph shows the ups and downs of inflation-adjusted GDP growth (in red) and the ups and downs of inflation-adjusted Total Debt growth (in black).

The ups and downs match. It a darn good fit... except for one thing: Mark's graph shows debt growth stable while GDP growth declines. The "good fit" nests tightly at the start, but by the end there are big gaps caused by the decline of GDP growth.

Mark writes:

I'm not sure where I stand on the black [debt growth] trend line. It is unsustainable. Should it actually fall at some point then I would expect the red [GDP growth] trend line to fall even more though. (It is the trend in the black line that is propping up the trend in the red line.)

I do not see a scenario where the red trend line rises over the long-term.

I thought this a clear and accurate statement: "It is the trend in the black line that is propping up the trend in the red line." It is debt growth that is propping up GDP growth.

And I sympathize with Mark's assessment. Given the history the graph shows, it doesn't look like we should expect a long-term improvement in GDP growth. But then, how could we? We use debt growth to "prop up" GDP growth, and we just can't afford to do that anymore.


Troy commented on Mark's post:

But as Commander Mark opined, it's the debt take-on that's giving us much of this GDP in the first place.

I don't really know where we go from here.

I don't understand the mid-90s turnaround so I don't understand the economy all that well -- whatever kicked in in the mid-90s may or may not kick in now.

"It's the debt take-on that's giving us much of this GDP in the first place." Yep. We use debt for growth.


If we use debt for growth, and we're not growing, then why do we have all this debt?

Oh, yes. We're not adding to the debt, now, and we're not growing now. The debt is all left-over from when we were growing, before.

That's right. When we're growing, expanding the economy, we need to expand the money supply also. That's why we use credit for growth. And that's where all the debt came from.

But here's the thing. Say we use credit for growth, and as a result we grow. So then if we were going to stay at that new, larger size, we would need a larger quantity of money. We would need a quantity of money more or less equal to the old quantity of money plus the credit we used to get that growth.

So it would be okay -- not inflationary, I mean -- to monetize that debt. Or, to just print that much money and put it into circulation, as long as the debt from that credit-use was paid back at the same time.

If we did that, we would be as we were before, only with a bigger economy. The GDP would be bigger, and the quantity of money would be bigger in proportion, and the debt we created by using that credit would be gone. So there would be no increase of debt to hold the economy down. And enough money to keep the economy going.

And then we could do it again, and grow more.

But we do not do that. Policy does not do that. Policy does not allow the quantity of money to grow in proportion to GDP:

Graph #1: The quantity of spending-money per dollar of GDP

When policymakers want to fight inflation -- which, until the recent crisis, was always -- they restrict the quantity of money in circulation.

But you know what? Back in the early 1960s, when we had about 24 or 25 cents of spending-money for every dollar's worth of GDP, inflation was only about one percent per year.

Today -- at the very right end of the blue line -- we have about half as much: about 13 cents per dollar's worth of GDP. So, basically, it's twice as hard to get by these days.

And this 13 cents, this is well after all that Quantitative Easing. Before QE, we had only like ten cents of spending-money for every dollar's worth of GDP. Because they thought they were fighting inflation.

But you can tell from a glance at Graph #1 that increases in the quantity of spending-money cannot possibly be the cause of inflation. No. It was all that credit we used, that caused the inflation. All that credit, as measured by Total Debt:

Graph #2: Spending-Money and Credit-Use per dollar of GDP

It was credit-use that caused inflation. Not the quantity of money in circulation. And the reason? Policymakers restricted the quantity of money to fight inflation, but encouraged credit-use to make the economy grow.

Policymakers forgot that the debt created by credit-use should be paid off. And they forgot that the quantity of money in circulation should be allowed to grow along with the economy. I guess, they forgot.

If they had not forgot those things, we would have more money and less debt today. And the economy might not be growing like gangbusters, but at least growth would not be held down by the shortage of money and the burden of debt. At least growth would not be held down by a policy-induced imbalance.

And there would be no problem with unsustainable black trend lines. And it would be possible for the red trend line to rise over the long-term. And we would use money to sustain the existing level of economic activity. And we would use credit for growth. Only for growth.


To tie up a loose end...

Troy said, "I don't understand the mid-90s turnaround..."

The trouble we have today is too much debt. Too much debt, because we used credit faster than we paid it off, so debt accumulated. Too much debt means too much use of credit. The trouble we have today is too much credit in use, and not enough spending-money. The trouble is an imbalance between money and debt.

Graph #3: Debt per Dollar, 1916-2009

We had the same trouble before. In the years leading up to the Great Depression, we accumulated more and more debt, relative to the quantity of spending-money. It caused the Great Depression. And after the DPD ratio fell (1933-1946) the economy started upon its so-called "golden age" growth.

And you know what else? See that wiggle there in the early 1990s? The DPD ratio fell from 1990 to 1993. And immediately after that we had "macroeconomic miracle" growth.

Unfortunately, neither time did we learn that we must restrain the growth of credit-use. So we ended up with another Depression. And what do policymakers want now? They want to get credit-use growing again.

It's the wrong plan. We need to restrict credit-use. We can create tax-incentives for accelerated repayment of debt. We can use accelerated repayment of debt to fight inflation. And we can let the quantity of money grow in proportion to GDP.

That's the long-term plan. But we also have to fix the crisis. The problem is debt. Excessive debt. So, print money and use it to pay off debt. Paying off debt destroys debt. It also destroys the money used to pay the debt. So if we print money and use it to pay off debt, the debt is destroyed, and the money is destroyed, and we do not cause inflation.

That's the plan.

Infinite Diversity in Infinite Combinations

Krugman writes:

The eurozone looks like the United States — there is no good reason to raise rates. To be fair, on the labor side things look a bit different: there are actual labor shortages in some parts of Europe, reflecting both low labor mobility and the extreme asymmetry of the European shock. But raising rates for all of Europe because parts of Germany are doing well is, as I’ve written before, worse than the one-size-fits-all policy euroskeptics warned about; it’s one size fits one.

Mmmm...

The 'one size fits one' link brings up a graph that shows Germany doing far better than Spain with respect to employment. Krugman's point seems to be that we need different policies for different conditions, even if those conditions occur at the same time.

Well, they could break up the European Union. As an American I rather like that approach. Why should anybody else in the world be as big as the U.S.A.?

But I have a better way to solve the problem. Below is an excerpt from mine of 23 July '09. What it says is we should stop jacking up interest rates to fight inflation. It says we should remember that the money that causes inflation is created by borrowing.

It says we should fight inflation by un-doing the thing that creates inflation: by paying off the debt that results from the borrowing that creates the money that causes prices to increase.

It says the biggest borrowers should pay the highest rate of taxes. It says the tax rate should come down if the borrower accelerates repayment of the loan.

It is a plan to reduce debt by fighting inflation and to fight inflation by reducing debt.

It is the sort of solution that Krugman is looking for but has not found.

From my old post:

I'm not big on making proposals. My interest is to understand the past or, rather, to understand the process. If we understand *how* the economy works, solutions will present themselves. However...

#1. The use of credit adds to the quantity of money in circulation. Therefore, the repayment of debt is a way to fight inflation. I would set up tax incentives to encourage people (and businesses) to pay off their debt a little faster than we have done since the 1970s say. Accelerated repayment of debt would fight inflation and reduce debt at the same time. Sweet.

#2. Taking that a step further, I would change the income tax. (I'm not talking about the LEVEL of taxation, but the EFFECT of it.) When a person (or business) borrows, his/her debt-to-income ratio increases. I would make the TAX RATE vary with the debt-to-income ratio. Your tax rate would become variable, like the rate of interest. And at a comparable percentage as well, I imagine. You could reduce your taxes by reducing your debt!

#3. The variable rate of taxation would *replace* the variable rate of interest in our economy. And the Federal Reserve would therefore be able to keep interest rates permanently low. This would be beneficial for economic growth.

#4. In the long view, I foresee that the "credit cycle" would become a thing of the past. Indeed, everyone would have his own credit cycle. But the economy as a whole would see no cyclic pattern. Thus, the major force that drives the business cycle would be eliminated. Economic growth would be driven by low interest rates and other factors, but there would never be an accumulation of debt that leads to recession or depression. Long view, of course.

Assessment

From Sunday:

Graph #3: The Monetary Base relative to Actual-Price Output

Graph #3 shows a remarkable decline in the quantity of money from the end of World War II until about 1981. Then a persistent, gradual increase lasting until just after the year 2000. Then a brief decline, followed by the Bernanke spike. That spike, however, does not this time appear to increase the quantity of money to a dangerous and unprecedented level. It only restores the quantity of money to the level it was starting from, at the end of World War II.

We came out of World War II with too much money. The evidence is not in the graph above, but rather in the wartime and post-war inflation we experienced.

A combination of rising prices and anti-inflation policy helped reduce the quantity of money relative to Actual-Price Output.

By 1960 inflation was almost non-existent. Soon, however, it started coming back.

In my view, after 1960 the quantity of money was insufficient. In my view, after 1960 the increasing use of credit was more and more responsible for inflation.

But policymakers continued to reduce the quantity of money until 1981. By that time, we didn't have enough money to have a vibrant economy. And by that time, the cost of credit-use was the major force behind inflation.


So the Sunday graph, at the top of this page... The quantity of money is back up where it was at the end of World War II. At that time, it was enough to cause inflation. So it is probably enough to cause inflation now. But there is more to the story.

Back at the end of WWII we had financial technology that could turn a dollar of base-money into 12 dollars of debt.

Today we have the financial technology that can turn a dollar of base-money into $60 of debt. Five times as much. So there is the chance that inflation can be five times worse now, as compared to the inflation we had in the years after World War II.

To prevent it, we need economic policies that encourage accelerated repayment of debt and policies that limit our exploitation of the financial technology.

Geanakoplos and the Can of Worms

Peter Schiff writes:

The government has been subsidizing housing since the Roosevelt administration, and we never had a bubble of this proportion. It was not until these guarantees were combined with a 1% federal funds rate that they became supercharged.

Schiff says the low interest rate causes problems. I think he's right. But I know the low rate is a policy intended to solve a problem. So the picture is not as simple as Schiff seems at first to suggest. But then he says:

The reality is that no one wants to blame the crisis on loose monetary policy because monetary policy is even looser now then it was [sic] then. If the commission had correctly blamed the housing bubble on easy money, then it would have called into question current Fed policy. Given the fragility of our economy and its continued dependence on low rates, no one has the guts to open that can of worms.

It could have been a good thing to call current Fed policy into question. If the commission was able to recognize not only that low rates create a problem, but also that there was a different problem that low rates were intended to solve, it could have put emphasis on that pre-existing problem.

A "can of worms" indeed. Peter Schiff clearly recognizes that the economy remains fragile and dependent on low interest rates. At the same time, he says low interest rates are "the primary factor behind the financial crash of 2008."

This low-interest-rate policy causes a problem the way U.S. fire-suppression policy did: A policy of prevention of small forest fires led to less frequent, more severe large fires. A policy of keeping interest rates low to prevent recession leads to bubble, panic, and severe recession.

But the economy is not a forest. An analogy to fire-suppression policy is not evidence that a policy of not preventing recessions would have beneficial effects comparable to the policy of not preventing small forest fires. Peter Schiff, however, seems to think the analogy applies:

We simply need to return to a sound monetary policy...

Jack rates up, he suggests, and everything will be fine. I don't agree. I think you jack up rates, and you make the pre-existing problem worse. Jacking up rates is like testing fragility with a hammer. As Schiff himself points out, our economy exhibits "continued dependence on low rates."

A Long-Term Problem

"Neither Democrats nor Republicans want the Fed to turn off the monetary spigots," Schiff writes, "for fear of the short-term shock."

The short-term shock. Schiff suggests that a sound monetary policy may make the economy hesitate briefly, but then everything will be fine. This is the difference between me and Peter Schiff. I think there is an underlying, long-term problem that is not addressed by his plan.

The short-term shock. The small forest fire. The minor crisis. It's a nice, symmetrical argument. But economic analysis does not depend upon symmetry of presentation. It depends on an understanding of the interaction of economic forces.

Our need for low interest rates did not arise from the financial crisis.

GRAPH #1

The need for low interest rates arose in response to a more fundamental problem, a pre-existing, long-term problem that Schiff does not discuss. And as a glance at Graph #1 will show, we have evidently needed lower rates for a long time -- since Paul Volcker decided it was time to ease, early in Reagan's first term.

The Growth of Debt

Schiff does not discuss the obvious consequences of easy money -- the increase in credit-use and the increase of accumulated debt. Rather, he sees the low-rate solution itself as the problem. This is circular analysis, for clearly there was a pre-existing problem, to which low rates were applied as a solution. That original problem, which came before the low interest rates, cannot have been caused by low rates.

Nonetheless, low rates surely do contribute to our problems. Low rates make the accumulation of debt bigger, faster than high rates.

The original problem, which we find already in the late 1960s, was an excessive accumulation of debt. In order to prevent the cost of this debt from crippling economic growth, policymakers found it constantly necessary to accelerate the increase in the quantity of money. That led to inflation.

In the 1960s we said the inflation was the result of "guns and butter" spending and the Viet Nam war. In the 1970s, the policy led to higher and higher rates of inflation, along with higher and higher interest rates. When the war ended and inflation did not, we at last understood that there was an economic problem. Then with Reaganomics in the 1980s came the trend of falling interest rates, as Graph #1 shows.

GRAPH #2

Surprising as it may be, the easy-credit policies in place since the 1980s did not cause accumulation of debt to increase noticeably faster than it did in the 1950s and '60s and '70s. The accumulation of debt continued at a remarkably constant rate, as shown by the straight-line trend of Graph #2.

In the years leading up to 1980, debt increased despite rising interest rates. But in the years since 1980, falling interest rates did not cause debt to grow faster. Our fix for the long-term problem pushed interest rates to lower and lower levels, simply to obtain a growth rate equivalent to the period before 1980.

The Ultimate Bubble

To summarize: Low interest rates lead to an increase in the growth of accumulated debt. But low interest rates were a solution. Policymakers applied low rates to a long-term, pre-existing problem. That problem was the excessive accumulation of debt. Yes, the solution contributed to the problem. But surprisingly, the rate of debt growth did not accelerate. Low interest rates only prevented the decline in debt growth that is a natural result of debt accumulation.

Schiff thinks the blame for the recent crisis should be placed on loose money policy -- for allowing the quantity of money to increase too rapidly, which allowed us to end up with too many mortgages and too-expensive houses. But there was no acceleration of debt growth due to the low rates. And it was the luck of the draw that housing turned out to be the place where the money went, this time around.

We've had one bubble after another, these past three decades. One crisis after another. That's far more significant than the isolated fact that the most recent bubble occurred in housing. The real question is: Why all the bubbles? What makes us bubble-prone? We have to figure this out and fix it before some ultimate bubble does us in for good.

The short answer: Bubbles arise because that's where the profit is.

The problem is that finance has become more profitable than production. So when we get growth, we don't get a burst of production. We get a bubble in the profitable sector, in finance, some part of finance. This time it was mortgages. We call it housing. It was finance.

Finance is more profitable than production because we use credit for money. No matter what we do there are finance charges, because we use credit for money. And we end up with an economy where Ford makes more money by financing cars than by making cars. Because we use credit for money. It's not good for output. It's not good for income. It's not good for the economy.

All that credit-use creates debt. All that debt has to be maintained. All that maintenance is a cost that holds our economy down.

GRAPH #3

Graph #3 shows the U.S. "capacity utilization" trend since the mid-1960s. Since that time, the high points have come at progressively lower levels. The economy has peaked, or inflation has arisen and the Fed raised rates to fight inflation at progressively lower levels. This is a result of the long-term problem. Accumulating debt is that problem.

There are two exceptionally low peaks in the 1980s that I did not mark with red lines, as they do not fit the down-stepping trend. These two severe lows are associated with the Volcker squeeze.

Those lows are examples of the "short-term shock" that Peter Schiff wants from policy. Graph #3 shows two things about such shocks. First, they are quite severe. Second, they do nothing to change the long-term down-trend of the pre-existing problem.

Accumulation

Albert Einstein's definition of insanity is "doing the same thing over and over again and expecting different results." By that standard, U.S. economic policy is insane.

It is time to stop doing policy the way we've been doing policy for 65 years: We raise interest rates, and we lower them. We raise them, and we lower them. It's insane.

When we lower interest rates, borrowing increases and total debt increases. When we raise interest rates, new borrowing decreases. Total debt does not. It's insane.

This is a "stocks and flows" thing, evidently. The "flow" of new debt stops increasing so quickly; but the "stock" of existing debt remains.

We need a plan to reduce the accumulation of existing private-sector debt. We have no such plan. This is the problem in a nutshell.

The Plan to Reduce Debt

In his Banks as Social Accountants PDF, Dirk Bezemer observes that

Geanakoplos called for an end to ‘the obsession with interest rates’ and asserted that ‘regulating leverage, not interest, are the solution for a troubled economy’.

Yes, absolutely. The problem is not that interest rates are too low, but that the level of accumulated debt is too high. We need to keep interest rates low and we need to reduce the accumulation of debt. Both.

People say we need credit for growth. It's true. But it begs the question: How come we have all this debt, and no growth to show for it?

The answer is, existing debt does not help the economy grow. What we need is new uses of credit. That's what supports growth. We don't need the accumulation of old debt. That's just an impediment to growth.

So what we need is easy money, combined with incentives designed to accelerate the repayment of debt. That's the whole plan, right there. John Geanakoplos called it "regulating leverage." I call it tax incentives to accelerate the repayment of debt. As an added bonus, we get to use the repayment of debt to reduce the quantity of money and fight inflation. If you think about it, this is the right way to fight inflation.

Conclusion

I do not think the lowness of the number is what bothers Peter Schiff about the federal funds rate. I think what bothers him is the consequence of holding that number down -- the growth of debt and the growth of credit-funded economic activity. And this is exactly the problem that is solved by a tax designed to "regulate leverage."

I should add that such a tax need not be a revenue-raiser. I always imagine my tax notions as revenue-neutral. But it could be used to cut taxes.

The great advantage of this policy will be that its effect is in proportion to taxpayer indebtedness. By contrast, the existing policy of raising interest rates affects all borrowers alike, and hinders new growth.

Anyone who likes the idea of raising interest rates at some point in the business cycle should keep an open mind to the notion of using tax incentives to accelerate the repayment of private-sector debt.

The Accelerated Repayment Tax hinders economic activity in proportion to taxpayer indebtedness: Those who have little debt are encouraged to borrow and spend. Those who are heavily in debt are encouraged to reduce their debt.

If we are thinking about eliminating the tax deduction for interest expense, we can replace it with the Accelerated Repayment Tax, and offset the stick with a carrot that helps heavily indebted taxpayers reduce their existing debt.

And we still have the interest rate to use as a policy tool if we need it.

The time to put this tax in place is now -- before interest rates start going up again, again.

What Einstein said.

SEE ALSO  AN ARTHURIAN FUTURE

Debt and Fiat Money

• MENU: How Debt Works
  • Part 1: How Debt Works
  • Part 2: Debt and Policy
  • Part 3: Debt and Fiat Money

In Part One of this series (see menu) I said that credit-use boosts the economy, but also creates debt, and that this debt

creates an "equal and opposite" drag on the economy, which must eventually balance out against the boost resulting from credit-use.

One could ask: So if there's no real gain from the use of credit, why bother?

Well... If there is inflation -- or deflation -- things don't work out exactly equal, because the dollars are not equal. That's the reason inflation is sometimes used to help solve debt problems. Inflation lets us pay off debt in cheaper dollars. So there's a "gain" to be had that way. But it's cheating.

Inflation is not a solution. It has been used as a "fix" for the debt problem, but it's not a solution. Still, it does tell us there are ways around the "no gain" problem.

We just need to find a better way.


"Why bother?" The objection raised by this question is that credit-use increases growth, but repayment of debt reduces growth -- "equally" -- so there is no net gain. This objection considers only the accounting of things, not the work that gets done. The objection ignores output.

Credit-use increases output. The increased output justifies expansion of the money supply. And increased economic activity requires such expansion.

Having achieved greater size, the economy demands a greater quantity of money.

If the debt arising from the credit-use is repaid (and if there is no other change in the quantity of money) there will be a decrease in economic activity, and a decrease in economic growth, or outright recession. This is the "equal and opposite" thing.

Up to now, it has been policy to allow debt to accumulate, in order to avoid the "equal and opposite" decline. This policy cannot be allowed to continue. The repayment of private-sector debt must be accelerated. It is the only way to prevent financial crisis.

But as debt is repaid, the quantity of money'n'credit in circulation decreases. And we must not allow that decrease to happen, as it undermines the advantage of credit-use.

As debt is repaid, the monetary authority must allow the increase of non-credit money enough to keep "money'n'credit relative to output" essentially stable. In other words, if a binge of credit-use helps our economy grow by five percent, it should be our goal to pay off the resulting debt and at the same time increase the quantity of non-credit money by five percent.^[1]

The government money must increase, replacing the credit-money that is destroyed by accelerated repayment of debt. That such an arrangement is even possible is the magnificent advantage of the fiat money system.


NOTES:

1. Milton Friedman made a similar suggestion to keep the quantity of money growing in proportion to output. But as I point out elsewhere, Friedman overlooked the significance of the difference between money and credit, and considered money in savings equivalent to money in circulation. [Return]

Re-thinking Policy

The only way to fix the economy is to get rid of some debt -- a lot of debt, actually. But remember, it is private-sector debt that holds our economy down. Not public debt. So it is private-sector debt that must be reduced.

When at last we do that, if ever we do, the economy will grow like gangbusters again. With 30 years' of growth incentives in place? There'll be no way to stop the growth!

But when we finally get the economy growing again, we have to do things differently. We have to fight inflation differently. We can no longer expect the Fed to restrict the quantity of money, and curse them when they don't, and curse them when they do.

We must demand from the Fed a quantity of money adequate to support the existing level of economic activity. This will be a much greater quantity than we had, at least greater than we had before the Quantitative Easings.

We must demand from policy that it encourage credit-use for growth, but not for everything. We must expect the Fed to provide sufficient money to support the existing economy, and Congress must understand that credit is only for growth.

And we must invent a policy that uses accelerated repayment of debt to draw money out of circulation when we need to fight inflation, which is always.

The point of these changes is to get monetary stumbling-blocks out of the economy's way, so the economy will perform as we know it can.

Reduction (3)

From this morning's post:

The problem is not that we have inflation. The problem is not that economic growth is weak. The problem is that we need an inflationary increase in the money in order to get decent growth. Since we have chosen to keep inflation at a low level, we are limited to a low level of economic growth. This problem cannot be solved by thinking of inflation and growth as two separate problems.

The solution we applied since the 1980s included a great increase our reliance on credit, as evidenced by the growth of public and private debt.

The great irony is, the cost of existing debt was the source of the problem in the first place. Our solution only made the problem worse.

The great mistake is, we failed to use accelerated repayment of debt to fight inflation.

Tradeoff

Suppose we eliminate the tax deduction for interest expense. Yeah, I know: Most of that deduction was eliminated back in 1990-91. But now, suppose we eliminate the rest of it. All of it. Gone.

That would be hard on a lot of people. I expect it would be good for the economy, after a few years maybe. But it would be hard.

So I propose a trade-off: Eliminate the tax deduction for interest expense, and replace it with a tax deduction for accelerated repayment of debt. That way, taxpayers break even, and we do good things for the economy.

Or set up the tax deduction for accelerated repayment of debt as an option. Give taxpayers the choice: Either take the existing deduction for interest expense, or take the new deduction for accelerated repayment of debt.

Oh, one more thing: It applies to everybody. Not just to people filing the individual tax form. It applies to businesses as well.

Then you'd start to see some changes in our economy!

The Pattern of Debt

This pattern of debt is the opposite of what you might expect. At the level of individual consumers, people tend to borrow when they are young because they are hoping for higher incomes in the future. As they reach middle age they start to pay off their debts and save for retirement. By extension, rich countries with their greying populations should be saving whereas younger, fast-growing developing countries should be borrowing heavily. But in fact it is the other way round.

FROM: A Special Report on Debt: In a Hole, The Economist, 24 June 2010.

Why? Rich countries with their graying populations should be saving, but they are borrowing heavily? Maybe it's just a bad analogy or something.

Or maybe this misbehavior is the result of policy -- policy that restricts the quantity of money and encourages the reliance on credit, and fails to encourage the accelerated repayment of debt. That would be my guess.

//

The Economists presents a multi-post article explaining that the growth of debt was unsustainable.

Now that life has shown the growth of debt to be unsustainable, the article attempts to show, not why it was unsustainable, but simply that it was unsustainable. As if paving the way for future articles that will claim it was nobody's fault.

I think, if you know why it was unsustainable, you write an article explaining why it was unsustainable. If you don't, you write the article explaining that it was unsustainable. I think, at The Economist they don't know why it was unsustainable.

This is a problem. If we don't know why it was unsustainable, it will happen again.

The Indebtedness

The great burden of debt in the world today -- in the U.S. and in nations that modeled their economic policy on ours -- is the result of U.S. economic policy.

A simple change is all that is needed to correct the policy: We must encourage the accelerated repayment of debt.

Unfortunately, we waited too long. We had the financial crisis, our Paulson moment, and then the economy started to fix the problem by itself. Everybody and his brother scramble to get out of debt.

One word comes to mind: disarray.

The new policy will help: Accelerated repayment of debt will help. It will ease cost burdens a bit, and it will create confidence that government is finally doing the right thing: Helping us do what everyone is already trying to do.

So we get the debt reduced a little faster this way, because of the coordination of effort. And the Second Great Depression lasts 8 years maybe, instead of ten.

Not good enough.

Almost everybody says the economy won't recover until we get the debt paid down a lot. And everybody is doing what they can. And the new policy will help. But we need to do better, faster. The longer we wait, the harder it is to recover.

As a temporary fix for the cyclical problem, I propose direct action. Let the Federal Reserve print another trillion dollars. Only don't let them use it to buy up bad debt from the banks. Instead, let them use it to pay off debt for people. Direct action.

A trillion dollars of debt goes away, painless and quick. The money goes into the banks, not into the spending stream where it may cause inflation. And, well, borrowing creates money, and paying off debt destroys money, so the trillion dollars vanishes.

Actually, a trillion dollars of credit-in-use becomes a trillion dollars of available credit again. Our savings, in the banks, ready to lend. Ready to create growth or inflation.

But with enough debt destroyed, new spending will create growth. The reduction of private-sector debt is the key to our next golden age.

The Great Indebtedness

It is often said that our great indebtedness is the result of excessive spending, public and private. Arthurian economics denies that. The source of our great indebtedness is bad policy -- a policy that limits the growth of money, encourages the use of credit, allows and rewards the accumulation of debt.

The purpose of policy is to change economic conditions. Existing policy has changed economic conditions by creating a monetary imbalance. The solution to our economic problem is to change the bad policy. The solution is to improve policy by rewarding the accelerated repayment of debt. Little else need be done.

Tax policy to encourage the accelerated repayment of debt would induce consumers and businesses to make a few extra payments on existing debt, rather than spending those dollars at the mall, say, or on new business software. It would draw money out of circulation; it would return money to the banks; it would retire debt.

Drawing money out of circulation, it would serve as an inflation-fighting policy. It would serve the purpose that Federal Reserve policy serves at present. The Fed, of course, can remove money from circulation. But it cannot reduce your debt. The new Arthurian policy would fight inflation by reducing your debt.

Accelerated repayment of debt strikes at the source of money-creation and solves the problem simply, by encouraging the completion of credit transactions. Note that the economy is moving in this direction on its own, anyway. This is a sign of what needs to be done and what is the right thing to do.

Accelerated repayment of debt would free up the Fed to increase the growth of money. New Arthurian policy would not only permit that, but would make it a clear necessity. Repayment of debt draws down demand -- as we well know from the experience of the past two years -- and is deflationary. To counteract these downward pressures the Fed would find itself required not only to increase the quantity of money, but also to make more credit available at lower rates.

But the Fed's response would not be inflationary. It would simply counteract the deflationary pressures from the accelerated repayment of debt.

The goal of policy must be to reduce the level of existing debt while encouraging new uses of credit. That is not a zero-sum change. By discouraging the accumulation of existing debt, Arthurian policy reduces the debt burden and fights inflation. By encouraging new uses of credit, the policy encourages demand and growth.

I Hereby Resolve...

"How to get out of debt in '10"

That's the page-one teaser in my local paper: Get out of debt. Story, page 32.

From page 32:

Get your financial house in order

It may be difficult, but it's not that complicated. Much of it is what our grandparents taught us. Don't owe a lot of money. Don't buy what you can't afford. Put something aside for a rainy day.

After the year the economy's had, no doubt many people are making resolutions to get their own finances in order.

And really, who could blame them?

An Arthurian Future

Could you reiterate that again?

I commented on Aquinum's:

Okay. Say your proposal had been set up 20 or 30 years ago. Say it was in place and working....

But Vince batted that back to me:

Say your proposal had been set up 20 or 30 years ago.

Oh. Well, I put an answer together. A satisfying answer. (You know how it is.) Anyway, I thought my economic proposal ought to be on this blog. So, here it is: