Unfair??

You think it unfair that so much money goes to pay interest? Unfair?

Well, I can't say you're wrong. It's your opinion and you're entitled to it.

But it is a weak argument. Argument based on opinion is weak. That's my opinion.

// See what I mean?

If existing policy relies on the increasing concentration of wealth and income, as Reaganomics does, then your strong argument is not that it is unfair, but that it is unsustainable. Obviously, concentration cannot continue beyond 100%.

The practical limits are lower, of course. And the moment those limits are reached, the whole system crumbles. As we have seen.

Look: If you think it's unfair, you are probably working toward the same economic goal as me. But you're not gonna win with a weak argument. You need to use the same kind of arguments that your opponents use: strong economic arguments.

Oh, and one more thing: You don't get to where you want to be by picking and choosing facts that fit your goal. That's what the other guys do. You get where you want to be, by accepting all the things that make sense. And then, prioritize them. The goal is to understand the economy.

Rent

Notes on Michael Hudson's Adam Smith critiques the Deficit Reduction Commission.

I don't get "rent."

I know, the place where you live, if you don't own a home, you rent. That's easy.

Adam Smith's factor costs are wages (for labor), profit (for capital), and rent (for natural resources). I'm okay with this. Renting a place to live is paying to make use of some piece of land. "Rent" as the name used to mean paying for natural resources is much like paying to make use of some piece of land, from which resources are taken.

What I don't get is the way economists use the word "rent" today. Here's Michael Hudson:

The 19th century elaborated the concept of economic rent as that element of price which found no counterpart in actual cost of production. and hence was “unearned.”

Unearned income is rent? Maybe. But it is too vague a notion, and blamey.

This is the policy that the Bowles-Simpson Deficit-Reduction Commission endorses. Its regressive tax proposals would shrink the economy, pushing it further into debt. This transfer of revenue from labor and business to property owners – and from them to their bankers and bondholders – threatens to force up the government’s fiscal deficit (as states and municipalities are seeing today) and turn the United States into a Third World type neofeudal economy.

Hudson worries about the "transfer of revenue from labor and business to property owners – and from them to their bankers and bondholders." Rent here includes not only payment to property owners but also to creditors. Just lump 'em all together. I don't like it. It is too vague and blamey.

Land is land. Money is money. Keynes pointed out that the mercantilists and the Church could easily distinguish between interest and profit, but that classical economics had blurred the two together, And it was wrong, Maynard said.

Economists today blur together the payment to land and the payment to money. It is wrong.

//

Smith’s argument against waging foreign wars was basically an argument that they were not worth the debt burden and the associated taxes to pay interest on it. These payments transferred income from taxpayers to creditors – largely foreign creditors, the Dutch in Smith’s day, Asians today.

Michael Hudson's concern is the payment to creditors. That's "interest." It only weakens the argument to call it "rent." And if Hudson means it's unfair that so much money goes to pay interest, well, that's an even weaker argument.

//

The way that Adam Smith would have addressed the deficit would have been, “Mr. Obama, pull out of Afghanistan – and perhaps 850 of our foreign bases.” And the century of free market economists who followed Smith would have said, “Tax away unearned rentier income...

...President Obama selected members of the Bowles-Simpson commission to provide a rationale – or at least a rhetorical cover story – for turning the U.S. economy into a neofeudal economy increasingly indebted to creditors...

I'm not big on blaming the military for our deficits. If we taxed away rentier income, maybe we could balance the budget even if we opened another 850 foreign bases.

Oh, and that "neofeudal" thing -- that isn't right. Feudalism comes before capitalism in the cycle, not after it. After capitalism comes the dark age.

Michael Hudson/Factor Cost

Changes accumulate, and as one gets older the world becomes irritatingly different. Little things. People use SLASH too much. People say it like a word, even.

Yet here I am with the post title: michael hudson slash factor cost.

Yeah, but you know, it's not like I'm saying "GNP/GDP" or something. Nobody thinks "michael hudson" is a number that you might mean to divide by a number called "factor cost." No ambiguity there.


A Gang8 message from Michael Hudson this morning links to his "article for Thursday’s Counterpunch."

From the article:

The rake-off charged by banks from sellers and buyers alike (not to mention late fees that yield the card companies even more than their interest charges these days) has been a major factor eating into retail profits and personal incomes.

The money that accrues to finance eats into profit and personal income. The factor cost of money competes with the factor cost of labor and of capital. The factor revenue accruing to the financial sector takes away from the factor revenue accruing to the productive sector. Excessive finance hinders productivity.

This is the source of the stagflation problem that arose in the 1970s, and has not yet been solved.

cf Interest as Factor Cost
cf How Debt Works

Boilerplate Economics

As William F Hummel puts it in Money and Inflation:

When the economy is operating well below capacity, cheaper credit will usually increase output without a significant increase in prices up to the point of nearly full employment. Thereafter the effects of cheap credit will generally lead to higher prices.

We are barely out of recession that was so bad it was almost a depression. We are now a few months into a listless, "jobless" recovery. And already, prices are going up. Some people admit prices are going up but say it isn't inflation, whatever that means.

We are barely into a jobless recovery -- our economy is operating well below capacity, certainly -- and already we have inflation.

Obviously, the boilerplate is wrong.

Actually, that is the point Mr. Hummel is making: "There are numerous forces that apply upward pressure to prices which are not driven by money supply growth."

SEE ALSO: THE LONG DECLINE.

This kid is no burger-flipper.

A long post, by my standard anyway, and not so much about the economy, but well worth reading: Bigvic's Why liberals are so dumb, a truly comical event.

You think this is bad?

The economy must not be allowed to collapse.

It is far more difficult to bring an economy back from a 10% drop than from a 5% drop. It is far more difficult to bring it back from a 20% drop than 10%. Far more difficult.

You think the problem is to attain recovery now? Just wait.

DPD

Debt-per-Dollar rises all through World War I. It rises through the post-war transition, rises through the Roaring Twenties, rises through the onset of Depression, and rises until the Depression hits bottom in 1933.

Debt-per-Dollar falls during the FDR years, 1933-1946.

Immediately after World War II, debt-per-dollar begins rising again. It rises all through the quarter-century of our post-war golden age. Excessive already by the 1970s, DPD kills off the golden age.

There are some hints of DPD decline in the Reagan years, the 1980s. Today we look back on those years as pretty good years.

There is a definite drop in DPD from 1990 to 1993. Immediately after that drop, we see a decade of growth comparable to the golden age.

Debt-per-dollar rises all through that golden decade. It rises high enough to quash the growth, and continues rising. And debt-per-dollar continues rising until the financial crisis of 2008.

The only way to fix our economy is to reduce debt-per-dollar.

"nothing important depends on this choice"

So I'm reviewing Robert Lucas's "Prize lecture" for my "No man is an island" post, and I come again upon this:

Figure 1, taken from McCandless and Weber (1995), plots 30 year (1960-1990) average annual inflation rates against average annual growth rates of M2 over the same 30 year period, for a total of 110 countries. One can see that the points lie roughly on the 45-degree line, as predicted by the quantity theory. The simple correlation between inflation and money growth is .95. The monetary aggregate used in constructing Figure 1 is M2, but nothing important depends on this choice.

The monetary aggregate used is M2, but nothing important depends on this choice.

Nothing could be further from the truth. Everything depends upon the money. In this case, everything depends upon the money used in the calculation.

Lucas reports a high value of .95 for the correlation between inflation and M2 growth. What he does not report is that in 1960, 45% of M2 was in the spending stream but in 1990 only 25% of it was in the spending stream.

Doesn't that throw a monkey wrench into the simple correlation?

Lucas ignores altogether the fairly significant notion that it is not the existence of money that causes prices to rise, but spending. And he ignores the fact that the 75% of M2 that was not in the spending stream in 1990 would have had no inflationary effect.

Lucas does not factor-in the distortion of the numbers caused by the significant drop in the circulating portion of M2, nor the effect this distortion should have had on the correlation. Nor does he consider that this effect is absent. He just takes the point-nine-five and runs with it.

This reminds me of something Milton Friedman said. From my 12 pages:

In Capitalism and Freedom, Friedman calls for "a legislated rule" designed to achieve "a specified rate of growth" of the money supply. But “the precise definition of money" established in this rule, he says, "makes far less difference" than just having the rule would make. For Friedman, any money is good enough.

Friedman wanted to carefully manage the quantity of money, but he didn't care what money was managed, what monetary aggregate. It didn't concern him at all.

But if it is spending that causes inflation, then spending-money is the money to watch. Not the money in savings.

Worth repeating

From Federal Debt As a Percentage of GDP by Thomas Charles, Demand Media:

Low Effects

The economic history of the United States shows there is not a direct correlation between low or falling debt to GDP percentages and strong, long term economic times. The federal debt percentages of GDP for 1835 to 1837 were zero, zero, and 0.02, respectively. The Panic of 1837 led to a depression with effects that lasted until 1843. Prior to the Great Depression, the debt as a percentage of GDP figure fell 10 straight years, from 34.98 percent in 1919 to 16.34 percent in 1929.

High Effects

Just as low or falling debt to GDP figures do not guarantee prosperous economic conditions, high levels of federal debt compared to GDP do not necessarily signal future severe economic times. From 1945 to 1947, each year's federal debt exceeded more than 100 percent of GDP. While the debt to GDP percentage fell beginning in 1946, it was still at 54.39 percent in 1960. The post-war years of Harry Truman and Dwight Eisenhower are seen as a period of massive economic expansion, with GDP more than doubling during this time.

Highlighting added.

News from 1930

An "A" from the Q&A on the Just what is the point of this blog? page at ikedim's News from 1930 blog:

I believe 1929-1930 has a couple of important similarities to 2008-2009. First and fundamentally, there was a big buildup of debt leading up to both. This was followed by a couple of major economic problems, including many banks running into trouble and a loss in perceived wealth by lots of people. These problems in turn have deflationary implications since they lead to less credit and spending ...

First and fundamentally, there was a big buildup of debt.

Kindleberger vs MMT

A bit of what I quoted earlier today, from Kindleberger's Manias, Panics, and Crashes:

In the manic phase, people of wealth or credit switch out of money or borrow to buy real or illiquid financial assets. In panic, the reverse movement takes place, from real or financial assets to money...

I just want to point out that Kindleberger seems to distinguish between "financial assets" and "money."

I think this is a useful distinction. As I see it, money is the yardstick, and assets are what people get into or out of in order to end up with more money. To put Warren Mosler's word on it, money is for "scorekeeping."

And a reminder from Joseph Schumpeter:

The distinction is, in a sense, quite unrealistic. But if we do not make it, we shall never be able to say any more than that everything depends upon everything.

Kindleberger

Manias, Panics, and Crashes

A History of Financial Crises
Fourth Edition (2000)
by Charles P. Kindleberger

(I'm only in Chapter One. We'll see how far I get.)
(I am breaking up his one paragraph into three.)

By no means does every upswing in business excess lead inevitably to mania and panic. But the pattern occurs sufficiently frequently and with sufficient uniformity to merit renewed study. What happens, basically, is that some event changes the economic outlook. New opportunities for profits are seized, and overdone, in ways so closely resembling irrationality as to constitute mania.

Once the excessive character of the upswing is realized, the financial system experiences a sort of "distress," in the course of which the rush to reverse the expansion process may become so precipitous as to resemble panic.

In the manic phase, people of wealth or credit switch out of money or borrow to buy real or illiquid financial assets. In panic, the reverse movement takes place, from real or financial assets to money, or repayment of debt, with a crash in the prices of commodities, houses, buildings, land, stocks, bonds -- in short, in whatever has been the subject of the mania.

Well, that is Kindleberger's paragraph. Worth sharing, I thought. A way to look at events of the past few years, I thought. Good enough to stand on its own, I thought.

More Wacky

Again from the Wikipedia Real Business Cycle Theory article:

By eyeballing the data, we can infer several regularities, sometimes called stylized facts. One is persistence. For example, if we take any point in the series above the trend (the x-axis in figure 3), the probability the next period is still above the trend is very high. However, this persistence wears out over time.

nnYeah. And here's what I wrote, back in 1977:

For an economy, good times mean growth: a better standard of living; more jobs, more productivity, more money to spend. But often, one side effect of the good times is rising prices -- inflation.

According to the theory, after the good times have lasted a while, inflation and other factors may begin to weaken the economy's growth. Eventually, conditions get bad enough that the economy begins to shrink. The result is a recession....

Things eventually get so bad that they 'can't get any worse,' and then the economy begins to grow again. Thus the pattern the economy weaves is a cycle of growth and recession.

And here's what I said of it later:

So in 1977 I thought that time, inflation, and other were the factors that cause recession. And that time and lousy conditions are the factors that restore growth.

Isn't that inadequate?

"This persistence wears out over time." Isn't that inadequate?

Wackypedia: Real Business Cycle Theory

My previous post offers an opinionated ending. So I wanted to check a fact or two, or get an impression to make sure I'm not too far off-base. So I looked at the Wikipedia article on Real Business Cycle Theory. I didn't find anything useful, but I did find this:

FIGURE 4

At a glance, the deviations just look like a string of waves bunched together—nothing about it appears consistent. To explain causes of such fluctuations may appear rather difficult given these irregularities. However, if we consider other macroeconomic variables, we will observe patterns in these irregularities. For example, consider Figure 4 which depicts fluctuations in output and consumption spending, i.e. what people buy and use at any given period. Observe how the peaks and troughs align at almost the same places and how the upturns and downturns coincide.

At a glance, yes, the red line (consumption spending) closely follows the fluctuations of the other line (GNP).

Yeah, I was amazed, the article refers to GNP, not to GDP.

But, at second glance, it occurs to me that consumption spending is the biggest part of GNP. So of course the two lines travel together. The graph shows nothing at all.

It's a shame, too. I was really liking the article.

Man-Q: Ridiculous Business Cycle Theory

The article is Economics in Disarray, by N. Gregory Mankiw.

Toward the end of the Mankiw article noted in my previous post, N.Gregory writes:

Controversy peaks when economists turn to the theory of economic fluctuations. Broadly speaking, there are two schools of thought: new classical and new Keynesian economics...

Those working in the new classical tradition have recently been emphasizing "real" business cycle theory. This theory proceeds from the assumption that there are large random fluctuations in the rate of technological change...

Real business cycle theory contrasts sharply with the consensus view of the 1960s. I will mention briefly three assumptions of these models that would have been considered ridiculous 20 years ago and that remain controversial today.

First, real business cycle theory assumes that the economy experiences large and sudden changes in the available production technology...

Second, real business cycle theory assumes that fluctuations in employment reflect changes in the amount people want to work... This assumption conflicts with the beliefs of many economists that high unemployment in recessions is largely involuntary.

Third, real business cycle theory assumes - and this is the assumption from which the theory derives its name - that monetary policy is irrelevant for economic fluctuations...

Well, you know my view is that money is the driving force behind economic fluctuations: the business cycle, the long wave, and the cycle of civilization. I don't know what that says about "monetary policy" ... But I say monetary and fiscal policy together have driven money out of circulation and replaced it with the use of credit; and I say absolutely and without question that this is the root of our economic problem. So I don't buy Mankiw's third point. Money is not irrelevant.

And as for the first point -- technological change -- again I say Real Business Cycle Theory has it backwards. I say technological change, or economic progress built on technological change, is hindered by problems of the money.

Economic progress is hindered by problematic money whenever the technological change adds to what we can achieve, as opposed to simply lowering the cost of existing technologies.

One could argue that "large random fluctuations in the rate of technological change" lead to a business cycle several years in length. But such fluctuations cannot account for cycles within cycles; only money accounts for this. And only money accounts for a slump long enough and deep enough to be called a Dark Age. There is no random fluctuation that could cause a dark age.

In his "Prize lecture" Robert Lucas wrote:

In a period like the post-World War II years in the United States, real output fluctuations are modest enough to be attributable, possibly, to real sources. There is no need to appeal to money shocks to account for these movements. But an event like the Great Depression of 1929-1933 is far beyond anything that can be attributed to shocks to tastes and technology. One needs some other possibilities. Monetary contractions are attractive as the key shocks in the 1929-1933 years, and in other severe depressions, because there do not seem to be any other candidates.

"Real" shocks can account for the business cycle, Lucas says, but not for cycles the length and depth of the Great Depression. The problem seems to be in the money, he says.

Remarkable.

I do recognize some irony here. Mankiw writes:

Before real business cycle theory entered the debate in the early 1980s, almost all macroeconomists agreed on one proposition: money matters... Real business cycle theorists have challenged that view using the old Keynesian argument that any correlation of money output arises because the money supply responds to changes in output.

The argument with which I disagree states that "any correlation of money [to] output arises because the money supply responds to changes in output."

"Responds to"?? No. Is intimately involved in? Yes.

My argument is that any correlation between technological advance and output arises because money helps or hinders the process.

And as for Point #2 of Mankiw's summary --

real business cycle theory ... conflicts with the beliefs of many economists that high unemployment in recessions is largely involuntary

-- I say, look at where we are today, and where we've been for the past two years, with unemployment near ten percent, and everyone nervous and angry about it. These people, these angry, nervous people, do not accept unemployment voluntarily. It is impossible to accept Point #2. It is ridiculous even to suggest it.

Man-Q: Rational Terrorism

I want to recommend an article to read. It isn't new, but it provides a history of the new economic thought that arose in the 1970s and '80s. The article is Economics in Disarray, by N. Gregory Mankiw, dated 22 June 1991, available at AllBusiness, a D&B Company.

Disarray is one of my favorite themes.

It's about a dozen half-pages long, and every time you go to the next page, the screen jumps around before settling down. But the article is definitely worth the hour it takes to read. Prob'ly less than an hour, for you.

From page 5 of Mankiw's article:

The argument against discretion is illustrated most simply in an example involving not economics but politics - specifically, public policy about negotiating with terrorists over the release of hostages. The announced policy of the United States and many other nations is that we will not negotiate over hostages. Such an announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping, rational terrorists won't take hostages. But, in fact, terrorists are rational enough to know that once hostages are taken, the announced policy may have little force, and that the temptation to make some concession to obtain the hostages' release may become overwhelming. The only way to deter truly rational terrorists is somehow to take away the discretion of policymakers and commit them to a rule of never negotiating. If policymakers were truly unable to make concessions, the incentive for terrorists to take hostages would be reduced substantially.

The same problem arises less dramatically in the conduct of monetary policy. Consider the dilemma facing the Federal Reserve. The Fed wants everyone to expect low inflation, so that it will face a favorable trade-off between inflation and unemployment. But an announcement of a policy of low inflation is not credible. Once expectations are formed, the Fed has an incentive to renege on its announcement in order to reduce unemployment. Private economic actors understand the incentive to renege and therefore do not believe the announcement in the first place. Just as president facing a hostage crisis is solely tempted to negotiate their release, a Fed with discretion is sorely tempted to inflate to reduce unemployment. And, just as terrorists discount announced policies of never negotiating, private economic actors discount announced policies of low inflation.

Mankiw's presentation rests on a few assumptions. First, it rests on the assumption that the Phillips Curve is a useful tool: that an increase in inflation can be used to reduce unemployment. But economists claim to have given up on the Phillips Curve.

Second, it rests on the assumption that inflation is generated by expectations. But if that is true at all, expectations are a weak force. As G. Thomas Woodward observed, it takes more money to support higher prices, and if more money is not forthcoming, inflation cannot long continue. No matter the state of expectations.

Third, Mankiw's analysis rests on the assumption that everyone -- the Fed and "economic actors" alike -- everyone understands the cause and cure of inflation.

"The Cause and Cure of Inflation" is a chapter title from Money Mischief

It is indeed a popular view, that everyone knows the cause of inflation and how to stop it. Nonetheless, we have never actually stopped inflation. This failure in the face of apparent certainty leads people to say the government doesn't want to stop inflation...

I am talking here of the 40 years BEFORE the crisis of 2008.

...leads people to say the government doesn't want to stop inflation, doesn't want to balance the budget, doesn't want to promote the general welfare, doesn't want to do the things that we want government to do.

I see things differently, of course. To me the failure to stop inflation is evidence that our certain knowledge is wrong. It is evidence that we do not in fact know the cause of inflation, and do not know how to stop it.

The feel bad factor

At the Gang8 today, Chris M of London writes:

I agree with both Dirk and Geoff that Japan has deep-seated problems, but I also look at the mass psychology as well - what the Bank of England in a fit of wisdom sometimes calls the 'feel good factor.'

That is the ultimate driving force in economic expansion. Do the people feel confident enough to take a positive gamble on their future? Or would they prefer to pull down the shutters, pay off their debt, stockpile food and wait for things to get better?

After that, Chris wanders into irrelevance:

Do the Japanese people at present trust their own government? Do they trust their nuclear inspectors...?

If it ain't economics, it is irrelevant.


The "feel-good factor" may be the driving force in economic expansion. But it is not relevant today; economic expansion, unfortunately, is not at issue.

Maybe math people are good at economics because we have a feel for infinity. Plain and simple, debt cannot expand forever. You will break the economy if you try. Isn't it obvious? Tell me you've not forgot. It shouldn't require even half a thought.

Why do people in Japan and all over the world prefer to pull down the shutters and pay off their debt?

Because the debt is too much. Isn't it obvious?

Rules

From Billy's of 16 March, 2011:

The national government of Japan can always afford to purchase concrete, wood, steel, glass, health care, road contractors etc as long as those resources are available for sale in Yen.

There is no question about that. It issues the currency as a monopoly provider (that is, as a consolidated treasury/central bank unit). It doesn’t make any sense to say that the issuer of the currency can be constrained in terms of using that currency.

Intrinsically that cannot be the case. Politically, it is a different matter and the politicians might attempt to put themselves in a straitjacket and pretend that they have to spend on a quantity rule...

Billy's argument, as always, is that the government "can" print money enough to buy whatever it decides it needs. "There is no question about that," he adds, but "Politically, it is a different matter."

Politicians "pretend that they have to spend on a quantity rule." Billy always says stuff like that, suggesting politicians should use their judgment about spending, rather than a quantity rule. I would bet he loses a lot of readers because of it. Politicians obviously need some kind of spending constraint, some kind of rule.

But I'm not sure Billy objects to politicians using a rule, really. I suspect he objects to them using a rule that is wrong. At least, that is my objection.

The accepted rule -- the wrong rule -- says that if there is inflation, somebody's been printing too much money. This is a major rule. We even have an institution created specifically for the purpose of making sure we have just the right amount of money in the economy, not too much money.

Some people today want to "end" that institution. Why? To restore financial stability to America's economy. Largely, because the Fed has failed to prevent inflation.

But ending the Fed is like shooting the messenger. The problem is the message. The problem is the rule that is used to prevent inflation, the quantity rule. You know: Printing money causes inflation. That rule.

Sure, the Fed is more than just a messenger. The Fed acts on the rule. But if the rule is wrong, it is the rule that must change. If we just end the Fed, best-case, we set up some other system, apply the same rule, and again get a result we don't want.

The correct solution is not to end the Fed, but to change the rule. So the question is: What is wrong with the existing rule?

The problem with the existing rule is that there could be something else, other than printing money, that is causing inflation. Something like the use of credit.

The Old Rule

The rule we use now says that if there is inflation, then we must reduce the quantity of money. As I have noted before, the rule is open-ended: It provides no lower limit to the quantity of money.

So then if something other than printing money is causing inflation -- if the use of credit is causing inflation -- then our rule will cause us to drive the quantity of money down to too low a level. Below optimum. Below reasonable. Below the minimum we need to keep our economy working, even. With this rule, as long as there is inflation, there is no limit to how low we may drive the quantity of money.

Furthermore, since the rule does not address the actual cause of inflation, the policy can never be successful. All it can do is undermine economic performance.

The history of the U.S. economy since World War II shows that we have in fact driven the quantity of money to an extremely low level (see Graph #1.) History also shows we have allowed debt to climb to an extremely high level (Graph #2).

Graph#1: Not Enough Money	Graph#2: Too Much Credit Use

Debt is the measure of credit in use. If we have a lot of debt, it means we have a lot of credit in use. And credit-use can cause inflation. In the Arthurian view, it is credit-use, not printing money, that caused the inflation of the past 40 years.

We stuck by our rule and drove money to an impossibly low level. And then to keep our economy working we used more and more credit in place of that money. This is the reason we have so much debt today, and so much trouble to pay it off.

The New Rule

The time has come to abandon the old, open-ended rule. It hasn't worked anyway for a long time. We never did end the inflation. We need a different rule to tell us how much money we need in our economy. We need a new rule.

The new rule is a lot like the Laffer Curve. Remember the Laffer Curve? It said there is a particular tax rate that will generate the most revenue. It said that other tax rates -- higher or lower -- generate less revenue.

The new rule is like that. The new rule says there is a particular ratio of debt relative to M1 money that will generate the best economic performance. It says other ratios -- higher or lower -- give us less satisfactory economic performance.

Let's say instead: a narrow range, not a particular ratio of debt to M1 money.

The new rule takes into account both money and credit-use. The old rule said if there is inflation there is too much money. But the old rule never did stop inflation. And obviously, the old rule did nothing to prevent the excessive use of credit and the excessive accumulation of debt.

The new rule says we must consider both money and credit-use, we must keep the ratio between the two at a level that gives us maximum economic performance, and that we should increase or decrease the quantity of "money and credit-use" together, as needed to fight inflation.

Dated 2-28-95

Another one from my old papers:

Definitions:

Money: Money is defined by our actions. That which we generally accept or pay in exchange for goods and services, is money.

Credit: Money on deposit at a lending institution.

Available credit: Deposits which have not been lent out but can be.

Credit in Use: Deposits which have been lent out.

Debt: Deposits which have been lent out. Same as Credit in Use.

Pinpointing the Problem

The problem is in the money. The whole of the economic problem, two decades of chronic global decay, has arisen from one simple problem with the money. In the words of the Wall Street Journal's editor Robert Bartley, "It's the money, Stupid!"

The particular problem with the money that is responsible for the economic problems of our time is an imbalance between credit-money and non-credit or standard money. If you are aware of the tremendous debt in this country and if you realize that every dollar of debt is a place-marker for a dollar of credit-money in use, you will begin to understand the severity of the imbalance.

Debt, The Measure of Credit-Money in Use

Take out a dollar and hold it in your hand. That's money. Now, say you put that dollar into the bank. It's still your money, but now the bank can make it available to borrowers. You have a dollar (in the bank) and the bank has a dollar (to lend); it is almost like there are two dollars. It is almost as if you created a dollar by putting your dollar in the bank. Actually, you have created potential money; your new deposit has increased the supply of available credit.

By borrowing money, you convert available credit to credit in use. Say that you go to the loan department and borrow a dollar from the bank. That would change the standing of one dollar of bank deposits from unborrowed to borrowed status. The deposits that are loaned out are in use; money lent is credit in use. Observe that the credit is in use, and the deposit is no longer available for lending, from the moment you borrow the money. You don't even have to spend the dollar to be using the credit.

By borrowing the dollar, you create a dollar's worth of debt. The debt exists as evidence that the credit is in use. By repaying your loan, you stop using the credit and so you cancel the debt. Then the credit becomes available for new lending.

For ha-ha's, a scan of the original page.

18 Years, Same Story

Something I wrote back in 1993:

THE BURDEN

As long as we can afford our debt, it is not a problem. It is when our ability to afford debt becomes strained that problems appear.

While others have been concentrating on the debt, now a problem, I have been thinking about what it means to 'afford' it. It means we can make the payments. It means that one's income is sufficient, in comparison to one's debt. More generally, it means that the income of the nation is sufficient, relative to the debt of the nation. The relationship between debt and income is very important.

In order to be available as income, money has to circulate. Our income is, by definition, circulating money. The relationship between debt and money in circulation is therefore very important.

Government statistics make it possible to examine the relationship between debt and money in circulation. These statistics show that in 1950, there was nearly $3.75 of debt for every dollar of money in circulation. Twenty years later, the debt had more than doubled. The figures for 1970 show $7.60 of debt for every dollar in circulation. After another twenty years, the debt had doubled again. In 1990, the figures show over $16.42 of debt, for each circulating dollar.

Compared to the amount of money in circulation, the outstanding debt in America keeps increasing, doubling every twenty years. No wonder our ability to afford our debt has been impaired. No wonder debt has become a problem!

Can this be a fluke? I don't think so.

The continuous growth of debt is not a random event and not a spontaneous occurrence. The growth of debt is a by-product of economic policy. Our economic policy is a guiding force which makes things happen in our economy. I believe the growth of debt is a side effect of policy, which policy-makers may simply have failed to notice.

An unobserved machine is at work in the American economy. It is a debt machine. The machine now creates 15 or 20 dollars worth of new debt each time the quantity of money in circulation increases by a dollar...

I'm still telling the same story today. Think it's interesting, though, that in 1993 I was saying there's 15 to 20 dollars of debt per dollar of M1 money... and by the crisis of 2008, 30 to 35 dollars of debt per dollar of M1 money.

Here's my DPD graph from 18 years ago:

Here's the Thing (2)

A partial re-post from mine of 15 November. For you, Greg, because "all their theories confirm" that public debt is the problem. Theories are nothing without data. But the data show their theory wrong.

The numbers in context

GRAPH #3: TOTAL DEBT AS A PERCENT OF GDP

A couple years back, there was a flurry of excitement over a graph showing that total U.S. debt had reached 350% of GDP. Graph #3 breaks that 350% into its public and private components.

The trend in government debt relative to GDP (the black line) is essentially flat from 1960 until the Paulson Crisis. And all that time, private debt (the red line) was climbing. So, if the increase in debt relative to GDP is a problem, the fault lies entirely with the private sector.

Here's the Thing

All I'm sayin' is debt is a problem. Everybody knows it's true. What's really odd is, no economic theory says debt is a problem. No theory but mine. Far as I know, anyway.

Beautiful Morning

Nature didn't care there might be a nuclear meltdown today.

Woodward: Interest and Inflation

I want to review another section of G. Thomas Woodward's Money and the Federal Reserve System: Myth and Reality.

Under the heading Interest and Inflation, one reads:

A criticism occasionally leveled at the Federal Reserve is that in raising interest rates to fight inflation it actually makes inflation worse, and that, indeed, it is a fundamental part of the problem with the monetary system because of its role in a system of lending funds at interest. According to this view, interest is the primary cause of inflation. Adherents maintain that interest payments are a cost of production, so that interest costs enter into the prices of individual goods and services. When these individual prices are aggregated into a price index, the influence of the interest rate on the inflation rate is direct.

Interest payments ARE a cost of production. Look at the recent years:

The historical record shows that in the 1950s, interest costs were negligible but growing. In the 1960s, interest costs became significant. In the 1970s, interest costs started hindering growth. Since then, interest costs have high but variable, while the accumulation of debt continued to grow. Even today, policy favors the accumulation of debt because policymakers still think credit-use is good for growth.

That hasn't worked for forty years. Policymakers equate new uses of credit, which contribute to growth, with accumulations of old debt, which only hinder growth. A large accumulation of debt offsets the benefit of new credit use, while new credit use only makes the accumulation bigger.

Interest-based cost theories of inflation are not uncommon. But they are not commonly embraced by economists. Their major shortcoming is ...

Interest-based cost theories of inflation are not commonly embraced by economists.

Oh -- You mean, not embraced by the people who didn't see the crisis coming? Not embraced by the guy who said the central problem of depression-prevention has been solved, and not embraced by the people who bought that absurd claim? We should reject "Interest-based cost theories of inflation" because those people reject them?

Sorry about that. But the statement that economists reject a particular theory is not an explanation of what's wrong with the theory, and deserves no more respectful a rebuttal than I have given. Nevertheless, I will start again:

You won't miss anything if you skim or skip this excerpt:

Interest-based cost theories of inflation are not uncommon. But they are not commonly embraced by economists. Their major shortcoming is that the effect of interest costs on the price of individual goods cannot be aggregated into an increase in the general price level. The assumption that such price increases result in inflation is considered an example of the fallacy of composition.

To say that the price of a good has increased is to say that it now costs more to buy the good in terms of whatever is used to pay for it. For an individual good or class of goods, an increase in price can mean an increase relative to other goods that are indirectly exchanged for it. Even though money must be used to purchase the higher-priced good, money was acquired through the sale of some other good or service. The rise in price of one good means the relative decline in the price of another. The total need for money in the economy does not necessarily increase when one price increases, because other prices can decline at the same time. Thus, the decreased need for money in transactions involving lower-priced goods can offset the additional need for money generated by goods that increase in costs.

But inflation is the continuous increase in the general level of prices. That means prices of all goods on average are going up -- not just some relative to the rest. And when all goods are rising in price, they cannot cost more in terms of other goods; they must cost more in terms of money. Hence, when inflation occurs, it takes more money on average to buy goods than before prices went up.

Consequently, for inflation to take place, there either must be more money to make the larger transactions, or money must be circulated more frequently to handle the extra need. But there are limits on just how much money can be recycled for more frequent use to accommodate the higher prices. Hence, if the additional supplies of money are not forthcoming, then the inflation cannot continue for very long.

Well, that was painful.

Woodward provides a standard explanation. Actually, if I prune it, his explanation is quite good:
1. "Inflation is the continuous increase in the general level of prices."
2. After prices go up, "it takes more money on average to buy goods than before prices went up."
3. "If the additional supplies of money are not forthcoming, then the inflation cannot continue for very long."

In short, prices cannot increase unless the quantity of money increases. Therefore (according to Woodward) inflation is not caused by costs: Not by the cost of interest, and not (one presumes) by the cost of wages.

Know what? I agree with that. At least, I agree that prices cannot increase unless the quantity of money increases. But there is more to the story.

From my comment at Winterspeak:

Suppose there's an oil-price shock that wants to create a recession. The Federal Reserve may respond by printing some extra money to avoid recession. One of the Fed's mandates is to promote growth. It's part of their job to avoid recession.

So the Fed's response to the cost-push shock is to provide money enough that prices in general go up a little. That said, the question is: Is this demand-pull inflation, or cost-push? I say cost-push, because it started with a cost problem.

On this model, the single most significant cost-push force since World War II is the rising factor-cost of interest due to our increasing reliance on credit. Not oil.

If there is a cost problem that interferes with economic growth, and if inflation is applied as a solution to this problem, then:
1. it is cost-push inflation; and
2. the right solution is not to stop the inflation, but to solve the cost problem.

In a normal economy yes, inflation is caused by "printing money." But in our economy, rising costs throughout the economy created significant problems. The only solution policymakers could come up with to avoid decline was to create a little inflation. The policy worked for a generation, because everybody remembered how bad inflation was in the 1970s, and the "little inflation" looked like nothing, compared to that.

Since the crisis, everybody lost confidence, and now the little inflation is seen as a problem again. People are fickle. The inflation was always a problem. But it wasn't the main problem. The main problem is rising cost. The cost problem arises from interest costs and the growing reliance on credit.

This explains why money growth is necessary for inflation. Higher costs - regardless of source -- cannot generate inflation unless the money supply grows to permit the price increases. If enough additional money is not generated to handle the increase in the size of each transaction, then the number of transactions must shrink. That is, when costs drive up prices in the face of a money supply that does not grow commensurately, economic activity must decline. Purchases drop, workers are laid off, and output falls.

Yes: Higher costs cannot generate inflation unless the money supply grows to allow it. Yes: If the money is not generated, economic activity must decline. Purchases drop. Workers are laid off. And output falls.

Yes. So if there is a cost problem that permeates the economy, and if we do not use inflation against it, the result will be unemployment and recession and decline. And beginning in the 1970s, we did use inflation as a solution to the cost problem.

But growth has not been good, even so.

The trouble is, inflation is not a solution to the cost problem. So, since the 1970s, the cost problem has grown worse. And economists stood by, patting themselves on the back and talking about the Great Moderation. Great... job... Brownie.

We have a cost problem, and three possible solutions:
1. The solution we went with, which was to accept some inflation.
2. The solution Woodward proposes, which is to accept decline.
3. The Arthurian solution, which is to solve the cost problem.

The decline in economic activity reduces the ability of firms to pass their higher costs on to consumers. Despite whatever pressures there may be on producers from the cost side, the reduction in demand holds back price increases. Whether the cost increase is from higher oil prices, interest costs, or increased wage demands, the increase in prices cannot be sustained without accommodation from the money supply. True inflation -- in the sense of continuously rising prices -- is never cost driven.

Y'know, sure: true inflation is never cost driven. But "interest-based cost theories of inflation" arise because problems exist, and explanations are needed. Are we going to reject these theories because of one "true" definition? Or are we gonna examine the problem, look under the hood, kick the tires, and figure the thing out?

Inflation is caused by printing money. If that's the end of the story, we will never solve the cost problem. If it's the end of the story, it's the end of The Land That I Love.

Moreover, the theory of interest-cost inflation has an additional shortcoming. Even if higher interest rates caused prices to increase, they could not explain inflation. Inflation is not high prices; it is not higher prices; it is rising prices; prices that go higher and higher continually. That means that interest costs would have to continually increase to produce inflation. Moreover, whenever interest costs fell, there would be deflation -- not slower inflation.

Note well, precious reader: In the paragraph above, Woodward writes of interest costs. But in his next paragraph, he writes of interest rates:

Of course, this is not what happens. Interest rates have fallen many times in the United States over the last 45 years. But not once did the U.S. price level fall. Inflation slows, but prices keep rising, even though -- according to the interest cost theory of inflation -- prices should fall because costs have fallen. If nothing else, this simple observation shows that the interest-cost theory of inflation is fallacious.

Woodward misses the obvious. Interest rates go up and down, he says, and prices don't, so the interest-cost theory must be wrong.

But it is Woodward that is wrong.

If you have one loan for a hundred dollars at ten percent interest, your interest cost is ten dollars. If you have five loans of four hundred dollars at one percent, your interest cost is twenty dollars.

Woodward overlooks the excessive reliance on credit. He misses the big problem.

From "The Flaw"

Looking at a small piece of "The 'Mathematical Flaw'" from G. Thomas Woodward's "Money and the Fed" (see yesterday's post for the link):

A popular theory about the Fed and money creation in the United States is built around the notion of a "mathematical flaw" inherent in introducing money by means of "lending" as opposed to "spending." This theory starts with the observation that money in the United States (and most other countries) is placed into circulation through the purchase of interest-bearing debt.

To inject money into the economy, the Fed buys federal securities, thereby acquiring an asset that pays interest. In the second round of money creation, banks, S&Ls, and credit unions, through the fractional reserve banking system, earn interest on the loans they hold as a consequence of creating checking account money.

Given that we distinguish between the public and private sectors... When the federal government borrows, it takes sedentary money from the private sector. And when the federal government spends, it puts circulating money into the private sector.

The government desires to do this, enough to be willing to pay interest to do it.

I am trying to look at what happens, without passing judgment on it.

When the Federal Reserve wants to increase the quantity of money in circulation, it buys an asset from the private sector. The Fed gets the asset, and the private sector gets the money. Note, however, that the asset itself was sedentary. The person or business that owned it, didn't need that money for gas and groceries.

Maybe circumstances changed, and now the money is needed for gas and groceries. Or maybe not. Maybe the person selling the asset has decided to change the way he holds his savings. In other words, the new money created by the Fed may not go into circulation at all. It may go directly into some form of savings, some sedentary money. That would defeat the Fed's purpose.

But all that aside... When the federal government borrows, it takes sedentary money from the private sector and replaces it with federal securities. When the Federal Reserve increases the quantity of money, the Fed gets those federal securities. The Fed ends up holding these government securities.

So the interest paid by the federal government on those securities is paid to the Federal Reserve. The Fed uses about 5% of that income to meet its expenses. The rest of the Fed's income is turned over to the Treasury. That money goes back to the federal government.

There is a name for the cost associated with the creation of money: seigniorage.

The interest on U.S. government debt held by the Federal Reserve, is money paid from one part of government to another. Five percent of that money is seigniorage. The rest goes back into the U.S. Treasury. Therefore...

The "popular theory" of which Woodward writes, where there is "a 'mathematical flaw' inherent in introducing money by means of 'lending' as opposed to 'spending'"... There is much less to this theory than meets the eye.

Say the interest rate on government debt is six percent. Then the seigniorage, the cost of creating that money, is five percent of that six percent interest cost. That comes to 0.3%, less than one-third of a penny per dollar created. Less than meets the eye.

The same cannot be said, however, for the "second round of money creation, [where] banks, S&Ls, and credit unions, through the fractional reserve banking system, earn interest on the loans they hold as a consequence of creating checking account money."

This is why it is important to distinguish the public and private sectors, and why it is important to consider "sectoral balances."

And this is how monetary imbalance is corrected: by using the unique features of public sector finance to make adjustments to private-sector finance.

The growth of federal debt since 1974 has been an attempt to make the correction. It failed, because it failed to prevent the continuing increase of private debt.

(reprise)

"Money creation," says G. Thomas Woodward,

"does not drive the creation of debt; the debt is already there regardless of how money is created. It is always there."

Debt is always there. But there isn't always $35 of debt, for every dollar of money.

The problem is really not difficult to understand. Five dollars of debt for every dollar of money, ten dollars, maybe twelve, okay. But thirty-five?

The solution isn't difficult to understand, either: We need tax incentives to accelerate the repayment of debt. We need to use those incentives as our primary weapon against inflation. And then the Fed can stop taking money out of circulation to fight inflation. And that will leave enough money in the economy so that the economy can grow.

Mostly, we need to get out of our head the notion that printing money causes inflation and using credit doesn't. And we need to get out of our head the notion that we always need to use more credit, even when there is already too much debt.

Woodward: The 'Mathematical Flaw'

I want to review a section of

Money and the Federal Reserve System:

Myth and Reality

G. Thomas Woodward
Specialist in Macroeconomics
Economics Division

July 31, 1996 Congressional Research Service Library of Congress
CRS Report for Congress, No. 96-672 E

"Economics Division" of what, the Library of Congress?

Under the heading The "Mathematical Flaw", one reads:

A popular theory about the Fed and money creation in the United States is built around the notion of a "mathematical flaw" inherent in introducing money by means of "lending" as opposed to "spending." This theory starts with the observation that money in the United States (and most other countries) is placed into circulation through the purchase of interest-bearing debt.

To inject money into the economy, the Fed buys federal securities, thereby acquiring an asset that pays interest. In the second round of money creation, banks, S&Ls, and credit unions, through the fractional reserve banking system, earn interest on the loans they hold as a consequence of creating checking account money.

This means that for every dollar of money, there is a corresponding dollar of interest-bearing debt. As a consequence of this arrangement, the argument goes, there is only enough money to pay off the principal of existing debt; there can never be enough to pay the interest that accrues on that principal. If there is to be enough money to handle interest payments in the economy, the theory continues, more borrowing must occur to generate the extra money. Of course, additional borrowing under this arrangement would mean even more interest that cannot be paid out of the existing money supply.

Money is created by lending, not spending. Well, yeah, that's how we create money. I don't get all upset about it, and I don't draw conclusions like "there is only enough money to pay off the principal." There'll be more money tomorrow.

I don't get upset about it because our system usually works. Yes, it gives us business cycles and depression-scale cycles -- but we've had those since finance became an industry. We had them even before the Fed, when we were on the gold standard. It is not the existence of debt that creates problems, but the excessiveness of debt.

What is significant so far is that Woodward uses the word "observation" -- meaning he thinks it a fact, not a notion, that money "is placed into circulation through the purchase of interest-bearing debt." Woodward accepts that as fact.

Just to keep the money supply constant under the system, according to this line of reasoning, debt must grow by the rate of interest. Since the economy grows over time, debt must grow at even a higher rate. As compounding occurs, the result is an explosive growth of debt. Thus, the argument is, policy must actually encourage households and businesses to take on new debt just to keep the money supply from shrinking.

Policy actually does encourage households and businesses to take on new debt, to keep the economy growing. The concern about keeping the money supply from shrinking is something recent, arising among policymakers since the financial crisis of 2008 and the threat of debt deflation.

Hmmm. That supports the theory Woodward wants us to reject.

My Debt-per-Dollar (DPD) graph shows "an explosive growth of debt." It also shows that debt varies, relative to the quantity of money in circulation (M1). The rising DPD peaked during the Great Depression. FDR lowered the DPD but it has been rising again since 1946. And the high level now is associated with the threat of another depression. In my view a high DPD is not merely associated with depression-like conditions, but is the cause of them.

I don't understand "MMT" really well, and a lot of it is irrelevant or worse. But I have no doubt that in their focus on "sectoral balances" leads to a solution to the DPD problem. This alternative, I think, makes "the popular theory" irrelevant, the theory Woodward is trying to shoot down with his so-so argument.

Allowing debt to expand is a problem, these theorists argue, because interest costs are a -- if not the -- principal cause of inflation. When the banks make loans, they charge interest. Interest represents a cost of doing business for borrowers which they pass along to consumers in the prices they charge for goods and services. Hence, it is reasoned, the more interest paid, the higher prices must be.

I agree: Interest costs are the principal cause if inflation. Interest is the "factor cost" of money. When DPD is high, this factor cost intrudes upon Adam Smith's factor costs -- wages and profits and rent -- and competes with them. To the extent that this increases costs without increasing production, it must lead to decline or to cost-push inflation.

Of course, credit-use does increase production. Or, we think it does. Or, it does, as long as the accumulation of debt is not excessive. But when we use credit for everything, when we use credit for money, the cost outweighs the benefit and inflation is the result.

If debt must mushroom over time in order to keep the money supply from shrinking, according to this line of thinking, then the cost of doing business must rise faster each year, and so must prices. In short, it is argued, the money supply process demands that debt grow exponentially. As debt grows as a proportion of total production, so do interest payments. And as interest payments grow relative to the rest of real income, it is claimed, prices must rise faster as well.

Debt DOES grow exponentially. I have shown it here and here and here.

But then, GROWTH is exponential. So... maybe it's no big deal. One must expect to see exponential growth in our economy, in money, in debt. In fact, it is the times that debt does not continue to grow exponentially that we see problems. Times like the present.

I am NOT arguing that we need the exponential growth of debt to continue. I am saying that this concept, that economic growth requires the growth and accumulation of debt, is the concept upon which we base economic policy. Therefore, our economy only grows while exponential increase in debt continues.

It is an important point. We must change the concept upon which we base economic policy. Our assumptions are wrong. We do need debt credit-use for growth. But we don't need to let debt accumulate.

We must use repayment of debt as our primary weapon against inflation.

Debt grows exponentially. Since the end of WWII, so has the quantity of money. These facts ought not be surprising. But now, the DPD divides debt by the quantity of money. Exponential growth, found in both numbers, should cancel itself out of the results. In other words, the effect of growth does not appear in the DPD graph. Therefore I point out that the exponential increase shown by the DPD is a consequence not of growth, but of pro-debt policy.

This dilemma, the proponents argue, is the inherent problem that causes instability in the current banking system -- an instability that the authors believe to be responsible for the business cycle.

Yes. The imbalance between money and debt (clearly visible on my DPD graph) is the problem that causes the depression-scale business cycle, as well as instability both in the banking system and in the overall economy.

Unfortunately, Woodward does not identify "the authors" of this view, and I have not a clue who he is talking about.

Most of those who advance this view believe that to correct the inherent instability in the current monetary system and simultaneously reduce inflation, the system of "debt" money must end. They argue that money must be spent into existence, or at least issued without charging interest.

I do not. I do not say the system of "debt" money must end. What I say is, we have to correct the imbalance between money and debt, the imbalance shown on my graph.

The problem is not that "for every dollar of money, there is a corresponding dollar of interest-bearing debt." The problem is that for every dollar of money, there is $35 of interest-bearing debt. The problem is excessiveness.

The problem is monetary imbalance.

This analysis is deficient on four counts. First, the banking system does not behave as presented above. The payment of interest on debts that arise through the money creation process will neither contract the money supply nor result in the growth of debt relative to the money supply. Second, there is no reason for the money supply to equal the sum of debt and interest. Third, debt is such a common and essential part of an economy, there is always plenty of it available for money creation without any need to encourage the creation of more. (The fourth reason, that interest costs are not the cause of inflation, is discussed in another section).

The crucial error made by the above arguments lies in the proposition that once interest is paid by the government to the Fed, money is "extinguished". If the interest earnings were simply put away into a vault until they were lent out again, the authors would be correct. But in fact, the money is spent back into existence.

The part of the Fed's income used for its own expenses and the dividend paid to member banks is, of course, spent back into existence. The rest the overwhelming majority of all of the income earned by the Federal Reserve -- that which is remitted back to the U.S. Treasury, is also spent. Thus, "lending money" into existence does not mean that debt has to constantly increase to make up for the money that is paid in interest and removed from circulation. It is not removed from circulation; interest payments to the Fed re-enter circulation as they are paid for expenses, as they are paid in dividends, and most significantly as they are paid over to and spent by the Treasury.

The argument has similar problems with its claim that money disappears from circulation as interest is paid back to commercial banks. Like the Fed, commercial banks have expenses. They must pay these out of their earnings -- spending them into existence. They also must pay dividends to their stockholders -- again spending them into existence. Most important among their expenses is interest on their deposits. Whether in the form of explicit interest paid to depositors or implicitly paid as free services (such as check-clearing, balance reporting, etc.), these funds are also spent into existence. Even those sums retained to increase the capital of the bank do not have to be lent, but can be used to purchase expansion of the facilities. There is no requirement in the system that interest earnings must be lent back into existence through new loans.

Woodward does not deal with the the part of the problem that concerns me. He says that money taken from circulation to pay interest is "spent back into existence." Okay. But that doesn't mean it is spent back into circulation.

Also, he equates government money creation with private money creation.

Much of the money received as interest just sits in those interest-bearing accounts where it can earn more interest. On my simple analysis, the money moves out of M1 and into savings, so that savings increases vastly relative to M1 in circulation, over the long haul.

Economists may object to my use of M1 and M2, which are old categories of money. I don't care. They are simple to understand. M1 is spending-money, or money that is circulating. M2 counts both M1 and money in savings. I am looking at money that is circulating, and money that is not circulating but in savings. If you don't want to use M1 and M2, that is fine with me. I don't care about labels. I care about concepts. Redo my DPD graph with your numbers.

Since the amount of dollars represented by the interest payment is returned to the spending stream and the money supply, there is no need for banks to lend continuously a sum equal to the interest payment to keep the money supply constant. Hence, there is no force causing debt to grow continuously relative to the available money supply. The current system is not inherently unstable.

Woodward says: "there is no force causing debt to grow continuously relative to the available money supply." But there is. The force creates an exponential increase in the DPD. The force is policy.

Again, much of the money "represented by the interest payment" is NOT returned to the spending stream. This is the problem. First, the money moves from circulation into savings, decreasing M1. Then, it gets LENT back into circulation, increasing debt. Both of these steps increase the DPD and make the monetary imbalance worse.

Nor is there any reason why there must be enough money outstanding to pay off all outstanding debt. The money needs of the economy are much smaller than an economy's total debt. Money circulates; it gets used repeatedly in the course of a year. Transactions take little time. As soon as money is used in one transaction, it is available for use in another. Consequently, the money stock need only be a fraction of the total transactions that take place in a year.

An economy only needs enough money to complete the transactions that occur in the course of normal business -- not a sum related to total debt. And the total amount of money needed is less than the total value of the transactions because the money is used more than once.

Finally, debt is not created because of a need for money. Every economy - even those without money -- has debt. Debt is a necessity in any modern economy. Indeed, debt pre-dates money in that it exists even in barter economies. It comes in a variety of forms and does not consist exclusively of bank loans. It exists because some people do not consume all that they produce, and are in the position to place some of their goods temporarily in the hands of those who need more goods than they have. Resources are not always in the hands of those who can best employ them. Hence, the lending of resources is common and even necessary for economic progress.

This is such a nice little story... But it neglects the long-term accumulations that lead to monetary imbalance and depression.

Consequently, debt is always present in private affairs. Healthy economies can always be expected to have private debt equal to many times the amount of money that they need. Even as some borrowers repay their loans, still others are ready to borrow. Money creation, therefore, does not drive the creation of debt; the debt is already there regardless of how money is created. It is always there. There is plenty of debt to be used by the banking system for the purpose of money creation with plenty more left over. This is true everywhere there are market systems. Debt does not exist because of a need to create money.

Again, a nice little story, but incomplete. Woodward writes: "Even as some borrowers repay their loans, still others are ready to borrow."

Wouldn't it be nice.

I think we can get it to work that way if we re-think policy and realize we have many policies to encourage the use of credit and the accumulation of debt, but no policy to encourage the repayment of debt.

In short, there is no mathematical flaw. And paying money directly out of the Treasury would have exactly the same economic effect as having the Fed create it by "lending."

There is no mathematical flaw. But there are policy flaws.

daylight savings time

I hate it.

Sorta like Hume. I don't care if we call it 4 o'clock or 5 o'clock. It's the transition that's the problem.

Bad Science

Robert Posner, from The Atlantic of 9 August 2009:

Government officials (many of them economists), business economists, economic journalists, and academic economists alike were, with rare exceptions, taken by surprise by the bursting of the housing bubble... The reason for the surprise was that leading macroeconomists and financial economists had believed until last September that there could never be another depression, that asset bubbles are a myth, that a recession can be more or less effortlessly averted... All these beliefs have turned out to be mistaken...

Robert Lucas, because of his distinction, and because of his famous (or should it be notorious?) statement in 2003 that macroeconomists had solved "the central problem of depression-prevention" and should move on to other subjects, contributed to the economics profession's, and the government's, complacency about the vulnerability of the economy to severe crashes, and contributed also to deflecting economists from improving their understanding of the risks of economic instability.

Well there it is again, the ego thing: macroeconomists had solved "the central problem of depression-prevention" and should move on to other subjects.

I disagree with the last part of Posner's statement there, where he says Lucas deflected economists "from improving their understanding of the risks of economic instability." That's passing the buck. Maybe it was a meme and they all giddily repeated each other's words and compounded the error, I don't know. If so, that's not Lucas's fault.

What I do know is, it was easy to tell from the Debt-per-Dollar graph that we were getting into trouble, and that when the problem erupted it would be a big one. All else is "distinction" and ego, and bad science.

Order of Events

If we get the economy to grow, we will reduce government debt. But this does not mean that if we reduce government debt, we will get the economy to grow.

More Debt Than Money

Reviewing this morning's post, one sentence sticks in my throat:

There is more debt than money to pay it off.
That sentence is an argument waiting to happen. I want to head it off at the pass. But first, a little documentation:

Under the heading "The 'Mathematical Flaw'" in Money and the Federal Reserve System: Myth and Reality by G. Thomas Woodward, one reads:

Nor is there any reason why there must be enough money outstanding to pay off all outstanding debt. The money needs of the economy are much smaller than an economy's total debt. Money circulates; it gets used repeatedly in the course of a year. Transactions take little time. As soon as money is used in one transaction, it is available for use in another. Consequently, the money stock need only be a fraction of the total transactions that take place in a year.

An economy only needs enough money to complete the transactions that occur in the course of normal business -- not a sum related to total debt.

And now I'm ready.


It has been pointed out that money circulates, so it is okay to have more debt than money in the economy.

Well, yeah. But that's the simplified version.

When there is $3.50 of debt for every dollar, money doesn't have to circulate very fast to cover the payments. When there is $35.00 of debt for every dollar of money, the money has to move ten times as fast. That's a big difference. There is a much greater chance that payments will be missed.

And there is a much greater chance of a cascade effect from missed payments.

Finally, it is worth noting that G. Thomas Woodward's view depends upon continuation of "the course of normal business," which is itself put at risk by the growth of debt.

Other than that, there is not much effect from excessive debt, except that the costs related to debt are much greater and more of a hindrance to growth. You know. 

She's not there

JB Peebles writes

I've been reading that Comex silver supplies are less than the total amount of Comex contracts outstanding. If Comex can't fill orders with actual silver, then the value of the silver on the open market could be higher, at least for those who actually own it and can physically offer it for sale.

"Comex silver supplies are less than the total amount of Comex contracts outstanding." This is a version of the perennial problem. There is more debt than money to pay it off. There is more money in savings than the Fed has issued. And there is more gold on paper than actual gold. 100 times more.

Twice as much

I want to say this:
There is more money in savings than the Fed has issued.Can I say it?

1. From the Board of Governors:

The major items on the liability side of the Federal Reserve balance sheet are Federal Reserve notes (U.S. paper currency) and the deposits that thousands of depository institutions, the U.S. Treasury, and others hold in accounts at the Federal Reserve Banks. These items, as well as the Federal Reserve's other liabilities, can be seen in tables 1, 10, and 11 of the H.4.1 statistical release.

2. From the H.4.1 statistical release: approximately 2.5 million million dollars, if I read it right. That's 2.5 trillion in total Fed liabilities.

I'm no banker, but I think I'm reading it right.

3. And from FRED, the graph of savings shows over $5000 billion in savings. That's 5 trillion, more than twice total Fed liabilities.


4. Yep, I can say that.

The Prize Lecture

The Robert Lucas article in Wikipedia includes a link to a Monetary Neutrality PDF, his 1995 Nobel "Prize lecture" (20 pages). Parts of it escape me, but parts are very good.

Lucas opens with an excerpt from David Hume from 1752. "From the beginnings of modern monetary theory," says Lucas.

Hume writes:

money is nothing but the representation of labour and commodities, and serves only as a method of rating or estimating them. Where coin is in greater plenty, as a greater quantity of it is required to represent the same quantity of goods, it can have no effect, either good or bad...

Lucas refers to such changes in money as "just units changes," comparable I suppose to reporting the temperature in Celsius instead of Fahrenheit.

Money, for me, is the central issue of economics. For that matter, misunderstanding money is the original cause of our economic troubles. I accept what Lucas says, and Hume, because it is a reputable idea of long standing, but I accept it tentatively. Money is of central importance. There is no "just" about it.

In 1752 we were near peak in the cycle of civilization and near the beginning of that 150-year "greatest age of the inducement to invest" noted by Keynes in 1936. At that point in the cycle perhaps one might observe that money "serves only as a method for rating or estimating" labor and commodities. Today, money serves also for accumulating and storing value. Stored accumulations of money do not circulate, or circulate only at extra cost. Either way, the consequences are significant.

Lucas offers a second excerpt from David Hume:

Were all the gold in England annihilated at once, and one and twenty shillings substituted in the place of every guinea, would money be more plentiful or interest lower? No surely: We should only use silver instead...

As Friedman said, money is "fungible." Interchangeable.

"These are two of Hume’s statements of what we now call the quantity theory of money," Lucas writes, "the doctrine that changes in the number of units of money in circulation will have proportional effects on all prices that are stated in money terms, and no effect at all on anything real, on how much people work or on the goods they produce or consume."

This, then, is a modern expression of the quantity theory: An increase in the quantity of money has a "proportional" effect on prices, but "no effect at all on anything real."

It is not true, of course. Should incomes and prices all magically double, our debt is suddenly half the burden it was before. That is a real difference.

For some reasaon, I want to attribute the shock-value in this to Krugman.

Lucas continues:

Notice, though, that there is something a little magical about the way that changes in money come about in Hume’s examples. All the gold in England gets “annihilated.” ... Is this just a matter of exposition, or should we be concerned about it! This turns out to be a crucial question.

He again quotes Hume, who says that an increase in the quantity of money "must first quicken the diligence of every individual before it increases the price of labour." In other words, Hume thought that the existing quantity of money, be it lesser or greater, had no bearing on economic conditions, but that a change in the quantity of money had significant consequences.

Again: Hume thought that the existing quantity of money, be it lesser or greater, had no bearing on economic conditions, but that a change in the quantity of money had significant consequences.

Says Lucas:

This tension between two incompatible ideas: that changes in money are neutral units changes, and that they induce movements in employment and production in the same direction, has been at the center of monetary theory at least since Hume wrote.

Lucas fantasizes a "tension" between ideas that are by no means incompatible. "Changes in money are neutral units changes," he writes. But the example of a change in money that Lucas provides is David Hume's "annihilation" of gold.

Hume did not use the annihilation of gold as a change of circumstances. He used annihilation to compare two different sets of circumstances. Circumstances were suddenly, "magically" different to provide two different cases for comparison. Hume knew well that changes in money affect the economy. He was not talking of changes having no effect.

With the annihilation he was comparing two different states or sets of circumstances: a society with gold, and the same society without gold. One set of circumstances, Hume said, is no better or worse than the other as far as economic conditions are concerned. But in neither circumstance is there any change in the money.

This is not the same as saying (for example) that a change from "having gold" to "not having gold" would be insignificant. But those are the words Lucas puts in David Hume's mouth.


In The General Theory, Maynard Keynes quoted Hume:

It is only in this interval or intermediate situation, between the acquisition of money and a rise in prices, that the increasing quantity of gold and silver is favourable to industry.... It is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still increasing; because by that means he keeps alive a spirit of industry in the nation, and increases the state of labour in which consists all real power and riches.

By that standard, one may glance at our trade deficit and conclude that China is the good magistrate today.

Clearly, Hume distinguished between levels of money on the one hand, and changes in those levels on the other. Lucas blurs that distinction.