Friday, 25 July 2014

Does QE 'finance' Government Spending? Of course it does. Get over it.

The Law School at the University of Sheffield as come up with an interesting paper about the legalities of QE - primarily in the context of the Eurozone.

Clearly QE is the central bank buying Treasury bonds by proxy. You can wave hands and make arguments as much as you like, but ultimately that is what is happening. The central bank's new money helps replenish Treasury's buffers and reduces the relative amount of interest that Treasury is paying into the wider economy.

That is just the central bank doing Open Market Operations by proxy - lowering the time preference reward on the longer dated paper. Once you consolidate the government accounts you get the true picture.
Consolidating Quantitative Easing does not significantly reduce the overall liabilities of government but it does reduce the number reported as government borrowing. Once intra-government transactions are eliminated, the scheme represents an exchange of gilts (liabilities of the National Loans Fund) for central bank reserves (liabilities of the Bank of England).
As MMT says, it's just an asset swap which results in relatively less interest coming out of the consolidated government sector into the rest of the economy. That then triggers a portfolio reconfiguration in the rest of the economy.

It is probably instructive to look at the mechanism of government bond buying relative to the banking system.

Government bonds need to be issued because there is insufficient taxation coming in and there is a silly rule in place saying that Treasury can't run an overdraft in central bank liabilities. What that means, on the other side of the fence, is that the non-government sector has stopped spending. Because if they spend, that generates tax which eliminates the need to issue some of the bonds in the first place.

So the starting assumption is that people have stopped spending and they haven't spent enough to offset government spending with taxation. That is what 'net saving' means.

At that point non-bank private entities only have two choices overall. Leave it in a private bank or buy government paper. If they buy the government paper, then some bank reserves disappear from banks and top up the Treasury's buffer.

If they decide to leave it in a private bank, then the private bank retains the extra reserves and they can decide whether to keep the reserves (in an account at the Central Bank), or buy Treasury paper. If they buy Treasury paper then some bank reserves disappear from the banks and top up the Treasury buffer.

So once all the private sector, including the banks, have finished doing their thing then either the Treasury buffer has been topped back up, or the Treasury buffer is short and the Central bank holds the difference as central bank reserve liabilities.

Now the Central Bank, if it is operating truly in the autocratic dictatorial mode that neo-classical economists aspire to, is caught in a quandary. Because its job is to maintain aggregate demand by persuading more people to borrow. If you're in a slump that doesn't happen. No matter how much you complain about banks they won't lend unless there are creditworthy borrowers at the front door.

If the central bank follows the silly restriction rules to the letter, then Treasury will be short on its buffer and won't be able to spend as much (assuming Treasury sensibly refuses to chase the market and calls the Central Bank's bluff. Remember we're assuming a hypothetical standoff situation here where the Central Bank will bounce the Treasury's cheques. The National Monetary Authority really, really believes in divine-right theory).

So aggregate demand will fall and people will lose their jobs. The Central Bank has nowhere to go. It can't push lending because that is pushing on string and Treasury can't spend to get the Central Bank out of a hole because of the dogmatic rule of the Central Bank. So the result would be a depression, which would then eliminate the private sector's savings because they would be forced to spend them. But the destruction would eliminate a lot of perfectly good capital as well.

All the Central Bank could do is start buying things itself, taking over the fiscal authority's job and enriching those it chooses without recourse to the democratic process.  And the days of Kings and Barons are thus restored.

As any first year law student will tell you, there is no law without enforcement. That way bad law can wither on the vine and fade away.

Monday, 7 July 2014

On the Nature of Banks - Payment Clearing

A couple of comments over the last week have suggested that the nature of the payment clearing system isn't perhaps obvious to all. I hope this post will help you see how it works, and show you why banks don't really lend reserves.

If you think about the bank payment system as a process during the day you'll realise that payments and deposits move around in a variety of different ways completely un-coordinated with each other and turning up at completely different times. Additionally it can take time before a payment requested in one system is recorded as a receipt in another.

Therefore the payment system is actually a specific implementation of a system pattern known as the Producer-Consumer problem The reason the problem is a problem is because of what is known as the 'boundary conditions' - what happens when there is nothing in the buffer or the buffer gets full. That is where it gets its other name - the 'bounded buffer problem'. I've probably spent most of my career trying to implement near optimal solutions to this problem.

Reams of papers have been written about it and many PhDs awarded, but there isn't a solution that operates all the time, handles the boundaries effectively and is optimally efficient. It is always a trade off. 

Here it is applied to central banking:

Lots of payers and payees all transacting with the clearing system asynchronously - the buffer here being the clearing accounts at the central bank. 

If you operate this system with bounded buffers then in certain circumstances - under strain or when there are mistakes - you will get cascade failures in the payment system. This is exactly the same as what happens when you take your mobile phone into a weak WiFi area. The network buffers exhaust or fill and you start to get applications generating errors or just exploding. Similarly if your disk fills up on your computer. Lots of errors, lots of information loss, lots of clearing up to do afterwards. 

The central bank gets around this problem in relatively simple way. It simply redefines the problem and makes the buffer essentially unlimited. Do that and the impact of boundary conditions vanishes. The system is guaranteed to work at its most efficient.

So, intraday, any central bank user gets an effective unlimited overdraft (technically an intraday liquidity repo) to ensure that the payment system always clears. Then at the end of the day everybody squares their positions with each other and the system resets to zero ready for the next day. 

Bank A and Bank B both start the day with zero on their account at the central bank, and the payments move around. Towards the end of the day there has been a net transfer of 100 from Bank A to Bank B

Position 1: Just before end of day
Bank A now has a debt to the central bank it needs to clear at the end of the day, so it makes an offer to borrow 100 in the overnight market which Bank B gladly takes up. This allows Bank A to clear its position at the central bank.

Position 2: Just after end of day
The extra intraday reserves vanish in a puff of accounting logic and the overnight position is in place.

You'll note that the overnight position is precisely the same as the one you get if Bank A did a direct transfer to Bank B. To allow the transfer to happen, Bank B has to take the place of the depositors that wish to move out of Bank A to Bank B. Bank B has to become the creditor of Bank A to balance the extra depositors it now has. 

So the extra reserves required to support additional loans made by the banks simply pop into being during the daily clearance process and disappear again just as quickly during the end of day clear up as the interbank lending market does its job. All dynamically, as required, to support the efficient operation of the payment system. 

Of course if the banks stop trusting each other and refuse to bid in the overnight market then the central bank has to take action. It then becomes the 'lender of last resort' and position 1 persists overnight with Bank A paying a fee to the central bank, and the central bank likely paying nothing to Bank B.

Another alternative to that facility would be to insure interbank lending, or simply do away with the interbank market completely and leave position 1 in place all the time. 

Tuesday, 1 July 2014

On the Nature of Banks - 'Insured' vs. 'In Specie'

I've never been entirely sure why banks confuse people so much. They really are very simple creatures. They make loans and back those up with deposits and other borrowings, charge a margin for one over the other in return for making an underwriting decision, and undertake to swap their liabilities around in various manners to maintain their liquidity.

And that's about it really. In fact all the problems start happening when you let lending banks do anything much more than this.

In a monetary system there are two main ways of setting up a banking structure. You can either have an 'in specie' system where the central bank issues actual liabilities and assets in the denomination currency to back the banking system (also known, inaccurately, as 'full reserve'), or you can have an 'insured' system where the central bank promises to issue actual liabilities and assets when certain events happen. For the rest of the time they remain 'contingent'.

This is what a commercial bank's balance sheet looks like in an 'insured' scheme:

Insured Deposits are those covered by the country's deposit insurance scheme (here in the UK it is 100% of the first £85,000 per person). All other deposits are uninsured or 'bailed in'.

Bank Bonds are corporate bonds issued by banks, issued on the money markets usually as traded securities. Examples include Permanent Interest Bearing Shares (PIBS), or Bank Subordinated Bonds.  These differ from the 'fixed rate bonds' that you hear banks selling, which are really just a form of term deposit.

Preference Shares are very similar to bank bonds but have a lower claim on the banks assets and therefore should pay a high interest rate to offset the risk. They are also classed as equity instruments rather than debt instruments.

Ordinary shares are the normal shares/common stock in the bank and which receive the bank's variable dividend payment.

If a bank's lending turns out to be bad and the loan section therefore shrinks, then the losses accrue to the right hand side of the balance sheet from the bottom upward. Ordinary shareholders lose out first, then preferred shareholders, all the way up to insured depositors.

The Bank is then insolvent and the central bank (or other authorised government body) steps in to administer the failed bank under the insurance arrangements. Where necessary it issues Central Bank Reserves to pay the insured depositors, and writes the loss out to its own balance sheet. The assets of the failed bank are sold to other market participants, the central bank recovers its loss form those assets and if there is anything left the other creditors get a fraction of their investment back. 

So in reality the insured depositors don't really hold their money with the commercial bank. They hold it with the central bank because the risk has been transferred via the insurance policy. Which is what insurance was invented for. 

Change the accounting policy of a bank to require that it shows the insured element explicitly and you get this:

Change it again to require that the balance sheet is split into responsibility areas and you get this:

Remove the word 'contingent' and that is what an 'in specie' system will look like under the current policy settings.

Any other magical powers ascribed to 'in specie' systems are either due to hidden policy changes, (which can be just as easily be applied to an 'insured' system), a misunderstanding of how banks or money things actually work on the part of those making the claims, or (mostly) just plain political propaganda.

'In specie' and 'insured' systems are operationally identical. You can transform the balance sheet of one into the other. Nothing substantive changes. That's why MMT has always been agnostic on the subject.

Friday, 27 June 2014

UK Sectoral Balances and Private Debt Levels - Q1 2014

Fairly stable structure here now that has been about the same for a couple of years - similar in shape to the 2002 to 2008 period.
The household sector is borrowing more and the non-financial sector continues to save. But so far the household sector really hasn't got into party mood and gone bonkers.

And the private debt levels:
The big news here is the continuing relative deleveraging of the non-financial sector. Businesses are paying back debt faster than they are taking it out and this is reflected in the sector lending by the reduction in net-lending to other sectors. Credit acceleration is now deeply negative and unless that changes it points to a pull back at some point.

Q2 preliminary data is mixed and confusing. Once again we'll only know when all the results are in. And we have to wait until September for that.

Source: Office of National Statistics, tables RPZD, RPYN, RQAW, RPZT, RQCH, DJDS (Seasonally adjusted Net Lending/Borrowing per sector plus residual error) and YBHA (Gross domestic product at market prices, seasonally adjusted). Private sector debt based on tables J8XI, NLBC, NKZA, NNQC, NNRE, NNXI, NNXM, NNWK, J8XK, NLSY, NLUA, J8XM, NJCS, and NJBQ (Lending, securites and derivatives per sector, not seasonally adjusted) scaled by BKTL (Gross domestic product at market prices, not seasonally adjusted).

Wednesday, 25 June 2014

Why MMT is Electric

Hands up all those who object to paying the Electricity Tax. "What Electricity Tax?" I hear you ask. The one you pay 50 or 60 times a second because you have modern equipment in your house.

Let me explain.

Those of you who went to school may remember the electrical power formula.

W = IV

Power in Watts is equal to the Current in Amps time the Voltage in Volts. What they may not have explained is that only really applies to Direct Current (DC) electricity supplies. 

We don't use a DC system around our houses. We use an Alternating Current (AC) system instead - because AC makes moving electricity around larger areas an awful lot easier than it is with DC.

With AC you introduce a direction change in the flow of the current and voltage, so that it wobbles backward and forward 50 or 60 times a second. 

Now with traditional style 'resistive' equipment like heaters, the W=IV equation still holds, and you get a waveform like this:

Here all the power delivered by the power company does work in your house heating things up (although of course if you're trying to boil a kettle and you're in the US, the heat death of the universe may occur first. My theory why Americans tend to drink coffee rather than tea is because they got fed up waiting for the kettle to boil).

In technical terms, what you have here is a Power Factor of 1. All the power delivered does useful work.

But as we get more sophisticated in our use of electricity, and introduce more effective and efficient devices like fluorescent lights, electric motors and mobile phone chargers then we change the way power works in an AC system. The capacitors and induction circuits introduce a phase shift between the current and voltage so they are no longer aligned precisely. Then you get a waveform like this:

What happens here is that some of the power is now negative, which subtracts from the power in the positive sections. This is known as 'reactive power'. What is happening is you are given lots of power, and then some of it is taken away again before you can use it (sound familiar yet?).

In technical terms, we have a situation where the Power Factor is less than one. Not all the power supplied does actual work, and some of it is taken away again. But if you don't supply that power and take it away again, then the devices will not be sufficiently energised and you'll get less output from them

The total amount of power you get in your house is measured in KVA (kilovolt amps), whereas what you are charged by the electric company is measured in kWh (kilowatt hours). So the KVA amount is the 'gross' power supplied, and the kWh amount is the 'net'. The difference is the Electricity Tax, and you're paying it all the time. Because without it your fridge won't keep your groceries as cool as they should be, your fluorescent lights wouldn't be as bright as they are (and may not turn on at all), and your iPad would be flat.

Now electrical engineers and power companies hate reactive power. It means that the wires have to be larger than they otherwise would be in an entirely 'resistive' world, and of course it means their generators have to push more electrons backward and forwards than would ideally be the case (some of which leaks as heat and therefore there is some running cost). But, being smart engineers not stupid politicians, they know they have to supply the reactive power into the system to allow the work society needs electricity for to get done.

So what has all this esoteric electrical theory got to do with the economy. Well...

Clearly we use a monetary economy, not a barter one. Just like we use AC electricity not DC. Therefore using ideas that only apply to DC systems on an AC system is going to be a shocking mistake (sorry).

We clearly need a generation system (the government sector) that has to circulate more money around the system (KVA) than would otherwise be the case to energise our advanced mechanised production system and ensure that it can deliver full output. If it doesn't then the system just generates less output.

The government spending/taxation cycle is the Reactive Power in the economy. With an advanced productive economy that has a Power Factor less than 1 (doesn't need all the labour to produce all the output), it has to be there to ensure that all the real work that could be done gets done.

Trying to get rid of Reactive Power is a fools errand. As any Electrical Engineer will tell you, the only way to get rid of reactive power is to get rid of the advanced economy. Why would we want to do that?

Learn to love Economic Reactive Power. It's what allows the most Real Work to get done.

Wednesday, 4 June 2014

How immigration affects the UK economy

It's very difficult to write anything mentioning immigration in the UK without getting accused of all sorts of demonic acts. And that's really all about closing down the debate, which I find a deeply disturbing development and distinctly authoritarian in attitude.

4th June has always been a good day to stand up to authoritarians, so off we go.

At the moment the UK is a member of the EU, which means we have unlimited border entry for anybody within the EU, and a normal visa application process for anybody outside the EU. The rational debate is whether the unlimited border entry is justifiable, or whether everybody outside the UK should have to go through a visa process.

Here is a chart published today of the estimated number of work hours demanded in the UK:

The total amount is fairly stable until 2004, which is when the new member states of the EU were allowed unlimited access to the UK jobs market. What you see then is the total amount of hours desired going up, along with the amount of hours worked, but the gap between the two tends to widen.

This is the effect of unlimited immigration. And the way it works is something like this:

Business puts out an advert for jobs. Any that are matched with the available workforce will disappear near immediately. That means that the 'total vacancies' number released every month by the ONS are jobs for which there is no current match, much as the outstanding bids and offers on the stock market are for shares where there is no current buyer or seller at that price.

Business then has a choice:
  1. Invest in training somebody that is available up to the standard required.
  2. Invest in plant and machinery to make the job redundant.
  3. Don't bother filling the job and let the competition steal a march on you by doing 1 or 2. 
(We'll assume for the sake of brevity that the bidding of people from competitors has already got to the futility point where alternative strategies have come to the fore).

All of those cost money, and business doesn't like spending money. So it lobbies for a further option - nick somebody suitable from somewhere else in the world. 

If government relents and gives business this option, then a new person comes in, the match is made, production happens, trade happens and the expansion of the economy creates further work opportunities. 

And that is the standard pitch - let the multiplier take effect and prosperity will ensue. 

But of course from the graph we can see that isn't really happening. And the reason is straightforward. For immigration to have a positive effect it needs to be of high value. That helps to ensure that the multiplier is large, and that the new jobs created by the cascade have a chance of being of a low enough level to soak up the remaining people on the unemployment queue. 

However if you allow an unskilled migrant to come in, then the chances of creating a job that will match somebody else decrease significantly. The multiplier doesn't have as strong an effect. More likely you will just recreate nearly the same job you just filled. 

And that is what we see. Over time the number of people goes up, the number of hours demanded goes up, but the rate of under engagement stays about the same. If the total goes up and the rate stays roughly the same then the number of people unemployed, underemployed and inactive continues to go up - each one of those cases being a personal disaster for the individual involved. 

So allowing unskilled migrants into the country is great for the business involved and great for GDP, but it offloads costs onto the existing unemployed (who don't get trained) and society at large (which struggles to maintain an infrastructure that can cope, and suffers lower productivity and wage growth ). Again business gets to socialise their costs to increase private profit, and we see the impact in terms of lower productivity and lower business investment across the economy and a degree of social unrest.

A rational immigration policy is one that concentrates on high value individuals and one that makes those visas very expensive for the businesses involved. That way business is more likely to choose to improve the capital stock of the nation rather than going straight for the 'nick somebody else from abroad' option.

Yes we need the release valve of immigration to get around persistent shortages on the supply side in high value services, but business should never profit if they use that option. The value should really accrue to the state to offset the additional social costs of maintaining a higher population.

Full employment is when you have more vacancies than people to fill them. In other words you can walk out of a job and into another one. Business should always be short of people and forced to innovate to get around that restriction. That's how we progress. That's how we avoid a persistent chase to the bottom.

All the old immigrant countries (USA, Canada, Australia, New Zealand, etc.) now have rational immigration policies that restrict the types and number of people entering into the country. There is nothing unreasonable about suggesting the UK should adopt the same approach. 

Thursday, 3 April 2014

How it all works - Quick Start Guide

Time and again you hear the same refrain: "it has to be paid for and those that want it never give a realistic view on how that is to be done".

Well we do. Constantly. But it is probably time to put it down in one place for easy reference.

So the 'quick start' version goes something like this:

The government invests in their programme. That money is spent by the recipients on goods and services, which are then made by the businesses for which they hire staff and pay wages.

All that activity causes an amount of taxation and an amount of saving to happen, which when you sum it up exactly equals the government investment. Each time, every time.

Therefore government investment is limited only by the dynamic capacity of the economy, both domestic and international, to produce stuff that people need - largely at the low income end of society. Importantly this is stuff that wouldn't otherwise get made or done.

So its all 'paid for' by making stuff we wouldn't otherwise make, using machines and people that would otherwise be under-utilised, and creating profits, savings and increased economies of scale we wouldn't otherwise get.

It's a win-win all round.