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Vimothy,

The Model SIM is too simple and is a way to build complicated models .. one by one ...

G&L models are frameworks and one is bound to find something debatable. More importantly the parameters which have been assumed to be fixed to start with such as propensity to consume bring more life one one starts thinking of them being changing all the time - a point mentioned in the book as well.

As far as wealth is concerned, they do not take future income into account in the definition of wealth, except for financial securities which have a market value because interest income is paid. But that is the spirit of national accountants as well. True, the latter are just measuring stocks and flows and not the future... but the important point in those G&L behavioral assumptions is that sectors on the whole do not care .. these have more to do with animal spirits which can't be measured and so forth.

There is a dependence of expectation of incomes and if you see some consumption function have expected income instead of the income. In the simplest case it is assumed to be the previous period income but one is free to choose something else such as 5% more than the previous period income. The models are written truly in the Keynesian spirit of uncertainties etc. You can give the propensity to consume a time dependence. The goodness of the models lie in the openness and the attitude of the authors is completely different from the ones you meet online :-)

The models are one end of abstraction but in fact if you read Wynne Godley's articles at Levy, he is seen trying to write about prospects for the US economy which is more about policy. Which brings me to the sectoral balances... you can learn more about them by reading his articles patiently. For example nowhere does he assume that it was governments forcing people to go into debt and that the severe day of reckoning the US was heading into was due to the irresponsible behaviour of all sectors of the economy including the foreign sector.

To me the idea of aiming a surplus is a slightly shady argument. The Clinton government went into a surplus not because of its own choosing but because of capital gains due to the dot com boom. The argument presented by Godley is that given the nature of such an attitude and with the CBO projecting a retirement of debt over the next 15 years (around 2000), the government's fiscal stance is going to be tight and if the propensity to save increases, it will cause a recession given that it may come as a surprise.

However his attitude was also that the economists assign a very limited role to the government and this is not the right path.

Also, one thing missed is what happened after the short recession around 2001 ... so you can read in Wynne Godley's articles at Levy that the US government actually relaxed fiscal policy by a humongous amount .. and that itself led to another process which led to further sectoral imbalances. So there is a story about the huge relaxation of fiscal policy which itself added to the cracks in the foundation of growth by contributing to imbalances in the private sector flows and the balance of payments.. the story which you won't find in the blogosphere.

I understand the points in your comment and you have to be careful in distinguishing arguments which seem superficially the same.

On, the other hand, there is an overkill in MMTosphere and this overkill is counterproductive.

Beowulf,

Great you noticed that.

True that was the Bretton Woods era and there is a balance of payments constraint. However to understand it itself needs a good description ... it doesn't matter NAFA=PSBR+BP and the dynamics is quite similar. Gold loss can be cured by borrowing from abroad if allowed by foreigners.

The present era is a Bretton Woods era without the gold and flexible exchange rates. The balance of payments constraint remains and endemic deficits can remain as long as foreigners allow just like any other institutional setups.

Abba Lerner was a friend of Nicholas Kaldor and the full description of the balance of payments constraint comes from Nicholas Kaldor - explained in detail by his followers.

Nicholas Kaldor and Lerner would have had influences on each other surely. This is what Kaldor wrote in 1941 before functional finance was being written:

It is impossible to judge intelligently the system of taxation, or the scale of public expenditures, without a quantitative record of the total economic activity of the nation, which forms the background. This is perhaps even more important in war-time, when the Government controls so much larger a part of the national income; but it is vital in peace-time as well. If a statement of this kind had been presented year by year, simultaneously with the Budget, many financial mistakes of
past Governments might have been avoided. Moreover, the regular publication of this document would
stimulate both Government and Parliament to look upon the level and the stability of the National Income, rather than the conventional and narrowly financial standards, as the true criterion of
budgetary policy; to regard the movements of the national expenditure, and not merely of the expenditures of public departments, as within their province. It is on the assumption of this wider responsibility that our best hope lies for the post-war world.

-‘The White Paper on national income and expenditure’

I vow to find something written by Abba Lerner on the balance of payments superconstraint in the Post Bretton-Woods era!

Min: "Don't some mainstream economists believe that it is, that the long run limit of G-T = 0? Not only that, don't they believe that that belief is rational?"

Hard to do math on Typepad (hard for me to do math anywhere), but:

Start with the short-run GBC (ignoring seigniorage, just for simplicity):

G +rB = T + B next period - B

Re-write that same equation for next period, solve for Bnextperiod, substitute it back into the first, then repeat for t periods, and you get:

B + PV(G up to t) = PV(T up to t) + PV(B in period t)

Now, we need to take the limit of that equation as t goes to infinity. If the growth rate of the economy is less than r, so that G, T, and B can't keep on growing faster than r forever, the answer is straightforward:

B + PV(G) = PV(T) (the weird term at the end must go to zero in the limit). That's the long run government budget constraint. Add in the PV of seigniorage if you wish.

But if the growth rate of the economy exceeds r, it's possible for the growth rates of G, T, and B to exceed r, so the Present Values are all infinite. That's when things get weird. Essentially, the economy is in a Ponzi zone.

I don't think Lerner's ideas on foreign trade are essentially different from "MMT", or is in a Ramananigm. It has some terminological difference - I had the Ramananigm impression at first. But imho Lerner is often clearer- of course foreign savings of dollars, in whatever form, constitute a foreign debt of the USA, as Ramanan rightly insists. But just as the modern MMTers, Lerner suggests using functional finance to offset demand leakages, foreign or domestic, and holds they are not essentially different. The Ramananigm is roughly what Lerner calls "sentimental internationalism" in his Economics of Employment, which he wrote, perhaps following Keynes', for "those at the gate" rather than "the cognoscenti in the temple". Both books are awesome.

Ramanan, as you know, Lerner developing the Lerner Symmetry Theorem in the 1930s, but don't know if he did any work on post-Bretton Woods trade.
http://en.wikipedia.org/wiki/Lerner_symmetry_theorem

To save a linkthrough on the "in-Ramananigm" Trump comment (apologies to Nick for going OT a moment). The Donald has made surprisingly MMT-friendly statements on fiscal policy with one notable exception that I figured would warm your heart... "The centerpiece of his deficit reduction program appears to be a 25 percent tax on all Chinese imports… Trump also sees no need to reform entitlements, which will magically attain solvency on their own. “When this country becomes profitable again, we can take care of our sick; we can take care of our needy,” he told Human Events. “We don’t have to cut Social Security; we don’t have to cut Medicare and Medicaid. We can take care of people that need to be taken care of. And I’ll be able to do that.”
And he says we won’t need to raise taxes either. Trump is suggesting that, as our economy improves, it will expand to cover trillions of dollars in future deficits...
(link above)

Instead of a "China tariff" it'd be better if he were pushing, how did Wynne Godley phrase it, "nonselective protectionism matched with fiscal relaxation" (i.e. cutting payroll tax) ,but I guess we're all works in progress. To make the initiative worthwhile to Canadians, of course, we should exempt our NAFTA partners (and back on topic!). :o)

Nick @ 6:47,

re: " It makes no sense for households to pay a premium for bonds over capital if they do not consider bonds to be wealth.", by "households" I was referring to the household sector.

Obviously an individual household in either world would value the government bond at some non-zero amount, as it delivers a stream of income. However, in the Ricardian world, the household will not pay a premium for the bond, whereas in the non-ricardian world, the household will pay a premium for the bond.

In terms of wealth, the future tax obligation is contingent on nominal income variations, and the return from capital is as well, but the income stream delivered by bonds is not, so households would prefer to have the variable tax obligation and the bond, rather than not having the bond or the tax obligation. Because they prefer it, they pay a premium for it, and because they pay a premium, the future tax obligation is reduced as well.

The economy need not be dynamically inefficient, or in a ponzi mode as you put it, as the return demanded of capital is higher than the return demanded of risk-free bonds, and the private sector, or at least the non-financial private sector, cannot borrow at the risk-free rate. They can only lend at the risk free rate.

This was Abel & Summer's argument. The capital stock is earning a higher rate, which can be greater than the growth rate of the economy. Low risk-free rates only tell you that households are credit constrained and risk-averse, they don't tell you anything about dynamic efficiency per se.

Calgacus,

Would verify that from original articles rather than relying on someone's account.

Nick Rowe: "Hard to do math on Typepad"

Thanks for the math, Nick. :)

RSJ: sorry. I had *totally* misread you.

Hi Nick,

"But if the growth rate of the economy exceeds r, it's possible for the growth rates of G, T, and B to exceed r, so the Present Values are all infinite. That's when things get weird. Essentially, the economy is in a Ponzi zone."

Now is the time to go to Moslers website and really understand the monetary operations of the fed and treasury. Now.

First, understand how the fed and treasury work, why debt = money. Then read Warren's "the natural rate of interest is zero." We choose the interest rate we pay on the debt. If you doubt me, see Perry Merhlings post about how the fed pegged interest rates throughout the WWII. http://ineteconomics.org/blog/money-view/the-new-federal-reserve#comments

You are so close! Welcome. When you get here, you'll find all your old skills will actually increase in value, and there is much work to do. And remember to pass the map to Brad Delong!

Rmanan:

>The 1970s I believe was the second most important period in Economics (first is the present shared with 1930s ?) .. the Keynesian demand management failed and economists were left with the task of explaining this failure.

I feel likewise, which leads to a request to Nick:

Could you take a stab (a post) at explaining stagflation from an MMT perspective? I've never found the monetarist or fiscalist explanations to be satisfying, and there doesn't seem to be much consensus. (Supply shock, yeah, but...) Though they often seem satisfying in some of their particulars, it's always easy to find other historical situations that seem to contradict their conclusions.

Oh and I meant to say:

> The economy is dynamically inefficient. The economy wants a Ponzi scheme.

!!! I will be pondering these statements for a long time.

Steve,

I think wages rose a lot during the 70s and hence prices. And hence wages and hence prices.

If wage bargaining gets troublesome, and workers demand more wages, firms need to price higher to recover the costs. This may result in a higher wage bargaining due to rising prices ... and dynamics along those lines.

The reason money supply is associated with prices is that in that period, I believe (no data with me) that the two rose together rapidly. So the Monetarists thought that the price rise was caused due to rising money supply (and only partly accepting it has something to do with labour unions). The reason the money supply rose was that more loans were taken by firms to pay higher wages ... (the reverse causality).

I haven't done any proper analysis on this, but there seems to have been an unfortunate indexation going around at that time as well.

What r < g means is that given *any* primary deficit/GDP bound, there is a (finite) Debt/GDP bound that is a function of the deficit to GDP bound.

Right, exactly. This is a surprisingly elementary mistake on Nick's part.

You can follow the procedure I described above, or the basically equivalent procedure of the original post, without any information about the current debt/GDP ratio. And you can follow it forever, and the debt/GDP ratio will converge on the same finite value, not matter where it is presently.

Reread your original post, Nick. Where does it say "Now look at the current level of public debt and change your behavior accordingly"? That's right, it doesn't. We set today's government deficit based on today's macroeconomic conditions. The debt-GDP ratio doesn't matter. That's the key takeaway from functional finance, and the fundamental difference from the mainstream view. And you've actually shown why functional finance is right and the mainstream is wrong, you just don't realize it yet.

Sorry, the statement quoted is correct, but it isn't quite what I met. If you are not concerned with the primary deficit but with the total deficit, then the debt/GDP ratio stabilizes at d/g (where d is the deficit as a share of GDP and g is the growth rate of GDP), regardless of the initial debt level and regardless of r. I think part of the confusion here arises because people are used to talking about the primary deficit, but functional-finance arguments are in terms of the total deficit.

It may be that following the rules of functional finance causes interest payments to rise as a share of GDP. But so what? Either inflation remains below target, in which case you haven't hit the long-run constraint and should increase borrowing more; or else inflation rises above target, in which case the rules of functional finance tell you to raise taxes regardless of the level of interest payments or debt. In other words, interest payments are just another addition to income for the private economy; and just like any other increment to private income, if they result in AD running ahead of potential output, then you raise taxes.

The larger point -- which unfortunately it's probably too late to expect a response on -- is that the argument of the original post directly contradicts Nick's later claim that an exogenous increase in debt, all else equal, implies a lower level of spending or higher level of taxes.

On the Lerner comment:
In the '70's I had a professor who was a colleague of both Allais and Debreu.
For some reasons we asked him what he thought of Joan Robinson eventually getting the Prize. He reacted in horror: " We won't let that happen!". She may have not deserved it but she was not " one of us".

JW: "The larger point -- which unfortunately it's probably too late to expect a response on -- is that the argument of the original post directly contradicts Nick's later claim that an exogenous increase in debt, all else equal, implies a lower level of spending or higher level of taxes."

Not too late. I'm still following. But too late for a response today. It's been a busy tiring day for me, and so my brain is not in the best shape to try to explain clearly.

Ramamman wrote:

I think wages rose a lot during the 70s and hence prices. And hence wages and hence prices.

If wage bargaining gets troublesome, and workers demand more wages, firms need to price higher to recover the costs. This may result in a higher wage bargaining due to rising prices ... and dynamics along those lines.

The reason money supply is associated with prices is that in that period, I believe (no data with me) that the two rose together rapidly. So the Monetarists thought that the price rise was caused due to rising money supply (and only partly accepting it has something to do with labour unions). The reason the money supply rose was that more loans were taken by firms to pay higher wages ... (the reverse causality).

I haven't done any proper analysis on this, but there seems to have been an unfortunate indexation going around at that time as well.

I have a different view. There is more than one kind of recession. I will say that again, there is more than one kind of recession. I have a little article demonstrating a Hayekian graphical model of the economy which I got from Roger W. Garrison in his book "Time and Money".

Before anybody screams at me for reading it, you can make Garrison's model behave in a completely Keynsian way by altering a few of the graphical interpretations and just applying Keynes's assumptions wholesale. I accept Keynesian economics but my little model shows how it can come up short. I like my model because it explicitly includes time and money in the macroeconomy and breaks out the supply side in more detail than is typical.

The heart of the model is the Production Possibilities Frontier, a curve on a graph of Consumption vs. Investment. The Investment axis is reflected down to break out the Funds Market, a graph of interest rates vs Investment. When an economy is on the PPF you get a stable, "natural" rate of interest with the money supply. You can draw two boundaries on the Funds Market to determine the total amount of money available for investment and consumption.

Anyway, recessions in my model can happen in two ways:

1: A net contraction of the Production Possibilities Frontier due to a supply shock. This will drag consumption and investment down and raise unemployment. This is what I call a Hayekian recession. It is caused a a shorted of real goods. This is what happened in the 1970's. Several books of the period detail that first wheat shortages developed after crops failed in China and Russia and the world had a grain shortage.

The United States had an oil supply problem in the 1970's as well. Until 1968 the US produced enough oil domestically to satisfy domestic consumption. By the 1970's these supplies were exhausted and the US turned to Persian Gulf and Venezuelan oil. For real and political reasons, the US had to expend more resources and more money to purchase this oil.

These shocks contracted the US Production Possibilities Frontier. The result was unemployment as industry contracted and also price increases as the economy adjusted to oil shortages. A steady money supply with a decreasing PPF implies price increases (same amount of money chasing less goods).

This is how you get unemployment and price increases occurring together, stagflation. This is the story of the 1970's.

This isn't the only kind of recession. Which brings me to

2) A Keynesian Recession.

Instead of the Production Possibilities Frontier contracting in response to a supply shock, assume the PPF stays steady. But contract the money supply. According to Keynes consumption is more steady or sticky than investment, so investment decreases. Remember that natural rate rate of interest that the [C,I] point on the PPF maps so nicely to on the funds graph? Well, that point is now BEYOND the Money Supply Frontier. Just as Keynes said, no amount of interest rate adjustment will get to recovery in this situation.

If the money supply contracts, it will drag the economy to a new [C,I] point off the PPF. A gap will open up, a production gap. If consumption starts to fall it will devastate the economy (modelled as a Hayekian triangle with stages of production), giving every stage a haircut. In real life it looks like random business failing for lack of demand, money problems or other non-supply related reasons.

Because the money supply contracted, we don't have enough money to accommodate all monetary transactions in the economy anymore. We get a demand shortage as uncompleted but desired transactions pile up. This is the story of the 1930's and the current Financial Crisis.

At root, and this is my own interpretation, my model has confidence-based money. Money isn't just notes, it's a product of the banking system and of companies reinvesting funds. The money supply is based on confidence because it is a product of financial actors (banks) who engage in loan activity where confidence in repayment is everything. If you get a panic it will cause widespread devastation. Sound familiar?

Roger Garrison would probably shoot me for giving his model the second interpretation, but that's life. So we now have two consistent and different modes of economic failure. One we went through in the 1930's and are in today, and one we experienced in the 1970's. Different problems, different causes, different solutions, same economy.

Nick: "But, *if* the banking system is competitive, the super-normal seigniorage profits of the commercial banks get competed down to zero, either eaten up in operating costs, or by paying interest on demand deposits."

I'd like to follow up on this debate between Nick, Vimothy, Andy and RSJ. This is one of the issues where I'm in almost full agreement with RSJ. Here is the main reason I disagree with you, Nick: the marginal cost of lending for a bank is independent of the rate on demand deposits: Term loans are benchmarked off term wholesale borrowing. Overnight lending (lines of credit/revolvers) are benchmarked off the interbank lending rate. The reason is that the liquidity of the funding source must match the liquidity provided to the borrower. If a customer draws a billion dollar revolving LOC, the newly created deposits flow to the banking system in general; not to the lending bank. Therefore the revolver must be financed off the interbank market that the lending bank can draw on on demand. There is *no* mechanism whereby the zero rate on demand deposits ever makes it's way into the pricing of a loan.

And Canadian demand deposits and most overnight savings deposits do not pay interest (or maybe 5 basis points on ON savings). I believe the reasons in the case of demand deposits are regulatory, but regardless, the supply of demand deposits is highly inelastic as a function of the rate paid on those deposits. The aggregates are huge but holdings only exist for a very short period in any given account, so people ignore the rate. They simply keep their checking accounts with the institution that provides their lending/brokerage/investment banking etc services. So demand deposits are a bit like land: a commodity whose supply is fixed (or at least independent of price) and which is a positive externality to the beneficiary, in this case the banking sector.

So RSJ is right: it should be taxed (as should land value) at the risk free rate. This would be a highly efficient tax with little or no impact on the cost of credit. Of course, they should also pay the fair market price of deposit insurance. A better alternative would be for the BOC to provide interest bearing transactional accounts to anyone, effectively just extending the service (LVTS) that they currently provide only to the commercial banks. Then revoke deposit insurance and let the banks raise capital at free market rates.

And as for Andy's point that the cost of transactions is high, it's simply not true. Back in the days of stage coaches and banditos, surely. But today it's a joke. Just look at the cost of executing stock trades for example (small fractions of a cent). And none of the costs are proportional to the size of a deposit. Look over *any* banks income statement. Try to find the expense item for payment systems. It's negligible and entirely funded by transaction fees.

K,

That's an excellent point, and one which I should have made earlier.

It is just like fixed and marginal costs, but each bank has a fixed "benefit" corresponding to interest income from supplying deposits.

This benefit is not variable with the amount of loans made -- each individual bank does not increase its (level) of deposit liabilities by granting a loan.

Therefore banks will continue to make loans up until the marginal costs (e.g. FedFunds + capital requirements, etc.) are the marginal benefits. They will not then charge an additional discount or supply more loans to remove the fixed benefit.

Price competition cannot reduce the fixed benefit, which is the aggregate level of deposits. Taxes should remove that benefit.

Trader'scrucible: "Then read Warren's "the natural rate of interest is zero.""

I did read it, and commented on it somewhere in comments to my last post, on MMT. Let me re-cap what I said:

If you believe the IS curve is vertical, because desired saving and investment are independent of the rate of interest, then: lowering the rate of interest will not increase AD; and the natural rate of interest is undefined. The rate of interest no longer serves any intertemporal allocative function in such a model; it merely re-distributes income between debtors and creditors. Fiscal policy has to bear the whole responsibility of AD management; and the central bank might as well set the rate of interest to zero.

That, to my mind, is the underlying assumption of MMT in general, and for Warren's argument for setting r=0. (I think Warren's way of expressing this argument by saying the natural rate is zero just confuses things, because he is not using the words "natural rate" in the same way the rest of us are).

It's reminiscent of Milton Friedman's theoretical argument "The Optimum Quantity of Money" for setting a nominal rate of interest at zero. Except that Friedman saw the natural real rate as positive, and wanted to get the nominal rate to zero through steady deflation.

But if you take the standard assumption that the IS curve slopes down, Warren's argument doesn't work. Because on average setting r=0 would mean very high AD, and so you also have to use a very contractionary fiscal policy to shift the IS curve left, making the natural rate zero, to keep AD from being too high. So the government debt would go to zero, and then get more and more negative.

JW: "In other words, interest payments are just another addition to income for the private economy; and just like any other increment to private income, if they result in AD running ahead of potential output, then you raise taxes."

That is the key assumption of MMT -- that interest rates merely re-distribute income between debtors and creditors. But that ignores the substitution effect of interest rates on desired investment and consumption -- on intertemporal consumption and production decisions -- that standard theory emphasises. If r is set to keep AD on target, and ir that requires setting r at or above g, then the Long Run Government Budget Constraint follows from standard accounting plus a bit of algebra, plus the assumption that the debt/GDP ratio must be finite:

Existing debt = PV(taxes)+PV(seigniorage)-PV(government spending)

"The larger point -- which unfortunately it's probably too late to expect a response on -- is that the argument of the original post directly contradicts Nick's later claim that an exogenous increase in debt, all else equal, implies a lower level of spending or higher level of taxes."

And it follows immediately from that accounting identity that if you suddenly find the existing debt is higher than you thought it was, the left hand side is bigger, so the right hand side must be bigger too. You must either increase taxes, or seigniorage, or cut government spending, either now or some time in the future.

The tricky bit is working out what happens when r is less than g, because then the algebra used to derive the LRGBC above doesn't work.

Because on average setting r=0 would mean very high AD, and so you also have to use a very contractionary fiscal policy to shift the IS curve left, making the natural rate zero, to keep AD from being too high. So the government debt would go to zero, and then get more and more negative.

I think one must always read the MMT r=0 arguments together with the corresponding policy proposals for the financial sector. One can't happen without the other. 90% of the control/stabilization would be via shrinking of the sector and not via 'interest rate discipline' - which MMT sees as blunt tool because it is economically ambiguous and socially questionable. The whole r=0 edifice rests upon a severely stunted banking sector that functions as private-public enterprises with a clear charter to pursue 'public purpose'.

Assuming for a moment, as economists like to do, that MMT=Mosler, here are his proposals for the US:

http://mosler2012.com/wp-content/uploads/2009/03/toronto.pdf

OK, so what about the case where r is less than g? (BTW, try to avoid the less than or greater than symbols, because one of them causes Typepad to freak out for some reason).

The standard model most economists use to explore this case is Samuelson's 1958 overlapping generations model. I discuss that world in this old post:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/do-we-need-a-bubble.html

The basic idea is that the economy is dynamically inefficient. Even at full employment. It would be possible to make the current old generation better off by transferring resources from the next young generation, and so on ad infinitum, without making any generation worse off. The economy needs a bubble, chain letter, Ponzi scheme (which are all the same fundamentally). Government debt could be that Ponzi scheme.

But, this does not mean government revenue from the Ponzi scheme is unlimited. As the debt/GDP rises, the demand for the savings vehicle is satisfied, and r rises until it equals g. There is only so much debt the young generation is willing to buy from the old generation, and that depends on r, so as the debt/GDP ratio rises, r rises until it is equal to g. (Clearly, if the young simply cannot afford to buy all the debt from the old, even with all their income, we have gone far past that limit.)

The revenue the government can earn from a Ponzi scheme is bounded, even if r less than g so the Ponzi scheme is stable, because as the size of the Ponzi gets larger, r rises until it equals g, and the Ponzi scheme becomes unstable.

Here's a follow-up post on the demand and supply of bubbles, in case anyone's interested in seeing more:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/the-supply-and-demand-for-bubbles.html

BTW. A couple of days ago an MMT blogger said I was "60% there" (or something like that) with this post. I was too busy to respond at the time, but now I can't find it. Anyone know who it was? Thanks.

K: Presumably, the administrative costs to the commercial bank of providing me with a chequeing account depend on the number of transactions I make, rather than the size of my balance.

So what we would expect to see in equilibrium would be banks offering chequeing accounts that pay the full rate of interest, but have fees based on the number of deposits and withdrawals.

AFAIK, they do offer some big accounts that look like that, but for most of us they don't. It looks like they subsidise transactions by paying a lower than market rate of interest and charging lower transactions fees. I don't know why they do this.

Here it is, Nick:

http://traderscrucible.com/2011/04/25/nick-rowe-begins-the-walk-to-mmt/

RSJ:

"Therefore banks will continue to make loans up until the marginal costs (e.g. FedFunds + capital requirements"

It should be capital requirements + liquidity cost, with FedFunds being just one of the liquidity sources. Liquidity cost is notoriously hard to model and price correctly, ALM procedures notwithstanding.

One is quite flabbergasted by some folks, who should know better, de-emphasizing the role demand deposits play in liquidity provision and going as far as to say that demand deposits are not even needed for bank operations. As a matter of fact, retail deposits are the most stable source of liquidity statistically speaking. Just ask Northern Rock who thought that wholesale market can provide all liquidity they need.

I went through that retail deposits subject several times in the past, with little success, so it's my last message on the subject :)

K (or RSJ),

Can you explain the rationale to me--the govt is just as good at banking as the private sector (maybe even better), so the govt can take over whatever aspects of banking with no loss to society as a whole and the govt gets to eat the banks' lunch? Is that right? (I'm thinking of RSJ's option 1 in his post "Leaving (Modern) Money (Theory) On The Table", and k's preferred option).

Vimothy,

Yes, I think pretty much anyone can offer vanilla deposit services. This does not require talent.

Extending loans and credit analysis requires talent. But no one is talking about squeezing banks out of the lending business, but rather taxing the profits they earn from providing deposit services.

Some nations -- e.g. Japan -- has its post offices provide deposit services of this form. I would be surprised if it was harder to to do this than to deliver mail. But we are talking about huge cash-flows. If the spread between MZM Own Rate and FF is 2%, then 7 Trillion * 2% = 140 Billion per year.

There's no way that this money is spent on the costs of retail banking.


Trouble is, if you tax the banks offering deposit services, some other financial institution will find a way around it. Or banks themselves will. I think (not sure) that was the final straw that drove Canada to zero required reserves and interest on reserves. Banks said it was unfair that only they were taxed.

Nick,

You can apply the same argument to any sort of tax, and to any sort of benefit.

Banks are highly regulated institutions. It's not a question of difficulty of implementation, but of political will.

RSJ,

Do you envisage the govt making loans as well, or just taking deposits?

No, not making loans, just providing vanilla deposit services.

I've always that of that guaranteed $140 billion a year (in RSJ's example) as the bribe we pay the banks to have them submit quietly to regulation. They get easy risk free money and we avoid a repeat of the '30s. At least that's the theory... In the US at least things didn't quite turn out that way.

RSJ:

"If the spread between MZM Own Rate and FF is 2%, then 7 Trillion * 2% = 140 Billion per year. "

Should not it be "were" rather than "is" ?

It _is_ 0.15% today (0.25-0.1). Therefore, $1.1T * 0.15% = $1.65B.

Where's $7T come from ?

Btw. you tax idea seems good, but the banks will find a way to pass it to the consumers, more likely than not :)

Related question: What are the returns on MMMF and MMA like?

Could be that any MZM-FF potential spread is about to disappear anyway...

Vimothy/VJK,

LOL, yes, in a zero rate environment, there isn't much of a spread. I was thinking, say, a bit longer term. Perhaps I'm too hopeful?

P.S. MMMF and savings deposits are part of MZM. Time deposits are not. Not sure where you would get breakdowns for time deposits or for MZM components. The MZM Own Rate is a weighted average.

Thanks JKH. That's the one.

RSJ: sure, you can make that argument about any tax. But remember one difference: the inflation tax is more distortionary than other taxes like VAT or income tax (it causes a bigger welfare loss triangle for a given rectangle of tax revenue). That's because you can avoid the inflation tax by reducing your money income (just like income tax and VAT), but you can also avoid it by increasing velocity of circulation for a given money income.

I was referring to your 10:22 comment regarding evasion of the tax on financial institutions. Perhaps we were arguing at cross purposes.

vimothy:  I didn't say anything about "whatever aspects of banking." In particular, I said *nothing* about lending, i.e. credit brokering. I'm merely proposing that the central bank let everyone have digital currency, an obvious 21st century extension of the paper money they already provide to us and the digital money they *already* provide to the commercial banks. Additionally I'd prefer that commercial banks raise capital in the free market, without benefit of public subsidy in the form of grossly discounted deposit insurance.

Nick: "So what we would expect to see in equilibrium would be banks offering chequeing accounts that pay the full rate of interest, but have fees based on the number of deposits and withdrawals. AFAIK, they do offer some big accounts that look like that"

But they don't. Rates on chequing deposits are exactly equal zero. That includes the almost $500Bn of "chequable deposits" in the BOC's weekly financial statistics report which doesn't even bother to quote the rate (though it provides values for every other type of account: overnight savings deposits: 0.05%, overnight savings deposits over $100,000: 0.5%, neither of which have changed significantly in 10 years or more). This the *the* distinguishing negative feature of a chequing account, and the only reason to have an overnight savings account. I challenge you to go into any large Canadian bank and get an interest bearing chequing account.  There is no such thing.  An efficient equilibrium is exactly as you describe.  In reality, you earn literally, exactly *zero*, whether you deposit one dollar or one billion, and whether rates are at 1% like now, or 20% like 30 years ago.  

Maybe the reasons are regulatory:  I've been explained that since demand deposits can be withdrawn at any instant, they can't pay overnight interest.  In the US, Glass-Steagal prohibited the payment of interest on demand deposits, a restriction that was only removed with Frank-Dodd last year.  I suspect similar constraints in Canada, though it's not easy to tell: Regulations are created both at the BOC and OSFI, so it's a tough slog.

A tax on demand deposits has little distortionary effect since no price is set off of it (I don't see any relationship to the inflation tax).  The marginal cost of overnight lending is the interbank rate.  The principal effect is likely to be that the rate on savings deposits would shoot up to attract depositors out of chequing accounts.  So it redistributes
seignorage profits, some (demand deposits) to the government and some (savings deposits) to the depositors.

1. " In the US, Glass-Steagal prohibited the payment of interest on demand deposits, a restriction that was only removed with Frank-Dodd last year."

In the US, the G-S prohibition was circumvented as early as in 1970 by introducing negotiable order of withdrawal (NOW) accounts. NOW accounts have unlimited check writing privileges and are no different for all practical purposes from demand accounts (with some "for profit". limitations). Both NOW and demand accounts are classified as transactional accounts.
The trick to bypass G-S was having a formal bank right to demand a seven day notice. The right has never been exercised in practice.

2. So, in the US, the reason that NOW accounts pay tiny interest rate is simple -- there is no incentive/comeptitive pressure for the bank to pay more than they do today.

Historically, NOWs were motivated by competition from the MMMFs.

3. I do not remember what the situation is in Canada -- it's been a while :)


For each individual bank, deposits are demand determined. Households lend deposits to the bank whenever they want for as long as they want. They are each lending money for a small period of time.

But FF is the rate charged for banks borrowing reserves whenever borrower wants and in whatever quantity they want.

What would be the market mechanism that would drive these two rates to be equal?

But in aggregate we know that there will be a system level of deposits that is more less a constant function of income, as the demand for deposits is relatively interest-inelastic, and are set by timing of expected future expenditures. If the household doesn't believe it will need the money for near term expenditures, then they purchase a bond.

Therefore in aggregate, the banking system as a whole will receive funding at below the fedfunds rate, but its marginal costs of funds will always be fedfunds.

To fix this, you don't need to tax deposits per se. It's enough to tax the balance sheet at the policy rate, and then give credits for interest payments to creditors.

That would convert marginal costs into average costs.

I still don't see the connection with inflation. We *want* to impose taxes on banks, and we *want* banks to pass these costs onto borrowers, because creating money should have incur costs. The higher the tax, the lower the inflation.

I agree with vjk that banks have basically quit making even a pretense of competing on deposit rates. The supply of deposits to each bank is simply insufficiently elastic as a function of the paid rate. I decided to do the work of digging up and plotting the historical Canadian bank deposit rates. Here they are. The graph shows the official "Bank Rate", the "typical" rate on overnight savings deposits and the rate on deposits over $100K. The trend is pretty clear, but I'll try to do more illustrative graphs soon (tomorrow night, if I have a chance). Over the past 30 years, as rates declined, the rate paid by the chartered banks on deposits declined even more. The overnight deposit rate was around 2% lower than the Bank Rate in the early 80s but the spread increased gradually until the deposit rate hit roughly 0 in the early 1993 where it basically stayed ever since, even as the Bank Rate went as high as 8%. Deposits over 100k follow a similar pattern, starting at around a 1% discount in 1990 and increasing to a 1.5% discount until the Bank Rate hit 2.25% in Feb 2002, after which the Bank Rate rose from 2.25% back up as high as 4.75%, but the deposit rate completely disconnects and just gradually trends downward to its current 0.25%.

It looks to me like there is a new oligarchic equilibrium at 0% deposit interest. I am not at all familiar with models of monopolistic pricing, but it seems to me that it would not be that hard to imagine an equilibrium in which raising the rate would cause a greater loss of profit margin than it would attract additional deposit especially if the Bank Rate is fairly low, so a change in the deposit rate reflects a larger fraction of the profit margin.

Oops. Forgot to mention: the rate for deposits over 100K doesn't actually exist before 1990. I simply held the spread to the Bank Rate constant going back to 1980. Otherwise the google graph widget wouldn't work. Ignore the yellow line from 1980 to 1990.

Think of a world where Government debt has two components: interest-bearing bonds and non-interest-bearing 'currency' (this could be dollar bills, or zero-interest deposits in a state-owned bank, or commercial zero-interest deposits in a banking system with 100% reserve requirements and no interest on reserves). Then the average interest rate on debt, r*, is a weighted average of zero and the bond rate r. Even if r is greater than the growth rate g, so the economy is dynamically efficient, the possibility of seigniorage on currency means that r* may be less than g and thus permit Ponzi finance. Clearly the more the Government can induce the private sector to hold its wealth as currency (and thus avoid paying interest) the greater the scope for such schemes.

In the UK pre-1970 (I'm not an expert on Canada or the US) banks did not pay interest on current accounts, although the profits from this arrangement accrued to the banks (via a cartel arrangement) rather than the Government (via taxes or zero interest on reserves). Banks also sometimes charged for current account transactions. The result was that a relatively small proportion of the population held chequing accounts, and currency was much more widely used. Such arrangements might appear to increase the currency/debt ratio, and hence allow extra seignorage. But they also meant that most workers were paid weekly in cash, and that both allowed them to economise on cash (reducing seignorage) and imposed substantial real costs. So any argument which suggests that Governments can increase seignorage revenue by eliminating interest on demand deposits (with a corresponding tax on bank profits) must recognise that such a policy would also change payment arrangements (as well as the fact that a privately-owned financial system would rapidly invent substitutes such as money-market mutual funds). And I doubt if you could uninvent the credit card, except in the context of a socialist system which prohibited privately-owned financial institutions.

In addition, even if the Government can reduce r* below g, the argument that it can finance unlimited deficits through debt creation is flawed unless the private sector is willing to hold a very large amount of debt relative to GDP. If r* is zero (an extreme case), the overall deficit and primary deficit are the same (since there is no debt interest to pay). If the Government runs a deficit (measured as a fraction of GDP) which is greater than the product of the growth rate of GDP and the current value of (debt/GDP), the debt/GDP ratio will rise. So, for example, assuming a growth rate of 3% and a debt/GDP ratio of 200%, the debt/GDP ratio will rise for any deficit greater than 6% of GDP. It is true that this increase in the debt ratio will (assuming the interest rate remains at zero) allow the sustainable deficit/GDP ratio to be larger in the future: but it really is unclear why individuals should wish to hold vast amounts of (illiquid) zero-interest debt if other assets are available. Since the effectiveness of all such schemes depends on the difference between r* and g, a more realistic assumption about the interest rate on bonds means that the required debt/GDP ratio becomes larger still.

There are two further points about debt and functional finance which seem to be worth making. Firstly, many of the problems with functional finance and cumulating deficits disappear if Governments can run deficits (thereby ensuring full employment) while simultaneously acquiring productive capital. In this case there is an asset and revenue stream which corresponds to the higher debt, and (assuming the investment pays off) no future tax liability. I suspect that it was this modest 'socialisation of investment' which many supporters of functional finance (including Keynes) wanted to see. Secondly, the argument that debt interest payments are merely transfers between debtors and creditors ignores the fact that the interest payments are in effect lump-sum, while the taxes are not. (Incidentally, Barro's original argument for Ricardian equivalence also makes the lump-sum tax assumption). If taxes are not lump-sum, then this is a further reason for rejecting the Ponzi escape route from the long-run budget constraint: significant deficits are only feasible if the debt/GDP ratio is high, and this will impose large tax-induced distortions. (I accept that in theory you could have a huge debt/GDP ratio and raise ALL revenue via Ponzi finance, but I don't think that a policy in which there are never any taxes is credible).

William: good comment. Agreed.

One minor addition: "Firstly, many of the problems with functional finance and cumulating deficits disappear if Governments can run deficits (thereby ensuring full employment) while simultaneously acquiring productive capital."

Agreed. But if the government were simply acquiring the productive capital that private investors would otherwise have acquired anyway, then there is a "direct crowding out" of private investment, so the deficit spending doesn't increase Aggregate Demand. Instead of the private firm building the factory and issuing bonds to finance it, the government builds the same factory and issues bonds to finance it. (Or the government buys ownership of the factory, and replaces private bonds with government bonds. Or, the government buys the private bonds and issues its own bonds to finance them, so it's really just acting as a financial intermediary.)

First of all, can we agree that the Long-Run Budget Constraint, as defined here, has zero content for policy? It's descriptive, not prescriptive. It says that a shift toward deficit in this period necessarily implies a future-period shift toward surplus of equal PV, but it says nothing about whether such a shift is desirable. In particular, it does not provide any basis for talking about a "fiscal crisis", as the very next post on WCI does.

One of the most striking features of this debate, from the heterodox side, is that there's this disconnect between the consensus position on theory (the government net financial position is always zero in the long run) and the consensus position on policy (policymakers should accept large costs in order to keep the government financial position within certain bounds), yet neither side seems to realize it. Seriously, Nick, how to do you reconcile this post with the following one?

Anyway, I think I can convince you that the LRBC does not provide any basis for taking the existing stock of debt into account when setting fiscal policy. First off all, the standard formulation that you give here is just wrong. It shouldn't be government debt on the left side, but total government liabilities *and assets*. The important thing about this is it raises the question, how do we know the government is actually on its LRBC? note that strictly speaking, the constraint is an inequality. It's supposed to be satisfied exactly for households only on the assumption that they have no desire to accumulate wealth for its own sake, but only to finance consumption. That's not a very realistic assumption, but at least it's households; for governments, there's nothing equivalent. As far as I can tell, the only reason to assume that the government is on its LRBC is "just because." Well, of course in a closed economy if the private sector is on its constraint then the government must be on its constraint too, but that just goes back to the assumption that household's desired stock of financial wealth is zero. Drop this ad hoc and unrealistic assumption, and there's no reason that an increased deficit today can't correspond to increased financial wealth held by the private sector, rather than to increased taxes sometime in the future.

But my main argument is that there is a logical inconsistency in your position. Question: Are deviations in aggregate income due to fiscal policy strictly temporary, or do they have a permanent component? In the first case, if in the long run output always converges to potential, and potential output is unaffected by current output, then all fiscal policy can do is shift income between periods. But, it follows from this that a downward deviation in demand today must correspond to an upward deviation in demand in some future period. So we never need to worry about the problem of taxes being required to meet interest payments, because if we borrow just enough to get AD up to potential output in a current recession, then the taxes required to pay off the debt will always be just equal to the taxes we would charge in a future inflationary period to bring AD *down* to potential output. So we never need to know anything about the debt. Following the functional finance rule "if inflation and output are below target, make the deficit larger; if they're above target, make the deficit smaller" will automatically ensure that the long-run budget constraint is satisfied.

That's if there is no permanent component to the changes in output resulting from fiscal policy. If there is, we can no longer assume that the need for expansionary policy today implies a need for contractionary policy sometime in the future. If the output gap follows a unit root process, then it is true that following functional finance rules could lead to changes in the permanent changes in the stock of debt. However, in this case there is no longer a present value of future taxes and expenditures, independent of the decisions made in this period. We can no longer say that government fiscal choices must satisfy the long-run budget constraint, because the long-run budget constraint itself varies based on current fiscal choices.

Your argument is contradictory because it assumes both that there is no permanent component to fiscally-induced changes in output (so that we can speak of a single long-run budget constraint) and that there is a permanent component (so that following a pure stabilization rule can lead to long-run changes in the debt/GDP ratio.) To go back to the example of whether finding some overlooked debt should cause us to run a lower deficit in the current period -- in a LRBC world the answer is No, because that additional stock of debt also tells us that future demand growth is stronger than we expected, and so future tax revenue will be higher. Now you might say this is silly, and I agree -- but if it's not true then the long-run budget constraint is not defined.

A further comment on Nick's point that productive Government investment may crowd out private investment. Surely the functional finance position was that Governments should undertake such investment when AD was deficient (since otherwise the zero-inflation objective rules out deficit finance). As an old Keynesian, I don't believe we should worry about crowding out in these circumstances.

William: I used to be an Old Keynesian too, when I was young. And I still am a bit Old Keynesian, some days. So let me offer an internal critique:

One of the things we Old Keynesians weren't very good at was thinking about what exactly it is the government spends on, and whether this could matter for AD. We just wrote down AE=C+I+G, added a consumption function and an investment function, and treated all three components as separate. G did not appear as an argument in either the consumption function or the investment function. And if we think about it, that only really makes sense if government expenditure is on something totally useless like pyramids. We added G to GDP, and then ignored it. G did not appear in the utility function affecting the marginal utility of either present or future consumption; and neither did it affect the Marginal Efficiency of private Investment.

The government builds a bridge. Is it the "bridge to nowhere"? Would private firms have built it anyway? Or does it create an opportunity for profitable private investment now they can get the goods to market over the bridge? Is it a substitute or a complement to private investment? Is it also a substitute or a complement for current consumption or current saving? (Does it mean the old folks can walk to the Bingo over the bridge, so we don't need to save as much for taxis when we are old? Crap example, I know).

We ducked all those questions. But it's hard to duck them when we start thinking about the future revenue stream from government investments. They matter not just for welfare when the economy is at "full employment"; but they matter for AD too. The fiscal multiplier depends on what the government buys. It could be zero, negative, or it could be much bigger than the Old Keynesians thought, even if you accept all the Old Keynesian assumptions about the LM and AS curves. What the government spends the $100 on will affect how much the IS shifts (and might even cause it to shift the wrong way).

That was what I was getting at above, on productive investment.

JW: I don't follow all your comment. Let me respond to the bits I think I understand, then try a shot-in-the-dark.

"First of all, can we agree that the Long-Run Budget Constraint, as defined here, has zero content for policy? It's descriptive, not prescriptive. It says that a shift toward deficit in this period necessarily implies a future-period shift toward surplus of equal PV, but it says nothing about whether such a shift is desirable."

Like all budget constraints, it is necessary but not sufficient for getting policy right. It can tell you we have to cut G or increase T sometime, but not when. You need to supplement it with something else, for example an argument for smoothing T and/or G over time.

Looking at the current US fiscal position, the LRGBC, plus forecasts, say that there will have to be some nasty cuts in G and/or nasty increases in T sometime in the future. If something big and nasty is going to happen, most people call that an impending crisis. (Though it does remind me of what a former Canadian Prime Minister, Jean Chretien said once: "Sure I am driving towards the cliff. But the cliff is still a kilometre away. So when I get there I will turn the steering wheel. That's not a crisis!")

"It shouldn't be government debt on the left side, but total government liabilities *and assets*."

Sure. Put "net debt" on the left hand side, provided the assets are valued at the present value of the income they earn. Or add revenue from government investments to the tax revenue on the right hand side.

"The important thing about this is it raises the question, how do we know the government is actually on its LRBC? note that strictly speaking, the constraint is an inequality."

Interesting. I would say that it holds as an equality. Just as the debt/GDP ratio can't go to plus infinity in the limit (because the young generation wouldn't be able or willing to buy all the bonds off the old generation), it can't go to *minus* infinity either (because the government would just run out of assets to buy, after it had nationalised everything, including all human capital).

"But my main argument is that there is a logical inconsistency in your position. Question: Are deviations in aggregate income due to fiscal policy strictly temporary, or do they have a permanent component? In the first case, if in the long run output always converges to potential, and potential output is unaffected by current output, then all fiscal policy can do is shift income between periods."

Temporary. (Actually, not even that, if monetary policy can and will be used as a substitute for fiscal policy, but let's leave that aside). I see where you are coming from with "...then all fiscal policy can do is shift income between periods." But if you just slightly re-write it, so it says "...then all fiscal policy can do is shift *aggregate demand* between periods.", that is precisely what we want it to do. We want to boost demand during a recession, to prevent income falling, and reduce demand during booms, to prevent inflation rising. That's classic countercyclical stabilisation policy.

"But", I think I hear you say, "what if Aggregate Demand is permanently depressed, so we are in a permanent recession? In that case, don't we need a permanent deficit, that might be large enough to violate your precious LRGBC?"

That's the Keynesian nightmare scenario -- secular stagnation.

Let me give two answers:

1. that's what monetary policy is supposed to handle. There's no limit to printing money, permanently (except inflation of course, but if you are worried about secular stagnation and deflation then a bit of inflationary pressure is just what's needed).

2. What about Japan? Well, if you can push r down to zero, into the stable Ponzi area, it's fine to run deficits. And it's only when the public is unwilling to hold the debt, and wants to spend it, that you have to raise r above zero to stop them spending it and causing inflation. But by then you are out of the secular stagnation anyway. [There is the "Ketchup problem", but let's leave that aside].

This is where you lost me: "To go back to the example of whether finding some overlooked debt should cause us to run a lower deficit in the current period -- in a LRBC world the answer is No, because that additional stock of debt also tells us that future demand growth is stronger than we expected, and so future tax revenue will be higher."

Let me try a shot-in-the-dark:

Our thought-experiment. Suppose we have the economy exactly where we want it. AD just right, and expected to stay just right in future, given our planned time-paths for G, T, and M. And those paths also satisfy (we think) the LRGBC. Then we discover an extra $100 debt hidden away. So I say we have to cut G and/or raise T. And you reply (I think) "But that will cause a recession!" And I respond by saying you may well be right. Let's assume you are right. So we need to increase M/cut r to offset the reduction in AD from cuts in G and/or increases in T. But those increases in M/cuts in r amount to a free lunch for the government. True, and the government should eat that free lunch. So, taking the offsetting monetary policy into account, the LRGBC says we don't need to cut G and/or raise T quite as much as we first thought we did.

JW: to sum up, if you assume the IS curve is vertical, so monetary policy is unable to affect AD, then I can make sense of everything you say. But I don't believe that. Most economists don't.

Nick,

You said

"One of the things we Old Keynesians weren't very good at was thinking about what exactly it is the government spends on"

Actually, how government spends is not much different than how a corporation spends. Decisions to spend have to be justified. Let us take the case of a VC investing in a small startup seeking $1 to $2 million in seed funding and a small SBIR grant given say by the US Government, say the Department of Defense, or the National Institute of Health.

At the VC Fund, a fresh MBA will look at the proposals, and finally will decide whether or not to invest -- in his view, considering the likelihood of success at producing a return for the limited partners. But that person will ultimately be promoted based on his success/failure rate.

The other side also employs professional decision makers. They will evaluate the proposals also for how likely they are to be successful. The criteria of success will be different, but it is never the less there. The proposal will be whetted by industry and academic professionals for the soundness of the science. Then, the risks are further lessened by giving a small amount first (say $250,000) and then on the successful completion of that first stage, a larger sum may well be given (upto $2M) -- the competition for such grants can be fierce.

So, are the SBIR grants crowding out the VC's? I would contend that they are not. They are much more likely to be complementary in nature. There is a further need of such programs in recessionary times. In boom times (e.g. the dot com boom), even the most stupid ideas got VC funding. In the current GFC, there is very little VC funding to be had - so great start ups are dying on the vine -- So where is the money to fund such entrepreneurial activities going to come from? McDonalds just hired 62,000 low wage workers from over 1,000,000 applicants. So is it that over 940,000 applicants were total losers? Do you mean to say that the Government cannot come up with reasonably productive jobs for these people to do?

An ELR/JG program (Employer of Last Resort/Job Guarantee) has to be there. One way for the program to work is to give ABOVE minimum wage for half time work -- that way, the worker can work at a minimum wage job, or look for higher paying jobs. The private sector will not be denied minimum wage workers, but they will only be able to hire them for less than full time work. A program like this would give dignity to the least among us!

Also as an addendum to the above post, in the 1930's,WPA hourly wages were typically set to the prevailing (median) wages in each area.[8] However workers could not be paid more than 30 hours a week.

Also, the 8 should have been a * -- the reference being - Bradford A. Lee, "The New Deal Reconsidered," The Wilson Quarterly 6 (1982)

Another good book is - "The Works Progress Administration in New York City"
By John David Millett 1978 http://books.google.com/books?id=b0_IowoZsw8C&pg=PP7#v=onepage&q&f=false

Another good article by Edwin Amenta, Ellen Benoit, Chris Bonastia, Nancy K. Cauthen and Drew Halfmann of NYU - "Bring Back the WPA: Work, Relief, and the Origins of American Social Policy in Welfare Reform" http://www.socsci.uci.edu/~ea3/Bring%20Back%20the%20WPA%20Studies%20in%20American%20Political%20Development%201998.pdf

Sorry for the disjointedness of my references

One of the things we Old Keynesians weren't very good at was thinking about what exactly it is the government spends on, and whether this could matter for AD.

If you'll pardon a hack like myself going through your two, thoroughly realistic :-), scenarios:

Gvt. builds pyramids by deficit spending, which in turn has 0 positive effect on future AD. The money that seeps into the economy via the pyramid building contractor in the same way that it always has and always will. The effect of the deficit peters out with savings. And thus, at some point B in the future, there will be a need for further deficits to keep the current inefficient economy running at full employment (unless people suddenly decide to dissave). We have something akin to secular stagnation (as has been the case in most western countries for at least the past 30 years). So, given some minor inflation, the government budget deficit will actually have to continually rise to keep AD on track.

In the second case, in which govt. builds the bridge that gets seniors to their bingo, the deficits lead to a booming future bingo paradise (aka hell), and the necessary path of government spending will be very different. Since, through its sly investment, AD begins to steadily rise, future deficits will have to be continuously smaller and maybe even have to become surpluses if bingo-ing gets totally out of hand. In this case, the initial deficit does have some sort of a budget constraint attached to it.

Current discourse, both professional and general, seems to invoke the inevitability of the first case in a moral way, when it calls for spending cuts, while simultaneously using the very optimisitc assumptions of the second case when 'substantiating' the arguments with hig-flying talk of budget constraints and such. MMT posits that reality is somewhat closer to the first case, not least because of savings desires. It also posits that the way to get closer to case 2 is by keeping people employed at all times. The aim is definitely Nr.2 , but Nr.1 is better than nothing at all.

In any case, given that markets and politicians behave the way they do, there is not one 'optimal' government spending path, but, taking these two scenarios as poles of a continuous line, in fact there are at least two, very different ones. They are both functional in terms of keeping employment full and AD below full-blown inflation, but only one is efficient. It is called functional finance, not efficient finance after all... This, in turn, is also one of the reasons that FF prefers fiscal over monetary policy. With fiscal policy it is, at least theoretically, possible to positively influence future AD by making smart investments and also to address inequalities (that feed into market inefficiencies) by targeting spending. Targeting with monetary policy is somewhat more difficult if one doesn't have a lot of blind faith in markets. The other argument is that reliance on monetary policy requires much higher levels of private sector indebtedness to achieve the same results, notwithstanding the fact that results would not be the same, but that's another discussion, I guess.... At permanently low nominal interest rates such private indebtedness is not a problem. But with varying interest rates (i.e. monetary policy) and with interdependencies of modern markets, this breeds instability and uncertainty. Also, monetary policy not only weeds out malinvestment (as it should), but, among other things, incentivises capital holders to seek higher interest rates to extract rents and thus disincentivises productive work (as it shouldn't). So there is a case to be made for looking for ways to have one but not the other.

Hope that makes sense.

Nick - on pyramids etc

I fully agree. My point was that the two types of spending (pyramids and useful bridges, or useful and useless public goods) have different implications for the future time path of tax rates. If you allow the government to invest in private goods (toll roads and hydro dams - in the 30s Governments hadn't privatised all of these) then there is a third type of spending, since these investments will be partly or wholly financed from future commercial revenue.

Oliver

As I understand the monetarist orthodoxy, a major objection to fiscal policy is that the market always makes smarter decisions than the Government. If you care about distribution (and I'm not sure many of them are that bothered) then your redistribution policy should be based on simple cash transfer mechanisms (progressive taxes and tax credits) which are not varied in response to macro shocks. There are aspects of this with which I have some sympathy (eg don't build 'bridges to nowhere').

don't build 'bridges to nowhere

absolutely. but identifying the quality of those 'bridges' is what the discussion should be about, not about deficits per se. and i believe that is the point that MMTers are trying to get across.

William Peterson said:
As I understand the monetarist orthodoxy, a major objection to fiscal policy is that the market always makes smarter decisions than the Government.

I think what is missed is that the market works for short term planning, and rarely works for medium and long term issues. Within corporations, planning may get done for the medium term (1-2 years) but rarely has a time horizon beyond that. Then there is the issue of long term risky investments -- which will never be undertaken by private capital, and can only be undertaken by the Government. That was the point of one of my examples above.

The second example above dealt with the responsibility of the Government, which is to maintain minimum standards of life, labor and dignity, and to make sure that the powerful cannot prey on the weak. This last is something that the market is quite antithetical to. There are some very good theoretical papers which show that in purely competitive markets, with the ability to extract wealth based rent, the wealth gets increasingly concentrated in the hands of the top 1% or so of the population with the passage of time.

"Looking at the current US fiscal position, the LRGBC, plus forecasts, say that there will have to be some nasty cuts in G and/or nasty increases in T sometime in the future. If something big and nasty is going to happen, most people call that an impending crisis."

It's only nasty if it's pro-cyclical. Cutting G and raising T in a boom is painless. Why do you want to smooth them?

Max: "Cutting G and raising T in a boom is painless."

Not to the people who want the benefits from the government expenditure, and who pay the taxes.

"Why do you want to smooth them?" standard micro reasons: diminishing marginal benefits from government spending, and increasing marginal deadweight costs of distorting taxes.

Max: "Cutting G and raising T in a boom is painless."

Nick Rowe: "Not to the people who want the benefits from the government expenditure, and who pay the taxes."

Mebbe so, but the pain of a surplus or balanced budget is much less during boom times. Despite that fact, for some reason legislators are more inclined towards such measures during hard times. IMO, legislation should make it as automatic as possible. We already do that with gov't spending, by mandating additional spending in hard times. We could do it with taxes, by having high marginal rates, but with automatic rebates outside of boom times.

Min says:
for some reason legislators are more inclined towards such measures during hard times

This comes from thinking that Government financing is similar to household and business financing. Think of former businessmen running for state and federal office -"I shall run the government as a business" Indeed if you are a household or a business, it is much easier to envision going into debt and to think that you shall have the ability to pay back the loan with interest during boom times, and lean times are times for budgetary contraction. Same thinking is quite valid for businesses as well.

What these people forget, is that the Government is the supplier of money, while the private sector is the user of money. This is one of the key tenets of MMT/Functional Finance. Government is the endogenous producer of money, and therefore theoretically has no budget constraints. The only constraint being inflation (which will happen only if the economy is at full resource utilization) - Thus counter cyclical finance is very alien to legislators and to the common person. This is one lesson that is NOT taught in colleges and universities -- having been through over ten years of business and economic curriculum at the graduate school level, I can assure you that this fundamental difference between government and household finance is not highlighted in the curriculum! If it is not a part and parcel of business school, and the economics department, then it is definitely not a part of Law School. A majority of legislators are lawyers.

So yes what you sau is indeed true, and is the cause of many of our troubles!

"If the spread between MZM Own Rate and FF is 2%, then 7 Trillion * 2% = 140 Billion per year."

OK, that's 1% of GDP in seigniorage profits. But let's talk about the REAL money. If Tsy applied the RSJ tax (or the Fed applied the remarkably similar RSJ user fee) to the Fed fund market, wouldn't that peg the Fed Fund rate as effectively as paying interest on excess reserves? If the lending bank must build in the cost of, say, a 2% tax (annualized) on overnight loans, its a safe bet the Fed Fund rate isn't dropping below 2%. Whenever Tsy (or the Fed) wishes to raise or lower interest rates, it'd simply adjust the RSJ tax, increasing or decreasing both Fed Fund rate and tax revenue in one fell swoop.

A tenet of MMT is of course, that the purpose of Tsy selling bonds (or the Fed paying interest on reserves) is interest rate maintenance, that is, if the govt didn't drain excess reserves, the Fed Fund rate would drop to zero. An RSJ tax that anchored the FFR would allow the govt to spend without borrowing (most straightforward way, if Congress authorized Tsy to electronically create US Notes-- Lincoln's Greenbacks-- whenever it needed to write a check). That means the present cost, 2% or 3% of GDP, of net interest on the debt would go away. Indeed the more excess reserves created, the bigger the tax base for RSJ's handy tax. Let me know if I missed something in that happy tale.

One final note about interest rates, remember SRW's point that while the prime rate markup has been locked at 3%, it used to vary and averaged less than 1.5%. The Fed could always order banks to increase or even decrease (ha!) the 3% prime rate markup.
http://www.interfluidity.com/posts/1160447599.shtml

I've added another graph to better illustrate the regime change in Canadian deposit rates. The second graph plots overnight savings rates and overnight savings over $100K versus the policy bank rate. I think it shows pretty clearly that deposit rates, since they hit zero, have become disconnected from the policy rate.

I know its very late in the conversation so I'm just going to summarize my main points:

1) Canadian deposit rates used to be 1-2% below the policy rate, and would follow that rate quite closely. The spread increased dramatically over the years, and furthermore deposit rates have ceased to follow the policy rate, and instead are stuck at zero even when the policy rate has risen as high as 8%.
2) There is no excuse for this in terms of marginal cost: technology and automation have increased dramatically and there are no new services associated with deposit accounts. If deposits could pay Bank Rate minus 1 or 2% in the 80s, they could pay more now. The only reasonable explanation for the current situation is the existence of a suboptimal equilibrium, i.e. a market failure as described in my comment above.
3) When there is strong empirical evidence of a large market failure, that is good cause for government to step in. The federal government should create a system of digital cash that pays the policy rate and charges transaction fees (like LVTS but for all Canadians). To complete the transition to a free market banking system, they should set a timeline for revoking deposit insurance. Investors in bank debt and other securities should be able to monetize their assets via repo at the bank of Canada, which would enable more than adequate money creation.

Forgot to add: The deposit rate dynamic described above is just the $200bn of overnight savings deposits. The government system would also provide an alternative for the $460bn of chequing deposits (currently earning nothing) and $570bn of term deposits that are also guaranteed by the citizens of Canada.

Finally, here is why I don't like RSJ's tax (though I like it better than the current system): It only further entangles government and banks, it further entrenches a fundamentally unstable system of money creation, and does nothing to enforce a market price for deposit insurance. Once there is a safe alternative system of money, we can be free of the moral hazard of deposit insurance and resulting public bank bailouts, and the banks can be free to intermediate credit, without burdensome regulation or other state interference. It's win-win.

beowulf: I don't understand. You can tax demand deposits at FF because they don't pay interest to the holder. But if you tax interest paying deposits (in an *efficient* competitive equilibrium), the interest will have to drop by the amount of the tax, i.e. the tax incidence will be on the depositor. If you tax the FF market, though, banks aren't going to use it. They'll find some untaxed way to lend: TRS, off-market trades, God knows what. Anyways, the interbank market is a *good* thing. It transfers balances between banks as required by the current system of payments. It's not some kind of vast source of monopoly profit (unlike demand deposits), so taxing it will only create market distortion. Perhaps I don't understand your proposal. If so, maybe you can make it clearer.

K,

There is no "market price" for deposit insurance. And no, guessing does not give you an efficient price.

Deposit insurance is required in any modern economy. We would have a much more unstable economy without it.

... which is another way of saying that the efficiency results fail to apply when people either are unsure of the utility that they will receive from a good (or claim), or when there is *any* disagreement about the probability of an event occurring.

Yes, you will still have a market price, but it wont be an ex-post efficient price, it will be an inefficient price.

In that case, it may be better for the government to provide the service at cost outside of the market allocation system. The welfare theorems only result in efficient outcomes when you know what you are buying or when there is perfect unanimity about the likelihood of events occurring.

That is why I am not a free-marketeer. If you let security markets price everything, then you will be in a horribly inefficient world.

"Deposit insurance is required in any modern economy."

That seems unlikely, given that formal insurance is limited in scope - only covering small bank deposits and completely ignoring the massive non-bank deposits held in money market funds.

Here is my layman attempt to summarize MMT/Functional Finance:
Govt deficit should be accommodating the non-govt sector’s desire to save currency + the growth of the economy. Any part of the govt spending that is not saved or does not result in growth (and thus does not pay for itself) has to be taxed away or inflation will occur.
Now, this is all good in "normal" regime. But...
if saving propensities change so abruptly that a regular fiscal adjustment is impossible, then price controls and rationing JK Galbraith style are in order.
The last bit refers to abnormal circumstances that can result from external shocks (natural disasters, wars, massive brain farts of the populace...)

@Nick Rowe:

That is the key assumption of MMT -- that interest rates merely re-distribute income between debtors and creditors. But that ignores the substitution effect of interest rates on desired investment and consumption -- on intertemporal consumption and production decisions

This is what I find baffling about mainstream economics (not having any training in economics) - this idea that the govt needs to bribe the non-govt sector not to spend via the interest rates on the bonds. The way I see it, there is never a person who says: the interest rates are too low, let me go and buy a canoe instead (using your own example from the Winterspeak thread :) ) The households decide what part of their income to save first and on the vehicle of savings later. Even more true for pension funds, that have funds they have to save. If there are no govt bonds, they'll have to channel their savings into some other vehicle, depending on their risk aversion (so, those that invest in govt bonds would most probably switch to the next available low risk low return investment like munis.) This money that is not used to buy the govt bonds starts running around the available savings/investment vehicles, lowering their rates/raising their prices to the new indifference level.

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