economics

Do economists need to talk about consumption?

This post was originally published here, as part of a series titled Demanding change by changing demand produced by environmental charity Global Action Plan. Some similar themes are explored in more technical detail in the context of lower- and middle- income countries in a recent working paper for the ILO, co-authored with Adam Aboobaker.

For much of the last thirty years or so, progressive economists have argued that macroeconomic policy is too tight. In simpler terms, this means that some combination of higher government spending, lower taxation, and lower interest rates will lead to more jobs and higher incomes.

Such arguments are sometimes presented as part of advocacy for initiatives responding to the environmental crisis, such as the Green New Deal. For the most part, however, the environmental implications of higher near-term economic activity in rich countries do not attract much attention – it is taken as given that higher economic activity, as measured by gross domestic product (GDP), is unequivocally positive.

The current situation of high inflation, driven by energy shortages, war and climate change, serves as a sharp reminder that there is something missing in analysis which sees higher growth as an entirely free lunch. Almost all economic activity depletes scarce physical resources and generates carbon emissions. Higher employment usually comes at the cost of higher emissions. Furthermore, it is possible that we are now also reaching the end of the historic period in which physical resources were usually immediately available – so that economic activity could quickly rise in response to higher overall spending. The era of the Keynesian free lunch may be ending, replaced by a regime characterised by recurring inflationary episodes.

This puts progressive economists, like myself, who believe that the economies of rich countries are predominantly demand driven – meaning that higher overall spending means more jobs and higher incomes – in an uncomfortable position.

This view relies partly on the idea of the “multiplier”. This is the claim, which is well supported by empirical evidence, that every pound of new spending in the economy will generate additional income and spending over and above the initial pound spent. The mechanism works, to a large extent, by stimulating consumption spending: if a new government investment project is initiated – to provide additional green energy, for example – the money spent on the project – on wages, transport and materials – will be received by individuals and businesses as income. Some of this additional income will be spent on consumption, generating a second round of additional new incomes.

Similarly, the argument that redistribution from those on higher incomes to those on lower incomes is good for growth relies on the fact that those on lower incomes spend a greater proportion of their incomes on consumption goods – redistribution from rich to poor thus raises total consumption expenditure and economic activity.

How are progressive economists to respond to the now inescapable fact that current resource use greatly exceeds planetary limits, and “decoupling” – the trend for energy and resource use per dollar of spending to fall as GDP rises – will not be sufficient to stay within planetary boundaries if steady GDP growth continues?

There is no single answer to this question – the appropriate response will require action on many fronts simultaneously. However, economists are beginning to consider whether we need to introduce constraints on consumption, at least for those on higher incomes in rich countries, as part of the solution. Rather than relying only on voluntary consumer choice and natural shifts in consumption patterns – such as the trend towards lower consumption of meat in some rich countries – it may be that state intervention is required to influence both overall levels of consumption and its distribution.

There are two main arguments in favour of constraining consumption. The first is straightforward: all consumption, whether of food, transport, clothing or shelter, involves carbon emissions and resource depletion. Reduced consumption growth should translate directly into lower emissions growth.

The other relates to the need to reallocate current resources, including labour, towards the investment needed to fundamentally reshape our economic systems. Lower consumption means fewer people working in industries which provide for consumption spending, and fewer raw materials devoted to the production of consumption goods. This frees up resources for green investment: people and materials can be re-deployed towards the investment projects which are urgently needed.

This raises some thorny questions: what policy tools can be used to shift the composition and scale of consumption? Which groups should face incentives – or compulsion – to reduce consumption and what form should these measures take? How will voluntary shifts in consumption interact with more direct measures to reduce consumption? And crucially, how can jobs and incomes be protected without relying on consumption as a key driver of macroeconomic dynamism?

Much of this comes down to issues of distribution. Statistics on poverty make clear that large numbers of people in rich nations are unable to consume sufficient basic necessities. Basic justice dictates that the average incomes and consumption of those in lower income countries be allowed to catch up with those of richer countries. The need for redistribution of income within countries, and income catch-up across countries is undeniable – yet such redistribution, if it were to occur without other changes, will lead to increased overall consumption and emissions.

It is therefore hard to avoid the conclusion that taxation and regulation will be required to limit some part of the energy-intensive consumption of those on higher incomes in rich countries, particularly consumption which can be considered “luxury” consumption.

One plausible response to such suggestions is to claim that voluntary shifts in the kinds of things produced and consumed will naturally lead to reduced emissions, even while “consumption”, as measured by the national accounts, continues to grow. This kind of voluntary behavioural and consumption change – buying fewer cheap clothes, holidaying by rail rather than plane, switching to electric cars – will have a part to play in the transition to a low carbon economy, alongside reorientation from goods consumption to a more services-driven “foundational” economy. It is unlikely, however, that such changes will be sufficient.

The politics of consumption constraints are daunting. Managing competing distributional claims in the face of opposition from increasingly concentrated wealth and power is hard enough when the overall pie is growing. As we move towards a world of potential genuine scarcity, the politics of redistribution will become even more malign. This only emphasises the importance of getting the economics right.

Any successful response to the climate crisis will inevitably involve action and change at all levels – from local organising and “organic” shifts in consumption to reform of financial systems and action to tame corporate power and concentrated wealth. Constraints on the consumption of the relatively well off should be part of such a response. A debate about the economics and politics of these constraints is overdue.

Fiscal silly season

We are entering fiscal silly season. As the budget approaches, we should brace for impact with breathless reporting of context-free statistics about inflation, interest rates and government debt.

The story is likely to go something like this. Inflation is rising. This raises costs on government debt because some of it (index-linked bonds) pays an interest rate linked to inflation. Costs associated with quantitative easing (QE) will also increase because QE is financed by central bank reserves which pay Bank Rate (the Bank of England’s policy rate of interest). Since inflation is rising the Bank will have to raise interest rates to control it. This will increase the financing costs of QE and the cost of issuing new debt for the Treasury.

The conclusion — sometimes implied, sometimes explicit — is usually some version of “the situation is unsustainable therefore the government will have to make cuts”.

While each part of the story is technically correct in isolation, the overall narrative — debt is out of control and the situation is going to get worse because of inflation — doesn’t stand up to scrutiny.

These stories are rarely presented with sufficient context. Instead, journalists tend to rely on statistical soundbites such as “public debt is the highest since … ”. This is rarely if ever accompanied by the fact that debt/GDP is a fairly meaningless number.

The problems associated with government debt essentially boil down to the fact that debt involves redistribution. In the case of the government this means redistribution in the form of transfers from tax payers to bond holders. This is politically difficult. (This is also why “but currency issuer …” responses to these issues are largely beside the point — the problems of debt management are ultimately political not technical).

The ratio of debt to GDP tells us very little about the current political difficulties arising from debt servicing. Instead, the relevant magnitudes are total interest payments and tax revenues.

Total interest payments are equal to the debt stock multiplied by the effective interest rate on government debt. Focusing on the debt stock in isolation is thus equivalent to representing the area of a rectangle by the length of one side.

A better indicator of the risks associated with public debt is the ratio of government interest payments to tax revenues, as plotted in the figure below.

Interest payments on government debt have indeed risen recently. A spike in June triggered media articles about the highest interest payments on record. In context, such statistics are shown to be meaningless. Interest payment have risen to around 6% of taxation over a four quarter period, compared with all-time lows of about 5.3%. (Calculated on a 12 monthly basis this rises to around 6.5%). It is hard to see signs that the sky is falling.

In fact, this indicator overstates current interest costs. This is because much of the interest paid by the Treasury is paid to the Bank of England which holds a substantial chunk (currently around 37%) of UK government debt as a result of QE (see chart below). Most of this interest is returned directly to the Treasury. Since the start of QE, this has saved the Treasury over £100bn in interest costs.

Adjusting for this reduction in interest payments produces the figure below: net interest payments sum to around 4.7% of tax revenues over the last four quarters (or 5.2% on a rolling 12 monthly basis).

What of the dangers ahead? It is true that if inflation rises, then interest costs will rise, all else equal. But the scale of these rises is not predetermined, and will be affected by policy.

First, persistent inflation is far from a certainty. If if inflation does persist in the short term, the Bank does not need to raise interest rates. Hikes in response to price pressures due to pandemic reopening and supply side bottlenecks will do more harm than good — instead the Bank should wait until the economic recovery is clearly underway. In this context, interest rate increases would likely be a good sign, and would be offset by rising tax revenues. Further, the Bank could introduce a “tiered reserve” system which would serve to hold down the rate paid on a substantial proportion of outstanding debt. Short term and index-linked debt can be rolled over at longer maturities, delaying the point at which higher rates would feed into higher interest payments.

In summary, simple claims such as “a one percentage point rise in interest rates and inflation could cost the Treasury about £25bn a year” are not useful without context and explanation of the long list of assumptions required to produce such a figure. The policy conclusions derived from such claims should be taken with a large pinch of salt.

Season’s Greetings and enjoy the festive period!

Loanable funds is not helping

Noah Smith has a Christmas post in which he intervenes in the debate over whether $600 government cheques should be given to rich people or poor people. This is the latest iteration of the age-old debate that stems from the dubious argument that income inequality is good because rich people use resources efficiently and poor people waste them. Noah correctly concludes that this argument is wrong and that cheques should be sent to those on lower incomes. But his argument contains several mistakes.

National Saving

Noah starts by discussing whether the rich or poor are more likely to save their $600 cheque, noting that although the rich have a higher propensity to save than the poor, the effect on “national saving” of windfall gains like a one-off cheque may be hard to predict: “if you want to increase national saving, you might want to give the $600 to Tiny Tim instead of to Scrooge!”

Noah’s assumption, at this point in the argument, is that unspent government cheques will increase “national saving”. Is this plausible?

The official definition of “national saving” is total income, Y, less total consumption expenditure, C, (including government consumption). Since “saving” for each sector is sector income less sector consumption, “national saving” is also equal to private saving plus public saving. Manipulation of accounting definitions demonstrates that S = I + CA, where S is national saving, I is total investment (private and public) and CA is the current account surplus. For a closed economy, CA = 0 and S = I. For “national saving” to increase, either I or CA must increase.

Why would members of the public — rich or poor — depositing government cheques at banks increase national saving?

If the cheques are bond-financed, then private sector financial investors have handed over deposits in return for government bonds, while households have accepted deposits. The overall effect is an increase in bond holdings by the private sector, and a redistribution of private deposit holdings. Since private sector income has increased but consumption has not, private sector saving has increased.

But public sector saving has decreased by an equal amount. National saving is unchanged — as is total income. (The same is true for tax-financed cheques.)

Loanable funds

Noah then poses the question “do we really want to increase national saving?”

On a charitable reading, we can assume that, by “national saving”, Noah means “private sector saving”, and his question should be read accordingly.

To answer the question, Noah uses the loanable funds model. Before going on, we need a brief recap on why this model is incoherent, at least when used without care.

As already noted, S = Y – C = I + CA: “National saving” is just another way of saying “investment plus the current account”. There is no such thing as a “supply of savings”: households can choose to consume or not consume. They cannot decide on the size of S, because it equals Y – C. Households choose C but not Y, therefore they don’t choose S. A macro model which has “supply of saving” as an independent aggregate variable is incorrectly specified.

Noah uses this model to consider what happens when the “supply of saving” increases (which he apparently takes as equivalent to the “supply of” what he calls national saving).

He starts by noting that the usual configuration is such that an increase in the “supply of saving” causes “interest rates or stock returns or whatever” to fall and this in turn raises business investment. He then adjusts the model by asserting, “OK, suppose that the amount of business investment just doesn’t depend much on the rate of return”. (By “rate of return” he means “interest rates or stock returns or whatever”, i.e. the rate paid on loans by business, not the rate of profit on business investment.) This gives a diagram like so:

Now, here comes the punchline:

OK, now suppose that in this sort of world, you give someone $600 and they stick it in the bank. That increases the supply of savings. But it doesn’t do anything to the demand for business investment. Businesses invest the same amount. And the rate of return just goes down … in fact total saving doesn’t even go up!

What’s going on here? The supply of savings has increased yet total saving doesn’t change? To understand what Noah thinks he’s saying, let’s switch to apples briefly. Imagine the same supply-demand diagram as above with a vertical (inelastic) demand curve but this time for apples.

This model says that, assuming the quantity of apples consumed is fixed, if the cost of production of apples decreases (because that’s what the supply curve represents, at least in a competitive market), then the price of apples falls. A similar outcome arises if, instead of the cost of production falling, a magician appears, waves a wand, and a stack of extra apples magically appear all harvested and ready for market. At the marketplace, if nobody knows about the wizard, it just looks like the price of apples has fallen.

This is what Noah is doing with the “increase in supply of savings (apples)” arising from the $600 cheques (magic apples): since the “demand for savings” (apples) is fixed, apple sales (business investment/”national savings”) won’t change, but the price (“the rate of return on stocks or whatever”) falls. On the diagram, it looks like this:

This is incoherent in its own terms because, as already noted, a “supply of savings” doesn’t exist in the same way that a supply of apples does: apples are not one number minus another number.

But even putting this non-trivial issue aside, There is a another problem.

Where did the apples go?

Remember that the “supply of savings” has increased in the sense that the price per unit has fallen. But the actual quantity of “savings” is unchanged, according to Noah.

In apple world, the way this works is that when the magic apples appear, the orchard people, understanding the inelastic demand curve of the marketplace, save themselves some effort, harvest less apples, but take the right amount to the marketplace.

How does it work for the “supply of savings?” Don’t worry, Noah has an answer!

You give the $600 to one person, they stick it in the bank or in the markets, that lowers interest rates or stock returns or whatever, and then other people save $600 less as a result. No change.

Pretty neat. Every time someone banks a $600 cheque, another person responds by spending exactly $600 on consumption! In the aggregate, Noah tells us, every dollar is spent! It’s actually impossible for the private sector to save their cheques!

Conclusion

This kind of incoherence is where you end up when you read results from pairs of lines that do not represent the thing that you are trying to understand. The conclusion that total consumption expenditure increases by an amount exactly equal to the total value of the cheques arises as the result of a sequence of ill-defined concepts and inappropriate assumptions, all bolted together without much thought.

In reality, what will happen is the following. Some cheques will be saved, some will be spent on consumption. Those that are saved will have no effect on national saving and probably little effect on the rate of interest, although they might nudge asset prices up a bit. Higher consumption will lead to higher national income, employment and imports. National income will probably rise by more than the amount spent on consumption because of the multiplier. “National saving” is a residual — income less consumption — and is a priori indeterminate. None of this requires us to go anywhere near a loanable funds model.

Loose use of terminology and hand-waving at poorly-defined graphical models does not constitute macroeconomic analysis.

Developing and emerging countries need capital controls to prevent financial catastrophe

A shorter version of this letter was published in the Financial Times on 25 March 2020.

All countries currently face the unprecedented threat of a simultaneous and global health crisis, economic recession and financial meltdown. But unlike rich nations, emerging and developing countries (DECs) lack the policy autonomy needed to confront these crises. The global currency hierarchy places DECs in the periphery of global financial markets, exposing them to sudden stops caused by triggers such as the COVID-19 crisis. The US Federal Reserve announced it would lend up to USD 60bn to the central banks of Mexico, Brazil, South Korea and Singapore. But this is not enough. Immediate capital controls, coordinated by the IMF, are needed to prevent financial disaster.

In a global financial crisis, there is a rush to hold liquid assets denominated in safe currencies, especially US dollars. This enables rich countries to respond to crises with the necessary fiscal and monetary tools. The opposite is true for DECs. Since the outbreak of the COVID-19 crisis, international investors have withdrawn large sums from DEC assets, leading to dramatic currency depreciation, especially for those exposed to falling commodity prices.

Over the past decade, ample global liquidity driven by rich country central banks, alongside sustained demand for liquid assets, has led to enormous flows of credit and equity investment into DECs, where bond and stock markets grew from about 15 trillion to 33 trillion US dollars between 2008 and 2019. ‘Frontier economies’ and DECs corporations have issued substantial volumes of foreign currency debt. With G20 encouragement, DECs opened their domestic currency bond markets to international investors. In what has been termed the second phase of global liquidity, new financial instruments and institutions, such as international funds and exchange-traded funds (ETFs), have enabled easy global trading of DECs assets, cementing the illusion of liquidity.

DECs are now confronted with a sudden stop as global liquidity conditions tighten and investors flee from risk: exposure to DECs remains a high-risk/high-return strategy, to be liquidated in times of crisis. In consequence, DECs face severe macroeconomic adjustment at precisely the moment when all available tools should be used to counter the public health crisis presented by COVID-19: some countries may be forced to tighten monetary policy in an attempt to retain access to the US dollar, while fiscal action may be constrained by fear of losing access to global markets. Foreign exchange reserves are unlikely to provide a sufficient buffer in all countries. This would have profound consequences for the global economy: DECs, both in the G20 and beyond, are now far more important for global growth and markets than even a decade ago. The failure of a large sovereign or quasi-sovereign borrower could trigger significant contagion.

There is an urgent need for action to prevent this crisis reaching catastrophic proportions in DECs. Despite long-standing calls for action, there is still no international lender of last resort. The only instruments currently available are IMF lending and foreign exchange (FX) swap lines between central banks. IMF loans typically impose fiscal tightening, which would be disastrous under current conditions. The US Federal Reserve stands ready to provide US dollars to a handful of major central banks: among DECs, only Mexico can access Fed and US Treasury swap lines under NAFTA provisions, and South Korea and Brazil have just had their arrangements re-opened. But these ad-hoc arrangements exclude a large proportion of DECs’ need for dollar liquidity.

We call for decisive action to constrain the financial flows currently transmitting the crisis to EMs. Capital controls should be introduced to curtail the surge in outflows, to reduce illiquidity driven by sell-offs in DECs’ markets, and to arrest declines in currency and asset prices. Implementation should be coordinated by the IMF to avoid stigma and prevent contagion. FX swap lines should be extended to include more DECs, in order to ensure access to US dollars. Finally, we concur with recent calls for greater provision of liquidity by the IMF using special drawing rights (SDRs) – but this must take place without the imposition of pro-cyclical fiscal adjustment.

The unfolding crisis is one of the most serious in economic history. We must ensure that governments can do everything possible to protect their citizens. In our globally integrated economy, coordinated action is needed to minimise the externally-imposed constraints on developing and emerging countries as they face the triple threat of pandemic, recession and financial crisis.

Organising Signatories

Nelson Barbosa, Sao Paolo School of Economics

Richard Kozul-Wright, UNCTAD

Kevin Gallagher, Boston University

Jayati Ghosh, Jawaharlal Nehru University

Stephany Griffith-Jones, Columbia University

Adam Tooze, Columbia University

Bruno Bonizzi, University of Hertfordshire

Daniela Gabor, UWE Bristol

Annina Kaltenbrunner, University of Leeds

Jo Michell, UWE Bristol

Jeff Powell, University of Greenwich

Signatories

Adam Aboobaker, University of Massachusetts Amherst

Kuat Akizhanov, University of Birmingham and University of Bath

Siobhán Airey, University College Dublin

Ilias Alami, Maastricht University

Alejandro Alvarez, UNAM, México

Donatella Alessandrini, University of Kent

Jeffrey Althouse, University of Sorbonne Paris Nord

Carolina Alves, Girton College – University of Cambridge

Paul Anand, Open University and CPNSS London School of Economics

Phil Armstrong, University of Southampton Solent and York College

Paul Auerbach, Kingston University

Basani Baloyi, South Africa

Frauke Banse, University of Kassel, Germany

Benoît Barthelmess, Le Club Européen

Pritish Behuria, University of Manchester

Kinnari Bhatt, Erasmus University Rotterdam

Samuele Bibi, Goldsmiths University

Joerg Bibow, Skidmore College

Pablo Bortz, National University of San Martín

Alberto Botta, University of Greenwich

Benjamin Braun, Institute for Advanced Study, Princeton

Louison Cahen-Fourot, Vienna University of Economics and Business

Jimena Castillo, University of Leeds, UK

Eugenio Caverzasi, Università degli Studi dell’Insubria

Jennifer Churchill, Kingston University, London

M Kerem Coban, GLODEM, Koc University, Turkey

Andrea Coveri, University of Urbino, Italy

Moritz Cruz, UNAM, Mexico

Florence Dafe, HfP/TUM School of Governance, Munich

Yannis Dafermos, SOAS University of London

Daria Davitti, Lund University, Sweden

Adam Dixon, Maastricht University

Cédric Durand, Université Sorbonne Paris Nord

Chandni Dwarkasing, University of Siena, Italy

Gary Dymski, University of Leeds

Ilhan Dögüs, University of Rostock, Germany

Carlo D’Ippoliti, Sapienza University of Rome

Dirk Ehnts, Technical University of Chemnitz

Luis Eslava, Kent Law School, University of Kent

Trevor Evans, Berlin School of Economics and Law

Andreas Exner, University of Graz

Karina Patricio Ferreira Lima, Durham University

José Bruno Fevereiro, The Open University Business School

Andrew M. Fischer, Erasmus University Rotterdam

Giorgos Galanis, Goldsmiths, University of London

Santiago José Gahn, Università degli studi Roma Tre

Jorge Garcia-Arias, University of Leon, Spain and SOAS, University of London

Alicia Girón – UNAM-MEXICO

Thomas Goda, Universidad EAFIT, Colombia

Antoine Godin, University Sorbonne Paris Nord

Gabriel Gómez, UNAM, México

Jesse Griffiths, Overseas Development Institute

Diego Guevara, National University of Colombia

Alexander Guschanski, University of Greenwich

Sarah Hall, University of Nottingham

James Harrison, Prof, University of Warwick

Nicolas Hernan Zeolla, National University of San Martin, Argentina

Hansjörg Herr, Berlin School of Economics and Law

Elena Hofferberth, University of Leeds

Jens Holscher, Bournemouth University

Peter Howard-Jones, Bournemouth University

Bruno Höfig, SOAS, University of London

Roberto Iacono, Norwegian University of Science and Technology

Stefanos Ioannou, University of Oxford

Andrew Jackson, University of of Surrey

Juvaria Jafri, City University of London

Frederico G. Jayme, Jr, Federal University of Minas Gerais, Brazil

Emily Jones, University of Oxford

Ewa Karwowski, University of Hertfordshire

Y.K. Kim, University of Massachusetts Boston

Stephen Kinsella, University of Limerick

Kai Koddenbrock, University of Frankfurt

George Krimpas, University of Athens

Sophia Kuehnlenz, Manchester Metropolitan University

Ingrid Harvold Kvangraven, University of York

Annamaria La Chimia, University of Nottingham

Dany Lang, Université Sorbonne Paris Nord

Jean Langlois, Le Club Européen

Christina Laskaridis, SOAS, University of London

Lyla Latif, University of Nairobi

Thibault Laurentjoye, École des Hautes Études en Sciences Sociales (EHESS), Paris

Dominik A. Leusder, London School of Economics

Noemi Levy-Orlik, UNAM, Mexico

Gilberto Libanio, Federal University of Minas Gerais, Brazil

Duncan Lindo, Vrije Universiteit Brussel

Lorena Lombardozzi, Open University

Anne Löscher, University of Siegen, Germany; University of Leeds

Birgit Mahnkopf, Prof.i.R., Berlin School of Economy and Law

Pedro Mendes Loureiro, University of Cambridge

Victor Isidro Luna, UNAM

Jonathan Marie, Université Sorbonne Paris Nord

Norberto Montani Martins, Federal University of Rio de Janeiro, Brazil

Olivia Bullio Mattos, St. Francis College, New York, USA

Andrew Mearman, University of Leeds

Monika Meireles, UNAM

Thorvald Grung Moe, Levy Economics Institute

Lumkile Mondi, University of the Witwatersrand, South Africa

Thanti Mthanti, University of the Witwatersrand, South Africa

Susan Newman, Open University

Howard Nicholas, International Institute of Social Studies, Erasmus University Rotterdam

Maria Nikolaidi, University of Greenwich

Patricia Northover, University of the West Indies, Jamaica

Cem Oyvat, University of Greenwich

Oktay Özden, Marmara University, Turkey

Vishnu Padayachee, University of the Witwatersrand

Rafael Palazzi, PUC-Rio, Brazil

José Gabriel Palma, Cambridge University and USACH

Marco Veronese Passarella, University of Leeds

Jonathan Perraton, University of Sheffield

Nicolás M. Perrone, Universidad Andres Bello, Viña del Mar

Keston K. Perry, UWE Bristol

Mate Pesti, UWE Bristol

Karl Petrick, Western New England University

Christos Pierros, University of Athens

Leonhard Plank, TU Wien

Jose Pérez-Montiel, University of the Balearic Islands, Spain

Hao Qi, Renmin University of China

Mzukisi Qobo, Wits Business School, University of Witwarsrand

Joel Rabinovich, University of Leeds

Dubravko Radosevic, University of Zagreb

Miriam Rehm, University of Duisburg-Essen

Marco Flávio da Cunha Resende, Federal University of Minas Gerais, Brazil

Lena Rethel, University of Warwick

Sergio Rossi, C University of Fribourg, Switzerland

Maria Jose Romero, Eurodad

Roy Rotheim, Skidmore College

Josh Ryan-Collins, UCL Institute for Innovation and Public Purpose

Alfredo Saad Filho, King’s College London

Lino Sau, University of Torino, Italy

Malcolm Sawyer. Emeritus Professor of Economics, University of Leeds

Anil Shah, University of Kassel

Dawa Sherpa, Jawaharlal Nehru University

Hee-Young Shin, Wright State University

Farwa Sial, Global Development Institute, University of Manchester

Crystal Simeoni, FEMNET, Nairobi, Kenya

Engelbert Stockhammer, King’s College London

Ndongo Samba Sylla, Dakar

Carolyn Sissoko, UWE Bristol

Celine Tan, University of Warwick

Gyekye Tanoh, Accra

Daniela Tavasci, School of Economics and Finance, Queen Mary University of London

Andrea Terzi, Franklin University Switzerland

Daniele Tori, Open University Business School

Gamze Erdem Türkelli, University of Antwerp

Esra Ugurlu, University of Massachusetts Amherst

Ezgi Unsal, Kadir Has University

Tara Van Ho, University of Essex

Sophie Van Huellen, SOAS University of London

Frank Van Lerven, New Economics Foundation

Elisa Van Waeyenberge, SOAS University of London

Paolo Vargiu, University of Leicester

Luigi Ventimiglia, School of Economics and Finance, Queen Mary University of London

Apostolos Vetsikas, University of Thessaly, Greece

Davide Villani, The Open University and Goldsmiths, University of London

Camila Villard Duran, University of Sao Paulo

Pablo Wahren, University of Buenos Aires

Neil Warner, London School of Economics

Mary Wrenn, UWE Bristol

Joscha Wullweber, University of Witten/Herdecke

Devrim Yilmaz, Université Sorbonne Paris Nord

A belated reply to Fazi and Mitchell on Brexit

Bruno Bonizzi and Jo Michell

In a Jacobin article earlier this year, Thomas Fazi and Bill Mitchell argued in favour of a hard Brexit. We published a reply, also in Jacobin. Fazi and Mitchell (FM) responded with accusations of strawman arguments, false claims, bias and muddled thinking. We intended to write a reply at the time, but other commitments got in the way. However we believe that FM’s reply was sufficiently inaccurate – and in places, dishonest – that a reply is required, even if belatedly.

Brexit predictions

In our Jacobin article we noted that pre-referendum predictions of immediate recession following a Leave vote were produced for political effect, while economists emphasised the likely longer run costs. FM dispute this interpretation, citing as evidence a letter signed by over 200 economists, warning of the likely economic effects of Brexit. One of us (Jo Michell) has some knowledge of this letter, having not only signed it but also having played a role in coordinating signatories – signatories which include a good cross-section of the UK heterodox economics community.

FM quote the letter as follows:

Focusing entirely on the economics, we consider that it would be a major mistake for the UK to leave the European Union …

The uncertainty over precisely what kind of relationship the UK would find itself in with the EU and the rest of the world would also weigh heavily for many years. In addition, there is a sizeable risk of a short-term shock to confidence if we were to see a Leave vote on June 23rd. The Bank of England has signalled this concern clearly, and we share it.

Compare FM’s edit with the original text of the letter below (our bold text).

Focusing entirely on the economics, we consider that it would be a major mistake for the UK to leave the European Union.

Leaving would entail significant long-term costs. The size of these costs would depend on the amount of control the UK chooses to exercise over such matters as free movement of labour, and the associated penalty it would pay in terms of access to the single market. The numbers calculated by the LSE’s Centre for Economic Performance, the OECD and the Treasury describe a plausible range for the scale of these costs.

Can you see what they did there?

The first substantial paragraph of the letter — conveniently deleted by FM – focuses on the long-term costs. Midway through the second paragraph, is the following sentence: “In addition, there is a sizeable risk of a short-term shock to confidence…” (our emphasis). The letter is clearly worded: we believe that Brexit entails long-term costs and, additionally, a risk of negative short-term effects.

FM also comment – referring to the first line of the letter – “And nothing ‘entirely’ economics about that. They were trying to influence the Referendum outcome in favour of Remain.”

Of course we were trying to influence the referendum outcome – that was the point of the letter – because, on the basis of the economics, we believe Brexit to be a mistake.

Finally, FM state, “This letter was published in the Times newspaper and so received widespread coverage.” This is genuinely funny. The (paywalled) letter was almost universally ignored by the UK press – to the point that Tony Yates’ frustration became a running joke on UK economics Twitter.

FM then highlight a report published by NIESR shortly before the vote. Again FM edit their quote carefully, removing the qualifier “albeit not unanimous” from the sentence “there is a degree, albeit not unanimous, of consensus that leaving the EU would depress UK economic activity in both the short term (via uncertainty) and the long term (via trade).” Aside from the quotation, FM devote no attention to the actual contents of the report, which summarises various Brexit macro modelling exercises, include the Treasury’s long term forecasts and both long and “near term” forecasts from the OECD, LSE and NIESR themselves. With the exception of the LSE modelling exercise, all are produced using NIESR’s NiGEM model.

What do the projections show? First note that the “near term” projections run until 2020, while the longer term projections run till 2030. The long-run projections of a hard Brexit do indeed predict a large hit to GDP. The shorter run scenarios suggest a smaller hit to GDP, of between 2.6% and 3.3%, by 2020. Does this prove, as FM argue, that economists “catastrophically failed in relation to the short-run impacts of the Brexit vote”?

At risk of stating the obvious, 2020 is four and half years after the referendum vote and beyond the Article 50 period: Brexit will have happened (this is the assumption in the projections, anyway). A 3% hit to GDP by 2020 seems perfectly plausible. But saying something is plausible is not the same as saying it is certain. In the case of both the economists’ letter to the Times and FM’s next piece of evidence, an Observer poll of economists, FM choose to ignore a crucial word: risk. Stating that there is a risk something will happen is not the same as saying it will happen. Fazi is a journalist. But Mitchell, an economics professor, really should understand the distinction between risk and certainty.

So, what of those statements that a hard Brexit increases the risk of a negative economic shock by 2020? Is the projection of 3% hit to GDP by 2020 in the wake a no-deal Brexit a “catastrophic failure”? How is the UK doing since the referendum?

GDP growth came to a halt in the first quarter of 2018 after declining steadily in the wake of the Brexit vote. Despite a bounce back in the summer, the UK growth rate is currently the lowest of the G7 economies. Of course, we don’t have the counterfactual — and since UK growth is pretty much entirely dependent on household spending, consumer credit and retail, this slowdown could have come at almost any point. But with the household savings rate and net lending now negative — and clearly unsustainable — further reductions in consumer demand seem inevitable.

What of manufacturing – the great hope of the pro-Brexit Left? Corbyn recently made the case that pound devaluation in the wake of Brexit will lead to a revival of manufacturing. But the UK pound has been depreciating for decades — alongside a widening current account deficit and a steady decline in manufacturing. Investment spending in car manufacturing has halved since the Brexit vote. Several major manufacturers including BMW, Siemens and Airbus have warned that they will cease manufacturing in the UK in the event of a hard Brexit. The Society of Motor Manufacturers and Traders (SMMT) issued a warning that 860,000 skilled manufacturing jobs are at risk in the event of a hard brexit. Leaked government reports predict that low-income, Leave-voting ex-manufacturing areas of the UK will be hardest hit by a hard Brexit. This week, the European boss of Ford warned that a no-deal Brexit would be “disastrous” for UK manufacturing. AstraZeneca has announced a freeze in manufacturing investment in the UK. We could go on.

Booming Brexit Britain?

In our original reply to FM, we took issue with their attempt to paint the post-referendum period as a boom. FM claim we have misrepresented them: “to their discredit, Bonizzi and Michell are just making stuff up when they make that claim about us.” Here is the section of FM’s original article we referred to:

UK exports are at their strongest position since 2000. As the Economist recently put it: “Britain’s long-suffering makers are enjoying a once-in-a-generation boom,” as the shifts induced by Brexit engender a much-needed “rebalancing” from boom-and-bust financial services towards manufacturing. This is also spurring a growth in investment. Total investment spending in the UK — which includes both public and private investment — was the highest of any G7 country during 2017: 4 percent compared to the previous year.

The reader can decide if we are “just making stuff up”.

Having attacked us for our interpretation of the above quote, FM even go on, without a hint of irony, to quote the same Economist sentence – arguing that pound devaluation and growing export demand has led to a “virtuous circle” in which manufacturers are experiencing a “once-in-a-generation boom … manufacturing is seeing its strongest growth since the late 1990s …”

This reinforces a point we made in our Jacobin article: FM seem to have trouble with the distinction between levels and growth rates. Manufacturing may have grown strongly in 2017 – before going into reverse and contracting at the start of 2018 – but this is in large part the result of “base effects”. Because UK manufacturing is now so small – output is still below pre-crisis levels – even small increases register as large percentage growth rates. This is not the same thing as a manufacturing “boom”.

FM made the same error in their original piece when discussing investment, where they incorrectly stated that “Total investment spending in the UK … was the highest of any G7 country during 2017” – actually it was the lowest. Now, we are prepared to accept that FM believed they were claiming that investment growth was highest – it was just a typo – but that isn’t what they wrote. Upon investigation, we discovered that FM’s error was in fact the result of carelessly pasting together two directly quoted half-sentences from the FT. Pointing out this error is not sleight of hand, and discussing base effects isn’t “throwing in some cloud” – whatever that means. (It is also good form to use quotation marks when cutting and pasting someone else’s text.)

Defenders of mainstream macro?

Next up, FM try and paint us as defenders of mainstream economics, arguing that “Bonizzi and Michell’s defense of the economics professions is thus very hard to comprehend.” This comes at the end of a long and incoherent section in which FM conflate DSGE modelling, gravity models of international trade, support for austerity and a number of other things – while, of course, stating that “it was obvious to Modern Monetary Theory (MMT) economists as early as the late 1990s that a crisis was brewing”.

FM appear to think that, because we find negative long term Brexit predictions to be plausible, we are defending every failure of economics modelling and policy over the last three decades. Clearly they haven’t bothered to check our views on this. When they conflate these issues by writing, “same models, same approach, same catastrophic errors”, they demonstrate their ignorance. DSGE macro models and gravity models may both have important flaws – but they are not the same.

Trade graphs, EU utopianism, nativism and the Irish border

There are multiple further sections in FM’s reply – on the interpretation of trade graphs, the importance of racism and the far-right, and whether the EU is a “utopia”. These are as incoherent and inaccurate as the points refuted above. To give just one more example, FM state that “… the contention by Bonizzi and Michell that the EU is the only thing preventing the UK from plunging into a quasi-fascist dystopia is untenable.” – a contention that is nowhere to be found in anything we have written. Elsewhere, FM abandon even the pretence of debate, and resort to throwing in statements like, “Hello! Is anyone there?”

FM claim – inaccurately – that in their articles and book, they have covered all the points we raise. But we raised one issue in our Jacobin article that FM conspicuously ignore in their reply: the Irish border. We wrote:

The UK government’s current position of aiming to leave the customs union without creating a hard border in Ireland is akin to a Venn diagram in which there is no intersection between the circles. For this reason, Theresa May is currently proposing two incompatible approaches, both of which are unacceptable to the EU.

As has since become overwhelmingly apparent, those who want to argue for a hard Brexit need to spell out a solution to the Irish border issue. Perhaps now would be a good time for FM to tell us theirs?

Finally, we note that in their incoherent attempt to conflate mainstream economics and opposition to Brexit, FM quote Ann Pettifor. In response to FM’s attack on us, Ann tweeted the following: “Bill Mitchell & Fazi need reminding that it is rise of nationalism & even fascism in Europe that is the threat. Progressives should lead – not walk away & vacate political space to the Far Right.”

Fazi and Mitchell have not engaged with our arguments in good faith. Their attack is not a serious attempt to engage in debate or respond to the points we raised. In a number of places it is transparently dishonest. Anyone who follows Fazi and Mitchell’s lead on these crucial issues should take a long hard look.

Argentina: From the “confidence fairy” to the (still devilish) IMF

Guest post by Pablo Bortz and Nicolás Zeolla, Researchers at the Centre of Studies on Economics and Development, IDAES, National University of San Martín, and CONICET, Argentina.

In recent days, it has become customary to recall the issuance of a USD 2.75 billion 100-year bond in June 2017. This was the most colourful event of the short-lived integration of Argentina into international capital markets, beginning in December 2015. Last week, Argentina returned to the front pages of the financial press when the government requested financial assistance to the IMF amidst capital flight and a run against the peso that authorities were struggling to stop.

This is the most recent episode in the typical cycle of an emerging economy entering financial markets, suffering a balance of payments crisis and adopting an IMF-sponsored stabilization program. It starts with the claim that we are now a respected member of the international community, with presence in the Davos forum, and the promise that this time, finally, the international “confidence fairy” will awaken and investment will flood the country because of all the profit opportunities this forgotten economy has to offer. When the fairy proves to be an hallucination, we find ourselves at the steps of the IMF, facing demands, as always, for fiscal consolidation and structural reform.

When explaining this story, it is important to have some background on the Argentineans’ fascination with the dollar, and on some very recent political history. Because of its history of financial crises and its underdeveloped capital markets, there are very few savings instruments available to the non-sophisticated investor: real estate, term deposits, and dollars. Real estate prices are denominated in dollars, but you need a lot of dollars (relative to income) to buy a house. So buying dollars is pretty much a straightforward investment in uncertain times, i.e. most of the time.

Added to that, Argentina has a higher degree of exchange rate pass-through than other developing countries. The main exporters also dominate the domestic market for cooking oil and flour; oil and energy prices are dollarized; and exchange rate movements are very closely followed at times of wage bargaining. Unlike other emerging countries, and despite the sneering of some government officials, in a semi-dollarized (or bimonetary) economy such as Argentina exchange-rate pass-through is alive and kicking, which discourages large devaluations.

It is important to remember that the previous administration of Cristina Fernandez de Kirchner had implemented pervasive capital and exchange controls, which led to the development of a (relatively small) parallel market, with almost a 60% gap between the official and the parallel exchange rate. As soon as the Macri government took power in December 2015, it lifted all exchange rate controls. The official exchange rate (10 pesos per dollar) moved towards the parallel (16 pesos per dollar), and it is one of the reasons for the increase in the inflation rate, from 24% in 2015 to 41% by the end of 2016.

The new authorities also made two big moves. One was cancelling all the debt with vulture funds with new borrowing. This officially marked the return of Argentina to international capital markets. The second move, by the central bank (now lead by Federico Sturzenegger, an MIT graduate and disciple of Rudi Dornbusch), was the adoption of an inflation-targeting regime, with a mind-set that preferred freely floating exchange rates, and not much concern for current account deficits[1].

But looking at the external front, one may even be forgiven for asking: why did this crisis take so long to burst? Argentina was haemorrhaging dollars for many years, and with no sign of reversal: since 2016 the domestic non-financial sector acquired an accumulated amount of USD 41 billion in external assets. During the same period, the current account deficit totalled another USD 30 billion, in the form of trade deficit, tourism deficit, profit remittances by foreign companies and increasing interest payments.

The well-known factor that allowed all these trends to last until now is the foreign borrowing spree that involved the government, provinces, firms, and the central bank, including the inflow from short-term investors for carry trade operations. In the case of debt issuance, since 2016 the central government, provinces and private companies, have issued a whopping USD 88 billion of new foreign debt (13% of GDP). In the case of carry trade operations, since 2016 the economy recorded USD 14 billon of short-term capital inflows (2% of GDP). The favourite peso-denominated asset for this operations were the debt liabilities of the central bank called LEBAC (Letters of the Central Bank). Because of this, the outstanding stock of this instrument has now become the centre of all attention.

It is important to understand the LEBACs. They were originally conceived as an inter-bank and central bank liquidity management instrument. Since the lifting of foreign exchange and capital controls and the adoption of inflation targeting, the stock of LEBACs grew by USD 18 billion. Moreover, the composition of holders has changed significantly since 2015: At that time, domestic banks held 71% of the stock, and other investors held 29%. In 2018 that proportion has reverted to 38% banks/62% to other non-financial institution holders, which includes other non-financial public institutions (such as the social security administration) (17%), domestic mutual investment funds (16%), firms (14%), individuals (9%), and foreign investors (5%). This is shown in Graph 1 and Table 1. That means that a large part of all the new issuance of LEBAC is held by investors outside the regulatory scope of the central bank, especially individuals and foreign investors. This represents a potential source of currency market turbulence because these holdings could easily be converted into foreign currency, causing a large FX depreciation.


Holders of LEBACs, May 2018	%
Financial institutions	39%
Non-financial public sector	17%
Mutual Investment Funds	16%
Firms	14%
Individuals	9%
Foreign investors	5%

Source: Authors’ calculation based on Central Bank of Argentina

What was the trigger of the recent sudden stop and reversal of capital flows? Supporters of the central bank authorities point towards the change in the inflation target last December, when the Chief of Staff Marcos Peña (the most powerful person in cabinet) and the Economy Minister Nicolas Dujovne moved the target from 10% to 15%. In light of the change in the target, the central bank started to gradually lower interest rates from as high as 28,75% to 26.5%, while inflation remained unabated, giving rise to rumours about the government’s internal political disputes. However, inflation remained stubbornly high even before the change in the target; and there were also some minor foreign exchange runs both before and after that announcement. In the meantime, the government did reduce the budget deficit. The problem is not of fiscal origin: one has to look to the external front.

Other analysts point towards the reversal of the global financial cycle of cheap credit, which has led to devaluation of emerging markets’ currencies across the board. The turning point, in this interpretation, was when the 10-year rate on US Treasury bonds reached the 3% threshold. In a similar vein, others highlight a tax on non-residents’ financial profits that was going to come into place on May 1^st, that triggered the sell-off by foreign investors. Indeed, the run was primarily driven by foreign hedge funds and big banks (notably, JP Morgan) closing their positions in pesos and acquiring dollars. However, the impact on Argentina dwarfed the devaluations, reserve losses and interest rate increments in other developing countries.

Finally, some blame the patently disastrous response of the central bank to the first indicators of a capital flight. The run accelerated in the last three weeks. The CB initially sold all the dollars that foreign banks demanded, in an attempt to control the exchange rate, without increasing interest rates. Then the devaluation accelerated, and the central bank started to increase the interest rate, to 30, to 33, and finally to 42%. Its intervention in the exchange market was equally erratic.[2]

These points have some validity, but are insufficient to explain the full extent of the run. The reason is that investors could enter the country and could leave it without no restriction whatsoever. The main problem is the total deregulation of the financial account and the foreign exchange market, for domestic and foreign investors. The government borrowed heavily in international markets and the central bank offered large financial gains, while the external front deteriorated and domestic non-sophisticated investors were demanding dollars at increasing speed. The most infamous and egregious measure of all is the abolition of the requirement that exporters sell their foreign currency in the foreign exchange market. Instead of having an assured supply of dollars, the central bank is now forced to lure them with a high interest rate. In such a context, where capital can move freely, anything and everything is an excuse to cash in and get out. It is therefore a mistake to focus only on individual issues. The problem is the setting – the whole policy framework. Now, the central bank is caught between only two alternatives when choosing interest rates: either to encourage carry-trade operations, or to suffer steep devaluations.

The decision to ask for an IMF loan was in the offing for some time but was rushed during the run against the peso. The government’s first intention was to obtain a Flexible Credit Line, the best (or the least evil) of all the IMF facilities, because it provides a decent amount of money with few conditionalities, or at least its minor cousin, the Precautionary and Liquidity Line (PLL), with less money but still not many conditionalities. The IMF, instead, told Argentine negotiators that there was no room for the PLL, and they would have to apply instead for the dreaded Stand-By Arrangements. All the international support and “credibility” that the Argentine government claimed to have was of no use when it came to the moment for banking on it.

But resorting to an IMF loan was not an unavoidable decision.[3] There were other ways to obtain dollars and to cap the foreign exchange run. The government could have forced exporters to sell their foreign currencies; they could have negotiated a swap agreement with some major central bank; or they could have erected barriers to capital outflows.

The report also shows what is to be expected from now on. The IMF will ask for tough measures on labour market flexibility (which was already on the government table), further cuts to public employment, wages, transfers and pensions, and lifting of the greatly reduced trade barriers. The devaluation has already happened, but it should be mentioned that previous devaluations failed to encourage exports, while they only fostered inflation.

It is impossible to forecast what will happen in 2019. On the economic front, there are at least four big risks. The first is a recession, because of the negative impact of devaluation on private consumption. The second refers to an acceleration in the inflation rate and its distributive effects. Nobody expects now that the 2018 inflation rate will be below the 2017 number (25%), and with further devaluations, inflation could spiral to new highs. A third risk, which will be persistent throughout the year, is the eventual demand for dollars by the non-bank LEBAC holders. The fourth one is a possible (though not likely) bank run. Banks have USD 22 billion of deposits denominated in dollars. Any bank-run will directly hit reserves.

This very short experience is another example of the typical boom-and-bust cycle of emerging economies borrowing heavily in foreign currency with totally deregulated financial flows and foreign exchange markets, while experiencing growing current account imbalances. If one were to obtain some “new” corollaries, we would have to point to the failure of the inflation-targeting policy framework in a semi-dollarized economy with no capital controls. The IT regime did not reduce contract indexation; exchange rate flexibility did not reduce the pass-through. And relying on the “confidence fairy” is no path to development; it is rather a highway to hellish institutions. We Argentineans thought we had rid ourselves of that devil.

[1] The inflation target, however, was set at very optimistic levels, was never achieved in the two years since the adoption of the IT regime, and was changed last December, something that many say had an influence in recent events.

[2] Some say that this behaviour was not a bug but a feature, since it allowed foreign banks to profit in their investments and leave the country at favourable interest rates. Others, in a less conspirative but equally perverse logic of action, say that the erratic initial response was an attempt by the central bank to prove the wrongfulness of the Ministry of Economy’s approach and regain full control of monetary policy. The unfolding of events is consistent with this argument, with the caveat that even after regaining political power, the central bank proved to be still unable of stopping the run for three weeks.

[3] In fact, when the news of the SBA came, the run actually accelerated, because one of the expected IMF conditions was a devaluation of between 10 to 25%, according to the last Article 4 Consultation Report. That might help to explain why the government wasted a loan from the BIS in less than 2 weeks.

Austerity and household debt: a macro link?

For some time now I’ve been arguing that not only does austerity have real effects but also financial implications.

When the government runs a deficit, it produces a flow supply of safe assets: government bonds. If the desired saving of the private sector exceeds the level of capital investment, it will absorb these assets without government spending inducing inflationary tendencies.

This was the situation in the aftermath of the 2008 crisis. Attempted deleveraging led to increased household saving, reduced spending and lower aggregate demand. Had the government not run a deficit of the size it did, the recession would have been more severe and prolonged.

When the coalition came to power in 2010 and austerity was introduced, the flow supply of safe assets began to contract. What happens if those who want to accumulate financial assets — wealthy households for the most part — are not willing to reduce their saving rate? If there is an unchanged flow demand for financial assets at the same time as the government reduces the supply, what is the result?

Broadly speaking there are two possible outcomes: one is lower demand and output: a recession. If growth is to be maintained, the only option is that some other group must issue a growing volume of financial liabilities, to offset the reduction in supply by the government.

In the UK, since 2010, this group has been households — mostly households on lower incomes. As the government cut spending, incomes fell and public services were rolled back. Unsurprisingly, many households fell back on borrowing to make ends meet.

The graph below shows the relationship between the government deficit and the annual increase in gross household debt (both series are four quarter rolling sums deflated to 2015 prices).

From 2010 onwards, steady reduction in the government deficit was accompanied by a steady increase in the rate of accumulation of household debt. The ratio is surprisingly steady: every £2bn of deficit reduction has been accompanied by an additional £1bn per annum increase in the accumulation of household debt.

Note that this is the rate at which gross household debt is accumulated — not the “net financial balance” of the household sector. The latter is highlighted in discussions of “sectoral balances”, and in particular the accounting requirement that a reduction in the government deficit be accompanied by either an increase in the deficit of the private sector or a reduction in the deficit with the foreign sector.

Critics of the sectoral balances argument make the point that the net financial balance of the household sector is not the relevant indicator. Most household borrowing takes place within the household sector, mediated by the financial system. Savers hold bank deposits and pension fund claims, while other households borrow from the banks. The gross indebtedness of the household sector can therefore either increase or decrease without any change in the net position. Critics therefore see the sectoral balances argument argue as incoherent because it displays a failure to understand basic national accounting. This view has been articulated by Chris Giles and Andrew Lilico, among others.

For the UK, at least, this criticism appears misplaced. The chart below plots four measures of the household sector financial position along with the government deficit. The indicators for the household sector are the net financial balance, gross household debt as a share of both GDP and household disposable income, and the household saving ratio. The correlation between the series is evident.

The relationship between the government deficit and the change in gross household debt is surprisingly stable. The figure below plots the series for the full period for which data are available from the ONS: from 1987 until 2017. With the exception of the period 2001-2008, where there is a clear structural break, the relationship is persistent.

Why should this be the case? One needs to be careful with apparently stable relationships between macroeconomic variables — they have a habit of breaking down. One reason for caution is that the composition of household debt has changed over the period shown: in the pre-2008 period most of the increase was mortgage borrowing, while post-crisis, consumer debt in the form of credit cards, car loans and so on has played an increasing role. Nonetheless, a hypothesis can be advanced:

If one group of households saves a relatively constant share of income — and this represents the majority of total saving in the household sector — then variance in the supply of assets issued by public sector must be matched either by variations in output and employment or by variance in the issuance of financial liabilities by other sectors. If monetary policy is used to maintain steady inflation and therefore relatively stable output and employment, changes in the cost of borrowing may induce other (non-saver) households to adjust their consumption decisions in such a way that stabilises output.

Put another way, if the contribution of government deficit spending to total demand varies and saving among some households is relatively inelastic, avoiding recessions requires another sector (or sub-sector) to go into deficit in order that total demand be maintained.

This hypothesis fits with the observation that the household saving ratio falls as the rate of gross debt accumulation increases. Paradoxically, the problem is not too little household saving but too much, given the volume of investment. If inelastic savers were willing to reduce their saving and increase consumption in response to lower government spending, then recession could be avoided without an increase in household debt. A better solution would be an increase in the business investment of the private sector: it is the difference between saving and investment that matters.

There is a clear structural break in the relationship between the deficit and household debt, starting around 2001. This is likely the result of the global credit boom which gathered pace after Alan Greenspan cut the target federal funds rate from 6.5% in 1999 to 1% in 2001. During this period, the financial position of the corporate sector shifted from deficit to surplus, matched by large rises in the accumulation of household debt. With the outbreak of crisis in 2008, the previous relationship appears to re-emerge.

Careful econometrics work is required to try and disentangle the drivers of rising household debt. But relationships between macroeconomic variables with this degree of stability are unusual. Something interesting is going on here.

EDIT: 22 November

Toby Nangle left a comment suggesting that it would be good to show the data on borrowing by different income levels. It’s a good point, and raises a complex issue about the distribution of lending and borrowing within the household sector. This is something that J. W. Mason and others have been discussing. I need another post to fully explain my thinking on this, but for now, I’ll include the following graph:

This is calculated using an experimental new dataset compiled by the ONS which uses micro data source to try and produce disaggregated macro datasets. Data are currently only available for three years — 2008, 2012, and 2013 — but I understand that the ONS are working on a more complete dataset.

What this shows is that in 2008, at the end of the 2000s credit boom, only the top two income quintiles were saving: the bottom 60% of the population was dissaving. In 2012 and 2013, the household saving ratio and financial balance had increased substantially and this shows up in the disaggregated figures as positive saving for all but the bottom quintile.

I suspect that as the saving ratio and net financial balance have subsequently declined, and gross debt has increased, the distributional pattern is reverting to what it looked like in 2008: saving at the top of the income distribution and dissaving in the lower quintiles.

Strong and stable? The Conservatives’ economic record since 2010

In a recent interview, Theresa May was asked by Andrew Neil how the Conservatives would fund their manifesto commitments on NHS spending. Given that the Conservatives chose not to cost their manifesto pledges, May was unable to answer. Instead she simply repeated that the Conservatives are the only party that can deliver the economic growth and stability required to pay for essential public services. When pressed, May’s response was simple: ‘our economic credibility is not in doubt’.

Does the record of the last seven years support May’s claim?

The first statistic always quoted in such discussions is GDP growth. A lot has been made of the latest quarterly GDP figures, showing the UK at the bottom of the G7 league with quarterly GDP growth of just 0.2%. But these numbers actually tell us very little: they refer to a single quarter and are still subject to revision.

It is more useful to look at real GDP per capita over a longer period of time. This tells us the additional ‘real’ income available per person that has been generated. The performance of the G7 countries since the pre-crisis peak in 2007 is shown in the chart below, with the series indexed to 1 in 2007 for each country. (Data are taken from the most recent IMF WEO database.)

GDP per capita in the UK only surpassed its pre-crisis level in 2015. By 2016, GDP per capita relative to the pre-crisis level was less than 2% higher than in 2007, putting the UK behind Japan, Germany, the US and Canada, slightly ahead of France, and well ahead of the Italian economy which remains mired in a deep depression. On this measure, the UK’s performance is not particularly impressive.

For most people, wages are a more important gauge of economic performance than GDP per capita. Here, the UK is an outlier. Relative real wage growth in the G7 economies is shown in the table below, alongside the changes in GDP per capita for the period 2007-2015.

Country	% change in GDP per capita, 2007-2015	% change in average real wage, 2007-2015
Canada	3.2	0.8
France	-0.2	0.6
Germany	6.3	0.9
Italy	-11.7	-0.7
Japan	3.0	-0.2
United Kingdom	0.7	-1.0
United States	3.7	0.5

Despite coming mid-table in terms of GDP per capita, the UK has the worst performance in terms of real wages, which have fallen by an average of 1% per year over the period. Even in depression-struck Italy, wages did not fall so far.

This translates into a fall of almost five percent in the real wage of the typical (median) worker since the crisis, as the chart below shows. This LSE paper, from which the chart is taken, finds that while almost everyone is worse off since the crisis, the youngest have seen the largest falls in income with 18-21-year-olds facing a fall in real wages of over 15%

With the value of the pound falling since the Brexit vote, inflation is once again eating into real wages and the latest figures show that, after a period of a couple of years in which wages had been recovering, real wages are now falling again and are likely to do so for the next few years. Average earnings are not projected to reach 2007 levels again until 2022 – by then the UK will have gone fifteen years without a pay rise.

A related issue is the UK’s desperately poor productivity performance. ‘Productivity’ here refers to the amount produced per worker on average. As the chart below from the Resolution Foundation shows, the UK has now experienced a decade without any increase in productivity — something which is historically unprecedented.

What causes productivity growth is a controversial topic among economists. Until recently, the majority view was that productivity is not affected by government macroeconomic policy. This position (which I disagree with) is increasingly hard to defend. As Simon Wren-Lewis argues here, evidence is mounting that the UK’s productivity disaster is the result of government policy: the Conservatives’ austerity policies have caused flatlining productivity.

Austerity — or, as it was branded at the time, the ‘Long Term Economic Plan‘ — was the central plank of Osborne’s policy from 2010 until the Brexit referendum vote in 2015.

As I and others have argued at length elsewhere, austerity was based on two false premises — ‘lies’ might be more accurate. The first was that excessive spending by Labour was a cause of the 2008 crisis. The second was that the size of the UK’s government debt posed serious and immediate risks that outweighed other concerns.

One thing that almost all macroeconomists agree on is that when recovering from a severe downturn such as 2008 — and with interest rates at nearly zero — the deficit should not be the target of policy. Instead, it should be allowed to expand until the economy has recovered.

Simply put, the deficit should not be used as a yardstick for successful management of an economy in the aftermath of a major economic crisis such as 2008. But since eliminating the deficit was the single most important target of the Conservatives’ so-called Long Term Economic Plan, we should examine the record.

In 2010, Osborne stated that the deficit would be eliminated by 2015. Two years after that deadline passed, the current Conservative manifesto states — in a passage that would not pass any undergraduate economics exam — that they will ‘aim to’ eliminate the deficit by 2025.

Even on their own entirely misguided terms, they have failed completely.

While the dangers of the public debt have been vastly exaggerated by the Conservatives, they have had little to say about private sector debt. It is now widely accepted that the only remaining motor of economic growth is consumption spending. But with wages stagnant, continued growth of consumption cannot be sustained without rising levels of household debt.

This is the reason given when economists are asked why their predictions of post-referendum recession were so wrong: they didn’t anticipate the current credit-driven consumption burst. But this trend has been apparent for at least the last two years. It shouldn’t have been too hard to see this coming.

Just as the Tories tend to stay quiet on private debt, they also have little to say about the ‘other’ deficit — the current account deficit. This is a measure of how much the country is reliant on foreigners to finance our spending. The deficit expanded from 2011 onward to reach almost 5% of GDP. This is an important source of vulnerability for a country which is about to try and extricate itself from economic integration with its closest neighbours.

Overall, the Tories economic record is far from impressive: stagnant wages and productivity, weak investment and manufacturing, rising household debt, and a large external deficit.

Now, a reasonable response might be that these are long-standing issues with the UK economy and are not the fault of the Conservatives. There is some truth to this. But if this is the case, Theresa May should identify and acknowledge these issues and provide a clear outline of how her policies will address them. This is not what she has done. Instead, she simply repeats her mantra that only the Conservatives will deliver on the economy, without providing any evidence to support her claim.

And then there is the decision to call a referendum on Brexit. It is hard to think of a more economically reckless move. Household analogies for government economic policy should be avoided — but I can’t think of an alternative in this case.

Following up on an austerity programme with the Brexit referendum is like sending the children to school without lunch money for six years and allowing the house to fall into serious disrepair in order to needlessly over-pay a zero-interest mortgage — and then gambling the house on a dice game.

Given this record, it is astonishing that the Conservatives present themselves, with a straight face, as the party of economic competence — and the media dutifully echoes the message. The truth is that the Conservatives have mismanaged the economy for the last seven years, needlessly imposing austerity, choking off growth in productivity, wages and incomes. They then called an entirely unnecessary referendum, gambling the future prosperity of the country for political gain.

Theresa May is correct — there is little doubt about the economic credibility of the Conservatives. It is in short supply.

Thoughts on the NAIRU

Simon Wren-Lewis’s post attacking Matthew Klein’s critique of the NAIRU provoked some strong reactions. On reflection, my initial response was wide of the mark. Matthew responded saying he agreed with most of Simon’s piece.

So are we all in agreement? I think there are differences, but we need to first clarify the issues.

Matthew’s main point was empirical: if you want to use a relationship between employment and inflation as a policy target it needs to be relatively stable. The evidence suggests it is not.

But there is a deeper question of what the NAIRU actually means – what is a NAIRU? The simple definition is straightforward: it is the rate of unemployment at which inflation is stable. If policy is used to increase demand, reducing unemployment below the NAIRU, inflation will rise until excess demand is removed and unemployment allowed to increase again.

At first glance this appears all but identical to the ‘natural rate of unemployment’, a concept originating with Friedman’s monetarism and inherited by some New Keynesian models – in particular the ‘standard’ sticky-price DSGE model of Woodford and others. In this view, the economy has ‘natural rates’ of output and employment, beyond which any attempt by policy makers to increase demand becomes futile, leading only to ever-higher inflation. Since there is a direct correspondence between stabilizing inflation and fixing output and employment at their ‘natural’ rates, policy makers should simply adjust interest rates to hit an inflation target. In typically modest fashion, economists refer to this as the ‘Divine Coincidence‘ – despite the fact it is essentially imposed on the models by assumption.

Matthew’s piece skips over this part of the history, jumping straight from Bill Phillips’s empirical relationship to the NAIRU. But the NAIRU is a weaker claim than the natural rate. As Simon says, all that is required for a NAIRU is a relationship of the form inf = f(U, E[inf]), i.e. current inflation is some function of unemployment and expected inflation. At its simplest, agents could just assume inflation will be the same in the current period as the last period. Then, employment above some level would causing rising inflation and vice versa.

More sophisticated New Keynesian formulations of the NAIRU are a good distance removed from the ‘natural rate’ theory – these models include imperfections in the labour and product markets and a bargaining process between workers and firms. As a result, they incorporate (at least short-run) involuntary unemployment and see inflation as driven by competing claims on output rather than the ‘too much nominal demand chasing too few goods’ story of the monetarists and simple DSGE models.

It is also the case that such a relationship is found in many heterodox models. Engelbert Stockhammer explores heterodox views on the NAIRU in a provocatively-titled paper, ‘Is the NAIRU Theory a Monetarist, New Keynesian, Post Keynesian or Marxist Theory?’. He doesn’t identify a clear heterodox position – some Post-Keynesians reject the NAIRU outright, while others present models which incorporate NAIRU-like relationships.

Engelbert notes that arguably the earliest definition of the NAIRU is to be found in Joan Robinson’s 1937 Essays in the Theory of Employment:

In any given conditions of the labour market there is a certain more or less definite level of employment at which money wages will rise … there is a certain level of employment, determined by the general strategical position of the Trade Unions, at which money wages rise, and at that level of employment there is a certain level of real wages, determined by the technical conditions of production and the degree of monopoly’ (Robinson, 1937, pp. 4-5)

Recent Post-Keynesian models also include NAIRU-like relationships. For example, Godley and Lavoie’s textbook includes a model in which workers and firms compete by attempting to impose money-wage and price increases respectively. The size of wage increases demanded by workers is a function of the employment rate relative to some ‘full employment’ level. That sounds a lot like a NAIRU – but that isn’t how Godley and Lavoie see it:

Inflation under these assumptions does not necessarily accelerate if employment stays in excess of its ‘full employment’ level. Everything depends on the parameters and whether they change … An implication of the story proposed here is that there is no vertical long-run Phillips curve. There is no NAIRU. (Godley and Lavoie, 2007, p. 304, my emphasis)

The authors summarise their view with a quote from an earlier work by Godley:

Indeed if it is true that there is a unique NAIRU, that really is the end of discussion of macroeconomic policy. At present I happen not to believe it and that there is no evidence of it. And I am prepared to express the value judgment that moderately higher inflation rates are an acceptable price to pay for lower unemployment. But I do not accept that it is a foregone conclusion that inflation will be higher if unemployment is lower (Godley 1983: 170, my emphasis).

This highlights a key difference between Post-Keynesian and neoclassical approaches to the NAIRU: where Post-Keynesian models do include NAIRU-like relationships, the relevent employment level is endogenous, due to hysteresis effects for example. In other words, the NAIRU moves around and is influenced by demand-management policy. As such, the NAIRU is not an attractor for the unemployment rate as in many neoclassical models.

Marxist theory also contains something which looks a lot like a NAIRU: the ‘industrial reserve army’ of the unemployed. Marx argued that unemployment is the mechanism by which capitalists discipline workers and prevent wage claims rising to the point at which profits and capital accumulation are depleted. Periodic recessions are therefore a necessary part of the capitalist development process.

This led Nicholas Kaldor to describe Margaret Thatcher as ‘our first Marxist Prime Minister’ – not because she was an advocate of socialist revolution but because she understood the reserve army mechanism: ‘They have managed to create a pool – or a “reserve army” as Marx would have called it – of 3 million unemployed … the British working classes have been thoroughly cowed and frightened.’ (This point is passed over rather quickly in Simon’s piece. In the 1980s, he writes, ‘policy changed and increased unemployment and inflation fell.’)

So we should be careful about blanket dismissals of the NAIRU. Instead, we must be clear how our analysis differs: what are the mechanisms which generate inflationary pressure at low levels of unemployment – conflicting claims or excess nominal demand? Is the NAIRU stable and exogenous? Does it act as an attractor for the unemployment rate, and over what time period? What are the implications for policy?

Ultimately, I think this breaks down into an issue about semantics. How far from the unique, stable, vertical long-run Phillips curve can we get and still have something we call a NAIRU? Simon adopts a very loose definition:

There is a relationship between inflation and unemployment, but it is just very difficult to pin down. For most macroeconomists, the concept of the NAIRU really just stands for that basic macroeconomic truth.

I’d like to believe this were true. But I suspect most macroeconomists, trained on New Keynesian DSGE models, have a narrower view: they tend to think in terms of a stable short-run sticky-price Phillips curve and a unique long-run Phillips curve at the ‘natural’ rate of employment.

There is one other aspect to consider. Engelbert Stockhammer distinguishes between the New Keynesian NAIRU theory and the New Keynesian NAIRU story. He argues (writing in 2007, just before the crisis) that the NAIRU has been used as the basis for an account of unemployment which blames inflexible labour markets, over-generous welfare states, job protection measures and strong unions. The policy prescriptions are then straightforward: labour markets should be deregulated and welfare states scaled back. Demand management should not be used to reduce unemployment.

While economists have changed their tune substantially in the decade since the financial crisis, I suspect that the NAIRU story is one reason that defence of the NAIRU theory generates such strong reactions.

EDIT: Bruno Bonizzi points me to this piece at the INET blog with has an excellent discussion of the empirical evidence and theoretical implications of hysteresis effects and an unstable NAIRU.

Image reproduced from Wikipedia: https://en.wikipedia.org/wiki/File:NAIRU-SR-and-LR.svg

Full Reserve Banking: The Wrong Cure for the Wrong Disease

Towards the end of last year, the Guardian published an opinion piece arguing there is a link between climate change and the monetary system. The author, Jason Hickel, claims our current monetary system induces a need for continuous economic growth – and is therefore an important cause of global warming. As a solution, Hickel endorses the full reserve banking proposals put forward by the pressure group Positive Money (PM).

This is an argument I encounter regularly. It appears to have become the default position among many environmental activists: it is official Green Party policy. This is unfortunate because both the diagnosis of the problem and the proposed remedy are mistaken. It is one element of a broader set of arguments about money and banking put forward by PM. (Hickel is not part of PM, but his article was promoted by PM on social media, and similar arguments can be found on the PM website.)

The PM analysis starts from the observation that money in modern economies is mostly issued by private banks: most of what we think of as money is not physical cash but customer deposits at retail banks. Further, for a bank to make a loan, it does not require someone to first make a cash deposit. Instead, when a bank makes a loan it creates money ‘out of thin air’. Bank lending increases the amount of money in the system.

This is true. And, as Positive Money rightly note, neither the mechanism nor the implications are widely understood. But Positive Money do little to increase public understanding – instead of explaining the issues clearly, they imbue this money creation process with an unnecessary air of mysticism.

This isn’t difficult. As J. K. Galbraith famously observed: ‘The process by which banks create money is so simple the mind is repelled. With something so important, a deeper mystery seems only decent.’

To the average person, money appears as something solid, tangible, concrete. For most, money – or lack of it – is an important (if not overwhelming) constraint on their lives. How can money be something which is just created out of thin air? What awful joke is this?

This leads to what Perry Mehrling calls the ‘fetish of the real’ and ‘alchemy resistance’ – people instinctively feel they have been duped and look for a route back to solid ground. Positive Money exploit this unease but deepen the confusion by providing an inaccurate account of the functioning of the monetary and financial system.

There is nothing new about the ‘fetish of the real’. Economists have been trying to separate the ‘real’ economy from the financial system for centuries. Restrictive ‘tight money’ proposals have more commonly been associated with free-market economists on the political right, while economists inclined towards collectivism have favoured less monetary restriction. One reason is that the right tends to view inflation as the key macroeconomic danger while the left is more concerned with unemployment.

The original blueprint for the Positive Money proposal is known as the Chicago Plan, named after a group of University of Chicago economists who argued for the replacement of ‘fractional reserve’ banking with ‘full reserve banking’. To understand what this means, look at the balance sheet below.

The table shows a stylised list of the assets and liabilities on a bank balance sheet. On the asset side, banks hold loans made to customers and ‘reserve balances’ (or ‘reserves’ for short). The latter item is a claim on the Central Bank – for example, the Bank of England in the UK. These reserve balances are used when banks make payments among themselves. Reserves can also be swapped on demand for physical cash at the Central Bank. Since only the Central Bank can create and issue these reserves, alongside physical cash, they form the part of the ‘money supply’ which is under direct state control.

For banks, reserves therefore play a role similar to that of deposits for the general public – they allow them to obtain cash on demand or to make payments directly between their individual accounts at the Bank of England

The only thing on the liability side is customer deposits – what we think of as ‘money’. These deposits can increase for two reasons. If customers decide to ‘deposit’ cash with the bank, the bank accepts the cash (which it will probably swap for reserves at the Central Bank) and adds a deposit balance for that customer. Both sides of the bank balance sheet increase by the same amount: a deposit of £100 cash will lead to an increase in reserves of £100 and an increase in deposits of £100.

Most increases in deposits happen a different way, however. When a bank makes a loan, both sides of its balance sheet increase as in the above example – except this time ‘loans’ not ‘reserves’ increases on the asset side. When a bank lends £100 to a customer, both ‘loans’ and ‘deposits’ increase by £100. Absent any other changes, the amount of money in the world increases by £100: money has been created ’out of nothing’.

The Positive Money proposal – like the Chicago Plan of the 1930s – would outlaw this money-creating power. Under the proposal, banks would not be allowed to make loans: the only asset allowed on their balance sheet would be ‘reserves’ – hence the name ‘full reserve banking’. Since reserves can only be issued by the Central Bank, private banks would lose their ability to create new money when they make loans.

What’s wrong with the PM proposal? To answer, we first need to ask what problem PM are trying to solve. They list several issues on their website: environmental degradation, inequality, financial instability and a lack of decent jobs. How does Positive Money think the monetary system contributes to these problems? The following quote and diagram, taken from the Positive Money website, give the crux of the argument:

The ‘real’ (non-financial), productive economy needs money to function, but because all money is created as debt, that sector also has to pay interest to the banks in order to function. This means that the real-economy businesses – shops, offices, factories etc – end up subsidising the banking sector. The more private debt in the economy, the more money is sucked out of the real economy and into the financial sector.

This illustrates the central misconception in PM’s description of money and banking. The ‘real economy’ needs money to operate – so individuals and business can make payments. This is correct. But PM imply that in order to obtain this money, the ‘real economy’ must borrow from the banks. And because the banks charge interest on this lending, they then end up sucking money back out of the ‘real economy’ as interest payments. In order to cover these payments, the ‘real economy’ must obtain more money – which it has to borrow at interest! And so on.

If this were a genuine description of the monetary system, the debts of the ‘real economy’ to the banks would grow uncontrollably and the system would have collapsed decades ago – PM essentially describes a pyramid scheme. The connection to the ‘infinite growth’ narrative is also clear – the ‘real economy’ is forced to produce ever more output just to feed the banks, destroying the environment in the process.

But neither the quote nor the diagram is accurate. To illustrate, look at the diagram below. It shows a bank, with a balance sheet as above, along with two individuals, Jack and Jill. Two steps are shown. In the first step, Jill takes out a loan from the bank – the bank creates new money as it lends. In the second step, Jill uses this money to buy something from Jack. Jack ends up holding a deposit while Jill is left with a loan to the bank outstanding. The bank sits between the two individuals.

The point here is twofold. First, the ultimate creditor – the person providing credit to Jill – is not the bank, but Jack. Jack has lent to Jill, with the bank acting as a ‘middleman’. The bank is not a net lender, but an intermediary between Jill and Jack – albeit one with a very important function: it guarantees Jill’s loan. If Jill doesn’t make good on her promise to pay, the bank will take the hit – not Jack. Second, the initial decision to lend wasn’t made by Jack – it was made by the bank. By inserting itself between Jack and Jill, and substituting Jill’s guarantee with its own, the bank allows Jill to borrow and spend without Jack first choosing to lend. But in accepting a deposit as a payment, Jack also makes a loan – to the bank. As well as acting as ‘money’, a bank deposit is a credit relationship: a loan from the deposit-holder to the bank.

A more accurate depiction of the outcome of bank lending is therefore the following:

Jill will be charged interest on her loan – but Jack will also receive interest on his deposit. Interest payments don’t flow in only one direction – to the bank – as in the PM diagram. Instead interest flows both in and out of the bank, which makes its profits on the ‘spread’, (the difference) between the two interest rates: it will charge Jill a higher rate than it pays Jack. This is not to argue that there aren’t deep problems with the ways the banking system is able to generate large profits, often through unproductive or even fraudulent activity – but rather that money creation by banks does not cause the problems suggested by Positive Money.

So the banks don’t endlessly siphon off income from the ‘real economy’ – but isn’t it still the case that in order to obtain money for payments, someone has to borrow at interest and someone else has to lend?

To see why this is misleading, we need to consider not only how money is created but also how it is destroyed. We’ve already seen how new money is created when a bank makes a loan. The process also happens in reverse: money is destroyed when loans are repaid. For example, if after the steps above, Jack were to subsequently buy something from Jill, the deposit will return to her ownership and she can pay off her loan – extinguishing money in the process.

One possibility is that instead of selling goods to Jack – for example a phone or a bike – Jill ‘sells’ Jack an IOU: a private loan agreement between the two of them. In this case Jill can pay off her loan to the bank and replace it with a direct loan from Jack. This would leave the balance sheets looking as follows:

Note that after Jill repays her loan, the bank is no longer involved – there is only a direct credit relationship between Jack and Jill.

This mechanism operates constantly in the modern economy – individuals swap bank deposits for other financial assets, or pay a proportion of their wages into a pension scheme. In fact, the volume of non-bank financial intermediation outweighs the volume of bank lending. The implication is that the demand from individuals for interest-bearing financial instruments is greater than the demand for bank deposits as a means of payment. Rather than banks being able to force loans on people because of their need for money to make payments, the opposite is true: people save for their future by getting rid of money and swapping it for other financial assets.

The quantity of money in the system isn’t determined by bank lending, as in the PM account. Instead it is a residual – the amount of deposits remaining in customer accounts after firms borrow, hire and invest; workers receive wages, consume and save; and the financial systems matches savers to borrower directly through equity and bond markets, pension funds and other non-bank mechanisms.

So the monetary argument is wrong. What of the argument that lending at interest requires endless economic growth?

Economic growth can be broken down into two components: population increase and growth in output per person. For around the last 100 years, global GDP growth of around 3 per cent per year has been split evenly between these two factors: about 1.5 per cent was due to population growth. The economy is growing because there are more people in it. This is not caused by bank lending. Further, projections suggest that the global population will peak by around 2050 then begin to fall as a result of falling fertility rates.

What about growth of output per head? Again, the answer is no. There is simply no mechanistic link between lending at interest and economic growth. Interest flows distribute income from one group of people to another – from borrowers to lenders. Government taxation and social security payments play a similar role. Among other functions, lending and borrowing at interest provides a mechanism by which people can accumulate financial claims during their working life which allow them to receive an income after retirement when they consume out of previously acquired wealth. This mechanism is perfectly compatible with zero or negative growth.

If anything, excessive lending is likely to cause lower growth in the long run: in the aftermath of big credit expansions and busts, economic growth declines as households and firms reduce spending in an attempt to pay down debt.

Even if we did want to reduce growth rates, history teaches us that using monetary means to do so is a very bad idea. During the monetarist experiment of the early 1980s, the Thatcher government tried exactly this: they restricted growth of the money supply, ostensibly in an attempt to reduce inflation. The result was a recession in which 3 million people were out of work.

Oddly, despite the environmental argument, we can also find arguments from PM about ways that monetary mechanisms can be used to induce higher output and employment. These proposals, which go by titles such as ‘Green QE’ and ‘People’s QE’, argue that the government should issue new money and use it to pay for infrastructure spending.

An increase in government infrastructure spending is undoubtedly a good idea. But we don’t need to change the monetary system to achieve it. The public sector can do what it has always done and issue bonds to finance expenditures. (This sentence will inevitably raise the ire of the Modern Money Theory crowd, but I don’t want to get sidetracked by that debate here.)

Further, the conflation of QE with the use of newly printed money for government spending is another example of sleight of hand by Positive Money. QE involves swapping one sort of financial asset for another – the central bank swaps reserves for government bonds. This is a different type of operation to government investment spending – but Positive Money present the case as if it were a straight choice between handing free money to banks and spending money on health and education. It is not. It should also be emphasised that printing money to pay for government spending is an entirely distinct policy proposal to full reserve banking – which do would nothing in itself to raise infrastructure spending – but this is obfuscated because PM labels both proposals ‘Sovereign Money’.

The same is true of other issues raised by PM: inequality, excessive debt, and financial instability. All are serious issues which urgently need to be addressed. But PM is wrong to promise a simple fix for these problems. None would be solved by full reserve banking – on the contrary, it is likely to exacerbate some. For example, by narrowing the focus to the deposit-issuing banks, PM excludes the rest of the financial system – investment banks, hedge funds, insurance companies, money market funds and many others – from consideration. The relationship between retail banks and these ‘shadow’ banking institutions is complex, but in narrowing the focus of ‘financial stability’ to only the former, the PM proposals would potentially shift risk-taking activity away from the more regulated retail banking system to the less regulated sector.

Another justification PM provide for full reserve banking is that issuing money generates profits in itself. By stripping the banks of money creation powers, the government could instead gain this profit (known as ‘seigniorage’):

Government finances would receive a boost, as the Treasury would earn the profit on creating electronic money, instead of only on the creation of bank notes. The profit on the creation of bank notes has raised £16.7bn for the Treasury over the past decade. But by allowing banks to create electronic money, it has lost hundreds of billions of potential revenue – and taxpayers have ended up making up the difference.

This is incorrect. As explained above, banks make a profit on the ‘spread’ between rates of interest on deposits and loans. There is simply no reason why the act of issuing money generates profits in itself. It’s not clear where the £16.7bn figure is taken from in the above quote since no source is given. (While Martin Wolf appears to support this position, he instead seems to be referring to general banking profits from interest spreads, fees etc.)

None of the above should be taken to imply that there are not problems with the current system – there are many. The banks are too big, too systemically important and too powerful. Part of their power arises from the guarantees and backstops provided by the state: deposit insurance, central bank ‘lender of last resort’ facilities and, ultimately, tax-payer bailouts when losses arise as a result of banks taking on too much risk in the search for profits. QE is insufficient as a macroeconomic tool to deal with on-going repercussions of the 2008 crisis – government spending is needed – and has pernicious side effects such as widening wealth inequality. The state should use the guarantees proved to the banks as leverage to force much more substantial changes of behaviour.

Milton Friedman was a proponent of the original Chicago Plan, and the intellectual force behind the monetarist experiment of the early 1980s. He was also deeply opposed to Roosevelt’s New Deal – a programme of government borrowing and spending aimed at reviving the economy during the Great Depression. Friedman describing the New Deal as ‘the wrong cure for the wrong disease’ – in his view the problems of the 1930s were caused by a shrinking money supply due to bank failures. Like PM, he favoured a simple monetary solution: the Fed should print money to counteract the effect of bank failures.

He was wrong about the New Deal. But his description is fitting for Positive Money’s Friedman-inspired monetary solutions to an array of complex issues: lack of decent jobs, inequality, financial instability and environmental degradation. The causes of these problems run deeper than a faulty monetary system. There are no simple quick-fix solutions.

PM wrongly diagnose the problem when they focus on the monetary system – so their prescription is also faulty. Full reserve banking is the wrong cure for the wrong disease.

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