The UK is now in a great rush to reduce GDP in order to reduce the financial deficit. But before we frame economic policy, we need to revisit economic theory, in particular the theory of money and macroeconomic demand theory.
On the theory of money
Money is an artefact, not a real physical commodity. It does not obey the laws of thermodynamics – it can be created and destroyed. The idea that macroeconomic budgets have to be balanced is a category error. It takes a microeconomic simplicity, that individuals or firms have to balance their budgets, and falsely transfers this to macroeconomics. It is the principle behind monetarism. It has the benefit of being simple to understand. But it is wrong and is currently driving a mistaken policy of cutting public expenditure and therefore GDP, when the real economy is in perfect shape and well able to grow. The tail of monetary policy is wagging the dog of real economic policy.
Banks have always created money. Their regulations require them to have strong capital reserves, but then allow them to lend a multiple of those capital reserves. This money is simply created. The idea that the amount of money in circulation had to be backed by gold in the Bank of England’s reserve was shown to be nonsense a long time ago. The last time this concept was allowed to drive economic policy was in 1925 with the return to the gold standard and the consequences were disastrous. And yet we are following similar thinking in 2010 by insisting that the macroeconomic budget has to be balanced, that money is somehow real, that is has to be borrowed and repaid. On the contrary, money can be simply created and does not need to be backed either by gold reserves or by debt. Rather the money supply has to be calculated to enable consumer purchase of the output GDP made available from the real supply side of the economy. Too much and inflation results, but too little and recession bites.
Cause of the crisis
It is popular to blame the banks for the current economic crisis. But again this is a false simplicity. There is also something ugly about societies when they turn on whipping boys. The amount of credit pumped into the economy was not excessive. If it had been, then inflation would have been the result. In fact we have emerged from the NICE decade of non inflationary growth. The amount of credit in the economy, some £55bn in 2007, was exactly the right amount to supplement consumer income so that income + credit sufficed to purchase output GDP without inflation. The real problem behind the crisis is deficient consumer demand. In another paper, I suggest that this is due to productivity increases (see http://tmseu.netgates.co.uk/financialcrisis.html) but this is not essential to the current debate. What is clear is that if consumer incomes are insufficient to purchase output GDP, then either consumer incomes have to be supplemented, or output GDP has to be cut and we have a recession. The first option was to supplement consumer incomes with credit. The problem with this strategy was not that this would lead to inflation, which it did not, but that the consumer debt becomes un-repayable in subsequent years. It is not a constant solution to deficient consumer income, since consumers cannot each year take out ever more credit. So we are now moving to the second solution, that of cutting GDP to reduce it to the level of macroeconomic consumer income.
Consequences of monetarism
The consequences of current monetarist thinking are exemplified in policies for public expenditure and pensions. If public expenditure is reduced to balance the books and wipe out the deficit, then recession is inevitable. Public expenditure accounts for some 50% of GDP. Cutting public expenditure by 25% therefore leads to a reduction of 12.5% in GDP. So the real economy will be devastated by a mere financial discipline based on an incorrect theory of money. Similarly with pensions where financial balance dominates thinking and policy, and the real economy is ignored.
Whilst an individual can believe that a financial asset, a pension policy, or savings, can provide for their consumption in retirement, the real macroeconomic truth is very different. There is of course, no way in which the individual can save and store the real products they will need when retired. In fact, today’s pension contributions are a transfer payment to today’s pensioners, not a saving for the current pension contributor.
The real determinant is productivity. If productivity and therefore real output were low when the individual retires, then no financial asset would suffice to fund their consumption. There would be rampant inflation. If on the other hand productivity and output grew exponentially, then we could all retire now. The monetarist urge to increase current savings to provide for future retirement is therefore misplaced in providing for that retirement. It is also misplaced in that its immediate effect will be to take demand out of the economy and aggravate the recessionary factors in play. The combination of reduced public expenditure and reduced consumer income from pensions contributions increases can only be disastrous for the real economy.
An alternative?
There is an alternative. It is a return to Keynesian theories of money and macroeconomic demand. We should surely opt for GDP growth when not everyone is rich and when employment is needed? Deficient consumer demand therefore needs correcting, not aggravating.
Consider a fully automated economy where goods and services were produced in abundance with no workers. In such a science fiction state, where there would be no wages, the only way of allocating these goods and services would be by a government issued citizen income. There is no reason an element of consumer demand today should not also be met by a limited citizen income. It would simply be issued as increased money supply and not supported either by gold or by debt in the bond markets. It would supplement consumer income to the point where it was sufficient to purchase output GDP without inflation. Its advantage over credit would be that it is non-repayable. The government issuing bank would monitor the GDP/consumer income gap, any increased savings balances resulting as the citizen income worked its way through the system, and any inflationary indicator. It would work and would avoid recession.
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43 Comments
Clever thinking.
I have thought for a long time that the inequitable distribution of money would be unsustainable if we want genuine economic growth. Allowing consumers to gain access to cheap credit, as you pointed out, is only a termporary fix to the problem. It is clear that to achieve a greater level of growth in our consumer economy the average wage must rise so as to provide many more people with much more disposable income. Allowing only a tiny fraction of people to benefit massively from economic growth is not good enough, as these people, the richest in society, have more disposable income than they could ever spend on consumer goods, and tend to save not spend (as Keynes would have us do).
We woul not need to fear globalisation and becoming uncompetitive if wealth was distributed (both by private secotr employers, and the government) more equitably.
Lost you in the sixth paragraph I’m afraid. Sorry.
Thanks for a good and thought-provoking article. I could add some stuff, but I won’t! It’ll detract from your point.
Agree with the thrust of this post.
Incidentally, if Dispatches allegations on tax avoidance by senior Cabinet Ministers are broadcast as promised tomorrow, Cameron is going to have his work cut out trying to convince people that ‘we are all in this together’.
http://etonmess.blogspot.com/2010/10/senior-tories-accused-of-tax-dodging.html
@Paul Walter
The sixth paragraph – and some of the seventh – is simply an illustration, though unfortunately a connected illustration. I had to read back when I got to 6th paragraph.
Thanks for your reminder of returning to Keynesian theory, Geoff. How would it fit with a situation which we have of needing to redefine growth to cut our physical resource and energy growth drastically to face up to climate change and other world environmental problems?
This is the same stuff that led to high and increasing levels of inflation in the 1970s. All good stuff except it doesn’t work.
Most of it is economically illiterate, exemplified by the absurd figure that the cuts will reduce GDP by 25%. Also ignores the fact that increasing the money supply would increase inflation.
What an excellent article. I’m fed up of people drawing parallels between the UK economy and a household budget when justifying spending cuts.
The allusion doesn’t even stand up in its own terms: entrepreneurs are celebrated by the right for risking bankruptcy in their efforts to succeed; ordinary people rely on semi-affordable credit to further their lives, on the assumption that individual or familial progress will suck up the costs.
The danger is that the Coalition starts with a fair observation – that much Government spending under Labour was wasteful – and takes that as a licence to cut indiscriminately, or, worse, towards some arbitrarily fixed target (e.g. what “the markets” have requested). When you cut spending on things which serve useful economic purposes and cannot be efficiently provided by the private sector, you weaken the economy in the long run. The “saving” from the spending cut is quickly wiped out.
Markets are riddled with paradoxes – have a look at the Prisoner’s Dilemma for a simple example of how a group of individuals can rationally demand the wrong thing. So the challenge, as George Soros wrote in this article in the New York Review of Books, is for “The world’s leaders […] to learn that they have to lead markets and not seek to follow them.”
Geoff: Forgive me if I’m being economically illiterate, but haven’t the government suggested that monetary policy should indeed be used as the main mechanism for staving off recession? Albeit not in the form of a citizens income. So, in crude terms, what you’re saying is that currently the strategy is to print money and give it to the banks to enable them to offer credit more cheaply, whereas you would prefer them to just print money and give it directly to citizens for free?
Also: You might well be onto something in Keynesian terms, I’m don’t know enough about economics to tell, but in terms of public opinion, is tying the idea of a citizen’s income to the idea of “printing money” (as it would inevitably be described by critics) just likely to damage the chances of introducing a citizen’s income any time soon, by making it sound like even more of a free lunch policy?
This article is basically just the Keynesian argument against the Monetarist argument, I’m not sure why people write such general articles such as this and reach such definite conclusions about policy when it is VERY clear from the world of academic economics that this debate is nowhere near settled and certainly not in an article this size. By all means write articles advocating Keynesianism but it would be nice if every one of these pontifications didn’t act like they’d suddenly ended an argument thats been going on since WW2 at Cambridge.
“Money is an artefact”
but it is not, cannot and must not be allowed to become arbitrary. That way lies Greece, Zimbabwe and Weimar.
Unless monetary values retain a quantifiable relationship to commodity values market behaviour becomes increasingly volatile and creates growing inequalities among market participants – in particular regarding access to basic services and products.
The simplest example is the house price bubble, where 25 years of access to cheap money created a whole generation of people who may never be able to afford to own their own homes, which has obvious consequences for communities and social mobility. The divergent interests of the debt-laden consumer class who are disincentivised from increasing their savings and investment rates is a constant source of conflict.
So the issue of spending cuts is, as Geoff hints, just as much a matter of controlling inflation and eliminating the productivity drag caused by false economies (quangoes, excessive red tape etc) which will lead to stagflation further down the line as it is about preventing a collapse in consumer demand and potentially causing a lasting recession during the interim.
Yes, we should reject cuts based on monetarist ideology, but we should also not return to fundamentalist Keynesianism where the state is encouraged to take the place of private or mutual enterprise.
It’s a delicate balancing act, and the challenge is in identifying the correct cuts and communicating how we calculate their ‘fairness’.
Student finance and child benefit have been two recent battles fought over this territory – and it’s clear there is a trend emerging. The Conservative definition of fairness discriminated negatively against single-income households (those with lower means), while the LibDem definition of fairness incorporated the principle that those who gain more can, and therefore should, help more.
In other words Conservatives still favour pre-existing advantage, while LibDems are still trying to even up the playing field.
And Labour oppose both because they still intend to tip the balance the other way.
This article really is half baked nonesense.
The suggestion that cutting current (not capital) government spending by 25% by 2015 (not immediately) will result in a 12.5% drop in GDP is laughable as it appears to be based on the assumption that the rest of the economy is completely inert and that no other factors will change. Most importantly of all it falls over for exactly the same reason that crude monetarism (in its proper sense rather than the polemicised version used here) also failed to work: in an international economy with fewer and fewer constraints on the movement of capital the actions of a government are a very small part of the economic story.
@Smcg
“Most of it is economically illiterate, exemplified by the absurd figure that the cuts will reduce GDP by 25%. Also ignores the fact that increasing the money supply would increase inflation.”
Did we read the same piece. The one on my computer never said ‘cuts will reduce GDP by 25%, only that GDP must be reduced in order to close the deficit this way, it also acknowledges that increasing the money supply would increase inflation if printing was not kept under control.
I don’t know whether you are economically illiterate, but you do seem to be illiterate.
@ Smallstate (a finely tuned name!)
“will result in a 12.5% drop in GDP is laughable as it appears to be based on the assumption that the rest of the economy is completely inert and that no other factors will change”
I think the only assumption that is laughable here is Osbourne’s assumption that we can have an export led growth in a country where exports have only been falling. Please tell us, oh wise one, how the hand of God is going to direct the private sector into filling the gap left by the government.
Thanks Rob for understanding and defending the article and to others for the debate.
Sorry Paul for the 6th paragraph. It’s really trying to say that all economic policies, including pensions, must be thought through in real terms and not simply in financial terms. So pensions can’t be analysed in terms of i) the amount of money saved in pension funds ii) the working life of individuals. What really matters is the future trend of real productivity in the economy. So if real productivity (output per person hour) when I retire is high, then my pension will provide my needs, but if this real productivity is not sufficiently high then no amount of money will provide for my retirement – we will all suffer rampant inflation. Equally the strategy of people working longer will only be effective if and only if their work adds to GDP. If they stay on at work and block younger, potentially more productive talent, then they may even reduce GDP. It all has to be analysed in real terms and not simply financial terms. The failure to do this is the main critique of monetarism. Analysing a real economy purely through financial measures is like trying to drive a car by manipulating its speedometer.
Tim 13 – I agree that we may want to make a decision to limit GDP for resource and environmental reasons. This is a separate but valid point to my argument. But if we do opt for lower GDP, we still have to ensure that the allocation of the lower GDP reaches citizens who have thereby lost employment. This applies even more if productivity still continues to rise. Unemployment benefit is a form of citizen’s income.
Smcg – calling someone’s work ‘economically illiterate’ is a poor substitute to debating the real points raised in my article. It’s a simple arithmetic truth that if public expenditure is reduced by 25% and public expenditure is 50% of GDP, then GDP is reduced by 12.5% as a result in the first instance. You claim that a citizen’s income would lead to inflation. But this would only be the case if such an income were excessive and led to disposable consumer income in excess of the value of output GDP. What I am arguing is exemplified in the 2007 economic data analysed in my other paper at http://tmseu.netgates.co.uk/financialcrisis.html. If the £55bn of consumer credit in that year which was necessary to enable consumers to purchase output GDP without inflation were replaced by £55bn of citizen income, then there would equally be no inflationary demand and more importantly no crippling debt to carry forward.
I would make the same reply to Andy Hinton’s polite and constructive comment. The amount of any citizen’s income paid in aggregate would have to be carefully calculated and limited to the gap between predicted GDP output value and consumer income (including wages, dividends etc). This would make it exactly take up the GDP value, but restrict it so that it did not become excessive and inflationary. Actually the banks have been quite smart in calculating this figure each year and have translated it into just sufficient consumer credit to purchase GDP without inflation – the so called NICE decade. But is has left consumer debt which a citizen’s income would not.
Joe Donnelly seems to dislike succinct articles per se. I am well aware of the ongoing debate you refer to and have read the academic literature carefully from Keynes General Theory onwards. I admit to being an unreconstructed Keynesian. He was correct in pointing out that aggregate demand needs managing in the economy (that wages are not simply a cost of production but also the funding of effective demand so that cutting wages In a recession will aggravate not relieve it). Since WW2 all governments of developed economies have incorporated Keynesian demand management into operational economic policy.
Smallstate, like Smcg, argues that the private sector will take up where public expenditure cuts release resources in the economy. This is presumably based on export demand, since demand in the UK economy will have been decimated by the same cuts. This is what Mervyn King, the governor of the Bank of England hopes will happen. But how can this be, when, as Smallstate points out, other governments are also implementing economic cuts so that demand in their countries will also be reduced which will reduce their imports of UK goods?
This is nonsense. The errors start within the first paragraph and just spiral from there.
“The idea that macroeconomic budgets have to be balanced is a category error.”
No one has ever said this. Obviously budgets do not have to be balanced, or debt would not exist. Equally obviously you cannot have a permanently unbalanced budget, otherwise you will just drown in debt. This statement adds nothing.
“It is the principle behind monetarism”
No it isn’t. The principle behind monetarism is that inflation is everywhere a monetary phenomenon. That inflation and output is directly linked to the money supply and not demand control. It has nothing to do with balanced budgets or otherwise.
“that money is somehow real, that is has to be borrowed and repaid”
What? Are you seriously suggesting that governments don’t have to repay debt? Or are you suggesting just printing money to pay debts. Hyperinflation anyone?
“Public expenditure accounts for some 50% of GDP. Cutting public expenditure by 25% therefore leads to a reduction of 12.5% in GDP”
Yes, if done at once in some magical manner. In reality since government gets its money by taxes and debt it is possible to cut the amount it spends by making government more economically efficient over time and actually increase GDP by not taking resources from possibly more productive and profitable enterprises. If this refers to any actual policy, the it is wrong as well. The coalition only plans to cut government expenditure by about 10% in total. And as this is over 5 years it can be easily swallowed by growth over that same period.
This article is basically a posh way of saying we only need to borrow and print as much money as want and no negative affects will happen. it is economic la-la land where there are pain free solutions to our problems. It is just a joke.
@Stephen W
“This article is basically a posh way of saying we only need to borrow and print as much money as want and no negative affects will happen. it is economic la-la land where there are pain free solutions to our problems. It is just a joke.”
No it really isn’t, and there isn’t the need to be so agressive. The problem many commentors here are having is that they are ignoring the nuance in the original article. Geoff Crocker is not saying that we can just print to repay our debts, only that we can increase the amount we print to match a rise in personal spending power. The conclusion is that if wages are raised and employment increased the government can also increase the amount of money in circulation, and use this money to pay off debt (without causing inflation). Inflation is only a problem when the money in circulation loses its value, Geoff argument doesn’t entail anything that would cause money to lose its real value.
And nothing Geoff has written is ‘absurd’. As pointed out, we ran a defecit of over 100% of GDP with no ill effects for many years (in fact having a post-war boom in some of those years). The Attlee government inherited a defecit of 150% of GDP and still managed to create the welfare state. There is a reason for this; the consensus at the time was Keynsian and we weren’t ruled by the fears of the ‘markets’. The real problem at the moment is that ‘the markets’ have far more economic, and thus political, power than the government and so call our economic policy (and it is quite possible for the spivs to support selfish policies which may seem in their best interest, but when pursued by all are mutually destructive- game theory). A deficit of 60% of GDP would really have been nothing in the past, but today it is portrayed as armageddon due to a false consensus foisted on us by the self-interested backers of a broken economic theory.
The problem over the last two decades has been that the government, rather than encouraging an equitable rise in real wages, has supported using debt instead of real money in order to support growth. The premise of this is in fact the same as Keynes’s: that granting more spending power to people leads to growth. The problem is that the government can’t ahve the best of both worlds, it can’t keep a laissez faire neo-liberal model whilst relying on cheap credit to fuel booms… that is fundamentally unsustainable and we will only see multiple repeats of this crisis if this is allowed to continue.
Interesting to see that the debate continued through the small hours. Thanks Rob for being ever vigilant in my defence 🙂 I fail to understand why Stephen W resorts to abusive terms like ‘nonsense’ and ‘posh’ and ‘just a joke’ to challenge the article. In response to the points he makes inbetween these tirades –
1 I agree that one implication of monetarist theory is that ‘inflation is everywhere a monetary phenomenon’. This is again an error of monetarism. As policy makers have more recently realised, inflation is also caused by capacity issues in the real economy – too much demand chasing too few goods will cause inflation and vice versa just as will excess money supply.
2 Yes I am suggesting that government issued money does not have to be backed up by debt anymore than it has to be backed up by gold in the vaults as used to be thought. Bank lending to multiple values of their capital reserves is commonplace and is how the financial system actually works.
3 No I am not proposing that ‘we print as much money as we want’. I am proposing that we print exactly the amount of money equal to the value difference in GDP output and consumer income. In 2007 this would have been £55bn. Any more would be inflationary, any less would lead to recession in GDP. It’s interesting how this mantra of ‘printing money’ has grabbed widespread consciousness as a nasty irresponsible perversity to be condemned in self righteous tones. Of course the Weimar republic got it wrong, but we clearly do ‘print money’, although virutally rather than physically – it’s just a matter of getting the amount exactly right. But it does not have to be backed with government debt.
4 I agree that the coalition will find 25% cuts in public expenditure either impossible or disastrous.
Geoff
Brilliant account of the real issues about pensions. I have been trying to get through to people for ages that money is not a thing in itself merely a claim on a share of resources and if the resources are not there for pensioners all the money in the world in a pension scheme will not feed, clothe and house them.
Thanks James – I did my economics degree (many years ago) at Durham and have very fond memories of the place…must revisit sometime
My apologies if my tone was overly dismissive. ‘Posh’ is not meant as an insult, I merely mean this is a complicated argument for a simple and (simply) flawed policy prescription. I do believe this article to be wrong though, and verging on nonsense.
I’m glad you accept that the quotes I mention mischaracterise at worst and are irrelevant statements at best. Some more issues.
You repeatedly state that what we need to do is print enough money to cover the difference between consumer income and GDP. Why are you ignoring government spending, investment and the trade balance here in the calculation for GDP? Do you mean every year? Since this could only conceivably work if the money supply was entirely under the control of the government isn’t this just as bad as the most naive monetarism? The reason monetarism failed is that the majority of money creation actually takes place within banks, because although loans are matched by capital levels banks do not wait to get individual deposits before lending out on them, they lend and then sort out capital supplies later (more or less) and hence the government has only imperfect control over the money supply.
You also repeatedly state that “The amount of credit in the economy, some £55bn in 2007, was exactly the right amount to supplement consumer income so that income + credit sufficed to purchase output GDP without inflation.” or words to that effect. This is just false though. CPI in 2007 was 2-3% and RPI was 4-5%, with CPI and RPI shortly to shoot up to 5% in 2008. If this is what you characterise as no inflation, then it would be interesting to know what you consider actual positive inflation to be?
As far as I can tell your suggestion basically consists of abolishing the extension of credit by banks or other non-government institutions and replacing it with total control of the money supply by government, with said government printing money each year to cover the difference between income and GDP, with the argument this would be more stable than allowing the extension of credit to be largely outside government control. Would this be a fair characterisation? What would we do with savings, for loans etc, if we did this? Would it not have a catastrophic impact on the ability of individuals to borrow money to invest in new enterprises and hence the efficient allocation of economic resources?
Or have I got the wrong end of the stick?
“Public expenditure accounts for some 50% of GDP. Cutting public expenditure by 25% therefore leads to a reduction of 12.5% in GDP. So the real economy will be devastated by a mere financial discipline based on an incorrect theory of money.”
It is also worth stating just how little this statement bears any relation to any plan anyone is actually putting forward. Even the fiscal deficit plan put forward by the Coalition, a pretty strong one I’m sure we’ll all agree only cuts actual useful public spending from about £660 billion to £600 billion in real terms, a 9% cut. Including debt interest the government is only cutting expenditure from about £700 billion to £670 billion (in real terms). We have here a financial discipline based heavily on spending cuts that will not devastate the economy as you describe. Thus forcing us to ask, why we may need your plan?
An actual 25% cut in public expenditure (over the next 5 years presumably) would be totally bizarre since one would expect taxes to rise over that period due to tax hikes and economic growth, and the deficit is only 11% of GDP or 22% of government spending anyway. Anyone planning to do this would, as you say, be insane. But since no-one is planning to do this I don’t really see how relevant it is to mention?
@ Joe Donnelly – Posted 17th October 2010 at 8:00 pm
LOL. If nobody was allowed to write “pontifications” that appeared to settle debates that have been going in academia for decades, there’d be nothing on LDV but Stephen’s round-up of the polls!
@ Geoff Crocker – Posted 17th October 2010 at 11:41 pm
If “calling someone’s work ‘economically illiterate’ is a poor substitute to debating the real points” you’d best have a word with Vince, as “economically illiterate” was his favourite phrase of 2009!
Stephen @ 12.44, this is straining my knowledge of macro economics to the limit but wouldnt total control of the money supply also mean shutting off international capital flows? Implementation exchange controls, tarrifs, that sort of thing. That sounds like a sure fire way of delivering economic oblivion to the UK, but I am not clear whether this is actually what Geoff is proposing. (That would also mean us being thrown out of the EU – you can pay your money and take your choice on whether that would lead to oblivion… 😉
Tom – every time Stephen posts about polls he tells us that LDV doesnt do polls so I am guessing they would dry up eventually too?
Re two more blasts from Stephen W,
1 Your first sentence again leads with non-substantive dismissal – the article simply does not verge on nonsense. You say it does, I say it doesn’t. Where does that get us?
2 I did not and do not ”accept that the quotes (you) mention mischaracterise at worst and are irrelevant statements at best”
3 Money supply is undertaken by banks but controlled by central government through the lending/capital reserve ratios. Anyway I am only proposing that government assumes responsibility for supplementing demand where it is deficient. Some people of course thought Keynes’ recipe for supplementing deficient demand was nonsense.
4 Some modest inflation is helpful to clear markets since prices tend to be sticky downwards and so can adjust their relativities in minor inflation. The current target as you know is 2%. The main point I am making is that it is not true to claim that excessive credit was to blame for the crisis – we had the long run experience of the NICE decade and need to understand this phenomenon
5 Yes you have got the wrong end of the stick
6 We don’t know until Wednesday what plans are being put forward. But it’s simple arithmetic that if A is reduced by 25% and A is 50% of B, then B is reduced by 12.5%. I am only pointing out the unlikelihood, inadvisability etc of such an idea.
Tom, yes I agree. Vince seems to like denunciation as a modus operandi, be it of Messrs Mittal and Abramovich (rich foreigners) by name at last year’s party conference, bankers always as ‘greedy’, this year’s conference speech bogeymen of ‘spivs and gamblers’, and as you point out the ‘economically illiterate’. It’s all caricature and distasteful. But having a word with him about it, as you suggest, is rather difficult 🙂
“1 I agree that one implication of monetarist theory is that ‘inflation is everywhere a monetary phenomenon’. This is again an error of monetarism. As policy makers have more recently realised, inflation is also caused by capacity issues in the real economy – too much demand chasing too few goods will cause inflation and vice versa just as will excess money supply.”
I have to take issue with this, its bizarre. The idea that “inflation is everywhere a monetary phenomenon” (taken from Friedman’s 1963 history of US monetary policy) is not “one implication of monetarist theory”, it is monetarist theory. The implication of this, as Friedman laid out subsequently, was that inflation being a monetary phenomena could only be solved by monetary means, ie, control of the money supply. Or rather non control of it, he advocated an automatic mechanism for increasing the money supply at about 5% per year to take account for economic growth.
If this clanger doesnt set alarm bells ringing then this certainly should; ” too much demand chasing too few goods will cause inflation and vice versa just as will excess money supply”. Now, I demand (in the economic sense) a BMW. But I cant afford one. I dont have the money so I stay out of the showroom and my demand plays no part in driving up the price (inflation) of BMWs.
However, the government expands the money supply and I now have money I didnt have before. I go into the showroom and try and buy the BMW. So are others. Demand for the BMWs has risen but there are only as many of them as there were before. So the seller puts his prices up. We now have inflation.
This is what you need to grasp Geoff. Demand without any money behind it cannot pull prices up. It is only the injection of new money which turned my inert demand into effective demand which allowed my to exert price pressure (at least in the short term; when BMW prices went up I was stuffed again). Thus, in the meduim to long term, Friedman was right. Inflation is always and everywhere a monetary phenomenon.
Thanks for telling me what I need to grasp Sean. Of course demand needs to be made effective through money supply, ie monetary policy, and I accept that my comment which you are attacking was too slack. Keynes offered his digging up of money in bottles proposal precisely to placate the monetarists. This is the whole thrust of my initial article that effective, ie monetarised, demand is deficient and needs to be increased by a monetary instrument not backed by debt.
But money supply will not cause inflation when there is slack in the supply side of the real economy.So inflation is a combination of real economy supply/demand balance measured against money supply. In your BMW example there would be no necessary inflation in BMW prices if the BMW factories were working at 50% capacity. You’re right that you can’t get inflation without excess money supply but the question is excess to what? An increase in money supply increases either saving or spending. If and only if it increases spending relative to saving, and if and only if also there is no excess capacity in the real supply side of the economy then inflation will result. There are therefore of course non inflationary increases in money supply and inflation can only be caused by money supply plus conditions in the real economy.
Essentially youre arguing that we are on the flat (or at least only slightly sloped) section of the supply curve. If this is the case explain how inflation has been persistently above 3% on the CPI measure?
There is nothing new in your proposal as you yourself admit. It is, in fact, exactly the same idea that lead to economic mayhem in the 1970s.
The proposal for a citizen’s income is not new but the argument for it is innovative. It wasn’t tried in the 1970s.
The Citizens Income is neither here or there though in terms of your proposal. It is just another outlet for newly printed money with all the inflationary pressure that entails. It could just as easily be spent on propping up British Leyland. You can argue for a Citizens Income on all sorts of grounds (even Charles Murray supports one) but heres its just another set of clothes for the old myth that if we double the amount of money in circulation we will be twice as well off.
The crux of your argument is that newly printed money (whether disbursed as a Citizens Income or one of many other ways) “would supplement consumer income to the point where it was sufficient to purchase output GDP without inflation”. To accomplish this you would need to constantly, at any point, know exactly what the gap between consumer income (really just the money supply) and GDP was but, given that GDP figures are constantly being revised, this is simply wishful thinking. This doesnt even touch the deficiencies of GDP as a measure. And why GDP and GNP?
Geoff, many good points but I would like to pick up on three points.
Firstly, you argue that, “the amount of credit pumped into the economy was not excessive. If it had been, then inflation would have been the result”. True enough of retail price inflation, but what of property price inflation? I see inflation as like silly putty squeezed in a closed fist. If you stop it coming out in one place it simply finds an alternative.
Secondly, you take exception to blaming the banks for the crisis. What you say about the amount of credit being just right for the output gap may be right at the macroeconomic level, but it wasn’t done by a citizens’ income and hence at teh macroeconomic level. It was through private debt and that has to be repaid. Had it gone on productive assets then the economy would have been larger in proportion and it would have been no problem. In fact it went on consumption and Ponzi housing so there is no additional income to repay it from. Now that the accumulated debt cannot in large part be repaid, the consequences are dire. In the build up there was a steadily growing transfer of income from debtors to creditors (hence in part the growing wealth inequality), and in the end bust banks that are not doing their proper role of supporting productive investment because their balance sheets are still devestated even after £ billions of public support.
Thirdly, when Keynes was writing international trade was a tiny fraction of today. I take the point that printing money is not a complete no-no but what if much of that leaks overseas as via our chronic balance of payments deficits? This then means that foreigners accumulate claims on us. Is that really sustainable?
Well Sean if you conflate my points with all your rhetoric about the 1970s then you do produce the nonsense you accuse me of. 1970s inflation was caused by the OPEC oil price hike before UK had the N Sea oil flow which as Tony Blair admits saved his administration’s economic policy. It was nothing to do with money supply policy – just a quadrupling of the imported oil price. Propping up B Leyland and a citizen’s income are entirely different proposals and routes for money supply with different effects and consequences.
Yes I do propose monitoring the GDP / effective demand gap on a constant basis, and supplementing demand deficiency with a citizen’s income not backed by government debt. We have the data to do it. And it would save us from recession. And it would be non-inflationary. It would work.
Liberal Eye – thanks for a thoughtful response. I agree that asset prices have inflated. The question is whether the effect if we had had £55bn less consumer debt in 2007 would have been i) to lead to recession because effective demand would have been withdrawn from GDP goods and services or ii) a reduction in asset prices. It’s complicated as we know by the specifics of the UK housing market and its high level of owner-occupation, the tendency for the government to use the interest rate to fine tune consumer disposable income through changes in mortgage payments rather than using the tax rate, and the shortage of land in the UK which bids property prices up – there are lots of land banks which need a downward price adjustment but the owners are unwilling to take the loss in book value.
What I do know is that there is a lot of consumer debt which was used to buy goods and services rather than property and which is now non-repayable and certainly can’t be added to and I strongly suspect that withdrawal of this element of consumer income will lead to GDP recession due to demand deficiency, rather than leading to a collapse in asset prices. But this would need a more detailed econometric study and I don’t have the tools to hand. I try to analyse these effects more thoroughly in my initial paper at http://tmseu.netgates.co.uk/financialcrisis.html.
I think in effect we both agree that there is an unsustainable level of debt in the private and public sector. My concern is that simple removing this debt will lead to recession by creating a deficiency in consumer demand and in public sector demand and I suggest that a citizen’s income would avoid this and is in fact the only answer, and has other things going for it eg sense of belonging and responsibility
As for your third point about the globalisation of the economy, Keynes did also construct the Bretton-Woods system, but yes demand can go to imports. Lower income consumers tend to purchase relatively more domestic produce, but the challenge is for UK industry to remain competitive and win the new demand a citizen’s income would create. Your critique probably applied very well to the car scrappage scheme which was a very specific sort of citizen’s income. But if the 2007 £55bn consumer debt were replaced by £55bn citizen’s income (as Simon Jenkins put it in the Times ‘Give us all a Grand’, then everything else, including the import share of demand would have been the same ?
Best wishes
@Geoff Crocker
“We don’t know until Wednesday what plans are being put forward. But it’s simple arithmetic that if A is reduced by 25% and A is 50% of B, then B is reduced by 12.5%. I am only pointing out the unlikelihood, inadvisability etc of such an idea.”
Geoff, I’m afraid I disagree. We already know a lot about what will be announced tomorrow, and the IFS have provided some helpful graphics to understand it. See page 6 of http://www.ifs.org.uk/budgets/budgetjune2010/tetlow.pdf
Although I wouldn’t look to Stephen W for guidance on diplomacy ;), he is essentially right about his statistics.
The 25% cuts you mention only apply to a few departments. The really big spending departments, social security, health, education, and defence are either being cut by far less than that, or are having their funding entirely ring-fenced.
So the cuts aren’t 12.5% of GDP (£350bn), but £83bn of spending cuts and £29bn worth of tax rises.
Have a look at http://www.bbc.co.uk/news/business-10810962.
Of course, there’s lots of contradictory figures around, because some don’t include capital spending, or don’t account for inflation, or debt interest. And, of course, there’s the difference between the structural and the cyclic deficit. But, broadly, we’re talking about a deficit reduction plan of £113bn.
I don’t see what you propose as Keynesian. Surely, as well as supporting deficit spending in a recession, Keynes also supported surpluses in the upturn. But aren’t you missing out the budget surplus part of Keynes’ approach?
Your comment about a limited citizen’s income is interesting. Arguably, this is what Ian Duncan Smith is proposing. A simplification of welfare, with the low paid allowed to keep some of the benefits, so the unemployed don’t face a poverty trap. How would your citizen’s income differ from this?
“1970s inflation was caused by the OPEC oil price hike”
I didnt think anyone believed this anymore. Inflation had been rising fast since 1970 and picked up in 1971/72 as Bretton Woods broke down. As countries no longer had to peg the value of their currency to the dollar (which, in turn, was pegged at $35 per oz of gold) they began to inflate. The oil price shocks were simply a handy cover for inflationists.
Ask yourself this; why did Germany, which imported more of its energy than the UK, have so much lower inflation? The answer is that they followed a tighter monetary policy. Also, the price of oil was rising before OPEC action as were the prices of other commodities, such as gold, which were seen as hedges against inflation. How on earth could the OPEC action have caused an inflation which started before, er, OPEC action?
You see, were back in the car showrrom again. If people have a fixed amount of currency and the price of an essential, like oil, goes up, they can only accomodate this new price if they buy less of something else. That leads to a fall in the price of that something else which offsets the price rise of oil and maintains a stable price level. This is a simple substitution effect.
Geoff,
As you say what might have happened in 2007 had we not had £55bn growth in consumer debt is complicated by the specifics of the housing market. But I think we can have a pretty good guess about the eventual outcome although not about the exact timing and sequencing of each step.
Absent that credit-fuelled extra demand there would have been a recession because of lack of effective demand. On this I think we are agreed. In such circumstances it is just not credible that house prices would have risen for long although they might have for a bit. For one thing they would have been facing a strong recessionary headwind, for another credit scarcity would have limited mortgage availability so only those with a large deposit could have bought which owould have limited the rush into property and the inflation in its price.
In the short term this would have been tough for first time buyers, but then the outturn was no better – prices simply ran away from them in direct proportion to the easy availability of credit and buying near the peak of a bubble is the worst thing you can do. Moreover the eventual losses would be taken by equity leaving the system as a whole, in particular the banks, in much better health.
That leaves us with the recession we would have had from 2004 absent all that credit. Actually I’m not sure that ‘recesion’ is the right word here; it would have been the economy permanent downsizing to reflect the weakness of UK plc’s international competitiveness eventually coming home to roost as the oil money winds down. We have had a ‘Wil E Coyote’ economy since then – lots of furious action but only putting off the inevitable long drop to poorer. This is not a problem for macroeconomics but for the real economy and is what has concerned me for years. You paper on productivity speaks to this but I am not convinced is correct – or rather that it’s only a very small part of the problem.
Incidentally, you should look up Steve Keen’s excellent blog which I think you would find congenial. He has done the econometrics and finds excess debt to be the issue.
http://www.debtdeflation.com/blogs/
George – thanks for raising the tone of the debate. I was as you point out using the press headline figures of 25% cuts in government department spend to get the very rough 12.5% cut in GDP which I intended to be indicative rather than accurate. Thanks for the accurate figure of £113bn cuts (spend + tax). Since GDP is (roughly) £1.3 trn or £1300bn, then the cuts are 8.7% of GDP rather than 12.5%. I’m not sure if you are suggesting that this is insignificant or that if phased over time it is manageable? I suggest that it will have a very substantial deflationary effect and almost guarantee the so called ‘double dip recession’?
You question my reliance on Keynesian analysis. I don’t pretend that my diagnostic is all of Keynesianism, and there is as you poin out, more to Keynes. Nevertheless, core to Keynes is that deficient demand needs to be managed in economic policy, and that money is virtual (although we must manage its value). So in this sense my analysis is true to Keynes?
In my proposal, the difference between Iain Duncan Smith’s proposals and the citizen’s income is that citizen’s income would not be backed by debt, but would be issued by a government bank with a capital reserve / citizen’s income ration set by the government each year as for normal commercial bank lending. The citizen’s income would replace this element of debt, whether consumer or government debt.
Sean. Well I don’t see how you can regard a 4 fold increase in the oil price as non-inflationary? Sure there will be subsequent substitution effects as well as income effects from such a price change, but it is an exogenous price inflation and would certainly enter the inflation indices as such. Why did Germany contain this inflationary element better than UK – in my view because of its effective growth in productivity.
Thanks Liberal Eye. Yes we (and Steve Keen – thanks for the link) all agree that excess debt was the problem. But we might mean that in rather different senses. I believe that the only way in which it was a problem was that debt is repayable and we need an instrument which is not repayable. The £55bn of 2007 consumer debt was used to purchase GDP, not assets. So without it £55bn of GDP would have remained unsold and output recession would have resulted. I would agree with your diagnosis that UK might be headed towards lower consumption (it might even want to do this for ethical or environmental reasons) but it doesn’t make sense to have real resources (including people) lying idle only because the financial system has got stuck in debt. If we were poorer because the real resources couldn’t deliver, then we shouldn’t inflate. But when the real economy is perfectly OK and can deliver, the financial market economy, ie excess of debt, shouldn’t stop it. Accepted that you might not buy the argument in my original paper that productivity is the root cause, but how would you counter my example of a fully automated economy needing a citizen’s income because there would be no wages to distribute the product? I suggest that there is an element of this mechanism at work.
Geoff
@Geoff Crocker “I’m not sure if you are suggesting that this (the coalition deficit reduction plan) is insignificant or that if phased over time it is manageable? I suggest that it will have a very substantial deflationary effect and almost guarantee the so called ‘double dip recession’?”
The short answer is that no one knows.
I believe that the deficit has introduced significant risks which are unavoidable.
There are many factors, but the two that seem most significant to me are:
(1) The real risk of another international crisis. I don’t know when it’ll happen, but my guess is four to five years. If we go into that crisis with a £100bn structural deficit, we’ll not have the credibility on the bond markets to fund a stimulus package. It’s a scenario that should worry us.
(2) The risk that if we cut too fast, we could trigger a spiralling lack of confidence, that could result in a double-dip recession. The OBR have modelled the likelihood of this, as has NIESR. Both say that the coalition’s programme will slightly reduce growth in the short term, but the programme is unlikely, on its own, to trigger a double-dip.
In my opinion, the risk of the first scenario is worse than the second.
One factor that makes me extremely sceptical of critics of the coalition strategy is their unwillingness to acknowledge the reason for this deficit. The financial crisis was just the trigger for the bubble bursting. The bubble, and the fact we relied on the temporary tax it gave us to fund long term spending commitments is the main reason for the deficit. The other is the £30-40bn deficits run up to 2007.
If those critics acknowledged this historic problem, rather than use the convenient scapegoat of greedy bankers, I’d have more trust in the objectivity of their analysis.
As I understand it, one of the fundamental features of Keynesian economics is that you build up a surplus in the good years to fund a deficit in the bad years. We did this for a few years, then prudence went out of the window.
I am pretty pessimistic about the medium term prospects of the world economy, and why is too complex a question for this already over-long comment. I fear the next four years may actually be our good years. I hope I’m wrong, but if I’m not, then sorting out the deficit now is an urgent priority. If a world crisis happens before the 2015 election, the coalition may get no thanks for sorting out this mess, but if their policies means the country is saved from a much worse scenario, doing the right thing is its own reward.
My main concern with coalition policy is not the deficit plan, but that it might be too inflexible. The coalition has invested a great deal of political capital in the programme. If an international crisis does hit us sooner than four or five years, will the government change gear quickly enough.
I confess I didn’t fully understand your article. You’ve been honest enough to acknowledge that the 12.5% figure wasn’t right, and it should have been 8.7%, but I’m afraid that lack of precision made it harder to read, because I wasn’t sure how literally to take your other assertions.
Then there were statements I simply disagree with. You talk of “a great rush to reduce GDP in order to reduce the financial deficit”. That is a very loaded way of putting it. The rush, isn’t to reduce GDP, but to reduce the deficit. The plan is that, by reducing the deficit, it will allow interest rates to be kept down, and therefore for the private sector to grow to compensate.
You say: “If public expenditure is reduced to balance the books and wipe out the deficit, then recession is inevitable”. The economists I trust never talk with such certainty. Recession *may* result from reducing spending, it may indirectly result from having too high a deficit, and the malign effects which deficits can cause.
The trouble I have with your solution is that you talk about growth, without addressing the question of whether it is sustainable growth. We’ve just had a long housing and debt bubble which produced lots of growth. But it was based on the pyramid scheme of ever-increasing house prices, and ever-increasing debt.
It seems to me that what we need is growth based on productivity, which would require businesses carefully investing in equipment, in the skills of its workforce, and in a way that increases the value of what they produce. I fear that there’s no short-cut way for the government to make that happen, but, to make it happen, it’s important to keep interest rates down.
George – I think your last paragraph is the most important one. Real productivity led growth in the real economy will generate all the financial outcomes we need. The S E Asian economies, particularly China know this, which is why they will not allow the financial artefact to constrain the real economy, but drive the real economy to determine the financial measures. So should we. Low interest rates as you say are part of this. But my argument is that funding demand with a non-debt backed instrument like a citizen’s income may also be.