Category Archives: Investment

The Green New Deal and Modern Monetary Theory (MMT)

Posted on February 8, 2019 | 1 comment

This post is a bit of diversion from my recent focus on the mobility and energy revolutions currently taking place (the solar posts are “to be continued”). The Democrats new super star Alexandria Ocasio-Cortez has been making waves since becoming the youngest woman to ever serve in the United States Congress. Yesterday Ocasio-Cortez submitted a non-binding resolution in the House of Representatives under the title “Recognising the duty of the Federal Government to create a Green New Deal“. If you haven’t read the actual document (a couple of pages long), I urge you take a look rather than get a second-hand interpretation. You can find the resolution here. And Ocasio-Cortez introducing the policy here:

The resolution is to be accomplished “through a 10-year national mobilization” to execute a series of projects and achieve a range of goals, one of which is “meeting 100 percent of the power demand in the United States through clean, renewable, and zero-emission energy sources”. Well I think Tony Seba would approve of that even if Tony would believe this will happen regardless of the government’s involvement through the magic of technology and market forces.

Criticisms, or course, have come thick and fast, but one of the most major relates to cost: who will pay for the Green New Deal? The frequently asked question (FAQ) sheet attached to the resolution gives this answer:

How will you pay for it?

The same way we paid for the New Deal, the 2008 bank-bailout and extended quantitative easing programs. The same way we paid for World War II and all our current wars. The Federal Reserve can extend credit to power these projects and investments….

The critical component of this response to the question of payment is the statement that “the Federal Reserve can extend credit to power these projects and investments”. And this is where I am heading with this post. Ocasio-Cortez is not only an advocate of a far-reaching environmental policy aimed at tackling climate change, but she is also an adherent to the rather arcane economic theory of Modern Monetary Theory, or MMT.

MMT focuses on the fact that modern monetary systems are based on fiat money. This means monetary systems where nothing backs the issuance of paper money, unlike under previous systems which were backed by gold or some other real substance. Under such so called ‘fiat money’ systems, the government can never go bankrupt since it has the power to print money. That said, while the government may not be able to bankrupt itself through printing money, it is quite capable of bankrupting the private sector through printing so much money that it sets off hyper-inflation: think Wehrmacht Germany, Zimbabwe or Venezuela. Nonetheless, MMT adherents see a world of difference between using debt and money creation in a responsible way to achieve policy goals and in an irresponsible way to support some form of crony capitalism.

Critically, the general public finds it very hard to understand the fact that the government can create money from nothing, but this is just an irrefutable fact.

Accordingly, the government can impact on the real economy through printing paper money in exchange for labour or goods. Under Ocasio-Cortez’s plan, the US government could print money, via the Federal Reserve, to buy wind and solar farms and pay workers to install them. It would use government debt to get to where it wants to go.

In many aspects, MMT is not far away from traditional Keynesian economics, which encourages governments to smooth out business cycles through engaging in pump priming the economy by running fiscal deficits whenever a recession emerges. Followers of MMT, however, believe that the government’s power over money creation should not just be used as a safety net in times of trouble but also in a much more proactive goal-oriented manner to solve current problems.

Under MMT, you needn’t worry about deficits and debt in and of themselves, but only if they result in the adverse outcomes of rising inflation and real interest rates. According to followers of MMT, if you run a big deficit and build up a lot of debt with neither inflation rising nor real interest rates spiking, then you have nothing to worry about. MMT also shifts the policy balance of power away from central banks to politicians.

At this stage, I recommend you sit down and spend a very fruitful 45 minutes of your time watching the following January 2019 lecture by the most famous advocate for MMT Stephanie Kelton. Kelton is that rare thing in an economics professor: a great communicator. Anyone who has got this far down the blog post will be able to understand the lecture — I promise (honest). More important, by the end of the lecture you will realize that government spending is not like household spending. So next time a politician says that a government must learn to live within its means just like a household, you will understand that the politician in question doesn’t know what he or she is talking about.

And, finally, in response to Prime Minister Theresa May’s claim that “there is no magic money tree”, well, actually there is, and in the UK it sits within the Bank of England (BOE). In a wonderful BBC Radio 4 programme called “Shaking the Magic Money Tree“, Michael Robinson descended into the depths of the BOE to see money created out of nothing: so the money tree does exist!

That said, magic can be a force for good or evil. I’m not saying that Ocasio-Cortez has no constraint over what the government can do deficit-wise in terms of executing a Green New Deal. But the judicious use of government’s deficits to finance ambitious government goals should not be dismissed out of hand. Financing such goals through deficits has been done before, and, handled well, it can be done again.

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Chart of the Day, 10 February 2015: Debt As an Existential Threat?

Posted on February 10, 2015 | Leave a comment

McKinsey Global Institute continues to run with a series of reports on the global credit bubble that spurned the Great Recession. The latest titled “Debt and (Not Much) Deleveraging” takes up the story seven years after the crisis (click for larger image).

Seeking Stability in an Indebted World jpeg

The report shines a spotlight on the world’s growth problem. Other things being equal, higher debt should translate into higher effective demand, either through increased investment or greater consumption. Again, other things being equal, more investment should result in a rising capital stock, which in turn should lead to more growth. Further, if growth were accelerating, then the debt-to-GDP ratio should be falling. Yet this text book economics isn’t panning out. Instead, we have rapidly rising debt and anaemic GDP growth. Result: debt-to-GDP grows and grows (click for larger image).

Change in Debt-GDP Ratio jpeg

This is interesting, but doesn’t really tell us anything new. And the McKinsey report avoids the big questions, the biggest of all being  “does debt matter?”

Commentaries at the doomer end of the economic blogosphere suggest that debt matters more than anything else–and, for some, burgeoning debt means the world is on the verge of a financial panic and subsequent collapse. But the relationship between the real economy and the financial economy is a complex thing. I can’t count the number of times that people confuse debt with stuff. Debt is not stuff: debt is a claim on stuff. Expand, contract or shuffle the debt–do what you will–and the same amount of stuff still remains.

Take the purest form of monetary collapse: the Weimar German  hyperinflation between 1921 and 1923. During this period, fiat money became worthless. Yet the real assets of the economy remained intact. Germany had almost the same number of factories in 1923 as it did in 1921. It had the same number of engineers, even if many lost their jobs. And, ultimately, this real economy was sufficiently robust to reignite within a year or two. Money died in 1923 Germany, the real economy didn’t.

What’s more, the real German economy then took a second financial punch in the form of the Great Recession in 1929. Yet despite undergoing all this turmoil (which makes our 2008 crisis look insipid by comparison), the German real economy had enough inherent strength to go on to support the expansionist policies of the Third Reich for a decade.

So when money died in Germany, the real economy didn’t. By contrast, what did die along with money were many of the original ownership claims on the real assets. Who owned what in 1924 (after the situation stabilised) was very different from who owned what in 1920 (before hyperinflation took off). Moreover, during the hyperinflation years, assets remained idle and incomes fell. So there were real effects–they just weren’t ever-lasting.

During the 2008/09 credit crisis we similarly witnessed under-utilised assets, and the claims on those assets were shuffled around to a certain extent. But the real assets that make up the real economy lived on. True, we had what Austrian economists call mal-investment. That is, the financial economy directed the real economy to make some real assets that no one wanted a year or two down the road. But the largest dead assets of America, such as the decaying factory and residential blocks of Detroit, are not the result of a credit bubble that went pop, but rather are due to far deeper and slow-moving underlying real economy forces.

For this reason, I don’t see debt as in the same league of existential threats to well-being as climate change or resource depletion.

To restate my argument: on the positive side, our most-pressing problem is not that of a dysfunctional financial system. But on the negative side, this means that the financial system will provide only limited help in solving our existing challenges.

Before the financial crash, it seemed that modern finance, derivatives and all, had led to a step-change improvement in matching limited resources with limitless needs (what economics is all about). That step-change improvement now appears a mirage. But this also means that real change will ultimately have to come from changing the real economy–and that, in reality, is a far tougher thing to do than fiddling around with our banks and brokers.

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Chart of the Day, 21 Jan 2015: Summer’s Secular Stagnation

Posted on January 21, 2015 | Leave a comment

I’m taking my charts today from the just-published Report of the Commission on Inclusive Prosperity, chaired by Larry Summers and Ed Balls. Summers, one of the highest profile economists in the world, was in London yesterday (on the way to Davos), promoting the report itself and describing the challenge of how to combat secular stagnation. Yesterday, I listened to Summers at a lecture held at the LSE, a podcast of which can be found here.

First, a restatement of the problem. Growth has slowed in almost all advanced countries (click for larger image):

Secular Stagnation Selected Countries jpeg

And what growth there has been has gone to the rich:

Bottom 90% Income Growth jpeg

In short, for the bottom 90%, productivity and income have diverged.

Productivity and Income Growth jpeg

While admitting there are supply side factors causing the economic slowdown (such as poor demographics), Summers places most emphasis on the demand side as the root cause of the problem, particularly with repsct to investment.

Critically, the relative price of investment goods has collapsed, making investment a meagre source of effective demand. By way of example, Summers points to the behemoth of the 1970s, IBM. The computer giant of its time had a repeated need to access capital markets in order to finance its investment plans and grow. Apple, however, generates more cash than it knows what to do with. Indeed, it is a source of liquidity in the capital markets through carrying out continued share buybacks.

Similarly, Summers notes that a company used to be partly valued on how much ‘stuff’ it had on its balance sheet, but now this is almost an irrelevance. So we have a situation where Whatsapp is worth $17 billion, with minimum assets and employees, but Sony, with an army of employees and a raft of factories, is only worth $16 billion. As a result, the price of money has fallen to zero.

US Natural Rate of Interest jpeg

Summer’s prescription: if the private sector doesn’t want to invest regardless of how low interest rates go, the state should step in, taking advantage of bargain basement borrowing rates to massively upgrade its infrastructure.

I am broadly sympathetic. However, I would point out that another state suffering secular stagnation, Japan, has tried the government-financed mega infrastructure investment strategy before. Indeed, for a time, academics dubbed Japan the ‘construction state’. This frenetic activity, however, did little to raise long-term growth rates. Sometimes, when growth has gone, it’s gone.

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Chart of the Day, 20 Jan 2014: Generation Rent and the New Rentiers

Posted on January 20, 2015 | Leave a comment

I’ve been looking for an excuse to link to a delightful commentary by the British novelist Will Self, carried by the Financial Times. But before I do, below is my chart appetiser, courtesy of the UK’s Office of National Statistics:

A Century of Home Ownership and Renting jpeg

Obviously, the UK was a land of the renter and the rentier before WW2; few but the relatively wealthy could afford to own their own home. Also noteworthy is the rise and fall of social housing. In Self’s piece, titled “A  rentier nation’s fading dream of home” (free access after registration with the FT), the author retells the failure of Thatcher’s grand sale of council housing stock, the ultimate aim of which was to make Tory voters of all of England by way of expanding the property-owing class.  It didn’t quite work out that way:

The current housing crisis is not so much emblematic of a transmogrification from a social market economy to a neoliberal one. It is constitutive of that process: the asset transfer from the state to the rich; the pump-priming of the value of those assets; the forcing of the poor into more expensive private rental accommodation — all of which measures are underpinned by a financial system heavily dependent on mortgage lending. Of all British bank loans, 76 per cent are for property, and 64 per cent for residential property alone. Any radical reform of the system entailing a fall in land and house prices would, ipso facto, result in a fundamental destabilisation of the banking system.

I quibble at bit at criticising Will Self’s mixing of prose, polemic and the underlying problem–but I will. At heart, we are just not building enough houses. From a Civitas report out last week titled ‘The Future of Private Renting“:

House Building by Tenure jpeg

On top of this, we face the growing problem of secular stagnation (more to come on that tomorrow), the only treatment for which is deemed by the policy-making classes to be huge dollops of easy money by way of a massive central bank-directed quantitative ease (QE). The economics 101 definition of inflation is too much money chasing too few goods. In the UK housing market, we have ever more amounts of money chasing ever fewer new-build houses. Which leads to this:

Factors Driving an Increase in Renting jpeg

QE, as operated through buying up bonds and forcing down interest rates, rewards those who have assets at the expense those who don’t. So the rentiers property becomes worth more, allowing he or she to leverage up with ultra cheap money, and so buy even more. In this game, if you start with nothing, you never catch up.

But it doesn’t have to be this way. The government could choose to build houses itself, funded by bond issuance that the central bank buys; if you were a populist by persuasion, you could call this the people’s QE. But how can we afford to pay interest on all those new 30-year housing bonds I hear you ask. Bloomberg tells us that 30-year UK gilts are yielding 2.16%. Private sector low-end rental property is providing net yields after maintenance costs of double that or more.

Here’s a toast to aggressive and acquisitive rental landlords; that is, government-backed ones.

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Chart of the Day, 19 Jan 2015: The 1% and the 0.1%

Posted on January 20, 2015 | Leave a comment

Forget the 1%–mere peasants–the real wealth lies with the 0.1%. From a study late last year by Emmanuel Saez and Gabriel Zucman (click for larger image):

Wealth and the 0.1% jpeg

Note we are talking about wealth. This is important because most studies of the 1% focus on income. Wealth is difficult to measure, especially for the uber-rich, which is why this is a landmark study. The authors backed out their wealth estimates using investment income tax return records. In the process, you can see that those poor 1% to 0.5% have been struggling. Forget the squeezed middle, next up is the squeezed upper middle class and then the squeezed lower upper class (click for larger image)?

Decomposing the 1% jpeg

Seriously, the charts suggest the precariousness of the game the super rich are playing. Immense wealth brings immense political power, at least in the United States. But as you eliminate more and more cohorts from the winners’ enclosure, even the most well-financed lobbying machine will start to struggle.

And the mechanism behind this wealth concentration? Saez is a long-term collaborator on inequality questions with Thomas Picketty of “Capital in the Twenty-First Century” fame. From a paper the two did together on income inequality (together with Anthony Atkinson):

Top 0.1% Income jpeg

So we have an ever-growing share of income by the 0.1%. But the income edge of the 0.1% then starts compounding away as return on investment, which then gets passed on to children and grandchildren if the tax regime permits (which it currently does). And– following Piketty’s iron law of inequality–when r (the return on investment) is larger than g (economic growth), wealth inequality explodes. What eventually stops this process is war, revolution, or, more prosaically, government redistribution. We shall see how this cycle ends.

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So U.S. Fracking Will Save Europe from Russia?

Posted on March 7, 2014 | 1 comment

So will U.S. shale gas save Europe from a belligerent Russia? This from The Financial Times (here, free access after registration):

The US should make it easier for Europeans to buy American natural gas in order to reduce its allies’ dependence on Russian energy, the top Republican in the House of Representatives has said.

John Boehner’s statement on Tuesday brought national security concerns into the centre of a debate on how the US should use supplies of oil and gas from its shale.

In my humble opinion, reportage on the Ukrainian crisis has generally been dire, but finding any decent analysis of the West’s reliance on Russian oil and natural gas has been especially hard. Let’s start with the big picture for gas. From the International Energy Agency‘s “Key World Energy Statistics 2013” (click for larger image):

Producers, Net Exporters, Importers Nat Gas jpeg

From the tables, we see that Russia is the second largest natural gas producer behind the U.S., but it is the world’s largest exporter. Russia also exports 28% of all it produces.

As always with energy statistics, every publication has its preferred unit of measurement, so we have to do some very simple math to compare. One cubic metre of natural gas is equivalent to 35.3 cubic feet, so Russia’s 185 billion cubic metres (bcm) of natural gas exports translates into roughly 6.5 trillion cubic feet.

And where does it go (from the Energy Information Administration‘s Russian analysis here)?

Share of Russia's Natural Gas Exports jpeg

Shale gas to the rescue? The U.S. government’s Energy Information Administration (EIA) released this graph in its “Annual Energy Outlook 2014“.

US Nat Gas Import Export 2014 jpeg

The chart shows LNG exports kicking in around 2016 and then rising to 2 trillion cubic feet in 2020 and then plateauing at approximately 3 trillion in 2025. At the same time, imports will be declining by around 1 to 2 trillion cubic feet or so.

This doesn’t entirely cover current Russian exports of 6.5 trillion cubic feet, but it is certainly a significant amount. Nonetheless, and notwithstanding the fact that U.S. LNG exports will not commence for a couple of years or more, the U.S. change in trade is material.

However, this all assumes an “other things being equal” type of world. But things will certainly not be equal going forward due to one particular country: China. From the EIA’s “International Energy Outlook 2013“.

Non OECD Asia Nat Gas Trade jpeg

Accordingly, it is a very moot question as to whether any U.S. origin LNG exports end up in Europe as opposed to the more likely destination of Asia—where insatiable demand will likely translate into premium pricing.

What about oil? Back to the IEA’s tables:

Producers, Net Exporters of Crude Oil jpeg

Now this is where it gets interesting. If Vladimir Putin decided not to play nice, then he would likely use oil to turn the screws on the West. As usual, we have a table with different units, but one metric tonne is roughly equivalent to 7.3 barrels of oil. Accordingly, Russia’s 520 million tonnes of production is around 3.8 billion barrels per year. This, in turn, is about 10.3 million barrels per day (bpd)—47% of which goes abroad. In short, he has a 5 million bpd oil cosh to beat the West.

In a recent post, I referred to the IEA’s observation that oil inventories have fallen considerably, mostly due to political troubles in Libya and Iraq, so any explicit, or even implicit, oil threat would be enough to send prices shooting higher—and global financial markets lower. Put another way, current global consumption is a little over 80 million bpd, and excess production capacity is estimated at around 1 to 2 million bpd above that. So if Putin turned the oil tap off, the global oil market would fall into a significant shortfall.

Overall, I see neither U.S. shale gas nor U.S. tight oil having any diplomatic impact on Russia. The major check on any Putin aggression will likely come from Russia’s oligarchs, who all have a major stake in the global capitalist status quo. Will that be enough? I don’t know.

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Links for the Week Ending 7 February 2014

Posted on February 9, 2014 | Leave a comment
  • Now is the time of year when a young (and not so young) person’s fancy lightly turns to thoughts of skiing (not least because of the Sochi Winter Olympics). Few, however, like to talk about the threat that climate change poses for winter sports. This spectre at the feast is met with passive denial—if we pretend it isn’t there, perhaps it will go away. So it is rare to hear a voice from within the industry itself, such as that of Powder Magazine‘s Porter Fox in an Op-Ed piece titled ‘The End of Snow?”  in The New York Times, calling for action.
  • Fox references a paper by the National Resources Defence Council (NRDC) called “Climate Impacts on the Winter Tourism Economy in the United States” if you like to dig into data.
  • Two weeks ago, I referenced a Mark Lewis article in The Financial Times disputing the peak demand theory for oil (here, free registration at the FT). As a contrast, I thought it worthwhile referring back to a 2013 Steve Kopits interview on resilience.org which gives the opposing argument (here). Personally, I believe that the intersection between price, demand destruction and supply response  is too complex to forecast accurately, particularly as these factors all play out over different time horizons. That said, my gut feeling is that oil is already putting a break on GDP growth at the margin, with more turbulence to come.
  • The U.K. has been plagued by floods over the last couple of months, with the head of the Environment Agency Lord Smith becoming the fall guy for middle England’s frustrations. In a frank letter to The Daily Telegraph, Smith had the temerity to argue that difficult choices have to be made, but this position has produced outrage in the shires. I always find irony in the fact that the political right argues for self-reliance yet runs crying to the state whenever it finds itself on the wrong end of climate change.
  • Southern Europe has become Ground Zero for the collapse narrative. And here is a post by one of my favourite bloggers Ugo Bardi of Cassandra’s Legacy looking at the situation in Italy. And a conversation between Bardi and Dmitry Orlov on the same topic can be found here.

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Links for the Week Ending 26 January

Posted on January 27, 2014 | Leave a comment
  • The current oil narrative in the U.S. is one of bountiful supply but structurally reduced demand. Yet Mark Lewis, in The Financial Times, disputes the latter story (here, free registration at the FT). He argues that the last five years have seen a cyclical, not structural, shift in demand. But now that the economy is picking up speed, demand for oil is kicking up a notch. Given the astronomical capital expenditures needed to bring new supply to market, however, the only mechanism able to maintain equilibrium will be the rationing effect of higher prices.
  • Again in The Financial Times are some fascinating statistics showing that 26% of young adults aged between 20 and 34 now live with their parents in the U.K., up from around 21% in 1996. A prime mover behind this trend is the 13% decline in real median incomes for this age group in the decade from 2001/02 to 2011/12. All part of the new normal.
  • In my former job running a hedge fund, I learned one great skill that is rarely developed in the general populace; that is, to believe both the buy and sell case for any individual position. So does this mean that I was unable to trade, like a deer caught in the headlights? Not really, because sometimes (but not often) you rate the rationale behind one side of a trade as a little superior than the other—and that’s when you place your bet.  This approach can be extended to most things in life. So in the case of my recent series on technology and unemployment (starting here), I  looked at a series of papers that suggested we have a serious problem with technology. Given that bias, my inclination is to find intelligent people who say we don’t have a problem. One such person is the progressive economist Lawrence Mishel, who in a blog post last week argues that technology is not the job killer; rather,  low wages, inequality and unemployment are caused by other, non-technological factors. My understanding of this topic is highly fluid, with argument and counter-argument going on to my weighing scales. I tilt towards worrying, but am still very receptive to opposing views.
  • Of course, in the case of climate change, the scales are dramatically weighted to one side—i.e., bad climate change outcomes. Marginally encouraging is the fact that corporations are slowly comprehending climate change risk. As evidence, climate change has elbowed its way back onto the agenda at Davos. The Guardian is one of the few publications to pick up on this trend and has been tracking the various seminars, panel discussions and presentations there (here, here and here). And The New York Times has an informative article by Coral Davenport on how big business is getting more concerned over global temperature rise.
  • The Guardian also has a very interesting article on the impact of ENSO cycles (El Nino and La Nina cycles) on global mean temperature. What is new to me is the claim, which originates from a note in the academic journal Nature Climate Change (full article is behind a paywall), that the ENSO cycle itself will change as the planet warms, leading to more extreme El Ninos and thus more volatility in temperature variation. Yet again we learn of another source of climate risk.

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Links for the Week Ending 28 December

Posted on December 27, 2013 | Leave a comment

Apologies for my absence, but I have been super busy over the holiday period.

  • Liam Halligan in The Daily Telegraph explains why oil prices will likely remain high in 2014. It’s a well-worn story in this blog, but Halligan provides a nice recap on the disappearance of “easy oil”. In his words: “The ‘upstream’ oil industry capital expenditure has risen, in constant dollars, from $250bn in 2000 to $700bn last year – almost a threefold increase. Over the same period, global oil supply rose just 14%.” In sum, shale oil is no free lunch.
  • Staying with The Telegraph, Ambrose Evans-Pritchard gives praise where praise is due with respect to the Fed and QE. I still think that the uber-aggressive version of QE we have witnessed in the US will only be vindicated once it is unwound. The imbalances it is causing are many, but they have manifested themselves in asset inflation not generalised inflation. Nonetheless, with both structural reform and active fiscal policy missing in action during the Great Recession, it was left to the Fed to stop the sky from falling down—which is what the Fed did, so all kudos to them. The next question is: can the US growth without QE? We shall see.
  • Being ‘poorer than your parents’ is  a hot topic on both sides of the Atlantic. Bloomberg has a lovely article comparing a dad and a daughter, but the statistics on US savings and pensions levels are what shocked me most. How will those boomers live through retirement with that amount of money?
  • Over the pond (and less anecdotal), the Institute for Fiscal Studies (IFS) has just published a report looking at the economic circumstances of different cohorts born from the 1940s to 1970s. Conclusion: for the middle-aged, you have little chance of matching your parents prosperity in your later years unless you can nail down a significant inheritance. If you don’t want to read the whole report, you can see a good synopsis in The Guardian here, but almost all the UK national press, whether from the left or right, reported on the IFS study.
  • Previously in the Links, I flagged Larry Summers speech at an IMF symposium. Here he is again talking about long-term economic stagnation in The Financial Times.
  • I frequently mention the thought-provoking work of Tyler Cowen, and have just finished reading his latest book “Average Is Over“. David Brooks has a nice piece in The New York Times expanding on Cowen’s employment theme and thinking about what type of people can thrive as technology upturns the job market.
  • And last but not least, over to climate change. The Carbon Brief has a wonderful post on the five-most important climate change papers of 2013, including the key charts. Required reading for anyone who has bought into the idea that the current temperature hiatus has lowered the risk posed by climate change. But then again, such a reader would be unlikely to stray far from Watts Up with That.

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The Absurdity of ‘Abenomics’ and the PM’s ‘Three Bendy Arrows’ (Part 4: Bubble Economics)

Posted on May 13, 2013 | Leave a comment

As I write this post, the yen has broken below 100 to the U.S. dollar and the Nikkei has closed at a five-year high. So surely Abenomics is working, isn’t it? Well, it is certainly pushing up asset prices. Indeed, if I were still in my old job as a Japanese equity hedge fund manager I would have swung the bat as hard as I could after Bank of Japan Governor Kuroda’s original April 4 announcement. And I would plan to keep swinging the bat well into the future. Indeed, if my risk manager was not having a heart attack by now, I would feel I had not done my job properly.

Strange as it may seem, this is the logical path to follow given that Kuroda has based his analysis lock, stock and barrel on New Keynesian monetary theory. The two canonical papers that sit behind this are Paul Krugman’s “It’s Baaack! Japan’s Slump and the return of the Liquidity Trap” and Gauti Eggertsson and Michael Woodford’s “The Zero Bound on Interest Rates and Optimal Monetary Policy”. The Eggertsson and Woodford paper, which we can think of as Krugman 2.0, has become the intellectual bedrock for the Fed in fighting deflation and is much quoted by Fed Governor Ben Bernanke.

Both papers are difficult reads for the non-economist, but, as I mentioned in my previous post, the Richmond Fed has made available a “A Citizen’s Guide to Unconventional Monetary Policy” for non-specialists that contains the core policy prescription of the two academic papers referred to above.  From A Citizen’s Guide, the critical passage is this:

In the Eggertsson and Woodford model, the com- mitment to making monetary policy “too easy” would only stimulate economic activity if the commitment is viewed by the public as highly credible. That is, markets must believe that the central bank will, in fact, hold rates “too low” in the future simply because it promised to in the past, despite the fact that at that point, it would wish to raise rates to avoid inflation.

Krugman, ever the wordsmith, put this more succinctly:

The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible…

Now we now that asset price inflation operates on a different time scale to consumer price inflation: indeed, Japan’s stock price indices are already up 50% from their December lows, while consumer price inflation has barely budged. Nonetheless, to whatever level asset prices go, Kuroda has to keep his mouth firmly shut to have any chance of the changing public perceptions of future inflation. He is not allowed to make Greenspan-type gnomic references to “irrational exuberance”, let alone pull back from Japanese government bond buying. He must drive Japan’s monetary policy as if he was in one of those defective Toyota cars that was recalled due to a faulty accelerator pedal that got stuck to the floor.

This, of course, is a bubble meister’s charter, since for Kuroda to succeed in changing consumer expectations he must keep the accelerator pedal depressed for years. It is also worth keeping in mind that the Bank of Japan’s newly minted 2% inflation target is only an intermediate goal. As I explained in my last post, what monetary policy is really trying to achieve here is the closure of an output gap, i.e., the difference between where the economy is currently operating and where it could be operating if labour and capital were fully employed.

Moreover, the problem is perceived as one of lack of demand, not supply. The idea is that households won’t spend today because they think goods will get cheaper tomorrow. In effect, even if they hold cash at the bank earning zero, deflation means that they are getting a comfortable real return. The policy goal a la Krugman, Woodford and Eggertsson is to make that real return negative. And the only way to create a negative real return when interest rates are zero is to have inflation. If you can persuade the populace that inflation is barrelling toward them in the future, then they will cut savings and increase consumption now—or so the theory goes.

In addition, if the economy is idling below potential with unused capital and labour, any sudden jump in demand will result in high productivity and economic growth. Growth, in turn, will lead to higher wages and greater government tax receipts. Thus—and this is where the magic of macroeconomics comes in—the act of spending more now results in higher wages and living standards in the future.

Surely, a classic win-win: more consumption and more growth. What’s not to like? Nonetheless, there are a number of problems. First, how smoothly this all works depends to a large degree on the extent of the output gap. An article by Gavyn Davies in The Financial Times takes a look at the difference between output gaps if we just extrapolate past growth and those if we take into account supply side phenomenon (click for larger image) for a number of countries.

Output Gap Measurement jpeg

He explains the graphs in more detail: Continue reading →

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