Thursday 30 April 2015

Is Technology Taking People's Jobs?

There has been a lot of comment recently, especially since the publication of 'The Second Machine Age' by McAfee and Brynjolfsson, about whether the robots are taking over. Citing examples of how technology can replace human input, the fear has been expressed that technology will increase the share of income going to capital and reduce the share going to labour.

In the extreme version of this scenario, robots are doing all the jobs and there are very few left for humans - the few jobs being for the people who program the robots. In this future of idleness, one would have to imagine a new way of splitting the fruits of the non-labour in order to allow humans the money to consume the bounty created by greater technology.

The recent decline in labour participation rate, coming at the same time as a rise in information technology has added to this fear. Computers replacing check-out operators in supermarkets, computers replacing check-in personnel in airports and cheque receivers at banks being replaced by online payments. Professions relying on higher education levels are no longer immune. Computers are replacing financial advisers and medical staff. You can find lists of jobs most likely to be replaced by robots, bizarrely the most likely one being telemarketer (who doesn't hang up straight away when a recorded telemarketer rings?).

Talk in the tech sector is of disruption. Everyone is looking for the next Uber of chest waxing (just press a button on your app and someone will be round to depilate you in minutes) or similar but slightly more realistic ideas. The basic idea is to use technology to enable cheaper entrants to established markets, with the cheapness based on workers who are prepared to work for less money with no job security. A future where the labour force is self-employed, always undercutting the competitor to get work and living with fear of not being able to pay next month's rent awaits us. Meanwhile the cool guys in Silicon valley take 20% for themselves and charter helicopters to have dinner in Napa.

It all sounds pretty dystopic to me, but I would like to offer a counter argument. That the long term fears that we have for the economy are based purely on the terrible economic situation that we have at the moment. Superficially unemployment is low, but this masks the people working part-time and zero-hours who wish to work full time. It masks the fall in participation rate by people leaving the labour force. And more than that, if you look at wages, it shows how people have been pushed into the bottom end of the labour market in jobs that could be done by a machine but are not because labour is so cheap. In fact, we have a real deficit of demand in the economy.

I believe, as I argue here, that this low demand is caused not by technology improvements but by debt overhang causing rent extraction which sucks demand out of the economy. I also believe that we have a way of solving this problem. But that as things stand we are going to suffer from chronically low demand for a long time.

What happens when there is chronically low demand? People who want to find work can't find work and often end up having to work part-time, zero hours on unpaid internships or whatever it takes to get by. Blame for this is then placed on immigrants or technology or scroungers whatever the fashionable scapegoat-du-jour is. 

But I feel that the whole 'Technology taking jobs' argument is a big red herring. I heard recently of an example where robots can now take blood for patients meaning that blood taking nurses are now redundant. Well, this is fine, but also I would like to wait less than three hours when I go into casualty with my kid - maybe the nurses can be put to use on other jobs that also improve patient care. Bank branches are closing down, replaced by online banks - bank tellers are made redundant. But at the same time, I can think of hundreds of ways that I could get better service in other areas. The tube could be less crowded - a better transport system could be built. Libraries are being closed. Youth clubs closed. Mental health charities could be given more funding. More carers are needed for the elderly and disabled. 

There are so many ways that life could be improved if the money was there to pay to give people jobs who do not have jobs. And many of these, machines can't replace. So I think that there will always be jobs available. It is just a case of using resources correctly - or in other words not having so much unemployment.

And the whole success of Uber (and similar) is based on people's desperation for work. If demand were high enough that everyone had jobs, then the dystopic vision of an Uber future will not become reality.

If we, as a society can effectively manage demand in a way suggested here then any savings caused by dividends accruing to the owners of the robots is negated by an increase in money supply elsewhere. We need not have unemployment and we need not worry about the future of robots taking over, but instead look forward to a future where more of our needs are taken care of.

Wednesday 29 April 2015

A Discussion on Criticisms of Modern Monetary Theory

I think that it is always good to be honest about one's shortcomings. I am not, by profession, an economist. The amount that I don't know about the theory of economics outweighs the amount I do know by orders of magnitude.

Why do I think I can make a contribution to the debate then? Because what I like to think that I am good at is simplifying systems, and the economy is just a system. And it is a system that is not working, and I think that I can see some of the reasons for this. Maybe in some ways it helps to be able to look at things without the framework that is already in place. I am not suggesting that someone with as little experience as me will have all the answers, but I do think that I may be able to help by prodding with some of the right questions.

Yesterday, I had a slight argument in the comments section of a post on Simon Wren Lewis's truly excellent blog. I am slightly embarrassed by this as he (and the fictional PK) clearly know a lot more than me and who am I to criticise? 

However, I do feel that in all of his explanations of the development of the UK economy post 2008, the issue of debt overhang is lacking. He compares the recovery from this downturn to the recovery from every other recent downturn as if they were equivalent and therefore it is solely the fault of government austerity (which I also agree with Simon  has been an economically illiterate policy). 

But in my opinion, the reason why this recovery is so different from the previous ones is that we have suffered from 25 years of monetary economics leading up to this. JK Galbraith famously said, in reference to Milton Friedman advising the Israeli government, "Any country that has Milton Friedman as an adviser has nothing to fear from a few million Arabs." Galbraith was right, but it took until 2008 for this to become apparent and still I feel that the lessons have not been learned. Private debt levels (and thus inequality) have risen to unprecedented levels.

In this post here I discuss the empirical cost of the debt - I believe that a 100% of GDP reduction in private sector debt would result in an extra 1.5% growth in GDP every year. It is difficult to overstate the significance of this, if it turns out to be true. 

In this post here, I explain the mechanism by which conventional monetary policy in the last 30 years has led to an economy with too high a rate of savings to support growth. The model explains the rise in inequality and the current secular stagnation and how it is all part of the rise of private sector debt.

Because of the debt overhang, the amount of borrowing that the government would have to do to get back to a normal trend growth is completely unsustainable. The private sector savings rate every year (due to interest payments and dividends being too high compared to wages) is so high that for the government to compensate it would have to keep borrowing too much indefinitely. Eventually the debt levels would get too high and then we would really be in trouble.

In any case, the reason I bring up my shortcomings is that after writing my previous post on why unemployment is a failure of the economic system I discovered that there was already a school of (hetereodox) economic thought saying exactly the same thing. To those more knowledgeable in economic thought than myself it will be obvious that this is Modern Monetary Theory (MMT).

I also read some criticisms of MMT on Wikipedia, which are therefore criticisms of my proposal, and wanted to counter them. My proposal was based purely on conclusions from my model of flows and what I wish to show is that actually there is no reason to think that economic management by trying to get the right level of private sector debt is in any way preferable to actually printing new money.

Just to briefly recap on my model, which is loosely based on the idea of Godley and Lavoie but with the economy divided into savers and workers, rather than into sectors.

The savers have savings, which are divided into Central Bank Cash (for which no-one in the economy has a liability), Equity (including houses etc.) and Debt. The liability to pay for all of this is on the future workers. The savings of the savers have no value at all unless the workers of the future will pay them. The workers of the future owe the savers dividends (including rental) and interest.

Because the marginal propensity to spend of workers is considerably higher than that of savers, when the dividends and rental are too high a percentage of income then the savings rate goes up and demand goes down.

The problem at the moment, as I see it is that we have a huge amount of debt. The amount owed by current and future workers to savers is too high to be sustainable by the economy and still give economic growth. I call the sustainable level 'Reasonably Serviceable Future Liabilities' (RSFL). I believe that the current level of liability of the future workers is much higher than the economy can cope with. 

The current situation looks like this:
And my proposed solution is slowly printing more central bank cash until the ratio of central bank cash to debt goes to a more reasonable proportion - thus making the future liabilities more serviceable - this would look like this:

For more details on how this works, please see the original post.

Now, the flows model is what determines nominal GDP and links one year of stocks to the next. It is discussed in full here, but the basic idea is that (starting with a closed economy - it can be extended) nominal GDP can be given by the following equation, where α is the coefficient of spending, d is total dividends (including rentals), i is interest, w is wages, L is new loans created, C is new central bank cash, ES are existing savings and γ is the proportion of existing savings spent in the year:

GDP= αd*d + αi*i + αw*w + αL*L + αC*C + γ*ES    (1) 

The unspent income is given by:

UI = (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αL)*L + (1-αC)*C - γ*ES

The New Savings (NS) in this system are given by UI minus the transfer of existing savings to the non-spenders. Note that previously in the post, I equated UI with NS which I now realise was missing out the transfer from current savers.

The problem that we have is that, given that αw  is higher than αd and αi , then wages are too low compared to dividends and interest. Alternatively, γ is too low to compensate. In any case the unspent income component, not including the creation of any new money is:   

UI without new money = (1-αd)*d + (1-αi)*i + (1-αw)*w - γ*ES 

If UI without new money is greater than zero, then, without new money, nominal GDP will go down. 

And because of the burden of interest and dividends, compared to wages, being too high, this is happening now. And the larger the debt is, the higher the interest payments and the higher the unspent income rate will be (unless we could find a way to increase γ).

Assuming that we are targeting real GDP growth of 2% and inflation of 2% then we actually need more money in the system. 

During the era of Keynesian economics for 30 years after the second world war, the government would regulate the economic growth by using debt issued by the government. This is generally cheap to finance and so does not leave much of a burden in interest payments. In good times the government would not run a deficit and growth would be allowed to reduce the real burden of the government debt. In this time, modern monetary theory and standard Keynesian theory were effectively the same thing.

However, in the past 30 years, economic growth has largely been regulated with private sector debt. This, as I show in my post here is a much more inefficient way to stimulate the economy. It has led to huge debt build up and high levels of inequality. The burden of the debt weighs on the next year's economic growth and more debt is required to keep up growth. This positive feedback loop was able to continue until the crash in 2008. And now we are in a stagnation caused by this.

I argue that since we can't increase new loans as the cost is too high, the only way to put money into the system is to increase the new cash.

This, to me, appears to be basic mathematical logic. More money is needed. We don't want more debt. What else can we do?

Looking at the equation, there are other options. One would be attempting to increase the spending of existing savings, maybe with a wealth tax. Another might be to try to force interest rate reductions on to credit card companies, banks and pay day loan companies. A higher income tax at higher levels of income would lead to more government spending and the coefficient of consumption for this may be higher than that of the richer people.

But the overwhelmingly more obvious, simple, and easy to control is the printing (and taking away) of new money.

So I wanted to look at the criticisms of this idea.

I have taken the Wikipedia entry on criticisms:

MMT has garnered wide criticism from a wide range of schools of economic thought, both for its analytical content and its policy recommendations.Fellow post-Keynesian economist, Thomas Palley argues that MMT is largely a restatement of elementary Keynesian economics, but prone to "over-simplistic analysis" and understating the risks of its policy recommendations.[25] In a later article, Palley criticizes MMT for essentially assuming away the problem of fiscal - monetary conflict and rebukes the MMT claim that old Keynesian analysis doesn't fully capture the accounting identities and financial restrains on government that can issue its own money; Palley shows that these insights are well captured by standard Keynesian stock-flow consistent IS-LM models, and have been well understood by Keynesian economists for decades. He argues that the policies proposed by MMT proponents would cause serious financial instability in an open economy with flexible exchange rates, while using fixed exchange rates would restore hard financial constraints on the government and "undermines MMT’s main claim about sovereign money freeing governments from standard market disciplines and financial constraints". He also accuses MMT of lacking of a plausible theory of inflation, particularly in the context of full employment using their proposed 'Employer of Last Resort' system, a lack of appreciation for the financial instability that could be caused by permanently zero interest rates, and overstating the importance of government created money. Finally, Palley concludes that MMT provides no new insights about monetary theory, while making unsubstantiated claims about macroeconomic policy, he argues that MMT has only received attention recently due to it being a "policy polemic for depressed times". [26] 

Marc Lavoie argues that whilst the neochartalist argument is "essentially correct", many of its counter-intuitive claims depend on a "confusing" and "fictitious" consolidation of government and central banking operations. [27]

New Keynesian economist and Nobel laureate Paul Krugman argues that MMT goes too far in its support for government budget deficits and ignores the inflationary implications of maintaining budget deficits when the economy is growing.[28]

Austrian School economist Robert P. Murphy states that "the MMT worldview doesn't live up to its promises" and that it seems to be "dead wrong". He observes that the MMT claim that cutting government deficits erodes private saving is true only for the portion of private saving that is not invested, and argues that the national accounting identities used to explain this aspect of MMT could equally be used to support arguments that government deficits "crowd out" private sector investment.[29] Daniel Kuehn has voiced his agreement with Murphy, stating "it's bad economics to confuse accounting identities with behavioral laws [...] economics is not accounting."[30]Murphy also criticises MMT on the basis that savings in the form of government bonds are not net assets for the private sector as a whole, since the bond will only be redeemed after the government "raises the necessary funds from the same group of taxpayers in the future".[29]The chartalist view of money itself, and the MMT emphasis on the importance of taxes in driving money is also a source of criticism.[27] Economist Eladio Febrero argues that modern money draws its value from its ability to cancel (private) bank debt, particularly as legal tender, rather than to pay government taxes.[31]

I would say that many of these criticisms are based on an assumption that the status quo is a good system and that there is some danger in changing it. I would argue from the opposite side, that the status quo is a dangerous system and that people are unaware of the dangers in the current system.

Palley argues that MMT is a restatement of Keynesian economics. I would agree with this, but would argue that it is a necessary one when the traditional tools of Keynesian economics are difficult to use (ie. when the government debt level is already very high and people are, rightly or wrongly, scared of more public sector debt). 

I would actually argue that there is virtually no difference between this and standard Keynesian theory except that this system does not have any interest costs to the government (and hence the future workers). The government is basically allowed to borrow at zero interest and it only needs to repay if it is economically reasonable to do so. This is completely sensible and in no way more destabilising than the current system, if used correctly.

For this reason, I think that criticisms of policy recommendations or instability or danger of deficits or inflation could all be applied to the current system. At the moment, the central bank tries to control how much private money/debt is created using interest rates. Instead it would do the same with public money.

This system would need to be executed sensibly and methodically by the central bank, attempting to maintain an increase in money spent each year of 4% (2% growth plus 2% inflation). If this is done reasonably well (and there is no reason to think it would not be - the central bank currently does this with interest rates which is a more indirect method) then the control over the economy and inflation should be better than the current system.

To reiterate, there is no more risk of high inflation with a sensibly executed MMT policy than there is with the current system. In fact, due to the direct effect of printing money, rather than the second order effect of using interest rates to try to control private creation of money, I would argue that there is less risk.

In terms of crowding out private sector investments, I think that Murphy's idea is a theoretical and bogus argument similar to the 'confidence fairy' argument that austerity would bring growth. In bad times, when people are spending less, the government would spend more/tax less. In good times they would spend less/tax more. The good and bad times here are exactly when the private sector would be reinforcing this cycle with expansion and retrenchment of their own. This is why Keynesian theory is so important.

Kuehn's argument that accounting is not economics seems very flawed to me. Of course economics needs to have accounting identities. Everything must add up correctly - it is impossible for it not to. Any economic system which ignores accounting identities needs to be seriously questioned.

Overall, I feel that the case for modern monetary theory to take over from the (very similar) standard Keynesian approach is very difficult to logically refute when you look at the accounting identities and the stocks and flows in the economy as they are.

Monday 27 April 2015

High Unemployment: A Failure of the Economic System or Unavoidable Phenomenon?

Use of the Flows model to show why, in my view, unemployment is a failure of our economic system

I think that we have all grown accustomed to the idea of economic cycles. Sometimes we have boom and the economy does well. Sometimes things are bad and we have low growth and unemployment. People also tend to assume that this is the natural way of things and is unavoidable.

I intend to argue here that this is not the case. I argue that unemployment, apart from in exceptional cases, such as skills mismatches due to declines in certain industries, is due to a failure of our economic system and I will also argue that this can be remedied by improving the system.

A simple economic system:

I will start with a simple economic system. It can be argued that this is not realistic but I feel that it shows enough about the real world to be a good demonstration of my point.

Imagine an economy with 1000 people. 1 person is working, 999 are unemployed. The 1 person is producing 1,000 units of food per year. A social security system is in place that unemployed people get half of the share they would get if they were working.

So here, tax is almost 50% on the one worker. Everyone gets half a unit of food, except the worker who has 500.5 units of food, doesn't know what to do with it all, and spends his spare time feeding the ducks trying to get rid of it. 

Now someone else comes in producing 1000 units of shoes. The total tax rate is now a little lower. The unemployed people have half a unit of shoes and half a unit of food. It's not that great for them as they have to wait until next year for the other shoe, but still it is clearly better. It is also better for the food-maker who now has 501 units of food and can swap some of them for shoes. And better for the shoemaker who has 501 units of shoes and can now exchange some of them for lots of food.

This system builds up until everyone has a job. Every worker added increases total production and improves the situation for everyone. On average each worker has 1,000 units of product each per year. In total now, 1 million units are produced per year. A system of money is brought in to facilitate the exchange of goods. We will call this unit of currency a Worldo (as the system represents the whole world). Assume that at the start 1 million Worldos of Central Bank produced cash exist and 1 million are spent per year.

It is not that all units are equal. 1 unit of lawyer service may be exchangeable for 10 units of cleaning services. This is a fully capitalistic system, responding to supply and demand. If no kids want Etch A Sketches for Christmas any more then the Etch A Sketch maker must retrain in making Nintendo Gameboys and this will lead to temporary loss of productive capacity. But overall, full employment is possible and desirable.

But as yet, we have not got any concept of savings. Here I need to divide up the idea of Savings into two strands: a) investment that will increase future productivity and b) savings that do not affect future productivity. 

An investment causes a loss of productivity in the short term. Supposing one worker in the system decides to spend a year building a new factory that could produce 1,200 units of trousers per year instead of the current 1,000. One year's productivity is lost (1,000 units) but the future capacity for making trousers is increased and the total productivity of the whole system would after this be 1,000,200 units of goods and services. This is good for everyone, especially the trouser maker.

An economic decline

But instead let's suppose that in one year, 100 people in this system decide to save 10% of their income (100 units each) - and they do this by putting it under their mattress. Still, in this system, no lending is allowed. Now, instead of a million Worldos being spent, only 990,000 Worldos are spent. In theory, this should not be a problem as the price of the average unit of goods should now go down from 1 Worldo to 0.99 Worldos. In practice, however, due to the concept of 'wage stickiness' this is not the case. Wage stickiness is the idea (empirically shown to be true) that people are very resistant to a cut in their wages. And employers are very reluctant to cut wages in nominal terms. Therefore the process of adapting to the new amount of currency in circulation is slow.

We can see the result using the Flows model where α is the coefficient of spending, d is total dividends (including rentals), i is interest, w is wages, L is new loans created, C is new central bank cash, ES are existing savings and γ is the proportion of existing savings spent in the year:

GDP= αd*d + αi*i + αw*w + αL*L + αC*C + γ*ES    (1) 

Before, d=0, i = 0, αw = 1, L=0, C=0 and ES=0, giving:

GDP= w = 1,000,000 Worldos

Moving on a year, d=0, i = 0, α= 0.99, L=0, C=0 and ES=0, giving:

GDPt+1 = 0.99*w = 990,000 Worldos

This gives Unspent Income of:

UI = 10,000 Worldos

The effect of the reduction of money spent in the system is that there is only enough money to buy 990,000 units. On average 10 people need to be made unemployed. Maybe the government decides that in order to make up the shortfall, it will reduce taxes and cut the least necessary parts of the economy; maybe, for example, the library service and the youth club service workers. 

The 10 people on social security now get a half share (495 units each) so the total for everyone else has now gone down to 985,050 units. So everyone who is working now get an average of 995 units each. The library and youth club workers have now had a cut in income of over half - so they are worse off. But everyone else has also lost out - they have have lost out on libraries and youth clubs for their kids. Maybe the richer ones don't use libraries and youth clubs, but these also may help future economic productive capacity which does help them.

So, everyone is somewhat worse off after these savings, except arguably the people who saved. Let's show this by rolling forward another year on the Flows model with 1% savings level. I will also assume a 10% spending of savings by the savers (so γ  = 0.1, ES is now 10,000):

GDPt+2 = 0.99*w + 0.1*ES = 0.99*990,000  + 0.1*10,000
= 981,100 Worldos

More people will now need to be made unemployed.

By repeating this process, the economy will have a stable savings rate at approx 909,000 Worldos. At this level, the savings made each year are equivalent to the amount of savings spent by exisiting savers.  We are in equilibrium as there are now no net savers. 

GDPinfinity = 909,091 Worldos

If there has been no deflation, then we will now have 9% unemployment. Eventually the deflation will be absorbed by the economy and it will return to full employment. The average price per unit will be 0.909 Worldos per unit and everyone will be happy again. 

But there was a lot of pain on the way there and a lot of lost production. All just caused by an increase in savings rate. 

The main point is that everyone is better off with full employment and yet this system does not provide it. This is a failure of the economic system - the result is clearly sub-optimal.

An economic boom

We can also use the Flows model to model the equivalent, which is people spending more than they are saving. Here, the results are more straightforward. There is more money being spent in the system but, because we are already at full employment, there is no increase in productivity. GDP goes up but it is all inflation. Wages go back up again, prices go up, employment levels and quality of life remain the same. 

Note that the boom and bust are not symmetrically good and bad. The bust is much worse than the boom because in the bust productivity is lost, but in the boom none is gained. Also, the boom leads to inflation which means that next time people decide to save, we will have more deflation and another bust.

How confidence cycles fit in here

I have not included credit in the simple above system, but credit can make the swings even larger. If money is borrowed because of confidence during good times, then forced to be repaid during bad times this cycle is only accentuated. And confidence is an important part of this system. Post-Keynesians are completely correct to stress the importance of what Keynes called 'animal spirits'. If one is more confident about the future, it makes sense to spend more. If one is less confident, one should save more. This is Keynes' 'paradox of thrift'. It makes perfect sense to an individual to save more in an economic downturn, but if everyone were to reduce spending with declining confidence and vice versa (ie. make the α of spending a function of confidence with negative sign),  one can see that GDP in the model suffers from positive feedback in both directions.

How the system is currently controlled

Stabilisers on this system are needed. Typically, in times of downturn, governments will borrow and spend money when the private sector is retrenching. Interest rates are reduced in bad times to encourage more borrowing and spending. Likewise governments should reduce their spending during booms (this is not always done) and increase interest rates.

In this system, looking back to Equation 1, a reduction in wages (w) is compensated for by an increase in new loans, L, both to the government and the private sector.

For the last 35 years, monetary policy has been the main tool for dealing with downturns. Not enough spending in the economy has been balanced out by continually increasing private sector borrowing. Finally, the zero lower bound has been hit, the economy can not be stimulated any longer, and the true cost of the debt overhang is finally being felt.

There is no room left for conventional monetary policy to regulate these cycles as the debt is too high.

More or less everything that I have said so far in this article is straight from Keynes. Keynes viewed government spending as the preferred tool for regulating the cycle. When confidence is high and more money is being spent, the government should withdraw money. When a consensus of gloom appears, it is up to the government to spend more money to balance the reduction of spending from the private sector equation and keep GDP up.

Whilst Keynes was absolutely correct (as he usually was), there is a major problem with this response now. The sheer level of private sector debt is too high. The amount of money lost to the economy through interest payments and dividends is too high and the government's burden is becoming too large.

What Keynes could not have accounted for was the huge savings glut that we have currently seen. Whilst he saw the government counteracting the savings with spending, he was not talking in a world where the savings are so high. 

If the government were to take on the debt necessary to counteract private sector savings then it would sink under the weight of its own debt.

So what is the solution?

Let's look at equation 1 again:

GDP= αd*d + αi*i + αw*w + αL*L + αC*C + γ*ES

To recap, the problem here is that the total of αd*d + αi*i + αw*w + αL*L + αC*C + γ*ES  is not high enough to allow GDP growth. 

In the past, monetary and fiscal policy would counteract this with an increase in new loans, L, but this is no longer possible or desirable. One can try to find methods to increase α and γ, but this is difficult. 

The other option here, and if you have read any of my previous posts, this will come as no surprise, is to increase C - new central bank cash.

C should be positive when the economy needs more money to operate at full employment, and negative when it needs less. This alone, if implemented correctly, can keep the economy at full employment and without the boom and bust cycle?

New cash being printed by the government should really not be a taboo issue. It is actually a far better method of deciding how much money is in circulation than leaving it to private banks.

How could it be implemented?

This is the tricky part. In sustained slump, investment projects should be undertaken. One could print money to fund one-off research projects, infrastructure investment and educational projects which would help future growth. On a fine-tuning basis, it is a little harder.

Tax cuts funded by newly printed money are one option. Similarly taxes could rise in a boom when people have more money. VAT could be altered to go up and down with the cycle, as could corporation taxes.

We currently in the Western world have a sustained deficit of demand which, without government deficits and rising asset prices would, I think result in no growth at all. The situation at the moment is so dire that it would not be ridiculous just to give every citizen of the country, say, £1,000 a year and let them spend it on whatever they want. This could be stopped when a more stable equilibrium is reached.

When would this not work?

One of the only ways to fail if using this framework (short of war, natural disaster or other major economic failing) is to have your debt denominated in another currency. My feeling is that there should be an international framework which rules that if any president of any country decides to borrow in a foreign currency they must, by law, be punched in the nose by their assistant and told to stop being so stupid. Next time they propose it, the same again. And again. Until so battered by punches and verbal abuse they will give up. 

Although the interest rates may be lower, it is a completely obvious way of destroying your economy when times turn bad. By printing money to service the foreign debt, the exchange rate goes down and you just have to print more. The end result is hyper-inflation. 

If the local economy takes a downturn, the cost, domestically, of servicing the foreign currency debt does not go down with the earnings of the people of the country. The result is a higher and higher debt burden that eventually will lead to your citizens paying more than they can afford and domestic GDP suffering.

If only the periphery members of the Eurozone had thought of this before joining the Euro.


Some unemployment is a fact of life. When a pit closes, miners need to find another job. Some people don't want to work and they will be happy on unemployment benefit. 

But unemployment caused by economic cycles is a sign that the system is failing. It is always better for people to be working rather than unemployed.

This framework shows how the government can intervene in the system by adding or taking away freshly printed money in order to keep GDP at the desired level. It can stop booms and avert busts using just this tool.

Application is the difficult part, but the most important stage is to get out of the mindset that the government should not just print and spend money.

Friday 24 April 2015

Model of the Economy using Stocks and Flows. Part 2; Flows

A bit of background

The idea behind this model came from a result of some empirical research. I was using the dataset from my study on the effect of increased levels of private sector debt (if you haven't read it, the conclusion is that it is a bad thing), and I was empirically testing Michael Pettis's idea that a current account deficit must lead to a choice between unemployment and debt. 

I find Pettis' work to be truly exceptional and could happily read him all day. But the surprise to me came that I couldn't find as strong a link as I was expecting. At most, and this was setting all surpluses to a maximum of zero and isolating as best I could the effect of other variables, I found an approximate 0.5% increase in debt for every 1% of current account deficit. This was dwarfed by the average of 10% per year of new debt taken out in every country over the period.

Something else had to be going on, so I decided to model it.

Once again, I make the caveat that I am sure that this model can not be original. It is very straightforward. I just have not seen things put like this before, and I found it very helpful in understanding the flows in the economy. It is currently very simple but it could be subdivided further to make it more complex.

In terms of understanding the 'Flows' Part of the model, it would help to first be familiar with the 'Stocks' part that was the subject of my earlier post.

Update: I have just realised that I missed out the concept of Transfer of Existing Savings (TES) which I am now including below.


I will start with a closed system - a country with no trade or financial flows abroad. For simplicity, I will make it a discrete model - with action taking place once every year. This can be made to calculate every day, every minute, or (if someone were clever enough to make a differential equation) continuously.

At the beginning of every year all the money is paid out and then during the year it is either spent or saved. At the beginning of next year we start again.

The sources of money are: 

1) 'GDP' from work done the previous year.

2) 'New Cash' printed by the Central Bank, C. This could, in theory, be negative.

3) 'New Loans' created by private banks, L. This could also be written as New Deposits. This can be positive or negative.

4) Money taken 'From Existing Savings' to be spent in the economy. Eg pensioners spending their private pension. In terms of the Stocks model, the existing savings, ES,  can be seen as the sum of CB cash, equity and debt.

The GDP is divided into three flows:

a) Dividends - this includes eg. rental payments on houses. It is any return on equity as defined in my post on Stocks. This is denoted by d.

b) Interest, i.

c) Wages, w.

There is not much more required for this simple system in order to calculate the path of nominal GDP and total debt. Real GDP depends on actual productivity increases, but nominal GDP in this closed system is just how much money is spent (if there is more money spent but no increase in productivity then it is just inflation). To calculate the nominal GDP and net new savings/debt, I just need to put in how much is spent on consumption.

I will call α the coefficient of consumption. So αd is the proportion of the dividends paid that are spent in the economy. Similarly, αi, αwαL  and αC  are the coefficients of consumption of interest, wages, new loans and new cash. Also, I will define γ as the proportion of existing savings that are spent in the year.

We can then find the next year's nominal GDP and the amount of net savings by using the following:

GDP(t+1) = αd*d + αi*i + αw*w + αL*L + αC*C + γ*ES

And we can define Unspent Income (UI) as:

UI  = (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αL)*L + (1-αC)*C - γ*ES

Now, imagine that one year I decide not to polish the leather on my yacht as usual and save the money (£25k) instead. This £25k is a loss to GDP as I am not buying the services of the polisher. There are a number of ways that this can be made up. The polisher's employer could take out a loan and continue to pay the polisher. In this case the UI becomes a net new saving in the economy. The polisher's employer could continue to pay the polisher out of her savings, in which case there is a transfer of savings from the polisher's employer to myself. Or the polisher's employer could lay off the polisher in which case there would be some transfer from the polisher's savings to me and some taking out of new debt by the government to pay unemployment benefit.

So this UI can be split up into New Savings (NS) and Transfer of Existing Savings (TES).

We can now calculate NS as:

NS  = (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αL)*L + (1-αC)*C - γ*ES -TES

This can then all be plugged back into the equation for the next year. 

The reason, discussed here, that we are have a stagnating economy is that αw is α lot larger than αd and αi  and that w is too low as a proportion of GDP (equivalently d and i are too high). But one can show that there are other ways to boost GDP - for example by increasing to replace the demand lost by UI > 0.

Note that in the absence of new central bank cash, new net savings must always equal new debt. So for the next year, we have the following inputs, corresponding to the four listed above:

1) GDP => GDP(t+1) 

2) New Cash => C(t+1) 

3) New loans => Lt+1  NS - C(t+1) 

4) Existing Savings => ESt+1  = ESt  + NS

And the whole loop can start all over again (this model of existing savings is a little simple though - some sort of equity and bond price model allowing for economic growth should be included).

The most important part here is that for the system to be in what I call equilibrium, New Loans should be zero and reasonable growth should be achieved.

How does this fit in with the Stocks model?

In the stocks model, there are three quantities. These are the following:

1) Central Bank Cash, CBC.

2) Equity, E.

3) Debt, D.

I will also need to define the growth rate (which of course can be negative) of the value of existing debt and equity - these will be gdebt and geq.

The stocks are affected by the flows in the following ways:

1) CBC(t+1)  = CBCt + C(t+1) 

2)  E(t+1)  Et   (1+geq

3) D(t+1)  = Dt   (1+gdebt+  NS  -  C(t+1) 

Any other flows are just shifting cash around from one place to another. For example, if people generally thought that debt was too expensive compared to equity then gdebt might be negative and geq positive, but all that it would mean is money transferred around to different bank accounts. 

If money is used to improve the productive capacity of the economy then still it is just money moving around. However, one would expect to see this improvement reflected in the value of geq.

Adding the government to this

Note that I have ignored the government in this model, as all they do is spend a part of the wages, interest and dividends, and borrow a part of the New Loans. To put the government in to the model, one would need to first divert some of the wages, interest and dividends to government. It is also necessary to separate the New Loans into Government and Private Sector. Then calculate how much of that spending goes on wages, interest and dividends. 

With external trading partners

This was a closed system. Now let's put in an external trading partner - the world. For simplicity I will net everything off so that there is only an input of either positive or negative savings. This can be changed but just confuses the issue a bit here.

Let Foreign Savings (+ve or -ve) in year t be denoted by FS. This is also known as the current account balance. A current account deficit gives a positive value for FS, a surplus gives a negative value.

This is how the stocks are affected:

1) CBC(t+1)  = CBCt + C(t+1)

2)  E(t+1)  E (1+geq

3) D(t+1)  = Dt   (1+gdebt+ NS + FS - C(t+1) 

For this reason I argue in this post that we need to increase C to equal FS to counteract the effect of a positive FS.

It could also be argued that Ct+1 should be made to equal FS + NS so that debt no longer increases. In other words, new cash should be produced to replace the amount saved (or taken away to replace net spending of savings).

Anyway, regarding the foreign savings, this seems pretty straightforward, and it looks at first glance that it is an accounting identity that an increase in FS must by definition lead to a 1 to 1 increase in debt or a decrease in GDP as the domestic economy would have to suffer enough so that domestic savings go down to compensate. 

However, empirically I found this not to be the case. Why is this?

It is important to note where the current account deficit comes from. For example, imagine a situation where the only foreign holding in the domestic economy is of government bonds. And the deficit comes only from interest paid on holdings in government bonds. Then, looking at the flows above,  GDP will only fall by αi*deficit. Here, some of the domestic savings are being diverted abroad. New domestic saving will go down by (1 - αi)*deficit . And FS is 1* deficit - so it all balances. 

Alternatively, if the current account deficit is all due to traded goods then one might assume that this is taking 100% demand out of the economy. Thus the α can be considered to be 1. The rest of the UI is unaffected so the FS leads to increase in debt in a 1:1 ratio with the deficit.

So the composition of the current account deficit is important when trying to find out whether it will affect GDP or mainly just levels of domestic savings. 

Defining αFS as the coefficient of new foreign savings that would be spent in the economy gives us:

GDP(t+1) = αd*d + αi*i + αw*w + αL*L + αC*C + γ*ES - αFS*FS 

And we can define unspent income as:

UI = (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αL)*L + (1-αC)*C - γ*ES - (1-αFS)*FS 

And net new savings is still:



There isn't really a conclusion here; it is more of a framework that can be used to analyse different scenarios. However, if I were to draw one it would be that new central bank cash should be printed in enough quantity to offset the net domestic savings plus net foreign savings in UI.

This ensures that debt does not grow.  Depending on the α here, it should cause some inflation. Slowly this inflation will erode the value of the current debt until finally an equilibrium is reached. I will be modelling this in the near future so I will be able to report back more on the expected effects.