Notes on the Next Bust

Wednesday, 22 April 2015

Rising inequality explained (not using r-g)

Using a stocks model to demonstrate how inequality and secular stagnation are the same thing, and how both are caused by high private sector debt

In my last post, I set out a 'stocks' model of the economy. The 'flows' part will follow, but in the mean time I wanted to use the model to show the reason, in my opinion, for the build up of inequality. This is actually the same as secular stagnation and I hope to show how these are the same thing. It is an inequality between those with savings and workers.

Please look at my earlier post here before starting, showing the empirical cost of private sector (and to a lesser extent government) debt. It is very high; each 10% of GDP increase in private sector debt is associated with a reduction in GDP growth by 0.15% per year every year going forwards. Considering we currently have over 200% of GDP in private sector debt in the UK, one can see that this is a potentially a large problem. This model provides a framework explaining why.

Going back to my previous post. I define the model (and it is really very simple) as this:

This model is intended to be based on accounting identities. In that sense, unless I have made an error in how I set it up, it must, by definition, be correct. I will set up the first part of the model here, and then go through how it can be used to look at the economy.

The idea comes from a system dynamics set-up, in which there are 'Stocks' which are the levels of things (eg. how many fish in a lake) and then 'Flows' which are the changes in these levels (eg. how many fish are caught by fishermen each year). Here I will be modelling at first a closed system (the world) and then later I will look at systems with impacts from external sources (individual countries).

I will begin by defining three assets that will represent in total all assets that can be held.

1) CB Cash: This is central bank produced money, net of any debt. This is actually only a small proportion of the total cash in bank accounts - the rest is loaned to some other party and thus cancels out for this purpose. Whereas private bank created money is liable for interest, cash from a central bank is assumed to be liable for no interest as it is not a loan.

2) Equity: This includes everything that isn't debt. So property and shares in companies are the main constituents of this. It also includes paintings and truffles. Holders of equity receive dividends or rent, and for simplicity we will call this 'dividends' from now on. This value of equity is net of debt held by companies and minus the cash held (the cash is counted in the other two parts).

3) Debt: This is government debt, private bank produced debt (total money in bank accounts minus the 'CB Cash' above), corporate debt etc. Holders of debt receive interest - or in some cases, the banks receive interest on their behalf and keep it for themselves. In any case, the borrowers pay interest.

This is the asset side of the balance sheet. One could describe this as all together as Savings.

I also wish to define a liabilities side of the balance sheet. This has one entry:

Future Liabilities: This is the liability that future people in the country have to the holders of assets above. For example, if someone was born today, with no assets, then they would have to work in return for cash paid out of current cash stocks held by someone now. They would have to pay rent to holders of housing equity. In general, all of the value of current assets must, as an identity, come from work done by people in the future.

Future Liabilities = CB Cash + Equity + Debt

I would also like to add on extra idea to this:

Reasonably Serviceable Future Liabilities (RSFLs): This is the amount of money that can be reasonably expected to be taken from the work of people in the future. For example, if they create £100 of economic output, it may be reasonable that they pay dividends (to the owners of the company that employs them - this is taken off before they get their salary), rent and interest of £40. I don't know exactly what this figure is, but it is somewhere between 0 and 100% of future economic activity. The 'coefficient of Reasonableness' (coR) will need to be empirically determined. The total amount is a function of future GDP as well as the proportion of assets that are in equity (E) and debt (D) and interest (r) and dividend rates (d) per year on these.

As an approximation, the amount paid, P, per year, is given as:

P=(r*D +d*E) / GDP (1)

The Reasonably Serviceable Future Liabilities (RSFL) are then:

RSFL= (Future Liabilities)*coR/P (2)

One may ask the question, why is there a level that is reasonably serviceable? After all, interest and dividends are only transfers from one person to another. The reason is that the payers of the transfers tend to be those with a high propensity to spend, and the receivers tend on average to have a low propensity to spend. Transfers of this type take demand away from the economy.

The gap between the spending of the two parties is given by the marginal propensity to spend of workers minus the marginal propensity to spend of savers (MPSw - MPSs) - it is assumed here that workers spend more than savers.

The cost to the economy, in terms of lost demand is:

Cost in demand = (r*D +d*E)*(MPSw - MPSs)

I will now take the concept of Reasonably Serviced Liabilities further. I will define it as the liabilities which can be serviced by the people of the country without an increase in debt whilst still allowing growth.

I will also define here that the 'savers' are the people holding the equities, the debt and having money in the bank. And the 'workers' are the people who have the liability to pay them in the future.

Now, using this model we will go through what I see as the main problem with the economy at the moment.

Let's start the clock 30 years ago, when Marty McFly was about to get in his time machine. I choose this particular year arbitrarily but it was a time before the recent explosion of debt. In the city, men with bowler hats could still be found, and finance was just taking off. Although hover boards and self lacing shoes have still not become ubiquitous, the economy has changed greatly since then.

Here is a representation of an economy at the start of the series. At this time, imagine that on my model we are in an equilibrium. By equilibrium, I mean that the servicing of the debt and equity by the workers of the country was not causing an increase in debt. Or put another way, net savings were not increasing.

As an aside, please note that in a closed economic system if anyone wants to save more money then, if GDP is not to shrink, either the central bank must produce more cash or someone must go into debt. The other option is that GDP shrinks, forcing lower savings on to everyone else to make up for the higher savings of the extra saver. For an economy to be in what I call equilibrium, then, there should be no net savings.

Now, imagine in 1985 that this equilibrium was broken by some people borrowing to buy new cars and houses. What would happen. According to my empirical evidence, for 90% of that money debt would replace equity (it is not spent in the economy) and 10% would Be spent in consumption and just cause an increase in debt. Debt would go up, and the total future liabilities would thus have risen by the amount of debt that did not replace equity.

However, the RSFL would not have gone up. It would be the same; as there is nothing that would improve future growth in what has happened.

The system is now out of equilibrium. And unfortunately in this system, unlike normal macroeconomic models, there is positive feedback rather than a stabiliser that returns the model to equilibrium.

What does this mean? The savers have now saved more and are now receiving more in dividends and interest from the workers. The holders of equity and debt, the savers, tend to be the richer members of society, the payers of the interest and dividends tend to be poorer members of society. The savers tend to spend a lower proportion of their income on consumption, the workers a higher proportion.

So in the next year, the demand for consumption in the economy has gone down by the change in interest and dividends paid multiplied by the differences in the two marginal propensities to spend. More simply put, there is less demand.

Also simply put, the (on average) richer have put some more savings away, the (on average) poorer have gone more into debt.

The next year, 1986, may see more people borrowing money that then flows through to consumption. But now, more borrowing is needed in order to replace the demand lost by the extra debt servicing costs. After this year the gap between liabilities and RSFL has risen.

Next year, the larger gap means that more needs to be borrowed. Standard macroeconomic policy will say to reduce interest rates to make up for lost demand. This does increase GDP, but does so with more borrowing.

This continues for 30 years. The gap between what can be reasonably serviced and the actual liabilities grows each year. Whenever growth slows, interest rates are lowered.

On top of this, the rise in debt has led to a worldwide rise in house prices. The unaffordability caused by this has dragged up rents. Thus now even equity can take more than can be reasonably serviced. Recently, corporate profits have also been rising as a share of GDP, having a similar effect. Both of these increase the savings rate. And as we have seen, an increase in the savings rate by definition means an increase in the debt rate.

Now, it is important at this stage to show the difference between debt and equity. Whilst it is possible for equity to take from people more than what is reasonably serviceable, it is a lot harder. Equity is a share of profits and if profits go down then so does the amount going to equity holders. Debt, however, while possible to write down is a lot more difficult. Debt will only be written down when it is impossible to pay. Equity will be written down when ability to pay goes down.

So when there is a market crash, the following happens (assuming RSFL was the same as future liabilities at the beginning):

The expected value of all future economic activity goes down and so the RSFL goes down. The equity shrinks a lot. The debt, though, does not go down much.

This is why debt is so much more dangerous than equity after a crash. It does not shrink as much and it makes unreasonable demands on the workers of the future.

On top of this, too much debt is often the cause of the crash in the first place; a self-perpetuating asset price rise spiral which feeds off debt and causes more debt.

Where we are now

The upshot is that after 25 years of rising debt followed by a major crash, our situation looks like this.

2015 figuratively

The savings have been going up and up. The rich have been getting richer and richer. Every year, the transfer of more and more expenditure to the savers - funded by the taking out of more debt - has caused a huge build up in savings.

But the ability to pay has shrunk. Because the amount that is reasonably serviceable is so much smaller than the actual liabilities. Workers are paying so much of their economic output in dividends, rents and interest that there is not enough left to spend in the economy.

What does this mean for interest rates? They are at zero officially but in real terms for borrowers they are still much too high. The cost of servicing current liabilities means that, if nothing changes, demand will be weak for a very long time and we are condemned to slow growth going forwards.

Government bonds give negative real and sometimes even negative nominal yields. Why? Because there is very little growth expected in the future. Bond and equity prices are going up because, realising that there is no economic growth to look forwards to, savers are eager to get whatever they can. The risk premium has gone down. The smaller and smaller pot of future earnings is being divided between a larger value of total assets.

Even with official interest rates at zero, there is still no investment. Why? Because there is the collective feeling that the return for doing so will not be high enough to cover the real interest paid. Economic growth in the future will not justify the outlay now.

In one way, the rise in asset prices has made the savers (typically the richer) richer. But in another way, they do not have a claim on any more of the future work, except where, for example the rise in property prices actually drags up rents to make them less affordable. But the claim that has already been amassed on future workers are much too high already.

This is secular stagnation.

We are now at a stage, due to savings increasing year on year, that the rich are richer than ever in living memory. This is how I would explain the rise in inequality, and it is not because r > g, it is because (r*D + d* E) > the amount that is reasonably serviceable.

The solution

We are in a spiral of weak demand, increased savings and then even weaker demand. This spiral needs to be broken out of.

What is the solution? This is from my previous post:

From equations (1) and (2) above, we can see that there are three things that could make the future liabilities reasonably serviceable

1) Lower interest rates (this suggestion is not helpful here, as we have just discussed)

2) GDP growth

3) Central bank cash to be a larger proportion relative to debt - therefore reducing interest payments

And so actually the zero lower bound is not, in practice, a problem. Possibility 1 may be out of the question, but if one were to

a) print money and invest it in future GDP growth, either through education, research or capital investment, and

b) print money and monetise government debt

then you would be fulfilling options 2 and 3. With the lack of demand at the moment it would probably not be too inflationary - but even if it were, it might not be a bad thing.

So actually to reduce inequality, you don't necessarily have to tax the highly mobile rich that are so difficult to pin down. What you need to do is change the distribution of liabilities from:

2015 figuratively

to the far more healthy:

Using just methods a) and b) above one could affect a large change. One could also add pure stimulus spending in the form of helicopter drops to this, if there were not enough investment opportunities.

Although no-one would actually have less money in nominal terms, the servicing costs of the liabilities would be so much lower that the workers would have much more money in real terms, and the savers would have a far smaller claim over the work of others in the future. Effectively the problem would have been solved by two methods: 1) inflation would erode some of the savers' savings and 2) economic growth would increase the workers' earnings.

Sunday, 19 April 2015

A Simple but Helpful Model of the Economy using Stocks and Flows. Part 1; Stocks.

Or: 'Why we need to print money to get out of the economic stagnation'

The part to get out of the way early:

1) I am not an economist or an accountant, so the definitions I use here will probably make some people irritated. But please look beyond this failing as I think that it is worth it.

2) This is all my own work, but, having said that, it is a simple model. I have no doubt that this has been done before. However it is not widely used, as the conclusions reached herein are not widely accepted.

Also, this is a first draft. I welcome any comments on errors.

Stocks

I will begin by defining three assets that will represent in total all assets that can be held.

2) Equity: This includes everything that isn't debt. So property and shares on companies are the main constituents of this. It also includes paintings and truffles. Holders of equity receive dividends or rent, and for simplicity we will call this 'dividends' from now on. This value of equity is net of debt held by companies and minus the cash held (the cash is counted in the other two parts).

This is the asset side of the balance sheet. One could describe this as all together as Savings.

I also wish to define a liabilities side of the balance sheet. This has one entry:

Future Liabilities: This is the liability that future people in the country have to the holders of assets above. For example, if someone were born today, with no assets, then they would have to work in return for cash paid out of current cash stocks held by someone now. They would have to pay rent to holders of housing equity. In general, all of the value of current assets must, as an identity, come from work done by people in the future.

Future Liabilities = CB Cash + Equity + Debt

I would also like to add on extra idea to this:

Reasonably Serviceable Future Liabilities (RSFLs): This is the amount of money that can be reasonably expected to be taken from the work of people in the future. For example, if they create £100 of economic output, it may be reasonable that they pay dividends (to the owners of the company that employs them - this is taken off before they get their salary), rent and interest of £40. I don't know exactly what this figure is, but it is somewhere between 0 and 100% of future economic activity. The 'coefficient of Reasonableness' (coR) will need to be empirically determined. The total amount is a function of future GDP as well as the proportion of assets that are in equity (E) and debt (D) and interest (r) and dividend rates (d) per year on these.

As an approximation, the amount paid, P, per year, is given as:

P=(r*D +d*E) / GDP (1)

The Reasonably Serviceable Future Liabilities (RSFL), if the one year amount is is extrapolated, are then:

RSFL = (Future Liabilities)*coR/P (2)

The gap between the spending of the two parties is given by the marginal propensity to spend of workers minus the marginal propensity to spend of savers (MPSw - MPSs) - it is assumed here that workers spend more than savers.

The cost to the economy, in terms of lost demand is:

Cost in demand = (r*D +d*E)*(MPSw - MPSs)

So, getting back to the model, we can set up this very simple model as Assets and Liabilities - which obviously must be equal to each other. We will also assume, in this initial example here, that the economy is healthy and that these liabilities are reasonably serviceable.

Please note that although assets and liabilities may not look equal to each other thanks to the formatting, they are always intended to be.

The future liabilities do not need to be 'Reasonable', however. They can be higher or lower than 'Reasonable'. When they are higher they place a real drag on the future economy, when they are lower they give a boost. This is the conclusion of my previous post, looking at the drag on the economy of too much debt, and the logic here will be explained in a future post, the Part 2 of this model, 'Flows'.

However, with just this extremely basic 'Stocks' framework, we will be able to model many macroeconomic scenarios.

Private Banks Creating Money

When a private bank makes a loan, it increases the amount of debt in the country. Often, in real terms, value of the future liabilities remains unchanged; it only alters the composition of the assets. In most cases it replaces equity because, for example, if a company takes out debt and buys back shares then the net equity (equity minus debt minus cash) goes down by the amount of the debt taken out. If a homeowner uses a mortgage then, again, equity minus debt also goes down with the increase.

Here, the value of the Reasonably Serviceable Future Liabilities will change depending on which is cheaper to service - equity or debt.

There are some examples where increase in private bank debt only increase the debt without any compensating reduction in the equity. For example, if someone took out a personal loan to buy this beauty. If the loan is used for consumption then future liabilities will rise with no rise in Reasonably Serviceable Future Liabilities.

Another possibility is that a company takes out debt and, rather than using it for share buybacks or takeovers, actually invests it in improving the productive capacity of their company. In this case, the amount of equity will stay the same and the amount of debt will go up, leading to an increase in future liabilities. But because of the future increase in economic activity the RSFL goes up too.

Central Banks Creating Money through QE

When a central bank undertakes a quantitative easing programme, then what does it actually do? It temporarily replaces some of the debt with some CB cash. This means a temporary reduction in the debt and temporary increase in the cash.

We therefore have the following (theoretical) before and after:

The fact that it doesn't actually do anything on this representation, led Ben Bernanke to make the famous joke that "The problem with QE is that it works in practice, but it doesn't work in theory."

All he was doing was replacing debt securities that were easily changeable into cash, for actual cash. In the Flows section it will be more clear why quantitative easing only causes a minimal increase in inflation and that is caused only by the rise in asset prices and not by the printing of money.

The reason that it worked in practice was the following...

Asset Prices Rising (/Falling)

By buying bonds, the Federal Reserve reduced the interest rates on bonds which led to a rise both in the value of debt and the value of equity (as the required return from equity went down with the bond yield). Future liabilities will hence go up. But, because these are based on lower yields, the total amount paid by future generations does not go up. Hence the liabilities are higher but they are equally affordable.

Assuming the original liabilities were reasonably serviceable, we now have the following before and temporarily after:

A small proportion of the increase in asset prices was then cashed out and spent within the economy, thus giving a stimulus to demand at a time when it was needed. This is the reason that QE worked in practice but not in theory.

More generally, asset prices and therefore future liabilities can rise (in real terms) for three main reasons:

1) The expected total future economic return is higher than previously thought. Higher economic growth is expected, therefore the reasonably serviceable amount of interest and dividends go up.

2) As in the example above, a lower interest/dividend rate is required. So the same economic growth can be split across more value in future liabilities now.

3) The expected share of the economic return paid in interest and dividends goes up. Although the total economic activity does not go up, the calculation is made that more can be extracted. This has been seen recently where corporate profits as a proportion of GDP have risen.

So, for example, the current equity and debt market rallies are based firmly in reasons 2 and 3. If anything the impact of 1 would have to be assumed to be negative.

Inflation and Deflation

These can be modelled although more needs to be known about the causes to fully understand the impacts. Inflation and deflation, all else being equal, do not affect the future liabilities in real terms. These stay the same. However, they affect the composition of the assets.

Below I will give an example of how it can be modelled, although different scenarios can be proposed.

Inflation, all things being equal, reduces the value of both cash and of debt. Equity will go up, as the value of debt held by the equity will go down and so net equity will be higher.

If we assume that inflation was caused by increased central bank cash, then cash will go up, debt will go down and equity go up a little bit.

Future liabilities stay the same before and after. But an interesting point is that, assuming that liabilities were reasonable in the 'Before', in the 'After' the Reasonably Serviceable Future Liabilities are higher than the actual Future Liabilities. This is because cash pays no interest and equity share remains the same. Therefore the cost of servicing the liabilities goes down.

Inflation caused by CB cash, before and after:

Inflation caused by greater CB cash therefore reduces the real future cost of servicing the current liabilities.

This reduction in debt share and increase in cash share is great for the future economy for reasons discussed here and here. In summary, one can expect more economic growth in future as less income needs to be paid to the holders of assets, who are less likely to spend. More on this in Part 2.

Inflation due to external causes, which does not increase the cash proportion and reduce the debt proportion, is unambiguously bad, however.

Internal deflation causes the value of cash and debt to go up. In this scenario, since the future liabilities remain the same, the value of equity must therefore go down.

Deflation before and after:

What happens in a crash?

In a market crash, the expected value of all future economic activity goes down. Or possibly the amount of future return required goes hugely up, based, maybe, on a re-evaluation of risk.

Therefore the Reasonably Serviceable Future Liabilities go down, as do the Future Liabilities. Since the amount of cash remains the same, the equity and debt must fall. Equity takes the main brunt, but there will also be some defaults on debt so we get the following before and after:

This situation is not so bad. The ratio of cash to debt and equity has improved, and the economy has a chance to recover after the revaluation.

However, what if the debt could not be cancelled or if not enough of it was written down? What if the 'After' looked more like this?

In this case scenario, the future liabilities are greater than can be reasonably serviced. I would suggest that this is probably more realistic.

From this, one can see the problem with too much debt after a crash (a crash which often follows from too much debt having been taken out). If the liability was to equity shareholders then the future liability would shrink to the reasonably serviceable liability. But debt is difficult to shrink. Instead of defaulting, society can end up for years paying back more than is reasonable and hampering growth.

I would argue that this situation may be one that we are in at the moment - called a 'Secular Stagnation'. I will get back to this discussion later in a discussion about the Zero Lower Bound to interest rates and why it is not really a problem.

What happens in a crash in a fixed currency mechanism?

There is an even bigger horror than the above, though. It is called being a Eurozone periphery member in the current crisis.

Here, the crash causes a large reduction in the expected value of the Reasonably Serviceable Future Liabilities. But at the same time the deflation caused (or to be caused) by the attempt to regain competitiveness against Northern Europe in a low inflation environment has led to an increase in the real value of the cash and debt.

This is a representation of Greece's Before and After:

It is a terrible scenario which has led to unemployment and suffering throughout Southern Europe. In effect this shows that, unless the debt is written down, the workers will have to pay a far too large a proportion of their earnings to the creditors. As this takes further demand out of the economy, the situation will worsen. It may have been possible if earnings could grow, but competitiveness has still not been regained and Northern Europe shows no sign of helping in this.

The impossibility of servicing the liabilities, as well as the extreme difficulty of regaining competitiveness are two reasons why I think that Southern Europe should default on debt as soon as possible, before a whole generation of young people suffering from over 50% unemployment atrophies.

The zero-lower-bound problem (or non-problem)

There has been much talk over the last few months about the zero-lower-bound to interest rates. That is that interest rates can not go too far below zero or people could take out cash and store it somewhere where the costs are lower. This puts a limit on stimulus caused by interest rates. In my opinion, this is a ridiculous argument because there is a perfectly reasonable well known for taxing deposits and it is called printing more money.

I believe that the situation that we are in now looks a little like this:

Here, the Reasonably Serviceable Future Liabilities are lower than the liabilities. Currently debt and equity prices are very high, but a reduction would not help as the dividends and interest would remain the same.

The problem here is that although the interest rate is officially at zero, no-one can actually borrow at zero so real interest rates for individuals and non-major corporations are high. Corporate profits, due maybe to improved labour saving technology, are also very high. So the amount of income that goes to consumption is too low. This reduces incomes further and the upshot is that even with official interest rates at zero, there is not the incentive to borrow to invest into the economy. It is collectively felt that the return for doing so will not be high enough to cover the real interest paid.

From equations (1) and (2) above, we can see that there are three things that could make the future liabilities reasonably serviceable

1) Lower interest rates (this suggestion is not helpful here, as we have just discussed)

2) GDP growth

3) Central bank cash to be a larger proportion relative to debt - therefore reducing interest payments

And so actually the zero lower bound is not, in practice, a problem. Possibility 1 may be out of the question, but if one were to

a) print money and invest it in future GDP growth, either through education, research or capital investment, and

b) print money and monetise government debt

then you would be fulfilling options 2 and 3. With the lack of demand at the moment it would probably not be too inflationary - but even if it were, it might not be a bad thing.

The taboo around printing money needs to be overcome. I hope this model helps to demonstrate how the composition of assets is important and hopefully will make a positive contribution to the debate.

My next post, as previously mentioned, will be about 'Flows'; how money moving about can create or take away demand. I haven't written it yet, but I imagine that the conclusion there will also be to print more money. That tends to be my solution to the Secular Stagnation we appear to be in.

Comments would be greatly appreciated here, by the way.

Friday, 17 April 2015

A View on the Economic Model Debate from a Non-economist (but someone who builds models for a living)

Frances Coppola recently took up the attack on the macroeconomics profession. Like Steve Keen before her, she attacked the 'loanable funds model' which is widely used by macroeconomists and takes no account of the money creation powers of banks. Quite a large oversight on the part of the macroeconomics profession considering that a) they are completely and unambiguously wrong on this point and b) in 2008 there was a financial crash which proved how wrong they were and they seem to have not changed their models.

As far as I am concerned, this is an open and shut case. However Krugman changed the focus recently in his reply - pointing out the impracticality of the non-linear models that Coppola and Keen suggest using. Annoyingly (and I do think he did it in a very annoyingly superior manner) I find myself inclined to agree with him on this.

I build models with data for a living, and I am acutely aware of the problems with using non-linear models to make any sort of accurate predictions - even with huge volumes of data to calibrate it with.

It is not that the systems are linear. They are hugely complex. My problem is that they are too complex to model even with non-linear models. My belief is that linear models do have to be used but with a full understanding of the non-linearity of real life. Also, the whole building of macro-models from first principles, based on 'rational' agents, is a complete joke of a way to design a model that is supposed to be used in the real world.

In any case, I want to give an example to illustrate how knowledge of non-linearity is important but building a complete model is impossible.

Take a country. For an interesting example, let's call it Australia. Now put lots of commodities there. Now let's create a world trading system around it. Already we are getting complicated. Now put a country called China in that is industrialising very quickly and has a high demand for commodities. Now put in a non-linear commodity boom and bust price model in to determine the commodity prices. What is going to happen to Australia?

Well, as the price of commodities rises, their exchange rate is going to go up and exporters of other goods are going to find fewer and fewer markets abroad for their goods. The other export industries in Australia are going to atrophy. It's not all bad though; lots of commodity money is flowing into the country and imports are cheap so people in Australia are happy for now.

Now, let's also model that China's boom creates a very high savings rate. And this money has to go somewhere. And Australia is nearby, stable and a safe place for rich Chinese princelings to put their hard earned cash. So the Chinese people buy a lot of Australian assets forcing a 4% current account deficit per year. Australia do not make a sovereign wealth fund to counteract this.

Now what's going to happen? On top of all of the commodity bounty coming in, there is now all of this unwanted Chinese money coming in. The high exchange rate makes imports even cheaper and exports even more expensive and the only way to keep domestic demand up is to take out debt. Hence private sector debt will go up. House price bubbles will ensue, but everything will still seem fine because the commodity prices are still high. Debt will rise and rise but times are good.

Next, the non-linear commodity model takes a downturn and commodity revenues drop. Chinese savings are still being parked in Australia so debt is needed to cope with that, but now more debt is needed to deal with the reduction in demand caused by lack of commodity income. There is not much export industry left and there is an economic downturn.

Eventually the house prices crash, debts become unsustainable and the economy enters downturn.

In this hypothetical example, the systems are hugely complicated. You have a model for commodity prices, a model for the Chinese savings rate and where the savings go, a model for domestic industry when the exchange rate is too high, a model for domestic credit, a model for house price bubbles. And fitting around all of that is a model for the entire Australian economy.

Making a model to do this is absolutely impossible. Or it is possible but it won't tell you anything more than you already know when you set the model up because further predictions are not going to have any level of accuracy in such a chaotic system.

However a knowledge of economic history enables one to piece together all of the non-linear parts of this and, with common sense, make a complete system.

It is a completely non-linear system outside of the bounds of the models of standard macroeconomics. But also one for which new models are possibly not needed as they are not necessarily going to add anything.

Update: Steve Keen wrote a response to this which can be found here.

Tuesday, 14 April 2015

A Comparison of the Long Term Effects of Private Sector vs Public Sector Debt

An improvement on the last post

Following a suggestion from Professor Steve Keen, I have made an update to my last post, to include in my regression the second derivative of the debt - the change of change of debt. The effect of this has been a great improvement in robustness. The reason is that, although an increase in the level of debt typically increases GDP growth for that year, there is also the problem of the direction of causality. In a year where the economy is doing badly, the poor performance of the economy will force an increase in the debt. Vice versa, when an economy is doing well, monetary policy may slow down the increase in debt. For this reason the change of change of debt helps to better isolate how increase in debt causes increase in GDP.

The other important change is that I am including government debt in the regression. Because change in government debt is almost always a response to market conditions, it is impossible to use this method to get a multiplier for the positive impact of government debt. I will leave this to people who understand it better than me. However, I can get an estimate for the negative effect of increased levels of government debt.

This enables a comparison. For X amount of growth one can either use Y amount of private debt (using the multiplier, Mpriv, calculated below) or Z amount of government debt (using the multiplier, Mgov, provided by more knowledgeable economists) - a comparison of the long term costs, the coefficient of which I will call LTC, is possible by comparing Y*LTCpriv to Z*LTCgov.

The new test

For the new test, I have regressed four variables against the growth rate. These are a) level of private sector debt, b) change in private sector debt, c) level of government debt, d) change of change of total (government and private) debt. Variable d is used as a bellwether for the general economic condition and thus helps to improve the robustness of results.

First, I will show a scatterplot of the regression results - showing how just using debt levels can give a very good estimate for GDP growth - the results are 61% correlated to actual GDP growth.

On an aggregate level, this prediction works pretty well. Below is a graph of actual average GDP growth vs a prediction made solely using the four debt variables:

As can be seen, this makes a pretty good prediction considering nothing is known about the economy other than debt levels (I think that the tick up at the end is related to austerity artificially affecting the second derivative).

The results from this are as follows.

Multiplier on Private Sector Debt:

Mpriv = 10.6%

Long Term Cost of Private Sector Debt:

LTCpriv = -1.5%

Long Term Cost of Government Debt:

LTCgov = -0.9%

And if anyone is interested, the change in change in debt coefficient (the economic condition proxy) was -8.9%.

What does this mean?

Supposing the economy is in a rut and, as a policy maker, you are given two choices to buy growth - either lower interest rates to increase private debt, or increase fiscal spending which increases public debt (in fact QE and helicopter drops are also possible but these are, to differing degrees, more frowned upon for now so I will ignore these here). You are trying to buy 2% economic growth above where it currently is.

The economy is not doing too well so let's assume a multiplier of 50% on government spending - ie. if the government spends $1m, $0.5m will be added to GDP.

To buy this growth one can either A) increase private sector debt by 2%/10.6% = 18.9%

Or one can B) increase government spending by 2%/50% = 4%

Now, the long term cost in terms of drag, DR, on future GDP per year is:

Case A: DRpriv= 18.9%*-1.5% = -0.28% per year

Case B: DRgov= 4%*-0.9% = -0.036% per year

Remember that this is for every year going forwards.

Conclusion: The cost of using private sector debt is almost an order of magnitude higher.

Given the two choices, public sector debt is always preferable. Of course other alternatives which reduce debt to GDP (possibly by inflation) but increase demand are even better. Helicopter drops and monetising of debt are the two that spring to mind.

As an explanation for 'Secular Stagnation'

I believe that the situation that we are currently in can largely be explained as a consequence of debt.

Below is the graph of expected GDP based just on debt levels and annual change in debt levels (not the second derivative, as this is cheating - it has some knowledge of GDP):

If this is the case, we can expect low growth until the debt overhang is reduced.

Below are individual graphs for the UK and the US. Both are severely hampered by the private sector debt overhang.

Due to a comment below, and the fact that a reader of this post may not have read the original post, I wanted to make a brief note on the mechanism for this effect. I believe that high debt overhang affects future economic growth in two main ways:

1) Because interest is being paid by the debtors to creditors. The marginal propensity to spend of the debtors is typically higher than that of the creditors (the creditors may in fact be foreign). Therefore demand in the economy is reduced.

2) Because debt causes financial instability. Typically one gets an economically destructive boom and bust cycle as well as a misallocation of resources due to housing bubbles, financial bubbles etc.

I also wanted to comment on the probable reason why public sector debt is so much cheaper to the economy. The interest rate on government debt is lower than that on private debt. Hence the interest drag on the economy is lower.