A Current Account Surplus is Obviously a Good Thing. Isn't it?

After my recent Coppola Comment post on a theoretical framework for making the Eurozone a genuinely viable currency union, I received a number of interesting comments in opposition to the idea.

There were three main ideas in the criticisms. The first is that it is politically impossible. This, I am inclined to agree with although, as Frances says, we have to try. Germany would never agree to this because it goes against their idea of economics. In fact, I would say that the Germans don't actually consider there to be any problem with the structure of the Euro, only the irresponsibility of the debtors.

I suppose really the point of the post was trying to plot out a minimum required level of cooperation for the Euro to be viable. Otherwise, the structural problems are so severe the best option for everyone would be a break-up.

The second criticism was of the blank cheque that it gives to governments within the Eurozone. Here I argue that all it gives is the same blank cheque that every other sovereign government has. And it is a 'blank cheque' that is necesary for sustainable economic growth. However, in order to avoid abuse, then any plan of this nature would probably need synchronisation of certain tax and spending policies. This may be unpalatable, but still is preferable to the alternative.

The third criticism is similar to the the first, but differs on a key point. It says not just that Germany won't agree, but that they should not agree to give up their victory in attaining a current account surplus. The idea is that it is not in Germany's interest to run a current account deficit for a while. On this, I disagree completely. I actually don't believe that running a current account surplus is necessarily a victory at all.

There are some circumstances when a current account surplus is a good policy. One obvious one is for producers of natural resources, who wish to both prevent their domestic economy from over-heating as well as save up for the future some of the value of the extracted resources.

Another would be for a small state to build up some kind of buffer against future uncertainty. In this case, the effect of their policy is tiny compared to the size of the economy that they are building up savings in.

But for a state with the size and level of development of Germany it really gives no advantage whatsoever, and actually many disadvantages when it affects the economic growth of its neighbours so badly as I  discuss in the Coppola Comment article.

Persistently running a current account deficit in a fixed currency regime [edited; thanks Frances (in comments)] is clearly a bad thing, and I am not saying that it is OK to have a deficit. I am saying that there is no symmetry here. For the reason for this, we need to look at what actually happens to create a surplus. The wages/purchasing power of the surplus country is artificially kept low, either by currency manipulation, tariffs or (as in Germany's case) wage agreements. This makes the saving rate in the economy artificially high. And these excess savings must be invested somewhere, and this somewhere must be abroad. The surplus country thus creates savings in the deficit country.

There is no increase in demand in the surplus country as the increase in exports is counterbalanced by a decrease in domestic demand. But there is a reduction in demand in the deficit country. The net effect is a reduction in world demand. It is a negative sum game.

It is true that Germany is building up credits with the rest of the world. The claims of Germany on future production by the rest of the world are growing every year by a large amount. But the thing about these claims is that at some point they need to be spent. If not, they are worthless tokens.

When is Germany planning to spend these tokens? If never, then why are they working so hard and forgoing consumption now to build these piles of bonds and equities. This is even ignoring the fact that the less competitive parts of the Eurozone are suffering an economic strangulation in the collateral damage of this policy.

It's all very well talking theoretically about the effects of a current account surplus. I would argue that these are accounting identities, but nevertheless, people will still claim that running a current account surplus is good for growth. So I have looked at OECD data for developed economies for the past 18 years.

Below is the result for Current Account Balance plotted against RGDP growth for 423 country years. I have excluded a few large outliers on either side by limiting the deficit to -10% and surplus to +15% (the assymmetry is because there are fewer surplus countries). I have also provided best fit lines. I have divided the graph into two halves, surpluses and deficits.

This graph very clearly shows no correlation between surpluses and RGDP growth. This is exactly as the above argument suggests it should be. Saving in a foreign currency does not help your growth at all.

This is really the main point I am trying to make - that for Germany to run a deficit will not hurt their economic growth at all, just spend some of the many claims that they have on the rest of the world.

An (I think) interesting aside 
 

You can stop reading now, unless you, like me, are interested in the interaction between the current account and both private and public sector debt.

An interesting feature of this graph is that it shows that higher deficits are correlated with  higher economic growth. This would seem counter-intuitive because a deficit means that demand is taken from the domestic economy. Here, one probably needs to look at the line of causation. A booming economy will be more likely to receive investments from abroad and will pay higher returns on that investment. This means a large current account deficit. The effect of this confidence could well outweigh the negative demand impacts.

Looking at private sector credit growth gives more explanation. Here the same is plotted but on the y-axis is the change in private sector debt year on year, divided by GDP.

 

The higher deficit countries have the highest increase in private sector debt to GDP too. This is both a symptom of the confidence in the economy (/bubble) and a cause of greater GDP growth despite the deficit.

There also appears to be higher creation of private sector debt to GDP in the large surplus countries. Here it may be something about the investment led growth model being followed, and much of the increase may be for investment rather than bubble building or consumption.

For completeness, it is also interesting to look at how the current account balance affects public sector debt to GDP.

 

On the positive side of the graph, as one would expect given a current account surplus and higher private sector debt creation, we see a declining government deficit. More interesting is the negative side, which shows that government deficit actually reduces with a higher current account deficit. This could be due to the higher confidence and higher private sector debt creation that goes hand in hand with the type of high confidence (arguably misplaced) economy that runs large current account deficits.

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A plan to turn the Euro from zero to hero

(this post is available in full as a guest post on Frances Coppola's excellent blog Coppola Comment)

It is difficult to read the history of inter-war Europe and the US without feeling a deep sense of foreboding about the future of the Eurozone. What is the Eurozone if not a new gold standard, lacking even the flexibility to readjust the peg? For the war reparations demanded at Versailles, or the war debts owed by France and the UK to the US, we see the huge debts owed by the South of Europe to the North, particularly Germany.

The growth model of the Eurozone now appears to be based largely on running a current account surplus. Competitive devaluation is required to make exports relatively cheap. While this may have been a very successful policy for Germany during a period of high economic growth in the rest of the world, it cannot work in the beggar-thy-neighbour demand-starved world economy of today.

As I've explained elsewhere, reasonably large government deficits are very important for sustainable economic growth. However, in the Eurozone this is prohibited both by the Stability and Growth Pact (SGP) and by the fear of losing market confidence in the national debt. At the same time credit growth for productive investment is constrained by weak banks and Basel regulation. And the Eurozone as a whole is already running a large current account surplus; the rest of the world will not allow much more export-led growth. Helicopter money would be a solution, but politically this is a long way away. Summing up, if economic growth cannot be funded by government deficits, private sector debt, export growth or helicopter money it is very difficult to see where nominal GDP growth can come from.

In a way, this can be seen as a Prisoner’s Dilemma. Every country knows (or should know) that if all states provided fiscal stimulus, the Eurozone would benefit from more economic growth. However, for any individual state, a unilateral fiscal boost would increase their own government debt whilst giving a fair amount of the GDP growth to other states (because some of the stimulus would go to increasing imports from the other nations). And if all others provide stimulus, then it is in an individual state’s interest to take the benefit of the other states’ stimulus, and become more competitive versus the rest.

The huge imbalances created by the fixed exchange rate system, described in this great piece by Michael Pettis, are still there. The enormous current account surplus built up by Germany makes it extremely difficult for the less competitive countries to run a current account surplus. The only way for this to happen, without German inflation, is by internal devaluation; a long and painful process to lower wages, which may succeed in achieving a current account surplus, but only at the expense of shrinking the economy. The debt owed to the creditor nations therefore gets larger in real terms. In the end, the debts owed by the South to  the North are unpayable without the Northern countries running a current account deficit and using the savings built up during the amassing of the surplus to buy goods from the South. But the Northern surpluses are only getting bigger.

On top of this, all countries in the Eurozone are committing the "original sin" of borrowing in a foreign currency. This can only be a time bomb, waiting to devastate Europe.

Read the rest of this post on Coppola Comment

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The Economy Simply Explained

Sometimes my friends tell me that they try to read them, but my posts are too complicated. I am using jargon that they don't understand and probably they are too long and confusingly written. To remedy this, I have decided to try to write a simplified version of this piece I wrote about how the economy works.

How can one picture the economy? The economy should be viewed as a flow of money. This may seem straightforward, but mainstream economic models do not include money at all. And yet, a lot of the workings of the economy can be understood by looking at who receives money and how much of it they spend.

 If everyone is working and producing goods and services, then people need to buy these goods and services. In order for people to buy these products they need to have enough money.

Money received by people for producing things is then spent by these people on more things. This cycle repeats itself and makes the economy run.

What if people don't have enough money? They can't buy the goods and services. In a perfect world, the price of everything would go down so that all of what is produced can be bought. Unfortunately, in reality this is not the case.

Why can't prices go down very easily? The reason that prices can't adjust very easily to not enough money is that people's wages tend not to go down. This is called 'stickiness of wages'. Because people generally don't like having pay cuts, producers can't reduce prices or they will be making goods at a loss.

If they can't reduce prices, what do they do? Instead they cut production and make people unemployed. This then, in turn, reduces the amount of money that people have to buy things. Leading to further job losses.

Eventually what would happen? Without any government intervention, in the end prices and wages would fall enough so that everyone could have a job again. But it is a long and painful process. It is much better to ensure that the correct amount of money is running therough the system.

How much money is the correct amount? A generally accepted nominal GDP growth target is 5% per year. This means that in total 5% more value in goods and services are produced each year. Some of this increase is due to inflation - one pays more for the same number of goods. And some of this is growth - more goods are produced.

If too much money is spent then we get more inflation. That is to say that the growth in production of goods can't keep up with the rise in amount of money spent. Consequently prices go up.

But if 5% more £ worth of goods and services are produced, doesn't that mean that people need to spend 5% more money each year than the year before? Exactly. Every year, for the economy to be healthy, 5% more money needs to be spent than the year before.

Where does this extra money come from? This is a very good question. And it is one that seems to be ignored by most economists.

The problem we have with the economy today is that actually it is being drained of money. If £1m of goods are produced and sold, then in the next year only approximately £970,000 will be spent. People are saving the other £30,000.

To be more exact, the gap between the amount people are saving and the amount of people's savings from previous years that they are spending comes to 3%, maybe even 4%, of GDP.

Why is this gap so large? There are a number of reasons but it mainly has to do with the difference in spending of the people who receive the money. Working people on low and medium incomes tend to spend most of the money they receive. But savers receiving interest and dividends spend less of it in the economy.

Private sector debt in the economy has increased hugely over the past 40 years, meaning more money goes to interest payments. And corporate profits as a percentage of GDP are at record highs. Meaning that workers receive less of the money from their work than they used to. And because of this, less money is spent.

On top of this, widening inequality means more income goes to richer people, who tend to have a higher saving rate than poorer people.

In the UK and US there is also a trade deficit - meaning that more money spent by people in the UK and US goes to other countries.

Currently, the average annual saving rate in the UK is probably 3-4%. The exact figure each year depends on how confident people are in the economy. 20 years ago, the average saving rate was probably only around 2-3%, and 40 years ago it would have been closer to 1-2%. These are approximate guesses but it shows the problem caused by the financialised economy we live in today.

So that means we need to send a lot more money through the economy every year? That's right. If we have a 3% saving rate, and we are looking to achieve a 5% nominal increase in GDP each year, we need people to spend an extra 8% of GDP worth of money each year.

So, again, where does this money come from? Historically it has come from two places.

First, governments normally run deficits of on average 4-5% per year. The multiplier of this on GDP (ie. how much of this gets spent on GDP additive goods and services) is approximately 1. So around two thirds of the historical gap comes from government deficits.

Second, private sector debt has increased year on year.This consists of, for example, money borrowed by individuals for mortgages or credit cards, and by companies for investment or to buy back shares. This has grown by 10% of GDP per year since the 1970s. Effectively 10% of GDP more money has been printed by banks and corporations every year.

However the private sector debt is not as efficient at getting people to actually spend the money. Much less of it is spent on GDP. So the increase in private sector debt, despite being twice as large,  makes up about a third of the new money spent every year.

Why is the economy struggling at the moment? Because private sector debt has hit such high levels. This means that interest rates are low, and that makes house prices very high. Because many people can not buy homes any more they do not take out more mortgages. Because the economy is not growing so much, companies want to borrow less. So we do not have the new money coming in from new private sector debt.

So what has the government done? Central banks have tried to do what they can to make more money be spent. They have enacted a policy called Quantitative Easing which prints new money and uses it to buy bonds. This pushes down long term interest rates and pushes up the prices of assets (like shares and houses). This makes (generally) richer people even richer and encourages them to spend more.

Our elected government has been working against this though, cutting money from poorer people who spend more, and trying to get the government deficit to zero.

Can the government cut the deficit to zero? No. Or they can, but if they did they would shrink the economy so much that the debt to GDP ratio of the government would rise hugely. This is because, as mentioned above, there is not enough other new money flowing through the economy.

In fact, austerity, if anything increases the government debt to GDP ratio as a) GDP does not rise as much as it could and b) private debt rises instead making financial crises more likely.

What is the effect of their attempts so far? Economic growth since 2008 has slowed hugely. As I discuss here, government policies to push the unemployed into low paying work has reduced the number unemployed, but the economy is not healthy. The graph below (taken from here) shows what has happened to productivity per hour worked in the UK. Historically this has grown by 2-3% per year, but since 2008 it has not grown at all. The low wage austerity economy has meant that increases in employment are in more menial rather than more productive labour. This is not to mention the human cost of austerity.

Also, by using lower interest rates instead of government debt to get the economy going, the government has pushed house prices up even further out of the reach of most of the population.

So the money to grow the economy must come from the government? YES.

The government must run larger deficits. As shown in my last post,by spending more money we get three beneficial impacts:

1. The economy grows much faster, meaning more and higher paid, better jobs. Productivity (which has stagnated in the UK's low wage austerity economy) will increase and the country will produce a lot more.
2. Interest rates will be able to rise, meaning private sector debt levels will fall. This makes economic crises far less likely.
3. Government debt to GDP actually will probably end up being lower - as although debt rises, GDP rises by just as much, and we don't get debt crises.  

But if the government spends too much money won't it go bankrupt? No. At least not in countries where the government has control of its own currency and borrows in that currency. In the UK, the Bank of England could print money to buy government bonds if there were ever the need. The Eurozone is a different story. For this reason, the Eurozone will suffer from permanently low growth (probably ending with a disastrous crisis).

But if we print money we'll end up like Zimbabwe won't we? No again. Inflation is created when money is spent. If we are going to have inflation it will be at the time the debt is taken out. If the central bank swaps newly printed money for government bonds at a later date, then all that happens is that people in the future will have their savings in cash rather than government bonds.

Doesn't the government borrowing more money now steal from our children? No. It does affect how future prosperity is distributed. But if you think about it, the way to give a prosperous future to our children is to invest in our productive capacity now so that the economy they inherit is blooming. The only way we steal from them is by penny pinching now and not investing. And of course destroying the environment, but I'll leave that lesson to Leonardo DiCaprio.

I understand it all now, thank you Ari. You're welcome, my imaginary friend.

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Why it is so important to use government deficits rather than negative rates to boost the economy (demonstrated with a lot of pretty pictures).

Many economists treat fiscal and monetary policy as equivalent, to be used interchangeably. This article by Martin Sandbu in the FT is an example, and he would have the support of a majority of academic economists in this view.

But it is wrong; they are not in any way interchangeable. The reason the majority of academic economists are wrong is that their models for the economy don't include debt. Because their models do not include debt, they are unable to explain why we are at zero interest rates (too much private sector debt), why we have secular stagnation (too much private sector debt), growing inequality (partly too much private sector debt), too high house prices (too much private sector debt) and I could go on, but I imagine you get the point.

To remedy this, I have created a very simple model, called a Demand Based Cash Flow Model (DBCF). It is much simpler than the DSGE models economists normally use. It has one major advantage, though, in that it does include debt.  It is based on simply looking at cash flows on the demand side of the economy, with an adjustment made to account for supply issues. And, in my opinion, it is a very powerful forecasting tool (relatively speaking, of course; the bar is set pretty low in economics).

Recently I was asked by Professor Robert Hockett at Cornell, if I could use the model to examine the spending plans of the US presidential candidate Bernie Sanders. In doing so, I programmed the model into a spreadsheet and found some very interesting results, which I will share below.

I will run three different scenarios for the US economy. In the first one, interest rates remain at the zero lower bound, and government deficits are kept at approximately the current level. The second will use monetary policy to stimulate growth. The third will use fiscal policy.

The spreadsheet is available on request if anyone wishes to see the assumptions made. In general these are taken from the DBCF model paper, which I recommend reading if you are interested in how these results were reached.

SCENARIO 1: NEUTRAL. The government runs a deficit of 4% of GDP, interest rates remain at zero.

In this scenario, we continue in the secular stagnation we have been in. Economic growth continues at around 1.8%:

 

Inflation recovers from the current lows, which are largely due to deflation in commodity prices. These declining prices cannot continue forever, however, and sticky wages mean that a low level of inflation can survive in very unfertile economic soils. Inflation does remain below the 2% target that the central banks have set themselves and growth can only be described as anaemic.

Average growth in this stagnant scenario is 1.8%. Central banks would be under pressure to try unconventional monetary policy.

SCENARIO 2: MONETARY POLICY. Same as Scenario 1, but cutting interest rates by 0.25% every year.

In this scenario, we imagine that interest rates can go as negative as required and that the effect is the same as reducing rates when above the zero bound. This is debatable, but not completely unreasonable. The lower interest rates work in three ways. First, they stimulate more private sector debt, which puts a flow of new money into the economy. Second, they increase asset prices, meaning more of a wealth effect and more savings that can be spent by people with assets. Third, they reduce the exchange rate for the currency which improves competitiveness. All of this is modelled in the spreadsheet.

This scenario, at first glance looks better (albeit at the end interest rates are approaching the negative 3% level):

Growth ticks along at around 2.5 %, declining slowly but not so much that anyone would notice.
And inflation?

That too is looking pretty good - exactly on target at 2%.

THE GREAT MODERATION! Rejoice all as the economy has officially been solved. If only we can keep reducing interest rates by a further 0.25% every year then we will have endless stable growth.

Of course, house prices have gone up even more and inequality is rising, but maybe those affected should just work harder. We have a great economy.

But not so fast...

This is the graph of private and government sector debt to GDP:

Private sector debt is back up to the levels of 2008. What if we have a crash?

Eventually if debt keeps building up, we must have a crash. Sorry, but this is true; debt can not grow forever, and, as we all know, what cannot go on forever must stop.

Let's put a crash in, in 2021:

OUCH!

Well, that needs some government spending to bail out the banks and keep the economy going. Let's put an extra 10% government deficit in 2021, 7% in 2022, 5% in 2023 and 2% in 2024 (this is on top of the neutral 4%).

We now get a growth chart that looks like this (actually similar to 2008):

With a debt to GDP chart that looks like this.

We have now had an average growth over the period of 1.7% and at the end are left with private sector debt to GDP of 230% and government debt to GDP of140%.

This is not pretty.

So… what if we had used fiscal policy?

Scenario 3: FISCAL POLICY. Run total average deficits of 7% per year for first 6 years and 6% thereafter. Raise interest rates by 0.5% per year

To clarify here, in order to get a good economic impact from running deficits, it is important that the money goes to people with a high marginal propensity to consume. Tax cuts to the very rich will create a deficit but not the demand required. Assuming from hereonin that the deficits are used to fund spending with a high multiplier (assumed to be 1 on NGDP)

In this scenario we get positively healthy growth:

 

Inflation is a little over target, but not damagingly so:

But importantly, look at the debt to GDP ratios:

Private sector debt to GDP is down from 195% at the beginning to just 121% now. Wages will be a higher share of GDP, meaning real wages will rise. House prices will be lower relative to GDP so those without assets will be able to own their own homes. Overall the economy will be healthier.

And despite all of the extra spending government debt to GDP has hardly moved; it started at 120% and finished at 120% of GDP. The reason for this is because debt is divided by GDP, and GDP has gone up far more than in the other scenarios.

The average real GDP return over the period is 3.5% as opposed to 1.7% in Scenario 2.
The total real GDP growth of the two strategies are shown in the below graph:

CONCLUSION

I hope this helps to demonstrate why austerity is such a dumb idea.

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Latest Version of my DBCF model paper, including derivation.

Download the full paper here:

The Relationship Between High Debt Levels and Economic Stagnation, Explained by a Simple Cash Flow Model of the Economy



For completeness, I have put the two parts of my paper together.

The first part described the model, simulated results, and also did a number of empirical studies of how debt impacts growth across the developed world, leading to a partial parameterisation of the model. It then used the model to show solutions to our current economic stagnation.

The second part was a more robust derivation of the model from first principles; this enables the model to be used in a practical setting to predict GDP growth.

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Negative Interest Rates vs Helicopter Money

Negative interest rates are the new QE in terms of central bank crazes and this is something that upsets me a lot. This is not because I care about savers losing their money. Unfortunately this is something that has to happen if the economy is to grow again.

It is partly because the policy makers don't realise that they have been stimulating the economy using private sector debt for years. Their rational agent models say that lower interest rates encourage people to spend more rather than save. They can quantify the difference with the Taylor rule. It all makes sense. But in reality, the way that lower interest rates increase growth is by increasing private sector debt.

The more debt, the lower the interest rate must be as there is only a certain amount of economic activity that can be diverted to bond holders and bankers. So eventually the interest rate goes down to zero. Instead of pausing here, and thinking maybe we need to change the model, they have come to the conclusion that what they need is to do more of the same.

They don't realise that their actions will create more private debt and mean that interest rates will need to be moved ever lower to stimulate the economy next time. The lowering the interest rate cycle is never ending. The imbalances of the economy (stagnant wages, high house prices etc) all get worse.

My distress is partly because it is an ideological decision. Given the choice of negative rates or helicopter money, from the point of view of the saver the effect is the same. One takes money directly, the other by inflation. Both encourage spending equally. So if the impact really is from rational savers bringing forward consumption, the two are equivalent.

But people often do not think about the fact that every central bank decision has distributional consequences. It takes money from some and gives to others. No decision is neutral.

If you look at the distributional impacts they are completely different from each other. Negative interest rates reduce the discount rate on asset prices and lead to their prices rising. The beneficiaries of negative interest rates are those with assets as the value of their holdings will go up. The bigger beneficiaries are thus the rich.

With helicopter money, given directly to people or spent by the government on investment or consumption, then the money goes to people who benefit from it more; the country as a whole. It is fair and it is targeted. With QE and lower interest rates it is unfair and scattergun.

And my distress is partly about the economic impact. Helicopter money directly boosts demand in a quantifiable and controllable way. It means that inflation targets can be hit. It means that investment gets made to increase future capacity.

QE and negative rates only boost demand very little through the wealth effect and by encouraging further private sector debt. They do nothing for future investment.

Both morally and economically helicopter money is the better option. Unfortunately the rich always win in these debates.

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Derivation of my DBCF model in a Stock-Flow Consistent Framework

After some very helpful comments from Jan Kregel at the Levy Institute, I have derived my DBCF model of the economy from first principles using a stock-flow consistent framework. This adds more rigour as well as giving more clarification of detail of implementation.

I feel that this model describes the real world far better than existing mainstream academic models for a number of reasons:

1) It makes no assumptions about behaviour, or rationality, of participants.

2) It can explain inflation and economic growth in a way that all loanable funds models used by mainstream macroeconomists are unable to.

3) It includes a balance sheet, the current bloatedness of which explains both economic stagnation and the zero interest rate environment.

4) It shows clear solutions to our current problems, by targeting money to increase demand.

5) It does not back up the neo-liberal consensus which has both failed economically and led to widening inequality, greater rewards for rent seekers and a diminishing share of returns for those doing the work in the economy.

The derivation of the model is here:

Deriving the DBCF model in a Stock-Flow Consistent Framework

And the full paper is here, with empirical data to support it:

The Relationship Between High Debt Levels and Economic Stagnation, Explained by a Simple Cash Flow Model of the Economy

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How high could a UK Universal Basic Income be?

Tom Streithorst, in Coppola Comment, discusses the rationale for a Universal Basic Income (UBI). He states that:

It may seem impractical, even utopian: but I am convinced the BIG [UBI]will be instituted within the next few decades because it solves modern capitalism’s most fundamental problem, lack of demand.

It is a view that that I have a lot of sympathy with. There is clearly not enough demand in the economy and this is one way of fixing this. Also, as Streithorst points out, and I discuss here, technology may be improving productivity, but it is up to us to make sure that this translates into improved quality of life for everyone rather than a bounty for the owners of technology and serfdom for the remainder. UBI is one way of distributing the wealth of society more evenly.

When a £72 a week basic income was included in the Green party election manifesto, at a cost of £280bn per year, Natalie Bennett, the Green party leader, was ridiculed for not having details of funding. However, I believe that it is possible and here I propose to work out an approximate level of basic income that would be feasible given that the government is trying to hit a nominal GDP target.

The basis of these calculations is the DBCF model I develop here. This model looks at demand and how targeting of cash flows can influence this demand and hence NGDP. The analysis from the paper is that the UK economy has a structural savings rate of around 3%. This is to say that for every £100 spent on GDP additive goods and services in year 1, only £97 is spent in year 2. The remainder of the demand is made up for  in government deficits and private sector debt.

We currently have a chronic shortage of demand and the UBI can fill this gap. For this reason, and because it has a high multiplier, it is valid expenditure. It can be funded either with a helicopter drop or with government debt; the important point is that a NGDP level is targeted and that it is done responsibly so there is no loss of confidence in the government.

I attach a spreadsheet here with the calculations so any assumptions made can be changed by the reader.

The assumptions are as follows (the reasons for these can largely be found in my paper here):

1. The structural savings rate in the economy is 3%.
2. NGDP growth target is 5%.
3. The multipliers of both UBI spending on NGDP and current government deficit spending on GDP are both 1.
4. Recipients will be all people 15 years and older.
5. Current government deficit is 4%.
6. All UBI is taxed at marginal rates of income tax.
7. The average marginal rate of income tax is 30%.
8. The UBI replaces 80% of current pension spending.
9. The UBI replaces 50% of current welfare spending.

Given all of these assumptions, a viable level for the Universal Basic Income is shown to be approximately:

£6,600

Note that this level is around the level of the basic state pension, so pensioners would not lose out. This could replace tax credits and also a fair amount of welfare spending (I have put 50% into the calculation above). 

Obviously it would be recommended that this is slowly built up to; the assumptions, especially around multipliers, may be incorrect. But it gives an approximate idea - and I think that this is important.

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Working Paper: The Relationship Between High Debt Levels and Economic Stagnation, Explained by a Simple Cash Flow Model of the Economy

UPDATE: Download latest, Feb 2016 version here. This version contains the derivation.



My working paper, in which I bring together the ideas from this blog in the past year, has now been finished. It is available here (this link may stop working - probably safest to use the above one):

The Relationship Between High Debt Levels and Economic Stagnation, Explained by a Simple Cash Flow Model of the Economy


Abstract:
Empirical data is presented suggesting that high private and, to a lesser extent, public debt levels place a strong drag upon economic growth. A simple, demand based, cash flow (DBCF) model of the economy is developed, separating out flows by marginal propensity to spend. This approach is both logically sound and empirically consistent with the data. It supports a prognosis for the economy and estimate of future NGDP growth. Importantly, it is a model that is flexible enough to incorporate high debt scenarios, and is able to explain the secular stagnation currently experienced by Western economies and Japan. A simulation is also provided to show the danger to stability of allowing private sector debt to fill lost demand. The conclusion is that the zero lower bound has been reached because there is too much private sector debt for the economy to sustain. Demand is perpetually too low because of structural excess saving. The proposed solution is to rebalance the economy using large, preferably monetised, government deficits.

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Why Shares are too Expensive. And, while we're at it, is the idea that shares always out-perform partly just a historical anomaly?

To start, a disclaimer... this is not a suggestion to trade, merely an observation on the economy and what it should mean for share prices. There is a reasonable chance that I am wrong; I invite you to look at the arguments and decide. And even were I correct that prices are too high, it does not mean that they will come down. In fact they can get a lot higher because, to paraphrase the great economist Hyman Minsky, whenever the market is too high, people are prone to get a little over-excited.

People have been arguing for a while now that shares are too expensive against their historical valuations. Various metrics are used to define this. For example, the CAPE Shiller ratio looks at the price of shares against 10 year trailing earnings. Historically US shares have traded at a median of 16 times earnings. In the past valuations have reverted to a multiple 16, but it is difficult to time this; in the dot com boom it reached almost 45. At the moment the multiple is roughly 25. This suggests that the market would need to drop by almost 40% in order to be fairly valued.

Nonsense, the bulls say. This model is irrelevant. Have you not seen what has happened to government bond yields? A thirty year US treasury now only pays you around 3% per year. The short term bonds pay almost zero. Stocks are cheap because there is nowhere else to get a good return. Central bank action will always support asset prices and they'll just keep printing more money. Even a mediocre return is better than nothing, and stock prices reflect this.

I believe that shares are substantially overpriced based on any normal return expectation. There is an idea that shares always perform well in the long term; this may be true in the very long term but a period of very high growth followed by a series of one-off changes have led to large rises in share values over the past 80 years and these are unrepeatable. I will discuss all this in the rest of the post.

First, the share valuation model. For those unfamiliar with corporate finance models, a share can be valued by taking the sum of all of its future dividends and discounting them to the present. This means that if you will expect to receive £100 in dividends next year, you will value it slightly less than if you had £100 now.

There are two components of this discount. The first is for the interest you could receive if you invested in a risk-free (in most cases) government bond. This means that you need to receive at least the rate of interest you could have got for no risk. The second component of this discount rate is called a 'risk premium'. It is the extra return that you need to receive for taking risk with your money. If one only receives the same as the government interest rate, why would anyone make risky investments? In the recent past the risk premium for U.S. stocks could be reasonably said to be around 4%. So people invest in stocks with the expectation of receiving the risk free interest rate plus a risk premium.

As I show here, in relation to the UK, the total amount of debt has skyrocketed over the past 45 years.  This means that the total gross wealth in financial assets (not including property) has gone up from around 4x GDP to around 13x GDP in the UK (these are approximations). Similar trends are observed internationally. There are therefore a lot more savings than there were before. A savings glut, in fact (which is the same as a debt glut but viewed from the other side). For this reason, I would argue that the risk premium should reasonably be a lot lower than it has been in the past - maybe 2%. This would mean that share prices should be a lot higher than they would be with a 4% risk premium. I am taking this into account and I say that, even despite this, equities are now too expensive.

From here on, I will be looking at the US stock market, specifically the S&P 500 index; the most traded share index in the world.

Since 1945 share prices have been in one long bull market. They have been going up almost relentlessly. This leads to the idea that shares always out-perform bonds or cash in the long term. As I say, this may be true, but in the time period we have seen a number of important changes that have led to one-off increases in share prices.

1. The reduction in government bond yields - 25 years ago a 30 year government bond paid 8%. Now it is closer to 3%. 
2. The reduction of risk premium required - in 1990 I calculate the implied risk premium using my dividend valuation model to have been around 2%. Now I calculate it to be 0%
3. Corporate profits as a share of GDP are at a high since 1945. In fact, the share has more than doubled since 1990. This would mean, all things being equal, a doubling in the fair value of shares.

These three effects would account for approximately a 20 fold increase in the value of shares since 1990. In fact the rise has been only around 6 fold.  As of 1990, the  S&P 500 was trading at around 350; at the time of writing (Aug 15) it is around the 2000 level.

Had these three one-time changes to risk preference and corporate rent-seeking ability not occurred then the stock market would actually have gone down considerably since 1990. 

Since 1990, owning the shares in the S&P 500 would not have been better than owning a portfolio of 30 year bonds. This is despite the doubling of corporate profit share to GDP and reduction in risk premium. This really highlights how poor equities’ performance has been since 1990 (relative to bonds) - and how the great fall in bond yields has managed to disguise this. Perhaps this has convinced investors that equities have a natural right to perform well in the long term.

The reason for this relative under-performance of the S&P 500 has been the performance of nominal GDP.

If the proportion of corporate profit to GDP remains the same, then corporate profit can only grow with nominal GDP. This is an extremely important point that many analysts appear to miss when making earnings growth projections.

Between 1945 and 1990 nominal GDP growth averaged around 8% per year. This means that total profits could be expected to grow by around 8% per year. In this period, there would be every reason to think that shares would keep increasing in value. However, between 1990 and today, GDP growth is closer to 4.6% PA. And in the current period of secular stagnation we may only be able to expect around 3.5%. In fact since 2008, we have averaged 2.7%.

Taken in conjunction, the change in the expected nominal GDP growth from 8% to 4.6%, along with points 1-3 above can account for the change in value of the S&P 500 since 1990.

Since 1-3 are one-off events, I would argue that there has actually been no evidence since 1990 that stocks are better than bonds in the long term, despite the apparent 6 fold increase in price.

So going forward, will shares outperform? I use the discounted dividend model above with the following parameters:

o Nominal GDP growth prediction of 3.5% per year
o Disruption rate set at 2%
o Dividend growth, g = Nominal GDP minus disruption
o Discount rate, r, of the US treasury 30 year yield (approx. 3%) plus 2% risk premium, giving r = 5%

By ‘disruption’ I mean that if one held a portfolio of all the stocks in the S&P 500, each year, 2% of profits will go to new companies that we did not already own shares in. In other words, if one bought the whole S&P 500 index today and held the shares for 30 years, one would only have shares in 55% of the S&P index at that future time. The index rebalances for new participants, but there is friction as it does so.  We assume that corporate profit share does not increase from this post-war high level, and that risk premiums and risk free rates do not decrease further from these all-time lows.

How realistic is this pricing model? Looking at the actual  performance of dividends against nominal GDP we can find the following. Given a) the increase in nominal GDP between 1990 and today and b) the share of corporate profit rising from 4.2% to 10.1% of GDP in the same time period, then we would expect dividends to rise by around 8.5% per year. In fact they rose by about 6.5% per year which accounts for the 2%  'disruption' discussed above. This means that a nominal GDP model for modelling dividend returns is not unreasonable empirically (as well as it being an economic identity).

So this pricing methodology has held well in the past. Now, it is dependent on the assumptions put in of course. All of these assumptions can be changed and all affect prices considerably. Maybe nominal GDP will be higher than 3.5%, maybe lower. Maybe corporate profit share will go up, maybe down. This is why evaluation of fair value is so difficult.

However, using what I consider to be the reasonable assumptions above, the only way that I can get that shares are fairly priced is by assuming almost a zero risk premium. This is absurd and can not continue indefinitely. 

With a risk premium of just 2%, I get that fair value is 40% lower than the current price. Or the S&P at around 1200. This actually broadly agrees with CAPE Shiller.

This is not to say that prices will definitely go down. They could just stay roughly where they are for many years before fair value catches up. But the market tends not to work like that and this is why I believe that, despite central bank intervention to support share prices, we will still see a large correction.

According to this model, calculated using a 2% risk premium, share prices have been overpriced since 1990 (with the exception of a short period in 2008-09).  The worst period was at the height of the 2000 dot com bubble where they were 300% overvalued. Stocks have kept going up despite this over-pricing, because of falling bond yields.  If bond yields stop falling then we may have reached the point where gravity takes its toll.  With so many central banks at the lower bound it is arguable that they cannot repeat their asset inflation success of the last 30 years.

My conclusion is that risk free bonds are a better investment than shares at this time in the long term. For those that worry about a large printing of money to stave off disaster, and the subsequent inflationary impacts, I would suggest that inflation linked bonds may be suitable, certainly on a risk-return basis. But as mentioned before, I am not giving investment advice and caution strongly against listening to me about anything.

I believe that low interest rates have driven shares to irrationally high levels and that ultimately they should either fall by a lot, or have a long time waiting for fundamental value to catch up with the current price. We will see if I am correct.

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A Union of Deflation and Unemployment

On Twitter recently, someone posted that anyone who doesn't understand the importance of the difference between a sovereign money supply and a non-sovereign money supply does not understand economics. I wholeheartedly agree with this. And the majority of comments I see on articles about the Greek situation confirms that most people don't understand economics.

I don't even know where to begin with criticisms of the idea of a shared currency without shared government. There are three main problems:

Problem 1: It is very easy to get into debt: 

A country in the Euro has no control of its monetary policy. Therefore when Greece had negative real interest rates during the boom time, there was nothing it could do to prevent people borrowing money. When added to a government also borrowing to appease special interests, this can be disastrous. But Spain had this problem even whilst running government budget surpluses. 

A country in the Euro has very little control over fiscal policy due to the rules determining how much governments can borrow and save. So even if a government wanted to combat loose monetary policy with correctly tight fiscal policy, it couldn't. There was literally nothing within the rules that Spain could have done to prevent the situation it is in now, with around 25% unemployment. 

The powers that be were very worried about government money creation as they did not want to debase the Euro. But they didn't bother worrying about private bank money creation. So when Ireland's banks built up huge books of loans, greatly increasing the money supply, nothing was done to stop them. Until it was too late. And the ECB forced Ireland's taxpayers to pay for it rather than the banks' bondholders. 

To add to this, one country in the Euro made it a policy to run huge trade surpluses by reducing worker incomes to subsidise exporters. As this was the largest economy in the Eurozone, these had a large impact on the rest of the countries in the union, notably the less competitive ones. The excess savings flowed into the poorer countries and, as Michael Pettis wonderfully explains, there was little they could do other than take on debt. 

So overall, it was pretty easy to get into debt.

Problem 2: Once in debt is impossible to get out of debt: 

There are three main ways a government has historically gotten out of debt. The first is economic growth; a growing economy means that debt to GDP ratios go down as GDP rises. The second is inflation; if a government's debt gets too large it can always resort to the printing press to help it out. The third is outright default.

Debt, when taken, is not allowed to be defaulted upon as this is against the EU rules. A limited one was allowed for Greece but this was when the holders were largely Greek banks and pension funds that the government had to recapitalise anyway so it didn't help much. Recently it has been made very clear that Greece will not be allowed to default on its government debt; although this may be relaxed a little on Sunday, they have had to go through a Great Depression magnitude loss of output to reach this and it will probably be not a large reduction.

Inflation is also verbotten. Inflation in Weimar Germany is cited as the reason why Germans are so anti-inflation. Whilst that episode was horrible for people with money; it was more the collapse of the economy caused by payment of reparations that caused the damage than the inflation. In fact, the wiping out of all internal debt helped Germany recover more quickly afterwards. It seems to have been forgotten that it was the depression caused by the deflation (due to the attempt to keep to the gold standard) in the early 1930s that actually brought Hitler to power. The important lesson from the inter-war period about money supply was that deflation is bad, but people seem to remember only that inflation was bad.

In any case, for whatever reason, the German government has shown by its actions that it would watch the Eurozone starve before abandoning a low inflation target. The inflation route has therefore been eliminated.

Then there is the growth route. Unfortunately that is out of the question too. 

Problem 3: After both of these are realised, economic growth becomes very difficult:

As I discuss here in order to have economic growth, the economy needs fresh sources of money. Since 1945, typically in the West this has been provided by credit growth, both by the government sector and the private sector. Another method could be printing new money.

As I also discuss in the above post, private sector debt is extremely inefficient in that for every 100 EUR of private sector debt taken out, only 13 EUR gets added to the demand in the economy. 

Governments, chastened by the experience of Greece and knowing that they are effectively borrowing in a foreign currency, can not borrow much more. A sovereign nation would have no problem issuing 150 or 200% debt to GDP. The central bank would support them and they would know that real interest rates could not get too high. Not so a borrower of a foreign currency. As soon as there is a fear that debts can not be paid, the interest rates can skyrocket and the economy can be destroyed. Greece only had around 100% government debt to GDP in 2007 but the internal devaluation and higher interest rates made it unpayable.

So no sane government will now borrow much money. In any case, they are bound to the (what would in a sovereign currency be a ridiculously low) upper limit of 3% of GDP. Greece is bound to run a primary surplus - they are taking money out of the economy every year.

The private sector is already over-leveraged. Even in the UK and US it is difficult to encourage much borrowing, despite interest rates being at the zero lower bound. The situation is accentuated in Europe because deflation will increase the values of the loans each year and real interest rates, especially in the periphery, are very high. So the private sector will not borrow.

There is therefore very little new money added to the economy from credit and the result is low growth. 

The necessity of running a current account surplus

There is one other source of new money each year, and this is the only one available to Greece now. It is foreign trade. Countries must run a trade surplus if they are to get any growth. 

This, in fact, seems to be the German idea of a perfectly functioning Euro. One where everyone runs a trade surplus. It is certainly the only Euro that is viable without debt disasters.

This comes with a couple of catches.

The first catch is that the only way to do this, since tariffs are not possible, is by reducing internal demand. This means effective internal devaluation and reduction of wages. This is a very slow and extraordinarily painful process if done in a world of low inflation. As I show here, the stickiness of prices means that as demand is reduced, prices and wages are very slow to react. Unemployment comes first and takes most of the impact. If average Eurozone inflation is 0.5% then a 2% adjustment per year means 1.5% deflation is required. The effect on the economy of this is huge. 

The second is that Germany already has a huge trade surplus (a structural change enacted during the boom times when it was much easier) and shows no signs of giving up on it. This means that the Euro is already too high for the rest of the Eurozone and the German exports are cheap relative to the rest of the Eurozone. Therefore the level of internal devaluation required is even higher than would be required anyway.

The third catch is that the rest of the world will have to be happy running a deficit to cope with the huge surpluses of the whole Eurozone. As it is a parasitic policy, bringing debt in the countries it sucks demand out of, they may object to this and retaliate. 

The downward spiral

The fourth, and quite important, catch here is that the more that each country does this, the more that the other countries in the Eurozone (and indeed the rest of the world) will react by doing the same. As one country reduces domestic demand so that they buy fewer imports, another country must have fewer exports. That country then needs to reduce internal demand to reduce its imports. This then affects the first country that then needs to further reduce internal demand.

This leads to a spiral of internal devaluations and unemployment that could last for many years.

The Conclusion

I think I show three things here:

1. The only policy a country can follow if it wants to avoid debt crisis is to run a current account surplus.
2. This leads to a policy of internal devaluation and deflation.
3. This creates a positive feedback mechanism which leads to a spiral of deflation and unemployment.

This is true certainly as long as Germany insists on low inflation and trade surpluses but possibly anyway, just by the nature of the riskiness of sovereign borrowing.

I would like to hereby offer my humble advice to the leaders in Europe; now is the time to give up on this unworkable idea before it becomes even more of a disaster.

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