Thursday 25 February 2016

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:


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:


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

Tuesday 23 February 2016

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.

Saturday 13 February 2016

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.

Monday 8 February 2016

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