By Simon Grey, on May 1st, 2012
Levels of copper, cadmium, lead and other metals in Southern California’s coastal waters have plummeted over the past four decades, according to new research from USC.
Samples taken off the coast reveal that the waters have seen a 100-fold decrease in lead and a 400-fold decrease in copper and cadmium. Concentrations of metals in the surface waters off Los Angeles are now comparable to levels found in surface waters along a remote stretch of Mexico’s Baja Peninsula.
Sergio Sañudo-Wilhelmy, who led the research team, attributed the cleaner water to sewage treatment regulations that were part of the Clean Water Act of 1972 and to the phase-out of leaded gasoline in the 1970s and 1980s.
Three questions that spring readily to mind are: 1) is this correlation or causation? 2) Are there free market alternatives that could have attained similar results? 3) Does this prove, carte blanche, that all government regulation of the environment is similarly beneficial?
Regarding the first question, it’s difficult to answer clearly from the synopsis of the paper. The lead regulations seem like they would generally contribute to decreases in lead content in the ocean, for lead particles would be in the water vapor that is a by-product of burning automotive fuel. This lead would then enter the oceans from the atmosphere. It’s not so clear with the other metals, so it might be possible that these levels had begun to decline prior to the introduction of regulation (much like how automobile fatalities had begun to decline prior to seatbelt laws). At any rate, it seems likely, though it is not conclusive from the summary, that the environmental regulation worked.
Regarding the second question, it’s difficult to say that government interference is necessary when it would be possible to establish property rights on the coastal waters that were polluted. Under a system of private property rights, owners of said property—in this case the ocean—would be able sue those who polluted (i.e. altered and damaged) their property. As such, it would fallacious to use this study as proof that the government regulation is necessary for environmental protection. Governmental regulation may be efficacious, but that is not the same as saying that it is necessary.
Regarding the third question, it seems obvious that many environmental regulations are misguided, to say the least, and often counterproductive. As such, it does not necessarily follow that one effective, or even necessary, set of environmental regulation proves that all sets of environmental regulations will be similarly effective and necessary. Stated another way, it dangerous to extrapolate a trend from a single data point.
The conclusion to be drawn from this study is that there appears to be one instance where governmental regulation yielded positive results. Of course, this regulation was necessary because of a prior failure (i.e. the non-allowance and/or enforcement of property rights), but nonetheless the government did something useful. However, trying to prove that governmental regulation is universally necessary and effective from this single data point seems rather ludicrous, particularly in light of government’s other failures.
By Simon Grey, on April 30th, 2012
Businesses aren’t investing in the United States because of a lack of consumer demand, International Paper CEO John Faraci said Friday.
“I think this was all about consumer spending and demand. You know, the problem we have is there’s inadequate demand to create jobs. We know how to respond when there is demand,” he said on CNBC’s “The Kudlow Report.”
The U.S. Commerce Department estimated that gross domestic product expanded at a 2.2 percent annual rate in the first quarter, falling short of analysts’ expectations it would grow 2.5 percent and slowing down from the fourth quarter’s 3-percent rate.
The more correct way of saying this is that there is a lack of consumer demand for products at profitable prices. There is plenty of demand for cheap goods (for example, imagine what would happen to iPad sales if the price dropped to $150 each). The problem is that cheap goods often have very thin profit margins.
Also overlooked in this admittedly shallow Keynesian market analysis is that purchasing power has declined. It’s not that demand has disappeared or necessarily reduced (who doesn’t want stuff?); it’s that people don’t have the ability to act on their demand. Put plainly, people don’t have money, regardless of whether we’re talking cash or credit.
Thus, saying that demand has declined is a rather shallow way of addressing the problem and thus begs a shallow solution (quantitative easing, e.g.). The deeper issue is that people’s real income has declined, alongside their ability or willingness to use credit to purchase things. Therefore, the proper solution is not a short-term stimulation of demand, but rather an attempt to fix the structural flaws that have caused a decline in real income. The causes for such a decline are various: free labor, inflation, free trade, and so on. Fixing these things won’t be easy—in fact, they’ll be quite painful in the short-term—but they will lead to a long-term fix. Unlike a stimulus.
By Ajay Shah, on April 25th, 2012
Many elements of infrastructure have natural monopoly characteristics. Under these conditions, if the owner of the infrastructure is profit-maximising, he is likely to impose high user charges and extract a monopoly rent. As a consequence, in many infrastructure services in most countries, independent regulators are established which control the user charge.
The critical building block that goes into this is assessing the `fair’ rate of return on equity capital. By and large, infrastructure projects have low betas; whether business cycle conditions are good or bad, they tend to generate stable cashflows. By this logic, the rate of return obtained by the developer should be relatively low.
India requires a trillion dollars of infrastructure investment in coming years. For this to come about properly, sound thinking on the appropriate rate of return is required. If this rate of return is set too low, then the required investments will not be forthcoming. If the rate of return is set too high, then developers will earn monopoly rents, and the economy will be hobbled with expensive infrastructure.
The regulated industry has strong incentive to lobby with the regulatory agency. Almost nobody else in the country has detailed technical knowledge about the activities within the regulated industry. This field is thus fraught with problems of governance, the capabilities of regulatory agencies, etc. High quality public discussion, and criticism of the activities of regulatory agencies, is thus critical to ensuring that the outcomes are sensible. Our puzzle in India is that of getting to an ecosystem comprised of well drafted laws that create independent regulators, high quality staff in regulators, high quality independent experts outside government, well educated journalists, freedom of press, etc.
In this setting, an important order has been released by the Airports Economic Regulatory Agency (AERA): tariff setting for the Delhi airport. This will be of great interest to people interested in the fields of infrastructure financing and corporate finance in India. In my knowledge, this is the first episode in the field of Indian infrastructure where high quality corporate finance knowledge has gone into tariff setting. The arguments and methods here will be relevant for other airports, and for other areas of infrastructure.
By Simon Grey, on April 23rd, 2012
In a prior post, I offered an alternative explanation for socialism’s failure. In doing so, I critiqued economists that defend the free market on the grounds of monetary incentive structure of being too narrow in their thinking. While monetary incentives play a role in human behavior, they are not the only motivator, and are often not the primary motivator.
Unfortunately, many economists ignore this simple truth in their analysis of various market-related issues. I suspect the main reason for this has to do with the very simple fact that many economists have a sort of penis envy towards physicists, by which I mean that economists seem to love complex mathematical models. Price points are extremely useful to these models, as they lend the models an air of objectivity and, in some cases, finality. While some of the more sophisticated economists know that they can assign value functions to non-monetary indices, the assignments of value often feel arbitrary, thus undermining the air of objectivity that economists are so desirous of, perhaps in their quest to gain some sort of influential power over policy-makers, which is thus ultimately a form of status-seeking.
This mechanistic approach to economic analysis is quite autistic in that it generally fails to account for value that humans place on things that cannot be quantified monetarily, like emotions. Indeed, the economics profession is filled with sundry examples of autistic jackassery that is fundamentally predicated on economists being, for whatever reason, completely unable to understand what motivates human behavior. To their surprise, humans are motivated by things other than money. The economists call these motivations irrational.
The most egregiously autistic economists are those that defend free trade and free labor, which usually requires the denial of the social constructs broadly known as culture and society. This in turn undermines the concept of the sovereignty of nations and states. Whether this is a good thing is debate best reserved for another post. For now, the relevant consideration is that not everyone thinks that free trade and free labor are good ideas because some people drive some value from what they perceive to be patriotism. To put it another way, there are a decent number of people who find the feelings they get from identifying with a collective entity (say, the US) or supporting a concept (say, Americanism) to be worth the cost of excluding foreigners. Because this imposes some quantifiable monetary costs without providing quantifiable benefits, those who oppose free trade and free labor are derided as ignorant, xenophobic, and/or simply stupid.
This autism extends to even the presumably least autistic branch of economics: behavioral economics. Here, people are defined and accepted as being irrational. As such, it is the policy makers who need to get on board with man’s irrationality and adjust accordingly.
But even this view, where human idiosyncrasies are tolerated and occasionally celebrated, is essentially predicated on the notion that value is only measured monetarily. For example, leading behavioral economist Dan Ariely tried to prove irrationality in his book Predictably Irrational. The irrefutable experiment undertaken by Ariely consisted of offering people chocolate for purchase. There were two options: one with a simple, sticky price (two pieces for five cents, if memory serves me correctly) and one with a more complex price (a differently-weighted piece for three or four cents, assuming my memory serves me correctly). The utility maximizing option was the latter one, yet the vast majority of people chose the former. From this Ariely concludes that people are irrational. He does not ever think to consider whether such a trivial decision merits any significant consideration as regards to utility maximization. Stated another way, when the stakes are so low, there is little point in weighing your options.
Like the mainstream economists, Ariely and other behavioral economists fail to account for non-monetary value, which in the aforementioned case would be the value of time. Is it really rational to use much mental energy for such a negligible decision? If not, how can it be considered irrational to not use one’s time to maximize a miniscule amount of utility?
Beyond this, economists seem to be unable to recognize the motivating forces behind common interactions, like gift-giving. Economists soullessly deride people for giving non-cash gifts, declaring such interactions to be “inefficient.” The theory is that if people valued the gifts they received at par with or in excess of market price, they would have bought the gifts themselves. That the recipients of a certain gift did not buy the gift for themselves is proof positive that they did not value the gifts at price, and therefore the giver is wasting money because the value the recipient places on the gift is not equal to or greater than the price of the gift. This analysis fails because it fails to account for the value of the gift exchange itself. Both the giver and the recipient place value on the interaction itself, and simply that which is being exchanged. The giver enjoys an emotional response to pleasure exhibited by the recipient and vice versa. Furthermore, the broader signal that the giver cares for the recipient presumably has long-term non-monetary value. Unfortunately, economists’ autism prevents them from seeing the emotional and social value of a gift exchange, thus leading them to deride a longstanding tradition.
This autism is occasionally, and quite perversely, worn as a badge of honor. Some economists often seem to view themselves as somewhat superior for having overcome some of their petty irrationalities. But doing this can be dehumanizing, since it is our so-called irrationality that makes each of us unique, and provides some meaning in our lives. Who cares if we’re more likely to buy chips when their cost is 2 for $5 than when they’re $2.50 a bag? This heuristic may not be totally rational from a pricing standpoint, but it is an efficient way of dealing with a trivial decision, which means less time is wasted thinking about trivial things and is instead spent enjoying life. Should people be begrudged for that?
Now, none of this is to suggest that the study of economics is worthless and unworthy of support. On the contrary, economics is an important subject, and most analysis is useful and worthy of study. However, economics does have some blind spots, mostly due to its current autism. Understanding economics’ autism is helpful, then, because it enables one to see the limits of economic analysis and adjust one’s interpretation accordingly. Thus, economics need not be scrapped; rather, people should be aware of its limits imposed by the autistic tendencies of its practitioners.
By Ajay Shah, on April 23rd, 2012
Many people like to envision worlds where the State will tax the rich and help “the needy” – this ranges from free health care to unemployment insurance to disability insurance, etc.
There are many problems with these schemes. One of them is the fact that people respond to incentives. We are not bricks, we are not stones, but men, and being men, we will optimise. When unemployment insurance is offered, people will try less hard to find a job, to acquire skills that will get them a job, to migrate to a place where jobs are more easily found, etc. When health care is free, people are more inclined to be fat or smoke or otherwise take less care of themselves. And so on.
Among economists, it’s considered obvious that people drive in a more rash manner when wearing a seat belt, but in the wider discourse, this raises hackles. When researchers found that drivers pass closer when overtaking cyclists wearing helmets as compared with overtaking bare-headed cyclists, economists were among the few who were not surprised. Laypersons generally recoil from the idea that the presence of a government giving out free open heart surgery increases obesity.
The first element of the behavioural change is lying and misrepresentation by citizens. When a government says it will give out disability insurance, people have an incentive to go to a civil servant and claim that they are disabled. I remember hearing a story from Holland, when a certain set of rules were constructed to give an early pension to the disabled, and policy makers had estimated that 1% of workers would be eligible for those benefits. In a few years, 10% of workers tried to claim these benefits, and front-line civil servants were placed in the difficult situation of having to identify the few genuinely disabled within the large pool that was claiming to be disabled.
The second layer is genuine changes in behaviour. Ljungqvist/Sargent have emphasised the damage caused by European-style welfare programs, which encourage or support withdrawal from the labour market. Some of these problems are now coming about with NREG. Migration out of villages is central to India’s future, but NREG is reducing the incentives of people to engage with the urban labour market and ultimately to leave.
I just came across an example of behaviour distorted by incentives that veers on the fantastical: An unemployed Austrian man sawed his foot off, to avoid being found fit enough to go back to work. We find it incredible that Aron Lee Ralson cut off his right arm (to avoid certain death). But sawing your foot off to avoid going back to work?
This is a colourful story and only an anecdote. The man is most likely a nutcase. It is nobody’s case that such extreme responses will come about on a large scale. The claim of the microeconomics literature is more limited: that on average, fairly significant behavioural changes come about in response to changes in the rules of the game. Through this, welfare programs have unintentional consequences that go far beyond those visible at the surface.
Politicians and bureaucrats in India like to roll out out more welfare programs. It would be useful to bring alternative perspectives on these questions, which are mainstream worldwide but are considered cutting edge in India: about the limited governance capacity of the State, about the fiscal crisis that the State faces, and about the behavioural changes induced by welfare programs. In this field, you may like to see a paper by Vijay Kelkar and me.
By Simon Grey, on April 19th, 2012
We do not just have governments in order to rob Peter to pay Paul. We have governments because there are things they can provide that the private sector is either unable or unwilling to provide effectively – courts, police, schools, roads, other infrastructure, etc. Conservatives focus so much on redistribution that they tend to ignore this fact, but if you think about it, you’ll realize public goods are why we have government in the first place. [Emphasis added.]
I will cede that the court system is best administered by the government, given its coercive touch. However, the idea that there is no way the free market can provide policing, education, roads, and other infrastructure is simply foolish.
Regarding policing, consider that private investigators and voluntary constabularies have both played major roles in law enforcement for a decent portion of American history (with the former still in existence). Of course, there is not likely to be any free market policing of victimless crimes, like speeding and drug use, but I don’t see this as a down side, seeing as how the negative externalities of these laws as the relate to property rights are already handled by the law.
Regarding education, it is laughable to claim that the free market can’t provide schooling in light of the present existence of private schools, private universities and colleges, and home schooling. While a free market model would increase the probability that people would have to pay directly for education instead of soaking other people for the costs via taxation, this will encourage more efficiency and lower costs in the long run (and, let’s be honest, the current results of the modern public school system are simply abysmal), and will likely end the public-school-as-free-daycare model of education that currently plagues society today.
Regarding private roads, I will simply note that privatized highways currently exist, and that there have been many cases of privately funded roads. In fact, the modern road system was initially built on private financing from businesses. Furthermore, it is quite conceivable that the free market can provide lots of infrastructure. Sure, it might be more expensive, given the market tendencies of those entities known as natural monopolies, but this will likely help conserve resources and distribute them more equitably over time.
What’s also ignored in this “analysis” is the crowding effect that the government plays in competition for these services. For example, the government providing education at no cost to it recipients (or, more accurately, their parents) makes it considerably more difficult for other companies to compete since they cannot coerce people to buy their product. Really, once one accounts for the competition-distortive effects of government, it should become readily apparent that the claim that the market is unwilling to provide certain things, and thus the government must is simply wrong. Whether this claim is made in ignorance, malice, or plain stupidity is for the reader to decide.
By Christopher Briem, on April 17th, 2012
Harvard and Manhattan Institute scholar Ed Glaeser is going to be in town today speaking at Pitt. Professor Glaeser is one of a very few wont to quote the late Ben Chinitz who was at chairman of the Economics Department here in the 1970s I believe. Chinitz along with Edgar Hoover were pretty much the folks behind the 4 volume Economic Study of the Pittsburgh region that was completed in the early 1960’s and remains a personal Rosetta Stone for much of my work.
Glaeser’s latest book The Triumph of the City has been in the news. On the book the Trib quoted him in an article last year.. the whole story is worth reading, but note this one quote:
“(T)he reason why … I would argue that Pittsburgh is successful is that it has smart people. … (A) third of Pittsburgh residents above the age of 25 have a bachelor’s degree, as opposed to 27.5 percent for the U.S. average — that’s very different than Detroit. Detroit’s at 11 percent. … That’s absolutely crucial to Pittsburgh’s success.”
Sort of connects everything in the news of late doesn’t it? If anything Professor Glaeser understates the emergent Pittsburgh exceptionalism (as contrasts to past Pittsburgh exceptionalisms). Note again that when you benchmark educational attainment for the entire population 25 and over you kind of are missing the Pittsburgh story. As we all know we have a skewed older demographic and the older generations did not go to school as much as younger generations do today. So when you look at specific age cohorts, and specifically younger working age cohorts the educational attainment of Pittsburgh jumps off the chart. Then consider that younger college educated workers are the most mobile parts of the population you will see why migration has turned positive of late for Pittsburgh more than for any other reason. It really does all tie together as much as many try to deny it.
By Simon Grey, on April 17th, 2012
In the first place, it is helpful to define collectivism and failure. Collectivism refers to any and all economic and political systems where goods and services are publicly owned and operated; it is also popularly known as communism and socialism, among other terms. Failure is defined as failing to satiate the maximum number of persons’ desires as feasible, or, more generally, failing to supply persons with their basic needs (healthy food, clothing in good repair, shelter from the elements).
There are many theories as to why collectivism fails, most of them having to do with incentive structures. This view is not necessarily wrong, but it is very limited, and does not account for the range of human emotions and motivations. Monetary incentives do impact human behavior; this is not in dispute. However, it is foolish to assert that human behavior is always and ever motivated by monetary incentives—as some economists seem wont to do—or that it is always a primary motivation. As such, it is helpful to look at the failure of collectivism more broadly.
One thing that is interesting about those who are more inclined toward the collectivist persuasion (henceforth called leftists) is that they are generally observed to be hypocrites, in the sense that they often demand collective action for something—say, welfare to help the poor—but do not themselves make any individual effort towards that end. More commonly, those of the leftist persuasion believe that their personal contribution to relieving the plight of the less-fortunate—however defined—is “raising awareness.” Thus, leftists often talk about helping the poor, in the name of raising awareness, but never themselves get around to actually helping the poor.
Ultimately, this is nothing more than status-mongering. Instead of actually doing something, the collectivists live in a world of ideals, wherein it is better (read: higher-status) to signal one’s affiliation to an ideal than to actually live by it. It is therefore better to preach selfless sacrifice in the name of helping others than to teach profit motive. While profit motive, as Adam Smith observed, can be a significant motivator, it is, in the eyes of leftists, a morally inferior motivator. Thus, one must call for selfless concern, and raise awareness for said type of concern. But one need not concern oneself with getting one’s hands dirty.
Thus, one potential explanation for the failures of collectivism is that a collectivist society places more emphasis on signaling group affiliation than actually getting things done. This stands in contrast to an individualist-oriented society, which by definition avoids group affiliation. The individualist society, then, has only personal accomplishment as a status signal, which strongly encourages productivity because the only way one has status is to create it for oneself. Collectivists, though, always try to appropriate others’ status for themselves. In essence, the collective identity enables some individual to credit for something even though said individuals have not actually done anything that can be meaningfully described as productive.
The collective political economy, then, is one based on higher-order status signaling, and not more direct (and productive) lower-order status signaling. As such, it is more likely to fail because most participants are too busy chasing status to make things. Basically, it’s better to signal status and identity than do actually do something.
By Claus Vistesen, on April 16th, 2012
The debate is on! Are we in a liquidity trap and if so what should we do? Why is the financial system depleted of collateral and what does this mean? Should policy makers and central banks be even more “irresponsible” [1] and conduct more monetized deficit spending? What does a lack of triple A rated/safe haven securities mean and is it real?
All these questions and more have recently gotten a fascinating treatment in the economics debate courtesy, mainly, of this piece by Credit Suisse. FT Alphaville has been given the question extensive and brilliant coverage and now even the IMF has pitched in. I think the issues raised are not only important but likely to form the framework of at least the next decade’s worth of research on macroeconomics, monetary policy and financial market.
So yes my dear reader. This is no time to shy back. Dig in, and dig in hard! In this first post of a series of 3-5 posts, I try to present the building blocks of the argument as I see them an answer the question of why the traditional view on the liquidity trap does not apply in the current situation.
Let me begin with the following key premises for my argument and the state of the global economy and financial system post 2008/09. I will try to develop each of these statements in the posts that follows.
- The crisis of 2008/09 has ushered in what is likely to be a period of severe stress in global sovereign fixed income markets. Sovereign debt distress and defaults are messy and costly affairs and take a long time to deal with. We have now entered a period where the next 10-20 years will see several developed economies default on their sovereign debt. Ageing populations, too low growth and insufficient future income/consumption to push forward mean that the OECD is now at an inflection point. For global financial markets this means that an unprecedented and systemic share of the global fixed income market is likely to be in distress at any given point in time over the next 10-20 years.
- There is an acute shortage of liquid triple A rated government securities. This shortage is structural and capital deepening in emerging economies is too slow and insufficient in size to take up the slack. Pension funds, insurance companies and big real money managagers are now essentially unable to construct their portfolios in such a way to match their future liabilities with a satisfactory (or perhaps even promised) yield. In addition, this leads to mispricings in remaining assets considered the last safe havens. US government bonds, UK Gilts, German Bunds, Danish Mortgage Backed Securities etc.
- Central banks are now acting as international clearing houses for the banking system. This is mainly seen in Europe where the ECB has been forced into taking up slack for an interbank market which has essentially been broken. Lowering of collateral standards, ever higher portions of liquidity and extension of maturities of its open market operations are all signs that the ECB is now effectively not only acting as the lender of last resort, it is de-facto the vehicle through which European banks can access liquidity across all maturities. However, whether the central banks buys government bonds outright or funnels demand through the banking system amounts to the same thing.
- The demand for credit is as much a problem as is the supply. Sifting through the references below, you will find that at least one solution to the problem is that governments must issue even more impaired debt instruments which essentially become assets backed by liabilities created by the central bank. We must understand however that the core of the problem is that there is now a structural lack of solvent sovereign and private credit demand. The argument goes that the higher demand for safe haven triple A rated assets must be met with supply by sovereign debt issuers, but the ability of governments to issue such securities is structurally impaired.
- Central bank monetization of government liabilities either outright or through open market operations providing liquidity to banks are not costless, even in a liquidity trap. Macroeconomic theory is currently informed by the notion that creating unlimited amount of excess bank reserves in the presence of a liquidity trap (zero velocity environment) has no malicious inflationary side effects. I think the evidence from more than three years of monetary experiment among the major central banks forces us to re-visit this conclusion.
The Liquidity Trap Revisited
In order to start somewhere, I will begin with Izabella’s exposé on this paper by Paul McCulley and Zoltan Pozsar. The main points from Monsieurs McCulley and Pozsar’s paper, with some slicing and dicing of quotes, are as follows.
At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.
(…)
… the operational mandate of a central bank operating in a liquidity trap environment should be changed materially.Rather than “policing the government to keep it from borrowing too much” the central bank should help it “to borrow and invest by targeting to keep long-term interest rates low by monetizing debt, with the aim of killing the fat tail risks of deflation and depression. ”The interests of the fiscal authority and the monetary authority rightfully become entwined. What’s more, the loss of the central bank’s independence should not be seen as a concern.
(…)
Critics invoke the orthodoxy that printing money is inflationary. But in a liquidity trap it is not. Money is as money does, and judging from the trillions in excess reserves on banks’ balance sheets, money isn’t doing anything. Printed money is unlikely to become inflationary until after the private sector has finished deleveraging and is bidding for funds again.
Generally, I find it difficult to see what new McCulley and Pozsar brings to the table here. This is liquidity trap and deleveraging economics 1.0, but I feel that we need a version 2.0 to understand what is really going on. The liquidity trap argument of old rightly emphasize that government should weigh against a necessary private deleveraging by running large and perhaps even, on the face of it, irresponsible deficits. This line of argument was, in part, inspired by the Japanese experience and the widely held perception that the BOJ was too timid in the initial phases of the Japanese bust.
I largely agree with this line of argumentation, but if the sovereign is an intrinsic part of the problem the argument breaks down. The problem today consequently runs a step deeper than the original liquidity trap argument.
While the initial symptoms of the financial crisis were rightly identified as too much private debt and reckless credit expansion in a key sector (housing and construction) the subsequent crisis in the euro zone has exposed two additional and critical aspects of the crisis.
Firstly, we have seen how governments will ultimately end up assuming private liabilities onto their balance sheet. Secondly, issues of fiscal sustainability in the OECD have been known for ages, but now time has run out. In my opinion, the crisis has provided a catalyst for the unravelling of the obvious mismatch between governments’ pension and health care promises to their populations and the inability to meet such promises due to ageing population and low growth environments.
If you accept my premise that sovereign debt sustainability is now a systemic part of global financial markets, you will also see that they role they are supposed to fulfill according to the original views on the liquidity trap becomes very difficult. I
Arguing that sovereigns should ramp up the supply of government debt and that central banks should add to the demand for such debt by creating money represents a misinterpretation of the problem. While it may surely mask the underlying issues for a while it cannot hide the fact that we are now at a crucial inflection point in the developed world. OECD governments’ business model is broken due to population ageing and future liabilities which they will not be able to pay off.
The financial system’s ability to create highly liquid and safe fixed income securities depends on current and future income to service such liabilities and traditional suppliers of such safe assets are simply out of time. Asking governments to act as counterweights against private deleveraging by creating even larger quantities of unserviceable debt cannot work. We see this most forcefully in Europe where sovereigns are being brutally cut out of the market, but there is, in principal, not much difference across the entire OECD spectrum.
It is my view then that for such highly liquid and risk free securities to survive and be continuingly issued, in the current environment, central banks must become permanent supporters of their issuance. We may certainly come to the conclusion that this is a warranted use of central banks’ power, but we should be under no illusion that their involvement on this will be, on any plausible definition, temporary. I think this part of the equation has been given far too little credence in the debate so far.
Once you accept this part of the argument, we are ready to move on to the issue of what such substantial central bank involvement in our economy means and and also why the collateral crunch is likely to continue and what it means.
Stay tuned …
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[1] – My readers who are well versed in the research on deleveraging, liquidity traps etc will understand the reference here. In the original literature and thinking about zero nominal interest rate bounds and liquidity traps, the central bank’s ability to act irresponsibly is seen as a key prerequisite for turning the corner on debt deflation.
By Simon Grey, on April 12th, 2012
What if borrowing money made you so much richer over the long-term that it paid for itself? It’s not crazy. Millions of families make such a decision every year when they take on debt to pay for school. Indeed, investing in yourself is a bet that often pays off. But can the same be true for an entire country?
Brad DeLong and Larry Summers say yes. In a provocative new paper, they argue that when the economy is depressed like today, government spending can be a free lunch. It can pay for itself.
Except here’s the thing: families don’t borrow from themselves; they borrow from other holders of capital. The government, on the other hand, basically borrows from itself. Now, economists like to get technical and explain that the Fed is not the same as the treasury. It’s also true that the department of the interior is not the same as the department of defense, but no one would suggest that the former loaning to the latter would constitute anything other than the government loaning money to itself.
Now, to answer the question at hand: yes, investing in the country over the long term should pay off. But let’s not kid ourselves. When the government borrows from itself, and particularly when the method for doing so is having the central bank purchase bonds from another department, all that happens is inflation. Inflation and investment are two different things. The latter, for example, is productive while the other is destructive. And it takes a significant amount of ignorance, deceit, or stupidity to call inflation a form of investment.
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