Episode 3 - To QE or not to QE

Recorded 5 September 2015


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In this episode we get stuck into a topical subject: the proposal for People's Quantitative Easing (PQE) that has been suggested by the UK Labour leadership contender Jeremy Corbyn.

Background

• Money is routinely created by central and private banks.
• What is helicopter money and why you'd use it?
• Quantitative Easing (QE) is when central bank created money is used to buy bonds, i.e. existing gov debt.
• All economists agree that investment is too low in the UK.

I am sorry - Dave Preston

PQE proposal

24m 15s

• Jeremy Corbyn's policy mentions PQE in passing.
• Richard Murphy's more detailed proposal.
• Criticisms of PQE

Jungle Moon - Yumi Kurosawa

What if?

1h 00m 55s

• Would Corbyn implement PQE?
• If so, what would be the implications.

References mentioned in the discussion

(In reverse chronological order)

Simon Wren-Lewis - 2 Sept 2015 - Helicopter money preferable to QE

Frances Coppola - 2 Sept 2015 - Real purpose of central banks - overview of central banks, MMT, PQE and reality of election cycle

Bill Mitchell - 19 August 2015 - Embrace money financing as the norm?

Simon Wren-Lewis - 16 August 2015 - On drawbacks of Corbyn's QE

Jeremy Corbyn - 22 July 2015 - Economic vision (no mention of PQE!)

Jeremy Corbyn - 22 July 2015 - p6 of this document briefly mentions PQE

Richard Murphy's - 12 March 2015 - Original description of PQE but called Green Investment Fund

A more detailed summary of the our conversation and conclusions can be found here.

People's quantitative easing (PQE)

The People's Quantitative Easing (PQE) proposal that is currently being debated in the UK media is the version proposed by Richard Murphy.  It involves local authorities issuing debt in the form of bonds to fund investment in infrastructure. The bonds would originate from a newly created public investment bank and would be immediately bought up by the Bank of England (BoE) using newly created money. The bonds, now held by the BoE would be effectively cancelled (though complications arise here due to the Lisbon Treaty). In this way, the investment is effectively funded by new money creation by the BoE, albeit through a slightly convoluted process.

Some of the main criticisms of this idea have been:

1. that simply creating money to finance government spending is inflationary
2. the independence of the BoE would be compromised
3. the same outcome could be done by conventional government borrowing, so PQE is a way to dodge persistent misunderstandings about the nature of government debt

In order to evaluate these criticisms and decide whether there is some merit to PQE, it is necessary to understand how the government and the BoE interact when the government spends. In other words how fiscal (spending and taxing) and monetary (inflation, interest rates, etc.) policies interact.

Monetary policy

The BoE is part of the the UK public sector. The remit of the BoE is to keep prices stable, which means controlling inflation. Interestingly, it does not attempt to prevent any inflation at all, but targets a low, positive rate of inflation - currently 2% (set by the government).

To do this, the BoE attempts (with greater or lesser success) to control the amount of money in circulation. (It doesn't directly target the amount of money but rather uses an interest rate target as a proxy). The main method for doing this is altering the amount of money in the reserve accounts of commercial banks. If there is too much money, the BoE sells some financial assets to the banks in exchange for their money. After such an operation the banks have a lower amount of reserves but do hold other assets (often government bonds) in their place. If the BoE estimates that there is too little money available to the economy it adds to the banks' reserves by buying assets from them.

In a sense, government bonds are interchangeable with BoE issued money (reserves). But since it is reserves which are typically used to clear payments between banks, the proportion of money which is held as reserves versus bonds determines (perhaps only loosely) how much money is readily available to the economy. The BoE simply adjusts this proportion as appropriate. It's worth noting that the BoE doesn't create its own bonds, but sells back to the private sector UK government bonds that had been previously bought up in earlier operations.

Fiscal Policy

The government (specifically the Treasury) adds new money to the economy when it spends. In principle, the government could simply leave it at that, i.e. create the money and leave the BoE to somehow drain it from the money supply according to its inflation target. But that would make the job of the BoE very difficult. And in any case, there are EU rules against directly financing government with central bank money creation.

Therefore, the UK government applies a rule to itself called the Full Funding Rule. This rule stipulates that any money added to the economy due to spending must be completely removed. To a large extent this is achieved through taxation but if the government spends more than it collects through taxes (a budget deficit) then the government removes the additional money by selling newly issued bonds. This works in the same way as when the BoE sells bonds to drain bank reserves - money is taken out of the economy - except that when the government does it they are selling newly created bonds. So a government's deficit is associated with an identically sized issuance of bonds which gives the appearance of  borrowing to fund its spending.

But that is not really what the intention is. What all this is supposed to mean is that the government's fiscal policy (spending and taxing) is neutral with respect to the amount of money in circulation, and therefore the BoE can go about it's job of targeting the right amount of money in the economy without any additional complications. 

Quantitative Easing

The recent programme of Quantitative Easing, carried out by the BoE between 2009 and 2012 was an extreme version of the monetary operations described above. The BoE bought £375 billion of government bonds from the private sector and therefore increased bank reserves by the same amount. The intention was to stimulate the economy by enabling banks to lend cheaply and by promoting investment in other non-government assets. A side effect (or possibly an intention) was/is that the cost of issuing bonds for the UK government stayed very low meaning that the very large fiscal deficits could be accommodated more easily. 

In effect, the UK government debt is now £375 billion less than the declared amount (about £1.4 trillion) since that amount is "owed" to part of the public sector. Indeed, this is what the government states when it "consolidates" the accounts of the entire public sector, and the BoE actually returns interest payments it receives to the government so this portion of the debt has no cost. It can also be argued that, since the bonds that the BoE has bought represent past government deficits, historical deficit spending to the tune of £375 billion has effectively been funded by money creation at the BoE. So while QE was a monetary operation, it can be argued that it has a significant effect on fiscal policy.

People's QE

PQE is similar to conventional fiscal operations in some ways and different in other ways. The fact that bonds are used in the first instance to fund the spending is similar to current practices although it is not clear why the bonds need to be from a newly created national investment bank when conventional Treasury bonds would do the same job.

One reason could be that normal government bonds (gilts) can be linked to non-investment spending such as paying a nurse, whereas the new national investment bank bonds are solely for investment spending, such as building a new hospital. This would help clarify the important distinction between these two types of spending.

The major difference is that in PQE the BoE stands ready to buy up any bonds issued to fund investment under the scheme. This makes it look a little like QE in the sense that QE involved the BoE buying up government bonds en masse, and QE arguably funded some government spending in an ex post sense. But there are differences in the rationales for QE and PQE, one being specifically monetary and the other fiscal with direct and specific social outcomes.

In any case, there is an obvious potential downside to the buying up of government bonds by the BoE. In the normal case, government spending is neutralised by taxing and bond issuance and therefore the BoE does not have to consider the effect of the government's fiscal policy when conducting its inflation targeting operations. But if the BoE is charged with buying the bonds used for PQE investments then it is being asked to introduce money into the economy which is not being neutralised. One conclusion that has been drawn by many is that the new money will therefore be inflationary. And perhaps it will, if the BoE do nothing more. But the obvious response from the BoE would be to sell some bonds (possibly original QE bonds) back into the private sector to drain out the added money. This is, after all, the normal response of the BoE when it perceives too much money in the economy. And so, if the net result of the PQE operation is that the government spends and the private sector ends up holding an equivalent amount of government bonds then it doesn't look much different from current practices. It doesn't matter whether bonds were sold by the Treasury or the BoE, the net result is the same. In which case we simply conclude that, as long as we want a central bank charged with keeping prices stable, PQE doesn't end up being any different from what already happens. 

And if we were in "normal times", we could leave it there. But we are not in normal times. At present, inflation in the UK is around 0% which means that the BoE is failing to hit it's +2% inflation target by a whole 2%. This is despite buying up £375 billion of government, flooding banks with the same amount of reserves and maintaining next-to-zero interest rates for 6 years. 

So the most extreme monetary policy used by the BoE appears to be insufficient - under current circumstances - for hitting the targeted level of inflation. One possible reason for this is that the current fiscal policy of targeting deficit reduction is sucking demand out of the economy. In this light, the charge against PQE - that it interfere's with the remit of the BoE's inflation targeting - is no worse than could be levelled against the policies of the current Conservative government.

So it is possible that a simple reversion to "normal", non-austere fiscal policies in which debt and deficit targets are not paramount would produce a sufficient amount of inflation to be in line with the BoE's target. In such a case it would be difficult to justify PQE since it would revert to conventional bond-backed spending, as argued above.

But under the current circumstances, when the tools of monetary policy have been exhausted and still the inflation target is being missed, then some inflation being produced by PQE-style money creation would not only be acceptable but would be positively welcome. In this guise - dropping the need for a new investment bank - this looks like the more general idea of "helicopter money", i.e. creating money and giving it to members of the public.

Summary

PQE, as presented, includes some useful ideas and some unnecessary ones. There doesn't seem to be any need for a new investment bank when conventional Treasury bonds fulfil the same role. And in normal times, when the BoE is more or less able to approximate its inflation target, PQE just ends up looking like the conventional methods of doing fiscal policy (spending neutralised by taxes and bond sales). But in extreme cases when the economy is struggling to produce any inflation and the government/BoE have exhausted all monetary policy options, the money creation/helicopter money aspect of PQE seems entirely reasonable and constructive.

Podcast

If you been affected by any of the issues in this post, listen to this podcast.

Unequal measures of inequality

That there is inequality in income is beyond question, but it's worth asking about the best way to measure it. A common approach is to state something like this:

The 30% of individuals with the lowest incomes in Scotland received 14% of the total income, whereas the top 30% receive 51%, and the middle 40% get 35%.

I've picked this just as one example, but you can find many more like this for many countries. In this post I'll argue why this is a poor measure of inequality, and how other measures can yield more meaningful information that is more sensitive to changes in inequality.

The mathematics that underpin the arguments here can be found in this blog post on my personal blog.

A simple distribution

Let's look at how these income percentages are calculated. I'm conscious that some might find this bit rather numerical and, well, boring, so if you really don't like it, eyeball the graphs then skip to the table

To keep it clear I'll start with the mathematically simple, uniform distribution, as illustrated in the graph below, and consider more realistic ones later on.

A uniform income distribution in which 5 million people are evenly spread between incomes of £0 and £50,000 per year.

It has a constant value of 100 from an annual income of £0 up to £50,000, and is zero above £50,000. This is telling us that no-one earns more than £50,000 in this population. The size of the population is the area under the graph, which is 100 x 50,000 = 5 million, roughly equal to a small country such as Scotland, Norway or Slovakia.

We can use the distribution to calculate the number of people in any range of incomes. So, for example, the number of people with income between £0 and £5000 is

100 x (5000-0)=500,000

Similarly, the number who earn between £45,000 and £50,000 is

100 x (50,000-45,000)=500,000

In fact, any £5000-wide range of income will have 500,000 people - that's the simplicity of a uniform distribution.

You'll notice in these two examples that we've given examples of the poorest and richest 500,000 people in terms of income. With a total population of 5,000,000 that means we're talking about the poorest and richest 10% of the population. In the jargon these are known as the poorest and richest deciles of the population. We can divide the whole population into ten such deciles ("dec-" means ten). The uniform distribution makes this simple: the boundary between the first and second decile is at £5000, the second and third is at £10,000, the third and fourth is at £15,000 and so on in increments of £5000 up to the tenth decile which starts at £45,000.

Next, let's calculate the total income of this population. This usually requires calculus, specifically integration, but since we're dealing with a uniform distribution there's a simple way to do it: multiply the income at the centre of the population, £25,000, by the number of people in the population, 5 million:

total income = £25,000 x 5,000,000=£125,000,000,000

The middle income is the mean (or average) income, which also happens to be the median income for a uniform distribution. The median is the income that splits the population into two equally sized groups. If you think about it, the median is equal to the upper boundary of the fifth decile.

Let's now calculate the total income of the bottom 30%, or, in other words, the bottom three deciles. This will be everyone earning up to 30% of £50,000, which is £15,000. The same trick as we used above still works, we multiply the mean income of this group, £7500, by its population, 30% of 5 million, which is 1,500,000:

poorest 30%'s income = £7500 x 1,500,000 = £11,250,000,000

So the total income is £11.25 billion. Likewise, we can calculate the income of the richest 30%, which is a group with the same number of people, but its mean income is £42,500, so:

richest 30%'s income = £42,500 x 1,500,000 = £63,750,000,000

The middle 40% has the same mean income as the whole distribution, £25,000, and 40% of 5,000,000 is 2,000,000 so

middle 40%'s income = £25,000 x 2,000,000 = 50,000,000,000

Now let's summarise all of this in a table, and also include the percentage of the total income:

Group	Mean income	People	Group income	% of total
Poorest 30%	£7500	1.5mn	£11.25bn	9%
Middle 40%	£25,000	2.0mn	£50.00bn	40%
Richest 30%	£42,500	1.5mn	£63.75bn	51%
Total	£25,000	5.0mn	£125.00bn	100%

Note that the percentages 9%/40%/51% are not too different from the reality of Scotland mentioned at the start, i.e. 14%/35%/51%. This might strike you as odd because the actual income distribution of Scotland is quite different to our toy uniform distribution. There's an interesting reason for this, which we can demonstrate by playing with our uniform distribution for a bit longer.

Imagine now that we double the top salary of the distribution from £50,000 to £100,000. The distribution looks like this:

A uniform income distribution in which 5 million people are evenly spread between incomes of £0 and £100,000 per year.

Notice that the population is 5 million, as before, because although the range has doubled (zero to £100,000) the height has halved to 50. You can think of this as everyone in the population having their income doubled. Intuitively, you might think that inequality is more pronounced with this distribution, and you can rationalise it as follows: the mean income of the poorest 30% increases by £7500, but that of the richest 30% increases by £42,500. The rich get a lot richer than the poor do, so inequality is greater.

But let's work out the income percentages. The mean salary is double what we had before at £50,000, as are the mean salaries of the poorest and richest groups. So if we were to amend the table above we'd need to double the Mean income column, which when multiplied by the number of people means that the Group income doubles also, including the Total. And here's the punchline: the factors of two cancel when calculating the percentages which meanins that the % of total column remains unchanged at 9%/40%/51%.

Scale invariant

This result is not just true for doubling: we could have halved income, tripled it, multiplied it by million or divided by a billion or pi; or any (positive) number. The percentages will stay the same. The percentages of 9%/40%/51% are true of a uniform distribution that starts at zero income and goes up to any maximum value.

This is an example of what is called a scale invariant property. The more astounding thing (unless you're used to mathematical statistics) is that this is true for any distribution, not just uniform distributions.

To emphasise the point, imagine if everyone in Scotland saw their income double. There would be a significant improvement in living standards for all, with the rich benefiting most in absolute terms, but the income percentages would remain exactly the same as they are today, i.e. 14%/35%/51%.

The bottom line is this: the percentages of total income going to income groups can be completely insensitive to dramatic changes in the distribution of income.

Symmetry invariant

But there's more. It turns out that for any distribution that's symmetric about its mean income, which is true of a uniform distribution and many others, you can mathematically prove that the middle 40% always have a 40% share of the income. The corollary of this is that the poorest and richest 30% groups combined will have 60%.

From this we can conclude that Scotland's distribution cannot be symmetric because its middle group receives only 35% of the income, not 40%.  You can think of the "lost" 5% as going to the poor which is 14% rather than 9%. This is a common feature of real income distributions: they are not symmetric but significantly skewed so that they peak towards lower incomes, with a long tail extending up to high incomes.

So what do income percentages tell us?

It turns out that the percentages are determined by two things:

1. the shape of the distribution
2. the width of the distribution relative to its mean

We've seen one effect of point 1 in considering symmetry, and will come back to it later, but let's consider point 2.

In statistics, the width of a distribution is usually measured by something called the standard deviation. I don't want to get into the gorey details, but rest assured there is a simple mathematical formula for calculating the standard deviation, and you can find it implemented in spreadsheets as the STDEV() function.

For the first uniform distribution we looked at above, the mean is £25,000 and the standard deviation is £14,434, as shown on the red distribution in the graph below.

Means are shown with blobs, and a standard deviation either side of the mean is marked with short vertical lines. The blue distribution's mean and standard deviation are twice that of red.

The blue distribution is the "doubled" uniform distribution discussed above. As you may have guessed, its mean and standard deviation are double the red values: £50,000 and £28,868.

If instead we imagined increasing everyone's income by £25,000, that would just shift the red distribution £25,000 to right, but leave the width unchanged, ranging from £25,000 up to £75,000:

Here the red distribution is moved to the right by £25,000. Its mean is £50,000, same as the blue's, but the standard deviation is unchanged.

The mean is now doubled, but the standard deviation remains the same. As a result the income percentages change significantly to 19.5%/40%/40.5% indicating reduced inequality. This suggests that the larger the mean to standard deviation ratio, the smaller the inequality, or, to put it more clearly, a more equal society has a narrower distribution about the mean.

A more realistic shape

Let's now look at a different distribution shape called a Gaussian (also called a bell-curve or a normal distribution). It falls off in a more realistic way than the "cliff edges" of the uniform distribution, but is still perfectly symmetric about the mean. The means and standard deviations of the red and blue Gaussian distributions in the graph below are identical to the uniform ones plotted previously.

Gaussian distributions with the same mean and standard deviation as the red and blue uniform distributions above. The vertical line marks the mean, and the horizontal line is two standard deviations long.

Although it may not be immediately obvious, the area under these two curves are the same as before, that is, equal to a population of 5 million (though notice that a small fraction of the population are on negative income).

The income percentages for both these distributions can be calculated (using calculus) as 10%/40%/50%, i.e. almost the same as for the uniform distributions.

In fact, for a whole range of realistic distributions the shape of the distribution has little effect on the percentages, generally altering them by no more than a few percentage points. However, as we saw above, the mean to standard deviation ratio can significantly change the income percentages.

A better measure of inequality

I hope that you're now convinced that income percentages are an insensitive measure of inequality. In addition, they lack an intuitive meaning for most people, because few would think of themselves as, say, belonging to the middle 40%, and would have little feel for the fraction of total income that group receives.

Instead, most people assess their prosperity relative to their peers with similar incomes; possibly feeling jealous of a neighbour's expensive holiday, or perhaps experiencing a slight smugness at having a better car. A good inequality measure would be both sensitive to changes in the income distribution, and present it in an intuitive way that accords with pre-existing perceptions.

Once you understand what the income percentages are telling you, as we've explored above, you might prefer to know the mean and the standard deviation. After all, the ideal of perfect equality is obtained when the width of a distribution is zero and everyone earns the same. In that sense, perhaps the best measure of inequality is the standard deviation divided by the mean, because as it approaches zero, so does inequality. However, although this might appeal to a statistician or mathematician, I think most people would be put off by the very mention of standard deviation. Also, the standard deviation to mean ratio is, like the income percentages, scale invariant, and so is insensitive to significant changes in income distributions.

Decile boundaries offer a better measure of inequality. They have a tangible meaning: if a person can see that their income lies between, say, the second and third decile boundaries, then they know they are relatively poor, but far from being the poorest. Further, if they see that both boundaries increase over time then they can conclude that they, along with all of their peers, are benefiting (assuming inflation is accounted for). In this sense they are sensitive to crucial changes in the income distribution.

And it needn't be any more complicated: instead of quoting three percentages, you could summarise the state of the income distribution by quoting just two incomes: the top of the poor 30% group and the bottom of the rich 30% group.

As we saw above, if a society did experience a doubling of everyone's income, then the income percentages remain the same, but all the decile boundaries will double. More importantly, if poor people gain more than the rich, this will evidenced by the poor decile boundary increasing more than the rich one.

Real data

Compare the two graphs below showing real data for Scotland and decide for yourself which is more informative about the state of its inequality over the last twenty years.

The Poverty and Income Inequality in Scotland report contains this graph in Chapter 2 showing the percentage of total income going to the poorest 30% (deciles 1-3); the middle (deciles 4-7); and richest 30% (deciles 8-10):

Income percentages going to bottom and top 30% groups and middle 40% group.

From data in the spreadsheet supplied with that report I constructed the graph below showing the changes in the boundaries that divide these three groups, i.e. the 3rd and the 7th deciles. Also shown for reference is the median.

Decile boundaries for Scotland. Income is stated after tax, including any benefits received, but before housing costs, and corrected for inflation so it's in 2013/14 prices. The spreadsheet with this data can be downloaded here - see Table A10.

The income percentages graph shows very little change whereas the decile boundary graph clearly shows an increasing trend and also a dip due to the recession after 2008. Interestingly, the dip is more pronounced for the 7th decile than for the 3rd decile, i.e. the recession slightly reduced inequality. There is a hint of this in the income percentages graph in that the poorest 30% changes from 13% to 15% during 2010.

If we look at the ratio of the 7th decile to 3rd decile we find that it went from 1.84 in 1994/5 to 1.71 2013/14. By this measure there has been a small but significant drop on in income inequality. In contrast, the income percentages in the previous graph are completely insensitive to this change.

A similar measure of inequality I've seen used is the so-called 90/10 ratio, which is just the upper boundary of the 9th decile divided by the upper boundary of the 1st decile. In this case it drops from 3.89 in 1994/95 down to 3.49 in 2013/14.

It's important to note that everyone has benefited from a real income rise in Scotland over the last two decades (even if they're unware of it because it has been gradual). The 3rd decile has risen by £4160 over the twenty years, an increase of 30%, and the 7th decile  by £5304, an increase of 23%.

The 1%

The Occupy movement popularised the notion of the top 1% as a symbol of inequality, and so I couldn't resist a brief look at the income percentages for the top 1% of the income distributions. For the uniform distributions described above, the income percentage is 2% and for the Gaussian it is 2.5%.

It's hard to find comparable post-tax figures that include benefits, but by combining data from this older IFS report (inflating using RPI) with the HBAI distribution, my rough estimate for the whole UK is 4%. It's likely that Scotland's figure would be little lower than this (London bumps up the UK figure), but still well above the 2.5% of the Gaussian. This is a reflection of the fact that the income distribution is skewed so that the peak is pushed to lower incomes and there's a "long tail" extending up to extremely high incomes.

There are much greater uncertainties in estimating the top 1% figures due because very rich people receive income in a different way to the rest of us, and because they can "tax efficiently" shunt money across national boundaries. See Thomas Piketty's book Capital in the twenty-first century if you'd like to understand why. In all probability most estimates are under-estimates.

Y U lie - inequality is increasing!

When I started investigating income inequality I fully expected to find what I'd been frequently been told and what I'd often read - inequality is increasing in Scotland. But the numbers above do not lie. It is a fact that post-tax income including benefits shows inequality has lessened over the last twenty years. But there's no contradiction here, for three reasons.

Firstly, I'm not talking about wealth inequality. It is quite different and much greater (see Chapter 7 of Piketty).

Secondly, most figures I've seen quoted on income inequality relate to pre-tax income excluding benefits which shows inequality as constant or rising slightly over the last twenty years. But, to my mind, ignoring the redistributive actions of tax and benefits is misleading: it includes a substantial of portion of rich peoples' earnings that is actually income to the government (tax), and excludes a significant portion of what makes up poor peoples' income (benefits). For some uses this may be appropriate, but I'd argue that post-tax income including benefits is most appropriate for headline figures.

Finally, I'm not looking at the extremes of the income distribution. The top 1% (and especially 0.1%) and bottom few % show distinct trends that require special analysis using other datasets.

This report by the Bell and Eiser gives further information on these points and their Figure 6 shows the drop in inequality that I've found, including across the recession since 2008. It's also interesting to compare how their work translates into headlines that lead on growing inequality, such in this article in the Herald. The plight of the super-poor is rightly given prominence, but the fact that the vast majority of households have seen their real income rise, and post-tax inequality has reduced, is only touched on.

Conclusion

Income percentages are insensitive to some significant changes in real income distributions. I've argued that stating the incomes which mark out the poorest 30% and the richest 30% provide a more intuitive measure of inequality that is better suited to highlighting important changes in the income distribution.

Taking the ratio of these two incomes, or using the 90/10 measure also gives interesting information, but I don't think such ratios should be considered alone. The problem with dividing the two numbers in this way is that it provides a scale invariant measure which, for example, would show no change if everyone's income doubled.

Unless there is good reason to do otherwise, I think it is most appropriate to work with post-tax income including benefits. This is the income that people receive and correctly accounts for a society's income redistribution.

Finally, it's always important to use the right tool for the job. I've concentrated on inequality measures for general use, but for specific purposes other measures must be used. For example, if you are looking at either extreme poverty or very high incomes, then that information is hidden within the first and last deciles. You can turn to percentiles rather than deciles (100 divisions rather than 10), but its important to remember that such statistics are one-dimensional and exclude important human aspects. In my opinion, the area that requires most attention and urgent action is extreme poverty, and for that you must consider foodbanks, homelessness, substance abuse amongst many other things. A statistic on income inequality is just one tool in the box for analysing society.

The mathematics that underpin the arguments here can be found in this blog post on my personal blog. 

Episode 2 - The Deficit Puzzle

Recorded 5 July 2015


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Introduction

Intro music - Money by Von Korf

What is a deficit?

1m03s

• Related blog post
• Difference between government spending and tax revenue
• Deficit is synonymous with government borrowing
• Deficit tends to be considered a 'bad thing'

Empirical data

6m53s

• UK and US governments in deficit >80% of time since WWII
• "Books not balanced" annually or over "business cycle"
• Large net, cumulative deficit - the government debt
• Are deficits really bad or something else going on?

Plenilune - Joram

Spending and saving

12m15s

• Equivalence of spending and income
• Stock of money and velocity of money
• Trade off between unemployment and inflation
• Savings are a leakage of spending from economy
• Banks do not recycle savings

What government debt is

24m46s

• Government recycles savings when it "borrows"
• Financial industry (e.g. banks, pension funds) "save" in government debt
• Debt of currency-issuing governments have zero default risk

Night - Tramo

What if?

32m45s

• What if the public don't want to save?
• What if the government doesn't want to run a deficit?
• Deficit dependent on tax revenue which varies with economic conditions
• Deficit as a measure of private sector savings desires
• Government debt is the net savings of the private sector

Foreign trade

44m43s

• UK has a trade deficit
• Trade deficit is a leakage of demand abroad
• Government recycles money earned by exporting nations by swapping for government debt
• ~25% of UK government debt is held by foreigners

Your reflection in the water - Dave Preston

Can the government pay off its debt?

50m19s

• Public and financial industry want government debt
• Importance of central bank

Rich in loss - Sandeep Bhandari

The deficit puzzle: are government budgets ever balanced?

A government "budget deficit" is the difference between government spending and tax revenue for any given time period (e.g. a year). In the UK it is officially labelled "Public Sector Net Borrowing", because any spending deficit is covered by issuing government debt.

The deficit and debt of the government have been discussed intensively by politicians and the media in the UK over the past 5 years - particularly in the lead up to the recent general election. Most discussion of these issues revolves around the idea that large government deficits and debts are a problem as they represent the government "living beyond it's means" and unjustly burdening the "next generation" with debt. This meme has had enormous success, with all the main parties in the UK accepting the need to reduce spending with an ultimate aim of bringing government finances into a position of surplus (tax > spending) within some stated time frame. A government budget surplus is therefore prized as an indicator of responsible management of the government finances and the economy in general.

Some data

Here's a curious thing. The charts below show the state of the UK and US government finances through the post war period quoted relative to Gross Domestic Product (GDP). For the period 1956-2007 (omitting the Global Financial Crisis (GFC)), the UK government budget was in deficit during 174 of 208 quarters, that is, 84% of the time. On average, the government balance was not zero, but was equal to a deficit of 2.38% of GDP.

For the US government, the period 1947-2007 (omitting WWII and the GFC) experienced a budget deficit for 49 out of 60 years (80%). On average, the US government budget was in deficit equal to 1.5% of GDP for the whole time period and 2.5% of GDP since 1975. Since the US data also include absolute dollar values of the budget position, the net deficit over the period can be calculated at $8 trillion dollars (corrected to FY 2009 dollars), or $16 trillion dollars if WWII and the GFC are included.

UK Public Sector Net Borrowing (1956-2014) as a percentage of GDP (source: ons.gov.uk)

US government budget deficit (1946-2014) as percentage of GDP (source: whitehouse.gov)

To anyone who has been listening to the main political parties or media commentators in the UK over the past 5 years, this should be extremely puzzling. Aren't we told that the "books" should be balanced each year, with governments only spending what is collected in tax? Yet government finances in both the UK and US have been almost entirely in deficit for six decades! A more nuanced view might agree that a budget deficit is to be expected during a recession - when tax revenues fall and social security payments rise. But in such a case, surely the temporary spending deficits are "paid for" by budget surpluses during the "good times". In other words, the books should be balanced "over the business cycle". But again, looking at the historical data, which spans multiple recessions, it is clear that the books are not remotely balanced over any business cycle or longer time scales.

There is a way to explain this, and it paints quite a different picture of the role of government (and government debt) in the economy to that normally offered by mainstream media and politicians. It is, however, pretty basic macroeconomics!

The spending merry-go-round

Let's consider the economy of a single country. The transactions that go on within that country can be called the "domestic economy". Every £ spent by one person or business is a £ earned by another person or business, who then goes on to spend it again, begetting yet more income for someone else. Spending and income are thus two sides of the same coin (pun intended). If spending stops, there are no incomes. If spending increases or decreases, so do incomes. In principle, there is a level of spending which equates to a sufficiently high level of incomes that every person who wants to work can have a job; that is, full employment. Should spending be lower than this amount, some unemployment will occur.

Since each £ gets spent many times in a given time period (e.g. a year), total spending can be considered in terms of an absolute stock of existing money (the "money supply") and the speed at which it is circulated (the "velocity of money"). If the stock of money decreases, then the remaining stock must circulate faster if the same amount of spending (and therefore incomes) is to be maintained. Equally, if the speed at which money changes hands decreases, then more money is required to maintain the same level of spending (and income). 

Incidently, this equivalence of spending and income is one reason why the analogy of the government as a household is flawed. The government's spending adds to national income which in turn increases government revenue (i.e. tax). It's a lucky household wherein income increases with increased spending!

The paradox of thrift

But what if not every £ of income is spent? For example, if I choose to save £100 (under my mattress or in a bank account) then this unspent money can be viewed as being held out of the circulating money stock. Another way of viewing it is as "low-velocity" money: the saved money is now circulating more slowly than the money which is immediately spent. If I save every time I earn some income (e.g. each month) then my savings will grow through time. But if my stock of savings grows through time this must mean that the amount of money in circulation is decreasing (or slowing). So if the private sector (people, business; not government) on aggregate wants to save some of their income, these savings represent a leakage of money from the existing money stock, or a slowing of the circulation rate of money. Either view has the same implication: the level of spending is being continually decreased by the build up of savings. 

This is famously known as "the Paradox of Thrift", the notion - identified by John Maynard Keynes - that, although an act of saving might be rational at the individual level, collective saving will be self-defeating, resulting in lower incomes for all as spending is reduced. As the incomes of citizens and businesses are reduced by the collective attempt to save, so those very savings will need to spent. This may be good news for the resumption of spending and incomes but the consequence is that saving is impossible.

The public bank

Imagine there was some entity in the economy that could take the savings of the populace and spend it in the economy. This sort of recycling would ensure that spending levels, and therefore incomes, are maintained. Of course, an obvious candidate for such a role is a bank. Don't banks take deposits from savers and lend them out to borrowers? Well, no they don't, but even if they did it wouldn't solve our problem. Banks lend to businesses and citizens and so even if saving by one party is matched by borrowing by another, the amounts would cancel out and the private sector as a whole would not be in a net saving position. What we are trying to figure out is how the private sector can save as a whole and yet maintain stable spending/income levels.

But hang on a minute! Haven't we just looked at some data showing that the government pretty much continuously spends more money in to the economy than it taxes away? Could it be that those deficits are what make saving possible? There is a nice symmetry here. The savings of an individual may be expected to increase through their life and then perhaps decrease during, say, retirement. But for the population as a whole, with overlapping generations, we would expect a more or less consistent savings rate to produce a stable stock of total savings. Factor in population growth, economic growth and inflation, and we would expect the total savings of the private sector to increase through time. And as the value of the savings in our bank accounts and pension investments grows through time so does the cumulative value of successive government spending deficits  - the government debt.

Is this symmetry just a coincidence or is there a more explicit link here? Who is it that buys government debt? Well, banks and other financial institutions - particularly pension funds - buy lots of government debt, for at least two reasons. First, government debt pays interest, whereas vast piles of cash do not. In this sense, swapping pounds sterling for UK government bonds is a bit like switching from a current account to a savings account. Secondly, the debt of a government which controls its own currency is regarded as a highly safe, essentially risk-free investment. So the very institutions that host the savings of businesses and citizens (banks, pension funds, etc.) choose to place their savings in government debt. As Frances Coppola recently remarked: governments are really banks!. Not only is government debt the ultimate, safe savings vehicle for the financial sector, but the government also recycles our savings directly back into the economy when it "borrows" and deficits spends in just the way many people (erroneously) think banks do.

So what?

This is a simplistic example featuring just the "leakage" of domestic saving as well as government spending and borrowing. In reality, there are many more inflows to and outflows from the domestic economy including taxation (only implied in the example), overseas trade, and bank credit. But hopefully the example shows that government deficit spending is not necessarily simply a matter of failing to manage the government's finances adequately. Government deficits perform at least two socially desirable functions beyond the funding of government programmes and services: (1) they maintain spending and incomes in the economy in light of private sector savings desires; and (2) the issuance of debt provides a safe and interest-bearing store for our long term savings. Simply put, if the private sector tend to want to save over the long term, then - all other things being equal - the government should be expected to run a long-term budget deficit in order to maintain a stable economy. And the national debt is not only equal to national savings, it IS the national savings.

This perspective is quite different from that we normally hear from politicians who like to couch the deficit only in terms of funding government. I am not sure how they reconcile their view with the historical record of massive, long-term, net deficits. The view described here also explains why the government debt never gets paid off. Why would savers intent on increasing their savings accept repayment of their savings? Will they suddenly decide that they want to spend the money they were saving? No. Government debt that is due repayment simply gets "rolled over" as continued savings.

So if you are one of those that doesn't approve of the government deficit and debt, then maybe the rational thing for you to do would be to help reduce it by cashing in your pension.

Shiny images, dull truths

People will judge your character by the state of your shoes.

I do hope Conway wears a suit and tie for the interview.

The first comment was made to me in the late 1980s by a friend's father upon seeing my dirty black leather shoes. He handed me a shoe shining kit as he said it.

The second was said by a Prof to a friend of mine just before said Prof interviewed me for a lectureship in 1997. He gave me a right grilling, but as I wasn't that keen on getting the job, and knew the odds weren't in my favour, I enjoyed the interview by giving direct and honest answers that deviated markedly from the ones he wanted. My only regret is that I went with the suit and tie instead of the Big Bird outfit.

These memories floated up in my mind because I was reminded by friends the other day that a) image matters and b) my approach to the world is too empirical, literal and rational. I can see why people feel the need to remind me of these things. It's not that I'm unaware of their significance; it's that I choose to interact with the world in my own way. For example, I'd rather listen to what a politician says and judge whether it makes sense than be swayed by their appearance or rhetorical skills or cheers from loyal supporters. It takes conscious effort and discipline to listen like that, and I don't always manage it.

I've been somewhat immersed in the fiscal nuts and bolts of Scottish politics lately, as my own blog clearly shows. (For immersed read obsessed if you want.) Clearly, my way of dealing with this highly irrational political situation (as most are) is to go all uber-rational on a subject closely related to it. In contrast, ardent supporters of the Scottish National Party, especially the post-referendum recruits, seem unfazed by fiscal and economic arguments. The empirical analysis that I and others write is therefore largely an exercise in self-satisfying preaching to the converted, or rather, reasoning with the rational.

I accept that many people, perhaps most people, aren't interested in making sense of the world in a consistent and logical way. They're not stupid or deluded. Few people can run and jump like a practised athlete, and equally there's no reason to suppose most folk can think like a disciplined scientist, and scientists themselves often lapse, especially outside their own discipline. Arguably, most people would rather have fun, embrace hope, surround themselves with peers with similar views and chase a common dream. Who wouldn't? Well, me, for one. I experience a repulsion to group-think, which can be partially rationalised. Let me explain.

A meme is an idea that spreads from person to person in a society, and certain, simple memes spread much faster than more sensible assessments of reality. Let me get to specifics with a couple of current political examples.

The Conservative party in the UK has got a sizeable chunk of the public believing that Labour crashed the economy and that public sector finances are like that of a household:

We must balance the books and zero the deficit! Pay down our debts! There was no money left when Labour gave us the keys to the Treasury - look here's the note! 

I see the appeal of the idea that underlies these pronouncements, but cannot accept it based on the evidence (see my many longer and more boring blog posts for why).

The current Conservatives are driven by a thinly disguised ideology to shrink the state, and to serve the interests of an elite stratum in society. In contrast, the Scottish Nationalists are up-front about their ideology. It's the first point in their constitution. No matter what the economic conditions, the fiscal circumstances, the result of a referendum, the situation in the wider world, the solution and ultimate goal is an independent Scotland.

But, is ideology bad? That is, is an organisation of people formed around a belief that they will not challenge always detrimental to society? Not necessarily, but it can be if the firm belief of a minority comes to dominate more diverse views of a society. Ideology can also win support for policies that are insulated from reasonable criticism by invoking a meme that superficially supports the unchallengeable belief.

Here are two memes that spring from these two very different ideologies:

• Substantial spending cuts are needed to pay down the national debt. This meme rests on the belief that personal or household debt is undesirable, and so by extension the same must be true for a country, therefore public spending must be reduced to equal taxes collected. No further explanation is required of why the cuts are necessary.
• Scotland will be stronger if it has full financial responsibility or independence. Being an independent individual and being responsible for your finances are desirable, and so this meme encourages you to view a country in this frame. Concerns raised about currencies, or forecasts of large deficits are less important than the principle of independence which will in any case bring with it new powers needed to deal with such problems.

These memes are superficially appealing and simple to express and so they spread quickly in society in all forms of communications, from tweets and brief conversations in the street, to newspaper headlines and public speeches. There are of course more elaborate and substantial arguments for both the Conservative cuts and Scottish independence, but those arguments are not responsible for convincing a sizeable minority of the population to accept the idea. Those arguments become effective only after the meme has seeded the idea.

Both these memes work by associating complex national issues with familiar individual ones. But you cannot swap a person for a nation in a given argument and expect it to remain valid. In fact, even at the personal level both of these are suspect. If debt itself is bad, why do most people prefer to buy a home with a mortgage rather than rent one? If independence is good for an individual, why do people sacrifice it in emotional and financial terms to embark on long term relationships?

If you're a Conservative or SNP supporter then you may have stopped reading this by now. That would be a shame, because I'm not saying that you are wrong and that I'm right. What I am doing is shooting down a couple of memes and saying they relate to certain beliefs that are inconsistent with my world-view. It is possible this is my failing rather than yours, and if it is then it has to be someone like you, or more specifically, someone who has built up a consistent view around such beliefs, that corrects my thinking.

Now ask yourself this: can you turn that last paragraph around so we swap places? If you can, that would be consistent with the fact that you've read this post to the end.

Episode 1 - What is money?

Recorded 4 November 2014, then gestated for 6 months!


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Introduction

Intro music - Money by Von Korf

Historical ideas

0m20s

• Barter, debt and IOUs preceded money.
• Eggs, fish, wheat are useful and common.
• But gold is rare so must have come later.

Difference (Calming down)

Functions of money

7m56s

• Medium of exchange - no need to barter
• Unit of account - value other goods, like and egg or a fish
• Store of value - money needs to hold its value
• Divisible - you can divide money up into smaller units, e.g. coins
• Fungible - each gold coin of the same size is equal in value

RDP - Sandeep Bhandari

Accepting money

12m6s

• Why accept money?
• How can you establish a new currency?
• Fiat money - money that isn't worth anything itself, e.g. paper notes.
• Governments will only accept tax payments in the currency approved by that government.
• Taxs comes from monarchs raising money for war, "crowd-funded" via the lords.
• We're now used to being taxed.
• Tax money is used for more positive things than war.
• Other currencies can be important in countries even if not demanded for tax, e.g. US dollar.

Due Acque - Robert Rich

Modern money

20m37s

Fiat money, inflation and gold

• Inflation - prices might increase.
• Gold standard - tie value of fiat money to gold.
• Money supply - creating money too fast can cause inflation.
• Gold discoveries have caused inflation.
• Inflation wasn't the norm prior to WW1.
• Bretton Woods meeting in 1944 and John Maynard Keynes.
• The International Monetary Fund (IMF) and naughty Britain in 1976.
• The collapse of Bretton Woods in 1971 - Nixon ended dollar gold standard.

 The Bank of England and the UK

• Currency (i.e. notes and coins) make up 3% of money in circulation.
• The other 97% are deposits held in bank accounts.
• Banks hold accounts with reserves at the central bank.
• Base money = currency (notes and coins) + bank reserves.
• Broad money = currency (notes and coins) + consumer deposits
• Bank of England Quarterly Bulletin with remarkably frank admissions.
• Vast majority of money is in consumer deposits.
• Bank transfers between consumers and between banks.
• Creation of money occurs when a bank loans money.
• There are rules to regulate money creation.
• It's also constrained by market forces - competition between banks.
• Interests rates are one area of competition.
• Financial crisis caused by these constraints being inadequate.
• David Cameron retracted his very unwise call for consumers to pay of their debts.
• If all debts are paid off, there'd be no more money.
• Can't have money without debt, just as you can't do business without trust.

Rich in loss - Sandeep Bhandari

Other links

An excellent take on debt from anthropologist David Graeber:
http://www.bbc.co.uk/programmes/b054zdp6

The wikipedia page on Bretton Woods:
http://en.wikipedia.org/wiki/Bretton_Woods_system