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Monthly Archives: May 2018

From golden fetters to debt shackles

18 Friday May 2018

Posted by beyondoverton in Monetary Policy

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It is the prerogative of the state to issue money. In the past, some states did it better than others: Roman Republic, Song China issued money in line with economic expansions and under the checks and balances of a solid institutional framework. During the Dark Ages, however, European states issued money to fund disastrous wars waged on the back of economic stagnations. The gold standard, introduced in part to limit the state powers in monetary affairs, did exactly that: it severely restricted the flow of money to the availability of gold, thus cutting the wings of any economic expansion.

When the Bretton Woods agreement in 1971 eventually put an end to the gold standard, and fiat money finally became the norm, governments, however, chose to delegate that function of money creation to their banking system: banks could issue new mediums of exchange only in the process of also issuing debt. This was a massive improvement over any monetary transmission mechanism of the past because it linked money creation directly to economic activity (assuming that the debt is used to fund projects leading to economic growth).

So, it worked well at the beginning: debt levels were very low to start with, the financialization of the economy in the 1980s made it much easier to obtain new debts and the 1st Digital Revolution made sure there were plenty of good project to fund. However, even that was not bullet proof: the system was set-up by default to encourage the creation of debt so that money is created. However, with good projects to fund becoming scarce, funding moved to less productive endeavors: junk bonds in the 1990s, mortgage debt in 2000s, and the pinnacle to top it off, corporate debt for share buybacks in 2010s!

With debt levels high and continuing to rise, how high can interest rates go before they nip the whole process of money creation in the bud? We had a glimpse of that post the S&L crisis in the early 1990s which eventually gave rise to shadow money; we had something similar post the 2008 financial crisis when debt deleveraging gave rise to crypto money. Both shadow and crypto money were designed as substitutes of the medium of exchange which had gone scarce as debt origination slowed down. The problem with that is, because they are not regulated, they do not carry the safety/convertibility features of inside money and thus at some point the whole process badly backfires.

In a sense, we ended the gold standard, only to put the monetary fetters back using debt as the anchor. Even though this process was an improvement, it is questionable, however, whether the banking system has done a better job than the state would have done, if it had taken full advantage of the fiat monetary system post 1971.

‘State’ money creation – this ghost from the past is badly needed for the future

17 Thursday May 2018

Posted by beyondoverton in blockchain, Monetary Policy

≈ 3 Comments

At present, majority of money (medium of exchange=inside money) creation in the developed world gets done by private banks. The state (government and/or the central bank =outside money) does create money but it is either as a medium of exchange within the banking system only, or on the back of demand for physical cash in exchange for inside money.

I have written about this before here (‘A simplified hierarchy of money’). The problem with the current monetary transmission mechanism (‘A simplified version of the monetary transmission mechanism’) is that it is set up almost by default to produce a scarcity of money. One alternative could be that the central bank distributes money directly using all the available data management techniques and recent advances of technology (central bank digital cash).

Given the state of our economy, and in order to properly address the level of technological advances we are experiencing, i.e. to minimize the risk of disruptions which could lead to social upheavals and loss of our prosperity, it could be a good idea to look at history to see how money was created and distributed in similar periods of development.

(Click to enlarge)

Indeed, inside vs. outside money creation is only a recent phenomenon (late 20th century) while state money creation had been the norm for the majority of human existence. And that’s the thing. Unfortunately, our current views of state money creation are really shaped by the most recent examples which had been disasters. For example, the Gold Standard came into existence to curb the rampant money creation to fund wars during the European Dark Age. In addition, that was a period without any major commercial innovations and characterized by population stagnation across Europe.

The late 18th and the 19th century, on the other hand, saw the 1st and 2nd Industrial Revolution which introduced new modes of production. The second half of the 19th century up to early 20th century was also characterized by a period of general peace (Pax Britannica). By then the great innovations of the previous two centuries were also commercialized. As a result of all this, Europe, in particular, became very prosperous.

Unfortunately, the existence of the Gold Standard, prohibited the state to issue enough money to correspond to the increased potential of economic activity. The Great Depression in the 1930s was thus characterized by a positive supply shock, on the back of these innovations, and a negative demand shock on the back of insufficient supply of the medium of exchange.

Early 20th century was probably the first time humanity was experiencing the fruits of progress on a basis similar in scale to the period of the Song Dynasty (960-1279) in China and the Roman Republic (509BC-27BC). Yet, policy makers failed to take full advantage of this by unnecessarily restricting the flow of money. It took a global war which destroyed/redirected a large part of Europe’s industrial capacity to re-address the imbalance between supply and demand.

Even then, policy makers, still did not take note that there was a paradigm shift in the late 1800s after the 1st Industrial Revolution, when a period of innovations massively shifted our economic potential much higher. While the developed world was slowly moving away from ‘scarcity’ and closer to ‘abundance’, they continued to operate from the basis that supply of resources is the bigger issue. The period from the end of the WW2 to the early 1970s continued to be characterized by a restrictive flow of money, the quasi gold standard. Luckily, it did take some time for capacity to come back on line after the war, so there were no major financial disasters.

In fact, it was quite ironical, that as soon as President Nixon decided to finally fully abandon the gold standard and introduce the age of fiat money, the world experienced a supply side crisis: due to problems in the Middle East, the supply of oil became restricted leading to a rise in inflation. This actually emboldened policy makers even further to focus on issues emanating from insufficient supply of resources and thus manage the demand side of the economy more closely to reflect that. The problem on the supply side, however, was short-lived, and as soon as the Middle East crisis subsided, oil started flowing back and ‘equilibrium’ ensued.

Nevertheless, even to the present day, our economic policy is still dictated by the mantra of supply side economics and inflation targeting.

Alongside these developments, the second half of the 20th century was also characterized by the start of the 1st Digital Revolution with the invention of the computer in the 1950s and its commercialization in the 1980s. Starting in the 1990s, globalization also took off. These developments boosted even further potential supply, while at the same time, money flow, despite no restrictions on actual money supply due to its fiat nature (but actual restrictions due to the separation of outside and inside money) continued to be restrictive.

These were the developments which led to the Great Financial Crisis in 2008, which, just like the Great Depression before, was characterized by a positive supply shock due to a burst of the commercialization of previous innovations and a negative demand shock due to insufficient money supply. The present time seems also to be the beginning of what could be called the 2nd Digital Revolution of AI and VR, which has the potential to even further increase our economic potential. Yet, when it comes to money creation, we are still operating with the mentality the Gold Standard: money is kept excessively restricted for fear of rising inflation.

In light of this, it could be worthwhile to point out that there were actually periods of successful state money creation in the past: Rome in the last five centuries BC and China between 10th and 13th century. Why did state money creation work back then? Three main reasons:

  • massive prosperity on the back of the commercialization of previous innovations,
  • a period of relative peace, and
  • a properly working institutional framework

It is important also to note that both in the beginning of the 20th century and now, all these three reasons above are present. If history is any guide, failure to supply the necessary amount of medium of exchange to ‘record’ this existing prosperity could lead to war, followed by disappearance of the economic prosperity, and in the worst possible scenario (did not happen during the Great Depression) the dismantling of the institutional framework. Or, if more recent political developments are any guide, could this time be different and the decline starts with the dismantling of the institutional framework, followed by war and the natural disappearance of prosperity?

To sum up:

  • state money creation is good when it is done within a solid institutional framework, and it follows (or is accompanied) by a positive supply shock brought about by previous innovations leading to economic prosperity (past examples: the Roman Republic, China during the Song Dynasty; no current examples);
  • state money creation leads to negative outcomes when it follows a negative supply shock brought about by war, natural population declines, or inadequate institutional framework (Europe during the Dark Age, the Gold Standard; more recent examples: Zimbabwe, Turkey, Argentina, etc.)

Is Japan doing that bad?

16 Wednesday May 2018

Posted by beyondoverton in Questions

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Latest GDP numbers out of Japan came out overnight and though the decline in GDP was expected, it was worse (-0.1% vs -0.6% actual). But is this really a surprise given the continuous decline in the Japanese population – deaths outnumber births now by more than 1,000 per day?

  • The growth rate of Japan’s population started declining in earnest in the mid-1970s, but it turned negative only in 2009. Absent massive rises in productivity, it is natural for GDP growth rate to decline as well in line with the decline in population growth.
  • Still, Japan’s GDP growth rate has been consistently above the growth rate of its population (another way of saying GDP per capita rises) except for a brief period post the 2008 financial crisis. Nevertheless, the average GDP growth rate since 2009 is still above the average growth rate of the population (0.6% vs -0.1%, respectively).

What does this mean? Positive labor productivity growth rate.

  • Since the 2008 financial crisis, Japan’s annual GDP per capita growth rate averaged the same as US’. Even since the 1990s, when Japan’s supposed stagnation started, its GDP per capita was on average just 35bps lower than that in the US.

  • GDP per capita growth can be broken by growth in labor productivity (GDP per hour worked) and changes in labor utilisation. Measured by GDP per hour worked, Japan surpassed USA in 1989. But measured by labor productivity growth, it has outperformed the US since the 1970s at least.

  • High labor productivity can come from many things (greater use of capital, low labor utilisation, innovation). In general, Japan tends to have a lower labor utilisation rate than US. That could mean more automation/ less employment of low productivity workers.

  • Perhaps that is why, Japan also tends to have a lower labor compensation (per hour worked) growth rate than US. However, in 2016, for the first time, that changed.

Bottom line is as long as population continues to decline, GDP should also be expected to decline given also lackluster productivity growth. However, as long as productivity growth is positive, GDP rate of decline should stay above population rate of decline. It could be better, but there is nothing bad about that either.

Is the effect of demography on inflation fading?

10 Thursday May 2018

Posted by beyondoverton in Questions

≈ Leave a comment

Good paper by M. Juselius and E. Takats on “The enduring link between demography and inflation” pointing to the fact that:

  • an increase in the share of the dependent population is generally associated with higher inflation; and
  • aging is set to increase the share of dependents, reversing a previous trend.

Is inflation then set to burst higher? It depends.

First, even though the global dependency ratio is rising, its level is not the same for each country. For example, China’s current dependency ratio at 40 is 58% of Japan’s at 68. US dependency ratio is forecast to rise the least; in fact, in the mid-2030s, it is forecast to start declining again.

Second, a lower dependency ratio, even though a rising one, should in theory cause less upward pressure on inflation. By that measure, US inflation may rise but would probably rise less than UK’s and EU’s; in fact, by 2050, with US dependency ratio the lowest among these major countries, one would expect US inflation to be the most subdued.

Third, Japan’s dependency ratio has been rising pretty much since the great crash in 1990, and, in 2007, it surpassed these other countries’ dependency ratios, while this whole time has coincided with a period of consistent deflation there: obviously there are other, presumably, much stronger determinants of inflation.

Fourth, and to the latter point, with the advance of technology, labor’s role in the production function is becoming less important. Does that mean that demography’s role in influencing inflation is also fading?

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