Thursday, 1 July 2010

Musgrave's Law solves the following problem.

The problem. Deficits and / or national debts allegedly need reducing. The conventional wisdom is that they are reduced by raising taxes and / or cutting government spending, which in turn produces the money with which to repay the debt. But raised taxes or spending cuts destroy jobs: exactly what we don’t want. A quandary.

The solution. The national debt can be reduced at any speed and without austerity as follows. Buy the debt back, obtaining the necessary funds from two sources: A, printing money, and B, increasing tax and/or reduced government spending. A is inflationary and B is deflationary. A and B can be altered to give almost any outcome desired. For example for a faster rate of buy back, apply more of A and B. Or for more deflation while buying back, apply more of B relative to A.


As the title above implies, the most common questions are or will be listed below. Additional questions welcomed. Please put them as comments at the bottom.

Abbreviations and definitions: 1. ML = Musgrave’s Law. 2. QE – Quantitative Easing. 3. The phrase "print money" is used below. Obviously the bulk of money nowadays is created "digitally" or on keyboards rather than in printing presses. The phrase "print money" will nevertheless be used to cover both the two latter forms of money creation.


The source of money for buying back ND under ML is first, tax and second printing. Are there actually any circumstances under which the apparent free lunch, i.e. printing, is possible?

The short answer is yes, and for the following reasons.

First, those who have their ND converted to cash won’t run out and spend much of this cash. This is because they were holding ND precisely because they regarded that chunk of their wealth as SAVINGS. And when that chunk is converted from ND to cash, they will continue to regard the chunk as savings.

However, those with these cash holdings WILL try to lend this cash, plus assets in general will be bid upwards, which will have a finite stimulatory effect. But to the extent that those with excess cash cannot find private sector borrowers, there will be a limited stimulatory effect.

This inability to find an adequate number of borrowers would occur if demand is subdued and remains so, e.g. because the private sector is deleveraging: very much the circumstances at the time of writing. Indeed “deleveraging” is almost by definition an attempt NOT to borrow and/or actually pay off existing debts. In this scenario, those who had had their ND converted to cash will not be able to find many private sector borrowers. To this extent, the “conversion” would not have much of a stimulatory or inflationary effect.

As to whether this is a free lunch, it’s some sort of free lunch, but not the biggest one in recorded history: a scenario where there is little economic growth is not much of a free lunch. But a minor gain from the “conversion” is that government (i.e. taxpayers) are excused funding interest on a chunk of ND.

The above is simply a reflection of the fact that given inadequate demand, government should be expanding private sector net financial assets with non interest paying securities (e.g. monetary base) rather than interest paying stuff (i.e. national debt). I’ll expand on that.

Where government borrows at full employment with a view to expanding the public sector relative to the private sector, government MUST pay interest, and indeed, must offer better interest than the prevailing rate so as to withdraw funds from the private sector and damp down demand from the private sector.

In contrast, given excess unemployment, government CAN go for Keynsian “borrow and spend”. But this is not a good solution because there is no need to offer interest: what needs to be done is to boost private sector net financial assets. This can be done by simply printing money and giving it to the private sector (e.g. via a payroll tax reduction or sales tax reduction).

The above argument can be summarised thus. Buying back ND may be stimulatory and even inflationary, but given excess unemployment, there is room for stimulus, and one way of effecting stimulus is to buy back ND. That is, given excess unemployment, there is scope for buying back some ND without there being much inflation in consequence.

2. ML will be inflationary because it involves printing money big time.

Answer. Wrong: ML has its own infinitely variable deflationary element (the “raise tax and/or reduce government spending” element) to deal with any inflation.

Secondly, there was an astronomic and unprecedented increase in the US monetary base in 2009. No inflation ensued.

Third, there is no sharp dividing line between money and non-money. The fact of increasing the monetary base does not necessarily mean that in total, the money supply has risen. Indeed, one of the causes of the credit crunch, as several economists have been repeating till they are blue in the face, is that in 2008 – 10 there was a dramatic drop in the total money supply.

The U.S. money supply fell from $14.2 trillion to $13.9 trillion in the first three months of 2010: an annual rate of contraction of $1.2 trillion. Or as Martin Wolf puts it “the monetary base does not itself have any impact on spending by the public.”

This Credit Suisse paper is readable and relevant. It considers the blurred line that exists between money and non-money. Plus it looks at the collapse of commercial bank created money during the credit crunch.

3. ML simply converts national debt to monetary base; given that the two are quite similar, does ML amount to much?

Answer: There are significant advantages in converting national debt to monetary base and having done that, having any subsequent government deficits or surpluses alter the base rather than the debt. One is that when running a deficit which is funded by increased debt, there is widespread disagreement on how much crowding out takes place. That is, uncertainty is involved. Policies that involve uncertainty are not desirable.

Indeed, if the amount of crowding out is very high, that means a huge increase in national debt is required for relatively little stimulus: hardly desirable.

Second, (to be cynical), the world at large is getting hysterical about debt, national debts in particular. If national debts can be made to disappear, or at least decline significantly, large numbers of simpletons (many of them in Congress and the U.K. House of Commons) will be much happier.

Replacing national debt with monetary base has other advantages over conventional policies. One is simplicity. The present monetary and banking system is way beyond the comprehension of 95% of politicians. In contrast, the system is all too well understood by bankers with top university degrees in economics and ten years experience in banking or finance. This helps banks outwit politicians. That is not a healthy state of affairs.

Thus even if the “simple” system were not as good as the more complex one, I’d be tempted to go for the simple one, on the above grounds. However, there is nothing wrong with the simple system, so let’s just dispense with the more complex one.

Second, the “simple” system cuts out some well-paid middlemen in the world’s financial centres and for the following reasons.

Conventional stimulus consists of the following. 1. Treasury borrows $X. 2. Treasury gives $X worth of securities to lenders. 3. Treasury spends $X. Where national debt is replaced with monetary base, stage 1 and 2 become obsolete. (This simple illustration assumes that the Treasury incorporates central bank functions, of course.)

A second advantage is that the likelihood of owing money to other countries is reduced. Third, government is less in thrall to ‘bond vigilantes’ because there are fewer government bonds or none at all.

4. ML implies abolishing or vastly reducing the national debt; who else advocates or has advocated this? Answer: first, it is thoroughly naïve to think that because one or more household names adheres to an idea, that that proves the validity of the idea. But for those impressed by household names, there is actually quite a long list set out below. Note that these authors do not advocate EXACTLY the same method of abolishing the national debt. But their ideas are certainly variations on the same theme.

a) Milton Friedman. See here or here.

b) Warren Mosler. (See 2nd last para in particular.)

c) Abba Lerner.

d) Advocates of the Monetary Reform Act in the U.S. This proposal actually combines two ideas: paying off the debt with printed money and full reserve banking. These two ideas (both of which I favour) do not actually NEED to go hand in hand.

e) Toby Baxendale of the Cobden Centre. As far as I can see, Baxendale’s proposal has similarities to the above Monetary Reform Act proposal.

f) John Wright Patman, Congressman and chairman of the Committee on Banking and Currency (1963-75) said:

“When our Federal Government, that has the exclusive power to create money, creates that money and then goes into the open market and borrows it and pays interest for the use of its own money, it occurs to me that that is going too far. I have never yet had anyone who could, through the use of logic and reason, justify the Federal Government borrowing the use of its own money... The Constitution of the United States does not give the banks the power to create money. The Constitution says that Congress shall have the power to create money, but now, under our system, we will sell bonds to commercial banks and obtain credit from those banks. I believe the time will come when people will demand that this be changed. I believe the time will come in this country when they will actually blame you and me and everyone else connected with this Congress for sitting idly by and permitting such an idiotic system to continue.”

g) Carl Herman (an economics teacher).

Finally, for some much more detailed reasons as to why national debts are largely a nonsense, see this paper of mine.

5. Inflation in the UK as of June/July 2010 seems stuck at over 2%. In that ML involves stimulus, this isn’t the time for stimulus, is it?

Answer: ML does not necessarily involve stimulus: not if the effect of the deflationary element exceeds the effect of the stimulatory element.

Second, where ML does involve stimulus, the "inflation" criticism can also be levelled at any other stimulatory measure, thus this is not a criticism of ML as such.

ML is hopefully an improvement to the theory. Moreover, while mid 2010 in the UK may not be the time for massive stimulus, it is certainly not the time for big scale deflation and a massive increase in unemployment either. Put that another way, ML reveals some big flaws in finance ministers' thinking, both in the UK and elsewhere.

6. An expanded monetary base (i.e. more bank reserves) would enable banks to go on a wild lending spree.

Answer. This idea has hardly been born out in the last year or so. We’ve had a massive base increase, and politicians are tearing their hair out at the FAILURE of banks to lend.

Second, it is a basic principle of banking that “banks are capital constrained, not reserve constrained”. (Anyone not acquainted with the latter phrase in inverted commas, just Google it.)

An increased monetary base does not increase banks’ capital, thus it does not enable them to lend more.

7. Given that U.S. and U.K. national debts were well over 200% of GDP (over double their present levels) just after WWII and without any big problems, is there any real need to reduce national debts?

Answer. On the basis of the above 200% point obviously not. Put another way, the present clamour for debt reduction is mostly hysteria. Or to put it yet another way, beware of anyone who advocates debt reduction for the sake of it. In contrast, several good reasons are given above for reducing or abolishing national debt.