Economic Theory for an Age of Ruin

2:24 pm in Failed government, Financial Crisis by masaccio

Flour Mill, Wolverhampton, England, photo by alienwatch via Flickr

As this financial disaster grinds through its fifth year, US economists haven’t seemed to change much about their analysis or explanations. The people who got it wrong continue to push their false theories, insisting that if we clap louder their reputations will be saved. It’s working for the hyper-rich. We’ve all seen the figures:

The numbers, produced by Emmanuel Saez, an economist at the University of California, Berkeley, show overall income growing by just 1.7 percent over the period. But there was a wide gap between the top 1 percent, whose earnings rose by 11.2 percent, and the other 99 percent, whose earnings declined by 0.4 percent.

Median household income, which was $50,054 in 2011, is about 9 percent lower than it was in 1999, after accounting for inflation.

Economists comfortable with progressive ideas offer the same solutions they always do: infrastructure repair paid for with borrowed money, hikes in the minimum wage, tax cuts for the workers who still have jobs, and so on. Perhaps they are familiar with some of the thinking that offers a better way forward. But let’s be realistic. There is little point in trying to teach any new ideas to Democrats in the legislature. They absolutely refuse to deviate from the standard American view: Chicago School Capitalism Good, Everything Else Bad. Heaven forbid anyone accuse them of being a liberal on economic matters.

Fortunately, some economists in the rest of the world saw that the economic theories they learned in college aren’t working, and are saying so in public. Lord Adair Turner is the Executive Chairman of the Financial Services Authority, presently the top banking and securities regulator in England. He recently gave a lecture entitled Debt, Money and Mephistopheles: How do we get out of this mess? Martin Wolf discussed it in this article.

In normal times, says Turner, monetary policy should work. The central bank lowers interest rates and that leads to an increase in bank lending. That isn’t working now, Turner says, because this is a balance sheet recession. People are paying down their debt, not taking out new loans. It doesn’t matter how low the interest rate goes, they don’t want to borrow, they want to get out of debt. Turner calls it pushing on a string. Turner points to long-term problems created by continuing on this feeble course. Japan is the primary school for this kind of failure.

Turner then addresses fiscal policy, deficit spending to provide tax cuts or infrastructure repairs. This tool has been ridiculed by economists for the last 30 years for several reasons the validity of which was unquestioned by any serious economist. Turner discusses a recent paper by Brad DeLong and Larry Summers arguing that those reasons aren’t applicable in the current crisis. He also points out that even so, they may have long term problems. That is because all deficits are financed using borrowed money. Deficit spending means the issuance of debt, and at some point that will be a serious problem, even if it isn’t right now.

But, of course, it is a huge problem right now, a problem not acknowledged by Turner, or by DeLong and Summers. The deficit hawks are insisting that the existing deficit is going to kill us and our children and their children, and it has to be stopped now, by suffocating cuts to Social Security, Medicare and Medicaid, and tax cuts for their corporate sponsors like @FixTheDebt.

Turner then opens the door to another idea that he calls Overt Money Finance. In the US, it would work like this. The Treasury has an account at the Fed. Congress appropriates money to pay for a program, say, purchase of new building in Pittsburg. Right now, that would be financed by issuing new Treasury bills. With Overt Money Finance, the Fed would simply credit the account of the Treasury with the amount appropriated. There would be no new debt, but the Treasury would have the money to pay for the building. You will note the similarity to the idea of the Trillion Dollar Coin. You will also notice the similarity to the way the Fed lends money to banks.

Overt Money Finance isn’t really a new idea. The most famous proponent was Milton Friedman in a 1948 paper, but it has been studiously ignored by all right-thinking people as much too dangerous. Turner explains that economists think that if politicians realized that they could just issue fiat money, they would destroy the currency by issuing more and more until we had hyperinflation. To prevent that bad outcome, we hobble ourselves with all sorts of laws and institutional rules about debt. One of those is the rule that the Fed can’t just lend money directly to the government. It finances the government by buying and selling Treasury debt in the open market. I suppose the theory is that the Fed is independent, so it won’t destroy the currency. Maybe, but let me point out that the Fed could easily have popped the last two bubbles, and didn’t, so its record on protecting the economy doesn’t give me much hope.

FDL readers will recognize Overt Money Finance, because we know about Modern Money Theory, thanks to the efforts of letsgetitdone and other diarists and commenters, and an excellent Book Salon with L. Randall Wray. Wray discusses Milton Friedman’s paper in Chapter 6 of his Modern Money Theory, A Primer on Macroeconomics for Sovereign Monetary Systems, and goes on to explain how it would work today and the steps that would be taken to prevent inflation. Turner has some ideas about that too.

Martin Wolf provides some helpful framing in his article in the Financial Times:

…[I]t is impossible to justify the conventional view that fiat money should operate almost exclusively via today’s system of private borrowing and lending. Why should state-created currency be predominantly employed to back the money created by banks as a byproduct of often irresponsible lending? Why is it good to support the leveraging of private property, but not the supply of public infrastructure? I fail to see any moral force to the idea that fiat money should only promote private, not public, spending.

I fail to see any moral force to that idea either. Why should those criminals get any help from government after wrecking the economy and ruining the lives of hundreds of millions of people around the world? Let’s do something nice for ourselves, preferably at the expense of the hyper-rich. Maybe we could fix some of those 70,000 structurally deficient bridges.