Friday, September 27, 2013

Assumptions


“I have found out what economics is; it is the science of confusing stocks with flows”

Michael Kalecki, quoted by Joan Robinson in Shedding Darkness

An excellent example of this confusion is how some economists think about inflation – inflation is a flow characteristic (since prices are expressed via transactions) yet many somehow think that changes in money stocks automatically produce inflation (e.g. the quantity theory of money). It is true that changes in stocks of money can influence money flows but it is incorrect to ASSUME an independent causal relationship. Instead, the relationship between money stocks and money flows is dependent on numerous other factors (e.g. money stock distribution, interest rates, animal spirits, etc.) which would need to be explicitly identified and controlled for if one wanted to quantify the relationship (this would be a very difficult, perhaps impossible, econometric task). You cannot simply assume the “velocity” of money is constant. Inflation can occur from any level of money stocks (think about what would happen if an asteroid was headed for earth). This leads to a central point I’ve banged the table about for years, and especially in my Applied Economic graduate studies – assumptions are of critical importance but which often do not receive an appropriate amount of attention. I believe that the root source of most mistakes in many fields of analysis stem from incorrect assumptions. I attribute my sensitivity to assumptions from my background in the natural sciences where assumptions are explicitly addressed even though in many cases they are far less pervasive than in economics (a social science). This last point is why I initially turned away from economics after my first few months of college (in the early 90’s), and why I choose to get a second master’s in Applied Economics with a focus on microeconomics (although similarly flawed I think mainstream microeconomic assumptions are less problematic).

Keeping with the assumptions theme, and putting on hold my economic policy recommendations (which the birth of my third child and a recent house purchase/move have prevented me from developing), I will now discuss a key assumption I made in a prior post as well as a CBO document that is full of bad assumptions.

 “I will assume that all financial assets not backed by a bank or the government cannot function as a money flow. I will ignore such items.”

I made this assumption because it simplified the discussion and did not influence the main points. However, this statement is not 100% correct – lending can occur between non-bank entities which results in a new financial asset being created that can be used as a money flow (e.g. accounts receivable (an asset to the owner) in exchange for a real flow). In addition to this type of transaction there is also “on-lending”, which entails the non-bank lending of existing money stocks to others (e.g. a deposit asset in exchange for a loan asset). While different at one level (“on-lent” transactions use bank/government money while A/R type transactions use money –like instruments) these processes are similar in that they both require someone to accept a non-bank IOU (asset) in exchange for a good, service or asset. The end result of such lending is that debt stocks now exceed money stocks and that all debt stocks can only be fully extinguished via multiple money flows through the economic cycle. A debt created from such lending is a stress on the system in the same way that interest expense is in that no money is created for its payment but instead payment must occur from existing money stocks. However on the other hand one can think of non-bank lending as being similar to lending via regular banks as it has the same short term macroeconomic consequence – it can result in additional money/financial asset flows that can increase real flows (economic output), assuming it is spent on good/service production.

Non-bank lending transactions can be performed by anyone, but due to trust issues and challenges in finding a suitable counterparty(s), it is usually facilitated by a non-bank financial institution (e.g. pension fund buying MBSs from a hedge fund). These non-bank financial intermediaries are part of the “shadow banking” system – which has been estimated to account for nearly 25-30% of the entire financial system1. I am still trying to fully understand the shadow banking system (by reading articles such as this: http://www.newyorkfed.org/research/epr/2013/0713adri.html ) but can briefly summarize such institutions as follows:

-       Shadow banks consist of – hedge funds, money market funds, SIVs, private equity funds, finance companies, etc.

o   Money market funds are different than other shadow bank entities – I will ignore them for now

-       They (shadow banks) do not have an account at the Federal reserve, they do not have access to Federal Reserve lending facilities, they do not issue FDIC insured deposits and they are not closely regulated like banks. The implications of these facts include:

o   The liabilities shadow banks issue are often explicitly tied to assets on their balance sheets (e.g. “secured” borrowing or borrowing via repurchase-type contracts)

o   An obligation issued from a shadow bank is not automatically accepted by regular banks because the lack of an account at the Fed means that the destination bank cannot receive reserves (an asset to the destination bank) when the transfer is made, meaning that the shadow bank must have some other asset to give to the destination bank in order for them to create the liability on their books. This factor contributes to shadow bank asset withdrawal timing restrictions and makes shadow bank liabilities (assets to the counterparty) generally unsuitable for use as “money”.

o   Shadow banks are risker than regular banks since they are much more likely to experience liquidity-driven problems (as actually occurred during the financial crisis until the Federal Reserve provided them with a lending facility)

-       The differences between banks and shadow banks are blurred because shadow banks are often owned by banks, undertake many activities that banks perform and require banks to facilitate their functioning (e.g. for interbank payments, etc.).

Shadow banking is a complicated subject because of firm and activity diversity, but in my opinion the reason for the growth of the shadow banking system can be attributed to banking regulations – the more we try to limit banking risk the more activities end up being pushed out of the system into the “shadows”. This is a troubling development, especially when one realizes that the recent housing boom and subsequent financial crisis would not have been possible without the shadow banks. This is a big topic for which I will try to write further. In the meantime, I would like to point out that the shadow banking system ends up funding housing debt with deposits (the original accounting entries on the bank’s balance sheet when the house loan/deposit was created) by a complicated chain (forming a circle when connected to the source bank) of repo transactions that breaks up the risk into pieces (e.g. liquidity risk, credit risk, interest rate risk, etc.) and results in:

1)      The removal of both the asset (loan) and liability (deposit) from the bank’s balance sheet [This is key because the liquidity, credit and interest rate risk associated with the accounting of the initial loan (a long term loan paired with a short term deposit) would require a significant amount of bank capital to be set aside (lowering bank leverage/profitability). Although this can also be mitigated by the bank converting the deposit to a different liability (e.g. term deposit, bank issued bond, etc.)2 ]

2)      An asset swap on the shadow bank system balance sheet (deposit asset (to regular bank) for loan asset (from regular bank))

3)      Multiple (up to 7 or so) loans between shadow banks (each balance sheet would have an asset in the form of a loan due to them and a liability in the form of a loan due to another shadow bank, with the underlying real asset (housing/land) securing each loan).

 

An example of bad assumptions undermining an analysis is the CBO’s “The 2013 Long-term Budget Outlook”. Below I analyze three particularly problematic passages of this report – it saddens me to think of the policy mistakes that follow from this incredibly flawed report. Wake up CBO!!!


 
Page 3:

 Harmful Effects of Large and Growing Debt
 How long the nation could sustain such growth in federal
debt is impossible to predict with any confidence. At
some point, investors would begin to doubt the government’s
willingness or ability to pay U.S. debt obligations,
making it more difficult or more expensive for the government
to borrow money. Moreover, even before that
point was reached, the high and rising amount of debt
that CBO projects under the extended baseline would
have significant negative consequences for both the

economy and the federal budget:
 

- Increased borrowing by the federal government would
 eventually reduce private investment in productive

 capital, because the portion of total savings used to
 buy government securities would not be available to

 finance private investment. The result would be a
 smaller stock of capital and lower output and income

 in the long run than would otherwise be the case.
 Despite those reductions, however, the continued

 growth of productivity would make real (inflation adjusted)
 output and income per person higher in

 the future than they are now.
 

- Federal spending on interest payments would rise,
 thus requiring larger changes in tax and spending

 policies to achieve any chosen targets for budget
 deficits and debt.

 
- The government would have less flexibility to use
 tax and spending policies to respond to unexpected

 challenges, such as economic downturns or wars.
 

- The risk of a fiscal crisis—in which investors
 demanded very high interest rates to finance the

 government’s borrowing needs—would increase.”

 

Page 77:

 How Increased Federal Borrowing Would Affect the
 Economy

 
Increased borrowing by the federal government generally
 draws money away from (that is, crowds out) private

 investment in productive capital because the portion of
 people’s savings used to buy government securities is not

 available to finance private investment. The result is a
 smaller stock of capital and lower output in the long run

 than would otherwise be the case (all else held equal).3
 Two factors offset part of that crowding-out effect. One

 is that additional federal borrowing tends to lead
 to greater private saving, which increases the total funds

 available to purchase federal debt and finance private
 investment. That response occurs for several reasons:


- Additional federal borrowing tends to raise interest
 rates, which boosts the return on saving;

 
- Some people anticipate that policymakers will raise
 taxes or cut spending in the future to cover the cost of

 paying interest on the additional accumulated debt, so
 those people increase their own saving to prepare for

 paying higher taxes or receiving less in benefits; and

 - The policies that give rise to deficits (such as tax cuts
 or increases in government transfer payments) put

 more money in private hands, some of which is saved.”

 
Page 81:

 With those two offsets taken together, when the deficit
 goes up by $1, private saving rises by 43 cents (so

 national saving falls by 57 cents), and foreign capital
 inflows rise by 24 cents, ultimately leaving a decline of

 33 cents in investment, according to CBO’s central estimates.
 To reflect the wide range of estimates in the economics

 literature on how government borrowing affects
 national saving and domestic investment, CBO produced

 estimates of the economic effects of the budget scenarios
 using three assumptions about those effects. Those

 assumptions imply that for each dollar that deficits rise,
 national saving is reduced by 39 cents, 57 cents, or

 71 cents, and domestic investment is reduced by
 15 cents, 33 cents, or 50 cents.”

  

Starting from the top – the first underlined section discusses investors being unwilling to “finance” the federal debt. This reminds me of the people who feared a credit downgrade by the rating agencies as it would increase US borrowing costs. The fact is US borrowing costs decreased after the credit downgrade because US borrowing costs are under the control of the Federal Reserve - not “bond market vigilantes”. My prior posts should make this point abundantly clear. In the worst case scenario the Fed would buy all the Treasury debt and leave the private sector with reserve balances (which have zero duration and a yield set by the Federal Reserve), unless of course you want to argue that the Fed will ignore their mandate and let the Treasury default.

 The second underlined point regarding the “crowding out” of private investment refers to one of the most problematic assumptions in economics – specifically the idea that there is a fixed amount of money and therefore an opportunity cost of using money to “fund” federal deficits. This is another point which I have discussed at length in prior posts – the “loanable funds” assumption is totally invalidated when one understands that “loans create deposits” and “investment creates savings”. There is not a fixed pool of money that is divided up between competing groups – in the real world money/loans expand to meet the needs of the economy. This flawed assumption is central to the IS/LM model, who folks like Paul Krugman use even though the model’s creator (John Hicks) ended up rejecting it.

The third point that larger interest payments makes required deficit limiting tax/spending changes larger is not accurate because the result depends on other factors. One of the main themes throughout my posts is that the fundamental building block of market-based economies is transactions, and that transactions REQUIRE at least two parties. In this case as Federal interest payments increase the other transacting party (the private sector) see an equivalent increase in interest revenue. It is this second automatic consequence of increased interest expense that makes the statement problematic – we need to make assumptions about who receives these payments, what people do with the interest revenue payments and what tax/spending laws exist at the time before we can ascertain what the ramifications will be regarding the overall fiscal stance of the Federal Government. Higher interest expense can reduce the budget deficit via the impact of the resulting monetary flows on the existing automatic stabilizers in place at the time.

The fourth point, about less flexibility in the event of an adverse economic shock, is just another implication from the assumption that investors may be unwilling to finance the federal debt. If this worry is not correct (as I have argued) then there is no reason why high debt would limit flexibility in regards to tax and spending decisions.

The fifth point, about increased risks of a financial crisis, is yet another way to state the incorrect assumption that investors may become unwilling to “finance” the federal debt. It’s really sad that after a private debt induced financial crisis people still end up focusing on public debt. “You can’t solve a debt problem with more debt” is the common meme, but again this idea fails because the analogy represents an incorrect assumption – private entities (without a money printing press) can fail to pay debts (and go bankrupt) while governments with a fiat currency and no foreign currency denominated debt can always pay their debts if they so choose. Before leaving this point I need to highlight that foreign holdings of public debt (or US$ financial assets in general) can be problematic in that quick movements of these funds out of the country can create exchange rate issues and problems in the banking system (since banks facilitate foreign currency conversion and can get caught with significant foreign exchange losses – this sort of scenario could be resolved via capital controls, or other regulations). However, this is a trade deficit issue, not a federal debt issue (sadly these issues are often confused).

 The sixth point, about federal borrowing increasing interest rates, is yet another consequence of the incorrect “loanable funds” assumption. In the past empirical support for this idea was only possible via omitted variable biased regressions (i.e. by not controlling for central bank reaction functions and different monetary regimes). Now even these biased regressions do not tell this story – public debt as a % of GDP has expanded almost everywhere, yet interest rates have gone down.

 The seventh point is one which I have explicitly discussed in a prior post – it’s the fairytale about Ricardian equivalence, which apparently is too closely aligned with “inter-temporal optimization” to discard. 

The eighth and final point is a quote that is actually consistent with the sectoral balance identity ((I - S) + (G - T) + (X - M) = 0). The problem with the quote is 1) the wide range of postulated effects from government borrowings (admission that they have no clue), 2) they did not mention that in their scenario the private sector ends up with an increase in net financial assets equal to $0.76 (and the foreign sector with a balance that is $0.24 higher than before) – either because they ignore balance sheets or because this realization would cast doubt onto their (incorrect) assumption regarding the effect of deficit spending on interest rates (i.e. that deficits increase them), 3) they did not mention the deficit’s impact on short term economic output but instead focused on investment which is moving in a negative direction due to bad assumptions about loanable funds and 4) they mix in negative foreign sector leakage effects without discussing the assumption explicitly (and in fact  discuss a trade deficit as if it is a good thing)

 I could go on and on – in addition to a total lack of understanding of banking and money the report is also full of the standard neoclassical assumptions (marginalist optimization, etc.) many of which are fundamentally flawed. Why can’t the CBO at least include a scenario/addendum that is derived from a different economic school of thought, especially in light of the fact that the economic school of thought they use has failed so miserably?


2 Much of my banking knowledge is thanks to fellow Canadian JKH from www.monetaryrealism.com