Three Experiments in Keynesian Stimulus

The Greek adventure is the latest example of Keynesian stimulation in the news.
Unfortunately for Greece, the adventure is ending badly with stimulation replaced with at least a forced national budget that must be in balance. This will be an example of one economic balance morphing into a second economic balance. We can learn lessons from this event.

The Greek example can be contrasted with the experience of China and Japan. Both China and Japan have also had high rates of monetary stimulus. The difference is that Greece obtained stimulus by borrowing from outside the national boundaries. China and Japan borrowed from within their national boundaries.

As this post is being written, Greece has been sent home with a demand to pass legislation acceptable to the remaining euro community. This with enough money to allow Greek banks to reopen soon. The goal for a Greek budget seems to be balance -- balance expenses with income. It will take a large change in the Greek economy to accomplish this goal.

One lesson here should be that Keynesian stimulation obtained by borrowing from extra-national sources exposes the borrower to a sudden stimulation stop due to denial by lenders. Loss of control is never a good option for a national government.

On the other hand, China and Japan have both borrowed internally to obtain their Keynesian stimulus. Both have run up their internal debt to multiples of their GDP. At the same time, both have acquired ownership of large amounts of debt from other nations. Both have more than $1 trillion in value of American debt.

This acquisition of foreign debt can be traced to internal debt being used to build products intended for foreign sale. Then the foreign nation must be willing to buy the products with borrowed money. The foreign borrowing does not need to be directly linked to the products. In America, the borrowing was for houses and American national debt; subsequently the money borrowed for houses and national debt was spent on China and Japan products. The final result was large amounts of American debt held by China and Japan.

There are more differences. The difference between internal and external borrowing of stimulus seems to have led to different internal economic distribution. In Japan, the stimulus led to very low unemployment and later, persistent GDP malaise. The malaise has coincided with a population decline as the population opted to have a birthrate less than death rate (but this may not be a direct result of stimulation).

The Chinese example seems similar but the record of stimulus in China is shorter and is being carried out in a one party political environment. China uniquely enacted a one-child policy that slowed it's population growth.

The Greek experience with stimulus has been different. Some groups (such as pensioners) seem to have done very well. Others, such as young workers, have done very poorly with unemployment rates near 25 per cent. Greek productivity seems to have greatly declined and imports have increasingly exceeded exports.

One lesson from Greece seems to be that groups favored by government do very well compared to groups not favored. This effect also seems to be present in China and Japan but is less visible.

We should also notice that the Greek borrowing was mostly done from within the euro zone. We can therefore examine if the Greek borrowing can be considered as a subset of borrowing within the larger euro zone, with the larger euro zone also having Keynesian stimulation but at a different rate with different distribution effect.

These observations are all anecdotal,  offered without charts and data support. Careful examination of the data is expected to support these observations and may dig out additional correlations or contrast.

Keynesian stimulation remains in the experimental stage. Year-after-year borrowing has only been widely undertaken by governments-world-wide since about 1973 when the gold standard was abandoned by the United States. The long-long term effects are yet to be recorded.

Greek Loan Repayment

The following is a comment made in response to a Ralph Musgrave post. An example of a young-couple-who-liked-to-borrow is used to question whether we really want to have Greece repay the loans it has received.

"Our community could have a young couple that liked to borrow money from the community bank for the simple reason that they liked to spend more than they could earn.

If this couple was very likable, they might be able to borrow more than they earned every year for many years.

In fact, they could do this until the bank said "NO MORE LOANS!".

A "NO MORE LOANS" decision would be a paradigm change. It would be a change in the annual way of running the local economy.

How might the economy change if, after many years of lending to the (formerly) young couple, the lending stopped? Those businesses that received the annual loan proceeds (the couple always spent the loan money) would see fewer sales and need fewer workers. This because less money each year would be spent.

Now if the bank also required the (formerly) young couple to repay the loan, there would be an additional effect that we might call a second paradigm change. The couple would need to work harder to earn money. Working harder would entail producing products already made by other workers which would increase sales competition. The  economic effect of loan repayment is the opposite of initial loan creation.

I think we can consider that Greece has been this (formerly) young couple. Now the loans are being denied. Do we really want them to repay the loans?"

The story of the (formerly) young couple illustrates that TWO paradigm changes occur when a series of annual loans evolves into a series of annual loan repayments. Paradigm changes are difficult events for entire economies.

Macroeconomic Stimulus Leaves a Remainder

Modern macroeconomic stimulus attempts to increase the amount of money flowing through the macro economy. The basic approach is to lower interest rates to encourage increased borrowing. An increase in borrowing results in more monetary transactions which translate into the exchange of more goods and services.

The increased borrowing comes from mostly from banks. The banks can be private commercial banks or a national central bank (usually government owned). 

New borrowing is accompanied by a loan document signed by the borrower. Modern banking in the United States does a good job of reporting the level of bank lending, which allows the investigating economist a window into how much new money is injected into the economy on an annual basis.

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Banking theory would hold that newly borrowed money remains in an economy until the loan is repaid. Unlike individuals who borrow money and then spend it, leaving an empty wallet, the macro economy circulates borrowed money until it disappears into loan repayment. (For example, a 30 year loan will have a declining portion of the original loaned money continue to circulate for the full 30 years.) 

When we go looking for money circulating from government and private borrowing, we cannot find that money as either currency or deposits. Part of the money has disappeared into the form of government bonds which are not counted as money. This disappearance is the result of efforts by government to control the rate of spending and thereby the value of the money. Money is moved to the sidelines by government borrowing, 

Yet, government does spend the borrowed money, and thereby does recycle the original money. More money movement, less actual money needed. The amount of money moved is recorded in the loan documents.

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Our goal is to learn how much stimulation (new money) has flowed into the United States economy in recent years. If MMT and Keynesian monetary theory is correct, the new money should have expanded the economy measured by GDP. The amount of new money injected should be recorded as increased debt. We should be able to look at the increase in bank loans and the increase in government debt, and then trace this increase as money that has flowed into the macro economy. This increase should increase the GDP on a dollar for dollar basis (at least), and should increase it more than that due to re-spending by the economic players.

Any stimulation should not only increase GDP, it should increase the taxes extracted by government. A pattern of stimulation, followed by increased tax revenues which generate partial stimulation recovery, would occur in every annual period. We could write this mathematically to say

       stimulation = remainder + change in tax revenue

where the term remainder is the amount of stimulus that remains in the economy at the end of the measuring period.

We could find the amount of 'remainder' from adding the annual government deficit and the annual change in total bank loans outstanding. The term 'change in tax revenue' could be found from the annual GDP change multiplied by the average tax rate.

Figure 1. illustrates the annual stimulation that has occurred in the United States beginning in 1948. It is a far larger number than the (about) four percent annual inflation that has occurred in price levels. The chart can be found online at the Federal Reserve Data Website.

Figure 1. Annual United States stimulation from bank loans and government deficits, expressed as a ratio to GDP. Possible stimulation from corporate or government sponsored residential loan activity is not included.

The actual amount of annual United States stimulation could be larger than shown in Figure 1. Mechanisms such as "Fanny Mae" and "Freddie Mac" purchase loans from private banks, thereby taking loans off the private books. No attempt to quantify this data deficiency was made for this post but it could be a large amount.

This effort to quantify annual stimulation is subject to a large amount of data 'noise'. For example, GDP is a calculated estimate (done with considerable care) but the estimate is dependent upon sketchy data. The distorting effect of bank loan sales has already be mentioned. Other distortions (such as corporate bonds) and data deficiencies may exist.

We can look for distortions in Figure 1. The declining stimulus from the early 1990's to 2000 is a particularly good example. This period contained the 'dot com' boom which collapsed about year 2001. Corporate borrowing and massive new issues of stock accompanied the boom. Government tax revenues would have increased, reducing the 'need' for government deficits. Indeed, government tax revenues exceed expenses for part of the period between 1998 and 2001.  All of these observations argue for the need to expand the observed data sets that would describe the term 'remainder'.

Epilogue:

Figure 1 demonstrates about 67 years of continuous economic stimulation. The rate of stimulation has varied from less than 2 percent to more than 10 percent of GDP annually.

No attempt has been made to relate interest rates to the rate of stimulus. A comparison may be the subject of a future post.

No attempt has been made to compare stimulation with employment levels. Any effort along this line of investigation should await a better analysis of which data is best used to quantify the term 'remainder'.

The lines between investment, 'new money', and borrowing are not as clear as macro-economist would prefer. For example, corporate bond or stock sales may not be to banks but may result in economic stimulation. For purposes of Figure 1, any financial activity that resulted in both economic stimulation and a stimulation remainder should be counted as part of the term 'remainder'.

The contribution to stimulus recovered by taxation should be independent of the 'remainder' term but may be related in a common (not yet determined) ratio.

A Simple Model for Government Borrowing

Brian Romanchuk has an interesting post on government debt. Brian's model describes 'reserves' and goes into the mechanics of government-to-payee transfers of deposits at a bank. I think this complexity obscures the true nature of government debt and the subsequent valuation of that debt. This post will describe a model that is much easier to understand.

At the Mechanical Money Blog, the goal is to build systems beginning with base components that the reader can understand as being sequentially plausible. Brian's much more complex model can be built from this base with little effort.

For purposes of this post, if the actions, cooperation, or trades COULD occur, pretend that they actually do. Then judge at the end to see if a reasonable, plausible financial model has been described.

Remember, we are discussing fiat money without physical backing (such as gold) to establish valuation.

Notice the importance of the Central Bank in the discussion. Remember that banks create money when a loan is made. Restated, a bank loan is always accompanied by a bank deposit in favor of the borrower. Remember also that a Central Bank needs no capital of it's own to perform a money making event. [1]

The Model

In the United States, we have a central bank (CB), the Federal Reserve Bank, that acts under charter from the Federal Government. It can be considered as an arm of the Federal Government. It produces a green money product labeled a “Federal Reserve Note”. This money product is available in both brief-case-compatible and electronic versions.

The United States Government has a Treasury department which acts to fund government. One of the functions of the Treasury is to borrow by issuing bonds whenever government funds threaten to become inadequate.

Periodically, a representative of the CB will meet with a representative of the Treasury and the two will exchange products. The representative of the CB will come to the meeting with Federal Reserve Notes and leave with Treasury Bonds. The representative of the Treasury will come to the meeting with Treasury Bonds and leave with Federal Reserve Notes.

Following the exchange, the CB will hold a bond and the Treasury will pay the obligations of government.

The reader can see that the CB has a risky asset but it paid nothing for it (except for the cost of printing). Government is happy because it can pay obligations.

Establishing Value

The reader must admit that the basic sequence modeled can occur and MUST occur in the broad scheme of macroeconomics. How is VALUE established?

The model states that government pays obligations with Federal Reserve Notes. It follows that all who accept the notes for payment are paid in full. The initial valuation of the notes is the prices negotiated by government with the private economy, the price to be paid in Federal Reserve Notes. For example, a week’s work as a secretary is traded for one week’s pay in Federal Reserve Notes.

The CB needs to set a valuation on the bond it holds. While the bond cost was only the cost of printing the Notes, any bank knows that this product trade can not go on for long unless the bond (to borrow a phrase from current Greek bond discussions) "is investment grade”. If the bond is investment grade, it can be sold to the private sector, which, in turn, creates conditions that allow the CB to buy and sell bonds from the private sector in an effort to control the value of the bonds.

How can the bank make a bond “investment grade”? The bank is a secondary player here. It issued the Notes and has a promise for return of the Notes, probably with interest. The CB is dependent upon government to fulfill that promise.

On the other hand, government has made a near impossible pledge. It is very difficult to return all the Notes. The first thing government did was to scatter the Notes into the economy where they can be held indefinitely or even destroyed. Yes, government can recover the Notes with taxation but that takes an indefinite period of time.

One possible path to investment grade bonds is for government to establish a credible pattern of taxation adequate to service the bonds. It follows that credibility could be lost by government refusal to tax or make any effort to actually repay the bonds.

Government has a choice of lenders

Following the initial sequence of money creating events (an exchange of products and government spending), government has two potential lenders as sources for future loans. It can meet with a representative of the CB (again) or it can borrow from the private sector. The choice will depend upon how government wishes to manage money supply, interest rates, foreign exchange, and a host of other practical concerns. And yes, maintaining an investment grade bond rating will be part of the consideration.

Today’s News

We can apply this model to today’s news about Greece. The European Central Bank (ECB) has just announced that they will no longer accept Greek bonds as collateral. The bonds are no longer “investment grade”.

The ECB is a bank that creates money by creating deposits. The ECB product, the euro, was established by trading euro’s (both briefcase and electronic versions) for government debt. The Greeks then destroyed the drachma and substituted the euro. The exchange was nearly without cost. Because each nation did this proportionally, the euro became a commonly traded currency in all participating nations.

Now, following today’s ECB announcement, a Greece Treasury representative will not be able to expand the euro money supply by meeting with an ECB representative and making a product exchange. The Greek Treasury still has the option of borrowing from the private sector.

Conclusion

Simple models have the great advantage that they can be easily understood and mathematically described. If there is basic validity, an accurate simple model can be expanded into real situations with added complexity. This simple model seems to pass that validity test.

[1] The European Central Bank began with "five billion euro in capital held by the member national central banks of the member states as shareholders". The shares "are not transferable and cannot be used as collateral". (quotes from the linked reference)

Exploring the Mechanics of Foreign Trade

Brian Romanchuk has an interesting post on JCB's and demographics. His article provided impetus for me to put into graphical form what I think are the mechanical aspects of trade with Japan. 

The chart below illustrates what seem to be the mechanics of international trade. There is nothing difficult here. Cars are a place holder for any product handled in international trade. The mechanics of unbalanced trade seem to result in large bank accounts in each of trading countries.

Unbalanced foreign trade results in large bank accounts.

Products cross the boarders of countries, currencies are much less mobile. Each country (except the Euro Zone) usually has it's own currency. The currency has a hard-to-determine-value in other countries. As a result of the difficulty of exchanging currencies, sales into foreign countries tend to result in ownership of bank accounts in the foreign countries. If trade is unbalanced over many years, the accounts owned by one nation but located in another nation can become very large. A current example is the accounts of Japan and China in the USA where values have reached $1222 and $1253 Billion respectively. 

If the illustration displays the mechanics of unbalanced inter-currency trade correctly, the producing country is trading physical products in exchange for bank accounts. How can the bank accounts be used?

Both Japan and China could go shopping in the USA. The interesting thing is that neither really wants to do that. Why might that be? One reason is certainly that products are less expensive in Japan and China so why would either country want to shop in the USA?  Raw materials and agricultural products would be exceptions because both countries have resource shortages. 

We can examine resources and agriculture further. Both of these product baskets are produced on a world wide scale in competitive markets. The USA has high labor cost which tends to make it a supplier of last resort. Stated another way, Japan and China will buy from the USA when the other suppliers are sold out. 

So what should the trading countries do? Well, first, what is the problem? One worry would be that the bank accounts could be lost to inflation, which would result in a long term very unequal labor exchange. A bigger worry is that trade patterns might change, resulting in less work (jobs) for one trader and more work for the other. Or maybe there is nothing to worry about.

This post will close by noticing that one result of unbalance trade is increasing bank accounts in both trading currencies. The unbalanced trade could not occur unless both currencies accepted the unbalance no matter if the currency ownership is private or government.