From a Woodford interview

I found an interview with Michael Woodford, by the editor of the Minneapolis Fed publication The Region. Here is the gist of the discussion at one point:

Region: ... What are the advantages of the latter, of a nominal GDP target policy?
Woodford: One advantage is it would be a single criterion; whereas, the thresholds that the Fed announced were two different criteria.
Region: Perhaps dueling criteria, at times.
Woodford: Right. There was a threshold for the unemployment rate, but there was also a threshold for inflation expectations. The question of whether those could be in conflict was being sidestepped.

The question of what to do if the inflation target and the unemployment target come into conflict was not addressed. Or not even. The question of whether the targets could come into conflict was not being addressed.

It's a good point in favor of NGDP. Or not really, but at least it's a good point against the current system. It doesn't mean NGDP targeting would be better; that's wide of the mark. But the idea of "what we need to happen with inflation" being in conflict with "what we need to happen with unemployment" is certainly a point worth pondering deeply.

If things get so bad that we have "dueling criteria" then I'm not confident even NGDP targeting can solve the problem. It leaves me confident only that somewhere along the way, our understanding of the economy went wrong. What we need is a massive re-think of all the things we are sure about.


In 1977 I wrote:

The solution to inflation is "less money." The solution to unemployment is "more money." This is a magnificent answer for an either/or problem. But when the problem is "both," the logical solution is to increase and decrease, at the same time, the country's money supply...

Our economy is facing a both problem. The solution to that problem is to do two contradicting things to the money supply.

Woodford and I both focus on the possibility that to solve the economy's problems we may need self-contradictory policy. But no: It was Woodford in 2014 who said we may run into that problem. Almost 40 years earlier I said we were already facing that problem. But at least we both recognize conflict within policy as a problem. (Apparently some people don't?)

Woodford's concern was that

"The question of whether those [policies] could be in conflict was being sidestepped."

I'm not sure sidestepping is the big issue here. Inflation and unemployment are our two main economic concerns, and getting them on target is the whole heart and soul of policy. If our economic policies are in conflict, this is no small thing.

Inflation was too high back in the 1970s. So was unemployment. Remember "stagflation"? It was a "both" problem, and the standard prescription called for self-contradictory policy. If that's the situation, doesn't it make you want to question our understanding of the economy? What -- We should wait for a financial crisis to raise such concerns?

Maybe there is something wrong with our understanding, and maybe our error is the source of our troubles. That's easy for me to say, of course, because I'm not an economist and I don't have the big investment in understanding the economy. It would be costly for economists to take the view that I take. So maybe we should expect their concern to be only "sidestepping". And maybe we should expect that their resolution to the conflict in policy would emerge from their conflicting conclusions, rather than from a rethink that begins at initial assumptions.


"Almost 40 years earlier I said we were already facing that problem."

The problem was that unemployment was too high, but also inflation was too high. It was a manufactured problem. We had created high unemployment by using recessions to fight inflation. And we had created high inflation, either by leaving old Keynesians in charge or by failing to address the cost-push issue that was being generated by a growing financial sector.

Well, we got rid of the old Keynesians. That didn't help...

A hundred dollars?

Last time I said:

One of the biggest distortions life creates is that in the real world our reliance on credit grows over time. If we start out borrowing an average of a hundred dollars a year, as in 1956, we can end up fifty years later borrowing forty-four hundred dollars a year. But that's what happens when economists and policymakers think that a constantly rising debt goes "hand in hand with improvements in economic well-being".

That hundred dollars.

To be clear, I was looking at household debt when I said it. Take household debt, change the units to "Change from Year Ago, Billions of Dollars", and make the frequency "annual" so you get only one number for each year. Then divide it by U.S. Population (with units in thousands; VERIFY IT) and multiply the ratio by a million (to convert debt in billions to debt in thousands) to get a per capita number.

Here's what I got last time:

Graph #1

101.16508 in 1956 ... about a hundred dollars ... and 4398.80697 in 2006 ... about 44 times as much debt per capita. As I said. But come to think of it, we should probably correct for inflation.

We're looking at the change in debt. That's a flow variable. So we can use the same calculation you'd use to convert GDP from nominal to real: divide the change in prices out of the debt numbers, and multiply by 100. I'll be nice, and use the Personal Consumption Expenditures: Chain-type Price Index instead of the CPI. (The Fed uses a PCE index, not the CPI.) But I'm not going with the one that excludes food and energy prices. I'm not all that nice.

Here's what I got now:

Graph #2

668.19738 in 1956, and 4932.83577 in 2006 ... something above a seven-fold increase, less than seven and a half. Seven, seven and a half versus a 44-fold increase, the difference between them due entirely to inflation.

But anyway, per capita household borrowing in 1956: $668.20. That's in today's dollars (or year 2012 dollars, really). Does that sound a little more reasonable than $100?

So as I was saying:

One of the biggest distortions life creates is that in the real world our reliance on credit grows over time. If we start out borrowing an average of a $668.20 a year, as in 1956, inflation aside, we can end up fifty years later borrowing $4932.84 a year. But that's what happens when economists and policymakers think that a constantly rising debt goes "hand in hand with improvements in economic well-being".

There is no doubt in my mind that we are a cashless society today because of our pro-credit-use pro-growth policies. We should change those policies before it's too late, because the reliance on credit is killing us.

Debt Effects

Suppose we borrow an amount equal to 10% of our income every year. And suppose we pay off 10% of our debt every year. What does our economy look like?

Assume the interest rate is always 5%.
Assume we start with zero debt.
Assume our income is $10,000 per year, always.
Assume our standard of living is equal to our income plus what we borrow minus the debt service we pay.

Assume we start work at age 16 and drop dead at 80.

I put all that crap in a spreadsheet.

Graph #1

We start at age 16 with zero debt. We borrow a thousand every year, and pay back 10% of what we owe. Our debt accumulates. But when it gets to $10,000, we're paying back a thousand every year, same as we borrow. So our debt stabilizes at that level, the $10,000 level.

In the real world our borrowing varies from year to year. Prices and, hopefully, incomes go up. Interest rates change. And terms of repayment change. In the real world accumulated debt differs from what this graph shows. But the graph shows the kind of thing that would happen if prices and incomes and borrowing and interest rates and terms of repayment weren't all changing. What happens in the real world looks like what the graph shows, but twisted and distorted by the facts of life.

One of the biggest distortions life creates is that in the real world our reliance on credit grows over time. If we start out borrowing an average of a hundred dollars a year, as in 1956, we can end up fifty years later borrowing forty-four hundred dollars a year. But that's what happens when economists and policymakers think that a constantly rising debt goes "hand in hand with improvements in economic well-being".

I can't believe they had the nerve to say that "hand in hand" thing.

Graph #2

With income of $10,000 and $1000 borrowed, we can spend $11,000 the first year. We started with no debt, so debt service that first year is zero. In later years, debt service takes some of our money, and our standard of living falls.

After 10 years or so, the debt service payment goes above $1000 a year. That's more than the thousand we borrow each year. So our standard of living goes below our $10,000 income level.

Our Standard of Living continues to drop thereafter, but more slowly. As we saw above, our accumulated debt eventually levels off. As our debt stops rising, our debt service stops rising, so our standard of living stops falling. Why does it level off $500 below our income level? Looks like it's due to the cost of interest. In my spreadsheet for this simulation, the interest portion of the debt service payment gradually approaches the $500 level. The numbers fit.


On the Standard of Living graph, the blue line runs above our $10,000 income for a while, and below it thereafter. In the spreadsheet calculation, the difference from the $10,000 level is due only to our borrowing (which pushes the blue line up) and to debt service costs (which drag it down). For those first 10 years or so when the blue line is above 10,000, we're ahead of the game. But after those early years, the Standard of Living goes below our income level and our creditors are ahead of the game.

That's a bit of a simplification. Creditors can have bad days, too. But you get the idea: We're ahead of the game in the early years, and behind the game thereafter.

The Standard of Living graph indicates our standing for each year separately. It doesn't add last year's number to this year's. For each year it shows how that year's borrowing and that year's debt service payment tally with that year's income.

In life, we may take things a year at a time, or a day at a time, but if we're ahead every year for ten years or so, things seem pretty good. And if we're behind every year, without ever a good one, things can seem pretty bad. So I want to look at the cumulative effect of being ahead of the game or behind it due to the effects of borrowing and loan repayment on income.

Graph #3

On the earlier graph, the Standard of Living graph, we start at $11,000, a thousand dollars above our income level. Over the next ten years the blue line gradually falls and eventually gets down to our income level. That year, there is no gain.

On this graph, the Cumulative Gain or Loss graph, the blue line starts at the $1000 level because our standard of living was $1000 above our income level. Over the next ten years the blue line rises as we add in gains from later years, but it rises more and more slowly because each year's gain is less than the one the year before. After 10 years the cumulative gain reaches a maximum, just below the 5000 level on the graph. At the maximum, the line is just about flat, because the gain from borrowing has just about dissipated, and our Standard of Living is just about equal to our income.

In the years thereafter, our debt service is more than the $1000 we borrow each year. As a result, our Standard of Living runs below our $10,000 income level. We're behind the game, and each year is a loss. When you take those annual losses and add them to our Cumulative Gain or Loss graph, what you get is a shockingly large cumulative loss.

And yes, I checked that $100 number, $100 per year per capita borrowing in 1956.

Non Sequitur: High debt ⇒ Low demand ∴ the public sector should borrow to fill the spending gap

Cecchetti et al, again, 2011 (PDF; page 4):

In principle, as highly indebted borrowers stop spending, less indebted borrowers or lenders could take up the slack. For example, wealthy households could purchase goods at reduced prices and cash-rich firms could invest at improved expected return. But they need not. As Eggertson and Krugman (2011) point out, it is the asymmetry between those who are highly indebted and those who are not that leads to a decline in aggregate demand. Those authors suggest that, in order to avoid high unemployment and deflation, the public sector should borrow to fill the spending gap left by private sector borrowers as the latter repair their balance sheets.

Here's what I get from that paragraph:

1. There is a lot of debt.
2. Higher debt service (or a decision to cut back on borrowing) means people with lots of debt must spend less than they did before.
3. People without a lot of debt could spend more and "take up the slack" but they do not.
4. The "asymmetry" between items 2 and 3 "leads to a decline in aggregate demand." And
5. "the public sector should borrow to fill the spending gap left by private sector borrowers"

But you can't really expect savers to turn around and bail out debtors just for the sake of improving the economy. People are not that altruistic. So it is nonsense to bring up "the asymmetry between those who are highly indebted and those who are not" and say that the asymmetry, rather than the cost of the debt, is what "leads to a decline in aggregate demand."

Don't fall for it. They're bullshitting you: Hey look over here! There's an asymmetry here that's making people spend less.

What? No! The problem is not that people who are heavily in debt cannot afford to "fill the spending gap" and people who are not don't want to. That's not the problem. The problem is there is so much debt it's choking off spending. The problem is the debt. Asymmetry is the distraction.

The problem is the high level of debt. Servicing it takes money that people would have spent on other things. So spending is listless. "Aggregate demand" is listless. And the economy is listless.

Since the private sector cannot solve the problem, Eggertson and Krugman say, "the public sector should borrow to fill the spending gap". Who else can fill the gap? The public sector, of course.

Again, no. When did we decide we should fill the spending gap? We didn't. The spending gap is not the problem. The high level of debt is the problem. The spending gap is a result of the debt problem. The spending gap is a result. Eggertson and Krugman want to fix a result. But what we need to do is fix the problem.

Eggertson and what's-his-name shift the focus away from the high level of debt. They shift the focus from the problem to the consequence -- "a decline in aggregate demand" -- and call this the problem. And then they propose a solution to this problem. But it isn't the problem. It is a consequence of the problem. Therefore, their proposed solution is a non sequitur. It doesn't follow from the given facts.

"Without debt, economies cannot grow"

Cecchetti et al, 2011 (PDF; page 3):

For all these reasons, financial deepening and rising debt go hand in hand with improvements in economic well-being. Without debt, economies cannot grow and macroeconomic volatility would also be greater than desirable.

On the one hand they offer "financial deepening and rising debt" without end. On the other hand they show us a world "without debt". Those are the extremes of the spectrum: using no credit at all, or the perpetual approach to using no money at all, and credit for everything. They are defending the view that financial deepening and rising debt are always good. And that comes from a paper that opens with these words:

Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be disaster.

I should add that immediately following the "Without debt, economies cannot grow" sentence, they go the other way again:

But financial development is not some magic potion. The accumulation of debt involves risk...

Hey, I don't have a problem with considering both sides of a problem. My problem is that Cecchetti, Mohanty, and Zampolli think that constantly rising debt goes "hand in hand with improvements in economic well-being". Shouldn't that idea be challenged as weak and baseless on the face of it? But weak and baseless or not, that's apparently what they think. And that's despite all their idle chatter about wisdom and moderation.

Add to this, then, my objection that they offer only all or nothing, with no middle ground. With no middle ground, they leave no room for the possibility that the level of credit use which best promotes economic growth is somewhere in the middle ground. All or nothing, those are the choices they offer.

No.

Talk is cheap. It's easy to say debt is a double-edged sword. But it's hard to assimilate that idea and work it into all your thinking. And that's what economists have to do.

Debt as a multiple of "Funds Readily Available for Spending"

Click either graph for an enlarged view:

Graph 1

Same thing, on a log scale:

Graph 2: "That's got to be man-made."

"Funds Readily Available for Spending" is the money we use to pay our bills. Nuff said.

Loans vs credit cards

If you are someone who always says "money is credit", you may have trouble with this post.

I think that when people say "money is credit" they mean "money is created by borrowing it", an idea that I can and do accept. However, I always distinguish between money and credit because I need to distinguish between money that does, and money that does not, involve borrowing and repayment and interest. Surely there is a difference between money I receive in my paycheck and money I receive as a loan.

In addition, for this post, I need to distinguish between money used to make final payments, and money used when payment is deferred.

In my view:

1. When you borrow money you receive credit (i.e., money plus the obligation to repay), and
2. When you spend the borrowed money, the obligation to repay remains with you, and the recipient receives money, not credit.

That last part -- "and the recipient receives money, not credit" -- is the topic of this post.


In a long blog post I've been working on, I write

When you take out a loan and spend the money, or when you use your credit card, you are putting credit to use.

I follow up on that thought a few lines later, saying

When you borrow and spend, or when you use a credit card, you are putting money into the economy.

But this is not accurate. I could say

When you borrow and spend, or when you use a credit card, you add to total spending.

That would be correct. But it doesn't allow me to make the next point that I want to make:

When you pay down a debt, you are taking money out of the economy.

For my logic to be clear, I need to have the use of credit "put money in", and the repayment of debt "take money out". However, even though a loan does put the money into the economy when you spend it, using a credit card does not. The problem is that, by comparison to loans, credit cards represent an advance in financial innovation. Things happen differently with credit cards.

With loans, you decide you want one, and you go to the bank to make the arrangements. With credit cards, you take one out of your wallet and use it. There is even an chance that you received the credit card by mail, unsolicited. In this case it's clearly not your decision to take a loan. It's the credit card company betting that if you have the credit card, you'll use it. Essentially, they are giving you a loan even though you didn't ask for it. They are "nudging" you into the use of credit; and (as is typical with behavioral econ) the nudge too often works.

With loans, you have the money in your wallet or your checking account or in your high-tech version of one or the other, but you have the money, and when you spend the money it moves from your account to the account of the seller. You will still have to pay off the loan, yes. However, at this point the seller has been paid and your transaction with the seller is complete.

The process is different for credit cards. With credit cards, you have the credit card in your wallet. And when you use it an amount of credit is transferred from your account to the seller's account. The seller does not receive money, but rather credit -- a place-holder for money. Therefore, I cannot say

When you use a credit card, you are putting money into the economy.

This topic came up recently in my Incomplete transactions post, where I quoted from The Evolution of Consumer Credit in America:

When a cardholder charged a meal, the restaurant sent the bill to Diners Club, and Diners Club then paid the price of the meal, minus a small commission, directly to the restaurant’s bank. Finally, Diners Club sent the cardholder a monthly statement (bill), and the cardholder sent Diners Club a check.

That was the Diners Club innovation: It inserted itself between buyer and seller, created credit for everyone else to use, and took full charge of the payments of money.

Any chance creating that credit-card credit is a form of counterfeiting?

//

Allow me to review and summarize.

Without a credit card, you first get the loan and then spend the money, and at that point the seller receives the money.

With a credit card, you create a new loan on the fly when you pay for your purchase, but the seller receives credit instead of money. An additional transaction is required, between the seller and the credit card company, for the seller to get the money.

Because of this financial innovation I am not able to say that putting credit to use puts money into the economy. Credit card use puts credit into the economy. So I have to stop and re-think things.

When I take a loan, I receive credit (money plus the obligation to repay). But when I use a credit card I receive only the obligation to repay. No money. (Plus I receive the thing I bought, but that's the original transaction and it happens with loans, with credit cards, and even with cash!)

When I spend the money I borrowed, the seller receives money. But when I use a credit card, the seller receives credit. So an additional transaction is required, where the seller exchanges the credit for money from the credit card company.

Either way, loan or credit card, I still have the obligation to repay, which also creates an additional transaction, this one between me and the credit card company.

//

Let me condense these thoughts.

When I take a loan new money is created, and when I spend it the seller receives money.

When I use a credit card, new credit is created, and the seller receives credit. There is a follow-up transaction between the seller and the credit card company where the credit is exchanged for money. And there is a follow-up transaction between me and the credit card company where money is exchanged for credit, fulfilling my obligation to repay. However, both of these follow-up transactions occur after the initiating transaction is complete. Money is not used at all in the initiating transaction.

No money is created when a credit card is used. A possible exception is the use of a credit card to get cash. But the statement is true for purchases: No money is created when a credit card is used.

Hm.


Up top, I said:

1. When you borrow money you receive credit (i.e., money plus the obligation to repay), and
2. When you spend the borrowed money, the obligation to repay remains with you, and the recipient receives money, not credit.

Now I want to add:

3. When you use a credit card you receive the obligation to repay (but no money), and
4. The seller receives credit, not money.
5. An additional transaction is required for the seller to exchange the credit for money.

In both cases, of course, an additional transaction is required for you to fulfill your obligation to repay.


Spending borrowed money "puts money in" and repaying the debt "takes money out".
The use of a credit card "puts credit in", and repaying the debt "takes credit out".
Okay. Maybe this is the reason J.W. Mason says

I don't think the idea of "money" as something that has a quantity applies to the credit-money world of today

and all that. Fair enough.

But there is something Mason's statement does not address: The growth of finance creates growing financial cost in our economy. And, since the financial and nonfinancial sectors are different and distinct, it is possible that growing financial cost can harm the nonfinancial economy.

More than just "possible" I think. I find it necessary that we reduce the size of finance in order to reduce the cost of finance. (Note that in credit card "follow-up" transactions both the buyer and the seller are likely to be paying interest or a "commission" to the credit card company.)

If it is necessary to reduce the cost of finance, which it is, then this "credit-money world of today" has got to go. We should cut credit-use by half, and by half again, and after that we'll see.

As always, it all comes down to policy. Don't let them forget it, either.