An S.O. Minifesto

Here's a summary of where I'm coming from, in general, in this blog.  I decided to lift most of this from a private exchange I'm having with one of our commenters; the time I have for composing articles has been significantly compressed, so I'm borrowing from my entries in that exchange. 

[To paraphrase Descartes: The following few-hundred-word summary is longer than I'd prefer.  I apologize for that, but I just didn't have enough time to make it shorter.]

Minifesto
Regarding my stance, I will try to be as clear and concise as I can.  My judgment about economics (macro, anyway) has gone through a four-decade evolutionary process.  Ideas I've discarded (after holding each of them at one time or another) include: doomsday is just around the corner; the budget should be balanced; deficits cause higher interest rates; money borrowed today by the feds must eventually be paid back without rolling the debt over; Samuelson's mathematizing of the field of economics was a good thing; utility, and its first derivative, marginal utility, improved our ability to quantify economic decision-making; and, most importantly, growth just happens (i.e., it's exogenous).

Ideas I've come to accept (some very recently), until better explanations come along, include: The decision process in the economy does not lend itself to present mathematics, because the economy is an evolutionary process driven by individual-level behaviors -- i.e., "the wisdom of crowds."  Those individual-level behaviors result from a mix of motives: sometimes they are driven by strict self-interest; but sometimes a desire for cooperation overshadows strict self interest; and sometimes a desire for punishment is top priority.  For the individual, the "economy" is more frequently a prisoner's-dilemma situation than an isolated, self-interest situation.  Consequently, the economy is best described as a complex-adaptive system, and the most accurate and concise description I've found of how people behave is this: People respond to incentives.  The best description of this, so far, is Eric Beinhocker's recent book, The Origin of Wealth.  Because of reading that book twice, I belatedly discovered that at least two economists had tried to tell the world about the evolutionary nature of economies; they tried to tell us sixty years ago, but hardly anyone listened.  I am now reviewing their work, and for the most part (with the possible exception of monetary economics) they nailed it.  "They" were nicknamed "the Austrians" (a pejorative, to keep them distinct from what was then "mainstream" thought).  They were Hayek and Mises.  They tried to tell us that economies were evolutionary processes; sixty years later, with the development of the theories of chaos, complexity, cooperation, and adaptive systems, we are now beginning to understand what they were saying.  Adaptation and natural selection are alive and well. 

Specifically, I'm not as interested as others are in the differential equations that "reveal" macro-level marginal utility, marginal cost, marginal benefit.  I think evolution (adaptation and selection) is better able to explain economic history.  I think equilibrium can almost never be expected because of the nature of evolutionary processes.

Regarding the national debt, my corporate finance career makes me favor the "net interest / tax receipts" ratio as more to the point than debt/GDP.  Successful corporations roll their debt over and over as they grow, and "times interest earned" is one key indicator of creditworthiness.  When analyzing the federal government's creditworthiness, net interest / tax receipts is the inverse of times interest earned; it takes into account interest rates as well as debt and income levels, and that's why I think it's a better technical indicator.  However, debt/GDP is easier to communicate (it's a more-established meme), and its numerator and denominator are reasonable proxies for their counterparts in the other ratio, so I use debt/GDP more frequently when writing.  In any case, just as corporations can stay healthy indefinitely by achieving reasonably constant times-interest-earned ratios as they grow their debt, their assets, and their incomes, so can the federal government.

Lastly: In a fiat money system, just as in any other monetary system, it is possible for a government to get itself into creditworthiness trouble by being fiscally irresponsible.  However, it is NOT possible for the government to "run out of money."  The irresponsibility shows up as unanticipated inflation.  If inflation is held to the 2-3% level, it is impossible for the government to "go bankrupt"; hyperinflation, and nothing else, is the closest a government can come to "bankruptcy" under a fiat money system.  Therefore, although it is politically effective to tout the debt level, the interest on the debt, and the deficit level, it is nevertheless uninformative at best, if not outright disingenuous.  The most concise paper on this is titled Soft Currency Economics at this link -- and it's accuracy has been verified in writing by a past vice chairman of the Fed.  Until it is refuted, that will remain the basis for my judgments regarding monetary economics.

That's my current stance -- subject to change, of course, if better explanations come along.

==========
End note regarding Karl Marx:

If the following is ambiguous in any way, please let me know, and I'll attempt to clarify.  This is important.

I have close to no use at all for Karl Marx's bankrupt, win/lose, cynical misinterpretation of the nature of the free-market capitalist economy.  It baffles me that a nontrivial portion of people still cling to those depressingly false ideas, and still use them, with modernized twists of phrase, to gain political advantage -- in spite of all we've learned to the contrary in the last 150 years.   

Comments

[Bob]

The applause is deafening. Encore! Encore! No one will sit down.

Bravo, Steve for the brave summation. While I no nothing about the Austrian thought I do think I know a bit about human behavior...and you're right. I'll take a carrot over a stick any day.

Also, since I'm not the most mathmatically gifted (I get by), I've often come up befuddled more than once by the attempts of various economists and forecasters
to mathematically describe human behavior.

And I couldn't agree more that our economy, indeed the global economy, is so incredibly complex
that attempts to seek equillibrium is, well, irrational.

So, again, I thank-you for this missive. It was well worth the wait.

[Andrew]

I just read the Soft Currency Economics essay you linked above. It was enlightening to say the least. I have been trying to grok Fiat Currency for quite a while, and never quite felt comfortable with the idea until now.

In one section he mentions that 'Transaction Taxes' are bad because they discourage trading of goods and services (transaction taxes being sales and income tax). Do you know of other alternative forms of tax that would serve the same purpose (provide end value to the Fiat Currency) without incurring so much friction in accounting/compliance?

Also, his proposal for Supplementary Government Workers (to achieve full employment) was interesting. Thoughts on that?

[mark]

Andrew
Mosler has some other good work on the subject. I believe the tax he favors is the real estate tax. Social Security tax is too regressive. Income tax compliance cost is too high. Sales tax discourage trade. Check out his article titled "Revisiting the Liberal Agenda". Another good source of information on a fiat money system is CFEPS.ORG. Articles by Wray are well written and easy to understand.
And thanks to Steve for his straight forward, no hidden political agenda, informative blog.

[William]

I'm sure you've come across this, but just in case: Thomas Sowell's Knowledge and Decisions....
www.amazon.com/Knowledge-Decisions-Thomas-Sowell/dp/0465037380

And, it is more unlikely you've come across this: [Sterman is great!]
http://www.amazon.com/Dynamic-Modeling-Business-Management-Introduction/dp/0387404619

Both are chock full of delicious unintended consequences of attempts to control non-linear dynamic systems, and the reasons why.

Cheers!

[Stephen Reed]

"Ideas I've discarded...deficits cause higher interest rates."

I'd really like to know why you discarded this idea. If there is a greater supply of debt, the only way to find enough willing buyers is to offer a higher interest rate. Basic supply and demand scenario it seems like to me. When supply is larger, prices fall (interest rates move in the opposite direction to prices).

[Stephen Reed]

Additionally, can you go into more detail on why you think economic growth is enhanced when a portion of federal spending is financed by debt as opposed to 100% financed by tax receipts?

[Steve]

Stephen:

[regarding "deficits cause higher interest rates"...]

I discarded it because there's so little evidence in support of it, and so much evidence against it. I've accumulated a lot of references on it in the last fourteen years, but one of the more recent ones, very well-written, is a paper by Alan Reynolds. Go to this link ( http://tinyurl.com/ypcqnk ) and download the pdf. The deficits vs interest rates section is p. 2-6.

After I read that paper, I emailed him and told him I liked it so much I wanted to thank him by buying him lunch next time I was in DC. He accepted; we subsequently had a good meal and a fun conversation.

Yes, I used to think deficits caused interest rates to rise; it just sounded so plausible, and so many economists were repeating the mantra (they call it the "Crowding Out Theory"), it just had to be true . . . didn't it? A lot of them wanted it to be true; a lot of them still do, because if it were true, it would advance their ideological agenda. The ones who still wish it were true can be found on the left, and on the right.

But then one day I started examining the evidence and the counterarguments. Result: In the fourteen years since then, in my mind's bookshelf, I've had to file the "Crowding Out Theory" way over there on the same shelf with Flat Earth, Blue Cheese Moon, Geocentric Universe, Toads Cause Warts, Clinton Didn't Inhale, Kris Kristofferson Assassinated Kennedy, and 911 Was An Inside Job.

[Jim Glass]

Hi, Steve!

I think there's a snag in your "If inflation is held to the 2-3% level, it is impossible for the government to 'go bankrupt'", observation. That's when a grossly fiscally irresponsible government using fiat money *will* go bankrupt.

E.g., Russia went bankrupt, ran out of money, and defaulted on its bonds and other obligations in 1998, while using fiat money.

Look at it this way: If a government's real obligations exceed the real value of funds it can obtain to pay them, effective or explicit default is unavoidable. Fiat money or not. After all, it can't pay off $5 of obligations with $3 any more than any of us can.

There are only two possibilities then:

1) Effective default through unexpected inflation, as you noted. The $5 real value of obligations is reduced to $3 real, and paid off with $5 nominal of money that was formerly worth only $3 real.

The government's creditors don't like it, but it is true that using unexpected inflation in this way to cover its finances a government "can never run out of money". (Although it can certainly run out of credit.)

Or else...

2) The government preserves the value of its money, avoids inflation, and runs out of money. It can't pay off $5 of obligations with $3 if the value of its money doesn't change. So it goes broke.

In 1998 Russia protected the value of the ruble through fixed exchange rates, so it couldn't inflate, and also couldn't collect enough tax revenue to pay its bills, so it ran out of money and went broke. Bankrupt with fiat money.

A government using fiat money can never go bankrupt if and only if it will inflate its currency as an alternative. Unless there's something I'm missing here?

[Jim Glass]

Following up on interest rates, ISTM that "deficits don't increase interest rates" is too broad a statement.

The deficits of the US government have never increased interest rates -- at least not by more than amounts so small as to be swamped and made invisible by other things that have affected US real rates far more, like inflation and the business cycle.

IIRC, the by-far-greatest deficits and accumulation of national debt that the US government has ever incurred, during World War II, didn't affect real long-term interest rates at all. So you are right about that.

But the US national debt has never reached anywhere near a scale to draw into question the US government's ability to service it, and the dollar as the world reserve currency is available for borrowing in such vast quantities that there's never been any question at all about it being available to borrow.

OTOH, the US is not the world. Reynolds' paper talked only of the US, from what I saw. But in Russia, as its deficits piled up before '98, and the risk to investors became apparent, interest rates went up to over 40%. Argentina has a recidivist record of being crushed by high interest rates caused by out-of-control deficits. There are other examples.

So as an empirical observation about the case of the US, I'd say "deficits don't increase interest rates" is true enough, due to the scale of US debt and the great resources available to the US. But as a statement of principle about fiscal policy generally for all nations, I'd be a lot more dubious about it.

And things change over time, even in the US. I wouldn't be reckless about betting the fiscal future of the US on the idea -- not with S&P projecting that on current law the credit rating of the US will go from AAA to Junk during 2017 to 2027, as baby boomers like me start collecting our due.

(And I'm sure as heck gonna get mine -- so watch out interest rates! )

[Steve]

Hi Jim! Hope all is well.

Although I agree with you that a government in a fiat money system has what appears to be two choices when it can’t meet its bond obligations – tacitly redeeming bonds with nominal money that’s worth less (two words) versus overtly declaring that its bonds are worthless (one word) – the second choice is merely an extreme version of the first. Using your example: (1) paying a $5 obligation with $5 face-value money worth only $3 is 67% inflation; the bondholders suffer the surprise that their bonds are really worth only 60% of what they had originally bargained for. But (2) “Default” is the precise mathematical equivalent of infinity% inflation; the bondholders suffer the surprise that their bonds are really worth only 0% of what they had originally bargained for.

Default is the most extreme possible case of hyperinflation. Infinity% inflation is a lot worse than 67%, or even a trillion percent.

[Tinfoil]

Your economics is totally wrong
=================================

1. Economy runs on Food/Fuel/Energy, it has nothing to do with Bank or Bankers, who in a fiat currency system are essentially parasites.

2. Currency is only representation of wealth it is not wealth, same applies to gold etc. Wealth =
Food/Fuel/Energy.

3. Fiat currency system can be easily toppled if Farmers stop accepting fiat currency and if Soldiers refuse to shoot the Farmers.

4. There is no rule in the world that only particular tribe of people can run banks. Soon White people, Black people, Latino people and Asian people will start their own banks.

Let the fun start.....

[AlfaCentavra]

Jim Glass posted: "In 1998 Russia protected the value of the ruble through fixed exchange rates, so it couldn't inflate ..."

It's almost the same, as a Gold Standart, but this is not a true fiat money.

[Robert Blum]

I really am anxious and truly look forward to your presence and unabashed willingness to stand up to present sound economic principals why the Amero (in the name of the North American Union) IS NOT in the best interests of the United States of America. Muchas gracias in advance.

[The Practical Skeptic]

In less than three decades, I have come to understand the true fundamentals of economics.
Ideas I embrace as distinct possibilities.

Doomsday is almost always around the corner and always will be.

Governments should strive to balance budgets; excessive debt slows growth. Government is virtually in capable of distinguishing between debt that provides for growth and debt that destroys.

Deficits do not cause higher interest rates; the Fed’s inflationary monetary policies cause higher interest rates.

Money borrowed today will eventually be have to paid back when other countries lose faith in the “full faith and credit of the U.S. Government” and fully embrace another currency other than the dollar to use as the world’s reserve currency.

According to Canadian economist Tom Green, Samuelson erroneously assumes that people continuously act in a rational manner, omitting the effects of culture, advertisement and other influences on human decision making. He writes:“Samuelson admits that utility is a construct that has no basis in psychology; although he uses the terms ‘consumer’ and ‘individual,’ his model is built around a fictional character that critics have dubbed Homo economicus. This economic man (yes, he is male) never had a childhood, never has children, has never depended upon a caregiver and does not have anyone he provides care for. He only experiences well-being by consuming. He is rational, selfish, a psychopath... he isn’t influenced by hundreds of billions of dollars in advertising or the purchases of his neighbors. If Homo economicus buys something, it gives him utility; his consumer sovereignty must be respected.

Growth happens but it is seemingly never enough.

Ideas I accept…The Austrian School of Economics

Regarding the national debt, government unlike business never creates; it always destroys by intervening in the private market. When government debt grows, it siphons away money that the private market could have used for far more growth-centered purposes. The debt to GDP ratio is simply a symptom of a larger problem: the unchecked growth of federal government.

Lastly, all governments inflate and all inflation leads to fiat currency devaluation. The “Mandrake Mechanism” will never allow government to “run out of money” but it will allow government to fleece the masses with taxes, print more money, and devalue its currency. Inflation is never what the government says it is. Government always underestimates inflation.

[Steve]

Robert Blum:

Sorry, I did not understand your point.

[Steve]

Skeptic:

Is it also possible that easy street is around the corner? Does debt that is not excessive also slow growth? And what is "excessive" debt (...eg, debt greater than zero)? Can the Fed also cause deflation? Is inflation an acceptable measure of our creditworthiness? How much growth would be "enough" and why? Do you also accept the Austrians' assertion that inflation is not the increase in price level, but the increase in the money supply? If government never creates, who should be responsible for creating national defense, a justice system, and common infrastructure? Lastly, if governments always inflate, are you asserting that the Fed did not cause the deflation that in turn deepened the Great Depression?

[Practical Skeptic]

It is possible that easy street is around the corner for a select few who control most American wealth. For the majority of Americans inflation continues to eat away the value of the dollar making it more difficult for most of us to meet our basic living expenses, food, clothing, shelter, education, health care, etc. The dollar has lost nearly all of its purchasing power over the past 100 years. One dollar is worth less than four cents today.

Growth or progress without sacrifice is the myth under which most Americans operate. A reduction of the size of government, which would allow most Americans to keep more of their own money will require Americans to accept that they cannot and should not rely on government to provide health care, education, etc. for them.

Government debt slows growth since it frequently results in a misallocation of resources drained from the private sector.

The Fed can deflate and inflate but it has been inflating and debasing the currency since its inception. The Fed is nothing more than legally sanctioned central economic planners incapable of managing the trillions of dollars in the private sector. A central bank is one of the planks of the communist manifesto and has no place in a representative republic based on free market capitalism. The market always wins, eventually.

Growth is more than simply a measure of how well we are doing. What kind of growth is the right kind?

Inflation is the increase in the money supply, which drives up prices.

By following the Constitution, which created a limited central government we could roll back the consistently harmful ‘growth’ of federal government. The primary purpose of a federal government is to provide for a national defense but the real question ought to be why must our defense budget dominate all expenditures? Overt and covert American military intervention in foreign governments propped up by the American government creates blowback thus creating the need for a national defense. Closing 700 military bases in more than 130 countries and following a non-interventionalist foreign policy based on diplomacy and trade would greatly reduce the need for government military expenditures.

The Fed created the Great Depression and then along with FDR “rescued” America from it just as central bankers created every bubble and every bust since 1913 the year the Federal Reserve Act was passed and interestingly enough the year the Federal Income Tax was passed as well.

[Joe D]

"However, it is NOT possible for the government to "run out of money." The irresponsibility shows up as unanticipated inflation. If inflation is held to the 2-3% level, it is impossible for the government to "go bankrupt"; hyperinflation, and nothing else, is the closest a government can come to "bankruptcy" under a fiat money system."

Lot of people don't understand that "Inflation" is the "rate at which" the aggregation of wealth happens or "rich get richer" in a fiat currency system OR the rate at which the wealth transfer happens from the poor to the rich.

Inflation = rate of "Evil" in the society.

[Jim Glass]

"Jim Glass posted: 'In 1998 Russia protected the value of the ruble through fixed exchange rates, so it couldn't inflate ...' It's almost the same, as a Gold Standart, but this is not a true fiat money."
~~~~
Hmmm... It's odd to think a fiat money isn't fiat money if it is "backed" through a fixed exchange rate by another form of fiat money.

But suppose there is no fixed exchange rate, there's an independent central bank with a constitutional mandate to maintain a stable, no-inflation value of its fiat money. The politicians come to the bank begging: "Please, please inflate the currency so we can escape our grossly irresponsible spending promises!" The central bank responds: "Go suck eggs." The money's value remains stable forcing a default crisis. Is that nation's fiat money now not fiat money due to the lack of inflation?

My point was, a government is capable of transferring a maximum % of national GDP to its creditors. If it promises more than that, the creditors are going to come up short by the difference.

Whether that goverment keeps the value of its money stable (through a gold standard, fixed exchange rate, central bank mandate, whatever) and so explicity defaults when it "runs out of money", or instead avoids running out of money by reducing the real value of its debts through inflation, is a distinction without a difference as far as the size of the loss to its creditors is concerned. (Though it may make a difference as to the distribution of their loss among them.)
~~~
"Default' is the precise mathematical equivalent of infinity% inflation; the bondholders suffer the surprise that their bonds are really worth only 0% of what they had originally bargained for."
~~~
I don't believe that's necessarily true. "Default" occurs when the borrower misses making a payment on a bond when it is due. But defaulting borrowers often (usually) work out an agreement where they pay later, pay a portion, pay a lower interest rate, whatever they can. They'd better, if they ever want to borrow again. Russia did. Anybody in Chapter 11 does.

[Robert Blum]

As an American with an economic background, I would like to know your personal viewpoint regarding the North American Union intentions in having Canada, Mexico and the US currencies adopt the Amero as its common currency; a similar transition the European countries made in adopting the Euro currency. What would be some of the significant issues in such a transition from a US historical perspective, or identity as a country. As an American economist, what is your gerneral interpretation or expectations to such a transition.