How to be wrong

“The tradition of all dead generations weighs like a nightmare on the brains of the living.” I was reminded of these words of Marx by the Telegraph’s report that some Treasury officials are pushing for tax rises and spending cuts in part because there is a “plausible” risk of a sovereign debt crisis.

Of course, Simon is right: there is no such risk as the Bank of England can, in extremis, buy up gilts. Certainly, financial markets aren’t worried; the latest gilt auction saw record demand. And it would be foolish to begin austerity before the recovery is well-established.

Which only poses the question: why do intelligent people believe such silly things?

Part of the answer lies in selection effects. The interests of capital constrain policy options, and the rise of financial/rentier capital and decline of Fordist capital has increased pressure for easier monetary policy rather than looser fiscal policy.

This is compounded by the fact that the marketplace in ideas is failing. John Stuart Mill thought that “wrong opinions and practices gradually yield to fact and argument”. But for various reasons – not least being our media – this does not happen. Nick Robinson’s claim on the Today programme yesterday that "the money has to be paid back somehow" shows that the myth of the government as a household stays obstinately alive.

But there’s more to it than this. There are also powerful psychological mechanisms that cause the Treasury’s error – mechanisms which, of course, occur all the time in other contexts. Here are three.

Formative years.

Napoleon was right: “to understand the man you have to know what was happening in the world when he was twenty.” Those of us in our 50s remember talk of the government having to go “cap in hand to the IMF”. And we were educated at a time when real interest rates were high and so we thought fiscal policy was constrained both by the fact that high yields would cause debt to increase and by the danger that borrowing would raise interest rates and so crowd out private sector spending. Of course, we now live in a completely different world of a savings glut, negative real rates and dearth of investment. But it’s hard for our minds to fully adapt. Marx was right; they are shaped by the past, not just the present.

We have good empirical evidence here from another context. Erin McGuire and Ulrike Malmendier (pdf) have both shown that our attitudes are disproportionately shaped by how the economy appeared to us in our formative years. People who suffered hard times, they show, invest less in equities even decades later. The distant past thus unduly influences behaviour today.

Bayesian conservatism.

We hate admitting that we were wrong. We therefore stick to our prior beliefs more than we should. If you sympathised with post-2010 austerity, therefore, it’s hard to admit you were wrong even in the face of strong evidence.

Again, it’s not just Treasury officials, journalists and politicians who make this error. People make the same mistake even when there is big money at stake. One of the strongest tendencies in equity investment is the so-called disposition effect; people hold onto badly performing shares because selling them would mean admitting – if only to themselves – that they were wrong.

Deformation professionelle.

Our professional training doesn’t just give us skills. It also inculcates particular biases into us – ways of seeing the world which are only partial. For decades, the Treasury’s role has been to watch the pennies – and in fairness somebody has to. This can easily lead to the belief that the pennies must be watched even when thy don’t need to be – a tendency reinforced by bureaucrat’s habit of mistaking bureaucratic convention for objective reality. And it is further reinforced by our reluctance to abandon ideas on which our career is built. As Upton Sinclair said, “It is difficult to get a man to understand something, when his job depends on not understanding it.” We apply the sunk cost fallacy to our beliefs.

Again, though, Treasury officials are not unusual here. Economists tend to over-estimate the role of financial incentives; lawyers over-estimate the role of the law as an agent for addressing social problems; and as for engineers…(pdf).

My point here is that it is incredibly easy to be wrong. The three mechanisms I’ve described here are powerful and ubiquitous. You can no doubt think of many other ways in which they apply – not least to me. This makes it all the more important that in politics we have filtering mechanisms which weed out errors. Our problem is that not only do we not have such mechanisms but that too often we have the opposite – ones that select not against error but in favour of it.

Comments

[Dave Timoney]

Have we ever had mechanisms in politics that filter for errors, beyond the consequences of failure and the ability to kick the bums out?

I take the points made in your 2017 post, that there are strong mechanisms that select for mediocrity among politicians, and that these have probably increased over time, but apart from the disappearance of the public intellectual, I don't see any decline in corrective mechanisms. There wasn't a Golden Age.

[John]

*. "Nick Robinson’s claim on the Today programme yesterday that "the money has to be paid back somehow" shows that the myth of the government as a household stays obstinately alive."

This really bugs me. We have been told this for years and years and we get it. But the people who make this argument never say if there is a limit and what that might be; what happens if you spend up to that limit and then suddenly need more cash for, say, a massive furlough scheme; and if there isn't a limit, why does every government not write itself a check for ten quintillion quid and have done with it?

Also, the people making the argument are never consistent. When wars, Trident, big business bail outs, royal yachts and so on are proposed, we get told that we shouldn't 'waste' the money: why aren't the people making the argument that "government isn't like a household" telling people making such arguments to shut right up?

[Jim]

"This really bugs me. We have been told this for years and years and we get it. But the people who make this argument never say if there is a limit and what that might be; what happens if you spend up to that limit and then suddenly need more cash for, say, a massive furlough scheme; and if there isn't a limit, why does every government not write itself a check for ten quintillion quid and have done with it?"

The logical conclusion of the 'there's no limit to what a sovereign state can spend' crew is that the government could print enough money to give everyone a million pounds. Which would work just fine, everyone would be rich,right?

There obviously is a limit, and the problem is no-one knows where it is. Indeed one suspects that the limit is an unstable entity, like uranium - what seems utterly stable today can be made unstable the day after by the addition of relatively little more debt, or a change in some other factor. Thus even if you may have country A that sustains very high debt levels for many years, it is by no means assured that country B can do likewise, or even approach country A's debt levels without precipitating a crash.

Printing money crises are rather like Eeyore's description of accidents - you're never having one, until you're having one.

[Ralph Musgrave]

I agree the “Sovereign debt crisis” story is nonsense. However it is actually possible, on perfectly reasonable assumptions that tax increases or public spending cuts will be needed post Covid. Reasons are as follows.

At the moment, government and central bank are basically just printing money to ameliorate the crisis. That means a big build up in the stock of money (base money to be exact) in the hands of the private sector. ALL ELSE EQUAL, it is reasonable to expect that will lead to excess demand and inflation. Ergo a rise in tax and/or cut in public spending could be needed to deal with that. (Alternatively there is a build up of government debt, but as MMTers keep trying to explain, government debt is simply base money which has been locked up for a while and which yields interest.)

But there is no good reason for that to lead to austerity in the sense of enduring a higher level of unemployment than is needed to keep inflation under control. I.e. the tax increases / spending cuts only need to be enough to hold demand at the full employment level: the level at which employment is as high as is feasible without too much inflation kicking in.

As to whether “all else” actually will be “equal”, that’s a big unknown: i.e. will levels of consumer and business confidence quickly return to pre-Covid levels? Who knows? But if they do, the above tax increases / spending cuts (or a rise in interest rates) would be needed.

[Ralph Musgrave]

Jim, The solution to the problem you pose is simple: it’s what might be called the “MMT / Simon Wren-Lewis” solution. That is, simply keep the deficit at whatever level appears to give us full employment (or something as near full employment as is possible in a Covid scenario) while keeping to the inflation target.

That may result in a huge increase in the debt or a dramatic fall in the debt. As long as interest on the debt is kept at zero or near zero (as proposed by both MMT and SW-L), why does a large debt matter? Darned if I know (speaking as a long time MMT supporter).

[Jim]

"That is, simply keep the deficit at whatever level appears to give us full employment (or something as near full employment as is possible in a Covid scenario) while keeping to the inflation target."

And you trust a bunch of politicians to walk that tightrope do you? Every politician wants votes, and spending free money gets votes. Raising taxes doesn't. Guess which of the two will happen more often?

[Ralph Musgrave]

Jim,

I don't favour politicians having control of the SIZE of the deficit: I favour the system advocated by Positive Money, i.e. technocrats decide the SIZE of the deficit (possibly the Bank of England Monetary Policy Committee) while politicians decide the NATURE of the deficit, i.e. whether it takes the form of tax cuts or increased public spending, and if the latter, whether the money goes to education, health or whatever.

[Paulc156]

@Jim
You talk about the danger of a little too much debt (the specific amount of debt required to trigger such a crash being entirely unknowable) plausibly leading to a crash as if to justify some kind of hard money approach.

Yet we know full well that were inflation to gain traction it is a relatively straightforward matter to increase interest rates and drain reserves from the system so restoring some price stability.

Furthermore we know low to moderate rates of inflation are commensurate with decent rates of real growth AND that the potential costs of pursuing something approaching a balanced budget in a recessionary environment is high unemployment and all the associated deleterious effects that has on the unemployed AND their children, much of which can be permanent.

So the trade-off can be one of budget busting to maintain levels of employment and limit rises in poverty and psychological damage to millions with some undefined risk of price inflation versus budgetary prudence and let unemployment and associated misery rip whilst mitigating inflation.

[Rocco]

Has anyone here heard of a country called Argentina?

[Paulc156]

@Rocco...
Why stop at Argentina when there's the Weimar Republic?
Not sure what a country riven by corruption which has borrowed huge sums largely denominated in US dollars 'before' coronavirus has to offer the UK by way of analogies. We owe most of our money to 'ourselves' and our our economy is not on thrall to another currency so we need better analogies vis a vis debt and hyper-inflation. Say...Japan?

[Blissex]

«there is no such risk as the Bank of England can, in extremis, buy up gilts.»

Please PLEASE, enough with the imbecilities if not misrepresentations:

* The BoE can only buy unlimited amounts of government debt denominated in sterling. That's a really important point. It has very little power to buy back government debt denominated in hard currencies.

* Essentially all imports of the UK are not denominated in sterling; imports must *always* be paid in "hard currency", whatever that is. The UK government can never force foreign supplier to take sterling as payment.

* Even for domestic purchases it can happen that domestic currency is not accepted by vendors, and the government cannot realistically force them to accept it, whether or not it is backed by the central bank. In practice there have been plenty of dual-currency regime countries (like Greece before the eurozone) where less politically powerful suppliers (e.g. workers) have to accept being paid in soft domestic currency, and more politically powerful ones get paid in hard foreign currency (in Greece it was bundesmarks or swissfrancs).

The only case in which a state can spend arbitrary amounts of domestic soft currency is dictatorial autarky.

Other than that all MMT really says is that if "the markets" are willing to accept bonds in currency X in some quantity at a low interest rate, then issuing currency X in the same quantity has pretty much the same effect, because nowadays even "term" bonds are as liquid as currency (again, only for non-soft currencies). And that's what the non-buffoon wing of the MMT does say.

[Blissex]

«There obviously is a limit, and the problem is no-one knows where it is.»

But detecting when the limit has been reached is very simple: when it becomes expensive to buy the hard currency demanded by foreign suppliers, or when politically powerful domestic entities start invoicing in hard foreign currency.
In banana republics, or operetta kingdoms, both things happen routinely. An example from the past from M Muggeridge's diary, 1942-03-19:

“Here in Lisbon is the last vestige in Europe of our old way of life now precariously existing. [...] Here are cafes, neon signs, money haggling, petit dejuner with fat pats of butter brought in on a tray, jangling trams and taxi cabs and newspapers of all the nations.
One deep and significant change may, however, be noted, the pound sterling has lost its magical qualities: rub rub at the lamp and no all-powerful djinn appears, at best only a reluctant slut who must be coaxed for any service at all”

[Blissex]

«Other than that all MMT really says is that if "the markets" are willing to accept bonds in currency X in some quantity at a low interest rate, then issuing currency X in the same quantity has pretty much the same effect»

Said another way, what MMT says is that governments can buy stuff with money obtained by issuing it, or purchased with bond sales, or collected with taxes, and what matters is not the way it is obtained, but the impact on "inflation", and in particular issuing new money or new bonds has fairly similar consequences, depending on the situation, and that in general the hardest constraint on issuing new money or bonds comes from imports, because the government cannot force foreigners to accept them.

[Bob]

Firstly, according to modern monetary theory, the UK has unlimited intraday overdrafts that fund spending and all government spending works via crediting bank accounts (put numbers up in account.) So you can argue spend comes first and what doesn't come back as tax at the end of day is borrowed. Secondly, according to modern monetary theory, loans create deposits so printing money does not result in inflation, and the money multiplier not accurate description of money creation:

https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy

"Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. The reality of how money is created today differs from the description found in some economics textbooks: • Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits. • In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits."

"As a by-product of QE, new central bank reserves are created. But these are not an important part of the transmission mechanism. This article explains how, just as in normal times, these reserves cannot be multiplied into more loans and deposits and how these reserves do not represent ‘free money’ for banks."

"For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates. In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England. The rest of this article discusses these practices in more detail."

Hence, the national debt doesn't matter. Governments don't have control over deficit level - if there is no saving you get all government spend eventually back as tax. Exchange not conversion in forex markets. Also if anyone spends from their savings or takes out a bank loan and no saving spending chain governments get all that back as tax. Say government spends at Tesco, get some back as VAT, pay employees some back as Income Tax and employees buy beer at a pub, beer duty and VAT. No saving in spending chain = all back as tax.

[Bob]

The key point is that if a currency moves down so that imports become ‘more expensive’, then the ‘inflation’ that goes off is a distributional response that tries to eliminate some of those imports so that the exchange demands equalise. That also eliminates somebody else’s exports.

The important thing to remember is that when a currency goes down, all the others in the world go up in relation to it and nations that rely upon exports (export led nations) start to lose trade – which depresses their own economy.

Any one of those other economies can intervene in the foreign exchange markets, purchase the ‘spare’ currency and that will halt the slide for everybody. And all exporters to an import nation have a central bank with infinite capacity to do that.

Export-led nations have to constantly provide liquidity into the rest of the world to allow others to buy their goods.
Otherwise the rest of the world runs out of the particular money that is needed for the export transaction to complete and the export never happens (UK buyers buy Chinese goods with GBP, but Chinese workers are paid in Yuan. The relative shortage of Yuan due to the export differential has to be provided by the Chinese or Chinese goods become, in absurdum, infinitely expensive).

So the important insight, IMV, is that exporters need to export and the central banks that support that policy with ‘liquidity operations’ will ultimately halt any slide for any important export destination – either explicitly or implicitly through their own banking system….

For me the policy response to sliding currencies is to control the distributional inflation by temporarily banning the import of ‘luxury’ items. That forces the problem onto the exporters, which they can relieve by systemically intervening and fixing the currency imbalance. Forcing them to do what they normally do through the course of trade.

"But detecting when the limit has been reached is very simple: when it becomes expensive to buy the hard currency demanded by foreign suppliers, or when politically powerful domestic entities start invoicing in hard foreign currency."

Generally foreign currency reserves are used for matters other than simply working capital. They are used effectively to bail out firms that have borrowed in a foreign currency but don't have the right foreign income. They then desperately try to get the foreign money with local money, push down the exchange rate, which the central bank then props back up by selling foreign reserves.

That is the wrong approach. The correct approach is to put such firms into administration, send the losses home to the foreign lenders and equity holders, and then offer refinancing in the local currency. That way you wipe out foreign money and demand for foreign money without hurting your own limited working capital supplies.

You come to that conclusion by looking at things *from the wider viewpoint*.

Single economy view is the wrong view to get a handle on how to manage the feedbacks across the FX boundary.

[Blissex]

«Export-led nations have to constantly provide liquidity into the rest of the world to allow others to buy their goods.»

That's ridiculous: it is the argument that balance of payment problems never happen because exporting nations don't allow them to happen.

While some export-led countries, for a while, are willing to partly subsidize their exports, by way of exchange rate manipulation, eventually that subsidy ends and they then want to be paid in hard currency so that can buy actual stuff instead of accumulating soft currency IOUs, to be rolled over forever.

If it were as you say then Argentina and Greece and the UK in the 1969-70s would have had their balance of payment problems eagerly covered by the saudis.

«Otherwise the rest of the world runs out of the particular money that is needed for the export transaction to complete»

You are not talking about exports, but donations of goods and services from munificent foreiogners.

«So the important insight, IMV, is that exporters need to export»

That works as long as their willingness to donate those exports (or equivalently, to be paid in cambodian riels or etruscan bonds) is unlimited. Good luck.

[Blissex]

«Secondly, according to modern monetary theory, loans create deposits so printing money does not result in inflation,»

That's an incredibly stupid generalization, and it was the theory used by Rudolf Havenstein, the Reichsbank president in the Weimar period :-).

In practice deposits can be spent, and become purchasing power. "printing UNSPENT money does not result in inflation", but usually printed money in most part does get spent.

What actually the non-buffoon wing of MMT says is that if there are unused real resources government money issued to buy those unused real resources does not create inflation, a rather reasonable proposition (with a few limitations).

[Blissex]

To illustrate a bit sarcastically what's wrong about the buffoon wing of MMT, imagine this conversations:

YV: Dear price bin Salman, we need a lot of your oil.
BS: Very good, how are you going to pay us?
YV: No problem, thanks to MMT we pay you in freshly printed etruscan banknotes, of which our bank has an unlimited supply, so we will always be able to pay you.
BS: And what can I buy with those? Sellers of weapons, slaves, palaces, executive jets, don't take etruscan banknotes.
YV: You can buy from us freshly printed etruscan bonds as assets, of which we also have an unlimited supply, so there is no risk of inflation.
BS: And what I can buy with your etruscan bonds?
YV: You can buy more freshly printed etruscan banknotes, as our central bank is always ready, thanks to MMT, to buy back the etruscan bonds at 100% of face value.
BS: Why would I want to accumulate etruscan banknotes or dollars in exchange for giving you oil to consume?
YV: Because as "Bob" said "exporters need to export".
BS: Guards! Throw this mocking infidel from the window into the shark pool under it!