...against fictions and other tall tales

Sunday, 29 January 2012

Interest rates and the housing bubble

In a recent post, Prof. Krugman seems to suggest that the Fed's low interest rates were to blame for the bubble in housing. I side with Robert Shiller on this issue:
The interest rate cuts cannot explain the general nine-year upward trend that we have seen in the housing market. The housing boom period was three times as long as the period of low interest rates, and the housing boom was accelerating when the Fed was increasing interest rates in 1999. Moreover, long-term interest rates, which determine the rates for fixed-rate conventional mortgages, did not respond in any substantial way to these rate cuts until the late stages of the boom. (2008:49)
Visually, this is what Shiller is pointing to (click to enlarge):

Source: Federal Reserve

Now, you can blame the regulators (and their political leaders) for having failed to stem the flow of toxic mortgages by setting prudent mortgage-lending standards, as I did in an earlier column. But to suggest that the Fed's low interest rates created the bubble is not right. On this point, the Financial Crisis Commission made it very clear: excess liquidity did not cause the bubble; rather, it was the failures in financial regulation and supervision that are to blame, including the "failure to effectively rein in the excesses in the mortgage and financial markets". (2011:xxvi)


National Commission on the Causes of the Financial and Economic Crisis in the US, The Financial Crisis Inquiry Report, Public Affairs: New York, 2011

Shiller, R., The Subprime Solution, Princeton Press: Princeton and Oxford, 2008

Thursday, 19 January 2012

Guest post by Joseph Laliberté: “Prudential liquidity” for a country with its own floating currency: frivolous and meaningless

The following is a translated version of a post originally published in French on Joseph Laliberté's blog, Défricher l'économie, dated November 19, 2011. In the post, Joseph examines a recent announcement by the Bank of Canada using insight from Modern Monetary Theory.

The Bank of Canada recently announced its intention to increase to 20% the share of the debt issued by the federal government that it buys directly at government debt auction (note: it should be noted that the auction itself is managed by the Bank of Canada). This initiative is set in motion in the context where the federal government wants to increase its 'prudential liquidity' by $35 billion.

A logical question from this would be where will the Bank of Canada find the $7 billion (that is to say, 20% multiplied by 35 billion)? The answer is nowhere. This money will appear on the balance sheet of the Bank of Canada as if by magic. Here's what will happen to the balance sheet of the Government of Canada and the balance sheet of the Bank of Canada when the operation is realized:

Government of Canada
+ Deposit at the Bank of Canada
+ Issued bonds

Bank of Canada
+ Government of Canada bonds
+ Deposit from the Government of Canada

All the Bank of Canada needs to create such accounting entries is...a computer with a spreadsheet program (for instance, a 286 computer equipped with the 1993 version of Lotus would do). It should further be noted that this transaction is internal to the federal government given that the Bank of Canada is a Crown corporation that is ultimately owned by the people of Canada.

I can already hear the good "old school" post-Keynesians saying that the example above holds only for the 20% share of new debt issuance that the Bank of Canada buys directly at auctions.

Moreover, these critics may also point out that in countries having their own currency, but where the central bank is not allowed to buy bonds directly from the government (i.e. its treasury or finance department), the above example would also not hold. In my view, it would still hold, but one small step would need to be introduced. Using the United States as an example, the Fed would need to first buy Treasuries (à la QE2) on the secondary market from private banks, and credit these banks’ checking account at the Fed (called excess reserves):

+ U.S. Treasuries
+ Excess reserves

Then the U.S. Government would issue new treasuries on the market, which would simply result in excess reserves being transferred from private banks’ checking account at the Fed to the U.S. government deposit account also at the Fed (that is, bonds issuance by the U.S. government would “mop up” or drain excess reserves):

No change
- Excess reserves
+ Deposit from the U.S. Government

Therefore, in technical term, it is the capacity of a country with its own floating currency to create reserves at will that renders the issue of whether such a country has enough "prudential liquidity" frivolous and irrelevant. Although Warren Mosler’s saying that a country with its own currency never has or does not have its own currency has been the subject of some friendly criticism lately, I still find it relevant: in both examples, Canada and the United States are not richer, poorer, safer or riskier because they suddenly have more prudential liquidity in their account at the central bank.

In a nutshell, the concept of prudential liquidity is relevant for countries that do not have their own floating currency (e.g. Greece, Ireland, Portugal, France, etc), just like it is relevant for households and businesses, but it is meaningless for a country with their own floating currency (e.g. U.S., Canada, Sweden, Japan, United Kingdom, etc).

Saturday, 7 January 2012

Canada's unemployment rate rises to 7.5%

Canada's unemployment rate rose for the third consecutive month in December. According to Statistics Canada's Labour Force Survey, while employment rose slightly in December (up 18,000), the unemployment rate edged up to 7.5% as more people participated in the labour market.

Unemployment rate, Canada, Souce: Statistics Canada
The most significant part of this month's figures is the very large rise in the unemployment rate in the province of Quebec. Employment in Quebec decreased for a third consecutive month, down 26,000 in December. Full-time positions in the province decreased by 34,000 while part-time work rose by 8,800 jobs. As a result, the unemployment rate rose 0.7 percentage points to 8.7% from a month earlier. If we compare with a year earlier, employment in Quebec is down 1.3% (-51,000), with half of this decline (25,700) occurring in December. All in all, this was a bad month for Quebec's labour market.

I cannot think of a better time than now for the large contingent of recently elected New Democratic Party MPs from Quebec to call upon the federal government to address this recent spike in unemployment.

Tuesday, 3 January 2012

Modern money: theory or approach?

A quick post. I've noticed a lot of discussion recently on other sites regarding the nature of modern monetary theory (MMT) and, more specifically, on whether its analytical and descriptive elements can be separated from the prescriptive policy proposals advanced by the originators of MMT.

In my view, it's clear that MMT as a theoretical framework encapsulates both descriptive and prescriptive elements. The descriptive part of MMT aims to describe the functioning of a modern monetary system and shed light on the nature of government finance. The main emphasis here is to explain that modern currencies cannot be understood without considering the legal and institutional context within which a modern, sovereign government (i.e., that has control over its own currency) exercises its authority. Specifically, the government's power to levy taxes and declare what it will accept in payment of taxes are the two important components for understanding modern currencies and identifying the options available to the government for financing expenditures and setting prices (e.g., of interest, manpower, commodities, etc). Flowing from this understanding of government finance is the fact that modern governments do not face operational financial constraints, but rather face self-imposed, legal ones that result from past political decisions, as well as constraints imposed through convention. Balancing the government budget on a yearly basis is one example of a self-imposed constraint.

As for the prescriptive part of MMT, my understanding is that it focuses mainly on (1) the implementation of a job guarantee (aka, buffer stock employment model) or an employer of last resort scheme as a way to achieve full employment and price stability, and (2) the application of a monetary policy where the central bank sets the nominal rate to zero, thereby letting the real rate adjust endogenously (resulting, in most cases, to a negative rate due to inflation). From a policy standpoint, I don't have any problem with the former, as I believe that such a proposal could gain considerable traction once the public understands how the policy would function. However, I can understand why some people have reservations regarding the viability of the proposal to put forth a zero nominal interest rate, as it would most likely lead to a negative real rate of interest. A good alternative, in my view, would be for the monetary authorities to set, as much as possible, the real interest rate equal to the rate of growth of labour productivity. In this way, the real rate of interest should remain mostly positive and an amount of money equivalent to one hour of labour time, if lent at that rate of interest, would continue to be worth one hour of labour time when paid back with interest.

But, setting aside this very minor point of divergence, it should be pointed out that MMT falls under the larger body of thought known as 'chartalism' or 'modern money approach', which is not tied to any specific policy prescription. This means that it isn't really a problem if people have different views about the prescriptive part of MMT: the chartalist or modern money approach allows for a wider range of points of view and policy recommendations. In a good article on chartalism, modern money economist, Pavlina Tcherneva, explained this point as follows:
...it is important to point out that Chartalist propositions are not necessarily tied to any particular policy prescription; they are simply a way of understanding the state’s powers and liabilities and its financing and pricing options. (2006:81)
So, to conclude, if you find MMT's framework for understanding the implications of modern money useful for analyzing the economy and government policy but aren't sure about the policy proposals associated with the framework, there's no big problem: you're still applying the modern money approach.


Rochon, L-P, and M. Setterfield (2008), "The political economy of interest rate setting, inflation and income distribution", International Economic Policy Institute, Working paper series, 2008-01

Tcherneva, P. (2006), "Chartalism and the tax-driven approach to money", in P. Arestis and M. Sawyer (eds), Handbook of Alternative Monetary Economics, (Northampton, MA: Edward Elgar), pp. 69-86.