Tuesday, May 24, 2011

Some nuances to setting the parameters of government activity in the economy

Several of the last few posts seem to elicit reaction from commenters who believe we shouldn't let government intervene in what would better be left as private affairs. While I agree that we shouldn't allow government to grow beyond its most prudent scope of state functions, I think the discussion should be more nuanced as to what is in the government's practical realm, and what should be left to the private sector. Here are four nuances that came up in comments of the last few posts:

1. How much government authority should there be in terms of regulating the private sector. I believe government's authority should be enough such that it can effectively enforce rules and regulations that best keep the private sector honest and well-functioning. This does not mean we want a government composed of control freaks who micromanage the affairs of the people.

A failure of government regulation means a need to change the regulator, not a complete stop to regulation itself. When we don't like what government is doing, we do what we can to effect a regime change. We don't say 'To heck with it, I'm my own government now'.If people are completely free to do what they want, we will soon have control freaks in the private sector taking over and impinging their own will on other people's rights. There will be no accountability for these private sector control freaks if there is no countervailing force against what they do. Hence it would be a race among every one of these types on who grabs the most overall control first so no one can else can take it instead.

Think of traffic in a busy highway. People will travel as fast as they can and cut other people, without regard to the danger they may cause to other people, for as long as they can get to their destination sooner. A countervailing force so people don't do this all the time is the threat of getting caught and getting a ticket. But there needs to be regulations first.

Without publicly acceptable regulation in the first place, there are no laws violated, and the government has no business prosecuting anyone.

2. What practical matters of operations should the state involve in. I believe government should involve in activities where absolute maintenance of people's trust about value and reliability is of utmost importance. Currency issuance is an important area, as my previous post highlighted.

The state should always issue the circulating currency. This is the only way to make it acceptable to any party that may enter the endless chain of transactions that would involve payment in this currency. No government backing, and the chain will unravel.

By comparison, I see private bank-issued currency as similar to equity stocks issued by private corporations. People buy them or accept them because of the belief that they can be sold or exchanged for state-backed money. People exchange their state-backed money for stocks because of the speculation that the stocks may rise in value vs. holding onto state money. But at the end of the day, that stock could lose value or even become worthless if the company that issued it became bankrupt. I believe the same with banks and private currencies. These currencies have value only to the extent that people can redeem them from the issuing bank for state money.

For example, checks and credit cards issued by banks have value because they are interchangeable at face value for base money. People who accept checks and credit cards expect to eventually exchange them for state money, which is what they can in turn use to pay for their own purchases. The thing about checks and credit cards is that they can only be accepted by the person directly transacting with the issuer. They involve private transactions involving directly transacting parties. For example, if you give me a check or pay me by credit card, I can't then turn around and use your check or your credit card to pay for my purchase with somebody else.

I would probably be open to the idea of granting private banks the license to issue private money, but even if we ever have private-issued currencies, they should always be complemented by state-backed money. People should have the choice to accept only state money if they want. If anybody wants to accept currency that can be suspended at will by a private issuer, then that's their business. But people who want to accept only state-backed currency should be free to do so. We should not impose on them a world where only privately-issued (and therefore susceptible to private suspension) currency exists.

I myself may have no qualms about accepting private bank-issued money, for example, but only for as long as I am directly dealing with the bank issuer. I would never accept private bank-issued money from someone else who dealt with the issuer himself, not without guarantees of that other person himself. And no other person should be influenced to accept private-issued money on the argument that it's better than state-backed money.

Only sophisticated investors should accept private currencies. There's a large element of speculation to it, and most people, who only want to get paid for goods and services rendered, will always want money they know will have universal acceptance when they in turn decide to spend it. A currency that is susceptible to instances of suspension is an assurance that that currency will fail. Currency allowed to circulate among the public always has to redeemable and convertible into the asset it has promised to convert to, or it is not acceptable currency at all.

Most banks only have 10% equity at the most. When the price of commodities backing their private currency loses even just this amount, these issuers are already insolvent. Further, I believe there's barely any earnings in issuing currency, unless you plan on counterfeiting it, and suspending conversion once this counterfeiting becomes evident. If private-issued currency recipients become poorer, and issuers richer, because of a suspension of convertibility, then fraud has been committed, and the issuer doing so needs to go to jail.

If you think the fed is doing a crime devaluing the currency, you should be even more leery of a private issuer with a profit motive doing the same. A Government issuing the currency can debase the currency, but so can private banks. Private banks with a profit motive even more so than the government. And if the banks find themselves insolvent, which is possible, they being private companies, they have every reason to debase their currency, or suspend conversion.

3. Should government increase spending in a depressionary economic environment. A growing economy creates the credit and demand growth necessary to sustain itself without government deficit spending. Conversely, in a depressionary environment, where people are conserving income, credit is withdrawn, and demand is therefore withheld from the economy, we need government to step in and fill the spending void left by the private sector saving. Not to do so would lead to private incomes being destroyed, due to withheld demand, which leads to a vicious spiral of more people not spending, and more demand being withheld from the economy.

Government budget deficit spending is also integral in an economy that experiences trade deficits. Someone has to spend the currency into existence that the surplus country eventually siphons out of the trade deficit country. Otherwise, the exiting of currency from the trade deficit economy leads to loss of circulating currency that could lead to loss of aggregate income.

Tom Hickey had a comment I find important to highlight: "fiscal balance is determined by two factors, domestic private desire to save and the ROW's desire to save in the country's currency."

In other words, whenever we see ROW's (rest of world's) increased desire to save in a first country's currency (e.g., the U.S.), ROW's normal reason is not to save in first country's currency, but to create jobs for ROW's own citizens. This need not come at the expense of jobs at first country, for if its government keeps spending to fund both the ROW desire, and to maintain its own citizens' local jobs, ROW will eventually realize that the savings it accumulates with its surpluses with first country is worth nothing, and will probably just cause inflation in its own economy, unless it starts spending it back on first country's production, too.

4. Should government set market interest rates. More often than not, we've seen government intervention in this area only creates speculative bubbles and unnecessary recessions, which would have otherwise been avoided, if government had only let the market decide the price level of interest rates. This control of the monetary rates subjects the entire economy's price level and inflation/deflation on the whims of a few technocrats with little or no accountability to the people. I believe this has to change. I previously made my stance on monetary policy evident here, here, here, here in the last few months alone.

We should start focusing more on what macroprudential controls should be in place once instead, so that private sector-led bubbles do not get out of hand either. And we should make the central bankers, if they will retain control of rate-setting, more transparent and accountable to the people.

There has actually been a proposal by some MMTers to do away with government debt issuance. Since state currency is no longer backed by the gold standard, it can fund any level of spending it wants without need to go into debt or collect taxes. It just has to print the money needed to pay for its expenditure. (With a corresponding ability to suck money back out of the economy via taxation).

If the government no longer determines the risk free rate via issuing government bonds, then private sector capital markets and debt interest rates would likely be determined purely by the market-assessed risk of a particular business or investment, not by how much premium investors want over a riskless government option.

I'm not yet sure of the positive over-all effects of taking out government debt issuance entirely (we would be taking away risk-free investments for pensions and and insurance firms). But interest rate-wise, this takes government out of the rate-setting realm altogether.

Update: W asks: "Please, a yes or no answer, do we have the right amount of government involvement in today's economy?"

Rather than right amount of government(which is not the right context), these are my positions on the whether we have the right approach of government on the four points I outlined:

1. No. We regulate the wrong areas, and focus too much on rules rather than principles. Hence, It's easy to game the regulators, and this has led to too many crises. Regulators should have the common sense if the spirit of a regulation has been broken, and they should be more empowered to enforce that spirit.

2. Yes. And the state should continue being the issuer of currency.

3. No. Government spends more during a boom than on a depression. That's because they think too much that they are only sharers of the currency with the private sector, rather than its issuer. So they spend when they think they have the tax funds, and refuse to spend when they lose the tax base (though during a depression is when they should be spending more, to recharge the tax base).

3. No. I think government should get out of the rate-setting game.

7 comments:

The Arthurian said...

Hi Rogue. Good post. Forgive me if I don't reiterate all the points I can agree with.

RE: Item 3... whenever we see ROW's (rest of world's) increased desire to save in a first country's currency (e.g., the U.S.), ROW's normal reason is not to save in first country's currency, but to create jobs for ROW's own citizens.

Yes, and as Keynes observed: "If nations can learn to provide themselves with full employment by their domestic policy... there need be no important economic forces calculated to set the interest of one country against that of its neighbours." The solution here is to stop cramming "free" trade down each other's throats.

And RE: Item 3... This need not come at the expense of jobs at first country, for if its government keeps spending to fund both the ROW desire, and to maintain its own citizens' local jobs, ROW will eventually realize that the savings it accumulates with its surpluses with first country is worth nothing, and will probably just cause inflation in its own economy, unless it starts spending it back on first country's production, too.
So in other words we should just keep inflating the dollar until everyone realizes our money is "worth nothing" ???
I'm not sure what my problem is with your statement, really. It is too hypothetical, I think. Yes, your word "eventually" is the problem. WHEN? Our trade imbalance has been getting worse for two generations already!

Milton Friedman's comparison of "money relative to output" with the price level suggests that the value of our money originates with output. Or at least that output provides a basis for the value of the money. This view underlies much economic thought today, and stands in opposition to the conclusions you draw from Tom Hickey's remark.

Neil Wilson said...

"we would be taking away risk-free investments for pensions and and insurance firms"

This can be replaced with a government annuity. You hand over your state currency savings (which are then destroyed) and the state promises to pay you an amount per annum for a set period (until you die for example).

What is interesting about this idea is that it is one way of 'recycling' net financial assets that have been saved by the private sector.

Rogue Economist said...

Arthurian, what I meant was that a surplus country which hoards another country’s currency will find that it’s useless for anything other than buying stuff in the deficit country. Ex. if the US accumulates lots of Canadian dollars from surpluses with Canada, it has to remember that all those CAD are only good for purchases in Canada. Beyond the jobs a surplus creates in the surplus country, accumulating foreign currency is pointless, and only increases inflation in the surplus country because more money is now chasing the few remaining goods in that country that haven’t been exported. Eventually, you have to spend it or you forego its worth.

Neil, is this annuity proposal a fully fleshed proposal? Do the citizens buy it? How is value determined, and how is the rate determined? Is it perpetual?

w said...

Please, a yes or no answer, do we have the right amount of government involvement in today's economy?

Thank you kindly, Mr Rogue..

Rogue Economist said...

W, rather than right amount of government(which is not the right context), these are my positions on the whether we have the right approach of government on the four points I outlined:

1. No. We regulate the wrong areas, and focus too much on rules rather than principles. Hence, It's easy to game the regulators, and this has led to too many crises. Regulators should have the common sense if the spirit of a regulation has been broken, and they should be more empowered to enforce that spirit.

2. Yes. And the state should continue being the issuer of currency.

3. No. Government spends more during a boom than on a depression. That's because they think too much that they are only sharers of the currency with the private sector, rather than its issuer. So they spend when they think they have the tax funds, and refuse to spend when they lose the tax base (though during a depression is when they should be spending more, to recharge the tax base).

3. No. I think government should get out of the rate-setting game.

w said...

RE, I concur completely with your comments (brilliant)...

Regarding the rate-setting game, are you suggesting the abolish of the Central Bank or its manipulation of interest rates?

Rogue Economist said...

Thanks, W. I'm thinking either or. Whether just taking out rate-setting from Central Bank functions or abolishing the entity altogether.

If it stays, its most useful function would probably be just to ensure that private players keep playing by the rules (play fair) and follow macroprudential controls, so they don't develop dangerous bubbles all by themselves.

I'm not yet clear on its keeping the lender of last resort function. It's important in preventing some bank failures from developing into full-blown systemic crises, but if it encourages moral hazard, that function becomes self-defeating. Maybe if it is able to ensure individual players always follow macroprudential rules, instances of needing a lender of last resort will be very few and far between. A failure of regulation should probably penalize both the regulated, and to some extent, the regulator. That should concentrate the minds of the regulator. I've been thinking of a post on this, maybe in a few days time.

If we do away with it altogether, its function of money issuance, meanwhile, can be integrated with Treasury, thereby doing away with a possibly unnecessary layer. Some MMTers have already written on this