I can’t resist a challenge. As part of the ongoing debate on ‘people’s QE’/Corbynomics being used to finance government investment there was a guest article on Coppola Comment, describing it as ‘snake oil’, by Paddy Carter. The gist of the article being that an inflation targeting central bank would automatically offset any state (helicopter) money creation. This struck me as a curious argument as in any such regime the central bank would operate under a different policy rule, and more importantly the author had assumed rather than demonstrated the key issue – whether it would be inflationary. It seemed to me that if the new money was purely spent on investment in productivity improvements then it would not be inflationary but deflationary. I tweeted this, there was some response on twitter including from Richard Murphy, and from Francis Coppola, challenging me to ‘math it up’.
I don’t think this is too shocking a position whatever school you follow in modern economics, almost all of which would disagree with the crude monetarist doctrine that inflation is due to ‘too much money chasing too few goods’ – a doctrine which neglects the prime importance of where the money goes to and where it is spent. Even the most NK orthodox such as a corridor sharer with Tony Yates would agree that if consumers expectations as to the price level were depressed because of investment which increases capital intensity and increases productivity, thereby increasing the amount of goods being chased by money, then they would have to agree, that if carefully targeted, that state money creation would be, at the very least over the medium term, deflationary.
Francis is in lucky in that I had already made a start – following a challenge from Dirk Bessemer – on formalizing a model of state money creation. They key issue here is mechanical production of money is easy – you print it or credit an electronic account. What is harder (to paraphrase Minsky) to explain is why that unit of account has value and what the relationship is between the volume of the unit of account and the price of goods and services. Holding and using different state currencies is not costless – using some will incur liabilities such as tax as well as exchange loss. So understanding how and why a portfolio holding is established in a currency cannot be done so without understanding the corresponding counterbalancing ‘liquidity services’ that the holding grants to the portfolio holder. Central amongst these is the ability to consume, trade or invest in innovative goods and services being produced in that currency area. It is not the monopoly power of money creation by the state by itself that creates seignorage – that is a necessary but not sufficient condition – but the ability to create revenue because of the arbitrage between the ability of a monopoly currency issuer to issue the unit of account at zero production cost and the revenue to be obtained from investing in new goods and services priced in jurisdiction that unit of account. So providing new money is thoroughly ‘backed’ by these goods and services creation of that money is not inflationary; indeed it can be deflationary.
What follows is an approach which attempts a synthesis of a number of streams of monetary thinking – such as Cartelism, circuit theory, MMT, the backing theory of money (the inverse of monetarism) and Keynesian monetary theory – but is none of those. However whatever your background, even DGSE and rational expectations, what I am saying is not so shocking if you think about it.
The Base Monetary Model – Tax and Spending in Balance
A golden rule is that all monetary models need to be expressed in double entry terms and meet the fundamental equation of accounting. That is assets = equity + liabilities. Anything else truly is theoretical snake oil. There are those who argue this doesn’t apply to central bank money creation. That these can create money ex nilhlio without backing by equity – quite unlike private banks. Those who argue this are making a fundamental error and making the extraordinary claim that the most fundamental equation in economics is not universal. An extraordinary claim requiring an extraordinary explanation. Of course I could set up the central bank of Pimlico (after declaring independence) tomorrow, but unless its issuance of units of account is ‘backed’ like all new monies this would just be so and so much valueless paper.
The first of these is a pure monetary steady state model of state money creation.
Here a central bank issue new state money to the state to spend, which is then spent in the private sector. This is exactly counterbalanced by the state issuing a tax demand to the private sector of exactly the same amount and the tax and spending exactly cancel each other out.
This is the simplest possible model of state money creation and taxation. It assumes no regulatory constraints- as for example in the treaty of Lisbon – on state money creation. More realistic models can be constructed on the back of this base simple model – for example with a debt management office issuing gilts and bonds. In balance the net effect is the same – tax balances spending and there is no overall effect on the price level of state activities. This has one enormous simplifying assumption. All spending in the economy is revue only – no capital spending.
This simple model has one striking feature – the State spends money into existence and taxation destroys it. This seems counterintuitive – which simply confirms the power of this circuitist doctrine. To think of wealth as a ‘hoard’ which you get by sitting on it – what I call the Smaug doctrine – is the powerful fallacy in all of economics. Indeed Adam smith based on his career on falsifying a version of it and created modern economics as we know it in the process. It is possible to accumulate wealth by sitting on it but never to create it. New wealth, and the money which creates new wealth, is always and everywhere spent into existence. Looking it in terms of assets and liabilities, in terms of modern money, this is undeniable. The mistake people make is to confuse the physical token of money, coins or cash, with the underlying circuit of accounting transactions. It is not the token which as value – look at a confederate note – but the participation of that token in the monetary circuit. All that is being recycled when you respend a coin or cash is the token – it is the ability of the state to drain money reserved to neutralize the aggregate demand impact of new money creation – which maintains the face value of that note.
The Base Physical Model – Taxing a Surplus
Now the simplest possible physical model of taxation. A one good model, such as corn.
There is a surplus of corn so that physical input of C produces C’.
This surplus can be taken as rent by the landowner. However imagine in the model a state which imposes a tax liability on the farmer. The farmer now either has to increase productivity in order not to starve or the landowner has to reduce their rent to maintain any surplus.
Here we can see tax for what it is – a form of economic rent – by a factor holder – in this case the state – in that one critical but neglected factor of production is money. Money historically often being forced into circulation by states imposing debts – tax liabilities.
The Base Growth Model – Labour Saving Technology
Finally we shall consider the simplest possible economic growth model.
Again we have one physical input and one physical output. In the base case there is no fixed capital. There is a small surplus.
An innovation – in the form of fixed capital promises to raise the productivity of output by a not insignificant amount. Creating this innovation requires dedication of labour to create the fixed capital, the new good, rather than the new one. This will take a number of months and a certain amount of labour. This is an essence a very classical model of fixed capital formation.
Here there is a very clear mathematical relationship between the increase in the rate of productivity of the machine and the amount and length of time it takes in forgone surplus in the original process.
The present value of the investment is found from the perpetuity formula FV (future value) / (1+r) where r is the discount rate (cost of investment} there is a mathematical relational ship between the rate of innovation and the rate of interest where investment is viable, space and the need to avoid a too technical explanation means this is better discussed in detail elsewhere.
Put most simply however In those cases where the interest rate islower than the increase in the rate of physical surplus from the innovation there will be a growth in credit until the excess profits from the innovation are eaten away back to the general rate of profitability.
If some of the psychical surplus is further invested we get compound growth.
Pulling the three models together
The creation of an innovation allows the capitalist who exploits it to charge a Schumpeterian rent to prices and earn super profits. The demand for the good creates a demand for the currency in which the good is produced from consumers, as well as from investors seeking a slice of the action. This creates the potential for seignorage in that currency.
If the units of account does not expand then after the innovation that monetary base remains fixed but the amount of goods increases. This deflates prices. This is not necessarily a bad thing for the consumer. However for investors each % fall in real prices is an additional % in the rate of surplus needed for an investment to make a profit. Why invest money if by sitting on it you can buy more good in the future? This is the curse of innovation with a fixed peg- like the gold standard. A burst oi innovation eventually completely loses steam as the fall in prices caused by the growth is eaten away. Eventually we get the growth runs out – a business cycle. Credit taken out on the assumption that growth will continue may be unpayable.
There is a solution. If the issuer of the unit of account expands the monetary base by precisely the amount of the rate of increase of the surplus then profits don’t fall. Indeed there is a market mechanism to do so. As a state can issue new money at zero cost then there is a market incentive for it to do so to earn the seignorage from investing it in the new technique. Then it earns a piece of the action. Providing the rate of increase in new money precisely equals the rate of increase in the surplus, the new money will precisely counteract the rate of deflation caused by the economic growth. It is entirely possible for the state to create new money and there to be deflation if the rate of investment is less than the rate of growth.
An objection might be raised as why the state should be investing, the market will chose the optimum investment globally. Globally is the issue. Capital from innovation need not flow back into investment in that sovereign currency area, it can go anywhere and might not benefit residents of the area at all. Whereas state money uniquely must first be spent in the sovereign currency area to exist at all.
This discussion implies a golden rule. If net state money creation is solely used to invest in productivity improvements, and at a rate less than the discounted rate of productivity improvement, it will not be deflationary.
The problem is it is very tempting for any government to spend state money on revenue, paying down old debt or on productivity reducing investments (arguably healthcare where an increase in spending led famously to a reduction in productivity under Blair). If state money creation is simply used to prop up state revenues and pay normal bills there is a risk of inflation and in the worst cases hyperinflation.
The solution is to recast the role of an independent central bank. Instead of running an inflation or nominal GDP rule it runs an investment rule, creating money and spending it on projects at a rate and in areas which it considers will maximize the rate of economic growth. The central Bank again becomes the state investment bank – its historical role. With such iron discipline Corbynomics would work in normal times not just times of crisis when helicopter money is gradually becoming accepted as a useful tool.
There are many examples of investments which would boost productivity. Notably solving the acute shortage of housing in this country, investing in energy efficiency, training, rail improvements etc. This is not to say that there are other useful things for the state to spend on, but these need to come from the results of growth.
There is a problem of timing. A project that might boost productivity in 5 or ten years will be boosting aggregate demand now and if there are some goods in the investment that temporarily in short supply these might add to inflation. The solution is to tax the superprofits and rents/or wages of those that get this boost readjusting aggregate demand. If expectations get out of kilter and consumers don’t adjust their spending and savings to account for future wealth and falling prices as opposed to temporary raised incomes and rising prices then temporary increases in consumption taxes may need to form part of this policy package.