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From the comments: inflation, monetary and economic stability and central banks

Larry Motuz, Paul Davidson and Don John weigh in on this post about central banks, different inflation metrics and monetary stability. What can we learn from them? Below, the comments. Below these, some remarks from me. First, however, the fact that a broader metric of inflation like domestic demand inflation (graph, source: Eurostat) shows a dramatically different development than consumer price inflation. ‘Dramatically’ as the differences add up. The total increase of the consumer price level in Germany between 1999 and 2009 was about 22%, the total increase in the domestic demand price level (which includes consumer prices!) was about 12%. Looking at one of the other does make a difference (and small wonder German households are so inflation averse!)! The comments:

  • Motuz totally agrees with the idea that central banks should not target (only) the price level but ‘monetary stability’ which includes sustainable (private) debts.
  • Paul Davidson is however quite critical:

Central banks should not look at the price level rate of change as a target at all. To do so is to implicitly accept the neutral money axiom– which Keynes rejected. This neutral money presumption simply stated is that changes in the money supply have no effect on employment and output — but have a major effect on the price level. The neutral money presumption is the basis of all classical economic theories– and especially Milton Friedman’s quantity of money theory.

The central bank should concentrate on maintaining all the liquidity the public desires and assure that financial markets maintain liquidity by providing the market maker in each financial market sufficient liquidity to assure that all financial market price changes are ORDERLY! ORDERLINESS is necessary to maintain liquidity in any financial asset market!

Instead the central bank has taken upon itself the function of creating an incomes policy that keeps labor wage demands closely attuned to increases in labor productivity over time. If labor demand for wage increases rises to more than 2% above productivity increases, then the price level of domestic producible goods and services will be inflated by more than 2 %.

In that case, the central bank will introduce a tight money policy to weaken labor power to demand inflationary wage increases– and in doing so, the central bank is using the level of unemployment as the lever in a disguised incomes policy! Why? because orthodox mainstream classical economists do not want the government to interfere directly into controlling labor wage demands that entrepreneurs will give into — as long as there is full employment and firms can sell at any price all that the full employment of labor can produce…

Some decades ago Sidney Weintraub had introduced TIP — a Tax based Incomes Policy– as a direct government control for constraining wage demands without having to create unemployment to limit workers power in the market!

  • Don John states:

If CBs have set policy as Paul describes, it is a failure: wages in most developed countries are growing more slowly than inflation+productivity. Labour power has been weakened to the point that the labour share of the economic surplus is declining and inequality increasing. It is hard to believe that central bankers can have run these policies with these effects for thirty five years and not done so deliberately

My remarks: I make two different arguments. The first: central banks have, at this moment, inflation targets which focus on the consumer price index. There is an ideological side to this: it is consistent with ‘new classical’ economic models. A case can however be made – when you look at inflation at all! – that using another, more broadly based metric would be better. New classical models treat government consumption as wasteful which is stupid already (coastal defences have no direct financial return but my country would not even exist without them) but which in the Eurozone of course also problematic as some services which in one country are provided by the government are, in another country, provided by the private sector. Non private consumption data should, therefore, be included too. Comparable arguments can be made for exports and investments. Also, substantial differences between the long term development of indices exist – we should really have a discussion about this. Inflation targeting is a flawed policy but even then focusing on the right metric matters. The GDP deflator is however not fit for this task as it is influenced by the terms of trade (i.e. the exchange rate of the Euro). I stick to this argument and add that – when we look at German data – that Germany has, by focusing on consumer prices, been strangling consumer demand while the real interest rate in Germany has been quite a bit higher than indicated by consumer price inflation. These data totally comply with the prolonged stagnation of Germany up to 2006. The ECB really suffocated the Germans. Not now. But between 1999 and 2006. Fortunately, German fiscal policy was, at the time, pretty loose.

Is it, however, wise of central banks to define lowe and stable inflation as the overriding goal of a central bank? Of course it is not. I totally agree with Paul Davidson: money is not neutral. Not in the short run and not in the long run (and even less so in the Eurozone). When I (and David) state this, we have a credit centered idea about money in the back and front of our head. Banks provide credit to customers (households, companies, the government) and create (together with their customers) money in the process. The government is pivotal in this system, as the government stipulates and guarantees that money created by, say, Deutsche Bank can be used to pay down a debt at Credit Agricole. This requires that banks are liquid at all times – and the central bank has the responsibility to make this happen (in Greece, Ireland and Cyprus the ECB reneged this role, with dire consequences). Which already indicates that money is not neutral. It matters, for one thing, who is borrowing. For those not yet convinced: in the Eurozone the main organizations borrowing from the banks are, at this moment, the governments of individual Eurozone states. And it makes a difference if the government borrows to pay for coastal defences (badly needed in the UK!) or if a company borrows the production of rubber boats. And not just now. But also in the future. A very large financial problem in the Eurozone are bad debts. Debts which are not paid back in time – a situation which threatens the entire financial system. Many of these debts are related to mortgages – one big change of the last decades has been that banks increasingly became vehicles to provide mortgages, two thirds or so of total assets on their balance sheets are at this moment mortgage related. Many of these mortgages can’t be paid back or refinanced because wages and pensions were cut, (long term) unemployment is higher than ever, households are ‘under water’ etcetera.

Now, I do think that the central bank has a role to ensure that mortgages can be refinanced (even when families are under water) and to prevent slumps and high unemployment by providing liquidity. Indeed: this is needed for the orderly functioning of markets! But I also am of the opinion that they have to ‘lean against the wind’ in the case of real estate booms. They did not do so – the ECB even made the fundamental mistake (which has been corrected about four years ago) to assume, in its monetary statistics, that securitizing mortgages not only led to the (optical) disappearance of these mortgages of the balance sheets of banks but also to a decline in the stock of money and debt… Shadow banks were in a sense no creation of the banks – but of the Central Banks! This was not a case of ideological blindness but an outright blunder. But it underscores my point that central banks should look at (not the same thing as: target) a whole array of indicators, not just of prices but also of household debt and income and the relation between such variables. Including debt and credit – two of the very aspects of ‘money’ which make this ‘social contrivance’ non neutral.

Don John in essence argues that wage moderation policies of central banks have ‘undershooted’ their target. Which is true: even central bankers are, at this moment, arguing for higher wage increases and one reason why interest rates are not raised is the very fact that wage increases are low and, in the Eurozone, becoming ever lower. Which Yellen and Draghi consider very troublesome.

  1. April 24, 2016 at 2:31 pm

    Yellen and Draghi are like the children who murdered their parents and then begged for mercy because they were now orphans. Are the really so naïve as to believe that after thirty five years or attacking wage growth central bankers aren’t at least partly responsible for the undershoot?

    Excellent original article and reprise, BTW.

  2. April 24, 2016 at 5:44 pm

    Another excellent post by you; and I agree also with Don John.

    I disagree with Paul Davidson.

    Ironically, I do so because I agree that money is not neutral. Price rises shrink the range of wants-spending out of income, reducing the range of goods that can be purchased with given incomes more towards needs-spending for the bulk of wage-earners. {The effects of the. crowding out of wants-spending to needs-spending by household is, in turn, very much a function of the distribution of incomes within the economy. The higher the pace of this crowding out in terms of the range of affordable consumption activity, the greater the risks of recession, for when consumer demand is hollowed out into a narrower range of purchasable/purchased goods and services over time then a race to the bottom occurs. I.e. just as bad currency drives out good currency, lower price and poorer quality goods {in terms of benefits from use} drive out higher price and higher quality ones.

  3. louisperetzperetz
    April 24, 2016 at 6:45 pm

    (L’inflation peut avoir lieu du seul fait de l’augmentation des échanges marchands).
    Inflation can occur solely because of the increase in trade. Money is a system which abrade itself when working. The inflation of price is only a way for producers to make good the loss. But sometime they increase the price just a little more than it be necessary. That is why banks choose, when they lend, a percent a little more than to compensate only the same loss.

  4. April 24, 2016 at 9:01 pm

    I am confused. You say “For those not yet convinced: in the Eurozone the main organizations borrowing from the banks are, at this moment, the governments of individual Eurozone states.” Really? Are you sure about this? Why would a government borrow from a bank at punitive rates when it can issue sovereign bonds? Is this the difference between the Eurozone and the UK, where as far as I know the UK government does not borrow from banks?

  5. louisperetzperetz
    April 25, 2016 at 10:28 am

    Mikeralph. Soverein bonds are made for the short time, with a big rate I suppose.

  6. louisperetzperetz
    April 25, 2016 at 10:33 am

    Of course there are bonds for the long time, whiche are called also soverein bonds.Some of them have to be for 14 years !

  7. April 25, 2016 at 11:33 am

    If economics is to gain any credibility as a rigorous discipline we need to be able to ask and answer precise questions. The article states “in the Eurozone the main organizations borrowing from the banks are, at this moment, the governments of individual Eurozone states.” I question whether this is true. It is a precise question that can be put this way: “are Eurozone governments the main organisations borrowing from the banks, at this moment?” (I assume that by “banks” we are talking about the private banking sector.)

    In response I am looking for empirical data. Can anyone supply empirical data to answer the question? If not why should I take anything in the above article seriously?

    • louisperetzperetz
      April 25, 2016 at 5:06 pm

      Here is a strap about french souverein debt “http://www.lefigaro.fr/economie/le-scan-eco/decryptage/2015/09/30/29002-20150930ARTFIG00087-la-dette-francaise-a-2100-milliards-pourquoi-c-est-vraiment-grave.php”

      • April 25, 2016 at 6:46 pm

        Hi Louis. Thanks for the link but my point was not whether governments are borrowing at high rates or not. My point is that they are not borrowing money from BANKS. The article said “main organizations borrowing from the BANKS are, at this moment, the governments of individual Eurozone states”. I am hoping for greater precision when economists make such statements. Would you agree with me that governments do not borrow from banks?

      • louisperetzperetz
        April 26, 2016 at 3:43 pm

        Mikeralph. In France, after th war, Governments used to borrow to people or to make its own money themselves. Since 1973 they were not allowed to because of a law called (Pompidou-Giscard) Of course those two chiefs of the governement were issued from banks firms. They used to say that the main reason to do so, was to stop the inflation. I do say in my book, that was a wrong reason. In the eurozone the Maastricht treaty (1992) tell that every contry have to do so. Of course this treaty was made for the bank-lobby to oblige every country, U.K too, to borrow to banks. If they nedd money, the BCE supply it.

      • merijnknibbe
        April 25, 2016 at 10:13 pm


        according to the ECB data on credit and money creation, governments are at this moment borrowing from banks!

      • April 26, 2016 at 11:47 am

        Hi Merijn T. Knibbe. Can you point me to data on government borrowing from private banks? Clearly private banks own government securities amounting to perhaps 3% of their balance sheet at a guess (solely for liquidity purposes), but do governments take out actual bank loans? If so how much?

  8. April 25, 2016 at 9:30 pm

    Mikeralphking:Are you sure about this? Why would a government borrow from a bank at punitive rates when it can issue sovereign bonds?

    This question is contradictory. “Sovereign” bonds issued by a Eurozone government and purchased by a bank is a case of “a government borrowing from a bank”. When you’re talking Eurozone, remember, this is a weird and wacky system. The ECB is basically the issuer of the Euro (behind it is the Bundesbank and Germany). The ECB sees its mission basically as protecting the private banks & suppressing national governments. If a national gov obeys the Eurocracy, the ECB will support the national govs bonds and the banks will load up on them – because they then get both highish rates and security.

    Is this the difference between the Eurozone and the UK, where as far as I know the UK government does not borrow from banks?
    Essentially, yes. Whoever holds its bonds, whoever “lends” to the UK, as long as it is denominated in pounds, the UK government is in the driver’s seat, not banks. This is true even if the banks hold most or all of the UK government debt – which is the reason for the qualification “essentially”, as any issuance of money or debt is borrowing. But this word must be carefully understood.

    A basic source of confusion is the little-noted but important (redundant adjectives these days) fact that (financial) borrowing & lending relations are symmetric. What happens when one borrows – say getting a mortgage from the bank to buy a house – is an exchange of IOUs. (Mortgage note in return for bank deposit). From this perspective, who is the lender? Who is the borrower? One needs more information – that the bank’s IOUs are generally acceptable, moneyish – while the individual’s are not – which is the only reason such a transaction ever occurs.

    When you say that “the UK government does not borrow from banks” you are recognizing that with the UK government vs a bank, like the bank vs the individual, the former is the entity in charge – despite the fact that your statement can be interpreted to be a falsehood.

    For the design of the Euro creates a medieval situation with private banks which are powerful money-issuers because they are backed by the ECB (in turn by Bundesbank, German gov & nation). This reverses the normal modern (& ancient) relation between the state and a bank. So if one digs up the data it surely supports Merijn Knibbe’s assertion – which is true under any interpretation, because of this data and because of the design of the Eurozone.

    • April 25, 2016 at 10:19 pm

      Hi Calgacus. You say: ““Sovereign” bonds issued by a Eurozone government and purchased by a bank is a case of “a government borrowing from a bank”.” My point is that banks purchase very few government bonds, making them an organisation that lends very little to government. Banks only purchase enough government bonds to meet liquidity requirements, but would prefer, as I understand it, to hold higher-yielding instruments. This is where I am looking for empirical data: what proportion of Eurozone government bonds are held by private banks? I suspect it is a small proportion of Eurozone government debt.

      • April 26, 2016 at 12:36 am

        Well, that’s for Knibbe to reply to. He has been trustworthy in my experience. My point is that the real problem in modern economics is conceptual, logical confusions, hidden by mathiness & too little, not too much mathematical rigor. All the empirical data in the world won’t help that, won’t be useful without fixing that. It may even obscure things if it is used the way current standard economics does.

        My point is that banks purchase very few government bonds, making them an organisation that lends very little to government. This does not appear to be true. The EZ presents problems of definition & sources & I don’t know exactly what MK meant. But the first response for “who holds european sovereign debt” on google is this 2015 Business Insider article giving end of 2013 data. The private bank exposure is the red plus the shaded white on the chart, at least, and is substantial for EZ & other states.

      • April 26, 2016 at 11:50 am

        Thanks Calgacus for the link. It suggests that EU domestic banks hold something like 20% of total EU government debt, most useful to know. However this does not mean, as Knibbe says, that governments are the main borrowers from banks – I would put the figure at about 3% of total borrowing, but I suppose it could be a bit higher. Do you have figures on this?

  9. louisperetzperetz
    April 26, 2016 at 3:47 pm

    About BCE you have to know that it makes coins (for banks and people), but never allow money for states.

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