• Plots of land given over to a particular land-use will be allotted into discrete locales within which ground rent per square foot is estimated as being approximately equal. Annual land permits specifying land-use and locale, and accounting in aggregate for the total square footage of the plots, will be issued each year via a public auction. In this way each plot can be occupied by a registered permitholder, leaving no land permits unused.
• Ordinary Land Permits (OLP) will be auctioned annually from day one. These cannot be held by individuals in excess of [10%] of a locale in order to prevent market manipulation/extortion of would-be occupiers. OLP will be post-dated to [ten] years after issuance, and so an OLP issued at launch will only permit occupancy in the [11th] year, and so on. OLP can be privately traded at any time on a public exchange, provided ownership remains registered.
• The annual proceeds of the auction of OLP will fetch a sum of rent for the public to be shared equally by the population. This annual citizen’s income is described here as Ground Rental Entitlement (GRE).
• In parallel to the issuance of post-dated OLP, a batch of ten Special Land Permits (SLP) – one for each of the first [ten] years – will be vested with incumbent landowners on day one in order to cover their actual land holdings (disregarding the [10%] limitation by locale). These SLP must always be held by the actual landowner: so if a plot of land is sold in the first ten years, it must be accompanied by contribution of the remaining SLP.
• SLP are designed to cushion incumbent landowners from the loss of their freehold. The net effect of the policy is that incumbents receive ten SLP for the land they occupy, as well as annual GRE; but in return they forfeit the freehold land value, although not the cumulative improvement to the land ie buildings.
• For more sought-after plots, once SLP have run out on the [tenth] anniversary of the launch, the value of subsequent GRE may be insufficient to cover the cost of OLP to the incumbent owner: in this case the first ten years of GRE represent a bonus capable of subsidising the deficit.
• What is notable under this policy framework is that GRE will be collected and distributed to all from day one, and all the while without unfairly expropriating landowners (granted ten years’ incumbency). The universality and immediacy of GRE, along with the care taken not to penalise recent land buyers/upsizers, will both be essential in establishing general support for the policy.
• While being post-dated, OLP present value should be similar to future value: as ground rent tracks growth in output and population, it should therefore show correlation with the rate of interest used in discounting future income. Consequently, the public ought to be able to collect approximately the full value of ground rent over time.
• Plots of land given over to a particular land-use will be allotted into discrete locales within which ground rent per square foot is estimated as being approximately equal. Annual land permits specifying land-use and locale, and accounting in aggregate for the total square footage of the plots, will be issued each year via a public auction. In this way each plot can be occupied by a registered permitholder, leaving no land permits unused.
Accumulating capital involves retention of an opportunity to consume in exchange for which surplus labour – labour whose subsistence needs are already funded – can be deployed as finance. Without finance being provided, any return on investment would not be realised, and this therefore confronts us with the following questions: how much of this gain is owed to holders of capital as interest, and what governs this?
In essence, a saver holding capital can provide finance by pledging a relatively liquid asset (typically money) in exchange for a relatively illiquid one (such as a receivable or equity). The shift from liquidity to illiquidity implies a cost measured by the delay (or the risk of economic loss on liquidation) that must be endured by the financier before being able to consume goods and services. This is offset by the gross gains made by the saver’s transaction counterparty, the investor, realised as greater future output.
Investing surplus labour means that consumption (principally workers’ subsistence) has been funded in advance of completion of the works. However, the full wages of labour still need to be paid (the consumption component owing to the provider of finance, which is thus repaid “at par”). Rent must also be discharged in full. The only basis for any excess remaining as a net investment return would be to cover interest charged by the provider of finance in satisfaction of the saver’s “time preference” for immediacy (liquidity).
In certain circumstances, the pure opportunity cost of deferred consumption may be zero, and if this could somehow sustain zero interest rates there would be no return on capital – allowing wages (including for intellectual property) and rent to absorb all the gains. (As intellectual property is diffused, rents take the lion’s share of gains; the biggest beneficiaries of antitrust laws are landlords.)
But savers do not just face a delay on consumption; in parallel, they face an opportunity cost measured as wages foregone by not investing in their own productivity. Zero interest rates would therefore imply an expectation of zero income gains to be made from investing (or else a monopoly on the expertise needed to achieve such gains).
Whereas for non-savers, surplus labour would need to be expended in raising productivity, savers already have the resources (surplus labour) with which to purchase equipment and thereafter enjoy higher wages (at least than would otherwise be the case). Accordingly, if the saver is instead to finance investment undertaken by someone else, in addition to receiving back par he should expect compensation for the loss of wages over the same period. This is a component of time preference and therefore interest.
Provided its fruits are not hoarded as goods – which would dampen aggregate consumption in proportion – but instead exchanged for the opportunity to consume (ie for capital in the form of debt, equity, rental receivables or money), surplus labour can be used to finance investment. Interest plays an essential role in this exchange, without which investment would be curtailed to the detriment of all.
Interest does not impinge upon the funds drawn on to pay wages. This is because wages (for generalised labour ie not “protected” by patented intellectual property) are constantly squeezed down towards the margin of cultivation, the socially-determined minimum return needed – after payment of rent – before labour will be supplied. The return on capital must, therefore, come out of what would otherwise have been drawn as rent. This exerts a stabilising influence on rents: in times of euphoria, higher interest offsets higher output; and vice versa.
Capital describes an opportunity for someone to consume a measure of goods now or in the future without having to expend labour. Assuming the goods to be consumed do not currently exist, labour will of course be expended to allow the opportunity to be taken. But this labour will be expended by others, to whom the capital under consideration will be distributed in order to elicit the goods.
So capital, in abstract terms, represents labour-time, namely the amount that must be expended to satisfy the opportunity to consume. Labour is the source of the only constraint on capital formation – it exerts the only fundamental cost on production – because, uniquely, human toil creates an additional subsistence need. Wages cannot fall below this margin of subsistence or else the labourer would not be able even to live.
The margin of subsistence must be capable of being met out of output or else the work is essentially non-productive. But workers may demand well in excess of this margin so as to save enough in anticipation of old age, when they will become decreasingly productive and eventually unable to work. Saving is precisely what motivates capital formation in the first place, and allows workers to create capital.
Whereas labour expended must consume part of its fruits, rent imposes no such constraint on capital formation: using the resources on which rent accrues does not imply additional consumption because land already exists, freely and in spite of human activity. It is this fact that actually defines rent, which is a key channel by which capital created is subsequently distributed.
It might appear that when high enough rent will constrain capital formation by leaving insufficient reward for the producer, thus removing the incentive to work. However this is a reversal of causality: rent does not constrain productivity but rather it is productivity that constrains rent. Far from being its nemesis, rent is a sign of productive opportunity: where land accrues no rent, this is because, at best, it scarcely yields enough to cover wages, and most likely is below the margin of cultivation dividing land that is in use from land that is idle.
By the same token, labour working on superior land does not automatically command higher wages, because rent absorbs any surplus over the margin of cultivation. This, Ricardo’s Law of Rent, is the consequence of competition over scarce resources (in this case location). As well as the significance of rent as a channel for distributing capital, this law is among the most important – and least prioritised – observations for economists. Socialising rights to rent, by taxing and remitting rent to all, is the only tool to combat poverty – and to democratise the use of capital.
Negative rates on bank reserves acts as a fixed tax on the banking system. The only way for the banking system as a whole to reduce its impact is to expand by lending more, increasing the ratio of (untaxed) ‘bank money’ to (taxed) ‘base money’. Unlike conventional profit or transaction-based taxes, negative rates fall most heavily on the least active banks, those with the highest reserve ratios. Conventional taxes, since they discourage activity (lending), are passed from banks onto wider society in the shape of higher margins on loans and lower rates on deposits. Negative rates, on the other hand, cannot be passed on, since they force lending up – all of these additional loans will need funding, and so deposit-taking cannot be deterred by banks trashing rates to savers. Radical policy would replace conventional taxes on banks with a negative rate on reserves deposited at the central bank.
The severity of the financial crisis is down to savers no longer “knowing”* what saving goods (especially bonds) are worth. While the crisis reflects major underlying problems, its immediate escalation is simply a draining away of liquidity from almost all saving goods. The one exception – so far – is money.
A holder of an Italian or Spanish government bond knows that it is backed by a promise made on behalf of million of taxpayers. Yes, both economies (as with all others in the developed world) are mired in difficulties of some description or other. But this diagnosis is not entirely new. Have Italian and Spanish workers all suddenly become less productive? No. Has the word of their sovereigns become questionable all of a sudden. No.
For all the theory directed towards macroeconomics, what causes a recession to occur after a period of growth is confidence. Factors of production – land, labour and capital – do not undergo sudden changes. Yes there are recurrent supply shocks, such as rising commodity prices, wars and natural disasters. But nobody is arguing that any of these is to blame for the current crisis.
Meanwhile, very many people recognise that confidence is key. Keynes talked of animal spirits, and this concept has recently made a comeback in the English language. Behavioural economics has never been more influential.
Yet this level of understanding among policymakers has not unlocked the present conundrum. The more savvy do realise that the key to de-escalating the Eurozone financial crisis is to furnish savers with a saving good whose worth they “know”*. So far, this has prompted calls for the provision of more money (ie ECB intervention). It is beyond the scope of this note to detail the difficulties of such a proposal – suffice to say there are major political impediments.
But as I argued recently (“Dear Mario: A Plan for Italy”**), formal ECB-driven quantitative easing (QE) is not required. No ECB intervention is needed for eurozone sovereigns to issue an instrument whose worth can never be in doubt. Previously this instrument was a government bond, although in this emergency savers now question whether distressed sovereigns are capable of honouring their promises. So a new instrument must be established.
This instrument is a Tax Credit. What distinguishes this from a conventional bond is that the worth of a Tax Credit (to a taxpayer in the year of exercise) is self-evident. This worth is independent of what other savers think or how they behave; it does not rely on a sovereign being in rude financial health in the future. A Tax Credit resembles money much more than it does a bond.
Whereas formal QE cannot be achieved by Italy or Spain (without abandoning the euro) – and might not even be feasible for the ECB given its political environment – Tax Credits can be issued by any sovereign unilaterally with immediate effect simply by offering to subscribe a sum of government bonds in exchange for another sum of Tax Credits exercisable in the future.
Whereas savers (who cannot know for sure what government bonds are worth) demand very high yields to hold bonds issued by distressed sovereigns, they would not have this concern about Tax Credits. Like money, their liquidity is as assured as taxes being levied. Consequently, the terms of the exchange would reflect a much lower (truly risk-free) rate of return: the opportunity cost of holding a Tax Credit (for the taxpayer) is the liquidity premium (on account of the delay before its exercise, at which date it is a cash equivalent).
The government would announce an auction/exchange date together with the sum of Tax Credits being offered (with different years of exercise). Using a risk-free rate of return to accrue value, a maximum exchange rate would be set. E.g. up to EUR110 of 10Y Tax Credits could be offered for EUR100 of 5Y bonds. (My previous note goes into more detail about pricing; the idea would be to offer Tax Credits whose present value corresponds with the surrendered bond par). Italy is running a primary surplus of around 1% of GDP – which, with debt of say 120% of GDP, suggests that paying average interest of 0.8% would mean the government would only need funding for bond repayment. While a yield of 80 basis points is probably ambitious, issuing Tax Credits holds out hope of reducing interest costs towards this breakeven level.
By staggering supply, the government could allow the price of Tax Credits to be bid higher as bondholders compete to exchange bonds for risk-free instruments. The higher the price of Tax Credits, the greater the saving for the sovereign. But by offering present value up to the bond par, this is achieved without imposing a haircut on bondholders, and without resorting to coercion or default. In this way, the sovereign sends a credible signal that it intends to honour its promises, which should encourage bonds to trade back up towards par. Conventional borrowing (bond issuance) would then fall back to affordable levels. (Returning to conventional bond issuance at some stage is desirable as it imposes greater discipline.)
Even with this level of generosity to bondholders (certainly in comparison to market prices), the sovereign would save itself a potentially considerable amount of interest over coming years – and also has the opportunity of postponing refinancing needs too. These two factors mean government – not bond vigilantes – can set the terms of necessary austerity. Restoring financial and economic health is not a given with such an emergency scheme – but by greatly boosting domestic liquidity and investor confidence while reducing interest costs, at least recovery would be back within governments’ sights.
*I use quotation marks in order to set aside wider questions of value and purchasing power, since these important ideas are not necessary in de-escalating the current crisis.
** Also available in the FT Long Room and at https://wealthoflabour.wordpress.com
The nemesis of any nation’s public finances is the moment investors demand risk premia correspondent with fears of bond default. To go from this inflexion point to an actual credit event can be rapid, a matter of weeks or even days – not least because the shift upwards in perceptions of risk actually heightens risk i.e. excessive fears become self-fulfilling.
In such circumstances it is imperative to identify and deploy a “circuit-breaker” as soon as possible, a task that has proved extraordinarily difficult to achieve for distressed eurozone sovereigns, whose credibility is constrained, after all. In this post I outline just such a circuit-breaker.
So what can be done? Leaving aside the host of official eurozone proposals being bandied about, what options short of default can distressed sovereigns really enact themselves that would relieve the funding pressures arising from unaffordable risk premia?
Unlike other borrowers, sovereigns can raise taxes from their citizens. Of course this power does not exclude sovereigns from being viewed as risky; however, the obligation to pay tax does mean that an instrument created for the express purpose of meeting this obligation would, to the holder at least, bear zero credit risk. In normal circumstances, this instrument is money: in the eurozone, euros. However, eurozone sovereigns cannot issue euros, part of the reason they are hard to come by in certain markets. But eurozone sovereigns are not prohibited from issuing alternative instruments that they will accept in settlement of taxes levied on their populations.
In present circumstances, issuing Tax Credits may be the least worst if not the last available method for weak eurozone countries to manage their debt and access funding – two vital pillars in any austerity programme. Moreover, a Tax Credit being another name for currency, such a scheme would in effect promote much-needed monetary easing, helping to restore the economic activity on which austerity depends, namely investment.
To meet these objectives, distressed sovereigns have to infuse Tax Credits with credibility. Whereas convincing investors to hold its IOUs means Italy has to offer unaffordable rates of interest, convincing them to hold a Tax Credit that can be used to redeem future tax obligations ought not to come at such a heavy price. This is because unlike for the government bond, the value of a Tax Credit does not rely on the government meeting an increasingly unaffordable obligation; it relies on the government continuing to levy taxes, which (along with death) is unlikely to end any time soon.
What should investors be willing to concede to the sovereign in exchange for Italian Tax Credits, I wonder? Judging by the risk premia being charged, one answer is surely Italian government bonds.
The difference between the risk premium charged on new Italian government bonds (currently around 7%) and that on Tax Credits (a truly risk-free rate) represents a net saving for the sovereign extracted without coercion. The circa EUR2 trillion question is how to exploit this saving (but no more) in order to achieve the goals of sound public finances and economic growth. Fine-tuning the terms of the debt exchange should be about alleviating the debt ‘stock’ and funding ‘flow’ pressures on the sovereign, while minimising the fallout for investors, many of whom, after all, are domestic savers (pension funds, retail investors) and financial institutions critical for the nation’s revival. Even foreign investors, many comprising important elements in the eurozone financial system, may go on to provide vital funding in the future, provided they are treated fairly.
So to the details. In the case of Italy, the treasury would, in exchange for cancelling surrendered government bonds due in t years, offer Tax Credits exercisable in year t + n. (Tax Credits exercisable per year would be limited, say to % of current collections, to ensure a minimum cash collection for non-debt service expenditures.) The exchange rate (r) offered by the treasury would represent the future value of the Tax Credit divided by the bond notional.
Subject to its terms, the scheme would boost Italy’s liquidity position i.e. its ability to run a budget surplus over the short term. However, liquidity comes at a cost for investors, who will therefore expect to be compensated at a risk-free rate of interest i over the corresponding term in return. As Tax Credits are not interest-bearing, i is implicit in r. That is, in quantifying the terms of the exchange (it is voluntary), investors will discount the future value of the Tax Credit (realised in t + n years) at a rate of interest i – using as a proxy some other benchmark such as the deposit rate at the central bank or yields on German government bonds with similar maturities – or maybe even domestic inflation.
In the case of Italy, with most of its public sector debt held by its own citizens, there is immediate scope to implement such a scheme (although foreign ownership is by no means incompatible with the basic premise as trading would repatriate most bonds). Italy, keen to preserve its status as a performing debtor rather than join the club of bailed-out states, will (unlike Greece, in a more perilous position) seek to avoid passing on economic loss to bondholders. This would be achieved by sizing r = (1 + i) ^ (t + n) for any bond being surrendered.
In discussion with investors, the treasury would have to select its own risk-free benchmark. If i = 1%, then for bonds surrendered with 5 years remaining Italy would offer Tax Credits exercisable in 5 + n years. With n = 5, the Tax Credits would be worth 110% of par. With a longer lag (say 10 years), r would rise to 116%. Yet despite no haircut, there is considerable saving for Italy owing to the difference in compounded risk premia over the period t + n. For a bond costing Italy 5% p.a., this amounts to a saving roughly of:
(1 + (5% – i)) ^ t during the term of the bond and the present value of (1 + (7% – i)) ^ n pending exercise of the Tax Credit (assuming bond yields stay around 7%).
This scheme could be offered immediately and should attract interest on all but the most short-dated bonds (of which bondholders might reasonably expect full repayment). For investors, counterparty risk is removed and there is no writedown of their investments. For the sovereign, cumulative debt service costs are slashed while some austerity is postponed, freeing up cash flow without undermining credibility.
Dear Mario, with such a scheme, Italy would have a reprieve – and the breathing space to commence on its programme of reforms as well as introducing some targeted growth-driven spending. There is a double saving: just as the break-even rate of growth necessary to restore sustainable debt dynamics would fall in line with funding costs, the prospects of securing this growth would also improve, both from the lightening of the fiscal adjustment and a de facto monetary loosening. Moreover the Italian yield curve would fall as bonds on all maturities trade up towards par, with investors heartened by having a concrete and credible exit in sight – and all without a cent of official support or ECB intervention!
Finally and crucially, the scheme acts as a circuit-breaker – more bullish investors might retain bonds in the hope of improved circumstances, whereas the more bearish would gladly surrender theirs. The composition of its investor base would migrate towards the more committed and away from speculators. Instead of escalating the crisis, periods of weakening investor sentiment (and there will doubtless be bumps along the way!) would give the sovereign more flexibility, not less as experienced presently.
Austerity, vital to reverse the deterioration in public finances, is not achieved by keeping productive resources idle – on the contrary, this is inexcusable waste. The scheme, unique among the raft of proposals for allowing for a controlled pro-growth stimulus within the confines of the single currency union, must be considered urgently if Italy – and indeed others – are to survive socially, politically and economically intact.
From a friend of Italy
What is liquidity and what is it for? The most liquid asset, money, we use to make purchases. Since what we ultimately use it to buy -consumable value- is constrained by available goods and services it may be tempting to construe liquidity as being similarly limited by real economic factors. This is incorrect.
In order to examine what liquidity is, it is necessary first to introduce the concept of purchasing power. This refers to the value a saver believes should be obtainable from or in exchange for an asset. Purchasing power differs from value in one critical way: whereas value is a measure of currently consumable surpluses, purchasing power does not specify the time of consumption. While it is its offspring, purchasing power is not yet constrained by saving; it allows for some projection of future, yet-to-be-produced value too.
So, what value is to consumers, purchasing power is to savers. Consumers demand goods and services on the basis of what value they offer now in relation to their price: value is assessed at purchase before being consumed as utility, both experienced subjectively. It should not matter to one consumer what the experience of another is. Savers, meanwhile, seek instruments on the basis of how much value these ought to return in the future, which is also a subjective determination.
However, actually discovering an asset’s purchasing power typically involves the intermediary step of monetisation, either at maturity (for redeemable assets) or upon sale. Both routes hinge on savers transacting with third parties. A maturing instrument will only pay off if its issuer honours its obligations. In a sale scenario, the views of prospective buyers constrain what price is fetched. In the latter, it is the proximity of one saver’s estimate of purchasing power with those of others that tells us anything about the instrument’s liquidity. This is not something capable of being conveyed in the instrument’s spot price, but only over time as price volatility (and only then to a limited extent). While an instrument’s liquidity may be signalled by the time that elapses between offering it for sale and completing the transaction, this is a function of the degree to which the seller’s (initial) price expectations may exceed those of prospective buyers. [Note 1: For a low-order good, a consumer may come to believe that he overpaid for it, but this will not be because he miscalculated other people’s assessments: value is always a subjective matter. In matters of pricing, liquidity is relevant only to purchasing power, since (unlike value) this determination is market-mediated.]
So while goods and services must be produced or performed in order to be consumed and offer real value, financial instruments are neither produced nor consumed; they are virtual and their purchasing power largely depends on sentiment. Durable “saving” goods fall somewhere between these two poles: a house, for instance, will be bought on the basis both of its current and residual utility; any bid reflects not only its usefulness as a dwelling to the bidder (its value), but also the bidder’s expectation of what others may be prepared to bid for it in the future (its purchasing power). A house appeals to an instinct to save inasmuch as it quenches the desire to consume: as with all high-order goods, a home is not consumed at once but over time through a process of gradual depreciation. [2: The phenomenon of rising house prices told us little about the value of the homes, which was depreciating. However, it did reflect the rising price of the land beneath, which accounts for a large part of any purchase price. Since land is in perpetually short supply, it commands rent, the level of which responds positively to both output and population. The rate at which the price of homes (including those in terminal decline) was rising indicates just how much general sentiment towards future economic activity was improving. Nevertheless, where prices have been slow to fall, this is probably not because of continued favourable sentiment, but may simply signal a lack of property transactions: with borrowing costs so low, many homeowners have been able to put off selling in the hope that their homes will fetch more acceptable prices in the future.]
Whereas policy should seek to ease economic constraints on value and financial capacity, the fact that sentiment is not subject to economic constraints has been exploited by policymakers. Neither purchasing power nor liquidity is subject to any fixed gravitational pull. The former should be left well alone by politicians; the latter, meanwhile, should be economised, as I argue below (following on from previous posts). This involves swimming against the tide, since it is easy to purport abundant liquidity as being an unambiguous good. Indeed the practice of modern banking is predicated on allowing all savers to be liquid: much of savers’ assets has been homogenised, eliminating purchasing power dispersion in the process. [3: Increasingly, payments are settled not in physical money (cash) but by transfers of savings held in the form of bank liabilities (deposits). In a given currency bloc, all bank deposits are considered identical in kind, and trade at par with the central bank’s own monetary liabilities. This identity (which ultimately hinges on an implicit or explicit public guarantee) is the basis of the liquidity enjoyed by money: there is nothing to distinguish among any holdings of money except their respective nominal amount.]
If we have demonstrated that liquidity need not be scarce, we are still to identify the problem of insulating savers (prepared to forgo higher returns offered elsewhere) from market risk. The short explanation is that this transfers price volatility from savers into the market for real goods, which affects a broader group and risks introducing into production a systemic, or cyclical, character. If changes in discretionary consumption can be made with impunity, shifts in demand for the products of labour will be registered as fluctuation in the price of goods and services. Not only would consumers be punished indiscriminately by rising prices, the opposite would only tend to reduce production.
Without any offsetting positive effect on interest rates as a result of rising consumption, investment could not be expected to fall in the event prices and production grew. Yet one might well hope that some counter-cyclical weight should bring to bear directly on consumption growth. A rise in the price of goods and services cannot in itself be relied on to reduce consumption demand; indeed, the reverse would happen if acquisitions were brought forward in anticipation of even higher prices to come, a self-fulfilling prophecy capable of entrenching inflationary expectations. The flip side of this coin -a fall in consumption and prices- could lead to a postponement of purchases, dampening production, income and subsequent demand, and prodding society nearer a veritable abyss: deflation. With prices stagnant in much of the West, deflation is currently high on the agenda of economists, who look to Japan’s experience with justifiable dread.
Yet the medicine prescribed so far has been the provision to savers of even more liquidity, administered via quantitative easing (QE) programmes (explored further below). An alternative that I have proposed in previous posts is to do the reverse: to tax, and thus to economise on, liquidity. In this way, only those wishing to transact would wish to hold money, with any excess actively marketed in exchange for non-monetary (and so non-taxed) instruments. For their part, savers not holding money would have to liquidate assets in order to increase discretionary consumption above what is ‘scheduled’ by the term structure of their savings. By doing so, they face possible trading losses, especially at times of high consumption demand when the call on liquidity would rise, and with it, the rate of interest. Conversely, should demand fall, the price of various saving instruments would rise, enticing savers to liquidate their holdings and increase consumption.
Note that changes in the price of redeemable instruments, by virtue of bearing a ‘face value’, would be less prone to positive feedback and path-dependency than in the market for goods and services lacking any nominal value. And even if speculative forces were to emerge -were savers to hold on to assets in the hope of even higher prices; or were holders of money to hold out for lower prices for saving instruments- they would be held in check by the taxation of money and the related urge to economise on liquidity. Taxing money increases its velocity, which, incidentally, is the intended outcome of QE – an outcome being thwarted by the Keynesian ‘liquidity trap’.
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A desirable consequence of my proposal would be that changes in demand for goods and services would first be signalled within the financial markets: the price of financial instruments would rise and fall inversely with demand for liquidity (required in anticipation of spending). A rise in the price of instruments would signal a fall in the price of money -a decline in the rate of interest- whenever consumer spending peters off; the prospect of profit-taking would prompt some savers to consider consuming instead; also, with rates low, investors could avail themselves of cheaper financing. These responses would stimulate greater demand for goods and services, causing an increase in the rate of interest. Remaining savers would now face steeper discounts on their assets, while prospective investors would find financing more expensive to come by. Here, rising interest rates would temper demand.
In this way, shifts in interest rates would act to flatten spending cycles, cushioning the real economy from swings in saver sentiment and stripping out considerable price volatility from the markets for goods, services, labour, land and capital. In this way, cyclical (systemic) disruption to employment and income would be reduced, largely freeing the allocation of factors of production from monetary influence. As we will see further down, the price of goods and services could still fluctuate, but this would be in response to actual changes in demand consistent with myriad choices as between consumption or saving, not to speculation about the course of future prices.
Thus far I have recommended a transition from an economy addicted to the most liquid savings (money) to one that can allow much more of its productive surpluses to be represented in less liquid forms. Of course our society has already invented various vehicles that savers can hold besides money, such as bonds, pensions, insurance and equity. Whatever methods are adopted, savers’ interests always remain rooted in production: only by investing in capital can saving (not involving outright hoarding) take place.
More will be required than simply to contrast against money some ideal saving instrument: the connection between the proposed method of saving and the processes of investment must also be revealed for this alternative arrangement to be considered credible. After all, in the current banking system the functional co-dependence of saving and investment finds some expression, however warped. Banks satisfy savers’ ‘liquidity preference’ at the same time as providing long term financing to investors, silently performing the task of ‘maturity transformation’ – or better, concealing the state’s ultimate responsibility for this. Yet by supposedly shielding both camps -savers and investors- from liquidity (or market) risk, banks have extracted huge public concessions and lodged themselves firmly into the financial sector – but only by making themselves extremely fragile.
So successfully has its ‘services’ been sold to the public that most savers and investors consider banking indispensable. Not only does the public act as guarantor to savers; not only does the related moral hazard distort the rationing of financing; more than these, banks’ promotion of liquidity provokes widespread and unnecessary misery by transforming the natural ebb and flow of economic life into often violent swings in prices and production, virtually institutionalising cycles of boom and bust. Banking has ensnared savers into a liquidity trap, and ultimately foisted massive fiscal stimulus on society in a perilous bid to stave off deflation.
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In the proposed model, current banking would be disestablished, with saving funds losing all privileges. Money would face continual taxation and redistribution to all (leaving its global quantity unchanged). Raising the tax rate would increase monetary velocity, and vice versa; this tool would be the principal level of monetary policy (as explored further below). Rent would be entirely confiscated in taxation and then redistributed to all, vesting in each citizen the right to receive an equal stream of rent over one’s lifetime – a natural asset base. [4: The due-dates of taxed rental payments (though not taxes levied on money) would be staggered across the population to smooth the demand for money that would arise for this purpose. The treasury would instantly remit these collections; expediency suggests that remittances should not be uniform, but rather staged such that each individual would have a periodic (say annual) payment.]
These high quality rental assets (secured under social contract and thus free from counterparty risk) could be auctioned by those seeking liquidity (for consumption or investment purposes) to anyone wishing to save. [5: It would be worth exploring whether and how to assure a notional payout on saving instruments. For instance, per capita rental dividends could be floored as an (admittedly arbitrary) percentage of what has been distributed at any time in the past. Equally, as an alternative to private life insurance, this same percentage could be further guaranteed in respect of anyone who dies above the age of 21 until such time that they would otherwise have reached say 60. Therefore any beneficiary of their future rental allowance would be able to rule out mortality risk. With these twin safeguards, a homogeneous class of saving instrument could be constructed to account just for the guaranteed rental dividend, allowing pricing for this to be based exclusively on the opportunity cost of liquidity for various tenors (i.e. the yield curve).]
All financial transactions involving these rental receivables would have to clear through a public exchange to allow for re-registration. Additionally, this would ensure that in spite of being taxed, scarce money would have to be acquired prior to consumption (including as part of investment). [6: In other words, payments could not be settled in non-monetary instruments such as these rental receivables (whose title would be evidenced exclusively in the public registry). Admittedly, at least in theory, some payments could be effected by offering real assets; however, as now such barter operations would impose punitive transaction costs.]
In sizing how much money to accumulate, prospective consumers would take their cue from the prevailing price of capital, goods and services. Investors would supplement this with the prevailing wages and rent charged in order to hire labour and land, and could accommodate scheduled costs by compiling a portfolio of instruments with a range of tenors. As liquidity over time is being economised at each point in time, the price of money -more generally, the rates of interest across various tenors- would regulate demand into the future, ensuring it responds to changes in the supply of goods and services (by which it is always constrained). This helps to prevent sudden swings in prices, with all the associated costs on production and employment.
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As hinted previously, economising on liquidity does not mean that prices in general are unable to rise, although this would require an increase in the velocity of money. If there was involuntary unemployment, then the cost of production could be contained even as consumer prices rise, implying growth in the return to capital (producer profits), which is a condition for greater investment. The increase in productivity associated with more capital should temper price rises (and profits) after the initial surge; savers are not compelled to assume their purchasing power has eroded.
If, instead, the supply of labour were inelastic, implying that any unemployment was voluntary (leisure), then rising prices would tend to push up wages, constraining producer profits and investment. By definition, a uniform rise in general prices is, in static terms, consistent with maintained output. It is true that savers will have passively yielded purchasing power to investors, although this transfer is only known ex post; only if this leads to an expectation of further increases in price will current savers tend to liquidate assets and the propensity to save fall. The resultant increase in interest rates will depress investment. Unless this moderates inflation expectations sufficiently and interest rates ease back down, the lower levels of investment will harm future economic growth.
What can we conclude from all this? If there is involuntary unemployment, then an increase in demand and prices can stimulate expansion, and higher overall welfare. The appropriate policy response to involuntary unemployment would therefore be to increase taxes on liquidity, increasing monetary velocity, stimulating prices, profits and production. (It should be noted that with the proposed reforms, there would arguably be next to no involuntary unemployment.) At full capacity, however, rising demand raises all prices, but leaves profits and investment unchanged. With no increase in production, should the price increase create a general expectation of inflation, and therefore higher rates, the policy response should be to lower taxes on money in order to temper price gains and therefore encourage lower consumption.
At present, this monetary policy instrument has not been used. Rather, in the wake of the banking crisis, and with central bank interest rates hovering above zero, authorities have instead directly expanded the quantity of money in QE operations. In his Prices and Production, Hayek analysed what would happen if demand was ‘artificially’ increased by an injection of new money (to consumers). In his analytical framework, which countenances neither the possibility of involuntary unemployment nor its counterpart, excess liquidity, Hayek reasons that by increasing consumer prices, such ‘forced saving’ will eventually lead to productive power shifting from high-order capital projects to low-order goods, as producers seek to profit from nascent price differentiation.
In due course, as the ratio of the supply of consumer to producer goods increases, this pricing differential is eliminated, removing the initial impetus to so-called ‘less capitalistic’ methods of production (caused in effect by higher interest rates according to Hayek) provoked by monetary expansion. Consequently, as the rate of interest falls to its ‘natural’ rate, the organisation of production also reverts to what actually corresponds to real demand. For Hayek, only relative prices are meaningful, and these cannot be tampered with in the long run by changing the quantity of money – that is, unless it is repeated on an ever-increasing scale. Since this comes with its own inflationary problems, Hayek concluded that monetary policy is rendered ineffective at averting recession (in his case the Great Depression), and if authorities intensify their efforts (as many are currently predicting) this may even worsen any downturn.
What can we make of Hayek’s analysis? In his model, money is neutral and lacks any lasting ability to alter economic equilibria. Yet by ignoring the tendency for savers to hoard money, he dismisses too the evidential phenomena of involuntary unemployment. Scarcity does not guarantee economisation, and may even do the reverse: when in fixed supply, savers can profit simply by hoarding money, adding downwards pressure on prices, and thus increasing their own purchasing power. Monetarism departs from the Austrian tradition (of which Hayek was a proponent) by recognising that money can be a real economic factor. In the early 1970s, monetarist-inspired lawmakers removed the outer limits that gold’s official price had placed around the quantity of money. Banks were given the power to alter the money supply at their commercial discretion, and became hugely more influential over economic life as a result.
With banks now in utter disarray, economists from the Keynesian tradition and those of a monetarist persuasion have entered into a temporary truce, uniting under the banner of QE. Each camp seems undeterred by Japan’s experience of combating deflation in the same way. Even if abundant liquidity is an effective inflationary palliative, in order to support this measure one must either be unaware of the volatility that it unleashes or else view it as an acceptable long term cost. Whether mainstream economists are unfamiliar with the option to tax liquidity, consider it politically unpalatable, or believe it would pose greater economic costs, a debate of its pros and cons is conspicuous only by its absence. The ideal of neutral money, as illuminated by classical economists centuries back, remains a valid goal. What is less well appreciated is that allowing money to act as medium of exchange and unit of account does not require it to serve also as a store of value; it requires holders of liquidity to be charged a premium.
Neoclassical economists contend that the opportunity cost of forgoing non-monetary alternatives will ensure that liquidity comes at a premium, as measured by the excess (risk-adjusted) yield offered over money. According to this, and provided it is high enough, a premium will entice savers to release money, averting a liquidity trap. In practice, when savers’ fears mount, especially at a time of panic, their breakeven premium hikes to such exorbitant levels as to rule out economisation of liquidity. With Knightian uncertainty savers flock back into liquidity (unless unopposed). [7: As opposed to risk, Knightian uncertainty eludes parameterisation i.e. where a lack of data or methods makes it difficult to estimate probability.]
It does not help matters that the mere fear of this outcome makes the likelihood and severity of downturn all the greater. Stockpiling liquidity raises term interest rates, accelerating the journey to economic contraction; QE is an attempt to avoid rates rising on the brink of a recession. However at this juncture more is required than avoiding interest rate rises, because to maintain spending it is necessary for the liquidity premium to increase, not fall. The only way to increase the liquidity premium without also raising interest rates is to tax money. [8: This may arouse opposition on the basis that for it to circulate, money must be in demand. This is correct – though despite what may be believed, this does not mean money should be a store of value (with which taxation would of course be in conflict). Compulsory demand for money is created by general taxation; moreover, as already outlined, under my proposal mandatory use of money would be extended to include any transaction related to rent i.e. not just for payment of taxes, but also for subscription of future rent.]
Assuming it was taxed judiciously, such innovation would neutralise money. When neutral, money provides an absolute, linear scale for value, and is no more subject to artificial interference than weight is for mass. Any linear scale is divided into an arbitrary number of units; the choice of unit makes no difference to the scale, much as different numbers of ounces and grams express the same weight. (It is similarly quaint of mankind to retain duplicate currencies to denote the same amount of money). It should be self-evident that the number of units into which a linear scale is divided makes no difference to the use of that scale. Increasing the quantity of neutral money would simply reduce the coverage of each unit of currency along the value scale in indirect proportion, and vice versa. Since taxing liquidity is a precondition for neutral money, altering this tax rate is preferable to QE as a monetary policy tool, which would allow the quantity of money to be stabilised, and the breach in the link between prices and production to be healed.
Falling consumption is feared more than most other economic phenomena – not without reason, because when measured across society, it is a clear sign of distress. Three responses are possible: consumption will bounce back, goods will be hoarded, or production reduced. For the former to occur without a change in preferences, goods will have to be discounted, which, by reducing margins, encourages producers to scale back production. Physical hoarding may take root for a while, but such an expensive method of saving will not be sustained for long. So out of the three outcomes, a fall in production is the most likely to prevail; as a result, idleness is enforced not by any desire for greater leisure but rather by the ill-effects of unmitigated austerity. This is no fault of savers, whose self-restraint is the well from which all capital is drawn. Nevertheless, as long as its net effect is to inhibit production, frugality is self-defeating, since by contriving to bring about economic contraction, it undermines the position of savers themselves. Incidentally, this is a version of an argument made forcefully by Martin Wolf in several recent FT posts, and after developing these broad macroeconomic themes, I will make some further recommendations.
Unless suitably offset in society (i.e. by investment), the desire of savers to reduce consumption cannot succeed in increasing their combined claim to wealth, a false economy neatly expressed by Keynes’ ‘paradox of thrift’. Keynes believed that all efforts should be taken to avert the spectacle of savers’ self-denial being rendered futile by involuntary unemployment, a miserable state imposed by the failure to offset savings with investment. What impedes entrepreneurs from taking advantage of capital opportunities may be psychological, structural, or political in nature, and while further discussion is merited, it falls outside the scope of this essay (though features in the previous post). Keynesian thinking, meanwhile, has traditionally been applied less to addressing the causes of crisis than to counteracting the effects on aggregate demand. Not surprisingly, in the current crisis, tools designed to boost aggregate demand in the face of dwindling private investment have garnered renewed interest (after decades of neglect). Further below I will pick up the thread of policy-making, especially in the context of deflation.
While sane savers would not want wealth production to decline, the importance of production being maintained if the desire to save is to be satisfied is rarely foremost in their minds. Saving entails deferring making purchases and accumulating purchasing power instead; nothing in this calculus influences whether production will be scaled-back as a result, which depends entirely on how producers respond to being unable to sell their wares. Warehousing unsold goods is deeply unsatisfactory, not only because of the associated rental costs, but also because hoping that goods that cannot be sold today will stand a better chance some time in the future is bordering on the reckless. Meanwhile, diversifying into other consumables leaves producers in the same structural position, assuming falling consumption was not driven by a paucity of sought-after goods, that is. The only viable option for producers is to diversify out of consumer goods entirely, and to produce capital and other high-order goods instead.
Capital formation is made possible by the ‘surplus labour’ produced by saving. Unless producer profits are sufficient in scale, this surplus labour will have to be ‘bought in’ if capital production is to commence. This financing function depends on savers being willing to redenominate income out of real goods and into financial instruments. While these instruments will one day need to be liquidated if savers are eventually to ‘overconsume’ (e.g. in old age), their austerity allows real goods to circulate and satisfy consumption demand exerted elsewhere. And because the demand to consume is to a large extent independent of the manner in which production is organised, a willingness to save facilitates the redeployment of productive forces from consumer into capital goods, from which a compensatory demand for consumables will stem, supporting production.
A process that is characterised figuratively as the channeling of savings into investment has the merit of forming a potentially virtuous circle of saving-stimulated productivity growth, on which savers’ interests ultimately rely. Keynes’ paradox of thrift only applies if frugality is met not with capital investment but instead with risk aversion. A fall in the rate of interest is the classical mechanism by which investor demand should respond positively to decreased consumption demand, although the financial market, dominated by a dysfunctional banking system, is not sufficiently free to allow this mechanism to work. This has traditionally been a matter of greater concern for Austrian School economists than for their Keynesian counterparts, who are prone to treating all investment demand equally. While Austrian School thinkers identify what they term ‘mal-investment’ as a cause of crisis, Keynesians have a tendency to treat any investment as welcome.
As mentioned earlier, physical hoarding (of goods, not scarce resources) cannot persist for too long because it will be suffocated by a consequent reduction in production. However, a milder variant may emerge in the form of ‘liquidity preference’. Broadly speaking, ‘liquidity’ measures the ease with which a saver can revert to consuming. Money is defined as the most liquid instrument available, and its promise of consumption-on-demand makes it highly prized among savers, whose interest in non-monetary instruments will only be piqued by a suitable offer of yield. The liquidity of money depends on the form it takes: for some time, physical currency was fixed (e.g. by the supply of gold), which meant that money could be hoarded – indeed more ruthlessly than any depreciating good could be. (This was once considered morally appealing: for the Enlightenment philosopher John Locke, hoarding gold was preferable to hoarding perishable goods, since the latter threatened starvation.)
Hoarding money certainly makes it less useful as a medium of exchange, which is, after all, its primary economic role. Under gold, liquidity preference was uncontrollable, and conspired in a tendency towards falling prices and underproduction that bedevilled society. So the removal of quantitative limits governing money in 1971 represented financial innovation, since if nothing else it meant hoarding money could be defeated. ‘Fiat’ money (so-called because its quantity could be determined under fiat i.e. arbitrarily) could now be supplied to meet any level of demand, and in a single stroke, gold ought to have lost its lustre. Yet the promise of abundant liquidity sold by the architects of fiat money, and repeated by their descendants in the banking system -the governor of fiat money- has proved hollow: liquidity is always scarce, no matter how money is constituted. If it is to mean anything at all, liquidity must speak to the ‘quantum’ of consumption that the instrument affords. If the supply of money is growing, its unitary purchasing power becomes volatile, dependent on the timing of purchases in relation to one another. If there is insufficient visibility regarding this, say if the money supply fluctuates (as now) in an unruly manner, the liquidity of money will be severely constrained.
Whether or not savers understand the liquidity limits of their deposits is unclear, though as I argue in earlier posts, the supposition that purely liquid, risk-free assets can earn interest should be evidence enough. Indulging liquidity preference by allowing the money supply to expand more or less on demand not only permits debilitating inflationary pressures to build up in the financial system; it has also failed to prevent a tendency towards deflation and depression from resurging, a deep embarrassment to the financial Establishment. Under the regime of fiat money, monetary policymakers were supposed to monitor general price movements for the risk of inflation, and yet by the early 1990s, arguably the most advanced economy at the time, Japan, had entered the grip of deflation, from which it is still to escape. It took flirtation with deflation some fifteen years later before Western policymakers were finally to be roused from a complacent, self-congratulatory belief in the advent of The Great Moderation.
Many commentators have sought to attribute deflation to falling consumption, which, while being a plausible marker of economic distress, as described above, cannot be regarded as its fundamental cause (except to the extent consumption is held down artificially). Politicians who focus on boosting consumption while stopping short of addressing the underlying problem, chronically weak investment, are guilty of conflating cause with effect – or worse, of populism. Nevertheless, in present circumstances even an agnostic boost to consumption may be part of the solution: where deflation is caused by slow-shifting stock encouraging producers to reduce factory gate prices, it can become endemic as consumers react by further postponing purchases in the widely-held anticipation of lower prices to come. Not only is saving as prompted by the allure of speculative gain unwelcome in and of itself -since it reduces consumption below the level that would otherwise have been targeted-, it serves to entrench even further a motivation for its continuation, i.e. falling prices. It is therefore understandable that authorities have sought to avert falling consumption either by running fiscal deficits or expanding the money supply, all in the hope of preventing deflation from setting in.
However, unless this corresponds with an increase in investment, Keynes’ central message is ignored. The co-conspirator with price discounting in entrenching deflation (and risking depression) is not falling consumption, but actually growing liquidity preference. When prices fall, postponing consumption rewards depositors with a greater claim to wealth, even before any interest accrues on their assets. Such economically sterile behaviour is indulged by our banking system and allowed to run amok in times of crisis. And because consumption is punished relative to holding money, deflation arises while production is discouraged, establishing a vicious cycle already well-rehearsed in the literature and media. What is typically left unexplored is the root cause, casually assumed to be falling consumption or deflation, or both. What’s more, while extended episodes of falling consumption almost always signal distress, deflation cannot be assumed to be symptomatic of stagnation, for it could just as easily accompany rising productivity.
Of course, the problem of deflation for policymakers (besides the difficulty in distinguishing from among possible causes) is that, unless actively resisted, it activates liquidity preference. Not only does retaining surplus liquidity inhibit the clearance of current stock and duly dampen production of consumables, it withholds finance needed for capital production and so snuffs out any remaining embers of growth. Note that the economic bad here is not deflation, but rather rampant liquidity preference, which, alongside deflation, establishes an economically lethal combination that produces Keynes’ “liquidity trap“. Until recently, this did not feature prominently in examinations of recession, with the result that instead of mitigating liquidity preference, money became much more abundant. If this was expected to forestall the prospect of a liquidity trap emerging, this has proved over-optimistic. Deflation cannot be extinguished with monetary expansion as long as agents are allowed (and prepared) to hoard it in ever-greater quantities, in an (ultimately futile) bid to insure themselves against economic crisis.
In previous posts I submitted some ideas as to how to contain liquidity preference within its natural economic borders, set by the desire to consume imminently. As part of this task, I outlined the basic terms of a renewed social contract that would, if enacted, make available to savers an abundance of risk-free alternatives to money offering a sliding scale of liquidity offset by yield. In a single stroke, money would be economised and the natural yield curve revealed. However, what I have not considered so far in my posts is how to neuter the specific effects that deflation could, by resurrecting liquidity preference, have on consumption.
The now-conventional wisdom states that one must always oppose deflation outright, and use monetary expansion as the tool (however discredited this approach appears in the light of recent experience). Implicit in this position is the false assumption that deflation is an economic bad, which fails to recognise that prices might just as well fall in response to benign economic forces. What has not been widely considered is whether instead of seeking to eliminate deflation, liquidity preference could be opposed so as to prevent deflation (whatever its cause) going on to hijack economic growth. A solution to this would be to tax liquidity at the rate of deflation, a version of a proposal made by Silvio Gesell in the early twentieth century, which occasionally resurfaces today, chiefly in the guise of negative deposit rates. With such a reform, demand for money would fall to the level needed for transacting; money would be economised, encouraging its velocity to settle on a stable level as money reverts to its classical role as medium of exchange; in turn, prices would become effective signals of supply and demand for goods, services and finance, a condition for a virtuous circle of growth to form.