## Sunday, August 8, 2010

Tony Abbott recently announced his plan to establish a debt reduction taskforce to reduce government debt that he believes Labor foolishly incurred. I have no problem with governments paying down debt and aiming to have a zero debt balance over the business cycle, but does he really think that governments should pay down debt while the citizenry is trying to do the same? To me this sounds like a recipe for disaster.

Debt deflation is what happens when indebted households and businesses start to pay off debt after a period of debt accumulation. Money used to pay debts is not used for consumption and no longer circulates in the economy. This decreases demand, but also reduces the money supply. The net effect is to slow economic activity and reduce prices (deflation). To read quality analysis of debt deflation read Steve Keen’s superb articles here.

The government response to this should be to print money. Because a portion of the new money is used to pay debts, a far smaller portion circulates in the economy to cause inflation. If it is done well, it should slow deflation, keeping demand and prices stable, and allow debts to slowly be repaid without the value of debt rising in proportion to incomes.  Whether this will promote further malinvestment (investing in non-productivity improving assets) remains to be seen.

Establishing a taskforce is a clear sign that it is not Abbott’s intention to pay down government debts by printing money. His plan appears to be the reduce government spending to pay debts – the exact same thing households are currently doing.

This will only exacerbate the decline in demand and accelerate our march towards deflation.

1. I agree with the author's take on Tony Abbot's plan to have a debt reduction task force but really what it does do is paint ourselves in the corner where there is no way out. I would love to read what this author's (Cameron Murray) suggestion to get us out of this situation where we appear to be between the mountain and the deep blue sea.

Evelyn Guzman
http://www.debtchallenges.com (If you want to visit, just click but if it doesn’t work, copy and paste it onto your browser.)

2. Murray: "(1) Money used to pay debts is not used for consumption and (2) no longer circulates in the economy. (3) This decreases demand, and (4) also reduces the money supply."

I am puzzled by the above statement.

- - (1) - - Money not used for consumption.

Say I borrow $1000 to buy a TV, then pay off the loan at$100/month for 12 months (including interest). I am using my production over time to buy the TV, by borrowing someone else's savings in the meantime.

The lender can make other loans with my payments to him, thus enabling consumption, just as the lender enabled my consumption through his loan to me. Borrowing does not change my consumption over time, only its timing.

If this borrowing is not bad for the economy, then how can paying off the loan be bad for the economy? Put another way, statement (1) laments the fact that I can't use my production (money) twice to buy things.

- - (2) - - No longer circulates.

The lender gets back his money. It continues to circulate in the economy.

- - (3) - - Decreased demand.

In light of the above, how does paying off a debt "decrease demand". First, my "demand" is only my production, my ability to offer goods in exchange. Second, what is this decreased demand compared to? What is it a decrease from?

- - (4) - - Reduces the money supply

I don't see any money disappearing in this generic case of borrowing and repaying.

EasyOpinions

3. CK Murray: "(1) Money used to pay debts is not used for consumption and (2) no longer circulates in the economy. (3) This decreases demand, and (4) also reduces the money supply."

I am puzzled by the above statement.

- - (1) - - Money not used for consumption.

Say I borrow $1000 to buy a TV, then pay off the loan at$100/month for 12 months (including interest). I am using my production over time to buy the TV, by borrowing someone else's savings in the meantime.

The lender can make other loans with my payments to him, thus enabling consumption, just as the lender enabled my consumption through his loan to me. Borrowing does not change my consumption over time, only its timing.

If this borrowing is not bad for the economy, then how can paying off the loan be bad for the economy? Put another way, statement (1) laments the fact that I can't use my production (money) twice to buy things.

- - (2) - - No longer circulates.

The lender gets back his money. It continues to circulate in the economy.

- - (3) - - Decreased demand.

In light of the above, how does paying off a debt "decrease demand". First, my "demand" is only my production, my ability to offer goods in exchange. Second, what is this decreased demand compared to? What is it a decrease from?

- - (4) - - Reduces the money supply

I don't see any money disappearing in this generic case of borrowing and repaying.

So, I don't think it matters that citizens are paying down their net debts at the same time that government is paying down it's net debt.

4. Andrew,
You will no doubt notice that monetary theory remains a controversial topic. I will try and explain my current understanding of money creation and debt.

When you borrow $1000 for a tv, the money supply increases by most of that amount. There is a reserve ratio that needs to be met by existing money. Say$900 is created.

You pay the $1000 for the tv, then the shop pays its wages and suppliers, who in turn spend the money on other goods. This$900 of new money circulates, and if the supply of goods does not rise by this amount in a similar period of time, we get inflationary pressure.

When you pay back the debt, you take that money that was circulating around the economy and give it back to the bank. Now, depending on which monetary theory you subsribe to, it either (a) sits on the sidelines waiting to act as reserves for new lending, or (b) is destroyed.

Now, if the debt balance is being reduced by households it means that in either case we have a reduction in the money supply. New lending is less than repayments od debt balances. So the even if (a) is correct, the money will wait on the sidelines and no longer circulate.

With less money in the hands of households due debt repayments, and an obvious saving attitude, they will be less inclined to spend - reducing demand for a period of time.

Remember, while in the long run your demand is equal to your supply of productive labour, you adjust the timing of the demand through debt. You brinng demand forward, then when debt is repaid, your demand is much lower. Demand declines from the above production amount (earnings plus debt) to below production amount(earnings minus debt repayment).

Maybe in the broader scheme of things you are right that it doesn't matter, but if your concern is price stability, justified or not, you need to consider the potential consequences.

5. good laughter in this one - printing money should almost never be the answer. Due to the inexorable fact of MV = PY, printing money directly leads to inflation, regardless of the circumstances. What I would do is figure out some way of increasing the velocity of money instead. Unfortunately that hasn't really happened since the invention of the aTM (and what an effect that had on national incomes!)

6. I'm happy to take ideas on increasing the velocity of money.

You also raise a good point Stephen, that I have not considered. Once governments realise they control the printing press, all hell could break loose. Why would we expect government to be responsible when it comes to priniting money, but not in any other area?

Modern Monetary theorists would argue that government seniorage is the best tool for ensuring stable prices and full employment, yet they don't identify the responsibility issue.

I would say that in the end, maybe the risk is too great to have governments active in the money supply arena.

You also say 'almost never', which implies there are some situations where it is warranted. I would like to hear more.

You will note in my last comment however, that the quantity of money itself is being reduced as we pay back debts.

In sum, I see a government with a relatively small debt rushing to pay it back while households, with significant debts, are doing the same as poor policy.

7. Evelyn,

You are right about painting us into a corner with debt. Until I hear a better suggestion, my basic guiding principle would be to shuffle debt from households to government through countercyclical spending or some other method (tax benefits for reducing debts? some other financial incentive - a government debt payent matching program?). The trick is to promote the mindset for households to pay down debts when they receive extra income, and to encourage lenders to tighten up their lending criteria so that we don't end up with high private and public debt.

I personally don't see deflation as such a bad thing, but if government wants to target low inflation

8. ...this policy is not a great idea.

9. Bill Mitchell has an excellent critique of the quantity theory of money here.

10. You'll find that as the velocity of money approaches the speed of light that it becomes heavier and hence increases in value. I launched some money out of the upper atmosphere of planet Earth in 1992 and I estimate that it is currently half way to betelgeuse and approaching a value of 10 galaxies. I have contacted Barnaby Joyce about this and he confirms that if we can somehow retrieve the money it should be sufficient to pay off Australia's debt.

11. To Cameron Murray,

You wrote: "When you borrow $1000 for a tv, the money supply increases by most of that amount. There is a reserve ratio that needs to be met by existing money. Say$900 is created."

This puzzles me. If I borrow directly from a person, he transfers $1000 of his bank account holdings to my bank account. I don't see any money created or destroyed in this transaction. If I borrow directly from the bank, it transfers$1000 from its account to mine. It gets this lendable money from its depositors and investors. Approximately $1,112 in deposits would allow the bank to lend me$1000, keeping $112 dollars = 10% in reserve. I don't see any money created or destroyed in this transaction. I buy the TV by transferring$1000 to the store's and manufacurer's bank accounts. No money is created or destroyed here.

So, why do you say that \$900 in new money is created by my borrowing to buy the TV?

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13. deflation is good....better than inflation, where the value of your money is weakened on a daily basis and under inflation, people's debt levels are inflated away.

Seems like you prefer the Krugman-Bernanke solution of just inflating our problems away

14. I think deflation with massive overhanging private sector debts is very precarious, and will require a massive reduction in interest rates (effectively to zero) to ensure there is no catastrophic shock to the economy.

In isolation I would be all in favour of a little deflation, but like inflation, it is not something you want to encourage further by government actions.

I am open to other suggestions of how best to deal with such vast sums of household debt, but in my mind the best course of action is to essentially swap the debt from households to government and tighten lending rules/standards so that new debts are only incurred for more productive purposes.

Government has many more tools to deal with its own debt than households, and then use them to ensure a degree of price stability.

I'm not actually sure that Bernanke's solution is going to be very good at fighting deflation unless he is genuine about printing money straight into private circulation - which is not typically a good idea. I would only be happy to print money to pay down government debt in a very slow fashion.