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Pragmatic Capitalism

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The Biggest Myths in Economics

Heidi Moore asked a good question on Twitter yesterday about the most prominent myths in economics. I’ve compiled a substantial number of “myth busting” articles over the last 5 years so I thought it might be worth touching on a handful of the more destructive ones in some detail. A lot of this will be very familiar to regulars, but should provide a nice summary regardless.  So here we go:

1) The government “prints money”.  

The government really doesn’t “print money” in any meaningful sense.  Most of the money in our monetary system exists because banks created it through the loan creation process.  The only money the government really creates is due to the process of notes and coin creation.  These forms of money, however, exist to facilitate the use of bank accounts.  That is, they’re not issued directly to consumers, but rather are distributed through the banking system as bank customers need these forms of money.  If the government “prints” anything you could say they print Treasury Bonds, which are securities, not money.  The entire concept of the government “printing money” is generally a misportrayal  by the mainstream media.

See the following pieces for more detail:

2)  Banks “lend reserves”.  

This myth derives from the concept of the money multiplier, which we all learn in any basic econ course.  It implies that banks who have $100 in reserves will then “multiply” this money 10X or whatever.  This was a big cause of the many hyperinflation predictions back in 2009 after QE started and reserve balances at banks exploded due to the Fed’s balance sheet expansion.  But banks don’t make lending decisions based on the quantity of reserves they hold.  Banks lend to creditworthy customers who have demand for loans.  If there’s no demand for loans it really doesn’t matter whether the bank wants to make loans.  Not that it could “lend out” its reserve anyhow.  Reserves are held in the interbank system.  The only place reserves go is to other banks.  In other words, reserves don’t leave the banking system so the entire concept of the money multiplier and banks “lending reserves” is misleading.

See the following for more detail on the basics of banking:

http://brown-blog-5.blogspot.com/

Also see this Fed paper on this topic:

http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf

The Bank of England also has a good paper on the mechanics of endogenous money here.

3)  The US government is running out of money and must pay back the national debt.

There seems to be this strange belief that a nation with a printing press whose debt is denominated in the currency it can print, can become insolvent.  There are many people who complain about the government “printing money” while also worrying about government solvency.  It’s a very strange contradiction.  Of course, the US government could theoretically print up as much money as it wanted.  As I described in myth number 1, that’s not technically how the system is presently designed (because banks create most of the money), but that doesn’t mean the government is at risk of “running out of money”.   As I’ve described before, the US government is a contingent currency issuer and could always create the money needed to fund its own operations.  Now, that doesn’t mean that this won’t contribute to high inflation or currency debasement, but solvency (not having access to money) is not the same thing as inflation (issuing too much money).

See the following piece for more detail:

4)  The national debt is a burden that will ruin our children’s futures.  

The national debt is often portrayed as something that must be “paid back”.  As if we are all born with a bill attached to our feet that we have to pay back to the government over the course of our lives.  Of course, that’s not true at all.  In fact, the national debt has been expanding since the dawn of the USA and has grown as the needs of US citizens have expanded over time.  There’s really no such thing as “paying back” the national debt unless you think the government should be entirely eliminated (which I think most of us would agree is a pretty unrealistic view of the world).

This doesn’t mean the national debt is all good.  The US government could very well spend money inefficiently or misallocate resources in a way that could lead to high inflation and result in lower living standards.  But the government doesn’t necessarily reduce our children’s living standards by issuing debt.  In fact, the national debt is also a big chunk of the private sector’s savings so these assets are, in a big way, a private sector benefit.  The government’s spending policies could reduce future living standards, but we have to be careful about how broadly we paint with this brush.  All government spending isn’t necessarily bad just like all private sector spending isn’t necessarily good.  And at a macro level debt doesn’t get “paid back”.  In a credit based monetary system debt is likely to expand and contract, but generally expand as the economy expands and balance sheets grow.

See the following pieces for more:

5)  QE is inflationary “money printing” and/or “debt monetization”.  

Quantitative Easing (QE) is a form of monetary policy that involves the Fed expanding its balance sheet in order to alter the composition of the private sector’s balance sheet.  This means the Fed is creating new money and buying private sector assets like MBS or T-bonds.  When the Fed buys these assets it is technically “printing” new money, but it is also effectively “unprinting” the T-bond or MBS from the private sector.  When people call QE “money printing” they imply that there is magically more money in the private sector which will chase more goods which will lead to higher inflation.  But since QE doesn’t change the private sector’s net worth (because it’s a simple swap) the operation is actually a lot more like changing a savings account into a checking account.  This isn’t “money printing” in the sense that some imply.

See the following pieces for more detail:

6)  Hyperinflation is caused by “money printing”.  

Hyperinflation has been a big concern in recent years following QE and the sizable budget deficits in the USA.  Many have tended to compare the USA to countries like Weimar or Zimbabwe to express their concerns.  But if one actually studies historical hyperinflations you find that the causes of hyperinflations tend to be very specific events.  Generally:

  • Collapse in production.
  • Rampant government corruption.
  • Loss of a war.
  • Regime change or regime collapse.
  • Ceding of monetary sovereignty generally via a pegged currency or foreign denominated debt.

The hyperinflation in the USA never came because none of these things actually happened.  Comparing the USA to Zimbabwe or Weimar was always an apples to oranges comparison.

See the following pieces for more detail:

7)  Government spending drives up interest rates and bond vigilantes control interest rates.  

Many economists believe that government spending “crowds out” private investment by forcing the private sector to compete for bonds in the mythical “loanable funds market”.   The last 5 years blew huge holes in this concept.  As the US government’s spending and deficits rose interest rates continue to drop like a rock.  Clearly, government spending doesn’t necessarily drive up interest rates.  And in fact, the Fed could theoretically control the entire yield curve of US government debt if it merely targeted a rate.  All it would have to do is declare a rate and challenge any bond trader to compete at higher rates with the Fed’s bottomless barrel of reserves.  Obviously, the Fed would win in setting the price because it is the reserve monopolist.  So, the government could actually spend gazillions of dollars and set its rates at 0% permanently (which might cause high inflation, but you get the message).

See the following pieces for more detail:

http://pragcap.com/i-want-to-come-back-as-the-federal-reserve-you-can-intimidate-everybody

http://pragcap.com/the-mainstream-economists-finally-realize-bond-vigilantes-are-mythical

http://pragcap.com/american-bond-vigilantes-asleep-at-the-wheel

8)  The Fed was created by a secret cabal of bankers to wreck the US economy.

The Fed is a very confusing and sophisticated entity.  The Fed catches a lot of flak because it doesn’t always execute monetary policy effectively.  But monetary policy is not the reason why the Fed was created.  The Fed was created to help stabilize the US payments system and provide a clearinghouse where banks could meet to help settle interbank payments.  This is the Fed’s primary purpose and it was modeled after the NY Clearinghouse.  Unfortunately, the NY Clearinghouse didn’t have the reach or stability to help support the entire US banking system and after the panic of 1907 the Fed was created to expand a system of payment clearing to the national banking system and help provide liquidity and support on a daily basis.  So yes, the Fed exists to support banks.  And yes, the Fed often makes mistakes executing policies.  But its design and structure is actually quite logical and its creation is not nearly as conspiratorial or malicious as many make it out to be.

See the following pieces for more detail:

http://pragcap.com/feds-dual-mandate-bull-sht

http://pragcap.com/who-owns-the-federal-reserve

http://pragcap.com/who-does-the-fed-serve

9)  Fallacy of composition.  

The biggest mistake in modern macroeconomics is probably the fallacy of composition.  This is taking a concept that applies to an individual and applying it to everyone.  For instance, if you save more then someone else had to dissave more.   We aren’t all better off if we all save more.  In order for us to save more, in the aggregate, we must spend (or invest) more.  As a whole, we tend not to think in a macro sense.  We tend to think in a very narrow micro sense and often make mistakes by extrapolating personal experiences out to the aggregate economy.  This is often a fallacious way to view the macroeconomy and leads to many misunderstandings.  We need to think in a more macro way to understand the financial system.

10) Interest Costs of the National Debt Will Lead to Uncontrollable Interest Burdens

This doesn’t make any sense.  First, the national debt is the non-government’s asset.  So its interest costs are a direct source of income for the non-government sector.  It’s hypocritical for people to complain about low interest rates and high interest costs.

More importantly, The interest burden in the USA is actually declining as a % of GDP and is entirely controllable if the government desires.  We pay about $250B in debt service every year. The Federal govt could actually reduce this substantially by reducing the maturity on their debt by issuing short-term debt instead of higher interest bearing long-term debt. They have complete control over their interest costs if they so desire.

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There is no ironclad law that forces the US govt to raise interest rates. Just look at Japan where interest rates have been zero for two decades. A government that is sovereign in its currency, has no foreign denominated debt and a central bank that can issue its own currency does not have to worry about someone else telling them that they need to raise their interest costs. This interest cost is not controlled by “the market”.  It is controlled by the monopoly supplier of reserves to the banking system (the central bank) and the Treasury which dictates the average outstanding maturity of the liabilities it issues. So this too is not a realistic concern.

See the following pieces for more detail:

11)  Economics is a science.  

Economics is often thought of as a science when the reality is that most of economics is just politics masquerading as operational facts.  Keynesians will tell you that the government needs to spend more to generate better outcomes.  Monetarists will tell you the Fed needs to execute a more independent and laissez-fairre policy approach through its various policies.  Austrians will tell you that the government is bad and needs to be eliminated or reduced.   All of these “schools” derive many of their understandings by constructing a political perspective and then adhering a world view around these biased perspectives.  This leads to a huge amount of misconception which has led to the reason why I am even writing a post like this in the first place.  Economics is indeed the dismal science.  Dismal mainly because it’s dominated by policy analysts who are pitching political views as operational realities.  It is, at best, a social science, but nothing resembling a hard science.

See the following piece for more detail:

Nerdy High(er) Leverl Myth Additions:

12) The MV = Py Myth (aka, the equation of exchange)

I’m pulling this one out of the AMA section because it’s a common question I see. Reader Oshe asked about the Equation of Exchange otherwise known as MV=Py, where M is the quantity of money, P is the price level, Y is total output and V is velocity, or the number of times that a dollar is used to purchased goods and services.  He asks how useful this equation and if its assumptions are valid.  I don’t think so.

First off, we should be clear that the Equation of Exchange isn’t used by many economists these days. The old school Monetarists who relied on this sort of thinking are largely gone.  This is the result of many erroneous assumptions in the theory that the empirical data simply doesn’t support.

That said, we can’t deny MV=Py. After all, this is just a tautology. You can’t debunk it.  But you can poke serious holes in the assumptions that go into it. So, what are some of those erroneous assumptions?

a.  MV = Py is only useful if V is constant. In this world V = Py/M. And if V isn’t constant then it can basically be fudged to mean whatever you want. So, if P is 1, Y is 1,000 and M is 10 then V has to equal 100. If you were an old school Monetarist then you would say that doubling M will double P because P=MV/y or P=((20*100)/1,000)=2.  But what if P doesn’t double for some reason? Well, then you can just say V went down. In other words, the demand for money increased.  It’s like voodoo economics. The equation can mean whatever you want it to.  That’s not very helpful.

b. The bigger problem in the Equation of Exchange is that it doesn’t define money accurately. “Money” in this model generally refers to the Monetary Base or Central Bank money. So, if you were applying an old school Monetarist sort of view then you’d have used this equation to conclude that QE would cause sky high inflation. In fact, we saw this sort of analysis all over the place in recent years.  But the problem is that “money” is a really complex thing in a modern economy. It is not merely Monetary Base, cash, coins or even deposits. Money, as I’ve described, exists on a scale of moneyness and different things meet the properties of money in different instances.  So, trying to peg “money” as Central Bank money is misleading at best and totally erroneous at worst.

In short, the Equation of Exchange is a very limited description of how the quantity of money actually impacts the economy and prices. And that’s primarily due to some broad theoretical assumptions that make it a lot less useful than many people think.

13)  The Myth of the Natural Rate of Interest

The “natural rate of interest” is a theoretical concept in economics that describes the interest rate at which the economy operates at full employment with stable inflation.  If we could calculate this figure then we could help devise policy that could steer the economy towards this “natural rate”.  There are a few substantial problems with this concept:

a.  There is no empirical evidence that this “natural rate” exists or that it can be sustained via policy.  

b.  The economy is not made up of one single interest rate so even if there is a natural rate we would have to discover millions of different natural rates in order to steer the economy towards an equilibrium point.  

Of course, when one understands the operational reality of the monetary system it becomes clear that the Central Bank only has a very indirect control over interest rates.  Therefore, even if this theoretical “natural rate” does exist then it’s unlikely that the Central Bank can do much to help us achieve that rate.

14)  The Myth of the non-accelerating inflation rate of unemployment (NAIRU)

NAIRU is a concept that describes the level of unemployment below which inflation rises.  This is based on the idea that when there is little or no slack in the economy then inflation must necessarily rise.  Economists theorize that they can calculate the figure at which that occurs although there is zero empirical evidence showing that this idea is valid or calculable.

A similar concept that often coincides with the use of NAIRU is the Phillips Curve.  This concept became popular in the 1950’s when an inverse relationship between employment and inflation was shown in some data.  This concept has not held up well over time, however.  In fact, over the last 40 years the level of unemployment has consistently remained above estimates of NAIRU and yet inflation has continually declined.  You would think that this would lead economists to dismiss this idea, but it is still very widely used.

15) American Living Standards are in Decline

The main argument against a broad increase in living standards is the fact that real median household incomes have stagnated for much of the last 30 years. This is undeniable and not a good sign for living standards. But the quantity of money we make isn’t necessarily a sign of being better or worse off. Instead, we should look at what those dollars buy and whether they afford us a better use of our time. In other words, do our current incomes give us more freedom to buy the things we want rather than the things we need. By this measure it is irrefutable that American living standards have improved dramatically even during a period when median incomes have stagnated.

A 2003 study from the BLS on American spending trends will help put this in some perspective. In the year 1900 80% of our expenditures went towards necessities (defined as housing, food and apparel by the BLS).³ Over the course of the next 115 years (I updated their study for the most recent data) we’ve seen that share of spending on necessities decline to just 48.9%.  Therefore, even though incomes have stagnated for the median income earner that income affords them a higher living standard because it increasingly goes towards inessential spending.

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The obvious response to this is that Americans now spend even more on things like healthcare and education, however, this isn’t accurate either. The median household spends just 10% of their income on healthcare and education. Therefore, we spend less today on apparel, food, shelter, healthcare and education than we spent on apparel, food and shelter in the 1970s. In other words, we spend so much less on the real necessities that now we can afford to spend even more on taking better care of our health and improving our intelligence. That’s a pretty definitive increase in living standards even for the person whose income has stagnated.

There’s a lot more where that came from.  You can read more myths here.  I would also highly recommend my paper on the monetary system.

* A video version of some of these myths can be seen here.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering low fee asset management, private advisory, institutional consulting and educational services.Cullen is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
Cullen Roche

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