The problem with the bank levy and other Pigou taxes

This is both extremely disappointing and also par for the course:

The Liberal Democrats plan to hit the UK banking industry with an additional £1bn tax bill, which the party says will help eliminate the country’s deficit.

The supplementary charge will be in addition to the existing bank levy, which is on track to raise £8bn in this parliament, said Danny Alexander, the Liberal Democrat chief secretary to the Treasury.

The annual levy on banks, which was introduced in 2010, currently brings in around £2.5bn a year. Mr Alexander’s proposals are expected to take that up to £3.5bn a year.

The point is that the bank levy is a Pigou tax. There’s an externality in the market which is not being included in prices. The tax is there to make sure that that externality is included in prices.

The externality is that the “too big to fail” banks receive, as they are too big for the government to allow them to fail, implicit deposit insurance over and above that on offer through the normal regulatory schemes to all deposit taking institutions. This means that they can finance themselves at lower than free market rates and it’s the taxpayer that picks up the risk.

The solution, as we noted and praised when the levy was introduced, is to charge an insurance premium on those deposits that are insured in this manner. And that’s how it does work: it’s only on the deposits of the too big to fail banks, it’s only on those deposits which are not insured through other schemes and it takes account of the riskiness of a run in said deposits (thus long term bond finance pays a lower rate than at sight deposits). That’s all how it should be.

And the point about Pigou taxes is that it doesn’t matter what happens to the revenue. Sure, it’s nice to have ‘n’all that, but the point is to correct the market, not to raise revenue.

Thus the idea that the rate should be changed in order to increase the revenue raised is nonsense. It’s violating the very point and rationale for having the levy in the first place.

It’s also entirely par for the course. No politician can see a potential revenue source without wanting to bathe in it. And that, sadly, is the problem with Pigou taxes. They’re economically efficient, rational and make the world a better place. Until we come to the politicians who implement them when, over time, they will inevitably lose their original justification and simply become another method of gouging someone or other so as to bribe the electorate.

What’s economically efficient, rational and making the world a better place when a Minister’s seat is at risk at a looming election, eh?

Better to reverse QE than raise interest rates

That is, of course, a chart of the American, rather than UK, money supply. But much the same has happened to our own money supply under the same QE program. And it’s also telling us that it would be better to reverse QE than it would be to raise interest rates. So the idea that that debt could just be cancelled doesn’t fly we’re afraid.

We all know that at some point we’re going to have decent economic growth again, unemployment will fall to a minimum (that frictional unemployment that reflects people changing jobs, not involuntary unemployment) and that then inflation will start to rise again. We all also know, because Milton Friedman told us so, that inflation is always a monetary phenomenon. And, finally, we all also know that base money creation is more inflationary than credit creation: or boosting M1 leads to more inflation than the same boosting of M4 would cause.

It’s putting those all together that tells us that we should reverse QE. Think through the future: so, we get out of this liquidity trap, this zero lower bound. The velocity of money returns to something like normal. At which point we’ve got two choices as to how to reduce the accompanying inflation. One is to raise interest rates, the standard response. But that works on M4, it slows credit creation. We could also reduce that money supply by reducing M1: reversing QE. And as above, we think that shrinking M1 would have more effect on reducing inflation than reducing M4 would.

Another way of saying the same thing is that the amount we’d have to raise interest rates to choke off inflation will be higher if we don’t reverse QE than if we do. And this will be true for decades to come as we gradually get back to the right sort of relationship in size between M1 and M4. Or, not reversing QE means that we have to accept more economic pain to reduce inflation than if we reverse QE. For decades.

Which rather puts the kibosh on that idea so trendy over on hte left. Which is that as one part of the government owns the debt of the government we could just cancel that debt and reduce the debt burden. But doing that permanently increases that base money supply and thus permanently increases the interest rates we’ll need to slay inflation in the future.

So, reverse QE before raising interest rates.

You should be very careful what you wish for

An interesting little observation from Ed Lazear:

There are basically two ways that the average economywide wage can fall. There might be a shift in employment away from high-paying to lower-paying industries; in other words, the economy is producing more “bad jobs.” The other way is that the overall composition of work might be the same, but wages for the typical job in most sectors have fallen.

Normally, economywide wage changes reflect what happens to the wage of the typical job. But between 2010 and 2014 there were also significant declines in the proportion of the workforce employed in two high-paying industries. Those declines contributed to overall wage declines—and they may have been caused by policy mistakes.

The share of the private workforce employed in the BLS-defined industries “financial activities” and “hospitals” decreased by about 5% between 2010 and 2014. Jobs in these industries pay 29% and 24%, respectively, above the economy mean. Because a smaller share of labor is working those high-wage industries, the typical job in the economy is now lower-paying than in 2010.

What has been happening here in the UK?

Well, our highest paying industry by a long way is wholesale finance, The City. And for several years that industry was shrinking. And average wages were declining. The City is now expanding again and average wages are rising. It would not do to insist that all of both the rise and fall depends upon the hiring practices of The City. But certainly some of it does.

Which leaves us in a state of some amusement. For of course it is those who have been whingeing most about the domination of the financial markets who have been complaining loudest about the fall in wages. Be careful what you wish for for you might well get it.

Competing monetary rules: modern free banking possibilities

With the emergence of new digital currencies and, in particular, crypto-currencies (the most prominent of which, being Bitcoin), one can wonder how different Free Banking might look in the modern economy.

In the past, monetary rules had been based on metallic content. Now, they are often focused on inflation-targeting, nominal-GDP targeting and so on. Though Free Banking would be desirable, Ben Southwood and Sam Bowman have previously argued for nominal GDP targeting in its stead, as the pragmatic, preferred alternative for monetary policymakers. Saying that, George Selgin argues that most free banking systems lead to effectively 0% NGDP targets.

Of course, the one thing that all these monetary rules have in common is their aim to foster expectations-stability. However, stabilising expectations with respect to one variable often still leaves unstable expectations with respect to another variable; modifications of the Taylor rule may stipulate that we should raise or lower interest rates according to the output gap, inflation rate etc. but this still does not mean that people will be able to forecast when or by how much the interest rates will rise in advance since one’s expectations with respect to other important variables are hardly stable.

Bitcoins have a monetary rule with respect to the rate of increase of the money supply that is determined by an algorithm that periodically halves the speed at which Bitcoins are rewarded to the successful miner (mining being the process by which they are created) and, furthermore, the number of bitcoins in existence can never exceed 21 million. However, Bitcoins still suffer from exchange-price volatility. Other crypto-currencies also have different monetary rules. So it’s quite clear that developments in the state of technology enable different types of monetary rules to be implemented.

In a modern free banking system, then, there would be competing monetary rules between the various different currencies (whether they are issued by banks or obtained through other mechanisms made possible by the state of technology). Since each monetary rule implemented hitherto attempts to stabilise expectations with respect to a certain variable, picking a currency would essentially involve each agent choosing between differing monetary rules and, therefore, independently and rationally stabilising their expectations according to their priorities.

Even Keynes wrote on the importance of understanding

The dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle … this means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is congenial to the average business man.

So even in a Keynesian framework, modern free banking, through more diverse, competing monetary rules, could help ease the excessive malaises of business ‘cycles’!

The ECB is fiddling while Europe burns

If not quite burning yet, the eurozone is kindling. For once, most people agree why: money is very tight.

The central bank’s interest rate is low, yes, but this is not a good measure of the stance of monetary policy. What matters is the interest rate relative to the ‘natural’ interest rate – ie, what it would be in a free market. It’s difficult to know what this natural rate is (as Hayek would tell us) but we can look at things like nominal GDP and inflation to help us guess. Both are way, way below levels that the market is used to. Deflation is back on the menu.

As Scott points out, whatever you think about the American or British economies since 2008, the Eurozone looks like a case study in central bank failure:

The eurozone was already in recession in July 2008, and eurozone interest rates were relative high, and then the ECB raised them further.  How is tight money not the cause of the subsequent NGDP collapse?  Is there any mainstream AS/AD or IS/LM model that would exonerate the ECB?  I get that people are skeptical of my argument when the US was at the zero bound.  But the ECB wasn’t even close to the zero bound in 2008.  I get that people don’t like NGDP growth as an indicator of monetary policy, and want “concrete steppes.”  Well the ECB raised rates in 2008.  The ECB is standing over the body with a revolver in its hand.  The body has a bullet wound.  The revolver is still smoking.  And still most economists don’t believe it.  ”My goodness, a central bank would never cause a recession, that only happened in the bad old days, the 1930s.”

. . . And then three years later they do it again.  Rates were already above the zero bound in early 2011, and then the ECB raised them again.  Twice.  The ECB is now a serial killer.  They had marched down the hall to another office, and shot another worker.  Again they are again caught with a gun in their hand.  Still smoking.

Meanwhile the economics profession is like Inspector Clouseau, looking for ways a sovereign debt crisis could have cause the second dip, even though the US did much more austerity after 2011 than the eurozone.  Real GDP in the eurozone is now lower than in 2007, and we are to believe this is due to a housing bubble in the US, and turmoil in the Ukraine?  If the situation in Europe were not so tragic this would be comical.

There is a point here. Economic news, by its nature, tends to emphasise interesting, tangible, ‘real’ events over things like central bank policy changes (let alone the absence of changes).

Of course that can be deeply misleading. The stance of money affects the whole economy (at least the whole economy that does business in nominal terms, which is pretty much everything except for gilt markets), and the Eurozone is experiencing exactly the sort of problems that the likes of Milton Friedman predicted that tight money would create.

Overall, the Euro looks like the most harmful institution in the world, except perhaps for ISIS or the North Korean govt. It may be unsaveable in the sense that it will never really be an optimal currency area, but looser policy (which free banking would provide) would probably alleviate many of the Eurozone’s biggest problems. Instead, what Europe has is the NHS of money – big, clunking and unresponsive to demand.

And the ECB seems wilfully misguided about what it needs to do. The only argument against this is that surely—surely—Draghi and co know what they’re doing. Well, what if they don’t?