Some myths about modern monetary theory and its developers

Today’s economics blog is about some reactions I have to the many pieces of correspondence I get each week about my work via E-mails, letters, telephone calls. It seems that there is a lot of misinformation out there and a reluctance by many to engage in ideas that they find contrary to their current understandings (or more likely prejudices). It always puzzles me how vehement some people get about an idea. A different idea seems to be the most threatening thing … forget about rising unemployment and poverty – just kill the idea!. So here are a few thoughts on that sort of theme.

To set the scene consider this graph which was published by the Financial Times in June which is meant to show why US voters should be scared of what the US Government is doing with respect to its budget. It was sent to me by someone who says I should learn from it and “wake up to myself and stop advocating socialism … that he didn’t want to work in one of my crummy public sector jobs”. Okay, I hope he has a job elsewhere.

scary_budget

You will note that the time period begins in 1997 which I think is good (although the article fails to appreciate the significance of that). In fact, the short sample is deliberately intended to deceive and bias the conclusion. As you can see it shows a big splash of red (outlays) currently and a corresponding rapid decline in receipts. Horror story really! Don’t you agree?

Anyone who isn’t quaking in their boots upon seeing this graph is evidently a “delusional or was it fanciful left wing nutter” who “wants to impose socialism on everyone” by forcing “everyone to work for the government”. More about which later.

The first thing to note from the graph is the Clinton surpluses in fiscal years 1998, 1999 and 2000 (increasing each year). And you can guess what happened? The private sector became more heavily indebted than before as the fiscal drag squeezed liquidity. Further, it set up the conditions for a major recession in 2001-02 with unemployment rising sharply and the automatic stabilisers pushing the budget back into deficit. So the stupid graph serves to illustrate some of that which was not mentioned at all in the article.

But consider my version of the graph which follows and begins in 1948 not 1997. It also scales everything to GDP and includes a lower panel showing the evolution of the federal budget balance over time alongside the unemployment rate. All data is available at US Office of Management and Budget (budget statistics) and the US Bureau of Labor Statistics (unemployment data).

Budget_UR_1948_2009

Now that should set things in a totally different context. The things to note are obvious. First, Federal deficits have been the norm in the US since 1948. Everytime the federal government has tried to achieve a budget surplus (or succeeded in doing so) the economy has faltered and unemployment has risen. The deficits that followed were driven by the automatic stabilisers – falling revenue and rising welfare outlays.

Second, the Clinton surpluses only endured for as long as they did without unemployment rising significant immediately because spending in the US economy was driven by the credit-binge. This unwound for consumers around the end of 2001 and as noted above the flight back to saving resulted in a serious recession – the one before this one. This is a very similar tale to the surplus period in Australia where the conservatives were only able to maintain them for a decade because the household sector went increasingly into debt. In both countries this was an unsustainable growth strategy. We are now living through the damaging aftermath of the folly – some are more damaged than others.

Third, the deficits in the past have been inversely related to the unemployment dynamics and during the 1982 recession were large (around 6 per cent of GDP) and persisted at those levels for as long as spending had to be supported. Even so, a case can be made that Reagan should have pushed the deficits much higher given the huge jump (and persistence) in the unemployment rate. If the US Government had have been serious about maintaining full employment (US style!) then the deficits would have been much higher than 6 per cent in 1983.

Fourth, the current deficits are the highest as a percentage of GDP but include extraordinary measures to stabilise the financial system which the neo-liberal deregulation had allowed to take the world economic system to the brink. You don’t nationalise (or do the same thing and not call it that) major banks and insurance companies and help underwrite a great proportion of minor banks, without some serious outlays. (Scott: care to comment on what is included in the outlays figure which is atypical and push the deficit/GDP figure up?).

You can also see the depth of the crisis by noting the fall in revenue relative to movements in the past. The current decline in revenue is very large (as a % of GDP) and so the unusually high automatic stabilisers are driving much of the budget dynamics in the US at present.

All that makes sense to me and doesn’t scare me for a moment. The lower panel of the chart – the grey shaded part – the dynamics of the unemployment rate is what scares me. With a federal government that is not revenue-constrained the budget deficit should be even higher than it is now given the rapid deterioration in the US labour market.

Which brings me to the point of the blog? I get sent a lot of E-mails every day – many are complimentary or inquisitive and some are hostile and vindictive (more than I care think about). I also get snail mail hate letters from punters who hear me on radio or read my Op Eds and now my blog. I also get sent messages telling me that other blogs allow commentary that significantly criticises my viewpoint in a fairly personal way (that is waxing lyrical about my sanity and political ambitions).

This has been going on for years and I am used to it. If you have a public profile that is what you might expect. Water off a duck’s back!

But the hostility reflects a real ignorance and fear of new ideas and that is the worrying aspect of all the communications. It means that the levels of comprehension about how the economy actually works among the lay persons and many mainstream economists is very low. In seems that the best defence of that ignorance, is to launch a personal attack on anyone who dares to think differently (and might just know what they are talking about). The hallmark of these attacks are that all sorts of economic concepts and technical terms that sound authoritative but are not are mashed into the one incoherent wall of words.

So here are some of the more obvious elements that are used by those who are struggling to understand what is going on to discredit modern monetary theory. They will be familiar themes to regular readers but some of them still amaze me – if only for the breathtaking audacity of the vehemence that is displayed given the level of ignorance that is endemic. They are only a slice of the sort of things that are out there.

Modern money theorists are fanciful left-wing nutters

There is a view among the deficit terrorists that the fiscal situation for the current period depicted in the graphs above is unsustainable and that rising interest rates will choke of the capacity of the US Government to spend.

In my blog – Twisted logic and just plain misinformation I said:

… this analysis does not apply to a sovereign government. Its capacity to spend in the future is not reduced if it holds debt no matter if the economy is growing or in decline. It can never be insolvent even if its tax revenue declines signficantly. Its balance sheet can never become precarious in the same way that a household balance sheet can.

You might also like to go back to first principles – Deficit spending 101 – Part 3

So my judgement is an economic one not a political one. We had a very interesting discussion recently about the importance of that distinction in the blog – Debates in modern monetary macro … – which might be considered a useful companion to this blog.

The voters might get scared and push the US Government into cutting back spending much earlier than they should – when assessed from a modern monetary perspective which says that if the non-government sector desires to net save then aggregate demand must be supported by the government sector for output and employment levels to remain high. All throughout the period shown in my graph above – those deficits were supporting a solid private saving ratio. And it is typical for the private sector to save a proportion of their income (in aggregate).

So if the political reality sees the US Government start contracting before the non-government sector spending has risen again then they will simply worsen their already parlous situation. A fair proportion of the deficits will be wiped away as the automatic stabilisers go into reverse on the back of economic growth. The best thing the US Government can be doing is supporting spending and inspiring confidence among private investors to get capacity building spending back on track and start employing people again.

Now the recognition of the national accounting relationships which underpin modern monetary theory are not matters of opinion. These include (but the list is not exhaustive):

  • That a government deficit (surplus ) will be exactly equal ($-for-$) to a non-government surplus (deficit).
  • That a deficiency of spending overall relative to full capacity output will cause output to contract and employment to fall.
  • That government net spending funds the private desire to save while at the same ensuring output levels are high.
  • That a national government which issues its own currency is not revenue-constrained in its own spending, irrespective of the voluntary (political) arrangements it puts in place which may constrain it in spending in any number of ways.
  • That public debt issuance of a sovereign government is about interest-rate maintenance and has nothing to do with “funding” net government spending.
  • That a sovereign government can buy whatever is for sale at any time but should only net spend up to the desire by the non-government sector to save otherwise nominal spending will outstrip the real capacity of the economy to respond in quantity terms and inflation will result.

These concepts and understandings of modern monetary theory don’t impose any political opinion at all about how the state might use these opportunities. There is nothing intrinsically left-wing or right-wing or any wing, for that matter, about these statements.

There is certainly nothing that hints of socialism or dare I mutter these words in public space – …. communism – embedded in these concepts.

The concepts are technical understandings of how a fiat monetary system – of the sort we have – operates. Modern monetary theory is different from Keynesian macroeconomics and neo-classical macroeconomics in the sense that it begins at the operational level. The knowledge framework that has been built up by modern monetary theorists did not start with some (untestable) a priori assumptions – that is, the deductive approach that exemplifies the neo-liberal text book macro.

Modern monetary theory starts with how the system works not how we assume or want it to work. On top of that a some basic insights from Kalecki, Keynes and others relating to uncertainty, investment dynamics and aggregate spending are added to the operational insights to form a coherent macroeconomics. It is a macroeconomic theory that is complete and holds up very well in explaining the revealed dynamics of fiat monetary economies.

You should always ask a neo-liberal to provide a coherent explanation of the evolution of the Japanese economy since 1990 using the principles laid out in their macroeconomic text books. So ask them to explain the years of high deficits, high public debt issuance, zero interest rates and deflation. They cannot!

So in that context, you have to separate the operational understanding that is only provided by modern monetary theorists – no other body of macroeconomics get this side of the economy remotely correct – from political statements that, say, I might make.

One could acknowledge the veracity of modern monetary theory yet still say that the government should run a surplus because they thought unemployment was a more functional way to ensure high profits (via wage discipline) than full employment. So the person would understand what will happen if the government uses contractionary fiscal policy but has a political preference for that state of affairs.

Whereas I say that I value people having work with an environmentally sustainable world above most other things and so my understanding of how the economy works tells me that the only way I can achieve those political (or ideological) aspirations (full employment) is for the government to run deficits up to the level justified by non-government saving.

You get the point – the ideological statement are entirely separable from the operational insights that modern monetary theory provides.

You might call me a left-winger because I value full employment but you would be totally ignorant if you said it because of the operational knowledge I seek to disseminate as a professor of economics.

Wanting everyone to have a job amounts to socialism

It is clear that I advocate full employment. It is also clear that one of the obvious insights that comes from modern monetary theory is that inflation can result if nominal spending chases goods and services offered at market prices.

So in that context I have for many years advocated the introduction of a Job Guarantee where the government offers a job at a minimum wage to anybody who wants one. By definition, unemployment reflects a lack of demand by the private sector for this labour. The only other sector than can provide employment with decent conditions and a living wage is the government sector.

There are many advantages arising from keeping people in employment. I have written extensively about these advantages – see this sample of my blogs and follow the pages if you want to refresh your memories.

So advocating this simple change in policy where the sovereign government uses its obvious fiscal capacity to prevent unemployment doesn’t seem to be remotely like socialism. The latter requires a major change in the ownership of the means of production in the economy to take place at the outset.

How does offering a job to anyone who wants one create large scale institutional changes in the ownership of capital? Especially when the overwhelming proportion of persons who would benefit from this approach to counter-stabilisation would be the most disadvantaged workers in our communities. How do they have any correspondence with capital at all – even in the best of times?

I might be a supporter of socialism as a political system. Then again I might not. But you won’t find anything in my publication list over many years – journal articles, books or even this blog – that will articulate that position. Nor in the writings of any modern monetary theorist that I know.

In fact, without disclosing names, some modern monetary theorists would be hostile to the urging for an overthrow of the capitalist system.

Deficits are unsustainable and just cause inflation

Well we have dealt with this myth many times but it still dominates the attacks that modern monetary. Supposedly, deficits cause inflation.

I also advocate abandoning all the voluntary constraints that governments have instituted (either by law or regulation) whereby they act as if they are still in a gold standard monetary system. So I would not issue any public debt when the government is net spending (running deficits). Why would we be providing the private sector with a guaranteed welfare annuity? Especially, when the segments of the private sector that have the most to gain from using the public debt as a risk free benchmark for their profit seeking seem to hate any other form of government welfare – that is, any support for the poor or regulations to protect workers? You might like to read this blog – The problem of being a macro economist where I discuss this issue.

So in that case, I would just have the central bank “funding” the net spending – which according the deficit terrorists will be instantly inflationary.

Again you might like to refresh the statements I have made by reviewing this sample of my blogs.

It should be clear that if the economy can respond to nominal spending in real terms then most firms will behave in this way. That is, they will desire to increase real output rather than put up prices. Why? Well if they didn’t some other firm would and they would lose market share. That is one reason. There are many others.

So if there is idle capacity and idle resources that can be brought into the process of production to increase the supply of goods and services then firms will increase their deployment of those resources if they can see a realistic possibility that they can sell the goods and services. That is, they sense there is adequate aggregate demand (spending).

Fiscal deficits add to aggregate demand and provide the underpinning for firms to increase output (and employment).

At some point, nominal spending growth can clearly come up against the real capacity of the economy to expand production. That is, firms can no longer expand production because there are no idle resources or capacity left to bring back into production. At that point, the economy hits the inflationary gap – a term which simply means that the firms will start hiking prices to ration the increasing nominal spending. That is, inflation is the result.

The other way of thinking about this is that the budget deficits are too large relative to the desire of the non-government sector to save. How would we know that was the case? Well very high levels of employment (zero underemployment) and very low unemployment would tell us that we were around that point in the business cycle.

High levels of unemployment tell us that there is significant idle capacity in the economy. It cannot be inflationary for the government to use its fiscal power to provide a job to this labour – which has no private sector demand by definition. The government would not be competing for any resources at market prices.

That is another reason why I advocate the Job Guarantee as a first step because it creates enough jobs for all but at the same times introduces a nominal anchor that disciplines inflation. Once you have this “loose” full employment (see these blogs for more on this) the government can then start thinking about other expansionary policies that would improve the quality of employment and/or infrastructure provision. But the first step should be to underwrite full employment with the smallest net spending stimulus that is required to do so.

So none of that says we ignore inflation. A concern for inflation is at the heart of modern monetary theory and the policies that most of the adherents of that theoretical structure advocate.

Modern monetary theory is just academic

Better get a real job, son (you better get a real good one – borrowing from that fantastic song by The Cruel Sea!)

Yes, a lot of correspondence tells me that I know nothing about the real world because I just sit in a university with my hand on my …… etc (and worse). Presumably the real world is somewhere else and evades my gaze.

This is a recurring theme. As a logical construct it always amuses me. It is always mouthed by those who feel content to mindlessly reiterate the stuff they get from neo-liberal text books or to rehearse what they have read or heard others say who themselves have accessed the nonsense from the same textbooks. Where do the mainstream text book writers work? Mostly universities!

I received a particularly nasty E-mail not that long ago from a character who started by saying that he was important because he “worked behind a major bank bond trading desk” (that is, how the E-mail began). Good I thought, he/she has a job and is contributing to aggregate demand.

But one of the hallmarks of the development of modern monetary theory is that the academics involved work closely with some major players in banking and the bond markets. One of the leading modern monetary theorists is on record as having created some of the largest “trades” in history.

Refer back to my earlier point – the roots of modern monetary theory is at the operational level. How banks work. How central banks work. How the treasury works. The mechanisms and operations that define daily life in a fiat monetary system. The academics have achieved this understanding by working closely with our financial market friends.

You also see that some of the main commentators here work in financial markets. They understand on a daily basis how the system operates.

The collaboration between the academic and financial market modern monetary theorists has produced this body of theory. No other body of economic theory comes from that sort of collaboration.

Ideological persuasions

To make sure you characterise my political positions correctly please consult my political compass result. And if you do some exploration you will find that I am in very good company out there in the lower left-hand quadrant – along with Nelson Mandela, The Dalai Lama, Ghandi and regular commentator here Sean Carmody.

Conclusion

By the way, the overwhelming proportion of correspondence I receive is constructive and generally supportive. But a significant minority is not!

Postscript:

Blogs that seem to be interesting and those that attract less attention – I will write about this another day. Seems to be the conceptual blogs attract marginally more interest, if my statistics are accurate, than those which focus on data analysis. The differences appear to be not so much in the traffic that each page attracts but in the number of comments.

The data blogs attract less interaction. One of the reasons I presume is that the data analysis is mostly Australian and I get thousands of overseas hits each day. Anyway, I am thinking about this at present. Not that popularity is the number one aim!

After all, devoting your career to the development of modern monetary macroeconomics is not a sure fire way to becoming particularly popular!

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    371 Responses to Some myths about modern monetary theory and its developers

    1. Sergei says:

      stone: your helpful and clear descriptions, of why banks seek retail savers, have confirmed my gut feeling about what the situation was. It confirms that high powered money is the limiting nucleus for credit expansion

      you keep on targeting at the wrong animal. It is not about high-powered money but it is about market share. If you imagine a two bank economy with one bank having 90% of the market and another having 10% then while “loans create deposits” the first bank will have to explicitly fund just 10% of the balance sheet while the second bank will have to fund 90%. Now, since deposits created from loans are typically on demand deposits and therefore essentially free funding, it will not be for long before the second bank goes out of business. This is the whole reason why and how we got to TBTF. This is their modus operandi, reason to exist. Please note that high-powered money plays no role here. It is just the medium of exchange in the payment system.

    2. stone says:

      Tom Hickey, I’m not sure whether you are implying that money from the carry trade did not find its way into inflating real estate prices. Think of the Northern Rock example that VJK gave. Where do you think the high powered money that they got on the wholesale markets originated from? Basically banks such as Northern rock that were making the 110% mortgage loans were buying wholesale money from financial intermedaries who were converting Yen into £ and USD.

    3. stone says:

      Sergei, am I right in thinking that you are saying that once we get to the point that there is only one private bank in the world, then we will no longer be able to blame the government because at that point infinite instant credit expansion will be possible by that monolithic bank without the limiting constraint of a finite stock of high powered money? That scenario is still a few months down the line :). As things stand now there are still a few banks and so we should still hold the government to account because the supply of high powered money is still a limiting constraint that the government is failing in its duty to keep constrained.

    4. JKH says:

      Stone, Matt,

      I agree with Matt’s explanation.

      my version …

      The idea that “loans create deposits” works at the macro level at loan origination.

      But the bank making the loan can’t ensure that it will retain/attract back the deposits that have been created by the loan without competitive pricing.

      The MMT theory is that the central bank is always there to provide a backstop in case of reserve shortfall. That’s fine. But the reality includes the fact that the banks will price competitively in order to manage their reserve positions in such a way as to avoid backing into the central bank.

      There’s constant fluidity in the balance sheets of the banking system such that competitive pricing is an ongoing factor on both sides of the balance sheets – trying to win loan business and deposit business through pricing.

      “Loans creates deposits” assures that the system balance sheet will be in balance and assures there is enough deposit money in the system to achieve balance in individual bank balance sheets – but only by retaining/attracting those deposits to the banks that need them through competitive pricing.

      “Equilibrium” pricing at a point in time is determined by banks assessing what prices they can afford on various assets and liabilities in order to achieve their overall target return on capital. They bid up deposit interest rates because they can afford to and still meet their ROC target on new business – or they need to because some other bank is being aggressive on deposits and they need to maintain their existing base or become short on reserves.

      Best to think of “loans create deposits” as a macro phenomenon where the distribution of loans and deposits at the micro level gets resolved through pricing. The resolution of loan and deposit distribution is what achieves the desired distribution of reserves as well – i.e. where there are no shortfalls or as few shortfalls as possible.

    5. VJK says:

      stone:

      Cash may be a limiting factor for credit expansion inasmuch as it hampers interbank obligations, not in direct way as capital requirement is.

      With some interbank settlement networks, cash requirements for interbank settlement can be greatly diminished.

      Consider Fedwire vs. CHIPS Ramanan mentioned earlier. With the former, so called “real time gross settlement” system, settlement requires as much cash as needed to settle each transaction while with the latter transactions are settled on the net basis, and only the leftover is cleared, with cash, over Fedwire.

      So, one can imagine a situation with two banks where each bank would grant a 1mil or 1trillion loan to the customer of the other bank. When settled over CHIPS, no cash is required. In effect the settlement would be achieved with credit money.

      f the interbank market was completely “frictionless”, zero cash would be required for settling interbank obligations regardless of the settlement network employed. But, then again in a totally frictionless world, there would be no need for intermediaries, such as banks, at all.

      In the real, world the banks that assume frictionless world, with little need for cash, end up as Northern Rock did.

    6. JKH,

      Everything you say about banks needing retail deposits is, of course, correct. But note that banks try to avoid going to the CB precisely because the CB has set the system up that way, or the legislature has required them to do so. One could set the system up quite differently and the CB could at least in theory replace much of the wholesale mkts financing of bank balance sheets–though retail mkts financing would still be preferable in terms of profitability for individual banks. Whether or not CBs doing this is desirable is another matter–and aside from crises, it’s generally considered by most CBs and govt’s that it isn’t desirable.

    7. Ramanan says:

      Scott,

      Note however, that the Euro Zone and even the financial setup of nations in the Euro Zone before it was formed had a system where the central banks would force the banks to be indebted to them. Both deposits and central bank overdrafts are a part of the banking balance sheet financing on the whole.

      Consider the Euro Zone before the crisis. Every week the Euro Zone would run the Main Refinancing Operation and the banks sector as a whole needs to go to the ECB (via NCBs) to borrow reserves. In fact except the Anglo-Saxon setups, most systems are like that. (?)

      However, I guess you are here talking of large scale financing.

    8. JKH says:

      Scott,

      Quite right – that is certainly a feasible alternative operational design for the monetary system. Also a useful one to put the existing dynamics into perspective. I recognize that from your own writing as well as Warren M.’s actual proposals of course (and maybe Bill’s? I don’t know).

    9. JKH says:

      P.S.

      Agree or disagree, it occasionally dawns on me how huge some of these Mosler (and others’) MMT related proposals are – while at the same time being so well thought out.

    10. stone says:

      So to sum up- Bill is talking rubbish whenever he claims that government deficit spending does not aid and abet destructive credit expansion such as led up the the 2008 crisis :).

    11. Tom Hickey says:

      stone, I think you are misunderstanding me here, and perhaps I am misunderstanding you, too. There is no doubt that carry trades can and do result in mispricing risk owing to lower rates obtainable abroad that distort a domestic market when large amounts are borrowed externally and converted into the domestic currency for speculation. There is no question that the yen carry trade affected asset prices negatively in many countries, not only the US, for decades. That’s inherent in international finance and free capital flows, and the invisible hand does not smooth it out.

      However, I read you as saying that this money was used to drive up RE prices in the US. I replied that carry trade funding is volatile and is therefore put into liquid assets, not tied up highly illiquid assets like RE. Carry trade money likely did contribute to the demand for MBS that generated a corresponding demand to write mortgages that where imprudent, if not fraudulent. Bundled into securities that were then misrepresented as AAA result in underpricing risk. The rest is history.

      If that is what you are claiming, then I would agree that the yen carry trade played a role, just like the underpricing of risk by the Fed’s keeping interest rates too low for too long. But these were contributing factors that may not have been causal at all. It is becoming clear now that the cause of the GFC was extremely imprudent lending practices, in many cases involving the large institutions like Countrywide, that were dominated by fraud originating from the top and pervading the process.

      However, if the carry trade was at the basis of the GFC, why did this not bounce back hard on the Japanese banks when loans went massively bad, like it took down North Rock and almost took down the largest US banks? I see no evidence of that having happened. In addition, there has been virtually no brouhaha in the US over the carry trade as having been heavily implicated and needing regulation. What am I and apparently most others missing here?

      There is now a carry trade in dollars that is potential more serious than the yen carry trade because there are many more dollars. As I said, I am not knowledgeable in international finance, so I cannot address this professionally. Perhaps one of the economists here will do so.

      As far as MMT goes, I am not an MMT economist either, so cannot speak to this professionally. As far as I can tell, the MMT position is that the first obligation of governments is to their own people, and this involves sustaining an economy at full employment when it is possible to do so, which it always is under the present monetary system, using expansionary fiscal policy to address lagging demand. Countries should not impose hardship on their citizens unnecessarily. However, sound economic policy also has to include reforming inefficient and ineffective pockets that develop, generating imbalances and leading to sub-optimal demand and distribution. But the ideal is to avert the danger that has not yet come though appropriate policy instead of trying to fix it after it has arrived.

      Governments have control over their banking systems. They can impose controls over how money is used and where it comes from. If foreign governments feel that their currencies are either under attack or that they are being flooded with foreign-based assets, they can defend their currencies in the fx market (as they do now) and they can erect capital controls to prevent the inflow of foreign capital (as emerging nations have been threatening). The G-20 are working on these issues right now, so far unsatisfactorily as far as I can tell. Geithner’s idea of limiting capital surpluses does not address carry trades, and I don’t know whether the issue was addressed at the meeting. Maybe someone here who is following it does. I would imagine it was raised, since emerging countries have been complaining lately.

      As a globalist, I see the world as a closed system with great asymmetries. For example, wealth and income, hence real resources, are asymmetrically distributed within nations and among nations. TI don’t see the problem as being about the amount of money created, but rather about distribution. There is something radically wrong with the distribution process than needs to be corrected in order to produce a more symmetrical outcome. The Keynesian solution is that income needs to be distributed symmetrically in order to generate symmetrically distributed demand. It is effective demand that elicits and distributes potential supply.

      This involves influencing the way that money flows, not the quantity that is created. If flow is not addressed, no matter how big or small the pie, the pie will still be sliced unevenly and the wealthy and powerful will have disproportionally large slices. The quantity of money by itself has little to do with the distributional issues that constitute the economic issues our asymmetrical world is facing. As far as I can see, these are issues that MMT’ers are addressing.

      However, I would like to hear more about how global problems can be addressed, in addition to national problems, because I think that this is at the core of what will be happening in a 21st century world dominated by globalization and the decline of the nation state in geopolitical importance as interdependence becomes more prominent than independence (“sovereignty”). So far nations are at the level of adolescents, trying to establish independence and boundaries instead of adults cooperating no longer based on kinship (families>clans>tribes>nations) but realization that the human species is a family united by kinship and that kinship links all life forms on the planet, extending to the emergence of the first cells.

      The problem has been the blind faith of neoliberalism in free markets, free trade and free capital flow based on “the invisible hand.” Zealots failed to recognize that these can easily be subverted and that the reaction of the invisible hand is a smack down. That blind faith needs to be made more realistic, and controls are needed that make the system work optimally for all, generating sustainable global prosperity to the degree possible given existing resources, including human resources, the chief of which are knowledge and wisdom.

    12. stone says:

      Tom Hickey “why did this not bounce back hard on the Japanese banks when loans went massively bad, like it took down North Rock and almost took down the largest US banks?”
      -because ,as I said before , the Japanese banks were making a continuous series of short term loans to financial intermediaries that banks like Northern Rock etc then converted into long term mortgages. As soon as the Japanese banks got nervous, they decided that they wouldn’t make another short term loan. It wasn’t until AFTER the last short term loan had been paid back that the shit hit the fan.

    13. JKH . . . it’s not about an alternative, really, though I know what you mean. The MMT approach to analysis (as opposed to policy, though policy proposals are obviously connected–and yes, big, for sure) is to always at least try to start from the most general operational perspective. So, central banks most fundamentally operate the payments system and set the price on CB reserve balances, taxes and bonds don’t finance govt spending, etc. Then, we can move to the specifics of real-world monetary systems and understand them as special cases of the general case. MMT policy proposals then address how the special cases are often mistakenly understood by economists and policy makers to be the general case. I think you already know this, but just wanted to point it out for others.

    14. stone says:

      Tom Hickey “The quantity of money by itself has little to do with the distributional issues that constitute the economic issues our asymmetrical world is facing.”-
      That claim is exactly the MMT assertion that I’m saying flies in the face of the reality on the ground. I’m using the Yen carry trade fueling the pre 2008 credit bubbles as an example of how the quantity of money created a global crisis that ultimately led to starvation of millions of people. Another example of stocks of money being the driver of poverty is the way that a government spending deficit enables a trade deficit. That allows wealthy elites in exporting countries to exchange the goods from their countries for personal hoards of USD. Also a constant increase in high powered money leads to a decade on decade increase in asset prices and that ponzi effect redistributes wealth to those who initially hold the most assets.
      As I see it, the reason why MMT is rejected by the public is not because the Harvard professors are not MMTers, it is because MMTers have a quasi religous aversion for facing up to the facts when stocks of money rather than just the flows exert malign influence. People may not have all bothered to unpick precise examples of how that is wrong but they can smell a rat and so ignore all of MMT including the sensible parts about aggregate demand etc.

    15. stone says:

      The MMT idea that flows and not stocks of money are all that needs to be considered is like an engineer saying to the inhabitants of a river valley that it is only flows of water and not stocks of water building up behind a dam that need to be considered. Hence it is entirely safe to have an ever higher dam entirely capturing the flow of river water and just build the dam 10 meters higher each day to prevent over flow. No one would want to live downstream of such a harebrained river dam. MMT is the economic equivalent -with the increased build up of high powered money like the build up of water behind an increasingly precarious dam.

    16. “The MMT idea that flows and not stocks of money are all that needs to be considered . . . ”

      And when has any MMT’er ever said anything so stupid? Honestly, I don’t know why anyone here engages you, MMT or not, as you clearly have no interest in actually understanding what you are critiquing.

    17. Matt Franko says:

      Stone,

      My hypothetical banking example above had nothing to do with ‘high powered money’. You are regressing. There is no analogy to be made between gravitational forces and accounting. You are way off base here.

      Resp,

    18. RSJ says:

      VJK,

      I have argued elsewhere that the private sector bond sales are also “K” credit.

      At the sectoral level, the non-financial business sector does not wait for widows to save their nickels before selling bonds, but they sell the bonds and spend the proceeds simultaneously, and this supplies the income necessary to buy the bonds, just as banks grant loans and simultaneously create matching deposit accounts. Or just as government deficit spending occurs simultaneously with government bond sales and supplies the income necessary to purchase government bonds.

      Here “simultaneously” is of course an approximation, as there is a discrepancy. But in an overlapping market with some bonds maturing and new bonds being issued, almost all of this nets out, just as with bank transactions. In both cases, there are short term funding markets to absorb these fluctuations. But as long as those short term funding markets are working, then both kinds of instruments are “K” credit.

      The distinction is really what happens when there is a crisis at which point the private sector debt stops being “money good”. But that does not mean that the risky instruments didn’t expand credit during the boom, or that they don’t do so in the normal course of events.

    19. VJK says:

      RSJ:

      they sell the bonds and spend the proceeds simultaneously, and this supplies the income necessary to buy the bond

      What you describe is impossible operationally.

      My simple point was that a party other than the commercial bank cannot create credit ex nihilo due to lack of special operational arrangements that only the commercial bank possesses. Such a party can only grant a loan which is 100% backed up by cash that the party has already at its disposal. The loan of this specific variety(a bond) would be an “M” loan rather than “K” loan due to the former 100% backing by cash under any circumstances..

    20. stone says:

      Scott Fullwiler: “The MMT idea that flows and not stocks of money are all that needs to be considered . . . ”And when has any MMT’er ever said anything so stupid? “-
      -Exactly that “stupid” claim is made every time each MMTer advocates long term deficit spending. Can you point me to a single Billy Blog post that does not do that?

    21. stone says:

      RSJ “they sell the bonds and spend the proceeds simultaneously, and this supplies the income necessary to buy the bonds”-Isn’t that just a case of the same pot of money being passed from party to party in contrast to an expansion.

    22. stone says:

      Scott Fullwiler: “The MMT idea that flows and not stocks of money are all that needs to be considered . . . ”And when has any MMT’er ever said anything so stupid? “-
      After all this is the comment section for a particular one of Bill’s Blogs so we should draw the example from this Blog post (though it could be from any of the others). True to form, Bill says:
      “a modern monetary perspective which says that if the non-government sector desires to net save then aggregate demand must be supported by the government sector for output and employment levels to remain high. All throughout the period shown in my graph above – those deficits were supporting a solid private saving ratio. And it is typical for the private sector to save a proportion of their income (in aggregate).”

      – The sane (in my view) view would be that although the “the non-government sector desires to net save” , taxation has to prevent that from taking place on a net aggregate basis because “aggregate demand must be supported by the government sector for output and employment levels to remain high” and as Scott you yourself point out it would be “stupid” to take the only other way out that the accounting realities dictate which would be to allow stocks of money to increase indefinately. Bill’s whole post is an advocacy of that “stupid” other way out.

    23. Sergei says:

      stone, it is your personal and political belief that savings are bad and should be taxed away before government spends anything. So feel free to express it next time at the ballot box. But other people are allowed to have beliefs as well and also different from yours. Why do you push so hard with your view and try to make sure everybody subscribes to it and if they don’t you say they are religious. Who is actually religious here, you or others including MMTers? Everybody has a right to have an personal opinion and express it but people will stop listening if you push too hard just because you want to make sure everybody blindly accepts your beliefs. This is religion.

      Regarding the carry trade you keep on pushing exactly the same arguments while this discussion has already been here a while ago and it was quite clear then that you have a rather weak understanding of currency markets operations. Now you raise this topic again as it has never occurred. So what new insight or question do you have to raise this issue once again?

    24. stone says:

      Sergei “it is your personal and political belief that savings are bad and should be taxed away before government spends anything.”-
      I’m just saying that stocks of money do have a major macroeconomic influence which is also what Scott seems to be aknowledging. So whilst everyone may “desire to net save”, it has to be faced up to that realistically that leads to crisis as it leads to ever increasing stocks of money. I keep bringing up the carry trade because people keep saying that empirically stocks of savings in one country do not correlate to an immediate crisis in that country (eg Japan in the last couple of decades). Bill has linked to his post saying that more than to just about any other post. No one has refuted that one way or another 1T USD found its way from Japan to the West. As such how can it be said that the “empirical evidence” that stocks of savings are benign can ignore such a carry trade. I don’t think these points are anymore “political” than any other economic points. I class myself among the six billion people who are not economists or financiers but who suffer the consequences of what they do. As such we ought to be holding them to account.

    25. Sergei says:

      stone, No one has refuted that one way or another 1T USD found its way from Japan to the West

      you think of carry trade as a flow but it is not. And you problem comes from the wrong association of currency markets visualized by flows of cash money. In order to enter a carry trade no one really borrows in the sense that you put into it. This is the key mistake that you make. If you want to enter an fx-transaction, you sell one currency and buy another one. The currency you buy serves as collateral against the currency you sell. Should the price of the “short” currency move against you then your position will be liquidated for you unless you put more money as deposit. This can happen any moment during 24/7 because currency markets are the most liquid markets of all and function 24/7. This means that currency markets do not work as flows! They work as electron-positron pairs created whenever a position is opened and then annihilated when positions are closed. It is a zero-sum game. Yes, there can be flows in this system but they are represented by the changes in the exchange rates. They are not represented by inflows of money. Carry trade is not an inflow of “hot” money. It is a bet on the exchange rate.

    26. MMT Proselyte says:

      stone –

      I find your posts increasingly unclear and ambiguous. To clarify, are you arguing that, because Japan’s allegedly MMT-style fiscal policy resulted in the USD-JPY carry trade and asset bubbles abroad, the US and UK govts would be wrong to pursue aggressive deficit spending today for fear of engendering similarly unfortunate consequences for other foreign countries?

      If so, then this wouldn’t refute people who “keep saying that stocks of savings in one country do not correlate to an immediate crisis in that country”, as it’s other countries where the ‘crisis’ would have occurred. Now you may say in return that, say, the UK govt has a moral obligation not to pursue policy which could harm other countries’ economies; this might not be a position many would agree with, but in any event someone could agree with you that this is the case and still encourage aggressive deficit spending since (1) MMT would prescribe large deficit spending for a huge number of countries (the private sector almost everywhere is retrenching), and (2) countries that might be ‘targeted’ such new such ‘carry trades’ have the ability to forestall crisis with a more thoughtful fiscal/monetary policy than the US displayed.

      I also think it’s unhelpful when you refer to “stocks of money” – it often sounds like you are referring to net financial assets rather than the money supply as such. MMT always points out that money is a relationship, not a thing, so it’s always preferable to be clear about whose asset or liability you are discussing. If I understand you, it is private sector net financial assets which trouble you; if you want to talk about stocks, are you able to articulate a threshold stock ratio of private NFA / GDP which you think starts to cause problems?

      Finally: “Exactly that “stupid” claim [that flows are all that should be considered] is made every time each MMTer advocates long term deficit spending.” This is pretty unfair: MMT always points out that the prescription of long-term deficits which grow or shrink along with idle capacity, will lead to higher GDP, shrinking private NFA/GDP.

      Best wishes
      MMTP

    27. VJK says:

      RSJ:

      Just to be clear. If a commercial bank buys a bond, the situation is no different from a non-bank buyer doing the same in the sense of extending M-credit rather than K-credit. In terms of a bond buyer’s balance sheet, no balance sheet growth happens, only mere asset swap (cash for bonds) occurs.

    28. stone says:

      MMTP- sorry for being unclear and ambiguous. Also thanks for the fact that despite all that you joined the dots and worked out what I was trying to say. You were right that I was trying to say that, thanks to carry trades, the global levels of high powered money needs to be thought of in the same way as we think of atmospheric carbon dioxide levels or chlorofluoro carbon levels. If one country deficit spends, the whole world feels the conscequencies. I agree that fiscal stimulus is currently needed in a most countries in the world. That is quite different from saying that deficit spending is needed. Massive fiscal stimulus could be achieved with no deficit by shifting the tax burden away from consumers and onto asset holders.

      ” MMT always points out that the prescription of long-term deficits which grow or shrink along with idle capacity, will lead to higher GDP, shrinking private NFA/GDP.”-
      My issue is that the growth in GDP that occurs in developed nations as a response to deficits is simply a growth in the FIRE sector which grows to deal with all that extra money that needs managing. As MMTers point out, a large FIRE sector is a burden on everyone. In that way “the prescription of long-term deficits” is a prescription for an ever increasing burden.

    29. Stone at 19:03

      I don’t see anything in Bill’s quote there or your further discussion that has anything to do with your statement that suggests there is an “MMT idea that flows and not stocks of money are all that needs to be considered . . . ” Where have MMT’ers ever said that stocks NEVER need to be considered?

    30. Stone

      MMT’ers have written A LOT on financial instability and the growth of FIRE. The US has had deficits that did not accompany financial fragility and exceptional growth of FIRE (1940s) and those that did (1980s, 2000s). The US also had surpluses that accompanied exceptional growth of FIRE (1990s). The common denominator is generally the form of (de)regulation in the FIRE sector, not the deficit itself. Furthermore, deficits can decrease the FIRE sector, at least theoretically; for instance, a large tax cut for indebted households (such as a payroll tax holiday) that led to massive deleveraging could actually end up shrinking the aggregate balance sheets of FIRE.

    31. Stone

      I should add that the Minskyan influence of MMT’ers requires us to acknowledge that “stability is destabilizing.” This means that both cyclical and secular growth/stability in the macroeconomy will grow the FIRE sector, left unchecked. And, to the degree that govt deficits contribute to such macro stability, there is absolutely recognition of a relationship in MMT between that and FIRE/financial fragility..

    32. stone says:

      Scott Fullwiler “Where have MMT’ers ever said that stocks NEVER need to be considered?”-
      I’m just delighted to at last have an MMT conversation about stocks. It seems you do consider stocks but I have failed to pick up on it-sorry . Please let me make up for lost time and educate myself all about MMT consideration of stocks.

      “The US has had deficits that did not accompany financial fragility and exceptional growth of FIRE (1940s)”
      – That is a very special case because a massive war was being waged and then the USA was bailing out europe with the Marshal plan etc. I said that increases in high powered money tend to increase the FIRE sector in DEVELOPED nations. To my mind the very special situation in the 1940s rendered the USA economy more akin to that of a developing economy. I totally agree that massive deficits could be run in much of Africa currently and so long as the economy was well managed the entire ensuing increase in GDP would be in the form of transforming sanitation, healthcare, transport etc etc “with no FIRE sector increase. The current situation in the UK and USA is quite different from that.

      “The US also had surpluses that accompanied exceptional growth of FIRE (1990s). “-
      What I’ve been saying is that the global increase in the stock of savings leads to an increase in the global FIRE sector. Japan had embarked on massive deficit spending in the 1990’s but much of the injections into the Japanese economy ended up as Japanese savings that the carry trade delivered to the USA, UK and Europe. Those fueled the UK and USA FIRE sectors.

      “Furthermore, deficits can decrease the FIRE sector, at least theoretically; for instance, a large tax cut for indebted households (such as a payroll tax holiday) that led to massive deleveraging could actually end up shrinking the aggregate balance sheets of FIRE.”
      -What has a payroll tax holiday, JG or any other MMT spending plan got to do with deficits? All of those spending ideas are great but need not be deficit funded. They could just as well be funded by a tax on asset values such that there was no deficit. I’m sure you are not saying that a payroll tax holiday matched $ for $ by an asset tax would decrease the FIRE sector less than a payroll tax holiday that was deficit funded.

    33. RSJ says:

      VJK,

      I think you are making a logical error here:

      Yes, in each specific asset purchase, a bond investor buys $X worth of bonds for $X worth of cash. But that does not mean that, in a given accounting period, that the amount of borrowing is constrained by the amount of cash in the economy, or by the size of household assets (assuming households are doing the lending) at the beginning of the period.

      For example, you have $100 in cash and $100,000 in other assets, say inventory. I sell a bond to you for $100. I buy $100 of your inventory. I sell another bond to you, etc. At the end of the day, I can sell you $100,000 in bonds to buy all of your inventory, even though you only started with $100 in cash. The amount of cash is irrelevant. You can lend up to your assets and/or what you can borrow. But part of your assets will be other people’s bonds, so you have endogenous credit growth. I.e. my balance sheet went from having a business idea to having $100,000 in inventory and $100,000 in bond liabilities.

      And you can see how, as a result of this, my dissaving will increase the value of other speculative assets or businesses whose inventory I purchase, so that they will in turn be able to obtain more credit by selling more bonds to fund their purchases, possibly of my products, etc.

      It is ex-nihilo credit just as with bank lending. Balance sheets expand, leverage expands, prices can be driven up, you can have bubbles, etc.

      It is the process of netting that allows credit to expand beyond the stock of cash, and not the fact that the deposit liabilities, or IOUs are redeemed for cash at a single geographic location rather than in a de-centralized market. The market mechanism just allows anyone who happens to have the cash at that time to redeem your IOU, whereas the bank teller knows how much total cash is in the vault and just hands it over. So what? In one case you have somewhat higher search costs in needing to announce public bids, but in both cases a fixed pool of cash supports a growing pool of credit.

      Under a gold standard, the reason why banks could expand deposits beyond the amount of gold in the vault is because they don’t need all that gold. There are both outflows and inflows, and the gold required is that needed to cover the discrepancy between outflows and inflows. Holding additional gold is wasteful, as it could be used to purchase interest bearing assets.

      And in this sense, the credit markets are no different. At any given time, bonds are being bought and sold, and the amount of gold required is only enough to cover the discrepancy. Credit markets are nothing more than de-centralized banks, but without any requirements for lending against collateral and also without government backing in times of crisis.

      As an aside, it was credit markets that were the first major creators of credit, in the form of Bills of Exchange to finance cross country trade. Starting with the middle ages, but continuing even today, merchants would issue negotiable post-dated checks to their suppliers to finance inventory, to be repaid when the sale was complete. The vendors would pay their own suppliers with these bills and the bills became a form of quasi-money that was interest bearing and short term in nature. Those with surplus gold offered to buy the bills for gold on demand at a small discount, or to “discount” the bills. In this way, they could obtain interest for their surplus gold.

      The bills of exchange became the quasi-deposits in the de-centralized bank that is the credit market, backed by a much smaller pool of gold.

      Established merchants would have a money desk, or a discount desk which was manned by a “bill discounter” that would buy and sell the bills of exchange and manage the cash-flow of the business, all using market funding.

      As long as people were willing to park their surplus gold in the form of these bills, then an arbitrary quantity of borrowing could occur. It was the first commercial paper market and, like any other bank, was susceptible to “runs” if everyone tried to redeem their bills at the same time.

      The banks would also tap these markets to manage their own cash-flow, and they would sell “bank bills of exchange” that circulated along with the “trade bills” sold by merchants, and they also had their own discount desks.

      During times of crisis, the Bank of England wouldn’t ship gold into the vault of banks facing a run, but would publicly offer to discount that bank’s bills, and sometimes merely the announcement of being willing to discount the bills of a given bank was enough to end the bank run.

      Then, as now, the difference between banks and merchants was not the creation of credit ex-nihilo but the government backing and subsequent lowered discount rates offered to banks over the rate offered to merchants. You can argue that bank credit is more prone to abuse, but both forms of credit allow for increasing leverage as well as bubbles.

    34. stone says:

      RSJ, what you are saying all makes sense and fits in with what I thought too. The critical thing is that the people selling the bonds inorder to buy overinflated inventory are not also holding retail deposits (in contrast to a bank) and so do not need to have government backing if they get in out of their depth. It is the extra false courage that comes from an expectation of a government bailout that makes the current set up so dangerous.
      A more minor point is that the growth in credit by the repeated bond sales is linear not exponential because there is only ever the £100 in cash that must be recirculated for each purchase. That slows down the bubble growth somewhat in comparison to a situation where with each cycle a larger purchase can be made such as when banks create private money. It also means that whenever someone in the market needs to liquidate a large part
      of their inventory for cash, they will not be able to do so. That will tend to put a dampener on the bubble expansion.
      Once bonds start getting used as pseudo money, then as you say they might as well be money. The key thing is for legal recognition of purchases to depend on cash having been exchanged.

    35. VJK says:

      RSJ:

      I think you are making a logical error here

      That’s quite possible, but unlikely ;)

      For example, you have $100 in cash

      At each step of this shell game, the lender extends an “M”-loan to the borrower — no “K” credit is created, a bond is exchanged for cash, cash is exchanged for inventory. The game is fully equivalent to the case when the lender would sell the inventory to a third-party and exchanged the cash resulting from such a transaction for the bonds.

      The lender balance sheet does not grow, the asset side simply changes its composition, the liability side is unaffected, no leverage therefore is used and no bubble is possible is this game.

      Note, that a modern commercial bank could also decide, for whatever reason, to extend a full or partial M-credit by funding it, fully or partially, through a bank asset sale.

      credit to expand beyond the stock of cash

      The stock of cash is irrelevant, at least to a point, for the commercial bank ability to create the asset/liability pair, K-credit, out of nothing. No other entity has access to operational arrangements to do so and is limited in its lending ability, at any point in time, by the available stock of cash for the lending transaction to clear.

      Without going into details, your historical references are for the most part, the modern commercial bank description, in essence. It is not applicable to modern non-bank entities unless I am missing some clandestine institution.

    36. stone says:

      RSJ, “my dissaving will increase the value of other speculative assets or businesses whose inventory I purchase, so that they will in turn be able to obtain more credit by selling more bonds to fund their purchases” and VJK “no bubble is possible is this game”-
      Is the point that in order for the price to keep being driven up, the sellers would only ever be able to put $100 worth up for sale at anyone time. So as the price was driven up, a smaller and smaller quantity of the goods could be put up for sale. It would have to be a very strange kind of market to get a speculative price increase in that way.

    37. RSJ says:

      No other entity has access to operational arrangements to do so and is limited in its lending ability, at any point in time, by the available stock of cash for the lending transaction to clear.

      Yes, the credit markets are constrained at any “point in time” by the available stock of cash, but at the next “point in time” that stock of cash is available to fund more borrowing.

      You can’t say anything about how much borrowing is possible during a non-zero period of time. This is a stock/flow distinction. During a given accounting period, the distinction between “K” credit and “M” credit is meaningless.

      And the effects are the same on the economy. The granting of credit “ex-nihilo” — which is *always* how credit is created, is when the borrower convinces the lender that his business proposition is “worth” a certain amount. That is when the borrower’s balance sheet expands from having assets of “business proposition” and liabilities of 0 to having assets of $100,000 and liabilities of $100,000. The fact that this balance sheet expansion occurred as a series of cash purchases and sales or as a series of transactional deposit purchases and sales, with cash settlement occurring later, makes no difference in principle.

      The lender balance sheet does not grow, the asset side simply changes its composition, the liability side is unaffected, no leverage therefore is used and no bubble is possible is this game.

      Leverage wasn’t used in that example to fund the bond purchases, but it could have been used. The lender could have sold bonds and used the proceeds to buy other bonds. Then the borrower’s balance sheet would have grown.

      If our economy consists of the borrower and lender, then leverage increased from 1 to 2 as a result of the transaction. The assets in the economy went from 1 business idea, $100,000 in inventory, and $100 in cash to $100,000 in bonds, $100,000 in inventory, and $100 in cash. Liabilities grew from 0 to $100,000 in business debt.

      If credit market investors decide that Verizon’s expansion plan is “worth” 10 billion, then they will fund it with 10 billion, without any recourse to bank loans, and without decreasing their assets by $10 billion in order to do so. Verizon will be able to place those bonds.

      You can still maintain that this is fundamentally different than a bank creating a loan for $10 billion, securitizing the loan and selling it as bonds to investors, or that that is fundamentally different from the bank granting the loan and keeping it on its books, but there is no economic distinction. The economy still went from state A to state B.

    38. stone says:

      RSJ, “You can still maintain that this is fundamentally different than a bank creating a loan for $10 billion, securitizing the loan and selling it as bonds to investors, or that that is fundamentally different from the bank granting the loan and keeping it on its books, but there is no economic distinction. The economy still went from state A to state B.”-
      Is the difference that the bond way will not be able to push up asset prices in liquid markets (due to cash becoming scarce) but it will be able to finance large expansion plans?

    39. VJK says:

      RSJ:


      Yes, the credit markets are constrained at any “point in time” by the available stock of cash, but at the next “point in time” that stock of cash is available to fund more borrowing.

      Not *all* credit markets are so limited, but only non-banks. You have not demonstrated, operationally, so far, how a non-bank can be *not* limited by the available stock of cash. One can create an illusion, as with tri-party repo settlement for example, that a security acquisition can be divorced in time from the final cash settlement, but under covers there is a commercial bank standing by and making an intraday loan to make the illusion look like a reality.

      Being constrained by the stock of cash at any point in time means being constrained along the entire time axis. The commercial bank is rarely so constrained due to well know systemic arrangements, but the non-bank, in particular the bond market, is, unless you add a bank, as a player, to the bond market. But such addition would be cheating.

      The granting of credit “ex-nihilo” — which is *always* how credit is created

      Perhaps, misunderstanding stems from the fact that we apply the ex nihilo locution to different counter-parties: me, to the lender and you to the borrower.

      On the bond market, the borrower exchanges an intangible asset(his reputation, idea, etc., i.e. “creditworthiness”) for cash. The bilateral credit/debt contract is created of something valuable to both parties. The creditor balance sheet is unchanged, numerically, on the asset side and not at all on the liability side.

      With a commercial bank, the borrower exchanges his creditworthiness for what is in essence nothing of value to the bank, a mere accounting record, on the bank book, at the point in time the loan was granted. The bank liability(deposit) may remain nothing of value to the bank, without need for the bank to procure cash, for the duration of the loan provided that all transactions happen within the same bank, or the netting settlement system ensures that the cash role is rather unimportant in closing positions. Now, the reality is more complicated and the details of that reality lie at the core of my disagreements with MMT’s presentation thereof. However, as an approximation one can adopt, as some real banks did to their detriment, that not much cash, if any, is needed to settle mutual obligations. So, one can approximate multiple bank behavior with a single bank creating the debt/credit pair with “a mere stroke of pen”, as it were.

      So, the crucial difference between K-credit and M-Credit is in the ease with which the debt/credit pair can be created (with all the attendant risks, too numerous and well known to list).

      In the balance sheet terms, we have a numerically constant M-lender balance sheet vs. an expanded K-lender balance sheet. Of course, the borrower sheet is the same in both cases, or so he might think.

      It is the M-credit something/something pair vs the K-credit nothing/something pair tremendously amplified by maturity transformation that, arguably, is at the root of uncontrollable credit expansion and various bubbles we have recently been lucky to witness in awe and admiration.

      Parenthetically, on the face of it, eliminating maturity transformation might be enough to eliminate uncontrollable credit expansion, but I have not thought that through.

      I won’t comment on “leverage” because my understanding of leverage==assets/(assets-liabilities) does not appear to match yours.

    40. stone says:

      Sergei I just saw your earlier comment: “Carry trade is not an inflow of “hot” money. It is a bet on the exchange rate.”-

      I’ve been trying to reconcile that with what I thought the term meant based from other places I had seen it used. The wikipeadia entry describes it as”investors borrow low-yielding currencies and lend (invest in) high-yielding currencies”- which was the sense I was meaning. They go on to describe:-
      “Since the mid-90’s, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies.[5] These activities include subprime lending in the USA, and funding of emerging markets, especially BRIC countries and resource rich countries. The trade largely collapsed in 2008 particularly in regards to the yen.”

      My understanding was that a trader would take out say a thirty day loan in Yen and convert the Yen to £. Then lend the £ to say Northern Rock bank for thirty days. At the end of the thirty days they would be paid back the £ by Northern Rock which they would convert back to Yen to pay back the loan in Japan. They would repeat the same thing for the next decade. Because they were getting 5% interest from Northern Rock and paying 0.5% interest to the Japanese bank they were profiting. The “inflow of hot money” came about because all of the money involved was in the UK and not in Japan whilst it was going on.

    41. RSJ says:

      “Being constrained by the stock of cash at any point in time means being constrained along the entire time axis. ”

      OK, water flows through a pipe of area 1. Assuming an incompressible fluid, the water is constrained by the area of the pipe. You know nothing about velocity. You don’t know how much water, in terms of volume, can flow through the pipe in a given unit of time. To get to volume, you need to integrate a variable flow. The total amount of cash in the economy does not constrain the amount of borrowing that can occur in a given accounting period.

      In terms of leverage, the total assets in our 2 person economy are 100,000 in bonds, 100,000 in goods and 100 in cash. I just ignored the cash due to rounding. The total liabilities are 100,000. Total leverage is therefore A/(A-L) = 200,000/100,000 = 2. Prior to this, the leverage in our economy was 1.

      Look, the real difference is the likelihood of abuse, not something fundamental about the “type” of credit created. If you asses a fee equal to the current GS10 yield on all non-cash assets on bank balance sheets, and prevented banks from holding any assets other than loans that they originate and cash, then this wouldn’t be a problem, even if you allowed them to borrow from the discount window in unlimited amounts at zero rates. Then you could also stop doing open market operations and have a yield curve set by the private sector.

    42. stone says:

      RSJ “The total amount of cash in the economy does not constrain the amount of borrowing that can occur in a given accounting period.”
      -That is true but it is also true that the amount of borrowing is not the only thing needed to create a bubble. A bubble needs the price to be supported by sufficient able buyers. If cash is limited to $100 there will not be any capable buyers to support a bubble.

    43. RSJ says:

      Stone, you are right in that the money supply needs to expand in a growing economy. The frictions are not zero. The CB makes sure that the market remains liquid by OMO. There are special provisions for banks, such as the discount window, but the provision of base money is economy wide, and is supplied to the money markets as whole.

      Nevertheless, a “shortage” of cash does not constrain lending. It’s just not helpful to think in terms of “running out” of cash, or not having enough cash to buy or sell an asset. Neither is it helpful to say that something can only be purchased with cash.

      An asset is purchased with another asset, whether via a bank or an investor, and the payment system is able to support that.

      All those banks complaining about being short of cash were really short of assets, or their assets were marked down. When Bear was unable to roll over huge overnight loans against pools of sub-prime mortgages, it was not because of a system wide cash shortage. There was no cash shortage, there was a system wide shortage of desire to lend to Bear. Because banks have such opaque balance sheets and hidden liabilities, the re-pricing of assets turns into a loss of confidence in the institution, and a corresponding lack of willingness to fund the institution. If that confidence was there, then there would be more than enough cash in the system to allow the funds to be supplied.

      Belief is what expands and contracts, belief is what funds credit, independently of the settlement technology. And even historically, none of the major financial panics occurred because of a shortage of gold against which to execute transactions, but rather because of a rumor that a bank had too many junk railroad bonds, which turned into a panic and run on the bank. Or perhaps the bank really did buy too many junk assets, and they declared bankruptcy, causing others to doubt the solvency of their own banks, etc.

      The great depression hit first with an asset repricing and bank failures followed in the early 30s, really exploding in 1933. Borrowing, together with house prices, began declining in 2006, and the recession hit in Dec. 2007, and the banks failed later. In all these cases there is a period of pretending as the banks watch their asset quality deteriorate, and then rumors start to circulate and finally there is a panic.

      To an individual trader calling out bids, it may seem that gold can’t be found, but the gold is available, just not to him or just not against the collateral that he is offering. And the reason it’s not available is not because there are too many transactions occurring, so that the gold is “busy”, but because the public has lost faith in his institution or in his collateral. The stock of base money against which transactions are made is not a constraining factor to the amount of money that can be borrowed. Gold standard payment systems are more fragile, but the source of the fragility is not that the stock of gold is finite, but that because the stock of gold is finite, commitments to bail out banks or depositors are not credible. A lack of belief, rather than a lack of gold, causes the crisis, just as the granting of belief, rather than the granting of gold, creates credit.

    44. VJK says:

      RSJ:

      In your stylized example, the final loan is limited by the lender assets whatever the velocity of the “liquid” is. My saying that lending is limited by available cash means just that. If the lender can and wants to convert his assets to cash that will be his available cash.

      Assuming the velocity of cash flow high enough to implement the desired swap of assets during the accounting period, the attained leverage, as you pointed out, would be 2:1.

      It is a remarkably low leverage. It is also maximum achievable leverage in your stylized example whatever the cash flow velocity is provided it is high enough for the swap to complete. If you take into account that a typical Canadian bank leverage is about 18, and the American number was about 40, and the LTCM unbeatable record was about 1000, the advantage of using M-credit should be obvious immediately — the disease won’t spread very far.

      then this wouldn’t be a problem, even if you allowed them to borrow from the discount window in unlimited amounts at zero rates

      I am not sure what would be the exact mechanism of limiting credit growth in your banking system model.

    45. VJK says:

      RSJ:

      All those banks complaining about being short of cash were really short of assets,

      Just wanted to point out that “those banks” refer to investment banks or investment divisions of commercial banks. The investment bank is dramatically different in its activity from the commercial bank being a non-depositary institution and not having any access either to the interbank market or the discount window.

    46. Sergei says:

      stone, you quote wikipedia saying

      a. investors borrow low-yielding currencies and lend (invest in) high-yielding currencies
      b. Since the mid-90′s, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies

      So what I am trying to highlight here is the fact that there are two currencies involved and as long as there are two currencies involved there is an exchange rate risk. Now there are two scenarios for final borrowers, i.e. those who actually spent money on something and not just borrow: 1) final borrowers really borrow in foreign currency 2) they actually borrow in their local currency

      I do not know how widespread is/was fx-lending in the UK/US but I would assume it was small meaning that final borrowers were actually borrowing in local currency paying local currency interest rates. It was different in Eastern Europe but in any case it is just tells you where the fx-risk sits. Nothing more.

      Do lower interest rates in one currency compared to any other currency prevent or tease anybody into entering a new fx-trade? Not at all. All that interest rates tell you is how forward fx-rates are calculated, i.e. the point where you break even on your currency bet. If you want to hedge out this risk then you effectively end up with local currency and local currency interest rates. So if “funding” currency has lower interest rates it just changes your break-even fx-rate in your fx-bet. Nothing more, nothing less.

      Conventional understanding of “carry trade” implies some inflow which creates demand which drives up asset prices. However Japanese yens never leave the Bank of Japan computer. The reality is that banks or whoever else were smart enough to push the fx-risk on borrowers who did not understand what they were doing (majority of retail in “borrowing” countries) or understood what they were doing but still decided to pursue it (financials in “borrowing” countries and probably majority of retail in Japan). But there is no inflow. There are a lot of fx-bets which happen all over the place all the time with all currencies in all directions. fx-markets are the most weird markets of all where hardly any fundamental logic can be found.

    47. VJK says:

      RSJ:

      Gold standard payment systems are more fragile, but the source of the fragility is not that the stock of gold is finite, but that because the stock of gold is finite, commitments to bail out banks or depositors are not credible.

      The system is fragile because it is broken by design. It is built on the foundation of practically unlimited leverage at a very little cost, at the proverbial “stroke of pen”, as well as maturity transformation leading to theoretically and practically unmeasurable “liquidity” risk and consequent runs on bank.

      A fixed stock of base money, gold or otherwise, would make continuing bailouts hard or impossible further exacerbating the fragility problem, that’s correct.

      Equity funded lending as in a typical bond buying scenario and maturity matched intermediation would eliminate need for a government backstop, liquidity risks, bank runs, intermediation interest risks (thanks to maturity matching) at a cost of arguably slower growth since credit would not be as easily available and could be obtained at a much steeper long-term price. That would perhaps make 30 year mortgages an avis rara, but at the same time would push housing prices down to sane levels.

      Arguably, eliminating maturity transformation would have led, in a natural way, to equity funded lending.

      In essence, defending the existing banking system implies defending the abhorrent idea of socializing losses and privatizing profits that have been happening and still are before our collective eyes.

      Even some central bankers start to realize the fundamentally flawed design of the system:


      King said that the banking system’s “Achilles heel” is still its reliance on short-term debt.

      “Risky long-term assets are funded by short-term deposits” and “that makes banks so hazardous,” King said. “Many treat loans to banks as if they were riskless. In isolation, this would be akin to a belief in alchemy. To work, financial alchemy requires the implicit support of the taxpayer.”

    48. RSJ says:

      “It is a remarkably low leverage. It is also maximum achievable leverage in your stylized example whatever the cash flow velocity is provided it is high enough for the swap to complete. ”

      Yes, the ratio will be 2, but this doesn’t mean anything about stability, credit growth, bubbles, etc. The reason is that the “assets” backing the liabilities can just be someone else’s liabilities. You can imagine, for example, a production chain in which consumers buys final output from firm 1, which buys intermediate output from firm 2, etc. At each step, a 10% premium is added, all the way to firm N, which does not borrow from anyone. Of that 10% premium, half goes to wages and half is profit. The profit is used to purchase consumer debt. All purchases are funded by selling paper to someone else. The consumer earns the wages of each firm and borrows an amount equal to the profits of each firm.

      There are no banks, yet this economy can have bubbles and can easily be in a ponzi state for an extended period of time.

      Everything is funded with “equity”. But the overall level of equity is also a function of how much is borrowed. There is no a priori objective “equity” that determines how much is borrowed. If the consumer borrows more, then firm assets increase, allowing other firms to borrow more and allowing the consumer to borrow even more, etc. Nevertheless at each point the leverage will be 2. So what? If banks could hold on the asset side of their balance sheet tons of corn or business propositions, then they would also have much lower leverage.

      Whereas as you are arguing that the value of inventory, the estimated profits of a firm, etc., are all independent of how much credit market debt there is, so that there is some natural limit in terms of “real” underlying assets. That isn’t the case.

      It has nothing to do with banks per se. Banks are pernicious because the opacity of the balance sheet and the government support, but credit itself provides instability and the possibility of ponzi finance, regardless of whether that is market credit or bank loans.

      In terms of maturity transformation, there isn’t a lot of demand for maturity transformation. Households keep about 2% of their assets in the form of checkable deposits, and about 15% of their assets in short term debt. Banks have to compete with the money markets in order to get savings, CDs, MM accounts, which means that households are fine with some maturity. And the remaining 80% or so of household wealth is split 2:1 as equity claims and bond claims. If anything, households want more maturity. I’m going by memory here, but this is about right.

      The service that banks provide, in terms of value add, is credit analysis, for those who can’t access the credit markets. Not maturity transformation.

      Which is not to say that investment vehicles or those closer to the credit creation process do not expand their balance sheet by borrowing short and lending long, but they are not providing some needed service, they are crowding out others who want to lend long.

    49. stone says:

      Sergei:-“Japanese yens never leave the Bank of Japan computer.”-
      Is the critical point that the Yens, rather than siting unused (in the Japanese bank that can fail to find borrowers in Japan) instead are lent out (to those conducting the carry trade)?
      In the example I gave;-
      “a trader would take out say a thirty day loan in Yen and convert the Yen to £. Then lend the £ to say Northern Rock bank for thirty days. At the end of the thirty days they would be paid back the £ by Northern Rock which they would convert back to Yen to pay back the loan in Japan. They would repeat the same thing for the next decade. Because they were getting 5% interest from Northern Rock and paying 0.5% interest to the Japanese bank they were profiting.”
      All of the fx risk is born by the financial intermediaries who are conducting the carry trade. The people borrowing from Northern Rock obviously are not bearing any such risk. The people conducting the carry trade clearly might sometimes loose (or sometimes gain) from exchange rate changes during the course of each thirty day loan. The primary purpose of the carry trade is not speculating on such exchange rate changes. It was simply exploiting the difference in interest rates that were available in Japan versus the west.
      It has just occurred to me that in a tiny way my brother and his wife contributed to it (except that they were not using borrowed money). They were living in Japan at the time (my sister in law is Japanese) and I know they saved for their wedding in a UK savings account, converting their Yen to £ and then before the wedding taking the savings out and converting back to Yen. I’m sure that they had never even heard of the term carry trade, they were just doing what seemed to be a no-brainer as they had bank accounts in both countries and the UK one offered massively higher interest at the time. All I’m talking about is the grand scale of the same process (which amounted to $1T USD in 2007).

    50. stone says:

      Sergei: further to my above comment, I appreciate that other people speculate on the fx markets- betting on how the exchange rates will move (that market amounts to $6T per day or something crazy). That is quite a different process to the carry trade (using the term as I understood it).

    51. stone says:

      VJK “at a cost of arguably slower growth since credit would not be as easily available and could be obtained at a much steeper long-term price. That would perhaps make 30 year mortgages an avis rara, but at the same time would push housing prices down to sane levels.”

      I wonder whether genuine technological development might not actually benefit greatly if all credit was from equity lending. In such a hypothetical future scenario, people seeking venture capital investment (which always has to be equity lending) would no longer be at an unfair disadvantage when competing for investment.

      PS: Everything you’ve been saying really chimes with how things seemed to me. It’s great to hear the same view point from someone who actually knows about the subject rather than just from a inarticulate, bystander such as myself :).

    52. VJK says:

      RSJ:

      imagine, for example, a production chain

      In your stylized economy profits are impossible as they would immediately be lent to workers to create the profits — operationally private maey flows will cancel each other.

      Unless, I misunderstand your description.

      In terms of maturity transformation, there isn’t a lot of demand for maturity transformation.
      Demand is irrelevant. MT is the core profit engine of the commercial as well as the shadow banking systems. An institution engages in maturity transformation each time it buys assets with short-term loans: e.g. zero-maturity demand deposits fund bank non-zero maturity credit facilities of various kinds, both on-balance and off-balance, as well as dubious long term investments such as MBS.

      The shadow banking zero/short term maturity loans were/are repos of various kinds and commercial paper, in particular ABCP.

    53. RSJ says:

      Demand is irrelevant. MT is the core profit engine of the commercial as well as the shadow banking systems

      Absolutely agree, and this was the point I made about funding costs. The funding costs are lower because short rates are lower than long rates, whereas the non-financial sector has long duration liabilities, so they are put at a relative disadvantage.

      This is why I suggested the asset tax, to cancel the net interest income that is attributed to MT, and leave only the income that is a result of credit analysis.

      My point was that MT doesn’t “enable” banks to create deposits and make loans at the macro level. They would create deposits and make loans, and simultaneous to that they would sell bonds, and households would buy the bonds with the deposits because they prefer longer maturity assets.

      You only need to do MT to just provide enough liquidity for the deposits to buy the bonds, or very little MT at any time, given overlapping transactions. For example, if the mean time before the creation of a deposit and the purchase of a bond was 10 days, and the mean period of the loan was 10 years, then at any given time, even though $1 of deposits was created simultaneously to $1 of loans, still only about 3% of the loans would be backed by deposits, and 97% would be backed by bonds or longer term liabilities. That is not a lot of MT at the aggregate level, and I don’t see anything wrong with that system.

      In your stylized economy profits are impossible as they would immediately be lent to workers to create the profits — operationally private money flows will cancel each other.

      I was sloppy as “profits” are a flow, but you do have financial profits, and they always boil down to accumulating IOUs on others. The cancellation of cash-flows is a feature, not a bug: cash in = cash out, and it allows a fixed pool of cash to support a larger pool of economic activity. When someone earns a profit, the cash out term is spent on the acquisition of financial assets, basically the IOUs of those who have dissaved. The amount dissaved is the amount saved.

      Just imagine 1 firm with 1 worker, who is also the consumer. The firm has $10 in cash. In period 1, the worker produces 2 goods, and is paid a salary of $10. With the $10 he buys one good. Now the firm has $10 again. The firm lends him $10 to buy the other good. Now the firm has an IOU of $10 and $10 in cash.

      If the accounting period consists of these two transactions, then the firm has revenues of $20, costs of $10, and earnings of $10, which were parked in pools of consumer debt. Here, profits = borrowing, and this is a general maxim.

      You can repeat this, so that after N periods, you have 10N debt and a consumer debt to income ratio of N. It’s unbounded, even though total leverage in the economy remains at 2.

      Obviously at some point there will be a crisis, but again no banks were needed. Credit market borrowing was enough. And it could be a while before the crisis hits, at which point the IOUs are repriced and the consumer cuts down on his purchases.

    54. VJK says:

      RSJ:

      Just imagine 1 firm with 1 worker, who is also the consumer. The firm has $10 in cash. In period 1, the worker produces 2 goods, and is paid a salary of $10. With the $10 he buys one good. Now the firm has $10 again. The firm lends him $10 to buy the other good. Now the firm has an IOU of $10 and $10 in cash.

      Interesting. Are you saying that the source of the firm profits is workers’ ever increasing indebtedness, “macro-economically” speaking? Besides, there is no room for the firm owners consumption, unless at the expense of the original $10 capital. They cannot eat the loan the workers cannot repay.

      I think the model needs fixing before showing its bubbly nature.

    55. RSJ says:

      Are you saying that the source of the firm profits is workers’ ever increasing indebtedness, “macro-economically” speaking?

      In this example, yes. It doesn’t always need to be this way. The source of the owner’s profits can come from government deficit spending, from the foreign sector, from other owners, or from investment. Basically his financial assets need to be matched by the liabilities of others. I think for the U.S. in the recent crisis, that this was the case. Basically the growing household borrowing was due to goods costing too much, and to workers overpaying for goods by purchasing them on credit, at least indirectly.

      At the end of the day, cash in = cash out. Some actors will have a cash-flow surplus in the goods market, and will subsequently spend that cash by acquiring assets in the financial market. The net acquisition of financial assets will be profits over that period. Those earning profits will be matched by those who are borrowing from them so everything balances to 0.

      Note that this is different from “Savings” in the NIPA sense, since in our example economy, Savings is zero. All output was consumed and there was no investment.

      If you want a more complicated example in which the owner also consumes, assume that the firm starts with an owner, $10 in seed cash, and that the worker produces 3 goods in a given production period.

      The worker is paid $10 and he uses it to buy the good. The firm sends a dividend check for $10 to the owner. The worker wants to consume more, so he borrows $10 from the owner and buys another good. The firm sends a dividend check to the owner for $10. The owner uses that check to buy the third good.

      At the end of this period, the owner has received an income of $20, of which $10 was spent on consumption and $10 was used to acquire a financial asset — the worker’s IOU. His profits for the period were $10. The worker’s indebtedness increased by $10. We are back to the same state as before, with the firm having $10 in cash and the worker busy creating another 3 goods.

      After N periods, the worker’s debt to income will be N. For the economy as a whole, GDP is $30, so total debt to income will be N/3 — still unbounded.

      Note that the interest rate is zero, but that is because the economy as a whole is not growing. If the rate of interest were > 0, then you would need a lot more borrowing. The worker would need to borrow the interest from the owner each period as well, or alternately, the owner could just mark up his assets by the interest and the worker would mark up his debt in the same way.

      Then debt/income would grow exponentially rather than linearly.

      Note that this situation can be stable — if everything is growing and *firms* are borrowing from both owners and workers in order to invest more, and subsequently produce more, then both worker and owner profit desires can be met. And some household debt is also OK, with the young borrowing from the old, etc to smooth consumption over their lifetime.

    56. VJK says:

      RSJ:

      or from investment.

      Let’s do that option, shall we ?

      The worker is paid $10 and he uses it to buy the good. The firm sends a dividend check for $10 to the owner. The worker wants to consume more, so he borrows $10 from the owner and buys another good. The firm sends a dividend check to the owner for $10. The owner uses that check to buy the third good.

      What is the original investment ? Where does the dividend come from ?

      I am curious.

      Thanks.

      I am curious.

    57. Robert says:

      Gamma @Saturday, October 23, 2010 at 3:42:

      “JKH @ Friday, October 22, 2010 at 22:29

      JKH and Robert,

      When you talk about “customer deposits”, are you only referring to demand / transacton account deposits, or do you include term and all other deposits in this?

      If you mean that only transaction account deposits must be backed with 100% reserves, then this proposal is not that different to the banking system as it exists currently.

      For example in Australia, the entire banking system contains around 1250bn of bank deposits, but only about 200bn of this is in demand deposit accounts. The banking system has about 75bn of reserves / govt bonds, around 40% of the level you want.

      On the other hand, if the proposal is that all deposits must be backed with reserves, then this is a radical change that would essentially eradicate banking as we know it. All bank lending would be have to be funded from equity.”

      Sorry not to have replied before; I awarded myself a week off.

      The proposal I’ve paraphrased here (not my own but which I support) would have demand/transaction-account deposits backed 100% – by means of requiring that they be lodged with the CB. It’s obvious that you’re better-informed about the banking system than me, so perhaps you’re right to describe this as “not that different”, although I would have thought myself that 100% was by any standards significantly different from 40%. That 75bn of reserves/govt bonds would have to be increased to 200bn.

      To reiterate, the aim is to stop banks creating money ex nihilo, as debt. From the instant a loan causes a deposit-account balance to be marked up the borrower can (and does) spend it because that’s what he requested the loan for. I don’t really understand your bracketing-together demand deposits (money created by loans) with loans having specified maturity dates (or extended minimum-notice periods) made to banks. The bank does not create this money; the lender forgoes the use of it for the period contracted. No new money is involved, instead existing money is transferred from the lender to the bank. I see nothing in common.

      Demand deposits have a zero term by definition: I’ve already said that I don’t know how 2-day term loan ought to be treated (although I would have thought it ought to be viewed as no different in principle).

      That aside, would you really not see forbidding banks to have any access to that 200bn in demand deposits as a significant change from the present system? Nor being allowed to create deposits by issuing loans?

    58. Panayotis says:

      The limit rule to any credit vehicle generation is dictated by the expected and variable worth and liquidity of its collateral. Money is its own collateral by identity (definition,measure) and thus the unit anchor for any collateral. Period!

    59. Panayotis says:

      A credit vehicle burden, net of any inflation effect, is convex to the risk and concave to the liquidity of the quantity of its collateral unless it is identical to this collateral. Period!

    60. RSJ says:

      VJK,

      What is the original investment?

      The original investment? The initial conditions are an owner whose assets are the firm. The firm, whose assets are $10 and 3 consumption goods. An employee that works for the firm (making 3 goods each period in exchange for $10 in wages). The model then begins with the payment of the wages to the employee (as he has just made 3 goods).

      I don’t define where the employee came from, or how the owner came to own the firm, etc, or where the $10 came from.


      Where does the dividend come from ?

      The dividend comes from the proceeds of the sale. Whenever the employee (or the owner) buys a good for $10, the firm has $10 and as the labor costs were already paid, it can send the proceeds to the owner for the sale of the goods. After the period ends, we are back to the worker having created 3 more goods, the firm pays him $10 and the situation repeats.

      I feel silly tracing out these transactions :)

      The journeys of our $10 bill are not important. But in order to see that, you have to convince yourself that the quantity of cash does not constrain spending, borrowing, lending, or anything else. No “expansion” of deposits via fractional reserve lending is needed. You can have an expansion of credit just via the credit markets.

      Once you’re convinced of this, then you don’t worry about “where money comes from”, you only worry about the price of money, the price of goods, the profit rate demanded of firms, the growth rate of income, wages, and assets. You realize that all of these can be disconnected from sustainable levels due to ponzi borrowing, and you monitor income inequality and financial asset accumulation to see whether there is a problem.

      If the employee was steadfast and did not buy more than 1 good until he was paid enough to buy 2 goods, then his real wages would go up and the owner’s profit would be zero. The owner could still earn a “profit” in terms of goods, which is where Kalecki’s “workers earn what they spend and owners spend what they earn” comes from. But the reality is that “workers earn *less* than what they spend, and owner’s spend *less* than they earn, and the discrepancy is the increase in financial claims”

      But suppose that the employee only stops being willing to borrow after, say, 20 years of excess borrowing.

      Now he stops buying in order to repay his debt. That period of holding firm means wasted output: the employee has $10 but is not buying, and the firm has goods and is not selling, because it believes its cost of capital is 33%, and so the goods rot. The firm can’t lower prices, as it is required to earn a certain margin.

      There is no need to introduce “sticky prices” — a sticky cost of capital is sufficient. But the cost of capital, because it’s forward looking, will always be more sticky than spot prices in the goods or labor market, regardless of how flexible those prices are.

      So in our model, the worker says “no more borrowing” and the owner retaliates by liquidating the firm, as he believes that the revenue collapse was due to something wrong with that particular firm as opposed to believing that the error was in all his previous years of earnings. All the firms say “we need to slim down, become more efficient, cut costs” in order to restore themselves to the level of profitability and earnings growth that they expect.

      No one wants to believe that for 20 years they have been earning “too much” relative to the wages of others, and permanently lower levels of earnings (for them) are required going forward, corresponding to permanently higher levels of earnings for others. That would be an interesting shareholder letter.

      It takes a long time for the long term cost of capital to fall, particularly if government is simultaneously subsidizing profits by deficit spending in response to a demand shortfall. You will find that “the stimulus worked but was captured by profits” and you will keep saying this over and over again.

      And if the worker is truly insistent on repaying debt, rather than just not incurring any more, then you need either debt cancellation or for the government to take the worker’s debt on its own books, as the firm cannot earn a negative profit. Now you have hit the zero bound. Economies find it very hard to tolerate a decline in aggregate borrowing.

      When Bill said:

      Marx focused on the special role that money plays and demonstrated that it is more than a “means of exchange”. It is the medium by which the exchange of commodities falls into two separate acts which are independent of each other and separate in space and time. This is the key to understanding crises in capitalism.

      The “separate in time and space” is the IOU. The capitalist wants to earn a positive cash-flow, but in terms of balance sheets, he is not adding cash to his balance sheet but financial assets generally. I.e. IOUs of others.

      Of course he spends whatever he earns, and he does sell in order to buy, but he sells a good in order to buy an IOU. He does not sell the good in order to buy another good. The profit motive is a desire to stockpile IOUs, e.g. financial assets. Say’s Law stops working as soon as you introduce credit markets, it’s not a question of the base money per se, or of the medium of exchange. Even in a barter economy, if you allowed debt (say payable in kind), then Say’s Law would be violated and you could have ponzi lending.

    61. Panayotis says:

      Rule again!

      A debt deflation process occurs not because credit is unlimited but because it is limited!

    62. Panayotis says:

      Rule again!

      Fragility of credit creation is positively related to the degree or chain of interdependence of credit counterparties (layers) and the surprise rate of unforeseen consequences. These are positively related to the size/quantity of credit creation. The combination of an expected and variable worth (risk) and liquidity of the corresponding collateral with the fragility of credit creation brings financial instability that can generate a debt deflation process. This is the basis of the Financial Instability Hypothesis (FIH) introduced by Minsky. Now combine all rules. Period!

    63. stone says:

      RSJ “No one wants to believe that for 20 years they have been earning “too much” relative to the wages of others, and permanently lower levels of earnings (for them) are required going forward, corresponding to permanently higher levels of earnings for others. That would be an interesting shareholder letter. ”
      -There is exactly such a shareholder letter as a pdf on the Bershire Hathaway web site!

      Do you think it would create a much better system if much more was funded using direct equity investment rather than credit? I read something about large UK homebuilder that ran an almost zero borrowing buisness model. They trailed way behind competitors during boom times but made up ground in each real estate market collapse. Overall they had slow steady growth of market share. If all taxation was in the form of a tax on gross assets (so a real asset bought via a matching financial asset would suffer double tax), then that would favour such a low borrowing style of buisness.

    64. stone says:

      RSJ, I’m still trying to get my head around the thrust of your argument. Is it that you consider neither the quantity of cash available for investment nor the ease of loan creation to be genuine limiting factors to unsustainable credit fueled bubbles? You consider that the crucial reform required is an asset tax set to the long term government bond rate and that if that were in place then all restrictions could be overlooked? My difficulty is that the situation seems to me to be an evolving one. I can see that currently the quantity of cash available for investment is not a limiting factor but isn’t that a fairly recent (last few decades) phenomenon that potentially could be reversed? Also as the amount of money availble for investment increases further and long term government bond rates fall further, then things will move to a next stage. Your clear simplified model ponzi economy did not include a government sector cross feeding government created money into the system and so alowing it to be perpetuated for longer before the indebted workers took fright.
      I think it was Ramanman who pointed out that the current Chinese real estate bubble is driven more by people spending their own savings on investment properties and less by people borrowing money to invest. I suppose that when such a bubble bursts, it does not create debt deflation and so only redistributes money to those who sell at the peak of the bubble. Nevertheless such non-debt bubbles still cause massive malinvestment, waste and enviromental destruction.

    65. VJK says:

      RSJ:

      I am still not happy with money flow. I do not care about individual bills, but, before thinking about the credit growth, I need to understand how the profit formation path in your stylized economy works.

      In your description, the investment of $10 and worker labor create 3x$10 goods. The worker get $10 in wages, buys one good and the owner recoups his original investment.

      There is no money in the system to buy two remaining goods because neither the owner nor the worker have money to do that. So, it is not clear how the owner can consume, much less grow.

      We agreed (I believe) to exclude other firms bankruptcies and the worker borrowing from the owner as sources of profit, leaving only the investment->profit path.

      Something is missing or I am misunderstanding.

      Of course, by the worker and the owner/firm, one means the entire collection of firms and workers.

      I am quite familiar with Marx’s M-C-M idea which is tangentially related to the discussion.

    66. RSJ says:

      VJK,

      In terms of interest, the rate was zero. But if you want a positive interest, that is also fine. Everything is doable as long as the economy is ponzi. When the next period rolls around, just have the worker borrow the interest from the owner as well, cutting out the firm and the purchase of the good. But now we need change for our $10 bill. Note that no interest will be required in the same period that all these transactions occur, as this is a discrete model.

      The point is that what prevents ponzi lending is accurate future knowledge about the income of the worker. The use of fractional reserves is not the source of ponzi lending.

      And you can see how even honest mistakes will propagate because as aggregate dissavings goes up, aggregate incomes go up, so the credit profile improves, causing lending to go up, causing incomes to go up, etc. For banks, you have the same dynamic of more borrowing driving collateral values up and incomes up, justifying more borrowing. So that you can argue that an individual bank is a price taker and is merely performing “good credit analysis”, however in aggregate the price of real estate during the boom is a function of how much banks are willing to lend against it. This is a classic case of externalities, and hence the “we’re still dancing” comments just before the crisis. I don’t see why, a priori, credit markets would do a better job of this than banks. Although I agree that with banks there is more opportunity for abuse as they don’t need to mark assets with markets so the bubble can keep growing longer.

      As an aside, this is one concern with the zero rate proposal, and the idea that we just need banks to engage in good credit analysis and then things will be OK. The payoffs need to be variable so that for each dollar lent, a fee is imposed equal to the additional unit of systemic risk created by the loan, together with insuring that the parameters of the idiosyncratic risk model are adjusted as the macro risk changes. This variable fee will end up looking like an interest rate reaction function.

    67. RSJ says:

      Stone,

      No, I am not arguing that the quantity of base money is irrelevant in the real world — you do need some base money, obviously, and this amount has to grow over time.

      I’m arguing that the dynamics of credit bubbles do not rely on an expansion of base money, nor on bank lending. Neither do we risk a bubble because base money increases. I’m also arguing that private credit is created in the credit markets just as much, or even moreso, than in the banking system. The source of endogenous money has nothing to do with loans per se, but with balance sheet expansion on the part of the borrower. Loans are just one way to accomplish that expansion, but selling bonds works equally well.

      The quantity of base money and the demand for credit are driven by different factors. For example, look at the time path of the monetary base from trough to peak of the last cycle. It grew at a slower rate than NGDP, yet debt grew significantly faster over that time. In the U.S. bank deposits as a whole did not grow faster than GDP, and household checkable deposits, even adjusting for sweeps, are basically at 1980 levels.

      I don’t think that the size of base money should go into any type of macro model, or that currency + reserves should go into the model. Interest rates, credit, incomes, expectations should go into the model.

      About China, I don’t think it’s accurate to say that housing is not credit driven. You have a lot of things going on, and the data is not reliable. On the one hand, households invest in informal lending markets that have high interest rates, because the rates paid by banks are controlled. So you can have a dynamic of the form:

      Someone owns a house, the house appreciates and so they borrow against the equity from the official banking system and invests the proceeds in an informal credit market, earning 10%. The borrower of another house borrows “prudently” from the bank (due to credit restrictions) and borrows the remainder from the informal lending market. Real estate prices appreciate. The house appreciates, so the borrower has equity. The borrower takes out an equity loan from the bank (at the low rates) and repays the informal market, etc.

      re: China,

      One consequence of the understanding that “loans create deposits” is the realization that at the macro level, dissaving can crowd out consumption by forcing a certain amount of savings to occur. So if you subsidize dissaving for capital investment via artificially low borrowing rates, then you must be somehow decreasing real incomes for a majority of your populace. That could be via inflation, or via a tax on consumption, or hidden taxes, wage control, etc. But the mechanism doesn’t matter. In aggregate consumption, and therefore living standards, will continue to fall relative to GDP until you stop subsidizing the borrowing rates. But at that point, you have massive overcapacity and insufficient household income to purchase the output.

      Those who can’t see that dynamic will declare “China is a nation of savers”, but this savings is forced. Consumption has fallen from, say, 2/3 to 1/3 of GDP, plus a trade surplus of about 10% of GDP — in that environment, whatever the true size of “G” happens to be, say, 20%, still that gives you an “S” of about 50-60% of GDP, yet wages and salaries are only about 40% of GDP.

    68. VJK says:

      RSJ:

      I am trying to digest your mesage, but here are some preliminary comments:

      Everything is doable as long as the economy is ponzi.

      As I commented earlier, workers ongoing borrowing implies that the owner extracts profits by getting the workers deeper into debt, dollar for dollar. Sort of zero sum game.

      The point is that what prevents ponzi lending is accurate future knowledge about the income of the worker.

      How exactly money flow would work in a non-ponzi scenario ? Could you spell out required transactions from an investment until the production cycle completion ?

    69. RSJ says:

      VJK,

      It must be a zero sum game in this economy, if you think about it, because the economy is not growing. Incomes are not growing. There is no investment, etc. In that context, all profits must be ponzi in nature.

      For a non-ponzi no-investment example in a constant economy, you can imagine young workers saving by purchasing IOUs from retirees. The retirees themselves purchased the IOUs when they were young, etc. The IOUs allow you to transfer consumption into retirement. In that case, barring demographic changes, the total stock of IOUs is constant. It just changes hands. Also a shell-game, but non-ponzi.

      For a non-ponzi investment example, things get complicated because we need a production and profit model in order to determine whether a given investment is worthwhile. And we also need a discount rate, etc. That drags in consumer choice, growth theory, etc. It can be difficult to determine whether an economy is in a ponzi state or not.

      I’ll give an example in a moment.

    70. stone says:

      RSJ “you do need some base money, obviously, and this amount has to grow over time.”-

      What do you think the consequence would be if the amount of base money was frozen and the tax burden was moved to being an asset tax (flat rate on cash, real estate, stocks etc)? I thought that that would lead to asset price deflation initially but then to a more stable and rational economy driven by maximisation of earnings rather than ponzi asset appreciation.

      I see what you mean about subsidized borrowing causing distortions (overcapacity, unemployment). That was why I thought it better to have a credit system where all credit was from loan companies (that couldn’t take deposits and sold bonds) rather than banks and the borrowing rates would be set entirely by the market with no government involvement.

    71. RSJ says:

      Stone, it wouldn’t lead to asset price deflation per se but to multiple payments crises and an increased risk premium. Having interest rates too high is also bad for the economy and can also lead to lower growth and unemployment.

      As VJK points out, the assumption that base money is not necessary is equivalent to an assumption that all transactions occur with infinite speed and zero cost. That isn’t true, and so you need base money to support the functioning of the payments system.

      My point was that when engaging in demand management and economic policy, you should focus on the economically important issues and assume that the payments system is working. You don’t take crime into account when setting fiscal policy, but that doesn’t mean that you don’t worry about it — it’s a law enforcement problem, but not an economic problem.

      A smooth payments system is the problem of the central bank, but it’s not an economic problem. That does not mean that the issue is not important, or that you can ignore it — but it’s not why we have 2 years of mass unemployment, or a lost generation in Japan.

      Central bankers are quite grandiose if they think that a shortage or excess of reserves has this effect. Of course they think the great depression was caused by “too little money” and that recovery was caused by “monetary expansion”. Of course they believe that by increasing reserves they can control inflation and economic activity. But we don’t have to believe that — we don’t need to be bank fetishists; we can look at economic causes of economic problems, and search for economic solutions. Offload the payment system to the central bank, and offload crime to the police, and then deal with unemployment via economically relevant policies.

      That does not mean that we should try to undermine the payments system. Relying on payments crises as a mechanism to try to enforce reasonable asset values seems insane. Why not argue that we can prevent real estate bubbles by letting houses burn instead of having a fire department? After all, if people lived in fear, then real estate bubbles would be less likely, and people would know better than to overpay for something that can burn down at any moment.

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