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Who is in charge?

Today I was looking over some macro data from Ireland which is leading the charge among the peripheral EMU nations (the so-called PIIGS) to impoverish its citizens because: (a) the amorphous bond markets have told them too; and (b) they had previously surrendered their policy sovereignty. Their actions are all contingent on the vague belief that the private sector will fill the space left by the austerity campaign. The neo-liberals are full of these sorts of claims. More likely what will happen is a drawn out near-depression and rising social unrest and dislocation. But as long as the Irish do it to themselves then the Brussels-Frankfurt bullies will leave them to demolish their economy. It raises the question who is in charge – the investors or the government? The answer is that the government is always in charge but what they need to do to assert that authority varies depending on the currency arrangements they have in place.

The UK Guardian carried a story yesterday (February 7, 2010) – Thousands to lose jobs as universities prepare to cope with cuts – which details how “(u)niversities across the country are preparing to axe thousands of teaching jobs, close campuses and ditch courses to cope with government funding cuts.”

As I noted last week in this blog – Another intergenerational report – another waste of time – for all practical purposes there is no real investment that can be made today that will remain useful 50 years from now apart from education. Unfortunately, tackling the problems of the distant future in terms of current “monetary” considerations which have led to the conclusion that fiscal austerity is needed today to prepare us for the future will actually undermine our future. The irony is that the pursuit of budget austerity leads governments to target public education almost universally as one of the first expenditures that are reduced.

So the UK government is just confirming they have no foresight. They are willing to sacrifice the chance to invest in future productivity growth because they are living in daily fear that the corrupt credit rating agencies will downgrade their sovereign debt standing and that the bond markets which ultimately call the shots will punish them.

The public at large share this myth intuitively and so political pressure means they are cutting. The cuts are needless once the false intuition is exposed.

The Guardian today (February 8, 2010) discussed the prospect that – Ireland’s suffering offers a glimpse of Britain’s future under the Tories.

The story then documents that vehemence of the Irish government’s fiscal austerity actions. The writer says that;

Unlike Britain, the United States, France, Germany, China and the rest of the G20, Ireland has not rediscovered Keynes. It has spurned counter-cyclical budgetary policy and instead has been raising taxes and cutting spending in a series of budgets and mini-budgets that have sucked demand out of the ­economy. Lenihan has cut child benefit by 10%, public-sector pay by up to 15%, and raised prescription charges by 50%. One eighth of the working population has no job, yet unemployment benefit is being cut by 4.1%. For the young ­unemployed, the measures are even more draconian: the dole has been slashed by 50%.

The popular line being pushed out of Brussels and Frankfurt is that Ireland is showing the other PIIGS what can be done and “will be rewarded for its prudence. Bond yields will come down because investors will grow less anxious about a default. The ratings agencies will think again about downgrading ­Ireland’s credit rating.”

Of-course, given the extremely depressed nature of the Irish economy, it is highly unlikely that private spending will fill the gap left by the fiscal contraction. The impoverishment of the Irish population will be drawn out and generations will suffer.

The Guardian said that:

Greece, Spain and Portugal – all under pressure to follow the Irish lead – also have to balance the struggle for “credibility” in the markets against the short-term hit to demand.

So the narrative is again that the markets rule! If you don’t have credibility then the markets will close down the government. So it is better for the government to close itself down by pursuing harsh austerity plans.

The case of Ireland (and the PIIGS) in general is, of-course, not comparable to that of the UK. The PIIGS are hamstrung as a consequence of their membership of the EMU which essentially means they ceded monetary policy authority to the ECB, pegged their real terms of trade via the common currency and abandoned any capacity to run an independent fiscal policy.

The interesting aspect of their decision to enter the EMU is that it set up the preconditions for their crisis. And now the same membership is making the crisis worse.

The Irish construction boom was driven by low Eurozone interest rates (in part) which the Irish government had no control over. Had they been a sovereign nation they may have tightened monetary policy (although that may not have been as effective as a fiscal contraction). But the EMU membership required they abandon an independent monetary policy without any corresponding fiscal redistribution mechanism being made available within the system.

There is now civil unrest growing in Ireland, Greece, Portugal and Spain as the “bond markets” allegedly force these governments into harsh, anti-social fiscal contractions.

The Guardian also carried a story yesterday (February 7, 2010) about Greece – The wider financial impact of southern Europe’s Pigs. It said:

Financial markets like to bet against countries and punish those who have policies or deficits that look unmanageable. Back in 1992 the pound came under brutal attack from speculators led by George Soros who were prepared to gamble that the Tory government of the day would not be able to maintain its peg to the Deutschmark in a bid to finally rid the country of inflation.

By the time Black Wednesday was over in September 1992, Soros had reputedly pocketed £1bn and the reputation of the government of John Major for economic competence was in tatters.

In a similar way, the governments of Greece and Portugal, and also Spain and Italy, are under attack from the bond markets. That may not sound like a national emergency for the countries concerned but the financial impact is real.

The writer said that the investors are selling “Greek government bonds with a vengeance” and this is a problem because “governments that run big deficits need to finance them by selling new bonds to financial markets. If people don’t want to buy them, they have to offer a higher coupon, or interest rate, to investors”.

So by “selling off existing Greek bonds, dealers pushed up the yields on those bonds because yields move inversely to price” which further drive up the budget deficits of the nations involved.

As noted above – the EMU nations have voluntarily signed up for this nightmare – to enter a system that allowed the bond markets to hold any country hostage.

But sovereign nations are not in that position which raises the question – why do they act as though they are operating at the behest of the amorphous bond markets?

There was some unintentional symbiosis today. After several commentators have been discussing how to best get the message of modern monetary theory (MMT) out to the public to gather support for it, given how unintuitive it seems to most people (I disagree that it is, but I am continually told otherwise), I have been reading up on the psychology literature on what in communications technology is called the last mile problem.

And then today, Scott Fullwiler sent me a link to a video about this issue in the context of reducing child mortality in India arising from diarrhoea – watch it HERE if you are interested.

The facts are that child mortality has fallen dramatically over the last 50 years or so after doctors found the application of oral re hydrations therapy (a very simple fluid supplement) worked. They fell from 24 per cent in 1960 to 6 per cent in 2009. But it still remains that around 400,000 babies still die from this totally preventable condition even though the technology is available and known.

The point is that a problem is not solved once you have solved the technology. I have noted before that we have long been able to solve most of the problems that still cause misery in less developed countries. But there is reluctance to provide these solutions for various reasons. In the case of the Indian mothers the problem solving requires working at the psychological level – the so-called “last mile”.

We react intuitively all the time and this blinds us to what is going on. An the example given in the video was the following. A bat and ball costs $1.10. The bat costs $1 more than the ball. How much does the ball cost? Most people in controlled experiments acting on intuition say 10 cents whereas the correct answer is of-course 5 cents.

I have been reading this literature for sometime now because I think it resonates with the challenge that MMT has in disabusing the wider public of falsehoods in macroeconomics that arise from the application of intuition. This intuition is continually reinforced by analogies between the household and government budgets, for example.

In my view, the last mile application relates to this hurdle. The first “90 per cent” of the paradigm development is done. I refer to the correct specification of stock-flow consistent macroeconomic relations and well-specified behavioural relations that drive these flows into the stocks. That has been a major theoretical effort and I consider it very robust.

I have been giving public presentations and have written millions of words about this stuff over many years and no mainstream theoretical attack has been able to be sustained. In most cases, the attackers give up and resort to mouthing the intuitive emotions that they hold about these issues.

So concepts such as hyperinflation; sovereign debt default; tax slavery; and all the rest of these emotional knobs are turned when the attacker has run short of logic. These emotional defences are what constitute the last mile and so a cerebral approach is needed. The technology of MMT is almost complete – there is further work going on at present on applying it to development economics – a book is coming!

Where might we start exposing faulty intuition which allows policy makers to devastate their populations via fiscal austerity packages at the height of a near-depression?

A basic confusion starts when we consider the so-called inter-temporal government budget constraint (GBC), which mainstream macroeconomists use as their organising framework. The public, of-course, are spared the fine detail of the GBC by the economists, but all the “takeaways” reinforce the intuition that the GBC is a down-to-earth concept that we can all relate to because it is what we do ourselves on a daily basis – spend according to a budget constraint.

The GBC is in fact an accounting statement relating government spending and taxation to stocks of debt and high powered money. However, the accounting character is downplayed and instead it is presented by mainstream economists as an a priori financial constraint that has to be obeyed. So immediately they shift, without explanation, from an ex post sum that has to be true because it is an accounting identity, to an alleged behavioural constraint on government action.

The GBC is always true ex post but never represents an a priori financial constraint for a sovereign government running a flexible-exchange rate non-convertible currency. That is, the parity between its currency and other currencies floats and the the government does not guarantee to convert the unit of account (the currency) into anything else of value (like gold or silver).

The following accounting relation, is the often erroneously called GBC and can be used to show the impact of budget surpluses/deficits on spending and private wealth:

where G is government spending net of interest payments on debt, i is the nominal bond rate, B is the stock of outstanding bonds, M is base money balances, and T is tax revenue. In an accounting sense, when there is a budget surplus then ΔM <0 (destruction of base money) and/or ΔB < 0(destruction of private wealth). So in English, this equation just says that government spending on goods and services (G) plus the interest payments on the outstanding stock of public debt (iB) minus revenue (T) comprises the budget balance which is a flow of currency. It has to manifest in the non-government sector as the sum of the change in the stock of high powered money (bank reserves) (ΔM) or the issuing of new debt (ΔB), which are stocks. The mainstream macroeconomics models then eschew the ΔM option, which they call "monetisation" (in other words, the central bank ratifying the treasury spending - which might involve for accounting purposes, the purchase of treasury bonds by the central bank). Why do they eschew this? They draw on the Quantity Theory of Money to argue that ΔM => ΔP – or money supply growth directly translates to price level growth and the longer the left-hand side of the equation (above) is positive (that is, a deficit) the longer the price level will continue to escalate.

In other words, it is a religious belief that ΔM causes inflation. The Quantity Theory of Money begins with an accounting identity MV = PY, where M is the stock of money, V is the velocity or the times the stock turns over per measurement period, P is the price level and Y is the real output level.

Clearly from a transactional viewpoint this has to hold. All the transactions (left-hand side) have to equal the value of production (right-hand side). That doesn’t get us very far.

The mainstream macroeconomists then assert the following – V is constant despite the empirical evidence which shows it is highly variable if not erratic – and Y is always assumed to be at full employment and as such is fixed. With these assertions it follows that changes in M => directly lead to changes in P because with V assumed fixed the left-hand side is driven by M and if Y is assumed to always be at full employment then the only thing that can give on the right-hand side of the accounting identity is P. Please read my blog – Questions and answers 1 – for more discussion on this point.

Of-course, with unemployment and idle capacity now common, Y (real output) can hardly be seen as fixed at full employment no matter how much the mainstream want to deny that mass unemployment exists. Even if V was constant then all you could say then was that changes in M lead to changes in PY – that is nominal GDP, which is a trivial statement.

The GDP growth is always mixed between changes in the price level and changes in real output. For any nominal increase in demand, it is the division between the two (prices and output) that is the issue at stake.

Keynesians (the real ones); Post Keynesians and MMT’ists consider that with costs relatively constant over the normal output range and firms setting prices by marking up unit costs – then the division will favour real output until the economy reaches very high levels of resource utilisation. The extreme position is that the economy has a reverse-L shaped supply curve (where price is on the vertical axis and real output on the horizontal). The right-angle is at the full employment level of real output.

In this case, there is a dichotomous response to nominal demand increases – all quantity (real output) up to full employment then all price (inflation) afterwards as no further output can be produced with the current capacity. The empirical reality support a reverse-L shape with some arcing in the right angle – so bottlenecks occur close to full capacity and there is some mix of price and output response after that point until no further output can be gleaned from the system.

Anyway, the intuition that has been successfully inculcated into the brains of most people with the help of imagery from the Wiemer Germany and more recently Zimbabwe is that ΔM will lead to hyperinflation as the evil government printing presses run overtime in seedy basements somewhere in our national capitals. It is clearly not a sensible conclusion to make. Excessive ΔM will be inflationary if it leads to nominal demand growth outstripping real output capacity.

So at full employment this becomes a major risk (if you care about inflation). But below full employment a demand-pull inflation is a remote possibility. But the imagery and the intuition is now ingrained.

The mainstream then focus on the ΔB part of the GBC. This is the change in the stock of outstanding bonds. So to avoid inflation and to maintain fiscal discipline, governments have to issue debt $-for-$ when they net spend [(G + iB) > T]. This is allegedly a major constraint because it ensures the “bond markets” can discipline errant governments by “closing them down” (that is, not funding their deficits).

It also provides a disincentive to governments to pursue deficits because once again the imagery and intuition about the alleged inevitability of sovereign default is ingrained in the public. That is what the hysteria at present is working on – this falsehood. The smart economists know full well that a sovereign (currency-issuing) government has no insolvency (that is, default) risk.

In the short-run, the mainstream clearly think that a public deficit that is associated with ΔM is more inflationary than one that is associated with ΔB.

But the mainstream have such an ideological obsession against government command of resources for to pursue a socio-economic program (because such programs are “wasteful”, “inefficient”, “roads to no-where”; “undermine incentives”; “enslave free people”, etc) that they realise they can pull the emotional strings and invoke this faulty intuition in the public.

If you then take the two intuitive arguments together the ΔM = inflation and the ΔB = higher taxes and likely default – then you have a powerful case against government deficits – despite both propositions being essentially erroneous depictions of how a modern monetary system works and the opportunities that a fiat currency presents to the government.

But if you think about it clearly and address the inflation, higher tax, sovereign default issues one by one then you will quickly realise that the ΔM option is easily superior to the ΔB option. That is, based on my understanding of MMT, I would have no public debt issuance. Our friend Scott Fullwiler called this a matter of “political economy” in his paper Interest Rates and Fiscal Sustainability. I urge people to read this excellent coverage of the literature.

I have covered the refutations of the arguments about inflation, higher taxes, sovereign default in many of my previous blogs. These blogs – Will we really pay higher taxes? and Will we really pay higher interest rates? – are good places to start.

Two things that then arise from this:

  • Can the bond markets dictate the cost of public borrowing?
  • Can the bond markets close down a sovereign government?

The answer to both questions is absolutely not! The intuition that is rehearsed daily in the media commentary and is being encacted by policy makers is flawed. The last mile requires us to work harder to clarify the flaws and to indicate how a better path can be laid.

Consider the first question: do governments have to pay what the bond markets demand? The correct answer is only if the governments conceded to the false authority of the markets. Otherwise, the government is fully in charge of the bond issuance process and the markets become compliant recipients of corporate welfare in the form of a guaranteed (risk-free) annuity (with interest) in exchange for non-interest bearing bank reserves.

The mainstream claim there is a finite pool of saving (which is directly taken from the discredited Classical loanable funds doctrine – see my blog – Studying macroeconomics – an exercise in deception for a critique of this docrine). They also believe that investors demand a risk premium in case insure again sovereign default.

They consider the government might absolutely default or the more likely “run the printing presses” to repay the debt and inflate it away. All strongly false intuitive elements in the public’s perception of these matters.

So it is presented as obvious that public debt competes for funds which could be deployed elsewhere and so this drives up interest rates. At present the emphasis on rising yields is mostly slanted to the default argument.

First, the empirical evidence is that there is very little relationship between fiscal policy positions and interest rates. So the basis predictions from the mainstream model are not supported by the data. The mainstream then introduce all sorts of dodges which I won’t bore you with to explain this anomaly (mainly concentrating on the role of expectations etc).

Second, the mainstream fail to comprehend that the central bank sets the interest rate at whatever level it wants. Bond market traders have no say in that decision. The central bank then stands ready to ensure that the reserve balances are maintained at a level where the interest rate target is maintained. Budget deficits, for example, add extra reserves which may be deemed by the commercial banks to be above the minimum levels they require to facilitate the cheque clearing house (payments system).

In that case, the central bank has to “drain” those excess reserves or lose control of the interest rate (because the commercial banks will try to lend the excess reserves among themselves in the interbank market which drives down the overnight interest rate).

The central bank can also control all rates along the yield curve (different maturities of investment assets) if it wants to. Please see my blog – Things that bothered me today for a discussion of how the central bank can announce explicit ceilings for yields on longer-maturity Treasury debt and enforcing those ceilings by committing to make unlimited purchases of securities (at those maturities) at prices consistent with the targeted yields.

Third, the government only ever borrows what it has already spent so there is no demand on “scarce” saving.

Fourth, government net spending increases output (as long as it is non-inflationary) which increases saving overall. There is no finite pool of saving in a growing or contracting economy.

Ultimately our intuition about the GBC (above) has to start from the knowledge which is undeniable – that a sovereign (currency-issuing) government is not revenue constrained.

In other words, the GBC has to be an ex post (after the fact) accounting statement of the changes in stocks that accompany the flow of net spending (positive or negative) rather than an a priori (before the fact) financial constraint.

Once you start from that understanding the erroneous intuitions are easier to break down.

The sovereign government can clearly pretend the GBC is an a priori financial constraint – the so-called gold-standard logic – but that is a political choice and is not ground in economic reality.

Once that is understood then that political choice has to be considered against all other political choices including enforcing major fiscal austerity programs on the population.

In the case of the PIIGs, it is a political choice to stay in the EMU. They could restore their sovereignty if they chose to. So that is another political choice that has to be assessed against their choices to impose harsh impoverishment on their citizens.

Once we get to that stage of understanding then it is quite clear that it is the sovereign government that is in charge rather than the bond markets.

The government (via the central bank) can simply enforce a yield structure onto bond markets. Like it or lump it. If the bond markets don’t like it then the central bank can buy the debt.

Better still, the government can simply avoid issuing debt altogether and deprive the “bond markets” of the corporate welfare.

The inflationary risk will be unchanged as I explain in this blog – Building bank reserves is not inflationary. The inflation risk comes from the impact of the net spending on aggregate demand. There is nothing intrinsically inflationary about the ΔM option.

It also clearly takes the bond markets out of the equation and would serve to disabuse us of notions such as the sovereign government has “run out of money”; or will “go bankrupt”; or “will not be able to afford future health care”; and all the related claims that flow from the flawed intuition that initially is advanced and exploited by mainstream macroeconomics.

Of-course, this approach would change the conduct of monetary policy – either a zero rate policy such as Japan has run for years or paying a positive return on excess reserves (as many governments have done in the crisis) would be required. This point relates to the impossibility of using ΔM (that is, monetising net public spending) if the central bank has a positive interest rate target and doesn’t pay a return on overnight excess reserves.


The last mile is the hard journey for all thought-changing struggles. Getting the message across to those who have ingrained intuition which is resistant but fallacious is the hard part.

I see my role as developing the conceptual ideas and structures and pointing out where faulty logic is being pursued. But I am also increasingly thinking about the last mile … to really drive these ideas into the intuitive understanding of those that lose out when governments needlessly pursue these austerity programs or enter into arrangements (such as the EMU) which prevent them from advancing the welfare of their citizens as a matter of structure.

That is enough for today!

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    This Post Has 203 Comments
    1. Scepitus, Bill Mitchell and Steve Keen had a debate here some time ago. It begins with, In the spirit of debate, and three follow up posts, Use the navigation at the top of the page to go to the next post. There is only one intervening post separating them. Steve’s portion of the debate is in the comments.

      I mentioned the complexity of government accounting because it is comprehensive. I don’t buy that these people miss anything. If it isn’t’ there, and I assume you haven’t checked, postulating it might be hidden or unrecognized is pretty close to conspiracy theory.

      Government liabilities are deposits, so it follows that there ought to be some loans that created them wouldn’t you say?

      Why? That’s adding apples and oranges. The government issues currency. (That’s a period). Bank loans create bank money. Two separate kinds of money. Nothing is required to create fiat money. “Fiat” is Latin meaning “Let it be.” In the reserve system, reserves are Fed liabilities and assets of the banks. Banks can just convert reserves for TSy’s, also goverrnment liabilities. It doesn’t imply that the Fed borrows reserves from anyone. It and it alone creates reserves. The banks can only get reserves when the Treasury spends and its reserves are transferred to the various banks as the checks clear in the interbank settlement system that only uses reserves.

      To understand how the monetary system operates it is essential to keep currency of issue and bank money distinct in your mind. They function differently and are accounted for in different systems. That’s what vertical and horizontal means.

      And you still fail to address my point that NFA given to the private sector by the government some part of which may be removed later for whatever reason is from the private sector point of view like a loan – it’s not money. This is a key point yet you persist in banging on about accounting identities without ever once addressing this very important point. A government runnnig a surplus can be considered analagous to a de-leveraging commercial bank. The purpose is the same – to de-leverage.

      This is only happening in your mind. It makes no sense in terms of the way the system is normally described or how it operates.

      the economy is a pure credit economy

      No. The commercial banking system creates bank money, aka credit money, through lending, which nets to zero. Currency issuance does not net to zero because there is no lending involved in creating it.

      Your example of the discount window suggests you don’t know how this operates. It is very seldom used, and it is a penalty form of borrowing resources from the Fed, which carries a stigma. It’s an emergency escape hatch that provides liquidity to a bank that hasn’t managed itself well.

      …This latter statement has no basis in financial accounting or double entry book-keeping – it is an ideological position and one that seems contradicted by other positions taken by MMT.

      Now you are talking nonsense. You need to study up on how this works.

    2. Dear Tom

      I would not have called it a debate. It takes two sides to have a debate. Steve barely participated despite inviting me to do so and left it to his brigade of deficit terrorists to mount the charge.

      best wishes

    3. Bill: Steve barely participated

      I got here though Steve’s site, specifically, the proposed debate that was announced there. I saw immediately that the vertical horizontal distinction you were making was key and was surprised to find that Steve apparently didn’t want to go there and just dropped out of the discussion. So jumped in here while I was also reading Randy Wray’s Understanding Modern Money, and was soon convinced.

    4. Tom: Excellent reply. I dont think anybody could have been more clear. It always beats me why there is so much confusion over vertical transactions. Sometimes I doubt myself to miss something.

    5. Secpticus said:

      Government liabilities are deposits, so it follows that there ought to be some loans that created them wouldn’t you say?

      Deposits are NOT the government’s liabilities. Deposits are bank liabilities. The combined government/CB liabilties are currency notes, bank reserves and government securities.

    6. Vinodh,

      No need to doubt yourself to have missed something. There are zillions of Fed articles to support the simple accounting facts made.


      There is nothing which is wrong in this blog from an accounting point of view. For example, please read the Chicago Fed’s Modern Money Mechanics. The accounting is consistent with MMT, but it is the dynamics written there which is not consistent with MMT. For example, it gets into the money multiplier concept, and gets into Monetarism, control of money supply etc. Good to learn the article and then unlearn. More fun.

    7. Scepticus,

      Also there is nothing ideological about calling zero interest rates as natural. For example check this article by some Fed authors on The Federal Reserve’s Primary Dealer Credit Facility. Page 5, Box 1 says

      When the Federal Reserve’s Open Market Trading Desk was targeting a non-zero federal funds rate, the reserve impact of PDCF loans was offset using a number of tools, including, but not necessarily limited to, reverse repurchase agreements, outright sales or redemptions of Treasury securities, a reduction in the size of conventional repo transactions, and use of the authority to pay interest on reserves. However, when the FOMC reduced the target fed funds rate to a range from zero to 25 basis points, there was no longer any need to offset or “sterilize” these loans.

      In short, the Fed was defending a non-zero overnight target rate and it had to do a lot of things to prevent the overnight rates going to zero.

      As Bill says, the last mile problem needs to be addressed. People mess up somewhere in the last mile. Some people at the Fed get a lot of things right, but somehow mess it up completely when it comes to the big picture.

    8. Ramanan, STF, JKH, and other knowledgeable folks-

      Did you see the macroeconomic balance sheet visualizer link I posted here a few days ago? Tom Hickey provided some helpful stylistic feedback but no one has commented on the content. I am still an amateur and would value someone checking accuracy-so-far.

      Bill and others have called for people to “spread the word” on MMT, and this is my first cut attempt at an alternate approach to the typical story-driven or news-driven blog commentary that is repeated in so many different permutations. My hope is that something visual and interactive can help eliminate some terminology confusion that often arises (for example the comment that “government liabilities are deposits” above).

      If my first draft content is too spotty and low-quality to be worth your time but you think the tool might have value, I’d be happy to use someone else’s content, choice of outbound links/credit, etc.

      There’s of course lots that can be improved and added in both content and functionality. One of the next things I’d like to do is a step-by-step “tutorial” that walks through government spending, taxation, etc, and shows the balance sheet validity of the MMT perspective. But I would consider other suggestions if there is interest.

      P.S. I realize I have not used the “consolidated government sector” approach that Bill and others like to use, but I don’t see how you can claim stock/flow validity without laying out in the open the actual assets and liabilities of the treasury and central bank balance sheets. Otherwise you’re just arguing via philosophy instead of real-world mechanics.

    9. hbl,

      Have to check – but sounds like a fantastic idea!!! Congratulations. Somehow missed your earlier comment. I also got this message

      Invalid Operation: One or more balance sheets has insufficient assets or liabilities. Try another operation first or reset the balance sheets

      which means you have paid attention to the details. Will surely try to play with it at length. Good you have included QE as well.

    10. Hbl

      Very impressive! You must have put a lot of work into it.

      Are you planning to expand the option “government issues debt” to include debt purchase by banks? So far there seems to be no way to put treasury debt on the asset side of bank’s balance sheet, and so QE via CB purchase of treasury debt from banks isn’t feasible. It would be good to see CB open market operations included too (your current QE is equivalent to an open market bond purchase, I think)

      Also, I wouldn’t class the treasury asset as ‘reserves’, since this could be confusing. I assume you mean the treasury deposits at the central bank, which are not technically ‘reserves’. So then taxation would reduce reserves, rather than leave reserves unchanged as your model shows. Also, base money should include currency.

      Good stuff!

    11. Sorry hbl

      Re: base money should include currency. I see that it does, my mistake. I was confused by the inclusion of treasury deposits as reserves.

    12. hbl,

      Yes, as PS points out, there is something funny happening with reserves, base money etc …

      Another thing: the Central Bank has a technical net worth of 0, as its profits are handed over to the Treasury/Government.

    13. Thanks for the comments so far!

      ParadigmShift –

      [1] Yes, there are still a number of operations I’m planning to add including banks buying/selling assets and typical CB open market operations. I probably should have included the latter in this first iteration so I will add it soon. Thanks.

      Incidentally I’m not sure how to treat the balance sheet liabilities resulting from equity (share) offerings as described by MMT, so would welcome any pointers on that. This topic still confuses me. If the market bids up the shares of a public company, do the executives really think “uh oh our book value is shrinking, if this keeps up we’ll be insolvent”?!? And would a soaring public share price impact the capital ratios of a bank and reduce its ability to lend? This seems like the logical result from the claim that the non-government sector can’t change its own aggregate balance sheet equity, so I’m probably missing something.

      [2] And regarding whether the treasury’s deposits at the central bank are called ‘reserves’, what would you suggest instead? Are they not a liability of the central bank, whatever you call them? The model currently does show taxation reducing reserves held by the non-government sector, but if my approach is confusing I’d be glad to change it.

      Ramanan –

      [3] If you can be more precise about the “something funny happening” I’ll fix it… I used this as a reference.

      [4] And regarding the central bank’s net worth of zero… Whenever I see published info on this, the central bank (at least the US Federal Reserve) does seem to have a small capital buffer unless I am misunderstanding, though I was aware that it just hands over profits to the treasury and does not attempt to increase its balance sheet equity. Will double check sources later but am happy to be given pointers.

    14. [2] And regarding whether the treasury’s deposits at the central bank are called ‘reserves’, what would you suggest instead? Are they not a liability of the central bank, whatever you call them? The model currently does show taxation reducing reserves held by the non-government sector, but if my approach is confusing I’d be glad to change it.

      As I understand it, the reserves that Fed creates to fund Treasury disbursements are liabilities of the Fed and assets for the Treasury, which settle the Treasury’s disbursements as they clear through the commercial banking system, the reserves then becoming assets of the respective banks that are used to credit the deposit accounts of the recipients of the disbursements. Thus, reserves are Treasury/commercial bank assets and Fed liabilities.

      [4] And regarding the central bank’s net worth of zero… Whenever I see published info on this, the central bank (at least the US Federal Reserve) does seem to have a small capital buffer unless I am misunderstanding,

      This is my understanding, too. I thought that the Fed transfers its equity account to the Treasury periodically, not daily.

      Thanks for correcting, if this is not the case.

    15. Hi hbl,

      I find the Flow of Funds Accounts of the United States – Z.1 Accounts very useful. Other countries also have it but I find this one very useful.

      You can get the terminologies from the table L.108 for the Treasury’s account at the Fed. I think they do not call this “reserves”. It is just called Treasury general deposit account under the heading Due to federal government. That is what I meant by something funny happening.

      The capital buffer is for “central bank independence” and talks like that. Meaning if the market value of assets go below liabilties, the central bank may lose its independence etc. – which are just talks which not do lead to anything. Simple to set the net worth to zero since the Treasury is always the owner :)

    16. Tom said “Deposits are NOT the government’s liabilities. Deposits are bank liabilities. The combined government/CB liabilties are currency notes, bank reserves and government securities.”

      If you view the operation of the government like a bank, then it is reasonable to view government debt of various forms as a depositing of the assets created via government lending to taxpayers. Its just a terminology thing so lets not split hairs.

    17. To conclude my points made in this thread, allow me to summarise my key objections to MMT in their most basic form;

      Objection 1: MMT holds that banks are never reserve constrained, therefore banks are not revenue constrained. MMT rightly claims that governments operating fiat currencies are not revenue constrained. I therefore see no reason why commercial banks and governments should be subject to different accounting regimes given that both are non-revenue-constrained entities.

      Objection 2: MMT is very vague on the real status of bank reserves. On the one hand they are held to be simply currency issued in full faith and credit. On the other hand they are held to be balance sheet entries like any other financial asset. I remain unclear what the official MMT line is on this point. Likewise on one hand MMT treats all government liabilities as essentially having the same liquidity effect on the private sector and hence interchangable, yet still (according to some commentators ) bond issuance is mooted as a way of dealing with excess demand. This seems like having ones cake and eating it.

      Objection 3: MMT remains unclear to me on how fiscal policy reduces aggregate demand given the statement that under MMT commercial banks will never become revenue (i.e. reserve) constrained. In this case it seems to me that government spending or taxation or other revenue related actions can’t have any direct controlling effect on private sector endogenous money creation.

    18. Hi Hbl

      I agree with Ramanan that “treasury deposits” would be a better terminology to use. Conflating these deposits with bank reserves masks an important distinction, IMO. Although they are still a CB liability, treasury deposits at the CB are not considered to be part of the money supply, and reserve liabilities of the CB should decrease with taxation, and increase with govt spending, to reflect changes in the monetary base with those operations. It also demonstrates the arguably somewhat semantic point that the government does not possess a stock of monetary assets which is increased by taxation.

      I think your model has great heuristic value and should help people to visualise what can be at times a highly abstract set of ideas. Look forward to seeing it evolve :)

    19. The statement that banks are not reserve constrained in lending is entirely separate from the statement that banks ARE constrained in lending by the availability of credit worthy customers and their own capital adequacy. Banks definitely face constraints in their balance sheet expansion strategies – it’s just that the central bank reserve position isn’t one of them (assuming adequate capital).

      The idea of “revenue constraint” is very odd. But because banks are capital constrained, and because internally generated capital is a function of revenues minus expenses, in that very indirect sense banks are partially “revenue constrained” in their ultimate lending strategies.

    20. hbl,

      “Incidentally I’m not sure how to treat the balance sheet liabilities resulting from equity (share) offerings as described by MMT”

      I still haven’t looked closely at your model, but on this point, I’d keep the accounting in general at book value. Think of the stock market as entirely outside of your model. It’s not your purpose to reflect that external valuation perspective on these various institutions. You can overlay an interpretation of market values as you wish, but keep market values outside of the model per se, I would say.

      The stock market has no direct impact on the equity book value of an institution. It will have an effect on capital ratios only to the degree that stock market effects are captured in any asset or liability values that are marked to market for accounting purposes. But I think you can stay away from that.

      The stock market will affect the price at which new equity can be issued to the market. That can have an effect on corresponding post-issue per share book value, according to the weighting of the new issue relative to pre-issue book value. But even if you start modeling new share issues, I would think you’d be modeling aggregates rather than per share book values, so you shouldn’t need to worry about that.

      That said, your idea to model equity issues at some market price level seems a bit ambitious. I’d probably stick with internally generated capital if you’re going that far with the bank component, but I’ve not looked at your model closely enough to make that judgement wisely.

    21. sorry, should have said the stock market can affect equity book value to the degree related marked to market accounting is used for some of the assets

    22. “banks ARE constrained in lending by the availability of credit worthy customers and their own capital adequacy.”

      I agree. However this is NOT a revenue constraint. Since loans create deposits, loans can also create bank capital. This process of banking sector capitalising itself from the outcome of its own lending is entirely beyond fiscal control if banks remain non-reserve constrained.

      In an excess demand scenario (particularly in the presence also of excess reserves) I don’t see why banks wouldn’t be able to attract sufficient capital. Also, banks determine for themselves who is credit worthy so again fiscal policy doesn’t alter the fact that both their own capitalisation and the definition of creditworthy are factors entirely under the banks control and therefore fiscal policy cannot affect the situation.

      Regarding customers, yes banks need customers to lend. But then governments need an excuse to spend too. The government customers are the voters who determine whether they wish the government to spend on their behalf or not. In an excess demand scenario the presumption must be that voters are inclined to make their own spending decisions and are therefore not going to be in favour of deficit extensions. So once again my analogy holds up nicely – banks need willing customers to loan to, and so do governments when justifying a deficit.

      You may say that such political considerations are out of scope for this discussion but of course they cannot be because ultimately all government deficit positions or attempts to manage demand must be validated at the ballot box.

      JKH, the use of SIVs and so forth allow banks to escape their capital constraints by spreading risk to other private sector entities.

    23. Scepticus,

      Reply to your posts,

      If you view the operation of the government like a bank, then it is reasonable to view government debt of various forms as a depositing of the assets created via government lending to taxpayers. Its just a terminology thing so lets not split hairs

      We are not in any sort of war here :) The important thing is to get these accounting as solidly as possible. I think one needs to get a lot of things right to understand how Modern Money works. Its crucial. The fact that deposits are bank liabilities and do not sit in the government plus central bank sector’s liabilities is an important thing in my view. This is why I took it up. Else it looks as if bank is “storing” a commodity.

      Objection 1: MMT holds that banks are never reserve constrained; therefore banks are not revenue constrained. MMT rightly claims that governments operating fiat currencies are not revenue constrained. I therefore see no reason why commercial banks and governments should be subject to different accounting regimes given that both are non-revenue-constrained entities.

      See JKH’s reply for Objection 1

      Objection 2: MMT is very vague on the real status of bank reserves. On the one hand they are held to be simply currency issued in full faith and credit. On the other hand they are held to be balance sheet entries like any other financial asset. I remain unclear what the official MMT line is on this point. Likewise on one hand MMT treats all government liabilities as essentially having the same liquidity effect on the private sector and hence interchangeable, yet still (according to some commentators ) bond issuance is mooted as a way of dealing with excess demand. This seems like having ones cake and eating it.

      There is no vagueness. There are two things apart from government securities: settlement balances and currency in circulation. The change in the level of reserves has no impact on economic activity. I do not know the exact statements of other commentators. My status is (learned from Wynne Godley’s work) – buying bonds does not reduce your propensity to consume. The decision to consume is based on expected income in the near future and the assets accumulated. The decision to allocate wealth is another decision. The consumption decision decides the size of the expected wealth to be allocated. There is a hierarchy of decisions here. Consumers first decide on how much needs to be consumed and then invest the remaining. This is very different from the mainstream view where “agents” try to maximize everything they can. From these agent-based models’ perspective, interest bearing debt will reduce aggregate demand because they try to maximize some objective function. Coming back, there is a feedback effect here. The effect of the issue of an interest bearing debt adds to aggregate demand in the long run instead of reducing anything: the interest income is higher in the case where debt is issued by the government than the case in which the government does not issue debt and hence adds to aggregate demand.

      Objection 3: MMT remains unclear to me on how fiscal policy reduces aggregate demand given the statement that under MMT commercial banks will never become revenue (i.e. reserve) constrained. In this case it seems to me that government spending or taxation or other revenue related actions can’t have any direct controlling effect on private sector endogenous money creation.

      I am assuming you mean that banks are never constrained on lending. The effect is through taxation. Of course Bill prefers lower interest rates – in fact zero overnight rates. On the other hand, Bill has written at various places about the government having a direct control (though regulation or taxing) loans obtained for purposes such as real estate. The facts that so many Ponzi loans were handed out in the Noughties does not necessarily imply low interest rates are bad, but it is any day better to say that such reckless behavior should have never been encouraged.

    24. Ramanan, I know that bank deposits are not government liabilities. What I am saying is that it is a valid thing to talk about government liabilities being _analogous_ to private sector bank deposits. I agree they are not the same thing.

      Regarding bonds, I’m inclined to agree that interest bearing debt issuance adds to aggregate demand if the interest payable on it is not sourced from taxation. However an MMT administration does not promise NOT to raise taxation to pay bond interest, its just that an MMT admin just says it will tax in future but not specify what the taxes are used for (they are in fact shredded). The question of whether or not RBs always pay zero regardless of aggregate demand is a key issue and unless it is fully and unambiguously specified then no conclusions about the relative impact of rbs or bonds can be reached. Therefore it is essentialy for all MMters to commit to interest free rbs forevermore, or to admit they may not be interest free, in which case you cannot utilise argumentation basd on the fact that rbs are interest free.

      So ramanan, in your MMT admin, would rbs be 0% at all times?

      Finally your points about using regulation to constrain lending is valid, and expected, but this is totally different to fiscal controls. With fiscal controls you set a government spending target and then leave the private sector to optimise their decisions. With regulatory control of spending, you in effect change the rules all the time to assist in managing demand. This is very different from just setting a deficit target and amounts to direct control of peoples spending decisions as a primary policy instrument. I think this would be regarded as unacceptable in a democratic system with pretensions to individual liberties.

    25. Scepticus,

      The idea that banks are not reserve constrained is based first on the fact that the central bank supplies the reserves required for the system as a whole to clear settlement balances at the policy target interest rate.

      There is no comparable automatic, systemic supply function for capital.

      Reserves are sourced by government fiat; capital sourcing is more comparable to a gold standard dynamic.

    26. JKH “There is no comparable automatic, systemic supply function for capital.”

      Which makes it even less likely the government can control it. Therefore banks are not revenue constrained due to CB accommodation, and as you kind of point out above, the absence of an obvious pathway for bank capitalisation precludes fiscal control of said pathway, which means that banks are not subject to any kind of limitations resulting from govt fiscal policy whatsoever, leaving only legislation as a tool to constrain private sector credit creation and demand.

      JKH ” capital sourcing is more comparable to a gold standard dynamic.”

      I would love to see an MMT analysis of this and how excess reserves don’t affect the process of capital sourcing, both under the deficient and excess demand scenarios. Is there one? If not, why not, because it seems critical to the integrity of the MMT edifice?

    27. Hi Scepticus,

      I see your point. The system is such that bank liabilities have the same status as currency and in fact you will agree that the common man does not care much and probably that is what you are trying to say.

      Reserve balances are actually close to zero in Canada but I guess if you agree with Bill’s design part of the banking system, reserves just keep accumualting because of deficits in every period, so they would be high in such a policy.

      Taxes are looked upon differently from a Modern Money perspective. You are completely correct about taxing and interest income. It so happens that governments try to go in an austerity mode to try to target a lower debt/GDP ratio and hence cut down on the primary deficit. The effect of going in such an austerity mode actually reduces aggregate demand than in the case where the government does not change its policy! This may sound contrary to what I mentioned in my previous comment, but the situations are different.

      Not sure about the political implications of one policy versus another, but the situation is so bad – the people in power and their advisors have no idea whatsover on how an economy works! In the US, there are characters like Ron Paul. In my country – India – they have better people in the Finance Ministry. The Indian FM had told other FMs in G7/8 meets to not withdraw the stimulus and is not so worried like others. I just hope he doesn’t take backward looking steps. The Reserve Bank governor’s viewpoints, on the other hand, are simply intolerable – all his statements sound like he thinks we are still living in the Gold Standard.

    28. Scepticus/JKH,

      There are two (and more) viewpoints. The first is the neoclassical – the Verticalist viewpoint and there is the Horizontalist viewpoint. The Verticalist viewpoint is not to be confused with the Vertical transactions mentioned at several places in this blog. They are called so because of how you view the money supply function to be. The y-axis is the rates space and the x-axis is the supply of money.

      In the Verticalists’ viewpoint, the central bank sets the supply of “base money” and the total supply of money is determined by the multiplier process. Interest rates are determined by where the supply and demand for money intersect.

      The horizontal position is very different. The money supply is always and everywhere an endogenous phenomenon. There is neither a shortage of money nor an excess. It is completely demand determined. The interest rate is determined by the central bank and the banks.

      Capital adequacy requirments seem to make a horizontal supply function line into a vertical one. However, there are some who argue that it is still horizontal. Here is what Marc Lavoie – one of my favourites – has to say on capital adequacy requirments: (My version of what he says in literature, not quoting him):

      The capital adequacy requirements seems to suggest that it has its own multiplier. However, that is far from the truth. The present rules of Basel 2 are very flexible. Banks raise capital easily by retaining enough of their earnings and issuing new equity. There is never a problem. Even the zombie Japanese banks did not have trouble raising capital, except for a few. If there is a problem, the central bank should capitalize the banks. So it seems he foresaw an event such as TARP in 2003 ;-)

      My personal position is that money is always endogenous/horizontal – even in the gold standard it was endogenous. It’s the endogeneity of money that led to the fall of the Gold Standard.

    29. Ramanan,

      The entire concept of capital allocation is based on risk supported by a ratio of capital to risk. Risk is a multiple of capital.

      “There is never a problem”.

      That’s silly.

      There’s no comparison with standard central bank reserve provision.

    30. Ramanan 3:30 – Thanks for the Z1 pointer, I’ve used it for other things but not yet for this visualizer (eventually I hope to plug its data into this visualizer as an alternative data set). I see the L.108 terminology, thanks… though this table does still imply a capital buffer at the Fed. I’m hesitant to set central bank net worth to zero in the tool without more evidence of real applicability vs implied only, but maybe I’ll add some commentary about this point when I attach mouse-over descriptions to each balance sheet.

      ParadigmShift 23:04 – Thanks, I will use the term “treasury deposits”.

      JKH 23:35 & 23:37 – “your idea to model equity issues at some market price level seems a bit ambitious” – Perhaps I am being too ambitious, but one of my ultimate goals is to visually document both the foundational circuitist and chartalist viewpoints regarding macroeconomic changes and outcomes. This will require showing the ability of markets to inflate/deflate the valuation of assets (stocks, bonds, etc) during valuation bubbles/busts, and the effects on wealth, spending flows, etc. I’ll need to add better visualization of the flows to be at all successful at this. I’m not knowledgeable enough to capture more than the basic principles of these fields, but one of my hopes is to help in moving the dialog (especially with newcomers, and some folks on who seem unsure of the accouting) beyond repeated explanation of the basic mechanics so that more energy can be spent on understanding the pros and cons of various solutions. If that proves overly ambitious and goes nowhere then at least I’ll have had practice learning a new programming technology :)

      And regarding your specific comments on market valuation of stock prices in the tool, other than suggesting I don’t attempt to go there, I think your key point is that the stock share liability held by a company that offsets the publicly held stock shares the company has issued will usually not be marked to market?

    31. hbl,

      I would go for a market value for equities issued by companies. You have brought out an important point about the market bidding up the prices of stocks and the net worth turning negative, if you include equities issued in the liabilities. In fact, this is closely related to Tobin’s-q. I don’t think that it would mean that the company must file for bankruptcy – in fact it would mean that the stock market is overvalued. In fact, it actually happened in the US in the early 2000s – the net worth was negative!

      The advantage for using the market value is that everything is balanced in a balance sheet matrix – as far as financial assets are concerned. The net assets of a closed economy is then the value of the real assets.

    32. JKH “There’s no comparison with standard central bank reserve provision.”

      nevertheless, banks may or may not be capital constrained, and either way it is out of the governments (fiscal) control.

      therefore I repeat my assertion that banks unconstrained by reserves cannot reliably be controlled by fiscal policy.

      the statement that banks shall always be unconstrained with respect to reserves completely undermines the MMT claims that simple fiscal tools can be used to manage aggregate demand. They can’t – its not a reliable or even close to universally applicable policy lever.

      it seems to me you must now adopt a more nuanced stance that leaves open the option of incorporating legislative AND monetary type controls. In order to make this move you would need to drop the natural rate is zero stuff. Alternatively you can propose management of demand purely via fiscal means combined with regular legislative tweaks (much like china with its stop, go, reserve requirement changes) , however I fail to see why this is preferable to control via monetary variables.

      At the very least you should show ___unambiguously___ how fiscal policy constrains (non-reserve-constrained) bank lending or give the legislative aspects of MMT demand management a much more prominent role in your theoretical writings.

    33. JKH,

      I guess that is from a perspective of the banking system as a whole than an individual bank. The banking system as a whole sets the price – the interest rates offered on their lending activities. Banks add sufficient spread for the risk of default of borrowers. If the economic activitty increases, then banks would temporarily increase the interest rates so that they earn enough to simultaneously satisfy their shareholders through dividends and to retain enough funds to add to their “own funds”. During a period of good economic activity, their ability to issue new equity also increases. When they earn enough, they again reduce rates. During a period of low economic activity, the demand for loans goes down as well as the creditworthiness of borrowers. The theoretical limit (which itself is a dynamic quantity) of how much the banking system can lend at any point of time is never reached (exception: the recent crisis on Wall Street). And of course banks have done heavy securitization, all these years. In other words, there is rarely a supply shock.

      Here’s the reference: A Primer on Endogenous Credit-Money

      The production side analogy to this is the reverse-L shaped supply curve (where price is on the vertical axis and real output on the horizontal) – mentioned by Bill in this post itself. It is the reverse which is not Г – the one can’t find an HTML symbol for :)There the curve is almost reverse-L-shaped with a bit of curvature near the corner. Just like demand creates a supply of products, increase in demand for loans creates more capital. The only time, an exception has happened is during this credit crisis.

    34. ramanan: “…increase in demand for loans creates more capital.”

      which is exactly what I have been saying, so thanks for the supporting links, which goes onto my reading list!

      However I think this only holds if we assume that demand for reserves is always satisfied by the CB?

    35. Scepticus,

      Fiscal policy by itself cannot control bank lending – I completely agree with you. I do not think Bill has claimed anything like that in the blog. The important thing is that when Bill talks of necessary conditions, it shouldn’t be taken as sufficient. That is why you see so much criticism of policy makers – complete failure to understand anything about the system. I don’t have links – but you can see him talking about various non-fiscal things about bank lending in this blog.

    36. hbl,

      My general point is that there is always a difference between the stock market value of an equity claim, and the value of the corresponding balance sheet equity as capital on the books of the issuer. But I probably jumped the gun on anything more specific than that, because I haven’t spent time on your model yet. Sorry.

    37. ramanan, using legislative procedures to manage aggregate demand is completely beyond the pale.

      It is a big brother, socialist tyranny of the first order. Why should I be made bankrupt because the government suddenly decided to raise reserve or capital requirements with no notice and thereby induce an asset price deflation? If I am to venture out and invest in the economy I need to know I can judge for myself the price signals as best I can and make my own decisions in a free market which is regulated for the sake of participants.

      I don’t want to live in a chinese style economy managed with such very blunt tools as they do. Do you?

      Legislation should be a tool to set a foundation for fair markets with the very occasional and well debated and telegraphed change, not something that is constantly being tweaked by government wonks to manage demand. It seems that under a chartalist administration, the CB wonks get turned into lawyers and bank regulators.

      If this is to be part of bills toolset he should be more explicit about how it shall be wielded, and how often. Is a legislative process even a suitable tool in a democracy for managing demand – it’s not like such tools can be instantly deployed … unless … its not a democracy.

      Bill? Care to comment on this?

    38. JKH, the current circumstances are that of deflationary depression in all but name.

      I and ramanan are talking about the case where we have an excess of demand, not a deficiency. Note that I said that banks may or may not be capital constrained and that fiscal policy has no control over that.

      Please address the question. If loans create deposits what is the detailed reasoned argument why loans can’t create capital?

    39. Scepticus,

      However I think this only holds if we assume that demand for reserves is always satisfied by the CB?

      Glad we agree on various things. Yes, but the central bank always has to satisfy the demand for reserves, else it won’t be able to achieve its target. There are a few confusing things here. This may sound contrary to whatever we have been talking with each other. It is important to remember in such analysis that the demand for reserves which arose because of demand for loans by banks’ customers is not very interest sensitive. Somehow “horizontalism” is closely tied to central bank operations.

    40. Scepticus,

      Where did I say loans can’t create capital?

      I said banks aren’t reserve constrained because the central bank provides adequate system reserves in order to administer the policy interest rate at target.

      Banks are capital constrained because the central bank provides no such comparable function as a matter of normal monetary architecture.

      What’s that got to do with whether or not loans can create capital?

    41. JKH @ 4.23,

      The recent set of events are an exception to the rule, as I had mentioned. Of course, I understand that even big banks had a lot of issues. I would just see it as a financial famine. It is analogous to the production side … Bill says there is always a problem with demand – of course he knows that there can be severe shortage of food sometimes, but that doesn’t disprove his point right ?

    42. Tom said “Deposits are NOT the government’s liabilities. Deposits are bank liabilities. The combined government/CB liabilties are currency notes, bank reserves and government securities.”

      If you view the operation of the government like a bank, then it is reasonable to view government debt of various forms as a depositing of the assets created via government lending to taxpayers. Its just a terminology thing so lets not split hairs.

      But the government is not like a commercial bank. Bank loans create deposits (bank or credit money) that nets to zero . Government deficit “spending” creates non-government NFA since there is no lending involved. Government “borrowing” (security issuance) just transfers that NFA from one form to another.

      This is a key fundamental of MMT. There is no way to interpret it differently.

      There is no lending or credit involved in currency issuance, other than the liabilities of the government being backed by “the full faith and credit” of the government, which basically means that you can exchange one government liability for another of equal worth. If you cash in a Tsy at maturity, then you get a credit to you deposit account in that amount. The government doesn’t create these funds anew or fund them with taxation, since this is just the transfer of one form of government liability to another, like making change.

      It is currency issuance that creates non-government NFA, not debt issuance. Reserves simply exist at the level of the CB for settlement purposes. Reserves are irrelevant to currency issuance and creation of NFA other than for settlement purposes. Settlement is operationally necessary for currency flow, but plays no role in currency creation.

      Now if you want to say that bank money and government issuance of currency and debt are similar in that all are liabilities of their respective issuers, then that is true. That just means that bank money as a liability of the bank can be used as an asset to satisfy liabilities to the bank. Similarly, government liabilities are used as an asset to satisfy tax liabilities to government.

    43. “I said banks aren’t reserve constrained because the central bank provides adequate system reserves in order to administer the policy interest rate at target.”

      According to bill there is no target except zero, and there will never be an explicitly managed rate target since bill will have made all the monetary policy wonks redundant.

      I guess perhaps you take your own line here? If you agree with bills line then there must be another reason for providing reserves.

      If the target is > 0 then it will be required either to remove excess reserves or pay interest on yet this invalidates the idea that the natural rate is zero.

      It is important to clarify where if anywhere you depart from bills line of thinking both in terms of current best policy and ideal future policy. Do you believe that the natural rate is truly zero?

      “Banks are capital constrained because the central bank provides no such comparable function as a matter of normal monetary architecture.”

      What’s that got to do with whether or not loans can create capital?”

      It has everything to do with it if the automatic provision of reserves enables banks to raise capital as they require when this would not be possible if banks were reserve constrained. Indeed, investors in bank equity will be much more forthcoming with investment once they understand that no bank will ever suffer form liquidity issues.

      Of course they are connected. To suggest they are not seems to me a triumph of academic thinking over common sense. Your response above has simply defined capital constraints in your own terms so as to avoid the common sense conclusion that a bank that is never liquidity constrained will find it a lot easier to raise capital than one which is, especially if that banking system can use the liquidity so provided to effectively capitalise itself.

    44. Tom, all the above in your post only applies as long as:

      1. all currency (which includes rbs) are set to zero interest in perpetuity.
      2. the stock of currency is left to circulate and is never destroyed or removed from circulation. The US government didn’t burn their greenbacks after the US civil war did they?

      its like giving a gift – no strings attached. You can’t give a gift and at the same time threaten to take it back.

    45. Scepticus, I look at it this way. According to MMT, there are two types of money, government currency issuance (exogenous, and vertical) and bank credit (endogenous, horizontal). Government finance is for advancing public purpose, and private finance is for advancing private purpose.
      In an ideal system, government would not influence the creation and flow of the horizontal system (bank money) other than to enforce fiduciary responsibility and prevent cheating, i.e. protect the public, as is government’s responsibility. However, we don’t have an ideal system and irresponsible handling of bank money can threaten the entire economy and social fabric, so the government influences the private system through such measures as regulations and guarantees (FDIC). But government tries to keep this to a minimum other than in extremis, when it needs to act to address economic disequilibrium and social disorder.

      The reason that banks are capital constrained is because this is want risk as the foundation of capitalism is all about. When banks accept a guarantee, they are implicitly accepting that they are a public/private partnership with the government assuming some of the risk in the interest of social stability. But the general rule remains is that lending and leverage put capital at risk. This risk is borne first by owners, then creditors, and then government as the backstop, if the rules are followed. Recently, however, the government stepped in to prevent the destruction of capital by taking on more risk, since the political leaders believed that this was necessary to advance public purpose, or so they said.

      Government uses government finance to advance public purpose by altering the composition of public and private space, depending on political factors and current conditions. It is a political decision as to what this distribution should be.

      Both government finance and commercial finance affect nominal aggregate demand through money creation and withdrawal. In a capitalistic society, the government attempts to make these adjustment with monetary policy through interest rates and through adjusting fiscal policy so that it cooperates with and complements the commercial system instead of competing with it.

      There is no inherent antagonism between the two systems if they work together properly. However, this objective is often vitiated through operational ignorance, ideological bias and powerful interests.

      Some proponents of MMT would like to keep the CB out of the business of targeting interest rates, because they see it as really targeting inflation and using employment as a tool instead of a target, which violates the CB’s congressional mandate to target both. Moreover, MMT holds that it is simpler and more direct to use functional finance instead of a monetarism that has shown itself to be both ineffective and based on an erroneous understanding of how the modern monetary system actually works.

      I agree, Scepticus, that a lot remains to be specified regarding the operational details. A major objection to MMT is that monetary policy is pursued by an independent CB, whereas fiscal policy requires specific legislation, which is always political, therefore lengthy and messy — unable to respond quickly and decisively (as we now see with our dysfunctional government in the US). The MMT answer, as I understand it anyway, is that fiscal policy should be administered as much as possible through automatic stabilizers, thereby reducing ad hoc political policy intervention other than in emergencies or changed conditions.

    46. Ramanan, Scepticus,

      I’m sorry. I shouldn’t have interrupted your discussion, because I haven’t followed it all. Feel free to reject my input here because of that. But I saw a couple of interesting points being raised.

      Let me go back to the beginning.

      The idea behind banks not being “reserve constrained” has to do with the erroneous textbook multiplier causality. That rendition opines that banks lend on the basis of a warehouse stock of reserves. That is plainly false as explained by MMT.

      Some time ago, I invoked the language of banks being “capital constrained”, not because it was the best language, but because I thought it was a useful parallel in the comparison between capital and reserves.

      The fact is that banks do lend on the basis of a warehouse stock of capital. The technical description that banks use for that warehouse is “excess capital”. Excess capital is capital that has not yet been allocated to risk. Banks need that excess capital in place before they can add new risk. If they don’t have it, they’re in contravention of regulatory requirements. Moreover, there is no comparable monetary architecture in place whereby the central bank or the government automatically provides such additional capital that may be required for the system to add to its risk. If you want to consider the intervention of a TARP mechanism every 80 years or so as covering such a contingency, feel free to do so. But that’s sort of like saying that the earth is not constrained by an event of the sun blowing up, because we know that Bruce Willis will save us. Fine.

      There is a question of degree in comparison of reserve constraint versus capital constraint. But what do I mean by capital constraint? I do NOT mean that banks can never raise capital when they need it, either internally or externally. That would amount to an argument in the limit that banks don’t exist, which is not quite my position. And I do NOT mean that an investor can’t take out a loan on the day of a new equity issue and buy stock.

      In the meaning of “constraint” there is the subset notion of a constraint that is “binding” versus one that is “not binding”. The binding characteristic describes the operative condition of a constraint that is strategic in its longer term influence.

      E.g. a bank that has excess capital in place has a capital constraint that at that point is not binding. It can go ahead and add risk. A bank that is exactly at its required capital level, with no excess capital, has a capital constraint that is binding at that point. Any further risk taking without capital infusion or accretion would tip it into regulatory non-compliance.

      Further, in terms of the degree issue, when the FDIC shuts down a bank on Friday, that bank is typically in reserve compliance at 3 p.m., even if that means having borrowed from the Fed. But it means that the bank is formally in capital non-compliance at 6 p.m., and it is wound down as a result. The bank’s ability to function from a liquidity perspective up until 3 p.m. is very much a function of the MMT proposition that banks are not reserve constrained. Its inability to function from a capital perspective 3 hours later is very much a function of my proposition that banks are capital constrained.

      Again I’m sorry that I haven’t picked up on all of your discussion, but that’s how I see the comparison of the two coming late out of the box.


      Scepticus, I’m not sure where you’re referencing a comment from Bill. But I’d bet thousand dollar bills to donuts that Bill has never said that the central bank doesn’t typically target a non-zero rate under the current monetary architecture and policy.

      The logic behind the zero natural rate is perfectly fine in my view. Whether or not the natural rate should be implemented is a policy question. Policy debates are quite separate from the prerequisite of understanding the logic, accounting, and operations delineated in MMT.

    47. its like giving a gift – no strings attached. You can’t give a gift and at the same time threaten to take it back.

      The government can. :), or :( as the case may be, form one’s point of view.

      Functional finance is based on the principles that 1) currency issuance is a fiscal operation that adds to non-government NFA, thereby increasing NAD, while taxation subtracts from NFA, thereby decreasing NAD, and 2) debt issuance is a monetary operation that drains the reserves engendered by currency issuance by storing them as savings of NFA in Tsy’s.

      This addition (“spending”) and withdrawal (taxation) is going on all the time, as it “borrowing,” which in reality stores non-government NFA as non-government savings at interest for subsequent consumption or investment.

      It may look like money in being redistributed by taking from those that have by taxing them and giving to those that don’t by transfer payments, for example, when what is actually happening is that government adjusting income distribution to balance NAD with real output capacity to maintain full capacity with price stability, which benefits everyone, when viewed in the big picture, by maximizing the potential of the economy.

      As many people point out, like Joe Stiglitz and Jeffery Sachs, not to mention Bill, operating at under-capacity is hugely costly in foregone opportunity. See also James Kwak, The Next Problem Hint: it’s structural unemployment.

    48. Dear scepticus

      therefore I repeat my assertion that banks unconstrained by reserves cannot reliably be controlled by fiscal policy

      The government can always influence the opportunity set of the banks’ customers via fiscal policy which is more important and effective. Banks respond to the opportunities that the customers have.

      best wishes

    49. Hi bill, you suggested above that:

      “The government can always influence the opportunity set of the banks’ customers via fiscal policy which is more important and effective. Banks respond to the opportunities that the customers have.”

      How, when there is an excess of reserves such that the short rate of interest is zero, a sufficient amount of bank capital can the government remove opportunities form the private sector if the private banking sector will immediately replace those opportunities? In this case there would be no reduction of aggregate demand.

      Can you elaborate a little on the details of this bank customer opportunity management policy? How does it work?

    50. “Functional finance is based on ……………………”

      yes tom, I know all that. I don’t care what you call it or the terminology you use.

      I call something that is gifted and later retracted a loan. If I give you my car to you and decalre that I give it to you in full faith and credit and then demand it back again leaving you stranded you might say that I had lent you my car, not given it. Had you known this up front, you would have acted in this knowledge to avoid being stranded – for example by not relying on having my car at your disposal.

      Now I can call this process of my giving you my car and then taking it back again, something like ‘functional favour disbursement’, but that doesn’t alter the fact that it is still a loan. Oh, and neither does the fact that I didn’t charge you anything for the use of my car besides normal wear and tear.

      If it walks like a loan and talks like a loan, then it is a loan.

    51. Tom, just to be clear, I agree that operating under capacity is idiotic. I also agree that it is exactly the sectors which caused the problems which are now hurting least.

      What we are arguing about is whether MMT and the prescriptions therein are likely to result in a safe return to full capacity, and more particularly, whether MMT would work for ongoing economic stability after that point. I remain unconvinced by a number of details as you can tell, however in the main you can generally consider me as being aligned with yourself, against the deficit terrorists.

      The differences are in the plan of attack and the nature of the weaponry involved.

    52. Dear scepticus

      You seem to think that commercial banks can set an agenda and follow it without recourse to market reality. Ramanan, Tom and JKH have all indicated in this debate that they cannot.

      If the government stifles the desire for credit (say by a tax hike) within the private sector then the banks can have as many reserves as you can count but they will not lend. Fiscal policy is a reliable means of adding and subtracting demand. Monetary policy is not.

      best wishes

    53. Hello bill,

      I think implicit in your statement above is that the economy will always be demand constrained. I think in a supply constrained economy (suffering from inflation as a result) banks holding 0% paying assets will indeed lend.

      “If the government stifles the desire for credit (say by a tax hike) within the private sector then the banks can have as many reserves as you can count but they will not lend. F”

      My whole point has been that in the cae of excess reserves, private sector demand and only fiscal tools to manage demand, the attempt to stifle credit demand will not succeed. Can you elaborate exactly how this net stifling will be accomplished under a cost push inflation scenario while at all times meeting liquidity needs of banks?

    54. Dear scepticus

      Banks do not lend reserves. But they do lend to credit-worthy customers who seek investment opportunities and/or want to buy consumer durables. Increased taxes and government spending cutbacks in an inflating economy will surely stifle the demand for credit. It then doesn’t matter what the supply side (that is, the banks) is like.

      best wishes

    55. I call something that is gifted and later retracted a loan…. If it walks like a loan and talks like a loan, then it is a loan.

      scepticus, you can’t just make up your own definitions and expect anyone to take that seriously. At the most, you might claim that it is similar to a loan, but even that I find far-fetched. I don’t see it as “walking and taking like a loan” at all. I don’t see that holding up in court.

    56. JKH,

      Of course, I do not support any Paulson put around. The reason I mentioned that is that I think it is the recent credit crisis is the only time credit worthy borrowers were turned down till banks got capitalized. Of course, once they were in a position to lend again, they continued their lending operations but it slowed a bit because of reduction of demand from credit worthy borrowers. The crash was going to happen – the domestic private sector in the US had been in deficit for a long time. A nicely regulated banking system not run by Neoclassicals is less likely to have failures.

      The other thing is that the view of looking at banks as allocators of wealth is more like saying that banks bid for IOUs from households and the production sector and that there is a demand-supply game in the “free market”. However, the better view is that banks are price setters and quantity takers. The only reason a bank will turn down a customer is if there are doubts about creditworthiness. The interest rate set by the bank of course depends on cost of capital. The banking system as a whole has a supply function which is best described as horizontal, with the level determined by the cost of capital and other markups.

    57. Scepticus my friend – you are confusing everyone here. :-) Sometimes you say things which contradict your earlier posts! I do not know why you think that banks will lend the whole world. Plus I couldn’t follow your analogy with gifts. If the government employs a contractor to build a highway, the compensation is not a loan right ? The role of the government makes everything a non-zero sum game.

    58. Ramanan,

      The purpose of capital is to insure against unexpected losses.

      Risk is the origin of loss.

      Risk management and capital management therefore are joined at the hip.

      Risk management includes the portfolio management of risk diversification. Risk diversification is the ultimate rationale for risk limits (risk quantity restrictions) and specifically limits on individual credits.

      I could add some new terminology here and say that banks are capital constrained and risk constrained. But the capital constraint necessitates and drives the risk constraint in order to be effective and compliant. So the capital constraint is binding on risk limits collectively.

      As banks grow, and take on more capital, they can grow their risk limits in specifically targeted areas.

    59. JKH,

      I understand your point. I am talking about direct lending by banks to households and the production sector. Banks are in a position to lend to direct creditworthy customers in whatever volumes they demand. The “constraint” is always on the demand side. They set their interest rates on these loans on expectations of various numbers such as target capital adequacy ratio, target profits – both dividends and retained, interest paid on deposits etc.

      The “risk limit” is in a sense, bad creditworthiness. I am not saying that banks will lend to anyone who walks in. But, at present there is no supply constraint on the amount of lending by the banking system – the upper limit is theoretical. A credit worthy “agent” will rarely have a problem getting a loan and will never have to wait for an “excess of money”. (Of course – Wall Street crisis: exception for a few months(?) )

    60. JKH : “Risk is the origin of loss. Risk management and capital management therefore are joined at the hip.”

      Hang on, loss can come through borrower default or liquidity risk. The latter is part and parcel of the process of maturity transformation so banks engaging in maturity matching should have some of their capital at risk against this liquidity risk that arises from this aspect of their business.

      By saying that reserves can never be in short supply and will always pay 0, there is never any liquidity risk. So, where has this risk gone? Has it been eliminated or moved elsewhere.

    61. Ramanan,

      Banks set risk limits for all borrowers (i.e. credit limits) – households and others.

      They certainly don’t lend in whatever volumes are demanded.

      The upper limit is not theoretical. It is a function of risk limits and capital allocation.

    62. Scepticus,

      Good point.

      Commercial banks have risk limits and allocate capital to the interest rate risk associated with maturity mismatching.

      They also have risk limits on the pure liquidity or cash flow risk associated with maturity mismatching. But they don’t allocate capital to liquidity risk directly. They allocate it where liquidity risk has a potential knock on effect on market risk (price risk due to interest rate risk, equity risk, foreign exchange risk, etc.) This happens mostly in the trading books of universal banks. E.g. a bank will assess the liquidity risk associated with a particular trading portfolio of debt, and assign capital based on the market risk (i.e. price risk) that might be associated with slow liquidation.

    63. JKH,

      Yes, of course. There are credit limits. A lot of this is micro vs. macro . . . one risky bank vs. the banking system . . . what I am saying is that supply side talks are about a “finite volume of money” competing for an allocation. Higher limits for one single customer decreases the credit worthiness, of course, but at the macro – they all do not simulataneously cross their limits.

      The changes in the stock of loans – the flow – are decided by the demand of those who want to get into higher debt, screened by banks’ creditworthiness checks, and not by anything else. The interest-rate sensitivity of those willing to go into debt is weak. The interest rate set is decided by the banks, based on their own algorithms. Banks face no constraints in accommodating this flow.

    64. Ramanan,

      There is no difference between micro and macro on the logic of risk limits and capital allocation.

      What you may be saying is that if there were no risk limits and no capital constraints, there would be no limit on the ability of the banking system to satisfy credit demand.

      And in that fantastic sense, banks are also not reserve constrained, obviously.

      It is also the case that banks are not reserve constrained in the real world.

      But they are constrained – just not by reserves. They are constrained by risk limits and capital, micro and macro.

    65. Ramanan,

      I would compare this discussion a bit with the question of whether or not governments are constrained in deficit spending. I would say they are not constrained financially or operationally. But they are policy constrained in the sense that MMT acknowledges “real economy constraints”, at least as a contingency. That’s the point at which deficit spending runs up against the capacity constraints of the real economy to absorb such spending without undue inflationary pressures.

      Those “real economy constraints” are the logical government analogy to the risk limits and capital constraints that impinge on non government credit and monetary activity.

      I wonder if Bill agrees or disagrees.

    66. JKH: “Commercial banks have risk limits and allocate capital to the interest rate risk associated with maturity mismatching. They also have risk limits on the pure liquidity or cash flow risk associated with maturity mismatching. ”

      With no possibility of reserve shortages afflicting a given bank, all liquidity risk due to maturity mismatching is automatically translated into an interest rate risk (at the discount window) is it not? Of course this is also a reputational risk, which is arguably more important.

      If they get bitten by interest rates as a result of poor liquidity provisions this can presumably end up eating into capital however – because bank capital can be eaten up by simply making a loss at the end of the year even if no borrowers defaulted.

    67. Scepticus,

      “With no possibility of reserve shortages afflicting a given bank, all liquidity risk due to maturity mismatching is automatically translated into an interest rate risk (at the discount window) is it not? Of course this is also a reputational risk, which is arguably more important.”

      That’s certainly the operational front end effect.

      “If they get bitten by interest rates as a result of poor liquidity provisions this can presumably end up eating into capital however”

      Yes. And that’s why banks allocate capital to interest rate risk in a more general sense.

    68. JKH 0:09 – exactly.

      My point belaboured throughout is the degree of manoeuvre in terms of real economy constraints afforded to a government having already a large deficit in the form of significantly excess rbs and little private appetite to buy bonds is determined by the level of excess liquidity.

      The room for quick action to accommodate changes in aggregate demand will likely be constrained by the level of excess liquidity wrt the level of excess capacity. This is analogous to an over-leveraged commercial bank having less scope to react to market interest rate and default risk changes.

      For example, one can go on adding liquidity ad infinitum in a demand constrained/liquidity trap scenario, and it have little or no effect on excess capacity (cf japan). However this makes you much more vulnerable visavis inflation pressure to small increases in capacity utilisation.

      Capacity utilisation can increase for example simply because demographic age-ing is reducing real output. On this matter, it is interesting to introduce the concept of a labour constrained economy. In the latter increasing dependency ratios bid up worker wages and depress the return on capital. This could initiate an inflationary spiral if producers put up prices to maintain profits. This would be an example of inflationary pressure in a contracting economy, and is I feel the largest risk to MMT inspired policy over the next 20 or 30 years. Historically with normal shaped population pyramids economies would never be labour constrained, therefore it is a potentially new economic variable which is unwise to ignore.

    69. Ramanan,

      BTW, you should read Nick Rowe’s comment at the Beckworth post.

      I’m not sure what the word for it is. You can probably come up with something appropriate.


    70. Scepticus,

      Good fundamental point.

      MMT assumes a judgement call on when those “real economy constraints” kick in, and what sort of fiscal trajectory adjustment would be required as a result.

      Two points:

      a) The priority I think is to acknowledge the difference between the truth of real economy constraints as a contingency, and the false arguments and ideology around the false story that the government is financially constrained right now at an operational level.

      b) A second point that I like to emphasize in terms of the liquidity issue is that it is not an issue at the level of excess reserves. At least it is not an issue if the banking system is acting rationally with respect to risk taking and capital allocation, because that process is entirely independent of the excess reserve issue, as per my comments at the Beckworth blog. Where it arguably might become an issue is the domain on the other side of commercial banking balance sheets, which is the M1 or broad M offset to excess reserves. Ironically, this is the side of the equation to which most monetarist economists seem oblivious. I guess it’s because they’re not particularly good at reading balance sheets. I also don’t think it’s a particularly alarming aspect, given that the gross M creation there largely offsets private sector deleveraging, and the Fed can phase out that part of its balance sheet intermediation over time. Anyway, that’s all a monetarist type concern which argues for additional diminished importance.

    71. JKH,

      a) agreed. However MMT needs to specify more clearly the linkage between the size of the deficit and the ability to act effectively and quickly via fiscal channel. IMO most MMT writings fail completely to do this.

      b) JKH, if rbs are paying 0, and cost push inflation is at say 3% pa, what is the rational risk taking and capital allocation for a bank in this situation? I would say that in this case the only way the risk can be managed is to offload much of it onto their deposit customers and bondholders.

    72. Scepticus,

      I suspect what you’re looking for in a) may be included in some of their deeper background papers. But I’d be interested to see more on this as well.

      It looks like you may be assuming the “future architecture” of a zero natural rate in your b). That’s an environment in which fiscal policy is supposed to start tightening against such conditions. Importantly, interest rate risk in terms of the risk free rate is essentially taken mostly out of the equation, since the zero rate structure is viewed as permanent policy. So the issue of risk becomes one of credit spreads and the pricing of the credit spread relative to the view of risk. That future architecture is a specific MMT proposal that I haven’t spent much time thinking through, though.

      Otherwise, in the current framework, I’d expect Fed funds and reserve interest closer to 5 or 6 per cent (assuming they keep reserve interest in place after “the exit”). In any event, banks tend to hedge as much interest rate risk out of their loan portfolios as possible – i.e. match fixed rate loans with fixed rate funding. In addition, credit risk premiums should incorporate the expected effect of future rate increases on credit risk per se. – i.e. the compensation for risk taken should be higher in an environment that is generally riskier from a macroeconomic perspective, which is sort of what you’re describing. Similarly, banks would be careful about risk limits and capital allocation in an environment that seemed to be unsustainable in terms of policy rates.

    73. “It looks like you may be assuming the “future architecture” of a zero natural rate in your b). ”

      At some point the rb excess (and the wider debt structure ) becomes sufficiently large that anything much more than zero is impossible.

      You can’t ‘tighten policy’ in a labour constrained economy except by reducing the dependency ratio.Normally tightening rates or liquidity results in unemployment which reduces wage demands and costs. I don’t think in a labour constrained economy (i.e. one in which labour availability is scarce but financial capital and capital goods are not) that controlling employment to control inflation is going to work.

      I am sticking for this discussion, with bill and other MMT-ers prescription that rbs are just currency in full faith and credit and therefore don’t pay interest. The whole point of MMT is that they tighten by fiscal control not by paying interest on reserves or issuing more bonds.

      This is the current architecture of MMT, not the future one. If they propose to tighten by using interest paying reserves what is the difference between MMT and neo-classical? because as soon as paying interest on reserves is official MMT blessed policy then rbs are CREDIT, and as such their issuance is not ‘free’, they have costs when it comes time to tighten.

      And I am asserting that tightening with fiscal only when holding open the discount window and paying 0 on reserves under all circumstances is not going to tighten anything very much.

    74. scepticus, you are assuming labor shortage developing in the future driving up the cost of labor and creating in inflationary labor environment. This is undoubtedly true in the developed world and even emerging countries like China, given the intergenerational demographics. The commentators I have been reading on this agree that the US is a better position then the rest to begin with, and it is a country that is built on immigration, unlike most others, which are still rather xenophobic. They expect that the US will fare OK in this, since they expect the shortfall to be met with increased immigration.

      There generally aren’t many variables that can’t adjust or be adjusted with changing circumstances. And there is a huge labor oversupply in the world. So this doesn’t seem to be an insurmountable difficulty, even though it is a political hot potato now.

      Of course, the future is uncertain, so your question about what MMT would do is still relevant.

    75. Tom,I’m not american so the US demographic situation doesn’t comfort me. The US is in any case not sufficiently well off demographically to be able to avoid confronting profound labour shortages in the next 20 years.

      “They expect that the US will fare OK in this, since they expect the shortfall to be met with increased immigration. ”

      A dangerous assumption and one almost certainly to be proved wrong.If europe and asia are having labour shortages you won’t be able to import labour from them since to do so the US would have to compete on wages. Hence the most age-ing nations will export wage bargaining inflation to the US to some extent.

    76. General price increase can happen for different reasons, including excess nominal demand (demand-pull), and exogenous shock (cost-push). A contributing condition of demand-pull inflation is often leverage. Most demand pull-inflationary periods are not correlated with excessive government activity but with excessive leverage in private finance.

      The way to address leverage is at the cause, which is too excessive risk-taking. A fundamental means for addressing this is through regulation, specifically capital ratios. Just as an over-heating equity market is cooled by increasing the margin requirement, an over-heating finance can be cooled by increasing capital requirements.

      In addition to cutting spending and raising taxes to cool NAD, some have suggested that the Treasury can also issue debt in excess of the deficit to increase saving. This is a kind of sterilization operation. This type of debt issuance could also serve to crowd out some private borrowing, since no new NFA would be created through currency issuance to offset the debt issuance. It could be counterproductive, however, if it crowds out investment that would be used to increase productive capacity that would offset the growing NAD. Moreover, the interest paid on the debt would eventually add to NAD.

      The larger problem that needs to be addressed, as is clear from the present crisis, is that depressions are the result of debt-deflation (Fisher) consequent upon Ponzi finance (Minsky). There are a number of factors that need to be fixed, including the shadow banking system. Warren Mosler offers some proposals for accomplishing this here.

    77. A dangerous assumption and one almost certainly to be proved wrong.If europe and asia are having labour shortages you won’t be able to import labour from them since to do so the US would have to compete on wages. Hence the most age-ing nations will export wage bargaining inflation to the US to some extent.

      scepticus, I would actually welcome an increase in the bargaining power of labor, which has been savaged politically by neoliberal policy. There are two possible results. The first is that productivity gains are more equitably shared, which they have not been for the pasts several decades. The other is, of course, inflation, which would likely have to met by progressive taxation, to which the US is no stranger, or draconian non-discretionary spending cuts. The top bracket here has been 90%, so there’s a lot of room for motion on the taxation side. Military spending is also bloated. I don’t see too much cutting in social programs coming, with memories of this still evolving debacle still fresh. But these are political decisions to be taken depending on conditions.

      However, I do think that there will be a lot immigration too. The demographics pretty clearly indicate this coming to the developed world. There’s going to have to be a lot of investment in training. The market has already been picking up on this dynamic.

    78. MMT’er Marshall Auerback talks about inflation growth in China (and impending collapse?) here.

      Here’s an inflationary test case in an otherwise seemingly deflationary world. What would MMT do?

    79. Steve Randy Waldman’s post, Can we handle the truth? brings up distribution/equity issues that must dealt with also. The idea that MMT is the “solution to all problems” is just not the case, in that it presumes, for example, a level playing field. That is just not the case now, and this needs to be fixed before an economic solution is possible.

      MMT is one of the tools that can contribute to a redesign of the system along line that advance but public and private purpose, which must be integrated in a money system that uses a single unit of account for government money and bank money, and the banking system is a public/private partnership. While the balance of public and private is a political decision, the design of a system that will work operationally is an economic one. The issues are pretty clear, but as SRW observes, they are not being addressed for a number of reasons, social, political, and “economic” (aka ideological).

      What MMT contributes is a reality-based view, correcting one based on ideology.

    80. Dear JKH and Ramanan

      I agree with this. Currency-issuing governments are never financially constrained (hence the title of this blog – Who is in charge? the government is always in charge). But they are always constrained by the available real resources. Unlike you and I, a currency-issuing government can purchase whatever is available (that is, real stuff) for sale which doesn’t mean it always should do that. The nuance in the discussion here is that sometimes it is even unwise to buy goods or services that are available in the market place if the purchase is at market prices. So the principle of running employment buffers, for example, is based on the idea that they can always buy the unwanted labour (which in that sense has a “zero” bid price – there is no demand for it) without adding price pressures because they are not competing with other buyers.

      In the case of the banks, I think to some extent you are talking past each other. JKH is correct in detail but I had thought Ramanan’s point was something like the “short-side” of the market rules. So even though the banks face the risk and capital constraints on their lending, when there is a dearth of borrowers coming to their doors these constraints are less the issue in explaining the lack of credit creation. But clearly if there is only one borrower approaching a bank for a loan (so some demand) yet the bank judges them to be an excessively-risky borrower then no credit will be given.

      As a real world experience, I have had discussions with one of the major 4 banks here last year who wanted to use our research on regional employment vulnerability (at a suburb by suburb level across the nation) – see some discussion of this work HERE – to improve their risk profiling. They actually have points systems in place (a penalty system) for suburbs where a person from that suburb immediately inherits the risk penalty irrespective of their personal circumstances. This is called statistical discrimination in social analysis. I declined to licence the work to them and make money at the someone else’s expense because it would have increased the penalties that the most disadvantaged workers faced accessing credit. I didn’t want to be part of that inequality-augmenting system.

      best wishes

    81. Tom

      I really like the Interfluidity blog. He was really my first connection to MMT because Winterspeak comments there sometimes and he linked to a post by Winterspeak a while ago called “Why Tax” which really tweaked my brain. I find him VERY thoughtful and sensible. I think he would make a great MMT advocate. I dont visit him as often any more since I’ve found Bill , Warren and the UMKC site but he is great.

      You are right. His latest post brings up many “elephant in the room” issues we have tried to paper over for years (like since we became upright and sentient).

    82. You are right. His latest post brings up many “elephant in the room” issues we have tried to paper over for years (like since we became upright and sentient).

      The challenge begins with the production of surplus by a theretofore subsistence society. Economics as such really begins at this point. The fantasy of economics growing out of a Robinson Crusoe or island tribe “barter economy” found in most texts is just that. Didn’t those economists read history?

      The production of surplus goods and services enabled the rise of specialists, whose technological contributions brought innovation and growth, and a military/governing class that imposed and maintained the political order necessary for stability. A money economy could arise in that environment to facilitate distribution. Since then, societies have been arguing about distribution effects, the workers claiming rightly that they provide the wherewithal for the specialists to subsist, and the specialists arguing that organization and order, and innovation and growth entitle them to a lion’s share of production.

      Economic history can be viewed from this perspective, with different societies and civilizations having produced quite different solutions, some more equitable than other, and some more successful than others.

    83. “The power of a made-up mind.” Unfortunately going in the wrong direction. :(

      I held out hope for him, too. Anyway, he hosted a couple of great debates, from which I learned a lot.

    84. Agree, Tom.

      BTW, JKH . . . marvelous job at Beckworth’s site. Hopefully some will read it and learn from it, even if the neoclassical “experts” didn’t. I may have to copy that off and require my students to read it as it’s probably a better discussion of how banks manage bank capital than can be found in any bank mgmt text. (Also BTW, LOVE the “so many smart people disagree with you that you must be wrong” comment–twice!–essentially an admission that he had no clue what you were talking about since he’d probably never actually seen an actual bank balance sheet throughout his entire graduate studies studying “monetary economics.”)

    85. Scott, I don’t know whether you saw it, it may have been on another thread, but someone asked Nick how mainstream economists got it so wrong. He said in effect, “We didn’t study finance.”

    86. While it is true that all of those bloggers save Waldman don’t understand reserve accounting, cb operations, and bank reserve operations, JKH and I were both misinterpreting the desired operations (by the designers of the proposal) of the “excess reserve tax” proposal for a bit. The basic proposal was to get banks to convert their ER into RR, not by lending (which would have been misapplication of the money multiplier model, which these bloggers do, but not necessarily in this proposal) but rather by buying assets over and over again at the micro level to create deposits and thus create additional reserve requirement, which from the macro level they recognized didn’t change total reserves, but rather the relative sizes of RR and ER).

      In the end of my post here ( I got as close as I have seen anyone regarding what would happen if the proposal was actually in place. This quote assumes a policy is in place in which there is an economically significant difference between a return to a bank set by the CB for holding ER (negative, or essentially a “tax”) vs. holding RR (perhaps positive):

      “Banks could in fact avoid the excess reserve tax and receive the interest payment on required reserves by making NO loans at all if they instead found ways to incentivize, entice, or even force customers currently holding non-reserveable liabilities (savings, CDs, money market accounts) to shift these to reserveable liabilities (deposits). In fact, rather than lending, this sort of reclassification of existing balances is probably the outcome of the excess reserve tax plus payment for required reserves.”

      “For instance, banks would probably cease all operations related to moving customer deposits into retail sweep accounts previously intended to avoid reserve requirements. This alone would reclassify about $600 billion or so in money market accounts as deposits and create somewhere around $50 billion in reserve requirements. As banks continued to “encourage” deposit accounts over non-reserveable accounts to reflect their own incentive to convert excess balances to required balances, still more balances could be reclassified.”

      “So again, like the currency tax, we just get a reclassification of existing balances . . . this time toward deposits rather than away from them as the currency tax would do [assuming the currency tax is applied to deposits, as Mankiw had proposed]. Also like the currency tax, then, we don’t get any more spending and we therefore don’t get more aggregate demand. In other words, just as my spending plans didn’t change as I moved away from deposits to avoid Buiter’s proposed tax on transaction balances in the previous post, my spending plans also don’t change as I move toward transaction balances to avoid banks’ newly imposed disincentives for holding savings-type of accounts resulting from the mix of excess reserve tax/reserve requirement incentive they are facing.”

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