Oh no … Bernanke is loose and those greenbacks are everywhere

My RSS feed and E-mails have brought some shockers in the last few days from the financial markets – official bulletins from banks that don’t make any sense at all (US about to default-type arguments); hysterical Austrian school logic (from a large player in the Asian markets) and news commentary from a so-called business insider magazine. The latter should immediately close its doors and declare they are not competent to comment on matters relating to banking. Coincidentally, I also received several E-mails in the last few days asking me to comment on the particular Austrian document noted above that has been circulating within financial markets recently. I deal with that later in the post. Anyway, apart from my main research and other writing activities this blog stuff is “all in a day’s work” – Friday March 19, 2010.

Bernanke about to kill the World

Yesterday (March 18, 2010) one Michael Snyder wrote in horror that – Bernanke Wants to Eliminate Reserve Requirements Completely.

He correctly notes that the US has maintained a “fractional reserve” banking system up until now although he doesn’t realise that this is just one of the many relics that remain from the gold standard/convertible currency era that ended in 1971. Everyone will catch up eventually.

You can read about the fractional reserve system from the Federal Point page maintained by the FRNY. For example, they say:

As of December 2006, the reserve requirement was 10% on transaction deposits, and there were zero reserves required for time deposits … The transactions-account reserve requirement is applied to deposits over a two-week period: a bank’s average reserves over the period ending every other Wednesday must equal the required percentage of its average deposits in the two-week period ending the Monday sixteen days earlier. Banks receive credit in one two-week period for small amounts of excess reserves they held in the previous period; similarly, a small deficiency in one period may be made up with excess reserves in the following period. Banks that fail to meet their reserve requirements can be subject to financial penalties.

So straight-forward but totally unnecessary.

Mainstream economics textbooks think that the fractional reserve requirements provide the capacity through which the private banks can create money. The whole myth about the money multiplier is embedded in this erroneous conceptualisation of banking operations. The FRNY educational material even perpetuates this myth. They say:

If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+…=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+…=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

This is clearer than Mankiw writes but just as wrong if it is trying to represent the way the banking system actually operates. And the FRNY knows it. If you read on they qualify to the point of rendering the last paragraph irrelevant.

After some minor technical points about which deposits count to the requirements, they say this:

Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.

Read: no role.

As we have discussed many times banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).

These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds as noted in the qualification above by the FRNY.

At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.

For further discussion on this, please read – Money multiplier and other myths .

Further, please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion on bank reserves.

That is all essential background for understanding the rest of the story.

So back to Snyder and his so-called expert banking commentary who is getting all hot under the collar about some testimony that the Federal Reserve Chairman Ben Bernanke gave to the US House of Representatives Committee on Financial Services on February 10, 2010. You can read the full text HERE.

Now if I wanted to be really mean I would conjecture that Snyder’s late reaction to this statement – more than a month has now passed and finally he is trying to beat up some story out of it as headline news – is because it challenges his capacity to understand even the most basic elements of the banking system. He might have been shifting restlessly wondering what it meant for the last 5 or so weeks and then read some Austrian school stuff or other equally vapid rhetoric and suddenly yesterday came to the conclusion that Bernanke wants to create “money out of thin air” and that “(i)t’s going to be a rough ride”.

Omigosh!

Here is what Bernanke said about eliminating the minimum reserve requirements currently in place in the US system.

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

End of civilisation is approaching.

Snyder, as if in a bad dream, posed what he must have construed to be a very deep question and the gave his response:

So is Bernanke actually proposing that banks should be allowed to have no reserves at all?

That simply does not make any sense. But it is right there in black and white on the Federal Reserve’s own website….

If there were no minimum reserve requirements, what kind of chaos would that lead to in our financial system? Not that we are operating with sound money now, but is the solution to have no restrictions at all? Of course not.

What in the world is Bernanke thinking?

Well Michael, Bernanke is finally showing that he might be starting to understand the monetary system that he has been in charge of (for too long). I might remind Michael that many countries no longer hang on to this gold standard relic. Australia, for example, abandoned reserve requirements years ago as it realised that in a non-convertible currency system they are totally unnecessary. Reserve accounts (called exchange settlement accounts over here) just cannot be in the red.

As an aside, the terminology used by the Australian system is much more meaningful in relation to the purpose of bank reserves – Exchange Settlement Accounts – that is, to faciliate smooth functioning of the payments system between banks. Bank reserves exist for no other reason.

Further, in the most recent crisis, Australian banks remained sound with zero bailouts (although helped by an Australian Government wholesale loan guarantee). There has been no chaos in the Canadian banking system which also has no requirements – indeed, the Canadian banking system is essentially sound unlike its counterparts across the border to the south.

What kind of chaos are you expecting Michael?

His article is a bit light on in that regard. He chooses to rehearse arguments made by Texas Republican Congressman Ron Paul who apparently “understands that creating money out of thin air is only going to create massive problems”. Paul tackled Bernanke at at the February 24, 2010 hearing of the House Financial Services Committee on “Monetary Policy and the State of the Economy” – the entire video is HERE.

The exchange was quite humorous in fact.

Anyway Snyder quotes the following Paul statement:

The Federal Reserve in collaboration with the giant banks has created the greatest financial crisis the world has ever seen. The foolish notion that unlimited amounts of money and credit created out of thin air can provide sustainable economic growth has delivered this crisis to us. Instead of economic growth and stable prices, (The Fed) has given us a system of government and finance that now threatens the world financial and political institutions. Pursuing the same policy of excessive spending, debt expansion and monetary inflation can only compound the problems that prevent the required corrections. Doubling the money supply didn’t work, quadrupling it won’t work either. Buying up the bad debt of privileged institutions and dumping worthless assets on the American people is morally wrong and economically futile.

What this statement has to do with eliminating the 10 per cent reserve requirements is beyond me and Snyder does not choose to explain. I guess he is still trying to catch up with the fact that this all went down 5 weeks ago.

Reflecting on Paul’s comments – I have some sympathy with them. The lax regulation of the monetary authorities in the US under Greenspan and then Bernanke was a major cause of the current crisis. This had nothing to do with having reserve requirements or not though.

It is also clear from the blogs I referred to above that expanding bank reserves does not expand the capacity of the banks to lend (create credit). It was always a foolish policy venture to think that quantitative easing would do anything other than stabilise the financial system. Japan proved that a decade ago.

But then I note that the US inflation rate yesterday moderated (that is, fell). So if Paul was correct we should be seeing rapid inflation by now. You will not in the foreseeable future see any inflation problems arising from the demand-side of the economy. Perhaps, those pesky OPEC oil barons will drive some supply-side price shocks into our economies but that will have nothing to do with budget deficits or the build-up of bank reserves.

At any rate, none of this has anything to do with the idea that minimum bank reserves (above zero) will cause chaos.

Snyder though finally says that the policy change would “give bankers power to make money up out of thin air” and be inflationary. Well commercial banks can already make create deposits by writing out loans – and they do this whether there is humidity in their office blocks or not (thin or thick air).

Japanese bankers can do it. They have had deflation for two decades.

Australian bankers can do it. No inflation problems here arising from this source of demand. And I could go on.

Snyder concludes that:

And things are only going to get worse. Especially if Bernanke gets his way and reserve requirements are eliminated entirely. The U.S. economy is a giant mess already, and we have got a guy at the controls who simply does not have a clue. It’s going to be a rough ride.

The only person who hasn’t got a clue is obvious here. The US economy is in a giant mess but the change in reserve requirements will have a zero impact on whether it gets worse or better.

The idea that you maintain financial stability by regulating the liabilities side of the banking system is erroneous. That is how monetary policy operated during the convertible currency days when central banks had to maintain a tight grip on monetary growth to ensure it was compatible with the need to defend the parity in the foreign exchange markets.

In a non-convertible currency system, there is no applicability at all to liability side management. All the regulation has to be put on the asset and capital side of the bank balance sheets, which is the current international approach – albeit poorly formulated.

Further, there is a case for general rules-based regulations – along the lines I noted yesterday. Reduce the capacity of the unproductive financial sector to grab real income by ensuring real wages grow in line with productivity (that is, increase the wage share) and then ban any speculative behaviour that is not connected with ensuring that the real economy is more stable (for example, forward markets that help manufacturers offload foreign currency exposure).

George Washington is dead and powerless

Another report I received yesterday was from the Hong Kong-based Jim Walker who calls himself Dr Jim presumably because he thinks that people will conclude – has Phd must know something. I have been in the academic game a fair while and I can assure you there is not even a strict correlation between those two things (all of my past students are completely excluded from that assessment (-:).

At any rate he is big in South East Asia.

His company puts out “member only” reports and the one I refer to now – sorry I cannot give you a link so you will have to trust me – was Issue 10/2010 published on March 2010 called ExposAsia – Tu ne cede malis sed contra audentior ito.

Which is a quote from the classic Roman poet Virgil and means from the Latin – Do not give in to evil but proceed ever more boldly against it. Profound!

Walker attended a conference last month in the US at the “birthplace of the Fed” at Jekyll Island in Georgia. The conference was organised by the Ludwig von Mises Institute (the foremost Austrian school institution) and consisted of 10 papers with around “2-300 like-minded individuals who value freedom, liberty and sound money” in attendance. Upstanding citizens all of them!

Walker devotes his financial briefing to his clients as a rapporteur of the conference. It is gruelling I can tell you – 11 pages of total tripe – and I suppose the only saving grace is that very few trees were sacrificed in its production given it is an electronic delivery.

I won’t go through it in detail but several people in the last few days who get the publication but are now reading my blog and getting more suspicious of the dogma coming from the Austrians wanted me to clarify a few things.

The paper has a section on “What do Austrians discuss when they get behind closed doors?” and while what they do is open to conjecture the section contained a rather parlous (amateurish) rehearsal of Kuhnian philosophy of science.

Here we learn that the pure Austrians who have never been listened to but are always right are about to tell us all “we told you so” as the dominant paradigm – wait for it – that evil “Keynesian-monetarist nexus on economics” finally collapses under the weight of the poverty of its ideas.

So this alleged degenerating paradigm the “Keynesian-monetarist nexus on economics” dominates at present and is characterised by the “insufficient aggregate demand approach”.

This was an eye-opener to me – I also have a Phd in economics and studied the evolution of Keynesian and Monetarist thinking in some detail. So the concept that a Keynesian-monetarist nexus on economics exists really had me thinking (-:.

This financial markets briefing from Dr Jim appears to be providing a major revision of the history of economic thought that has evaded scholars for all these years.

Say it out aloud – the “Keynesian-monetarist nexus on economics”. You soon learn reading this stuff on a daily basis (year-in and year-out) that misrepresentation is the key to the literary style practised by these commentators.

Any basic understanding of the macroeconomics literature would not define any nexus between the Keynesians and the Monetarists.

In my recent book with Joan Muysken – Full Employment abandoned we cover this paradigm shift in some detail. Specifically we show that Friedman’s work unambiguously aimed to build on the early research of Irving Fisher and was up against a new macroeconomic orthodoxy in the 1950 – Keynesian thinking.

By the 1920s, Irving Fisher was setting the groundwork for what became Monetarism some 42 years later. The work of Fisher was obscured by the rise of Keynesian macroeconomic orthodoxy. The Phillips curve, reflecting the adjustment of nominal magnitudes to real disequilibrium in the labour market, was a central expression of the confidence acquired by policy makers through eliminating the business cycle during the 1960s.

However, Friedman and others were working on the foundations of a resurgence of Neoclassical macroeconomics based on the Quantity Theory of Money during the 1950s and 1960s. The Monetarist reinterpretation of the trade-off between unemployment and inflation, which emphasised the role of expectations, revived the Classical (pre-Keynesian) notion of a natural unemployment rate (defined as equivalent to full employment). The devastating consequence was the rejection of a role for demand management policies to limit unemployment to its frictional component.

They recast the Phillips curve to be a relationship where mistakes in price expectations drove real shocks (via supply shifts) rather than the way the Keynesians constructed the relationship – real imbalances driving the inflation process (via demand shocks). The two approaches are not the slightest bit similar and constitute two separate paradigms (or philosophical enquiries) although one cannot cast it as a Kuhnian shift (see below).

The importance of this shift in macroeconomic thinking after the OPEC oil shocks to Monetarism was that it scorned aggregate demand intervention to maintain low unemployment. Any unemployment rate was optimal and the a reflection of voluntary, utility-maximising choices. The policy emphasis shift from full employment to full employability and the period of active labour market programs began in earnest.

The rise in acceptance of Monetarism and its New Classical counterpart was not based on an empirical rejection of the Keynesian orthodoxy, but in Alan Blinder’s words:

… was instead a triumph of a priori theorising over empiricism, of intellectual aesthetics over observation and, in some measure, of conservative ideology over liberalism. It was not, in a word, a Kuhnian scientific revolution.

However, the shift in the Phillips curve in the 1970s as the OECD economies began to fail was a strong empirical endorsement for the Natural Rate Hypothesis, despite the fact that the instability came from the supply side. Any Keynesian remedies proposed to reduce unemployment were met with derision from the bulk of the profession who had embraced the new theory and its policy implications. The natural rate hypothesis now became the basis for defining full employment, which then evolved to the concept of the NAIRU.

So how Dr Jim can create a nexus out of these developments is a mystery to me and would qualify him for the Nobel Prize in Economics.

But not to let some real analysis get in the way, Dr Jim chooses to quote from one of the papers at the Conference in Georgia he attended. Some character “summed up the insufficient aggregate demand approach and the Austrian objection to it as follows”:

Taking resources from one part of the economy and giving them to another part, doesn’t make us richer. Printing green pieces of paper with pictures of past Presidents on them, doesn’t make us richer either.

So you get the gist. This is the Austrian macroeconomics course 101. Apparently macroeconomics is about redistribution of resources and printing green pieces of paper (except over here in Australia we are more colourful with our currency designs – but we get the idea eh!).

Now I cannot comment on the “Keynesian-monetarist nexus” because I have never understood there to be one. But in a fiat currency system the principles are clear although governments do not always understand them or implement them to best advantage.

Several commentators (regularly) suggest I have a naive faith in governments. Please be informed that I think governments are highly flawed institutions that are prone to corruption and mistakes. But if you understand the way the monetary system operates then you also realise that they are the only show in town with the currency-sovereignty which they have to use to transact with the non-government sector.

Once you realise that then the progressive agenda has to be to spread that news as widely as possible to influence public debate and hopefully force a citizens’ take-over of the democratic process – “to keep the bastards honest” as a former Australian politician once said when he broke away from one of the major parties and launched his own party (read about him HERE).

Anyway, the logic of Modern Monetary Theory (MMT) is clear and it is a body of thought that implicates insufficient aggregate demand (spending) as the primary reason why national output and income falls and unemployment arises.

The other reference to “(t)aking resources from one part of the economy and giving them to another part” presumably is about taxation. Taxation is not designed to make anyone rich. Taxation is a flow that aims in the main to balance the public and private purchasing power. It has nothing to do with “funding” government spending but has everything to with limiting the purchasing power of the non-government sector to ensure aggregate demand growth is consistent with the real capacity of the economy to absorb it.

So to think that anyone thinks it is designed to make us richer misunderstands its purpose.

Other taxes deliberately aim to influence resource allocation by discouraging what society considers to be damaging behaviour (for example, smoking).

Redistributive policies within the non-government sector certainly improve the resource access of the recipients while reducing the resource access of those who pay the taxes. There is no robust empirical research literature to support the claim that taxation reduces work incentives. That is another myth that cannot be empirically supported. At the macroeconomic level there has been no discernible negative effect detected by countless studies. At the margin of the welfare system there is an issue of overlap when you have benefit-retrenchment at marginal tax rates of 100 per cent as you earn extra income. But that is a different matter altogether.

Having understood that, the second part of the claim can be put in a better context. From the MMT perspective the statement that “(p)rinting green pieces of paper with pictures of past Presidents on them, doesn’t make us richer either”, however folksy, has no relevance to the monetary system we live in. Governments do not spend by “printing money” – they credit bank accounts in the main.

Quantitative easing did not even involve any money being “printed”. It was just a swap of a bank reserve for some other asset. Net change in financial assets denominated in the currency of issue – zero! This is all covered in the blogs I referred to earlier.

But we know that they are referring to government spending so lets just take it at that level. There is another issue about whether we should be talking about economic growth (that is, growth in national income – a flow) or growth in wealth (a stock of financial and real assets). I will come back to that.

It is unambiguous that government spending directly boosts aggregate demand and as long as there is spare capacity in the system to produce extra goods and services – this spending should stimulate income growth. We can construct all sorts of examples where the government is so incompetent that it cannot actually go into a shop and order 10,000 shirts for the army or 1 million reams of paper for the education system or whatever.

But the reality is that government spending is going on every day and adding demand and boosting national income. You cannot deny that.

Clearly, if government spending drives nominal demand faster than the economy can produce then once inventories run out inflation emerges and no further real national income can be gained.

All this only tells us that the risk of too little government net spending (relative to the other sectoral balances) is rising unemployment and lost income opportunities and the risk of too much government net spending is inflation. MMT is clear on that.

Now, to understand how this might influence wealth creation we need to delve into those sectoral balances again. Dr Jim goes straight there.

Here is his version of what he calls “Keynesian/monetarist logic”:

The mainstream breaks down the economy into three macroeconomic ‘balances’: the private sector balance, the public sector balance and the external balance. It contends that, at any given point in time, the private sector in any economy will either be in surplus (saving more than it spends) or in deficit (spending more than it saves), so too will the public sector and so too will the external balance with the one condition being that the three balances MUST add up to zero.

Apart from the “Keynesian/monetarist logic” tag, the representation of the sectoral balances is fine although you will rarely find them in a modern mainstream macroeconomics textbook these days. You will also rarely find a mainstream macroeconomist even referring to them and often they will make statements which violate the accounting consistency that is required by the balances.

So statements like the government has to run a surplus so the private sector can save when a nation is running an external deficit is often heard but is just fundamentally impossible.

Dr Jim applies this framework to his (invented) “Keynesian/monetarist logic”:

… in a recession, the private sector will be moving from deficit to surplus (or from surplus to even greater surplus) ie, it is ‘hoarding’ or saving more. Therefore, there will occur a deficiency in aggregate demand to meet current supply. In order to stop the downturn, it is argued, the public sector must save less or spend more (and, in the best of all possible worlds, the external sector will contribute by moving, say, from deficit to surplus thus easing the burden on the public sector). But it is this fundamental distinction between the private and public purses that is at the heart of stimulus programmes around the world. It forms the rationale for all current government policy. In other words, Private sector balance + public sector balance + external balance = 0.

The last equation is true by definition as he points out. And by and large his representation would be consistent with a Keynesian position (and a MMT position) but not a monetarist position – but lets not get tied up by that. Governments at present have behaved in a fiscal sense according to this logic and in doing so they have saved the world from a depression.

The fact they have also been pursuing useless monetary policy interventions (quantitative easing) just tells you how fractured the policy making understanding is at present. Policy makers have been listening to the mainstream macroeconomists telling them that Keynesian use of fiscal policy was dangerous and ineffective anyway and the only aggregate policy tool to use was monetary policy and then only to target inflation rates. The alleged market processes would ensure “optimal growth” if inflation was stable.

That orthodoxy collapsed in this crisis and after toying with their monetary policy tools for too long early in the crisis – as it got worse they were forced to take a reality check and implement fiscal interventions.

So policy is a shambles at present – caught between paradigms. But having said that – the crisis has shown that fiscal policy rules. Get used to it!

Dr Jim though is not happy with this because he thinks it stops natural processes of capital destruction from occurring which are necessary to cleanse the system and realign the capital structure.

This is a popular argument that the Austrians use – that it is better to let a total meltdown occur – which destroys bad capital sure enough but also takes down good capital; impoverishes millions; interrupts the generational process of human capital augmentation and entrenches permanent disadvantage as a consequence; and reduces the future growth path because of well-documented asymmetries in physical capital formation.

Their religious belief that these processes are rapid so the costs are minimal is without empirical application. Even with significant government intervention a major cyclical event such as a recession takes years to work through. The Austrians, however, never commit to a time profile for this adjustment.

At least the Monetarist, Milton Friedman did finally disclose some temporal forecasts. He was famously asked to actually put a time frame on his recommended disinflation processes to expunge inflationary expectations. He said that unemployment would have be very well above the alleged “natural rate” for around 15 years – and he didn’t even blink an eyelid when he delivered this wisdom.

The other point is that government intervention does not have to “save” high cost capital. That should be allowed to die and the growth cycle should start with a younger vintage of capital and renewed productivity growth. I agree with the Austrians on that need. But attenuating demand shocks will not save the marginal capitalists anyway.

Anyway, Dr Jim thinks that the idea of supporting aggregate demand when there is a major collapse in private spending is “rubbish”.

The whole point is that, while definitionally neat, there is no difference between the private and the public sectors. For the public sector to increase its spending it must take the money from the private sector (it could borrow from abroad but that just acts to reduce spending there). This is because, when all is said and done, governments have no money of their own. They do not create wealth in the way that the private sector does but merely live off the fruits of private sector labour.

So you can imagine that I just sank back in my chair at this stage, eyes glazing over … I was still trying to get to grips with Dr Jim’s Nobel Prize winning “Keynesian/monetarist nexus” and then I get confronted with the notion that a fiat currency-issuing government is just like the private sector and has “no money of their own”.

Will someone write to the University that awarded him his Phd in economics and raise questions about their academic standards please?

First of all Dr Jim has clearly not learned anything in his macroeconomics courses at university and better start at the beginning – Deficit spending 101 – Part 1Deficit spending 101 – Part 2Deficit spending 101 – Part 3.

First, the private sector has no currency until the government issues it. The private sector cannot pay its tax obligations until the government spends the currency. The government doesn’t spend by taking anything off the non-government sector.

Second, the government only borrows the funds that it has previously spent – irrespective of whether domestic institutions/residents or foreigners purchase the debt. In a fully stock-flow consistent macroeconomics that has to be the case.

Third, it is true that a “government” has no intrinsic labour power. Taxation, in part, functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

The orthodox conception is that taxation provides revenue to the government which it requires in order to spend. In fact, the reverse is the truth. Government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. It follows that the imposition of the taxation liability creates a demand for the government currency in the non-government sector which allows the government to pursue its economic and social policy program.

This insight allows us to see another dimension of taxation which is lost in orthodox analysis. Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the non-government sector. The unemployed or idle non-government resources can then be utilised through demand injections via government spending which amounts to a transfer of real goods and services from the non-government to the government sector.

In turn, this transfer facilitates the government’s socio-economics program. While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities. Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue. Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes.

So it is now possible to see why mass unemployment arises. It is the introduction of State Money (which we define as government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment.

Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages). Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account through the offer of labour but doesn’t desire to spend all it earns, other things equal.

As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

Now we can extend that to wealth creation which takes us back to the sectoral balances. If the non-government desires to spend less than it earns and there is an external deficit (common in most countries), then unless the government balance is in deficit, national income will fall and the saving desires of the private domestic sector will be thwarted.

So the stock implications of the net public spending flow is that it provides support for the income flow such that the non-government sector can net save in the currency of issue and accumulate wealth in the form of financial assets. The private sector can convert their financial wealth into real wealth in addition to this.

With a consolidated private sector including the foreign sector, total private savings has to equal private investment plus the government budget deficit. In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. In a closed economy, NX = 0 and government deficits translate dollar-for-dollar into private domestic surpluses (savings).

In an open economy, if we disaggregate the non-government sector into the private and foreign sectors, then total private savings is equal to private investment, the government budget deficit, and net exports, as net exports represent the net financial asset savings of non-residents.

Please read my blog – Stock-flow consistent macro models – for more discussion on this point.

But by this stage Dr Jim is on a high and just cannot restrain himself:

In short, the private-public-external balance argument is a fraud. There are only two relevant balances, domestic and external. In a gold standard system a persistent deficit in the latter brings about fast adjustment in the former through reduced money supply (gold has to be exported to the surplus country) and deflation of domestic demand. Unfortunately, in our fiat money system imbalances can be sustained for much longer – meaning that capital structures can become misallocated for much longer too – because of the inflation process that masks the deficiencies in real funding for capital projects or real demand for consumers goods. Once these deficiencies become apparent though, the process of correction (the bust) begins. Throwing more good money after bad in an effort to artificially raise demand regardless of consumer preferences merely prolongs the process of adjustment and probably makes it worse.

So there you have it – he wants to return to the gold standard and have America ship all its gold to China and impoverish Americans with continual unemployment and wage deflation.

You also realise this stuff just comes from the heart when you read that “the inflation process that masks the deficiencies” in real spending. Which inflation process pray tell? Japan has had significant public deficit support for aggregate demand for two decades (bar a short period where they went crazily neo-liberal) and they have had no inflation – the opposite in fact.

At present the World is experiencing significant swings towards public deficits and no inflation.

What the fiscal interventions are helping to do is maintain enough demand so that “good” capital doesn’t go down the drain with the “bad”. A global depression that would have lasted at least a decade without the policy interventions would have destroyed massive volumes of private wealth (both real and nominal) and many people would never have recovered – not just the wealth but the lost skills and educations etc.

The evidence is very strongly in favour of the view that interventions reduce these costs and get economies moving again so that new investment in best practice technologies can occur and drive out the old unproductive capital. The damage to the skill composition of the labour force is also less the shorter and more moderate the downturn is.

Further, while Dr Jim claims it slows down the private deleveraging process the contrary is true. As long as the distortions in the credit markets (lax credit policies etc) are regulated away, the income growth from the fiscal support allows heavily-indebted households etc the room to increase saving and reduce their debt exposure while retaining employment.

The Austrian solution would replace this process with mass bankruptcy and life-long suffering (damaged credit ratings, forced foreclosures, loss of life savings etc).

Dr Jim closes by telling all his supporters to Buy Gold. So you gold bugs out there get all the cash you can assemble and buy some of the sweet ore and put it under your bed or hire a private militia to guard it for you – although you will have to persuade them to take gold coins because you won’t have any cash left – it will be worthless anyway before long. And for god sakes … feel good about yourselves – after all you are all for “freedom, liberty and sound money” … except you haven’t got any money left because you bought the gold.

Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for more discussion on this point.

Conclusion

The weekend is coming! Its been a fun few hours this afternoon … not! But I hope I cleared up all your queries.

Saturday Quiz

Will be back sometime tomorrow – sharpen your pencils and wits.

Answers and analysis sometime Sunday.

That is enough for today!

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    77 Responses to Oh no … Bernanke is loose and those greenbacks are everywhere

    1. Bill gives us a stimulating read, as usual. My only disagreement is with the standard MMT idea that it is tax that gives money its value. Obviously tax bolsters the state’s money; but I don’t think tax is an absolutely essential prop.

      Suppose government spending as a proportion of GDP dramatically shrinks because the health and education systems are privatised. Plus Worldwide peace breaks out, so the armed services are no longer required. At what point would people suddenly lose faith in money: when government spending is 5% of GDP…3%…1%???

      It strikes me that as long as the currency was administered competently, people and firms would still very much value the currency so as to enable them to buy, sell and generally do business.

      The really valuable aspect of state money is that only the state can create and spend extra money, and thus expand private sector net financial assets, so as to deal with a recession; or (the opposite), raise taxes and extinguish money in an inflationary boom.

    2. Andrew says:

      Hi Professor Mitchell,

      I have an issue that I still cannot understand.

      When the US federal reserve buys back a Treasury bond from the private market in its day to day operations to control the interest rate, this bond then goes onto the Fed’s balance sheet as an asset.

      But what happens when the bond matures?

      Is taxpayer money paid by the Treasury to the Fed to pay back the principal (to the Fed)?

      Or is the bond effectively paid back when it was bought by the Fed from the private market?

      Regards,
      Andrew

    3. ParadigmShift says:

      Andrew, what I gather happens is that the bond is either rolled over (which I understand is the only occasion that the Fed is permitted to buy debt directly from the Treasury), or, if the bond is allowed to mature without replacement, then the Treasury balance at the Fed (a Fed liability) would drop by the amount of the bond principal, and the maturing treasury debt would vanish from the asset side of the Fed’s balance sheet.

    4. Sergei says:

      Andrew, and to add what ParadigmShift has said, any profit that FED made in the meantime, e.g. coupon payments, will go to Treasury as part of the annual process

    5. Ramanan says:

      Yes PS . . . that is also my understanding . . . except that at maturity, there is also a coupon payment complication ;-)

      This talk by Brian Sack of NY Fed – Preparing for a Smooth (Eventual) Exit is nice.

      Somewhere in the middle, he says

      These considerations leave open a range of outcomes for how the two instruments will be used. In his February 10 testimony, Chairman Bernanke described a possible approach for managing the size of the balance sheet. In particular, he indicated that he does not currently anticipate that the Fed will sell any of its asset holdings until the economic recovery is more firmly established and policy tightening has gotten underway. Until that time, the portfolio would shrink only through asset redemptions. Chairman Bernanke noted that the Fed’s holdings of agency debt and MBS are being allowed to roll off the balance sheet, without reinvestment, as those securities mature or are prepaid, and that the FOMC may choose to redeem some of its holdings of Treasury securities in the future, as well.

      This thing is also related to the Treasury’s Supplementary Financing Program and the recent changes.

      Here Credit Easing Policy Tools, you can see the Fed’s holding of Treasuries, redemption and further purchases of Treasuries as a part of the Large Scale Asset Purchases program – at a later date

    6. joebhed says:

      Bill,

      I have to ask you directly to address this matter of monetary sovereignty that is one of the foundation issues of MMT.
      Recognizing, in theory, that it is a nation’s ability to issue its ‘currency’ that provides all the cohesion to a system where money works for the people(ELR, etc.), and not the other way around, I don’t understand how you square that essential fact with the present (from Bretton Woods forward) global network of private central bank money creation, such that step 1 of MMT reform must be to restore monetary sovereignty to national governments.

      This is the MAJOR of what I see as your description of the ‘self-imposed’ restraints that ‘floating-rate, fiat-currency’ sovereign money systems have today. While societally-speaking, this may be considered a self-imposed restraint, in my way of thinking, the legal and political reality is that there can be no move to the benefits of an MMT-inspired monetary system without abolishing these private money-creation powers, and replacing them with the un-restrained powers of actual sovereign money creation. And at that point, the question of whether it is self-imposed or imposed by the global money will have to determined. Who was it said, the issue that has come down the ages and will have to be ultimately decided, is that of the people versus the bankers.

      To me this is more of the fundamental issue than understanding the stock-flow equations among the economic sectors. Whose money system is it, anyway?
      Thanks.

    7. pebird says:

      “The idea that you maintain financial stability by regulating the liabilities side of the banking system is erroneous”

      Bill, beautiful statement.

    8. Captain Teeb says:

      “So there you have it – he wants to return to the gold standard and have America ship all its gold to China and impoverish Americans with continual unemployment and wage deflation.”

      Um, isn’t the unemployment and wage deflation exactly what happened under our current (non-gold) standard? I think the guy’s point, here willfully mis-read, is that a series of short, sharp shocks is preferable to infrequent, catastrophic shocks. Under a commodity standard, the US and China would never have gotten this far out of balance.

      I suppose that the ‘nexus’ might be seen as a shared belief, to paraphrase Friedman, that ‘inflation is always and everywhere a good thing’, provided it’s not done too quickly, and that central banking is the best of all possible worlds, it being a miracle that economies ever developed without it.

      As for Japan, the causes of its problems are more subtle than this author cares to acknowledge. For a vastly more insightful take, try Andy Xie:

      http://english.caing.com/2010-03-15/100126807.html

    9. Tom Hickey says:

      Another great post, Bill. This will be come one of the classics.

      To amplify on joebhed’s question: the privately created money supply is dominant in quantity, and MMT admits that the government is not in a position to control it effectively. That is to say, in deflationary times, the government cannot force banks to lend and during inflationary times, it cannot forces them to stop lending either, even when credit standards are inordinately lax.

      It seems that the only thing that government can do is use fiscal policy to mitigate the effect of the banks under-lending in deflationary times and over-lending in inflationary times, effectively handing control of the system to the whims of the private financial sector and cleaning up after them. For such reasons, various proposals are being advanced to abolish private money creation and shift entirely to state money and using state money to advance public purpose, while eliminating the inefficiencies of the middlemen (“financial intermediaries”), whose objectives tend often toward rent extraction rather than productive contribution.

      This is gaining momentum in the US right now,.e.g., with the proposal of the American Monetary Act. What would MMT have to say about this?

    10. Winslow R. says:

      joebhed “Whose money system is it, anyway?”

      Nick Rowe at “worthwhile Canadian initiative” made it clear to me the money system in Canada (as in Australia?) belongs to the Queen through a crown corporation.

      Those south of the Canadian border have the ‘illusion’ that it belongs to the people. Clinton, Summers, Rubin made it clear that deficit spending (fiscal policy) was to ‘rightly’ be replaced by bank created money. Americans may not have a queen but we do have a powerful amorphous elite, which now appears near impossible to change. Bankers know they are part of that elite when they receive direct or indirect government bailouts on the bad money they created.

      Not every banker has access.
      http://www.calculatedriskblog.com/2010/03/unofficial-problem-bank-list-at-641.html

    11. Tom Hickey says:

      Or is the bond effectively paid back when it was bought by the Fed from the private market?

      Andrew, perhaps your difficulty lies in thinking of government as similar to nongovernment. It isn’t a matter of paying back debt in the ordinary sense of extinguishing a private loan. When the Fed buys a bond on the market, it takes the bond on its balance sheet as an asset and credits the reserve account of the seller’s bank, a Fed liability. Then the bank marks up the seller’s deposit account by that amount. The seller has exchanged a relatively illiquid asset for a liquid one. As the Fed is concerned, this is just the shift of one asset form for another in the interbank market, i.e., reserves for bond. This is how the Fed operates. It just switches assets and liabilities around to influence nongovernment liquidity. Liquidity is like oil for a machine. It reduces friction. By buying bonds it increases liquidity and vice versa. When the financial system freezes up, like it did recently due to lack of inter-bank trust, the Fed has to step up and increase liquidity through purchases, lending, and guarantees in order to prevent a real breakdown of the economy. (It also gaves banks favorable treatment to remain solvent and help them rebuild capital.)

      Say the Fed had bought a corporate bond and held it to maturity, e.g., like Fannie and Freddie paper if they were private corps. Then at maturity, the corp would owe the Fed money and it’s reserve account would reflect the payment. This would have an impact on the financial state of nongovernment because some assets would be transferred from nongovernment to government.

      But if the Fed buys a government security and it matures, then there is no actual payment made that affects nongovernment. It is just a markup of accounts within the government accounting system, because the Fed has already paid into nongovernment for the bond.

      Similarly, when the Fed buys a bond, the interest is removed from nongovernment. Government does not “get the money” because government neither has nor doesn’t have money. Thinking of government and nongovernment in the same terms is adding apples and oranges. Because the same accounting terms are used, this confusion often arises. But all these apparent transfers ares just reflected on the government books that show the state of the budgetary balance and national debt. The budget balance and national debt only have significance for the economy in terms of their implications for nongovernment net financial assets. The government doesn’t become richer or poorer through it, because it is currency issuer and therefore doesn’t have or not have money. It creates nongovernment net financial assets by spending and withdraws them by taxing.

      There is a further consideration, however. The Fed has bought some dodgy stuff to get it off the bank’s books. This also has solvency implications. The Fed likely intends to hold the worst stuff to maturity and take the hit instead of letting the banks do it. This affects the government’s balance sheet but it doesn’t make the government poorer as it would a bank. The justification is that a lot of this Fannie and Freddie paper, and the government now effectively owns Fannie and Freddie, so it’s no big deal to eat their losses since it’s only intragovernmental.

    12. Tom Hickey says:

      “Then at maturity, the corp would owe the Fed money and it’s reserve account would reflect the payment” should read “Then at maturity, the corp would owe the Fed money and it’s bank’s reserve account would reflect the payment.” Sorry for any confusion. Only banks have reserve accounts.

    13. CrisisMaven says:

      “he wants to return to the gold standard and have America ship all its gold to China and impoverish Americans ” – Look, that’s a bit overblown – if you’d return to a gold standard NOW then of course you wouldn’t have enough of the stuff to satisfy your debt. Recipe: don’t get a nation into thatm mess (“the mess that Greenspan made” – actually Nixon, actually Roosevelt to be precise). This “fear of deflation” is just a ruse by central banks to keep inflating the money supply. Deflation does not keep people from spending – they always spend what’s necessary. And money NOT “spent” is then saved which means it is credit to someone who invests it for capital goods etc. thus it is again being spent, only not for consumption. Money never lies completely idle to any extent whether there’s inflation, deflation, stability or a solar eclipse. For deflation to seriously happen, not only the current extreme credit expansion by the central banks and states (through “quantitative easing”, stimulus packages, monetising and then spending national debt etc.) but also the money that was released into the economy PRIOR to the collapse would have to be “mopped up” again. This is nowhere to be seen nor would it be technically possible (confiscation aside) so we will rather see inflation than deflation.

    14. /L says:

      This “fear of deflation” is just a ruse by central banks to keep inflating the money supply. Deflation does not keep people from spending – they always spend what’s necessary.

      But the serious problem with deflation is that it will hamper investment. Lets say the farmer that use credit to invest in a crop. He borrowed money in a situation where price per unite crop is for example 100, this price reflects the cost of production with let’s say a 5% profit margin. He borrows and has costs of 95 but when the harvest is in there has been deflation and market price per unit crop is only 90 and he have cost and credit to pay that amounts to 95. A recipe for bankruptcy. Over simplified but as I understand it that’s the problem.

    15. Greg says:

      Crisis Maven

      What have you been smoking? Deflation doesnt keep people from spending? If it leads to unemployment, which it universally DOES, it leads to people to not spend, because they have no income.

      The problem with the “liquidation” option is that not only the people who invested poorly get screwed. It wouldnt be so bad if only the capitalist that malinvested took the brunt of it but no, people who just want a job to support a family get screwed out of an income and still have debts to pay.

      Deflation is way worse for the average guy than inflation, especially if you are indebted. Sure those with no debt love deflation ( pick up lots of stuff at fire sale prices!!)but that is about 5% of the population that the rest of us are in debt to.

    16. Min says:

      /L: “Lets say the farmer that use credit to invest in a crop. He borrowed money in a situation where price per unite crop is for example 100, this price reflects the cost of production with let’s say a 5% profit margin. He borrows and has costs of 95 but when the harvest is in there has been deflation and market price per unit crop is only 90 and he have cost and credit to pay that amounts to 95. A recipe for bankruptcy.”

      That kind of thing happened over and over again in the U. S. during the Long Depression of the late 19th century. Some people do not call it a depression, but it was a period of persistent deflation. Many farmers went bankrupt, and when farmers organized to try to get better terms from the banks, the banks refused to lend to them. The Grange and Populist movements in the U. S. grew out of such experiences.

    17. /L says:

      Min,
      That kind of thing happened over and over again in the U. S. …

      Yes it’s reading about the American farmers where i learned about it, populist movement wanted US to get of the gold standard and use silver. Ill guess Keynes description of real investment and financial investment apply, the financial investor can any time leave the farming biz if the prospects start to get dim and in the afternoon be in the steel production biz. The farmer is trapped with his investment. To make our economy primarily suited for financial investments is a road to disaster.

      But who cares about the economy today? Every day, media is filled with news and analysis of what pretend to be about the economy. But there is no discussion of the economy, only of the finances. Short- and long-term interest rates, budget deficits, equity quotes and whatnot are discussed, but not the economy.

    18. ED says:

      Hi Bill,

      I have found the MMT and your writings on it very informative and attractive. From a flow perspective they make complete sense. From the stock perspective this is where I get somewhat confused.

      For example, what does a deficit (long-term not annual deficit, ie stock) of the public sector mean (other than the fact that the sum of the external sector and the private sector is positive). What are the consequences? What if it is high relative to GDP? Does that mean that previous spending did not have a suitably positive long term effect on the supply and demand curves?

      MMT talks to the stock of money (I assume that is M3), does it have any reflections on assets and asset values? What does it say about asset values? For example, lets say that we hit another crisis and they triple the the FHOG, this will increase peoples assumed asset values by stoking demand in the housing sector, which will then feed through to general demand (partly in the building sector and depending on how it is structured). However, if we assume it is mostly for existing housing stock, does this lead to any meaningful change in the supply and demand curves towards future prosperity? Has it changed our productive capacity?

      This may all be a question about how government allocates resources in that deficit spending. If it does not change supply and demand for the long term in a positive way is it wasteful (other than some of the flow on effects you discuss such as loss of skills of unemployed, social costs etc)? I whole hartedly agree with your comments that we should be spending big time on education, not just building bs classrooms (construction spending dressed as education spending).

      So in summary, can you touch a little further on the stock side rather than flow side of things, because MMT can also construe that the public sector has a BOTTOMLESS WALLET and as such “HOW IT SPENDS IS IRRELEVANT SO LONG AS IT SPENDS”

      Cheers
      Ed

    19. Fed Up says:

      “The transactions-account reserve requirement is applied to deposits over a two-week period: a bank’s average reserves over the period ending every other Wednesday must equal the required percentage of its average deposits in the two-week period ending the Monday sixteen days earlier. Banks receive credit in one two-week period for small amounts of excess reserves they held in the previous period; similarly, a small deficiency in one period may be made up with excess reserves in the following period. Banks that fail to meet their reserve requirements can be subject to financial penalties.”

      It seems to me that cheating is part of the problem.

      If a “bank” is short of reserves but the fed believes it is producing debt to prevent price deflation, will the fed “look the other way”?

    20. Fed Up says:

      “If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit.”

      To best explain this, I believe you need to clearly define “lend out”?

    21. Fed Up says:

      “As we have discussed many times banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).”

      What about collateral standards? Specifically, since housing prices “never go down a lot”, credit-worthy customers don’t matter as long as the house can be sold or another loan obtained against it.

    22. Fed Up says:

      “The lax regulation of the monetary authorities in the US under Greenspan and then Bernanke was a major cause of the current crisis.”

      It seems to me the cause of the current crisis was too much debt with lax regulation being one element for too much debt. Which brings me to …

      What is the point of low reserve requirements, low interest rates, low capital requirements, lax regulation, negative real earnings growth on the lower and middle class, and a price inflationary attitude (maybe others)?

      How about to debt enslave the lower and middle class to the rich and the bankers so the lower and middle class can never retire while the other group can retire at about anytime but won’t?

    23. Fed Up says:

      “It is also clear from the blogs I referred to above that expanding bank reserves does not expand the capacity of the banks to lend (create credit).”

      But do they “preserve” capital?

    24. Fed Up says:

      “Further, there is a case for general rules-based regulations – along the lines I noted yesterday. Reduce the capacity of the unproductive financial sector to grab real income by ensuring real wages grow in line with productivity (that is, increase the wage share) and then ban any speculative behaviour that is not connected with ensuring that the real economy is more stable (for example, forward markets that help manufacturers offload foreign currency exposure).”

      So does that mean tighten up the labor market (reversing the policies of the 1980’s)?

      How about getting interest rates up to near or above the expected rate of return of the financial asset? For example, if goldman has to borrow at 8% and the return on the financial asset is 8%, they won’t get much of a return.

    25. Fed Up says:

      “Quantitative easing did not even involve any money being “printed”. It was just a swap of a bank reserve for some other asset. Net change in financial assets denominated in the currency of issue – zero! This is all covered in the blogs I referred to earlier.”

      I suppose it depends on how “money” and “printed” are defined. IMO and since the gov’t the way it is now won’t let the fed fail, I believe that central bank reserves are overnight, gov’t debt in disguise.

    26. Fed Up says:

      “In an open economy, if we disaggregate the non-government sector into the private and foreign sectors, then total private savings is equal to private investment, the government budget deficit, and net exports, as net exports represent the net financial asset savings of non-residents.”

      What will it take to get people to disaggregate the non-government sector [actually the non-currency printing entity(ies)] into the private rich, the private lower and middle class, and the foreign sector? The foreign sector might need to be broken down also.

    27. joebhed says:

      To Tom @3:04

      “That is to say, in deflationary times, the government cannot force banks to lend and during inflationary times, it cannot forces them to stop lending either, even when credit standards are inordinately lax.”

      One of the reasons why monetary policy under direct control of the government is superior to the present systemn of the central bankers(public or private) using excess reserves for pushing on the money rope is because it solves for this problem.

      We want to agree that one purpose of a sound monetary system is to respect overall price stability, while maintainig as close to full-employment as is feasible. To me, by definition, that means a reversal of the pro-cyclicality that is endemic with fractional-reserve banking as Tom describes it here. I can’t think of a greater truism of monetary system “operations” as the MMTers enjoy describing it, than the Robert Hemphill quote regarding the need for a “permanent” money system.

      As a result, to me again, the necessary reforms must include the elimination of the dependence for our economic prosperity on the willingness of any banker to make any loan to anybody. Let that choice be made by the banker and his/her depositor to be whether investment is made in this or that sector of the economy, NOT to have the existence of any prosperity be dependent on the decision being made, or not being made.

      Having public money-creation on a debt-free basis removes the requirement for future “growth” of the money supply only for the purpose of making the interest payments on the money already in existence. Instead the sum of the debts in existence will be at a much-reduced level, made by private banker-depositors for the additional public purpose of moving the already existing and adequate quantity of money to its most economically-optimal location and use.

      And we can only move in the direction of this solution by recognizing the sovereignty of our money systems.

      To Winslow R – I know what Rubin, Clinton, Summers and the bankers think. And I know they are acting as if they do “own” the money system. But if you reverse the Congressional mindset that we need to save the banking system in order to save the country, you have in your hand the same pen with which they stole the right of the people to issue our own money in 1913. And we would save true free-enterprise at the same time.
      Only the Congress shall have the power to create the nation’s money, plain and simple.

    28. Tom Hickey says:

      One of the reasons why monetary policy under direct control of the government is superior to the present systemn of the central bankers(public or private) using excess reserves for pushing on the money rope is because it solves for this problem.

      joehbed, I’m afraid that is a gratuitous claim. This is hotly contested. Opponent assert that government is more easily corrupted than business, for example, and also that politicians make bad bankers. There is also the neo-liberal claim of the superiority of markets in dealing with complex information. These objections cannot just be brushed off. The people that are most in the know about the GFC attribute it not only to the financial system but also to the people in government charged with oversight. Moreover, now Congress is not doing anything material about it. So I am not sure that government is the obvious solution by any means.

      It doesn’t strike me that monopoly public banking is necessarily the panacea. There are advantages and disadvantages to everything. As an old Oriental proverb sagely observes, “The bigger the front, the bigger the back.” There are unintended consequences to everything involving any degree of complexity, and when human frailty is involved the picture darkens considerably. Why couldn’t public banking be hijacked by a corrupt process, as many fear it would? To many this looks simply like a switch from crony capitalism to crony socialism.

      That’s why I’d like to see a separate investigation of this from the vantage of MMT, with a good debate. Maybe Bill will do a post on it sometime. :)

      BTW, Ellen Brown has summarized some of the forward motion on state banking here. Looks like it’s getting some legs.

    29. nah says:

      i dont think the world is going to end soon… but as i see it banks have no insentive to borrow from the people already… banks and funds just slop up the messes they infact create and destroy the same currency they esentially controll… as they and their familys enjoy the fruits of our labor
      .
      personally banks have a massive government entitlement that didnt exist ‘in the open’ 4yrs ago
      .
      banks have proven they are driven to exploit their access to credit to the detriment of industry and proper acounting so that record bonuses and bank shares can outrun the rest on wall street mergers and all
      .
      i guess what im saying is that in a perfect world where noone goes to prison a strong argument for even easier credit standards modeled by the banks themselves to facilitate economic growth and rational consumption mite be valid
      .
      but thats why we have a markets and rules… because in this world people do go to prison and the bankers are mega crooks who are destroying capitolism by fudging the rules into a mega state of hidden truths
      .
      we need a free honest fair society with a good work ethic THAT is power… like i said we could change the rules when we get there

    30. Tom Hickey says:

      Let me clarify what I see as the problem in finance relative to economics and policy. Finance supposedly exists primarily to intermediate between savers and investors. Investors obtain the use of savers’ funds at a rate commensurate with risk/reward, and the intermediaries receive a fee for brokering the deal. The presumption is that investment will increase the capital invested, both providing the wherewithal to service the debt and also increase the investors’ net worth. The primary purpose of finance is capital investment, and the assets that are expected to increase are either financial or real. If the assets are real, then the investment is considered productive. Otherwise not.

      However, in the contemporary economy a great deal of financial intermediation involves credit extension through consumer lending. Consumer debt draws demand forward by spending future income in the present. This is indirectly productive by increasing present nominal aggregate demand based on the expectation of future growth from this stimulus, due to increased investment, hence, increased income.

      All well and good until the business and financial cycles are introduced. What happens is that irrational exuberance sets in. Credit standards are relaxed, consumers overspend relative to income and equity, and investment turns from productive (real) to speculative (financial). Owing to the latter, supply growth doesn’t keep pace with increasing demand, and inflation flares. So, while this kind of inflation is chiefly a demand problem, supply is also involved. If growth in production was sufficient to absorb increased demand, inflation would not occur, providing that resources were in sufficient supply to sustain the pace of growth without price increases on that front. As a practical matter, petroleum-based energy seems to be the upper bound presently. The availability of skilled labor is also a constraint, as are any other resources that cannot be quickly brought on line as required.

      This cycle creates both speculative bubbles and a flight from money to goods as investors become speculators and consumers spend in the present to avoid future declines in purchasing power. This is unsustainable for consumers, and eventually consumers are tapped out and speculative bubbles burst. Boom turns to bust.

      Credit tightens, consumers retrench, and businesses cut back, resulting in an output gap, rising unemployment, and recession. Automatic stabilizers kick in and budget deficits increase as tax revenue falls and safety net payments mount.

      What this means from the macro vantage is that at peaks speculative excess substitutes for productive investment, stifling growth, and at troughs automatic stabilization consumes public funds that could have been used more productively for public investment. In short, both public and private investment are adversely affected by these cycles, resulting in economic inefficiency (output relative to cost) and ineffectiveness with respect to national prosperity and general welfare as production suffers from investment that was diverted into less productive use.

      The notion that markets are self-correcting and economies self-organizing does not seem to be the case given the history. Since these cycles continue to occur, is this a natural occurrence? Or can it be improved upon, e.g., by changing incentives.

      Is there an optimal solution to this problem? If not, what are the promising heuristic solutions, and what are the criteria for deciding which of them is most promising? What does MMT have to say about a better way to avoid the consequences of the business and financial cycles?

      I am abstracting from sustainability here, although it is admittedly one of the incentives that needs to be promoted relative to investment, both public and private, if not the chief incentive.

    31. flow5 says:

      Legal reserves are a credit control device. The money supply is not self-regulating. The only policy tool at the disposal of the Reserve Authorities thru which the volume money and the rate-of-change in monetary flows can be controlled in a free capitalistic society is via legal reserves. The money supply can never be managed by any attempt to control the cost of credit. The high point for reserve ratios in the US, (the weighed arithmetic average of reserve ratios applicable to deposit liabilities), stood at 91.1 in May 1941.

      Main street economists acknowledge that reserve requirements are no longer binding. Increasing amounts of vault cash (including ATM networks) plus retail deposit sweep programs have wiped aside such binding requirements. The member banks are currently unencumbered and unimpaired in their commercial bank lending operations (with the exception of bank capital adequacy ratios).

      The euro-dollar market functions with prudential reserves. These prudential reserves are liquid balances in the U.S., or any other major currency country. All prudential reserve banking systems have heretofore “come a cropper”.

    32. Lucky Punch says:

      Tom and ors,
      an optimal solution for this complex problem is a long way off. I have thought about it at the micro level of a worker.
      At a practical level I have observed my employees over 20 years. If wages go up relative to goods inflation a worker spends more on goods creating growing demand. If goods go up relative to wages they spend less on goods for a time, then demand more wages as the cost of basic living gets difficult. Where we are in the cycle determins the results. If the business has pricing power due to good demand the worker gets the increase. If not the worker does not get the increase and demand falls. Basic results based on where we are in the cycle. (apologies for simplification but I hope you get the gist) In my view it should be the Gov job to regulate the highs and lows perhaps using MMT so that the worker and hence the business has certainty within a tolerable variable range.
      Any Gov system is unlikly to work if a worker has to provide for their own retirment. Workers are using small amounts of excess wages right now to gear up investments with massive borrowing on the basis that real estate never goes down ( who could blame someone for thinking it never goes down when it has not gone backwards for nearly 20 years. Average Joe beleives the banks would not lend to him if it was risky) This desperate attempt by the over 40s to provide for retirement is soaking up savings that would otherwise be spent on goods. Retirement desperation pushes up asset values until I expect a Minsky Moment will interupt the momentum. This desperate cycle will continue to repeate as long as workers are left to fend for themselves in retirement. The social consequence is to reduce a workers focus to his and his families welfare as no one else will help. So the worker and hisher family is an independant island state that only the worker can provide for and protect.
      It is unforgivable for a Gov to abandon its people in this way.

      In regard to Australia the States borrow money but cant create it so they are causing dissruption to the cycles due to a need to balance the State Budgets. The States infastructure spending should be fully funded from Canberra, not from State taxes.
      Spending money on infrastructure will allow business to create employment. Who needs a state anyway. In Queensland we needed a new dam, after 2 years of planning and land resumptions a minister for Kevin said no! Its Canberra who realy run things so why bother having a Premier and her state Gov.
      The sooner we get rid of State Govts the better chance MMT will have to work.

    33. Tom Hickey says:

      The sooner we get rid of State Govts the better chance MMT will have to work.

      In the US, the states are losing revenue and tanking financially, most having to cut services and employment and even raise taxes. This is counteracting the stimulus provided by the federal government.

      Government employee unions are also under extreme pressure as other workers react against state employees and insist that they be brought down too.

      Hard for MMT fiscal solutions to work in this environment.

    34. Alan Dunn says:

      The problem for the Australian states as opposed to the Federal government in Australia is one of vertical fiscal imbalance.

      WIth Suplus Mania infecting all and sundry these days the states are a pursuing the impossible – Surpluses.

    35. flow5 says:

      Dr. Milton Friedman didn’t start the “Chicago School”. He didn’t even understand monetarism. Contrary to economic theory, and Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, and for (2) inflation, are historically, always, fixed in length. However, the FED’s target, nominal gdp, varies widely. If you understand money & central banking then you can make accurate forecasts. Real output collapses at the end of April. The world is full of pretenders.

    36. joebhed says:

      Tom @ 2:35,
      That’s why I’m here.
      To make that claim and to have that debate.
      But again, when the flagged progressive element resorts to attacks on my claim using either neo-liberal or further right sources for their concerns, then I tend to think I’m winning, even if that sounds gratuitous.
      Just wanna be clear, you’re saying that governments don’t make good bankers is opening up a rabbit hole that ignores the fact that nobody is asking for government bankers here.
      The opposite is true – it is to let the bankers get back to banking and no federal banking except of course the public central bank.
      The power we are talking about is the money power, not the banking power.
      Are you agreeing that free markets are more capable than the government in determining the amount of money that should be in existence, giving traditional monetary policy objectives?
      The shadow–banker, derivative-based Trillions of non-job producing ‘vehicles’ that act as money and debt are the true manifestation of free-market created finance.
      I am hoping that Bill and Randall and the others will take up the question that is contained in this video that questions one of the principles that drives MMT.

      http://www.youtube.com/watch?v=mVVxeEp3P1Y

      This is not my position, though I am mentioned in the video.
      But it is a question that needs addressing sooner or later.
      Thanks.

    37. bill says:

      Dear Joebhed

      I will respond in time to the stuff you and Tom and been musing about.

      But in relation to our mystical one on the YouTube link you posted I can offer the following brief comments. They only have to be brief because the presentation really misses the point.

      He doesn’t represent our position very well and admits he doesn’t understand it. So the whole concept of some sort of monetary oracle (the video presenter) who has deep insights into the monetary system is somewhat flawed when you cannot come to terms with the basics of your target.

      There are also factual flaws in his representation which means he has done very little related research to ensure that what he is saying by way of stated facts is 100 per cent accurate (independent of the opinions provided).

      But having said that his chief issue is to query the limits on what he claims we say is a “limitless” system? Modern Monetary Theory (MMT) has never held out that the economy is a limitless system. That is patently not an accurate representation.

      The constraints on a sovereign government are three-fold: (a) the availability of things to purchase – that is, real resources; (b) political – what they can get away with; and (c) environmental – obvious but most nearly always ignored.

      On the first, while the government can “financially” pay for the “complete health care system” or “buy everybody a house” it can only actually do that if the real resources are available. If there are health care resources available to purchase the government can always buy them. It doesn’t need to “fund” those purchases.

      On the second, it might not be politically possible to ensure everyone has adequate health care (given available real resources). Each era chooses its own mix of public/private production and the composition of the mix within each sector. That is nothing that MMT can address.

      The impression the presenter gives his unwitting audience is MMT tells us that there are limit. He keeps saying “there must be a limit?”. If he had read my work and that of Randy etc in detail and understood it before he had set himself up as some sort of monetary guru or taking the time to E-mail me to ask specific questions (if they are as important as he claims) then he would not have bothered to upload that 9 or so minutes of faux analysis.

      That being said I am happy that people from different walks of life from different countries are inquisitive and seeking out new ways of thinking. I encourage you to get the Mr Mystic to engage with us here after reading all the previous blogs and being comfortable with what they do and do not understand and ensuring that questions they have have not already been dealt with.

      Thanks for all your input into my blog.

      best wishes
      bill

    38. RSJ says:

      The notion that markets are self-correcting and economies self-organizing does not seem to be the case given the history. Since these cycles continue to occur, is this a natural occurrence? Or can it be improved upon, e.g., by changing incentives.

      Markets and economies are clearly self-correcting — the question is of scale. If you don’t mind frequent depressions, then you will see everything self-correct.

      Can we achieve the corrective benefits of the contraction without the social cost? Yes, if we are wise enough to do so. But odds are that we will not do this, and instead will try to take the road of least resistance — e.g. social spending to alleviate suffering, but without internal reforms.

      Giving money to the poor is a no brainer, but shutting down banks and wiping out disproportionate financial claims is hard to achieve, politically.

      In the post-WW2 era, we benefitted from solidarity due to a fear of communism (e.g. give workers a decent wage and they wont revolt), fresh memories of the depression, and wise leadership.

      Will we experience such a trifecta again, or is it a Gilded-age redux on an endless loop of living standards asymptotically declining to the minimum wage?

    39. Panayotis says:

      The following propositions for discussion.

      1.Some but not all unemployment is created by tax liabilities which is also also created from private spending deficiency.

      2. Some but not all tax liabilities are independent of income. For most tax obligations income is required.

      3. Not all currency is created by government spending as Central Bank reserves can be forthcoming backed by private debt and lender of last resort facilities.

      4. The conditions for involuntary unemployment include not only net saving preference (convention/tradition) that constrains spending activities but also net liquidity preference (uncertainty/ignorance) that constrains spending decisions of the private sector.

    40. Tom Hickey says:

      joehbed, I caught a few minutes of that YouTube vid, too, long enough to note that the guy is confused about MMT. I see this all over the net these days (I have a Google alert set on Chartalism). I don’t know whether this is hard for people to get, or whether they just have a knee-jerk reaction based on bad memes infecting their brains.

      Regarding your points, first, please let me be clear that I am not espousing neo-liberalism, but rather simply saying that there are some apparently cogent objections that need to be met coming from that side. For example, a key principle of the neo-classical position philosophically is argued by Hayek in a short essay, The Use of Knowledge in Society. He observes that markets are the most efficient determiners of price, and price constitutes an important source of economic information. Hayek claims that price as information is one of the great inventions of humanity, as well as markets as the most efficient means of price discovery. He cites thinker across the spectrum who agree with this view of price as information, including Abba Lerner. He then argues that societies in which markets determine price are more efficient and effective than societies that use command systems of control. This lies at the basis of the neo-classical and conservative suspicion of government intrusion into the economy. It is not a bogus argument by any means and needs to be met by those who seek greater governmental intervention.

      For example, government can and do influence interest rates (price of credit) in a supposedly free market capitalist economy. I am not convinced that this is a good strategy.

      Then there are the libertarians of the right and radical of the left (of which I one). Both extremes think that individuals are the focal point of economics, rather than institutions. Libertarians an radicals see both conservatives and liberals as too concerned with institutions, so concerned that both are comfortable with a supposedly necessary degree of unemployment in the interests of “the economy,” or the health of the “financial sector.” For libertarians and radicals, “the government” is an institution not be trusted very far in that it is dominated by institutional interests, not concern for people.

      Regarding public banking, what I have said previously is that I’m unhappy about the way bank’s can create money at present for two principal reasons. The first is the one I cited above, namely, that it is generally the lax creation of bank money at peaks and lack of bank money creation at bottoms that underlies the business and financial cycles, although this is much more the case for financial cycles than business cycles, when Ponzi finance takes over.

      Secondly, I am concerned about bank money relative to consumers and small business much more than capital (commercial and financial). Commercial and financial interests are considered sophisticated players, whereas consumers and small businesses are not, largely because they cannot afford the required advisors. Moreover, deposit guarantees apply to consumers and small businesses much more than to the larger players. In addition, a great deal of lending to consumers involves mortgages, and housing underpins the economy.

      Therefore, I am persuaded that it may be more efficient and effective in the end to make small banking a governmental responsibility, since small deposits carry a government guarantee anyway and Fannie and Freddie already dominate the mortgage market. This would eliminate the banks as middlemen, which seems fair since they really carry no risk for this activity, which is backed up by the government.

      I am less convinced that government should be directly or indirectly involved in capital lending. It seems to me that it should not. There should be no guarantees, rescues, or bailouts. To big to fail should mean to big to exist. There should be no moral hazard in finance. This also means that banking and shadow banking has to be carefully constructed and regulated to obviate systemic risk, especially with the growth of the global economy where we are talking about bringing down whole countries.

      RSJ, while I admit that theoretically economies are self-organizing and eventually return to equilibrium, albeit at a different scale, that hasn’t always worked out historically. Just as markets are efficient but stay irrational longer than any single player can stay solvent, so too economies can spin out of control to the degree that a political solution is imposed before the economy can self-correct, as the history of social unrest, revolution, and war goes to show. Even the New Deal was a reorganization of the US economy undertaken to avoid social unrest, and eventually the resolver was war anyway. I don’t think that any serious historian would fail to implicate global depression in the lead up to WWII.

    41. Burk says:

      Hi, Bill-

      I fail to see the problem you have with the expression “printing money”.

      “Governments do not spend by “printing money” – they credit bank accounts in the main.”

      I think that everyone understands the expression at issue.. that printing money is a synecdoche by which the easily understood process of printing currency bills is applied to the general government capability of creating money ex nihilo (er, bank balances, if you prefer).

    42. Hi Burk

      The problems with “printing money” is it usually implies reckless, inflationary behavior compared to a deficit accompanied by a bond sale. That is, it is supposed that printing money is directly inflationary, while a deficit with a bond sale is not due to the assumption of a loanable funds market and crowding out from government borrowing. But this dichotomy is entirely wrong unless you are operating under a gold standard or similar monetary regime. In fact every time a govt spends they credit a bank account whether or not they issue a bond. And when they accompany the deficit with the issue of a bond, they don’t reduce the purchasing power, ability to create loans, credit worthiness, etc. of the non-government sector. It is only when govt spending is accompanied by taxation that any of these happen.

      In other words, “printing money” is not any more inflationary than a deficit accompanied by bond sales. In fact, I maintain that the latter is probably more inflationary since there is both a deficit and interest paid to the non-govt sector in that case, instead of just the deficit (that is, a deficit with a bond sale creates over time more net financial assets for the non-govt sector than a deficit without a bond sale)–indeed, even neoclassical theories of hyperinflation inducing deficits are almost always based on the inflationary effect of the interest payments more than that of the deficits.

      (A side issue is that, absent a zero-rate target, “printing money” is not operationally possible, as either the cb or the Tsy must offer the non-govt sector an interest-bearing alternative to the reserves created by the deficit spending).

      If one is using the term “printing money” to equate to “credit bank accounts,” then that’s not necessarily wrong, but realize that the vast majority of individuals use it as I’ve described above, and that’s where the problem lies.

      Best,
      Scott

    43. /L says:

      Krugman says hyperinflation is well understood:

      “Hyperinflation is actually a quite well understood phenomenon, and its causes aren’t especially controversial among economists. It’s basically about revenue: when governments can’t either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press, trying to extract large amounts of seignorage — revenue from money creation. This leads to inflation, which leads people to hold down their cash holdings, which means that the printing presses have to run faster to buy the same amount of resources, and so on.”

      Wonder if there is any difference if both or one of the options mentioned is available but governments use the printing press anyway. And isn’t there a some problem whit the comparison, to lump together to get revenue from taxes and borrow, the later usually means that there is created a deficit but the former that the same amount extracted from the private sector is returned to the economy via government spending.

      I‘ll guess Krugman conclusion in some way is that deficits not necessary cause hyperinflation if the government stay away from the printing press. His take on the inflation in the 70s inflation is that “the only question was whether and when we’d be willing to pay the price in high unemployment of bringing inflation back down“.

    44. flow5 says:

      NO, one is a managed currency and the other is a fiat currency. The loss of confidence in a fiat currency is inflationary & creates inflation expectations.

    45. RSJ says:

      “But this dichotomy is entirely wrong unless you are operating under a gold standard or similar monetary regime.”

      I think the gold-standard regime precludes the possibility of spending without bond sales, but if in theory you could do that (say you had enormous reserves), then the effect would be the same.

      In fact, I maintain that the latter is probably more inflationary since there is both a deficit and interest paid to the non-govt sector in that case, instead of just the deficit (that is, a deficit with a bond sale creates over time more net financial assets for the non-govt sector than a deficit without a bond sale)

      I thought we had agreed, from simple accounting principles, that bond sales do not increase the financial assets of the private sector, and therefore the payment of interest on bonds is an increase in NFA that leaves A unchanged, not affecting demand.

      Any demand effects come from other channels — e.g. lower interest rates may encourage more borrowing. More long safe long duration assets may lower the costs of issuing debt, encouraging more borrowing, etc.

      Do you care if each $1 of deposits is backed by 7 cents of currency and 93 cents of bonds, or 7 cents of bonds and 93 cents of currency? Or even 50 cents of currency of 150 cents of bonds? Each time a coupon payment is made, your deposit is backed by a bit more cash — whoppee!

      (A side issue is that, absent a zero-rate target, “printing money” is not operationally possible, as either the cb or the Tsy must offer the non-govt sector an interest-bearing alternative to the reserves created by the deficit spending).

      Only if our financial architecture is designed by bankers of criminal intent would we do this. There is absolutely no economic reason to pay banks money or offer any interest bearing security to them in order to control their marginal costs. We can directly control their marginal costs without paying them anything.

    46. Hi RSJ

      “I think the gold-standard regime precludes the possibility of spending without bond sales, but if in theory you could do that (say you had enormous reserves), then the effect would be the same.”

      The point about the gold standard is that’s where the loanable funds market model can apply. Agree with the rest . . so if you’re “printing money” you’re devaluing essentially in a gold standard.

      “I thought we had agreed, from simple accounting principles, that bond sales do not increase the financial assets of the private sector, and therefore the payment of interest on bonds is an increase in NFA that leaves A unchanged, not affecting demand.”

      When a bond is sold, we’ve always agreed that there is no increase in NFA. Just as true, though, is that once the bond/bill/note matures, the investor (assuming he/she just collected the interest and kept it in a deposit account for simplicity, not that it changes anything qualitatively) now has deposits equal to the original investment plus accumulated interest, and financial net worth has risen by the amount of these interest payments. That’s an increase in NFA, just as the interest payments themselves are income for the non-govt sector and raise the govt’s deficit.

      Over the life of the bond, I’ll just repost here what JKH said at Mosler’s site a bit ago:

      “Other things equal, a fixed income security accrues incremental value equal to one coupon payment over each period between coupon payment dates. Such value accrues between coupon payments, and when the coupon is paid, the value of the security drops by the amount of the coupon, but the security holder’s cash position increases by the amount of the coupon payment. (“Other things equal” means the yield curve progresses over time such that the value of the security reverts to par immediately following each coupon payment. That just means that market yields follow the original implied forward yield curve of a bond originally priced at par.) The cycle repeats over each period between coupon payments. When the bond matures, the holder has his original principal plus the accumulated portfolio from cash coupons, however that has been invested.”

      Regarding demand effects, my point has always been about the NFA, which is to say I make no particular assumptions about how much inflation there will/won’t be, only that more NFA is “if anything” going to tend to be more inflationary than less NFA, ceteris paribus (though, again, for the bond sale, I recognize this occurs over the life of the bond and not at the same time as the deficit). Again, this is consistent even with the neoclassical view of deficits and inflation (not that this necessarily makes my point more correct, but that even neoclassicals forget this most of the time). But I don’t necessarily disagree with your comments there.

      “Only if our financial architecture is designed by bankers of criminal intent would we do this.”

      Yes, we’ve been over this many times before, and I’m sympathetic to your point here, though at the same time I don’t completely share your aversion IF it turns out that banks are not more profitable as a result of interest payment (and I grant there are a number of scenarios where this wouldn’t be the case, though there are some that do).

      “There is absolutely no economic reason to pay banks money or offer any interest bearing security to them in order to control their marginal costs. We can directly control their marginal costs without paying them anything.”

      Completely agree that it’s not necessary for that purpose. Regarding CB operations, I support interest payment where they are so muddled that it is the simplest change to enable achieving a positive overnight target rate with precision (though even then you don’t necessarily need a lot of additional reserves to do that, just a bit of an increase will usually do). And even in that case, interest payment altogether could be avoided if more efficient methods of achieving the target were employed (the US Fed is a great example of fairly silly operating procedures that achieve the target with moderate precision and which–as we’ve seen–are not robust to a financial crisis). Canada, for instance, has shown quite clearly that the target can be achieved with very good precision even if banks hold no balances overnight (the BOC does pay interest, but no banks actually receive any given how well the BOC can achieve its target).

      Best,
      Scott

    47. MDM says:

      hi Scott,

      I’m at work and cannot check your paper Ínterest rate and Fiscal Sustainability’. Is the following consistent with your representation of the various balance sheet effects of government spending and issuing of bonds. As I was under the impression from that paper that a bond say infact increases NFA, with household net wealth increasing.

      “”When a bond is sold, we’ve always agreed that there is no increase in NFA. Just as true, though, is that once the bond/bill/note matures, the investor (assuming he/she just collected the interest and kept it in a deposit account for simplicity, not that it changes anything qualitatively) now has deposits equal to the original investment plus accumulated interest, and financial net worth has risen by the amount of these interest payments. That’s an increase in NFA, just as the interest payments themselves are income for the non-govt sector and raise the govt’s deficit.””

      Regards,
      Mark

    48. RSJ says:

      Scott,

      When a bond is sold, it does not increase the “A” of households

      As per JKH (and my) comments,

      a) when a coupon payment is made, the “A” does not increase either (and neither does NFA) — as the bond decreases in value by the coupon.

      b) when the bond matures (and over time), the price of the bond is growing — by the discount rate (which changes with the maturity of the bond). This is because the discount rate is the expected rate of return for that instrument, so on average the instrument will meet expectations.

      But the price of *all* the household assets at that maturity are increasing at that same rate. Everything is growing: the economy, incomes, profits, etc.

      The household only bought the bond at a discount X, if it thought that it could earn a return of X by holding a non-government bond, and the act of buying the treasury forced the household to sell an equivalently priced non-treasury asset.

      Now you could argue that if the government did not sell the bond, then the household would be forced to keep the proceeds in deposits; e.g. households are helpless, sitting around empty handed as they wait for the government to supply them with assets to purchase:P

      But households are always able to hold assets at whatever maturity they want: financial intermediaries will supply synthetic instruments to meet this maturity mismatch. This is why tsy sales are effective at removing excess reserves from the banking system. If bond sales (to the domestic sector) decreased the level of non-financial domestic deposits, then they would not reduce excess reserves. Banks do not want fewer non-financial deposits, they want the same level of household and business deposits backed by less currency, and it is only because the level of non-financial deposits is unchanged as a result of a bond sale that excess reserves are drained.

      What the banks want is fewer interbank liabilities, but the same level of household and business deposits — and operationally this has been the result of selling government debt.

      So the asset relinquished by the domestic non-financial sector to buy the treasury is not a deposit, but some other non-treasury asset. Can we track down which assets are given up to buy treasuries? It’s complicated since if A buys a treasury, he sells an asset to B, who sells another asset to C, etc. It is like Newton’s Cradle, but we know that either that some asset must be ejected from the domestic non-financial sector, or that this sector must expand its balance sheet in order to absorb the treasury. Generally the second case does not occur, and the asset relinquished is what replaces excess reserves in the financial system.

      So if you assume that the return characteristics of the asset given up to buy the treasury are the same along each stage of Newton’s cradle, then you might as well assume that all domestic treasuries are purchased by the financial system in order to eliminate excess reserves. Of course the actual *holders* of the treasuries are different — all securities change hands endlessly and diffuse throughout the system as they trade at indifference prices — but the *effect* of selling the treasuries is limited to an operation on financial sector balance sheets, and does not touch household balance sheets at all.

      Btw, this is *not* a theory of “crowding out”, as every debtor can get funded via balance sheet expansion on the part of the financial sector.

      * * *

      I think it is easier to understand these issues with a different mental model.

      When looking at financial assets, there is only one source of wealth, which is the expected stream of profits = expected flow of dissaving by government, households, business, and the foreign sector.

      If a business sells bonds, it is diverting dividend payments into interest payments, but total capital income does not change. The equity value decreases and the fixed debt value increases, but the household sector does not hold more (gross) financial assets as a result of the debt sale.

      If the debt sale is accompanied by deficit spending, the latter *does* increase the profits of everyone else — all other asset holders receive profits exactly equal to the deficit spending of the business.

      So there are two operations:

      1. financial sales/purchases, including debt service, redemption, etc.
      2. dissaving by spending on goods and services in the non-financial economy

      Only the second increases the financial assets of households, whereas the first is just a series of portfolio shifts at indifference prices.

      In the case of the private sector, all dissaving must come from liability issuance, so you cannot separate 2) from 1). But with government, it is possible to dissave without issuing a liability, and so unless you are clear about the distinction between 1) and 2), you will believe that financial market transactions at indifference prices, including debt repayment, will cause an increase in gross household assets.

      Let’s follow the money:

      The financial net worth of households (e.g. B100.e in Z.1) is about 44 Trillion, divided roughly as 20% Deposits (8T), 10% (e.g. 4 T) credit market instruments, and 70% (30 T) equity claims. These ratios have been fairly constant over time.

      But what happened to the 10 Trillion in domestically held foreign and corporate bonds? What about the 3 Trillion in domestically held treasuries, etc? These are all hiding as balance sheet expansion, netting out against each other and against equity, and delivering no net return.

      We can sanity check this: The CBO has detailed data on household income from 1979-2005. Take the cash capital returns: dividend, interest, pension, other business incomes. Discount by 3% + current inflation rate (a proxy for expected future profit growth rates). This models the current profit levels as a stream of coupons, divided by the return demanded (the return expected), and you get a decent proxy for the FoF Household Financial assets amounts. You could have even used this to get a first order estimate of asset bubbles. Now what the financial markets do is a bit different, but not necessarily more accurate. E.g. they try to estimate future growth rates and future profit levels, but over time, this becomes the historical profits divided by the historical profit growth rates.

      If no corporate bonds were sold (but the same dissaving occured, funded by issuing corporate equities) then there would *still* be 44 Trillion in net worth, but it would be broken down as:

      20% Deposits
      80% Equity

      The 10% in credit market claims would disappear, but as these subtract from equity claims, the latter would increase.
      In the same way, if government sold no bonds, then you would still have 44T in net worth, broken down as

      20% Deposits
      80% Equity

      Except in that case, MZM would yield less, but the deposit interest is paid for by banks who are also owned by households, so any foregone interest payments would result in increased dividends elsewhere in the economy.

      In all cases, you need to take everything into account: interest payments come at the expense of dividend payments. Going long a treasury requires going short a non-treasury. If you only follow a partial equilibrium analysis (e.g. interest payments are paid for by tooth-fairies, and do not subtract from dividend payments, treasuries are given away to households, etc.) then you will make policy recommendations that don’t have the desired effect.

    49. joebhed says:

      Tom.
      Thanks very much.
      I agree there are many ways of looking at economics and the way economic systems function and come to grand philosophies of how society should operate.
      I take a different approach and I want to join all those who came to economics as a study and abhorred the experience for what it misses. The cranks, the heretics and especially the accidentalists among us are all welcome in my part of the discussion.
      If the “scientific study” is in economics, then, like studying the environment, this means that it includes everything else that become part of this science. Monetary systems and monetary science are a part of the economic science.
      Having said that, I have read of Hayek’s and other libertarian thinkers that the free markets are great at establishing the price for goods and services bought and sold among the participants in the economy. They are great (efficient) responders to supply and demand signals.
      It’s how they get from that price realization to the baseline principle that guides how economies should operate – governments everywhere are shit and corrupt and ought not to exist, especially where anybody’s welfare (an economic term) is concerned, that I become opposed to that way of thinking.
      The efficiency of markets has a strength that does not go to the public welfare, and so we must think of other aspects of achieving that welfare through the political system. As such, the sovereignty of the monetary system becomes, to me, the foundation reality of we the people acting to promote the general welfare.
      Toward that end, the monetary system becomes more of a factor of our political-economy than as a factor to support the free markets based pricing mechanism.
      They can have the pricing mechanism. We want the money system back.
      In terms of the economic scientists I am perhaps obviously a student of Frederick Soddy.
      It was Soddy who advanced the scientific approach to so-called economic cycles that economists like to predict and trend and study the cause of.
      And it was in so doing that he realized and wrote clearly that the cause of the booms and bust cycles was the non-scientific operation of the money system.
      In his book The Role of Money is the story of what needs to be done to impart scientific operation of the money system. This scientific approach is something the chartalists are vying for a proper role to the nation’s economy as well, albeit on the basis of the unit of account by which we denominate our currency.

      Again, using the Chicago Plan and American Monetary Institute’s models, there is nothing in either case for what I think of as public banking. By that I mean the national monetary system would operate primarily on the basis of providing the circulating medium required to ensure “price stability” and as close to full employment as we can muster.

      In that regard, a switch to public money creation and the restoration of that power to the people would mean that monetary policy would become involved with the quantity of supply issue(adequate circulating medium), and not a pricing issue. Let the free market set interest rates, like for everything else. Think of setting the price for a commodity for which there was a secure and stable supply and demand for that commodity on a year-in and year-out basis.

      Ensuring that there is a sufficient quantity of circulating medium to exchange goods and services does not put the government in the banking industry. The bankers would run the banking system, under the rules of soundness that includes full-reserve banking. Bank runs would be impossible, absent outright fraud.

      And, since the depositors would be aware of their control of the lending policies of the banks in which they make savings deposits, and also provide funds for investments, that level of fraud is all but impossible.

      As to public banking at the state level, that is something completely separate from any discussion about national monetary policy. I see no problem with state-run banks or credit unions once the national monetary system has been transitioned to government issue of money debt-free.
      Like Soddy called for.
      And Henry Simons.
      And the Chicago Monetary plan reformers.
      And Friedman.
      So, the reason we don’t need to argue for public banking as monetary policy issue is because it is not part of the system of reforms. Not at all.

      As such, there are no problems associated with the free markets in capital. Once the money is created and entered into the bank accounts of the recipients, it is the owners of the money that determine where it goes and where it is spent.
      The Money System Common.
      Thanks for your thoughtful work on this topic.

    50. Hi RSJ,

      I’ll read the rest later, but just to clarify, I’ve never said that when a bond is sold it increases the assets of housholds. The deficit does, not the bond sale. The bond sale is an asset swap. I’ve always said that.

      Best,
      Scott

    51. RSJ says:

      Oh, I wasn’t trying to suggest that you said this. But if buying the asset does not increase household’s A = gross financial assets, then keeping the asset until it matures doesn’t, either :)

      What I tried to outline in my (wordy) post is that:

      * Gross Financial Assets of households (as measured by B.100e in FoF) are fully determined by the expected future flows of deficit spending (by households, businesses, foreign sector, and government), discounted by the growth rate of those flows.

      * Therefore given that A is fixed by dissaving. Treasury sales, although increasing NFA, will not increase A.

      In that case, one wonders what (other than increasing NFA), treasury sales do. There I argue that it is equivalent to assuming that all domestic government bond purchases are by the financial sector in order to reduce interbank liabilities. Of course the actual instruments diffuse throughout the economy, but the effect of issuing these instruments is limited to financial sector balance sheet intervention. This leads to an increase in MZM rates. I argue that the latter is offset by less income from bank dividends and other sources, so that in aggregate, there are no effects on the aggregate “A” of households, reinforcing the argument that A is set by the expected stream of future dissaving.

      Sorry for being so wordy — being brief is hard work :P

    52. JKH says:

      The effect of deficit spending on non government sector gross and net financial assets is unambiguous. Deficit spending creates income for the non government sector. That income must be saved at the macro level because the output that generated the income earned by the factors of its production cannot be purchased by the non government sector, by construction. That income will be saved (operationally) at the macro level in the form of bank deposit liabilities (and bank reserves) unless debt (or currency) is issued to “drain” both. In any event, income, net saving, and net financial assets are created for the non government sector as a result of deficit spending. This is all a matter of accounting identity.

      As described previously, the combination of the Z1 household sector balance sheet and the net foreign balance sheet invested in US assets captures all net worth in the US economy – net financial assets corresponding to cumulative government deficits, plus the market value of cumulative gross saving apart from that.

    53. JKH says:

      In normal accounting, upcoming interest payments on government debt are accrued between coupon dates. Therefore, net financial assets held by the non government sector accrue continuously upward, at the margin. The actual coupon payment when it happens replaces corresponding accrued interest with cash, with no momentary effect on net financial assets – the associated net financial asset increase has already taken place.

      It is convenient to think of the interest accrual as a government “payable” and a non government “receivable” in this context. Such a payable/receivable is equivalent conceptually to an expanding duration “mini-bond”, reflecting an incremental deficit and an increase in non government net financial assets.

      In some cases, interest payments may be accounted for on a cash basis rather than an accrual basis. This just means that accounting would ignore the periodic accrual amounts, and recognize net financial asset increases as a “step function” according to coupon payment dates.

    54. JKH says:

      The preceding depends partly also on whether or not marked to market accounting is being used. If so, the value of the interest accrual is fully reflected in the market value of the bond. If not, the interest accrual is typically accrued separately in the accounts as described, along with book value amortization of premium or accretion of discount (i.e. premium or discount on original purchase price relative to par).

    55. RSJ says:

      JKH,

      Yes, I am claiming that the deficit spending increases both A and NFA, and that bonds increase in value with the discount rate. That is all obvious.

      I am also claiming that the interest payments of either government debt or private sector debt do not increase A — gross financial assets of the household sector. This is because, for private sector debt service payments, the interest is diverted from equity, so the increase in debt comes at the expense of a decrease in equity, resulting in A being unchanged. I.e. to go long debt, the private sector must go short equity.

      Similarly, for government debt service payments, in order to purchase the government bond, the private sector must go short a non-government bond (or equity, etc) so it can only absorb the government bond in the first place by balance sheet expansion, so this nets out.

      At the end of the day, all you are left with is the discounted stream of deficit spending (both private, government, and foreign), and bond sales or redemptions will not affect this, one way or another. The only thing that affects this is deficit spending, not the offsetting bond sale.

    56. RSJ says:

      ..And I should add that the discounted stream of deficit spending is what gives you “A”, not *net worth*., which is A-L.

      Household financial assets themselves already contain a lot of netting, as balance sheet expansion of the financial or business sector is netted out.

      I think part of the problem here is that there is too much focus on NFA, even though economically NFA does not reflect private sector demand or household financial wealth — particularly when the majority of “A” is an off-balance sheet liability of the government sector: 90% of mortgages, and about 9 Trillion worth of domestically held bonds are government guaranteed, as well as virtually all deposits, etc.

      In particular, it is not the case that an increase in NFA leads to an increase in “A”, all things equal. If the increase is due to deficit spending, then yes. If the increase is due to government bond repayment (but deficit spending is unchanged), then the answer is “no” — all that happens is that deposits are backed by a bit more cash, leaving household A unchanged.

    57. Hi RSJ

      Rather than getting into a lot of technical details, let me just start with this and see where it goes. You write at 6:11 that “that the only thing that affects this is deficit spending, not the offsetting bond sale.” Of course, a current deficit accompanied by bond sales creates larger future deficits than a current deficit not accompanied by bond sales, ceteris paribus. This is also the basic point raised in the so-called inter-temporal government budget constraint neoclassicals use.

      Best,
      Scott

    58. Professor Scott –

      Question: Fed Reserve has tens of billions of “toxic assets” or assets related to the mortgage crisis on its books – much of it is overvalued – IMO. But what happens in worse case that economic situation worsens and those assets are deemed worthless?

    59. RSJ says:

      Hi Scott,

      One way to see think about this to reduce all the fixed debt contracts to zero coupon bonds. In this case, to “borrow” is to sell the bond, and to “repay with interest” is to buy the bond.

      Now, *if* you accept that government, by transacting with households at market prices, does not increase the financial net worth of households, then you must also accept that debt service and debt-repayment does not either — as the latter is a special case of the former.

      In terms of the deficit increasing due to interest costs, you are right, and I was a bit sloppy there. It is only the primary deficit that counts. Actually, it is lower — only the primary deficit net of debt service counts. And actually, you also have to subtract out leakages to the foreign sector.

      This is because the interest payment coming from the government is offset by the short position, which is also increasing in value or otherwise requiring an interest payment. That’s the underlying mechanistic explanation, but you don’t need to follow the transactions, but keep track of the invariants as above.

      —-

      I would go further, and argue that it does not increase even the gross financial assets of households, with the proviso that households do not expand their balance sheets when they invest, but engage primarily in covered sales and purchases. But that’s a separate issue of whether households are benefitting or not from the interest payments.

      “This is also the basic point raised in the so-called inter-temporal government budget constraint neoclassicals use.”

      Yeah, that’s a funny group of people :)

    60. JKH says:

      There is still some confusion about the distinction between balance sheet equity (net worth) versus an equity financial claim (and the idea of a “short” position in equity).

      Net (deficit) government expenditure creates an equivalent amount of income for the non government sector. At the macro level, the non government sector saves this income, because it is an amount that can’t be spent on corresponding output, because the government has already paid for that output.

      The non government sector acquires new bank deposits created by government expenditure. The corresponding flow of revenue/saving becomes additional balance sheet equity. And that equity ends up invested in new government bonds, issued by the government (effectively) to drain the bank deposit balances and reserves otherwise created by its spending.

      The bonds are a financial asset. The consolidated balance sheet equity position is not a financial asset. Because balance sheet equity is not a financial asset, it is not a short position in any sense. It is purely a measure of net worth.

      An example follows.

      Suppose the government pays for costs of building a bridge. That includes payments to factors of production and other costs (which are attributable downstream to their factors of production, etc.). The total cost of the bridge must now show up as non government sector macro income and saving. It is income that must be saved because it exceeds the aggregate economic output available to be purchased (because the government has already paid for the bridge). This saving is forced by accounting identity at the macro level.

      On the financial asset side of things, the government credits bank accounts with the total cost of the bridge at the outset. It issues bonds in the same amount. Both the initial aggregate level of bank account credits and the bonds issued to “drain” the same amount of bank accounts must equate to the flow of income and consolidated saving in question.

      Assume for simplicity that micro and macro converge in the income and saving dynamic, as follows:

      Suppose company X helps build the bridge. Part of X’s bridge revenue ends up as profit and retained earnings for X. X buys a new government bond with its initial bank credit. The bond is now the net financial asset held by the non government sector.

      The income accrued to company X, which saved it as retained earnings. That increased the book value of X’s balance sheet equity position.

      Suppose X has stock outstanding held by households H.

      From an MMT perspective, the value of stock issued by X cancels out against the value of stock held by H. The corresponding non government sector net financial asset position is zero, as it pertains to the stock (not the government bond).

      That is a statement about “horizontal” financial assets. It is not a statement about “vertical” or net financial assets. And it is not a statement about the relationship between either of those and balance sheet equity. MMT accounting doesn’t automatically drill down into all vertical and horizontal balance sheet components. But it can do so easily in a way that is fully compatible with the flow of funds Z1 presentation.

      From a Z1 perspective, the increase in X’s balance sheet book equity gets translated to some sort of effect on the market value of X’s stock, as interpreted by the market. That stock is issued by X and held by H. Because H holds that stock as a financial asset, a change in its value also gets reflected in the balance sheet equity (net worth) of H.

      Thus, Z1 captures business sector saving through the market value of financial assets held by the household sector. That asset value is mirrored in the balance sheet equity position (net worth) of the household sector.

      (Outside of this example, the same dynamic holds for the foreign sector when it generates current account saving and balance sheet equity, and acquires financial assets as a result).

      From an MMT perspective, X’s stock issue cancels out against H’s holdings of X’s stock as a financial asset. That has to do with horizontal financial assets. But the ultimate offset against the original government bond purchased by X is the balance sheet equity of H. This household equity is not a “short” position in any interpretation – MMT, Z1, or otherwise, because households do not issue equity financial claims and are not liable to anyone further down the line for the management of their balance sheet equity position.

      Thus, and as explained elsewhere in more detail, the MMT and Z1 de-consolidations of non government balance sheets are completely compatible.

      Other points:

      – Interest on government debt creates a non government net financial asset in the same way as a primary deficit (unless the interest payment is matched by incremental taxes). This is trivial. It is a “mini deficit”, in effect.

      – NFA increases are obviously GFA increases at the margin for the sector in question.

      – The question of interest accrual versus cash interest payment is/has been dealt with already as a matter of accounting clarification.

      – “Discounted stream of deficit spending” has little meaning unless there is some evidence of a logical fit/connection with valuation and double entry book keeping for financial claims, real assets, and balance sheet equity, as per MMT and/or Z1, etc. Otherwise, it is a concept somewhere in the air.

      – The issue of risk distribution across financial assets (e.g. FDIC insurance) is separable but interesting and no doubt connectable to the issue of the demand for net saving and government deficits. MMT is only a constraint in thinking clearly about this and other issues to the degree that one is cloudy on MMT as a necessary accounting foundation for understanding economics. It’s the lack of understanding that’s the constraint; not the understanding.

    61. JKH says:

      Scott,

      Some things still on the back burner, including:

      – That discussion on Ricardian equivalence and FTPL: still way back

      – Recently, I’ve started thinking (glacially) about what banking system accounting entries might have looked like under the gold standard. I’ve developed a nightmare, wondering if historic descriptions of gold standard operations are as inaccurate as present day descriptions of fiat are when they resort to the money multiplier. After all, they’re written by the same people for the most part. If those people don’t understand how it works today, why would they understand how it worked historically? By accident?

      Regards,

      JKH

    62. Ramanan says:

      JKH,

      Even I think about the gold standard dynamics sometimes! I think the neoclassicals where as wrong about the it as they are with the present setup. Money was still endogenous in the Gold Standard era! Here is my take (a bit of speculation)

      The only difference as far as the balance sheets are concerned is the appearance of gold in the assets of central banks. Banks would have held higher reserves and government bonds. There would not have been a supply side issue as far as lending is concerned – the banks would sell government bonds to the non-banking sector (when loans are demanded) so that they are still satisfying the reserve requirements post the loan making. This would however translate into higher rates. Countries with current account deficits would automatically have less demand (both for borrowing and in general) because (a)current account deficits reduce demand and (b) the government spending would be cut with a “wishful thinking” that it would reduce imports. A tax rate increase would further cut demand. However the private sector wouldn’t behave as David Ricardo thought.

      An increase in demand would increase the interbank rates but that is equivalent to a rapidly fluctuating central bank reaction function in a non-gold-standard scenario.

      The whole thing is unsustainable because some countries will find themselves with a loss of gold and there is hardly anything that can be done except taking further pains.

      So what I am saying is that the games that the central banks and the government played would hardly make money less endogenous and nowhere close to being exogenous even though the central banks would have thought that they were controling money supply.

      However, the government spending would be “more endogenous” than a non-gold-standard case. Of course governments in a fiat system have to make a lot of payments such as social security etc but one could still say that they are exogenous – the deficits and the public debt are however endogenous because – even though the tax rate is exogenous, the total taxes paid is endogenous.

      Hopefully I am correct in parts. Heavy usage of the word “endogenous” – like the word!

    63. JKH says:

      Ramanan,

      I’m pleased you surfaced on this.

      Here’s a test:

      Suppose the entire world were on an international gold standard today.

      Describe the transactions that would cause a flow of gold between the Federal Reserve and the PBOC (including the direction of the flow).

      Include Fed and PBOC balance sheets, US and Chinese current accounts and capital accounts, etc., and compare to the actual balance sheets today.

      In answering this, you are not allowed to default by insisting the world would never have gotten itself into the imbalances it has under an international gold standard. Just assume it did.

    64. Ramanan says:

      Hi JKH,

      Pleased too to have a discussion. I will try to use words instead of making diagrams or tables

      Let us say that an exporter from China exports T-shirts worth $1m to the US. Let us fix the exchange rate to be ¥7. So the Bank C – the Chinese’s exporters bank would increase his account by ¥7m and the PBoC would increase the Bank C account by ¥7m, The PBoC will also receive ¥7m worth of Gold from the Fed and let us say it ships it instantaneously. The Fed’s assets will go down by $1m because of the loss of Gold, but its liabilities will too – by $1m. Because: Let us say that the importer’s bank is BoA and BoA’s account at the Fed will reduce by $1m. The importer’s account at BoA will also reduce by $1m.

      I’ll assume that the Fed is targeting the overnight rate and it has to necessarily do an open market operation to bring the reserves back to the original level (assuming $1m has an impact, if not – one can construct something similar in billions).

      As far as the capital account transactions are concerned, it is exactly the same except that a purchase is not a real good but a financial asset.

      In the present world, the transactions may be a bit different because central banks are not “directly” involved and the Chinese Bank C may have an account directly at BoA – which need not be the case in the Gold Standard era. However, even if that is the case, the the Chinese bank C may exchange $s for ¥ and the PBoC will credit Bank C’s reserve account by ¥7m. The PBoC, however has an account the Fed, not BoA and the US payment system (Fedwire) will take care of it and the Fed’s liabilities to BoA will reduce by $1m and it’s liabilities to the PBoC will increase by $1m, with the Fedwire debiting BoA’s account and crediting PBoC’s account.

      So in the present case, the Fed’s assets/liabilities have not reduced in $-terms, pre-OMO. In the Gold-standard setup, the size of its balance sheet reduces by $1m pre-OMO. Post OMO, in Gold-standard it comes back to the original (with $1m in Treasuries instead of Gold) and in the fiat system it increases by $1m.

    65. Ramanan says:

      Another peculiarity is that since Gold is an asset without a liability (declared to be an asset) in the Gold Standard, the financial net worth of an economy is the amount of Gold times the price times (or divided by) the exchange rate.

    66. JKH says:

      That’s pretty good, Ramanan.

      So one thing you’re saying is that the MECHANISM for Fed interest rate control is really no different under the gold standard than it is under fiat. In that sense, gold is just another balance sheet transaction around which the Fed has to manoeuvre in order to control the overnight interest rate target. Gold introduces a pricing constraint, but the mechanism for incorporating that constraint is the same as, say, it would be in the Fed’s policy response to a CPI spike today. That suggests to me that anybody who doesn’t understand the interest rate control mechanism in the existing system (just about everybody) can’t possibly understand it historically under the gold standard.

      Also, I’d prefer for comparison purposes to see an example where the Chinese exporter is still paid in dollars and exchanges those dollars for Yuan through PBOC. But that’s a small operational adjustment, I think.

      Then you’re saying (implicitly I think) there’s a (pricing) rule whereby PBOC requests gold from the Fed in exchange for dollar surpluses.

      BTW, are you quite sure that PBOC has a direct TRANSACTION/CLEARING account with the Fed in today’s arrangement?

      People seem to assume that. Or does PBOC operate in dollars through the big US clearing banks?

    67. JKH says:

      Don’t understand your 2:28 conclusion, and disagree with it at first look.

      But you may know better than I.

    68. Ramanan says:

      JKH,

      2:28 was nothing to do with other points really.

      I think PBoC has an account at the Fed. The Chicago Fed article “Modern Money Mechanics” says that at page 32. However, the Fed does not report it in the statistics I believe. It just reports the SOMA account or some superset. The article also has nice T-account tables for various transactions. It also says that banks lend first and look for reserves later! However, it ends up making the money multiplier error! Imagine! The article is available at Wikimedia here

      If the exporter has an account at BoA, then an exchange of $1m for ¥7m will result in the following transactions. The exporter initiates a transaction, I guess using e-banking. BoA just debits his account by $1m and the Fedwire debits BoA’s account at the Fed by $1m and credits PBoC’s Fed account by $1m. The exporter is unlikely to call up PBoC and his bank is likely to … oops its a bit complicated! I didn’t intentionally press “Backspace” on my keyboard. I don’t know international payment settlements. If there is a bank which operates in both countries, then its easier.

      So let me leave out China – if I were an Australian exporting T-shirts to the US, I’ll get paid in dollars and I can just request Citibank to convert the USD into AUD in which case, Citibank will just debit my $-account: $1m and credit my A$ 1.1m. (assuming an exchange rate of 1.1) – no involvement of either central banks.

      Are there international clearinghouses – whats the role of BIS ?

      You said:

      Then you’re saying (implicitly I think) there’s a (pricing) rule whereby PBOC requests gold from the Fed in exchange for dollar surpluses.

      I think – am not sure myself – they had to go through the IMF to fix the price etc. Not sure. There are three things to be fixed if the US and China are the only two countries – the price of gold in $s, the one in ¥ and the exchange rate, though two of them determine the third. The question is who fixes them and how is it agreed etc. I just assumed someone fixes them.

    69. Ramanan says:

      Yes JKH 2:28 was not correct. A capital inflow may result in increase of gold but that doesn’t increase the net worth of a country.

    70. RSJ says:

      JKH,

      There is still some confusion about the distinction between balance sheet equity (net worth) versus an equity financial claim (and the idea of a “short” position in equity).

      Indeed, there is confusion, but not on my part :)

      I was referring to the market value of equity, as this discussion was about the equity claims of households on the business sector, and how households cannot increase their gross financial claims if the non-financial business sector issues debt.

      A business can only issue $X of debt (at market value) if its equity (at market value) declines by $X as well. That is the consequence of diverting a dividend payment into a debt service payment — the market value of equity will decline, along with the reduced dividend payment, cet. par.

      This is known as the “M&M” theorem, which says that the market price of a firm does not change when the firm shifts its capital structure, cet. par. (e.g. there maybe tax distortions that favor debt over equity, etc.)

      If this was not the case, then a firm could increase its market value simply by taking out a loan to buy back shares, or issuing shares to retire debt — e.g. there would be arbitrage in the financial markets, and therefore these markets would not be competitive.

      Of course, some arbitrage does happen — but it is difficult to sustain. A competitive capital market is one where there is no free money in the financial markets. The returns arise from making a capital commitment, rather than by purchasing one asset or another. And this no-arbitrage assumption has several consequences which may be surprising to those not used to thinking about asset prices in these terms. When looking at the macro-economy, it is just as binding a constraint on expected behavior as is double-entry bookkeeping, even if investors completely mis-price future earnings.

      An example follows.

      Here there is more substantive disagreement.

      Your example assumes that the business is behaving irrationally — keeping a larger deposit than it wishes to hold as it waits for the government to sell a bond to it.

      Banks can be forced into holding an excess amount of reserves, but households and non-financial businesses cannot be forced to hold an excess level of deposits. All they need to do is spend money a bit more quickly and their level of required deposits decreases. As they do this, the banking system, which engages in netting, finds itself with a excess of interbank liabilities.

      So while your example — a business reducing its deposit level in order to purchase a long term asset — could happen, it generally does not.

      What is more likely to happen is that the household (and its better to look at households, as non-financial businesses rarely purchase bonds) has already allocated its financial assets at the maturities it wants, and when it buys the government bond, it is selling a private sector asset that offers the same risk-adjusted return, with similar maturity. Therefore the government interest payments provide no net benefit to the household, nor do they increase the financial net worth of the household sector as a whole, as this sector must sell an equivalent financial asset in order to purchase the government asset.

      So there are two options, both consistent with double-entry bookkeeping:

      Option 1:
      ———–

      Household Balance Sheet before the bond purchase
      $300 Deposit |
      $1000 long term Asset 1 |

      Bank Balance Sheet before the bond purchase
      $300 Reserve/Vault | $300 household deposit
      [other assets/liab]

      Household Balance Sheet after the bond purchase
      $100 Gov. Bond |
      $200 Deposit | — deposits now at target
      $1000 Long Term Asset 1 |

      Bank Balance Sheet before after bond purchase
      $200 Reserves/Vault | $200 household deposit
      [other assets/liab]

      N.B: the bank has not lowered the ratio of reserves/deposits.

      Option 2:
      ———
      Household Balance Sheet before the bond purchase
      $200 Deposit | <— Deposits *already* at target level
      $1100 long term Asset 1 | — Assets *already* at target level

      Bank Balance Sheet before the bond purchase
      $200 Reserve/Vault | $200 household deposit
      [other assets/liab]

      Household Balance Sheet after the bond purchase
      $200 Deposit |
      $1000 Long Term Asset 1 |
      $100 Gov. Bond | — bond purchased at indifference prices

      Bank Balance Sheet before after bond purchase
      $100 Reserves/Vault | $200 household deposit
      $100 Long Term Asset 1
      [other assets/liab]

      N.B: The bank has lowered the ratio of reserves/deposits.

      In option 2, the interest payments are offset by the loss of interest payments from the asset sold, whereas in option 1, they are not. In option 1, the household sector is able to improve its financial net worth simply by purchasing financial assets at market prices, whereas in option 2, it is not. In option 1, the banking system fails to reduce the ratio of reserves to deposits, whereas in option 2 it succeeds.

      So which example is better at describing what happens?

      Double-entry book-keeping will not help you decide — but only one option — option 2 — is consistent with competitive capital markets.

      At the end of the day, the issue is not consistency with accounting, but incorporating additional constraints on allowed behavior.

      Interest on government debt creates a non government net financial asset in the same way as a primary deficit (unless the interest payment is matched by incremental taxes). This is trivial. It is a “mini deficit”, in effect.

      The government, when repaying or otherwise purchasing a bond is merely replacing a $100 bond (as it matures, the market price will converge to the face value) for $100. Replacing a $100 government liability with another $100 government liability does not increase the seller’s net financial assets. That is obvious (and trivial). Everything can be reduced to the case of zero coupon bonds, in which debt repayment is the same as purchasing a bond. These are all standard constructions — no need to spill more ink over this.

      – NFA increases are obviously GFA increases at the margin for the sector in question.

      Agreed — for the sector in question. I.e. the NFA of households is not the NFA of the private sector. If a household sells an asset to the financial sector and uses the proceeds to buy a government bond, then then household sector’s financial net worth does not increase as a result of government expenditures on debt service or debt repayment.

      “the increase in X’s balance sheet book equity gets translated to some sort of effect on the market value of X’s stock, as interpreted by the market. ” [emphasis added]

      “Discounted stream of deficit spending” has little meaning unless there is some evidence of a logical fit/connection with valuation and double entry book keeping for financial claims, real assets, and balance sheet equity, as per MMT and/or Z1, etc. Otherwise, it is a concept somewhere in the air.

      Indeed, there is “some connection” between the discounted flow of earnings and the value of financial assets :)

      More seriously, this hamfisted approach to valuation is about as productive as a disregard for accounting. After all, accounting is worthless unless financial assets are properly valued — these things are not arbitrary, and it is no accident that asset bubbles coincide with widespread periods of accounting fraud. Accounting is useless without a proper asset valuation model, and any reasonable model must prevent financial net worth from increasing as a result of fair market value asset purchases and sales.

      MMT is only a constraint in thinking clearly about this and other issues to the degree that one is cloudy on MMT as a necessary accounting foundation for understanding economics. It’s the lack of understanding that’s the constraint;

      Accounting is easy to understand once you adopt the right paradigm. We are not talking about schemes or arithmetic geometry here — this is basic stuff. MMT is fighting a valiant fight to get people to drop the household “oikonomos” model and to appreciate constraints arising from sectoral balance sheet flows, even if this is counter-intuitive. The problem is not that the accounting is difficult to grasp, but that people refuse to believe in the conclusions.

      In the same way, we should also drop (haphazard) assumptions about valuation. Anytime your analysis leads you to believe that someone is increasing their financial net worth merely by engaging in financial transactions at market prices, then something is wrong with the analysis. Your financial assets *will* increase in value by the discount rate appropriate for that maturity, but not because of your selection of a particular instrument. The source of the increase in value is your own capital commitment, not the sector that you hold claims against.

      If MMT were to replace the ad-hoc assumptions about valuation (e.g. government “announcements can control all yields”) — with assumptions that are consistent with competitive capital markets, then it would strengthen the theory and close several holes that hinder its acceptance. And you can do this in a way that is fully consistent with double-entry bookkeeping while maintaining the focus on public purpose banking and social welfare. You would only need to re-think your intuition about asset prices, rentier profits, and the effects of government debt sales, but these beliefs are not founded in accounting, nor are they central to the opportunities that fiat money can provide. Nor do they have empirical support.

      The benefits of taking valuation seriously would be a tighter theory that is not only stock-flow consistent, but more consistent with human behavior, and as a result, more accurate and useful.

    71. JKH says:

      The top down MMT accounting framework is fully compatible with the flow of funds Z1 presentation. Both formats are macro level accounting presentations based on macro level accounting identities and logic. Neither is in contradiction with any micro level sorting out of balance sheets and income distribution. Conversely, the summation of all micro level outcomes cannot be at odds with macro level accounting identities.

      There is nothing in either model that contradicts any particular micro outcome for actual marked to market changes in assets, liabilities or equity. But the sum of all such outcomes is constrained by macro level outcomes according to accounting identities.

      You’ve completely missed the MMT point about vertical intervention, which is that non government income, saving, and equity changes as a result, at the margin. For example, neither MMT nor Z1 contradicts or proves or disproves anything about the Miller Modigliani theorem. But in any event, MM analysis is irrelevant and used erroneously in this case. Miller Modigliani tests the effect of capital structure with respect to the same asset composition – not a changed asset composition, nor a changed balance sheet size. You are completely ignoring the fact that the vertical intervention of the government sector changes the macro asset composition of the non government sector as well as its balance sheet equity. More fundamentally, you are ignoring the effect of income flows on balance sheets over time. MMT net financial assets result from income flows generated by government expenditure.

      You’ve repeated the same error about interest accruals and payments for the umpteenth time now. There is no point in repeating the correct explanation here once again.

      You can’t disprove macroeconomic accounting identities by fiddling with microeconomic perturbations. In this case, horizontal fiddling with micro level asset composition and market values and capital structure is irrelevant to the main point about the effect of vertical intervention at the macro level.

      The value of macroeconomic accounting identities is that they are a logic check for those who understand them and a traffic block for those who don’t. More than a micro jackhammer is required to appreciate the full macro composition.

      I think we’re done here.

    72. Vinodh says:

      JKH and Ramanan:

      @4:01: wasnt the pricing rule the Bretton Woods agreement?

    73. RSJ says:

      Woah,

      “You’ve completely missed the MMT point about vertical intervention, which is that non government income, saving, and equity changes as a result, at the margin. ”

      This debate is about the form these marginal changes take.

      The horizontal sector is not some monolithic blob that shifts in the opposite direction of what the government does. The financial sector, household sector, non-financial business sector — they often shift in different ways as a result of government actions. It is possible to shift in many ways yet still maintain sectoral balance sheet consistency.

      Bond sales are actually a great teaching moment here, because the sale of the bond to the household sector (typically) causes the banks to hold fewer reserves but more claims on the other sectors, and it causes the household sector to leave their deposit levels unchanged, but to rotate out of some other private sector asset and into the government bond.

      It’s a great example of how the effects on the margin of the government sector causes the other sectors in the economy to react in different ways — this should have been a pleasant and interesting conversation. Scott should teach these shifts in some of his classes, to show that government sales can have complex and non-trivial effects at the margin, that are different for each sector of the “horizontal” world, even though on a net basis the sector as a whole of course moves in the opposite direction.

      These points went unanswered — possibly not understood — and the response was a rant about the glories of accounting and the beauties of vertical integration. No one is disputing that. “option 2” is just as accurate from an accounting and sectoral balance sheet consistency view as option 1, but when confronted with option 2, the result is babbling about the importance of Z.1 and accounting. And this is not the first time.

      Now if households simply rotate out of a private sector asset to buy the government bond, then you cannot argue that their financial net worth is increasing as a result of interest payments — only if the bonds are mispriced will this happen. That is my contention that started this debate.

      No need to address your misunderstanding of MM, or the belief that the increase in the market price of financial assets over time is simply an artefact of accrual accounting. LOL. Of course, all financial assets are nothing more than an expectation of future payment, so the market price will reflect some internal accrual valuation process by each market participant; nevertheless, the source of the increase in market price over time is due to the opportunity cost of investing elsewhere in a growing economy. And the price will reflect this.

      Anyways, I do agree that we are done, but it’s a bit disappointing that an intelligent person would not understand that dX + dY + dZ = dG can have more than one solution. This debate is about selecting which solution will actually happen. Far from being “horizontal fiddling”, it is crucial to get to the right welfare analysis and economic conclusion.

    74. Ramanan says:

      Vinodh,

      The question is if someone wants to devalue or revalue, what are (were) the steps. How often can one do it etc. There should be an old IMF paper which has the details. Am sure there would have been a lot of politics involved. Want to do some case study.

    75. mdm says:

      Bill,

      FYI:
      Looks like the NYFED changed their website and removed the description of the lagged-accounting arrangement for reserve requirements. I think I have a copy of the website on my computer (somewhere). I’ve tried searching their website for key words, but it hasn’t turned up within anything.

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