Saturday Quiz – October 30, 2010 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you work out why you missed a question or three! If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of modern monetary theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

Question 1:

Quite apart from whether they understand that they do not face any financial constraints, governments are now trying to reduce their budget deficits because they correctly understand that additional fiscal stimulus would increase the public debt ratios which would worsen their political positions.

The answer is False.

Again, this question requires a careful reading and a careful association of concepts to make sure they are commensurate. There are two concepts that are central to the question: (a) a rising budget deficit – which is a flow and not scaled by GDP in this case; and (b) a rising public debt ratio which by construction (as a ratio) is scaled by GDP.

So the two concepts are not commensurate although they are related in some way.

A rising budget deficit does not necessary lead to a rising public debt ratio. You might like to refresh your understanding of these concepts by reading this blog – Saturday Quiz – March 6, 2010 – answers and discussion.

While the mainstream macroeconomics thinks that a sovereign government is revenue-constrained and is subject to the government budget constraint, MMT places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue.

However, the framework that the mainstream use to illustrate their erroneous belief in the government budget constraint is just an accounting statement that links relevant stocks and flows.

The mainstream framework for analysing the so-called “financing” choices faced by a government (taxation, debt-issuance, money creation) is written as:
gbc

which you can read in English as saying that Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.

Remember, this is merely an accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been corrected added and subtracted.

So in terms of MMT, the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.

For the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).

That interpretation is inapplicable (and wrong) when applied to a sovereign government that issues its own currency.

But the accounting relationship can be manipulated to provide an expression linking deficits and changes in the public debt ratio.

The following equation expresses the relationships above as proportions of GDP:

debt_gdp_ratio

So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP. A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.

The real interest rate is the difference between the nominal interest rate and the inflation rate.

A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary budget balance is zero, public debt increases at a rate r but the public debt ratio increases at r – g.

So a nation running a primary deficit can obviously reduce its public debt ratio over time. Further, you can see that even with a rising primary deficit, if output growth (g) is sufficiently greater than the real interest rate (r) then the debt ratio can fall from its value last period.

Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.

The following blog may be of further interest to you:

Question 2:

The recent practice of large-scale quantitative easing (so-called printing money) in many nations and the fact that inflation is benign, strongly refutes the mainstream theory of inflation embodied in the Quantity Theory of Money, which claims that growth in the stock of money will be inflationary.

The answer is False.

The question requires you to: (a) understand the Quantity Theory of Money; and (b) understand the impact of quantitative easing in relation to Quantity Theory of Money.

The short reason the answer is false is that quantitative easing has not increased the aggregates that drive the alleged causality in the Quantity Theory of Money – that is, the various estimates of the “money supply”.

The Quantity Theory of Money which in symbols is MV = PQ but means that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and Q is always at full employment as a result of market adjustments.

Yes, in applying this theory they deny the existence of unemployment. The more reasonable mainstream economists (who probably have kids who cannot get a job at present) admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.

In general, the Monetarists (the most recent group to revive the Quantity Theory of Money) claim that with V and Q fixed, then changes in M cause changes in P – which is the basic Monetarist claim that expanding the money supply is inflationary. They say that excess monetary growth creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).

One of the contributions of Keynes was to show the Quantity Theory of Money could not be correct. He observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed. There is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will re

The mainstream have related the current non-standard monetary policy efforts – the so-called quantitative easing – to the Quantity Theory of Money and predicted hyperinflation will arise.

So it is the modern belief in the Quantity Theory of Money is behind the hysteria about the level of bank reserves at present – it has to be inflationary they say because there is all this money lying around and it will flood the economy.

Textbook like that of Mankiw mislead their students into thinking that there is a direct relationship between the monetary base and the money supply. They claim that the central bank “controls the money supply by buying and selling government bonds in open-market operations” and that the private banks then create multiples of the base via credit-creation.

Students are familiar with the pages of textbook space wasted on explaining the erroneous concept of the money multiplier where a banks are alleged to “loan out some of its reserves and create money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations. Please read my blog – Money multiplier and other myths – for more discussion on this point.

The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the central bank does not have the capacity to control the money supply. We have regularly traversed this point. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

So when we talk about quantitative easing, we must first understand that it requires the short-term interest rate to be at zero or close to it. Otherwise, the central bank would not be able to maintain control of a positive interest rate target because the excess reserves would invoke a competitive process in the interbank market which would effectively drive the interest rate down.

Quantitative easing then involves the central bank buying assets from the private sector – government bonds and high quality corporate debt. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserves. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.

For the monetary aggregates (outside of base money) to increase, the banks would then have to increase their lending and create deposits. This is at the heart of the mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. The recent experience (and that of Japan in 2001) showed that quantitative easing does not succeed in doing this.

Should we be surprised. Definitely not. The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.

The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.

Those that claim that quantitative easing will expose the economy to uncontrollable inflation are just harking back to the old and flawed Quantity Theory of Money. This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase. Should quantitative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.

So the fact that large scale quantitative easing conducted by central banks in Japan in 2001 and now in the UK and the USA has not caused inflation does not provide a strong refutation of the mainstream Quantity Theory of Money because it has not impacted on the monetary aggregates.

The fact that is hasn’t is not surprising if you understand how the monetary system operates but it has certainly bedazzled the (easily dazzled) mainstream economists.

The following blogs may be of further interest to you:

Question 3:

Bank lending is capital-constrained rather than reserve constrained. If the central bank forced banks to maintain a reserve ratio of 100 per cent then lending would also be reserve constrained.

The answer is False.

In a “fractional reserve” banking system of the type the US runs (which is really one of the relics that remains from the gold standard/convertible currency era that ended in 1971), the banks have to retain a certain percentage (10 per cent currently in the US) of deposits as reserves with the central bank. You can read about the fractional reserve system from the Federal Point page maintained by the FRNY.

Where confusion as to the role of reserve requirements begins is when you open a mainstream economics textbooks and “learn” 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 also 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 not an accurate description of the way the banking system actually operates and the FRNY (for example) clearly knows their representation is stylised and inaccurate. Later in the same document they they qualify their depiction 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.

In other words, the required reserves play no role in the credit creation process.

The actual operations of the monetary system are described in this way. 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”.

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.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the reserve requirements that might be in place at any point in time do not provide the central bank with a capacity to control the money supply.

So would it matter if reserve requirements were 100 per cent? In this blog – 100-percent reserve banking and state banks – I discuss the concept of a 100 per cent reserve system which is favoured by many conservatives who believe that the fractional reserve credit creation process is inevitably inflationary.

There are clearly an array of configurations of a 100 per cent reserve system in terms of what might count as reserves. For example, the system might require the reserves to be kept as gold. In the old “Giro” or “100 percent reserve” banking system which operated by people depositing “specie” (gold or silver) which then gave them access to bank notes issued up to the value of the assets deposited. Bank notes were then issued in a fixed rate against the specie and so the money supply could not increase without new specie being discovered.

Another option might be that all reserves should be in the form of government bonds, which would be virtually identical (in the sense of “fiat creations”) to the present system of central bank reserves.

While all these issues are interesting to explore in their own right, the question does not relate to these system requirements of this type. It was obvious that the question maintained a role for central bank (which would be unnecessary in a 100-per cent reserve system based on gold, for example.

It is also assumed that the reserves are of the form of current current central bank reserves with the only change being they should equal 100 per cent of deposits.

We also avoid complications like what deposits have to be backed by reserves and assume all deposits have to so backed.

In the current system, the the central bank ensures there are enough reserves to meet the needs generated by commercial bank deposit growth (that is, lending). As noted above, the required reserve ratio has no direct influence on credit growth. So it wouldn’t matter if the required reserves were 10 per cent, 0 per cent or 100 per cent.

In a fiat currency system, commercial banks require no reserves to expand credit. Even if the required reserves were 100 per cent, then with no other change in institutional structure or regulations, the central bank would still have to supply the reserves in line with deposit growth.

Now I noted that the central bank might be able to influence the behaviour of banks by imposing a penalty on the provision of reserves. It certainly can do that. As a monopolist, the central bank can set the price and supply whatever volume is required to the commercial banks.

But the price it sets will have implications for its ability to maintain the current policy interest rate which we consider in Question 3.

The central bank maintains its policy rate via open market operations. What really happens when an open market purchase (for example) is made is that the central bank adds reserves to the banking system. This will drive the interest rate down if the new reserve position is above the minimum desired by the banks. If the central bank wants to maintain control of the interest rate then it has to eliminate any efforts by the commercial banks in the overnight interbank market to eliminate excess reserves.

One way it can do this is by selling bonds back to the banks. The same would work in reverse if it was to try to contract the money supply (a la money multiplier logic) by selling government bonds.

The point is that the central bank cannot control the money supply in this way (or any other way) except to price the reserves at a level that might temper bank lending.

So if it set a price of reserves above the current policy rate (as a penalty) then the policy rate would lose traction.

The fact is that it is endogenous changes in the money supply (driven by bank credit creation) that lead to changes in the monetary base (as the central bank adds or subtracts reserves to ensure the “price” of reserves is maintained at its policy-desired level). Exactly the opposite to that depicted in the mainstream money multiplier model.

The other fact is that the money supply is endogenously generated by the horizontal credit (leveraging) activities conducted by banks, firms, investors etc – the central bank is not involved at this level of activity.

You might like to read these blogs for further information:

Question 4:

In an endogenous money system, a central bank cannot reduce bank lending while maintaining its target monetary policy rate by increasing the rate that provides reserves to the commercial banks.

The answer is False.

The facts are as follows. First, central banks will always provided enough reserve balances to the commercial banks at a price it sets using a combination of overdraft/discounting facilities and open market operations.

Second, if the central bank didn’t provide the reserves necessary to match the growth in deposits in the commercial banking system then the payments system would grind to a halt and there would be significant hikes in the interbank rate of interest and a wedge between it and the policy (target) rate – meaning the central bank’s policy stance becomes compromised.

Third, Any reserve requirements within this context while legally enforceable (via fines etc) do not constrain the commercial bank credit creation capacity. Central bank reserves (the accounts the commercial banks keep with the central bank) are not used to make loans. They only function to facilitate the payments system (apart from satisfying any reserve requirements).

Fourth, banks make loans to credit-worthy borrowers and these loans create deposits. If the commercial bank in question is unable to get the reserves necessary to meet the requirements from other sources (other banks) then the central bank has to provide them. But the process of gaining the necessary reserves is a separate and subsequent bank operation to the deposit creation (via the loan).

Fifth, if there were too many reserves in the system (relative to the banks’ desired levels to facilitate the payments system and the required reserves then competition in the interbank (overnight) market would drive the interest rate down. This competition would be driven by banks holding surplus reserves (to their requirements) trying to lend them overnight. The opposite would happen if there were too few reserves supplied by the central bank. Then the chase for overnight funds would drive rates up.

In both cases the central bank would lose control of its current policy rate as the divergence between it and the interbank rate widened. This divergence can snake between the rate that the central bank pays on excess reserves (this rate varies between countries and overtime but before the crisis was zero in Japan and the US) and the penalty rate that the central bank seeks for providing the commercial banks access to the overdraft/discount facility.

So the aim of the central bank is to issue just as many reserves that are required for the law and the banks’ own desires.

Now the question seeks to link the penalty rate that the central bank charges for providing reserves to the banks and the central bank’s target rate. The wider the spread between these rates the more difficult does it become for the central bank to ensure the quantity of reserves is appropriate for maintaining its target (policy) rate.

Where this spread is narrow, central banks “hit” their target rate each day more precisely than when the spread is wider.

So if the central bank really wanted to put the screws on commercial bank lending via increasing the penalty rate, it would have to be prepared to lift its target rate in close correspondence. In other words, its monetary policy stance becomes beholden to the discount window settings.

The best answer was false because the central bank cannot operate with wide divergences between the penalty rate and the target rate and it is likely that the former would have to rise significantly to choke private bank credit creation.

You might like to read this blogs for further information:

Question 5 – Premium question

In the context of population ageing, the fact that a sovereign government is never financially constrained may become irrelevant in terms of their capacity to provide first-class health care and pensions given rising dependency ratios.

The answer is True.

Does the dependency ratio matter? It surely does but not in the way that is usually assumed.

The standard dependency ratio is normally defined as 100*(population 0-15 years) + (population over 65 years) all divided by the (population between 15-64 years). Historically, people retired after 64 years and so this was considered reasonable. The working age population (15-64 year olds) then were seen to be supporting the young and the old.

The aged dependency ratio is calculated as:

100*Number of persons over 65 years of age divided by the number of persons of working age (15-65 years).

The child dependency ratio is calculated as:

100*Number of persons under 15 years of age divided by the number of persons of working age (15-65 years).

The total dependency ratio is the sum of the two. You can clearly manipulate the “retirement age” and add workers older than 65 into the denominator and subtract them from the numerator.

If we want to actually understand the changes in active workers relative to inactive persons (measured by not producing national income) over time then the raw computations are inadequate.

Then you have to consider the so-called effective dependency ratio which is the ratio of economically active workers to inactive persons, where activity is defined in relation to paid work. So like all measures that count people in terms of so-called gainful employment they ignore major productive activity like housework and child-rearing. The latter omission understates the female contribution to economic growth.

Given those biases, the effective dependency ratio recognises that not everyone of working age (15-64 or whatever) are actually producing. There are many people in this age group who are also “dependent”. For example, full-time students, house parents, sick or disabled, the hidden unemployed, and early retirees fit this description.

I would also include the unemployed and the underemployed in this category although the statistician counts them as being economically active.

If we then consider the way the neo-liberal era has allowed mass unemployment to persist and rising underemployment to occur you get a different picture of the dependency ratios.

The reason that mainstream economists believe the dependency ratio is important is typically based on false notions of the government budget constraint.

So a rising dependency ratio suggests that there will be a reduced tax base and hence an increasing fiscal crisis given that public spending is alleged to rise as the ratio rises as well.

So if the ratio of economically inactive rises compared to economically active, then the economically active will have to pay much higher taxes to support the increased spending. So an increasing dependency ratio is meant to blow the deficit out and lead to escalating debt.

These myths have also encouraged the rise of the financial planning industry and private superannuation funds which blew up during the recent crisis losing millions for older workers and retirees. The less funding that is channelled into the hands of the investment banks the better is a good general rule.

But all of these claims are not in the slightest bit true and should be rejected out of hand.

So you get all this hoopla about the fiscal crisis that is emerging. Apparently we have to make people work longer despite this being very biased against the lower-skilled workers who physically are unable to work hard into later life.

We are also encouraged to increase our immigration levels to lower the age composition of the population and expand the tax base. Further, we are told relentlessly that the government will be unable to afford to provide the quality and quantity of the services that we have become used too.

However, all of these remedies miss the point overall. It is not a financial crisis that beckons but a real one. Dependency ratios matter because they tell us how many workers will be available to produce real goods and services at any point in time. So we can make projections about real GDP growth for given projections about productivity once we have an idea of these underlying dependency ratios.

Clearly we want to be sure that the projected real needs of the population are capable of being met with the likely available resources.

So the only question we need to ask about the future population trends relate to whether there will be enough real resources available to provide aged-care, etc at a desirable level in the future? However, that is never the way the debate is framed. The worry is always that public outlays will rise because more real resources will be required “in the public sector” than previously.

However these outlays are irrelevant from a financial point of view. The government can purchase anything that is for sale in the currency it issues at any time. There is never a question that the government cannot afford to buy something that is available.

It is the availability that is the issue. As long as these real resources are available there will be no problem. In this context, the type of policy strategy that is being driven by these myths will probably undermine the future productivity and provision of real goods and services in the future.

It is clear that the goal should be to maintain efficient and effective medical care systems. Clearly the real health care system matters by which I mean the resources that are employed to deliver the health care services and the research that is done by universities and elsewhere to improve our future health prospects. So real facilities and real know how define the essence of an effective health care system.

Further, productivity growth comes from research and development and in Australia the private sector has an abysmal track record in this area. Typically they are parasites on the public research system which is concentrated in the universities and public research centres (for example, CSIRO).

Unfortunately, tackling the problems of the distant future in terms of current “monetary” considerations which have led to the conclusion that fiscal austerity is needed today to prepare us for the future will actually undermine our future.

The irony is that the pursuit of budget austerity leads governments to target public education almost universally as one of the first expenditures that are reduced.

Most importantly, maximising employment and output in each period is a necessary condition for long-term growth. The emphasis in mainstream integeneration debate that we have to lift labour force participation by older workers is sound but contrary to current government policies which reduces job opportunities for older male workers by refusing to deal with the rising unemployment.

Anything that has a positive impact on the dependency ratio is desirable and the best thing for that is ensuring that there is a job available for all those who desire to work.

Further encouraging increased casualisation and allowing underemployment to rise is not a sensible strategy for the future. The incentive to invest in one’s human capital is reduced if people expect to have part-time work opportunities increasingly made available to them.

But all these issues are really about political choices rather than government finances. The ability of government to provide necessary goods and services to the non-government sector, in particular, those goods that the private sector may under-provide is independent of government finance.

Any attempt to link the two via fiscal policy “discipline:, will not increase per capita GDP growth in the longer term. The reality is that fiscal drag that accompanies such “discipline” reduces growth in aggregate demand and private disposable incomes, which can be measured by the foregone output that results.

Clearly surpluses help control inflation because they act as a deflationary force relying on sustained excess capacity and unemployment to keep prices under control. This type of fiscal “discipline” is also claimed to increase national savings but this equals reduced non-government savings, which arguably is the relevant measure to focus upon.

So even though the government is not financially constrained it might adopt a policy platform that undermines productivity growth and leaves the economy short of real productive resources at a time in the future when they will be needed to fulfill its socio-economic program.

You might like to read this blogs for further information:

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This Post Has 42 Comments

  1. Recently at Mark Thoma’s website I had yet another discussion about the effect reserves have on the supply of money. This time the discussion was with someone calling themselves “Uh, no,” not Professor Thoma himself. In the discussion “Uh, no,” made the assertion that if you use the proper monetary index, then the money multiplier can be observed by dividing that index by the monetary base. He/she claimed that by using the M1 index the MMT folks have been misleading and that if you use the proper formula for calculating the money multiplier it is clearly observable. I asked for that formula and to provide some evidence to to the effect that the relationship can be empirically observed, but so far “Uh, no,” has not responded. I was wondering if any of the more knowledgeable MMT proponents have a few minutes, maybe they wouldn’t mind looking through the discussion and commenting. I felt I was unable to respond to some of “Uh, no’s,” points properly because I did not have the requisite knowledge about more complicated formulas for calculating the money multiplier. Here is the link to where the conversation started:

    http://economistsview.typepad.com/economistsview/2010/10/friedman-was-all-wrong-about-japan-and-the-great-depression.html#comment-6a00d83451b33869e201348892141f970c

    Thank you for your time.

  2. NKlien1553, if I recall correctly, MMT’ers hold that the “money multiplier” emerges an ex post accounting phenomenon rather than being an ex ante cause as the theory holds.

  3. “uh no” says loans create deposits=nonsense. Waste of time. It’s just accounting, for crying out loud. Even neoclassicals are figuring this out. Some of them, anyway. And, yes, as Tom says, the multiplier model has the causation backwards, while the multiplier measured empirically can certainly be stable with no contradiction to MMT.

  4. Interesting answer on the Premium question about the worries about future pensioners.

    In the new “reformed” public pension system in Sweden there is regulated that the payouts in a year can never be bigger than what is paid to the system that year. A minor buffer there is but in principle it shall balance. A larger part is also placed on speculative financial markets.

    Now there is talk about higher retiring age. Booth right and left are in total agreement that there have to be budget surpluses and public “savings” to meet future obligations, at the same time people are told that they have to save more them self and not trust the public pension system.

  5. Wow, “Uh, no” surely comes across as condescending.

    Addressing some of his/her points:

    I mean really, “loans create deposits” is just stupid — it jumps right in the middle of the multiplier process and actually demonstrates it.

    Anyway, it’s hard to make sense of whether or not ‘uh, oh’ has actually read the literature on endogenous money. He states that ‘loans create deposits’ ‘jumps right in the middle of the multiplier process’. This can be interpreted in two ways:
    1. He/she actually understands the endogenous theory of money creation and believes that the theory is wrong and actually demonstrates conventional theory, or;
    2. He/she has no idea.

    I’m more inclined to go with 2. Particularly when they ask the following question: “Where did the money for the loans come from in the first place?”.

    The theory of endogenous money is as follows:
    Money is a social institution, and it is a debt-credit relationship – that is, ‘money’ is a financial asset and must have a matching liability. Any entity can create money the issue is in other entities accepting your liabilities. If any entity can get its liabilities accepted, then ‘money’ is created. When a bank creates a loan it is essentially create a credit which is convertible into state money. The act of loan creation creates a matching deposit as a matter of accounting.

    To answer the question: the ‘money’ is created ex nihilio; by the very act of loan creation. If he is referring to ‘money’ in the sense of reserves, then clearly that financial asset can only come whatever entity has that money as a liability (i.e. is the source), in the case of reserves/state money it is the government (central bank + treasury). No other entity can create this type of financial asset.

    Re the money multiplier:

    Uh oh says the following:

    Wow. The simplest formula for the multiplier is 1/(r+e), i.e. 1/(reserve requirement plus excess reserves) and you can’t figure out how excess reserves affect the multiplier? You can’t see how an increase in excess reserves lowers the multiplier? [Adding in the complications for the multiplier for, say, M2 doesn’t change the relationship between excess reserves and the multiplier]

    The money multiplier is simply an ex post accounting identity. It is simply a ratio. It is mainstream theory which has interpreted it as an ex ante constraint.

    The ironic thing about all of this is that you can easily find persons outside of the post Keynesian and MMT paradigm whom accept the endogenous money framework and reject the conventional theory. For instance, I’m fairly certain the phrase ‘loans create deposits with reserves sought after the fact’ was derived a quote of a FED central banker (possibly Holmes?).
    The ex governor of the RBA:

    “When the dust has settled and statistics collected, it will be seen that there is a reasonable relationship between the cash base … and bank deposits. IT is this relationship that has traditionally been referred to as the multiplier between money base and money supply, but as the forgoing suggests, causality between the two variables is a complicated process and not a mechanical one, as estimated equations for the multiplier would imply. The main channel of causality runs from interest rate to deposit growth and then cash or bank reserves. The multiplier shows a simple supply relationship but that is because it leaves out the chain of causality” (Macfarlane, 1984, p.116)

    most Central banks will describe their behaviour as follows:

    “The Reserve Bank has no prescribed target for the level of settlement balances [reserves], supplying whatever amount is needed to keep the cash rate near the target (RBA, 2003, p.4)

    This is how I interpret it: the word ‘accommodating’ implies that the supply of reserves comes after – as a response/defensive operation- and it is supplied so that the RBA can maintain its target rate. Which would be consistent with a paper published by the BIS late last year which stated that banks do not consider their reserve position prior to making a loan, and that banks are interest rate inelastic, if the central bank wishes to maintain its target then it has no choice but to both defend and accommodate the demand for reserves, otherwise it can expect much volatility in the overnight rate:

    The underlying premise of the …proposition, which posits a close link between reserves and credit creation, is that bank reserves are needed for banks to make loans. Either bank lending is constrained by insufficient access to reserves or more reserves can somehow boost banks’ willingness to lend. . . in fact, the level of reserves hardly figures in the banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constraint the expansion directly. The reason is simple… in order to avoid the extreme volatility in the interest rate, central banks supply reserves as demanded by the system. (Borio and Disyatat, 2009, p. 19)

    The extreme volatility arises because banks are interest rate inelastic:

    “…the implied highly ineslastic demand curve is what obliges the central bank to meet the small demand for (excess_ reserves very precisely, in order to avoid unarranted extreme volatility in the rate…” (Borio and Disyatat, 2009, p. 18)

    If I have made a mistake anywhere please let me know. Sorry about the length as well.

  6. Sorry I forgot to add the reference list:

    Sources:

    Borio, C. & Disyatat, P. 2009. Unconventional monetary policies: an appraisal. BIS working papers no 292. Novemeber 2009.

    Macfarlane, I. 1984 Methods of Monetary Control in Australia. Reserve Bank of Australia Bulletin, 110-23 [Accessed from a thesis paper].

    RBA. 2003. The Reserve Bank’s Open Market Operations”. Reserve Bank of Australia Bulletin, June 1-7.

  7. Bill, I’m generally on board, but here’s a devil’s advocate question to elicit your best formulation.

    You’ll agree that austerity in private consumption — enforced via ration coupons for gasoline, rubber, sugar and other basic products — conserved real resources for the war effort. Does it not follow that austerity in government expenditures assures a greater availability of resources for private consumption, via the simple mechanism of opportunity cost?

    Yours, EconCCX

  8. mdm,

    Holmes:

    [The orthodox idea] suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. .. . In any given statement week, the reserves required to be maintained are predetermined by the level of deposits existing two weeks earlier…. Since banks have to meet their reserve requirements each week, and since they can do nothing within that week to affect required reserves, that total amount of reserves has to be available to the banking system

    Holmes, Alan R. 1969. “Operational Constraints on the Stabilization of Money Supply Growth.” In Controlling Monetary Aggregates. Boston: Federal Reserve Bank of Boston.

  9. NKlein1553,

    The backdrop on that site includes the fact that Mark Thoma himself does not understand this subject at all. That’s been demonstrated numerous times in his previous posts. So in that sense you’re up against a fortress of misunderstanding there.

    And it’s very obvious from the comments that you understand far more about it than “uh no”.

    Ramanan – that must be one of the older references on the subject.

  10. MDM and Ramanan–Excellent quotes/points.

    NKlein–valiant effort. The points made by MDM and Ramanan should help if you need further rebuttals. Also, my paper here–http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1658232–makes use of a good deal of neoclassical literature that could be of use, though it was written before the recent efforts by Borio and some others at the NY Fed were published that further confirm the fallacy of the money multiplier as an ex ante constraint.

  11. Scott,

    The paper that hasn’t been written yet, top down in my view, is the one that distinguishes between CB liability driven reserve operations and CB asset driven reserve operations.

    CB liability driven reserve operations are covered correctly by MMT (e.g. your paper) in terms of payments systems function, multiplier fallacy, ex post supplying of required reserves, interest rate control, etc.

    CB asset driven operations describe what happened in the early part of the financial crisis, in terms of the “credit easing” phase. They’re asset driven because the CB is using excess reserves to absorb and transform credit risk previously held by the private sector. This requires balance sheet expansion beyond a certain point – credit risk assets and offsetting reserves. It is (mostly) unrelated to the basics of reserves in terms of their payment system purpose and their interest rate control purpose. Instead, they become critical to the CB in terms of its own asset-liability management in credit risk matters. They still remain irrelevant to the banks in terms of a commonly misunderstood “multiplier” effect.

    Now we’re back in boiler plate quantitative easing mode – which is liability driven from the consolidated G/CB standpoint. But the “credit easing” phase was asset driven, whether considered at the stand-alone CB point or from the consolidated perspective – because it required accumulation of assets that were not G liabilities.

    (I’m not saying MMT hasn’t covered these issues – just that I haven’t yet seen a paper anywhere that takes this particular view of it. Then again, maybe nobody else thinks of this way.)

  13. JKH

    I responded, but it’s awaiting moderation since I have a rather long link there. In the meantime, I’ll add to that note that Marc Lavoie at the Univ. of Ottawa has argued for years, even decades, that there are two approaches to monetary operations. He calls the first the “asset-based” approach, which corresponds with your liability approach, in which the CB buys/sells financial assets held by the private sector. He calls the second method the “overdraft” approach, in which the CB manages interbank markets by providing credit. Marc points out that the asset-based approach is historically the one taken by CBs of Anglo-Saxon nations, while the overdraft approach has been historically the one taken by Continential European CBs. While Marc didn’t emphasize the credit-risk implications in the “overdraft” approach, it’s a rather small stretch to get there from his starting point. I briefly discussed Marc’s work on this in the “general principles” paper linked to above in principle 9.

  14. If I remember correctly, Paulson initially wanted Bernanke to handle the incipient crisis from the assets side by taking the big banks’s bad assets onto the Fed’s balance sheet, and Bernanke responded that since solvency was fiscal, this kind of operation was the job of Congress. As a result Paulson got Congress to jam through a rescue package (back of the envelope 750B) and then follow up on it with the AIG bailout, etc.

    Subsequently, Bernanke took a lot of the MBS onto the Fed’s balance sheet in QE1, leading some to charge that this was a disguised fiscal operation being pursued under the guise of emergency powers. Denninger and others were calling foul, but nothing legal came of it. Now QE2 seems to be on the way, and it is unclear what the Fed will purchase this time around and why. I guess we’lll see this week.

  15. JKH, yet again,

    While waiting for the other post to be moderated, I presented a paper in September 2009 in which I added 5 more principles as a result of the financial crisis–central bank requirement of collateral is redundant (and dangerous in a crisis), CB can set lending rates at any point in the term structure, “unconventional” operations are about rates and spreads, the overnight market is a waste of resources, and “exit strategies” are both simple and operationally unnecessary.

  16. Scott,

    Yes, I now recall Ramanan referring to the “overdraft system” differentiation, somewhere. Clearly I should have paid more attention to it. No doubt R. must be slumbering now, or he’d be all over this.

    If I refer to one model as the “Fed model”, my point would be about differentiation of Fed reserve operations depending on overriding purpose. I don’t know if that should be viewed as the same type of differentiation intra-system as between the two systems or not.

    I didn’t review your paper closely enough this time, and missed the “non-traditional” reference. Although this appears to have been written before the Fed’s balance sheet expansion started in earnest and before payment of interest on reserves was authorized. (I recall a facilitating blip in Treasury special account balances back then).

    I’m mixing a couple of ideas. One is whether the assets acquired are private sector, since CB acquisition of government bonds amounts to consolidated liability mix changes. But either way, the second point is whether the reserves created in the process are in response to bank demand for reserves or not. It’s clear that the MBS program created reserves that were not (or at least not all of them) in response to demand for same. So that’s what I would consider to be “asset driven” in my inverse terminology. (I suppose MBS might arguably be considered private or public, but in fact they don’t normally show as part of public sector consolidation.)

    I can see your +5 principles as MMT on theme, in the context of the crisis.

    I guess my underlying point is that the degree of confusion about why those excess reserves are there now simply compounds the problem of de-programming mass delusion on the issue of the money multiplier.

    I’ll await your other link.

  17. Scott,

    Just saw the link – which I’ll look at – but meanwhile:

    Reviewing the “Principle 9” section of your paper more closely, it appears that the distinction between “asset based” and “overdraft” is based on the nature of the financial instrument or accounting entry used in the process of creating reserves. That is not the same as the distinction I’m making between “asset based” and “liability based”, which refers to the primary balance sheet objective of the CB rather than the instrument used for reserve creation. (And I also note as I think you do as well that the asset/overdraft distinction is ambiguous, since the overdraft facility translates to a central bank asset (loan) as the financial instrument or accounting entry that corresponds to the creation of associated reserves; and “asset based” reserve adjustments are typically in the form of repos that are functionally equivalent to lending and therefore to overdrafts.) In any case, the instrument of reserve creation is NOT the point of the distinction I’m making. In my usage, the mode is liability based if the primary objective of policy is to supply CB reserve liabilities in response to the demand for reserves; it is asset based if the primary objective of policy is to acquire (private sector) assets that create reserves as a by product of an asset policy action, rather than as a response to the demand for reserves per se. By coincidence, nevertheless, my use of asset and liability correlates more positively than negatively (as you seemed to suggest) with the use of asset and overdraft in the other paradigm.

  18. JKH,

    Yes, agreed, I was just pointing out that Marc had made a distinction earlier and, as I noted, “while Marc didn’t emphasize the credit-risk implications in the ‘overdraft’ approach, it’s a rather small stretch to get there from his starting point.” The key point, as you note, is intent on the part of the CB. But the understanding of how it could be done was already there, which was my point. As such, Warren Mosler, for instance, almost immediately (if not immediately, in fact) suggested the Fed take on what you are referring to as an asset approach as the crisis started up in late summer 2007. Also, note Marc’s Levy WP 606 that I referred to above.

  19. 1.Re Marc lavoie’s paper (WP 606): the exchange he had with Keister is interesting. I have provided it below for convenience:

    Marc lavoie:

    You seem to imply that the textbook multiplier still applies when reserves earn no interest. I think that this is a misleading statement […]. It implies that there is a bunch of agents out there, waiting for banks to provide them with loans, but that they are being credit rationed because banks don’t have access to free reserves. This contradicts your September 2008 article [Keister, Martin, and McAndrews 2008] where you show that the Fed normally tries to supply the reserves demanded by the banking system at the target interest rate. So it means that if banks make more loans, hence create more deposits, and need more reserves, the Fed will supply them to keep the fed funds rate on target. Rather what happens when excess reserves are being provided with no remuneration of reserves is that the fed funds rate drops down, as banks with surplus reserves despair to find banks with insufficient reserves, having no alternative but a zero rate. The drop in the fed funds rate may induce banks to lower their lending rates, and hence induce new borrowers to ask for loans or bigger loans, but it really has nothing to do with the standard multiplier story. If there is no change in the lending rate, new creditworthy borrowers just won’t show up. There is never any money multiplier effect.(lavoie, 2010, pp. 15-16)

    To which Keister responds:

    I agree with you on the money multiplier, but I would state things in a slightly different way. In order for the money-multiplier story to make sense, it must be the case that it (implicitly, at least) works through lowering interest rates. The process must go just as you described, with the increase in reserves lowering market rates, which makes more potential projects profitable. I understand your comment to be that this mechanism is not the ‘money multiplier’ as commonly described. We decided to be more generous to the textbooks and say that this mechanism must be what they had in mind, even if they left out the part about interest rates to simplify things for the students. Importantly, I think we agree on the point that discussions of the money multiplier have done more harm than good in terms of helping people understand what is going on. (lavoie, 2010, p. 16)

    2.Another question for Uh, Oh is where do deposits come from? Who has created the financial liability which corresponds to the financial asset (deposit)? Or is this an instance where the deposit creation violates accounting principles?

    3.Disclaimer: I haven’t properly thought this through, but it seems to make sense when relating it to banks and loan creation.
    I’ve often thought of the loan and deposit creation process as similar to the transactions between business entities which results in Accounts Receivable and Accounts Payable. The basic process is as follows:

    There are two business entities: Business A – which sells goods- and Business B – which buys the goods for whatever reason.
    Business B lacks funds – maybe hasn’t been paid for past jobs.

    *ignoring the institutional arrangements, business B may be required to fill out a credit ratings form, provide references, there may exist a good credit relationship – i.e. trust, but this is irrelevant.*

    Business A in essence extends a credit to business B, allowing Business B to purchase Business A’s goods on credit. The credit is spent simultaneously with Business B purchasing good X from Business A.

    The end result is a transfer of goods from Business A to Business B and the creation of an Accounts Receivable on Business A’s balance sheet and Accounts Payable on Business B’s balance sheet.

    Both entries are later ‘destroyed’ when the Business B clears his debts with business A.

    This transaction occurs all the time!

    Business A in effect is creating a loan, of course the main difference is that Business A’s credit isn’t ‘marketable’ like a bank’s credit is. Regardless, no prior reserves are required; the credit isn’t somehow loaned out from a pool of ‘savings’ or funds.

    An aside: The other important point is that the creation of the credit (which is spent immediately) creates a financial asset and liability. It would be nonsensical to talk of accounts receivable without a matching accounts payable existing on another entities balance sheet. As the definition of an asset is a stock in which an economic benefit (flow) ‘flows’ into; it wouldn’t make sense for an entity it have an asset from which no possible economic benefit could ever flow into.

    If I am wrong anywhere I appreciate being corrected! thanks.

  21. “So it means that if banks make more loans, hence create more deposits, and need more reserves, the Fed will supply them to keep the fed funds rate on target.”

    Assuming I am understanding that correctly, are the reserves supplied at the fed funds rate or the discount rate?

  22. “So it means that if banks make more loans, hence create more deposits, and need more reserves, the Fed will supply them to keep the fed funds rate on target.”

    Or will the fed wait and hope that the deposit moves from say a checking account to a savings account (0% reserve requirement I believe) so that the effective reserve requirement goes down?

  23. VJK,

    I am still not happy with money flow

    Well, it is a ponzi model 🙂

    But the purpose of the model is to show that ponzi borrowing is operationally possible without banks. What does it mean that you are “not happy”? Which flow is operationally impossible?

    I need to understand how the profit formation path in your stylized economy works

    Profits always work in the same way. One actor spends less than they earn (in the goods/labor market), and another actor spends more than they earn (in the goods/labor market). The discrepancy is made up in the financial markets, as the actor earning the profit buys the IOU of the deficit actor. It’s a simple arithmetic constraint, and the assumption that cash-in = cash-out in all markets means that the quantity of cash is irrelevant. This is a Walras law argument.

    Operationally, you can stylize private sector deficit spending as follows: the creditor and the borrower both agree on the possibility of repayment — e.g. “equity” and on a rate of interest. The borrower then sells an IOU to the creditor, and uses the proceeds to buy goods from the creditor. The creditor has earned a profit in the goods market, and the borrower has deficit spent. This was made possible via borrowing.

    For a very simple non-ponzi model with investment, just take an OLG model in which the young buy IOUs from the old.

    As for whether the debt is “backed by equity”, one firm’s equity is just the estimated discounted stream of dissaving that it will obtain from the rest of the economy, and this number measures how much the firm can dissave today. So a general increase in expected future dissaving will result in higher equity levels today, which means more dissaving today. At the micro-level, you can assume that the demand to dissave is exogenous to the firm, so that the equity value of the firm will be an idiosyncratic function of the firm and the economic climate. But for the economy as a whole, equity size does not constrain (final) borrowing, but both rise or fall together. Investment is self-financing, and more generally, dissaving is self-financing.

  24. Thank you to everyone that responded; especially mdm, Professor Fullwiler, and JKH. In my conversation with “Uh, no,” I feel I got too bogged down in trying to show that the money multiplier cannot be empirically observed. That seems to have been a mistake as some relationship between the monetary base and a broad measure of monetary aggregates may in fact exist if a proper monetary index is created. However, as I realize now, that really doesn’t have anything to do with the fact that the operational constraint on bank lending are capital adequacy requirements and not required reserve ratios. This was the initial point I was trying to make, perhaps not very well, in response to Professor Krugman’s post challenging Milton Friedman’s assertion that the Fed can always stop an economic downturn by simply injecting large amounts of reserves into the banking system. As I tried to point out, that kind of supply-side recommendation is A) inappropriate in the face of a collapse in aggregate demand, and B) not even a properly specified supply-side recommendation. As the conversation in this post between Professor Fullwiler and JKH makes clear, a proper supply-side analysis should be focused on what JKH calls the asset side approach.

    Finally, in response to Professor Fullwiler’s suggestion at 11:52, that I copy and paste the conversation mdm posted at 10:49, I have to apologize, but I do not feel I have the patience to engage with “Uh, no,” any longer. The way that conversation at Professor Thoma’s website was carried out was rather upsetting for me and I don’t think I want to take it any further. I’ve been visiting Professor Thoma’s website for well over a year now and even if I do not believe Professor Thoma’s analysis of the banking system is correct, I greatly enjoy the conversations I have with several of the regular commentators there; especially those commentators calling themselves paine, Bruce Wilder, don, Min, and Goldilocksisbleachblond. I fear that continuing such an unpleasant conversation will sour me on commenting at Professor Thoma’s website so for the time being I’m going to abstain from further comments on the post in question. Again, thank you to everyone for your time.

  25. NKlein . . . that all sounds good, and completely understand your desire not to continue to engage. It sounds to me like you have a very good grasp of these issues overall.

    JKH . . . after more thought, perhaps trying to expand “overdraft” operations to ultimately be consistent with your asset approach isn’t that useful. One could envision the asset approach being applied to either overdraft (US credit easing) or asset-based (Japan’s QE, US MBS purchases) operations. (As an aside, an overarching theme of my work is that for what you term the liability approach, EVERY CB actually runs what Lavoie calls overdraft based operations, whether they know it or not.) I think the foundations for understanding this are in my general principles 8 and 9 in the SSRN paper I linked to above. Then, once those are understood, the additional 5 general principles I mentioned related to the crisis explain a good deal of the context for understanding what you call the asset approach. In my chapter I linked to above from my book, the first four of these principles are described; the lack of necessity for an exit strategy, which isn’t in that chapter, is probably the most obvious of these once one understands how interest on reserves works.

  26. Few points + rant.

    1. Going back to Uh, oh’s question: “Where did the money for the loans come from in the first place?”

    He/she seems completely unaware that Post Keynesians and MMT define money not as a thing but as a relationship. It must seem almost nonsensical to someone with that ontological position (money as a thing) to comprehend the ‘loans creates deposits’ process. Hence the question, which I don’t think he/she is asking you literally, rather, its rhetorical: ‘there is no way that process could be correct, the bank can’t lend if it doesn’t have any money to lend’. If they had taken you seriously, I’m sure the tone of the comments would have been something other than overbearing confidence.

    Given that he is unaware of the ontological position of MMT and PK, it is puzzling how someone can then infer that the paradigm is a cult or cult-like. I would have thought that to accuse a paradigm of being cult like the bare minimum would be that you have an understanding of what they are saying, their hard-core beliefs, etc. rather than dismissing it out of hand. Mark Thoma has made similar claims in the past – and it seems to be fairly common across that blog and associated blogs – but when he did he conflated the rejection of the money multiplier as being solely a MMT theory, when as far as I understand it (and if we assume that MMT and Post Keynesian economics are distinct) it is actually a Post Keynesian theory which MMT accepts, so to dismiss a paradigm based off of a misunderstanding of where various theories are derived from seems erroneous.

    2.Uh Oh endless repeating the money multiplier seems to miss the point as well: you’re raising the issue of whether the money multiplier is a valid concept in understanding causality and whether it describes operational constraints – i.e. why is the money multiplier deposits to loans, and why is it assumed to be an ex ante constraint – for uh oh to just repeat what the money multiplier doesn’t address your concerns. There’s no denial that the money multiplier exists – it’s an ex post accounting ratio – but whether or not it is important and deriving an interpretation of the ratio – i.e. causality – requires theory which is something distinct from the ratio itself.

    3.An aside and a bit of a rant and probably wrong:

    Uh oh says:

    There’s also a pretty clear relationship in the data between the spike in excess reserves and the fall in the multiplier, so it’s not clear what you are trying to prove by pointing people to the data. It shows just the opposite of your claim.

    Something I have always wondered in my econometrics class (undergrad) is how do we avoid committing the following fallacy post hoc ergo propter hoc? You’re required to make and use assumptions (a lens by which you view the world) when constructing an econometric model and when analysing the data, but when are these assumptions actually tested themselves: that is when is the assumption that banks lend reserves actually tested?

    I’ll provide another example to clarify what I mean: the common example of the fallacy is that spending comes before Christmas, therefore spending causing Christmas, of course, we know that in fact the spending is caused by the Christmas and causation is thus reversed, but we only get to this result because of an underlying assumption of Christmas. If we were to assume that for whatever reason the act of spending was in fact the cultural significant event (celebrating the act of consuming), and Christmas occurred because of this, then if we were to look at a relationship in the data, we would see the causation exactly how we initially assumed causation to go, in fact, it would be nonsensical to speak of the spending occurring as a result of Christmas, because ‘why would anyone celebrate Christmas – which is merely the afterthought of the celebration of spending’. The point is that how is this avoided in econometrics when from my limited knowledge it seems as though this would be a problem.

  27. MDM . . . that’s all very good, but just one clarification–“loans create deposits” isn’t MMT “theory,” it’s just basic accounting and it simply couldn’t be any other way. For people like “uh, no,” my preferred response is to ask them to show how the transaction in question affects the financial statements of those involved. Then you see if they have a clue. As I’ve said repeatedly in the past, every transaction affects the financial statements of those involved, and if you can’t correctly illustrate the effects on financial statements, you don’t actually understand the transaction.

  28. Late in the discussion, would add a few things.

    Marc talks of three behaviors of central banks – accommodating, defensive and dynamic. He also distinguishes between “asset based” banking setups and “overdraft type” monetary systems.

    The accommodating behavior of central banks in asset based monetary systems through which central banks do outright purchases of government securities to help banks satisfy reserve requirements and help the banks meet the private sector demand for currency notes. In overdraft monetary systems, it happens via higher claims on banks.

    The defensive operations of central banks are the neutralizing operations. In asset-based monetary systems, it happens via open market operations through repurchase agreements. This is done to prevent the interbank lending rates from deviating from the target. These operations neutralize flows such as the Treasury spending, taxes, bond issuance etc. It can also be to offset reserve effects due to purchase/sale of foreign exchange by the central bank. (And also due to flows in and out of foreign central banks’ accounts). It can also be achieved by transfer of government deposits in and out of the banking system such as in Canada.

    In overdraft systems too, transfer of government deposits is used for defensive operations.

    This way of describing is good and clears a few things. In overdraft monetary systems, such as the Euro zone and the setups before the Euro – when these nations had control over their central banks, the repos are of the accommodating type, whereas in asset-based systems, they are of defensive type – even though both used the same terminology.

    Central banks can also be “dynamic” or monetarist – out to kill demand. In that case too, they are just changing interest rates. (in Monetary Base Endogeneity And The New Features Of The Asset-Based Canadian And American Monetary Systems:

    As to the supply of high-powered money, after a long intermission driven by the monetarist fad, central bankers are coming back to the view that movements in money aggregates or in the monetary base contain no useful information for monetary policy; they are a sideshow-“a meaningless abstraction” as Albert Wojnilower once put it (1980, p. 324). The new procedures put in place in Canada are particularly enlightening. Central banks do not attempt to control the monetary base. The latter is entirely demand determined. The monetary operations of central banks are entirely defensive. Their purpose is precisely to ensure that the supply of high-powered money is exactly equal to its demand, at the target interest rate of their choice. The central bank may also intervene in specific markets, besides the repo market, to make sure that interest rates in these markets are in line with the target overnight rate. Monetary operations are always interest rate maintenance operations.

    Thus, perhaps it would be best to distinguish between “defensive” and “accommodating” behavior, as done by Eichner (1987, p. 847) and, more recently, by Rochon (1999, p. 164). In my opinion, central banks pursue “defensive” or “neutralizing” operations at all times, as emphasized by the neo-chartalist authors. High-powered money is thus always fully endogenous. This is a key feature of horizontalism. On the other hand, central banks can be accommodating or not. When they are, they will peg the interest rate, whatever the economic conditions. When they are not accommodating-that is, when they are pursuing “dynamic” operations as Victoria Chick (1977, p. 89) calls them-central banks will increase (or decrease) interest rates. As shown above, to do so, they now need to simply announce a new higher target overnight rate. The actual overnight rate will gravitate toward this new anchor within the day of the announcement. No open-market operation and no change whatsoever in the supply of high-powered money are required. One should thus conclude, as I wrote some time ago, by saying that “money is in some sense endogenous whether central banks are dynamic or not” (Lavoie, 1984, p. 778).

    There are also other central bank behaviours described in lit which Scott has referred to. One is the lender of the last resort behaviour on which Minsky has a chapter on – in Stabilizing An Unstable Economy, 1986

    Chapter 3 – The Impact Of Lender-Of-Last-Resort Intervention:

    Whereas Big Government stabilises output, employment and profits by its deficits, the lender of last resort stabilizes asset values and financial markets; for example, the Federal Reserve buys, stands ready to buy or accepts as collateral financial assets that otherwise are not marketable; it thereby substitutes or stands ready to substitute, its own riskless liabilities for assets at risk in various portfolios. Whereas Big Government operates on aggregate demand, sectoral surpluses, and increments of government liabilities in portfolios, the lender of last resort works on the value of inherited structure of assets and the refinancing available for various portfolios. Both sets of stabilizing efforts are necessary to contain and reverse an income decline associated with financial trauma such as took place in 1974-75 (and in 1969-70 and 1981-82).

    Then there is also “large scale asset purchases” which keeps yields low. However it has been stressed that fiscal policy is simply the only way to go – due to lack of animal spirits, why would anyone borrow just because yields are low, direct effect of fiscal policy (chap 2 – The Impact of Big Government: Minksy’s book)

  29. NKlein1553,

    As JKH put it so well, you are up against a “fortress of misunderstanding” at that site.

    Max Planck, a physicist said it well – and he was talking of any academic discipline, not just his:

    A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it

    There are two ways to look at this quote. One is in a pessimistic way “there is no hope” and the other is in an optimistic way – take it as a challenge. It can also be used to empathize one another for the efforts.

    The biggest problem is simply that the majority of economists in universities and policy simply refuse to listen. It requires a revolution and their students can play a part. The change can happen only by the students.

  30. All three of Lavoie’s categories appear to fall under my “liability driven” classification and none cover the “asset driven” one.

  31. @Ramanan
    Well said. At least students are trying something. Berkeley: Kick It Over Manifesto. They take the Martin Luther approach and nailed it on the door of Nobel laureate Daniel McFadden. But students will have a hard time. As far as I can judge the mainstream reacts with a time-proven strategy. If you don’t like it ignore it and it will eventually go away.

  32. RSJ:

    I am afraid the message does not belong in this thread, but anyway.

    To realize profits, one has to sell goods for money (regardless whether the money flow is credit based or capital based), that much is clear. Operationally, in your example, monetary profit realization does not appear possible, as I wrote earlier, — you cannot regard unsold inventory as part of such profit.

    Understanding how profit is monetized is important to see whether a credit bubble, as described in your stylized example, is possible in the real world. Marx, by the way, was unable to show how M becomes M’ in his M-C-M’, other than in a hand-wavy way.

    I may be wrong in my understanding which I readily admit 😉

    We can migrate to the original thread.

  33. JKH,

    Are you looking to see something being written about purchases of MBSs and agency debt etc ?

    I think they (PKEists and MMTers) have written about this and made it clear that it doesn’t really help much. To some extent it may help to keep the borrowing costs low. But there is less evidence that it has worked to help the economy. The only way to proceed is through the fiscal route.

  34. VJK,

    I can’t even find the old thread!

    All of the inventory in the example is sold. Profits are being earned in the example.

    If it does not appear to be possible based on first principles, then I’m not sure what to say. Find other principles? 🙂

    It is certainly possible to earn “monetary” profits in the goods/labor market that are offset by asset purchases in the credit markets, but the latter just means that you are a net purchaser of financial assets. And seeing as how that is the goal of earning a profit — to acquire more financial assets — I don’t see any contradiction. In the example, the owner is earning a profit, as he has an income of $20/period and only spends $10/period on goods, therefore he spends $10/period on buying IOUs.

    The example is ponzi because none of that $10 is going into actual investment. But even over the medium term, there is no market pricing mechanism that prevents an aggregate increase in unproductive assets, because “imprudent” dissaving is just as stimulative as government dissaving. Moreover, there is no mechanism to prevent the assets from being mispriced. And I would argue that over the short term, there are incentives to do all of the above. Only over the long term do these things equal out, and that’s basically a recipe for perpetually re-curring price adjustments.

  35. RSJ:

    In the example, the owner is earning a profit, as he has an income of $20/period and only spends $10/period on goods, therefore he spends $10/period on buying IOUs.

    In the example, the owner invests $10 and recovers only $10 because the workers were paid only $10 in wages so they can buy only $10 worth of goods so the revenue will be $10. There are no more wage units on the market to pay for the remaining two goods in unsold inventory. It’s simple arithmetic.

    Where do additional $10 in revenue come from ?

    There are no banks as per initial conditions and the workers are unwilling to borrow as hopefully we agreed.

  36. Here’s your thread:

    http:

    //bilbo.economicoutlook.net/blog/?p=4157

    (Not trying to suggest anything; just trying to be helpful – at least for your ease of reference)

    🙂

  37. Where do additional $10 in revenue come from ?

    The worker borrows $10 from the owner, spends it on a good. The firm has the $10. The firm sends it back to the owner. The worker borrows …

    Who are you to say that only one such transaction can occur in an accounting period? Any number of such transactions can occur.

    The purpose of the example is to illustrate how deficit spending can create the assets needed to buy the debt. In this case, the $10 acted as the buffer — just a technical device. The real activity was happening in the income flows. The quantity of base money — our $10 bill — does not constrain the income flows.

    Similarly,

    Taxpayer/firm has $10. The government sells $10 of bonds. Government buys a good from firm. Firm now has $10 again. Government sells another bond. ….

    Repeat a trillion times. Government sells 10 Trillion of bonds and deficit spends $10 Trillion. The deficit spending created an flow of private sector savings that was used to purchase the debt. Government did not “crowd out” investment from the private sector, but supplied profits to the private sector.

  39. JKH:

    Thanks.

    Maybe you can suggest something 😉 since a while ago you commented on Steve Keen’s unusual profit accounting and suggested that you do not see a profit conundrum from the accounting point of view. Somehow I cannot locate your old message.

    I must be missing something simple, but I cannot figure out the profit source in the absence of workers borrowing.

  41. Ramanan:

    Link:

    //bilbo.economicoutlook.net/blog/?p=4157&cpage=4#comment-11810

    (Monetizing profits in a stylized economy — that’s a lemma needed to [dis]prove a bubbly outcome 😉

  42. Ramanan (23:56),

    Thank you for the providing the Holmes quote, very helpful. Now I have a proper reference for the quote. I suppose the rest of that reference makes for good reading?

    Nklein (12:54),

    No problem. It’s a shame that the ‘discussion’ was at such a poor level. I understand completely that you do not wish to continue it.

    Scott (14:41),

    Thank you for the clarification. I agree, I should have expressed it as: ‘loans create deposits, as a matter of accounting’, rather than defining it as being a theory. If I understand correctly it is nonsensical to talk of deposits creating loans, as this is akin to stating that financial assets create liability, when in fact it is the converse which is true: financial liabilities (e.g. bonds) create financial assets (for entities other than the bond issuer). I may need to rethink how I expressed that, brain is dead from over study!

    For people like “uh, no,” my preferred response is to ask them to show how the transaction in question affects the financial statements of those involved. Then you see if they have a clue. As I’ve said repeatedly in the past, every transaction affects the financial statements of those involved, and if you can’t correctly illustrate the effects on financial statements, you don’t actually understand the transaction.

    I agree wholeheartedly agree, this is perhaps one of my favourite quotes on economic methodology:

    “… any transaction in a capitalist economy results in changes in the agents’ financial statements; if the hypothesized supply and demand relations are not consistent with the actual changes occurring within the financial statements of the relevant agents, then the hypothesized model is irrelevant…” (Fullwiler, 2007, p. 1006)

    The only issue with responding to ‘Uh, oh’ is that I only have a basic understanding of accounting, if he were to respond with a series of balance sheets which depicted the loan creation, etc. then I don’t know if I could properly evaluated beyond a superficial level of checking to see that the balance sheets balance, that four entries have been made, etc.

    source:
    Fullwiler, S. 2007. Interest rates and Fiscal sustainability. Journal of Economic Issues. Vol. XLI no. 4 December 2007.

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