I am still catching up after being away in the UK last week. I will…
A celebration of 75 years since Keynes turns into a farce
In yesterday’s blog, I mentioned that Paul Krugman gave a plenary lecture over the weekend just gone at a conference held at Cambridge University. The conference – 75th Anniversary of Keynes’ General Theory – seems to have been a remarkable event. First, I don’t know everything but I always know when there is a major “Keynesian/Post Keynesian” conference and sometimes I even go. In the case of the 75th Anniversary conference I didn’t even know it was being held. It seems that wasn’t exceptional. As Ann Pettifor points out the UK Post Keynesian Economics Study Group, which is a leading group who focus on studying Keynes and, arguably, has the leading UK Keynesian scholars among its membership, “found out about the conference by accident.” Second, if you examine the speaker’s list and read the papers that are available you might wonder what this conference had to do with Keynes. Certainly if the Cambridge organisers were aiming to “honour” the message that Keynes gave, then they had a strange way of doing that. The reality is that the celebration of 75 years since Keynes was a farce.
Second, if you examine the speaker’s list and read the papers that are available you might wonder what this conference had to do with Keynes. Certainly if the Cambridge organisers were aiming to “honour” the message that Keynes gave, then they had a strange way of doing that.
One might think that one of the major messages that Keynes sought to focus on was the role that effective demand played in creating unemployment – a state he considered to be beyond the capacity of the workers to remedy – hence his terminology involuntary unemployment.
The current economic crisis has brought mass unemployment into focus with some advanced nations enduring jobless rates of between 15-20 per cent and world leading nations struggling at around 8-10 per cent. After three years of crisis the unemployment situation hasn’t really improved.
Keynes would have had a lot to say about that and so I thought a conference “celebrating” his General Theory (published in 1936) at the height of the Great Depression would seek to have sessions staffed with experts in the field that explored this issue. After all, historically, the current crisis is the worst since the Great Depression so there is continuity with Keynes in that fact.
There was only one paper explicitly about unemployment in the program and was presented by an economist affiliated with the European Central Bank (ECB), which was one of the sponsors of the conference.
Over the last decade or so, I have noticed that the ambit of certain conferences has changed as they introduce new sponsors. In Australia, the once excellent Labour Market Workshop (an annual event) has become diminished (in my view) by the way in which the “new” sponsors – the Federal Government – manipulated the themes to promote papers that advanced their neo-liberal agenda.
The other insight is that the “unemployment” paper tells us that it was actually “Prepared for the NBER Macroeconomics Annual 2011 Conference, held in Cambridge, MA on April 8-9, 2011”. The NBER provides an avenue for the mainstream economists to build national prestige and a range of influential appointments. If you examine the research and publication agenda of the NBER you will appreciate that it continually promotes neo-liberal economic policies including the privatising the US pension and the health systems and the optimality of deregulating the financial sector. Please read my blog – Martin Feldstein should be ignored – for more discussion on this point.
The NBER Macroeconomics Annual Conference has always been a showcase for the worst in macroeconomics. So a paper that was written for that conference would hardly seem fit to be worthy of inclusion in a conference celebrating the work of Keynes.
The “unemployment” paper – Unemployment in an Estimated New Keynesian Model begins with a confession:
Over the past decade an increasing number of central banks and other policy institutions have developed and estimated medium-scale New Keynesian DSGE models. The combination of a good empirical fit with a sound, microfounded structure makes these models particularly suitable for forecasting and policy analysis. However, as highlighted by … [many economists] … one of the shortcomings of these models is the lack of a reference to unemployment. This is unfortunate because unemployment is an important indicator of aggregate resource utilization and the central focus of the policy debate.
Fancy that.
DSGE – or Dynamic stochastic general equilibrium models are one of the latest fads of the mainstream – who are intent on remaining irrelevant.
Even mainstreamers like Willem Buiter described DSGE modelling as The unfortunate uselessness of most ‘state of the art’ academic monetary economics.
And you might like to read the evidence that Robert Solow gave to the US Congress Committee on Science, Space and Technology – in its sub-committee hearings on Investigations and Oversight Hearing – Science of Economics on Jul 20, 2010. The evidence is available HERE.
Here is an excerpt relevant to the topic:
Under pressure from skeptics and from the need to deal with actual data, DSGE modellers have worked hard to allow for various market frictions and imperfections like rigid prices and wages, asymmetries of information, time lags, and so on. This is all to the good. But the basic story always treats the whole economy as if it were like a person, trying consciously and rationally to do the best it can on behalf of the representative agent, given its circumstances. This can not be an adequate description of a national economy, which is pretty conspicuously not pursuing a consistent goal. A thoughtful person, faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.
An obvious example is that the DSGE story has no real room for unemployment of the kind we see most of the time, and especially now: unemployment that is pure waste. There are competent workers, willing to work at the prevailing wage or even a bit less, but the potential job is stymied by a market failure. The economy is unable to organize a win-win situation that is apparently there for the taking. This sort of outcome is incompatible with the notion that the economy is in rational pursuit of an intelligible goal. The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.
Solow also said that the DSGE fraternity “has nothing useful to say about anti-recession policy because it has built into its essentially implausible assumptions the “conclusion” that there is nothing for macroeconomic policy to do”.
None of the DSGE models (or papers) anticipated the financial crisis despite the portents of it being obvious for at least a decade or more.
In our recent book (2008) – Full Employment abandoned – we consider the standard DSGE approach in detail. I summarised a bit of that discussion in this blog – Mainstream macroeconomic fads – just a waste of time.
The alleged advantage of the New Keynesian approach (which incorporates DSGE modelling) is the integration of real business cycle theory elements (intertemporal optimisation, rational expectations, and market clearing) into a stochastic dynamic macroeconomic model. The problem is that the abstract theory does not relate to the empirical world. To then get some traction (as Solow noted) with data, the “theoretical rigour” is supplanted by a series of ad hoc additions which effectively undermine the claim to theoretical rigour.
You cannot have it both ways – first, try to garner credibility by appealing to the theoretical rigour of the model – but then, second, largely compromise that rigour to introduce structures (and variables) that can relate to the real world data.
This is the fundamental weakness of the New Keynesian approach. The mathematical solution of the dynamic stochastic models as required by the rational expectations approach forces a highly simplified specification in terms of the underlying behavioural assumptions deployed. As Solow says this simplicity cannot remotely relate to the real world.
Further, the empirical credibility of the abstract DSGE models is highly questionable. There is a substantial literature pointing out that the models do not stack up against the data.
Clearly, the claimed theoretical robustness of the DSGE models has to give way to empirical fixes, which leave the econometric equations indistinguishable from other competing theoretical approaches where inertia is considered important. And then the initial authority of the rigour is gone anyway.
This general ad hoc approach to empirical anomaly cripples the DSGE models and strains their credibility. When confronted with increasing empirical failures, proponents of DSGE models have implemented these ad hoc amendments to the specifications to make them more realistic. I could provide countless examples which include studies of habit formation in consumption behaviour; contrived variations to investment behaviour such as time-to-build , capital adjustment costs or credit rationing.
But the worst examples are those that attempt to explain unemployment. Various authors introduce labour market dynamics and pay specific attention to the wage setting process. One should not be seduced by DSGE models that include real world concessions such as labour market frictions and wage rigidities in their analysis. Their focus is predominantly on the determinants of inflation with unemployment hardly being discussed.
Of-course, the point that the DSGE authors appear unable to grasp is that these ad hoc additions, which aim to fill the gaping empirical cracks in their models, also compromise the underlying rigour provided by the assumptions of intertemporal optimisation and rational expectations.
The Cambridge paper is no exception. It claims that in relation to the failure to include any fundamental explanation for unemployment, a number of DSGE papers “have started to address this shortcoming by embedding in the basic New Keynesian model various theories of unemployment based on the presence of labor market frictions”. None of these papers are capable of understanding mass unemployment.
Do they really want us to believe that the world economy just encountered a massive build up of frictions within a short period of time starting mid-2008?
The Cambridge paper has a new twist – unemployment in their model:
… results from market power in labor markets, reflected in positive wage markups. Variations in unemployment over time are associated with changes in wage markups, either exogenous or resulting from nominal wage rigidities.
Keynes would have turned in his grave. His concept of involuntary unemployment had nothing to do with frictions or rigidities. He absolutely rejected the idea that if you eliminated downwardly rigid money ways (and implemented the classical dream) involuntary unemployment would fall.
Indeed, it could get worse because the reduction in money wages may have caused a further reduction in aggregate (effective) demand. It was the state of demand (spending) at the macroeoconomic level that caused mass unemployment.
Please read my blog – What causes mass unemployment? – for further discussion.
In the Cambridge paper, despite pages of mathematical reasoning, the essential message is the same as all mainstream approaches. Unemployment arises because workers insist on a real wage above the perfectly competitive outcome. So while they claim that at the “business cycle frequency” demand shocks drive unemployment this only occurs (in their model) because real wages are rigid and excessive.
So the fluctuations of unemployment around its “perfectly competitive or natural rate”:
… should thus be attributed to the presence of wage rigidities, interacting with the different shocks.
This is an anti-Keynes result.
The Cambridge paper provides a Figure 1 to outline their wage mark-up model in simple terms. It is a very standard marginal productivity classical labour market which I explain in more detail in this blog – Money neutrality – another ideological contrivance by the conservatives.
Here is a summary. The simple classical model (which the Cambridge paper doesn’t improve on but is consistent with) claimed that to examine household choice, we only need to know: (a) the initial goods endowment (wealth); (b) the terms of exchange between goods; and (c) Tastes and preferences of households. The first two define household income.
They consider two goods: (a) Corn (C); and (b) Leisure (L). The relative price of leisure is number of units of C that you give up to have one unit of L. Giving up L involves offering equal units of labour so relative price of leisure is the real wage rate, w. The relative price of corn is thus 1/w.
So the workers are deemed to have a labour-leisure choice (per day). Unemployment equals leisure.
The Classical labour market is represented by the following figure:
The real wage is w and is the ratio of the nominal wage, W and the price level P.
The real wage is considered to be determined in the labour market, that is, exclusively by labour demand and labour supply. Keynes showed that this assumption is clearly false. It is obvious that the nominal wage is determined in the labour market and the real wage is not known until producers set prices in the product market (that is, in the shops etc).
The labour supply (Ls) function, which is based on the idea that the worker has a choice between work (a bad) and leisure (a good), with work being tolerated only to gain income (in the simple model – units of Corn). The relative price mediating this choice (between work and leisure) is the real wage which measures the price of leisure relative to income. That is an extra hour of leisure “costs” the real wage that the worker could have earned in that hour. So as the price of leisure rises the willingness to enjoy it declines.
The worker is conceived of at all times making very complicated calculations – which are described by the mainstream economists as setting the “marginal rate of substitution between consumption and leisure equals to the real wage”. This means that the worker is alleged to have a coherent hour by hour schedule calibrating how much dissatisfaction he/she gets from working and how much satisfaction (utility) he/she gets from not working (enjoying leisure). The real wage is the vehicle to render these two competing uses of time compatible at a work allocation where the worker maximises satisfaction.
There are complications when the real wage changes (which I explain in the more detailed blog) but essentially the upshot is that the worker will supply more labour when the real wage rises and less when it falls. Hence the positive sloped labour supply curve.
The model assumes there are millions of firms and labour is one factor of production and indistinguishable from any other (inanimate) input. The single good is produced (Corn). Technology defines a “production function” which maps how much output is gained by adding successive units of input to a “fixed” stock of capital.
The downward-sloping labour demand (Ld) function is determined by the ad hoc imposition of the so-called law of diminishing returns which claims that as extra units of labour are added to a fixed stock of capital they become increasingly unproductive and hence there is diminishing products (returns). Hence, the labour demand function is downward sloping with respect to real wages.
The argument is that firms have to pay the real wage (an amount of actual product) to the marginal workers and so they will only hire extra labour if the amount the worker contributes to production is more than the real wage. The assertion of diminishing returns assures the demand curve will be downward sloping – so the firm will only be prepared to hire extra workers if the real wage is reduced.
There are many things wrong with this stylised interpretation which I explain in the referred blog.
So firms will only hire if what they get from the worker at the margin (the marginal product) is equal to what they have to give up in real terms (the real wage).
Given the assertion of diminishing marginal products the firms know that as the real wage falls (on the vertical axis of the labour market diagram) firms will hire an additional worker (who is less productive at margin than last hired).
If you put the supply and demand ideas together you get the classical labour market which guarantees continuous full employment. With no borrowing or lending (simplifying assumption), then a price adjusting economy (if excess demand, price rises) will always guarantee full employment. If there is unemployment (that is an excess supply of labour) then the real wage will fall and vice versa.
In the corn economy this is a simple proposition. If there are workers wanting a job who do not have one then the corn wage falls and firms react by hiring more workers because it is profitable to do so at the lower rate. The corn wage falls until all those who want to work have a job.
So unemployment can only arise if the real wage is above the competitive level (w*) at point A.
These models thus say that if the real wage is free to adjust then the economy would never have involuntary unemployment. There can never be what we call generalised over-production – that is, where firms supply more than is demanded in aggregate.
Keynes showed categorically that you could get generalised over-production with or without flexible real wages. In terms of the diagram above, consider the vertical line that hits the horizontal axis at E1. This is what we might consider to be an aggregate demand constraint on the labour market – that is, total consumption, investment, government spending and net exports generates this much demand for labour (E1).
You can readily appreciate that even if the “classical labour market” was a accurate depiction of how things work then the aggregate demand ration changes everything.
Imagine if we were truly at Point B initially (or the point in the Cambridge paper’s Figure 1 where they claim unemployment can exist). The real wage is at w1 and unemployment in this model (the difference between labour demand (B) and labour supply (C) at that real wage) is the quantity BC. So the Cambridge paper calls this a wage markup rigidity interacting with a shock!
If there was no change in the macroeconomic level of aggregate demand (so the vertical ration line remains fixed) and we somehow cut the real wage to w* would we eliminate unemployment?
The answer is no because the level of employment is a function of the level of effective demand (the vertical ration line). Even if workers are “cheaper” to hire firms will not take on extra workers to produce things they cannot sell.
The argument gets more complicated than that but I will leave it there.
The point is that this paper on unemployment at the 75th celebration of the General Theory and at a time when unemployment has clearly sky-rocketed around the world is a disgrace to our profession. It is just another gymnastic exercise that has no relevance to the real world.
Krugman at Cambridge
And as to Paul Krugman’s plenary lecture which I only touched on yesterday – here is a glaring example of where his analysis goes astray.
After attacking the mainstream paradigm for not learning the lessons provided by Keynes, Krugman writes:
I’m not quite done here. If much of our public debate over fiscal policy has involved reinventing the same fallacies Keynes refuted in 1936, the same can be said of debates over international financial policy. Consider the claim, made by almost everyone, that given its large budget deficits the United States desperately needs continuing inflows of capital from China and other emerging markets. Even very good economists fall into this trap. Just last week Ken Rogoff declared that “loans from emerging economies are keeping the debt-challenged United States economy on life support.”
Um, no: inflows of capital from other nations simply add to the already excessive supply of U.S. savings relative to investment demand. These inflows of capital have as their counterpart a trade deficit that makes America worse off, not better off; if the Chinese, in a huff, stopped buying Treasuries they would be doing us a favor. And the fact that top officials and highly regarded economists don’t get this, 75 years after the General Theory, represents a sad case of intellectual regression.
Here is the full article by Rogoff that is being referred to – After the Scandal, More of the Same at the I.M.F. (June 15, 2011).
We continually read that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings. This claim is particularly potent in the current US-China context which Krugman acknowledges.
He refutes that claim by arguing that: (a) there is already plenty of savings in the US at present given the collapse in private spending; and (b) if the Chinese stopped buying government bonds this would manifest in a smaller trade deficit which he thinks is good.
From the perspective of Modern Monetary Theory (MMT) trade deficits make a nation better off – not as Krugman suggests worse off. We normally measure standards of living (or welfare) in real terms (that is, separating out the inflationary impacts from what lies underneath – access to real goods and services).
I realise that the conception economists have of welfare and real income is highly flawed given that it typically fails to incorporate transactions that are not included in the narrow GDP measure – such as, environmental degradation. But that failure doesn’t alter the point.
I consider current account issues in the following blogs – Current accounts and currencies and Do current account deficits matter?.
In MMT, the “Chinese are bailing us out” claim makes no sense. A trade deficit can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the trade deficit. This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (goods and services) and net ship them to the country that has the trade deficit, which, in turn, enjoys a net benefit (imports greater than exports). A trade deficit means that real benefits (imports) exceed real costs (exports) for the nation in question.
A trade deficit signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance our trade deficit) on its head in recognition of the true nature of exports and imports.
Subsequently, a trade deficit will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the trade deficit gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But at least we should understand why it is happening.
We should also comprehend what a trade deficit means for a nation in financial terms. It is essential to understand the relationship between the government and non-government sector first. A common retort is that this blurs the private domestic and foreign sectors. But the transactions within the non-government sector are largely distributional, which doesn’t make them unimportant, but which means you don’t learn anything new about the process net financial asset creation.
In the case of a trade deficit, what mostly happens is that local currency bank deposits held say by Australians are transferred into local currency bank deposits held by foreigners. If the Australian and the foreigner use the same bank, then the reserves will not even move banks – a transfer occurs between the Australian’s account in say Sydney, to the foreigner’s account with the same bank in say Frankfurt.
The point is that the AUD never leaves “Australia” no matter who is holding it. The same goes for the USD and all the fiat currencies.
If the transactions span different banks, the central bank just debits and credits, respectively, the reserve accounts of the two banks and the reserves move.
What happens next depends on the approach the commercial banks take to the reserve positions. We know that, in the absence of a central bank payment for excess reserves held with it, then the existence of excess reserves put downwards pressure on overnight interest rates and may compromise the rate targetted by the central bank.
The only way the central bank can maintain control over its target rate and curtail the interbank competition over reserve positions is to offer an interest-bearing financial asset to the banking system (government debt instrument) and thus drain the excess reserves. It can also just offer a return on excess reserves.
Krugman also thinks that Americans will be better off with less imports relative to exports. This is a common thread that runs through the mainstream view – that policy should be focused on eliminating trade deficits. From the perspective of MMT this would be an unwise strategy.
First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.
Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).
Second, trade deficits reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.
A trade deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.
As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.
However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.
Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.
The national government can always service its debts so long as these are denominated in domestic currency. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.
In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.
Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.
Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.
I would qualify this assessment in this way.
Ross Gittins (Sydney Morning Herald economics writer) wrote today (June 22, 2011) in – Iron-clad formula for decades of prosperity that:
For many years – most of the second half of the 20th century – it looked like Australia was on the wrong tram. In a world of ever-more high-tech, sophisticated manufactured goods, we were hewers of wood and drawers of water. To put it less biblically, we paid for our imports mainly by growing things in the ground or digging stuff out of the ground.
His basic hypothesis is that for years Australia was considered backward because we hadn’t developed high-tech IT and value-adding industries. We were after all a whole in the ground and when we weren’t digging up and exporting minerals we grew things and exported them instead. Steadily, our export prices were falling and it was predicted we would end up a backwater. I sympathise with the view expressed by Gittins in this article.
But for our purposes, when MMT considers exports to be a cost and imports to be a benefit it doesn’t specify absolutes. Digging huge holes in the ground and loading the contents onto ships to be used elsewhere is definitely a cost in the sense that these resources could have been deployed in domestic uses. The other angle to the cost argument is the legacy that certain export industries leave once they decline or relocate. If you ever catch a small plane from Newcastle and head west you soon see the incredible scarring that the coal industry (one of the world’s largest areas of mining) has left. The damage to the natural terrain is substantial.
The question then is how much of a cost giving up some minerals represents. Very few labour resources are deployed in the mining sector. What better use could the ore be put to? My sense is that the “cost” to us of exporting our minerals is relatively small when measured in opportunity cost. Having said that I would prefer them to be left in the ground and we developed eco-tourism instead.
The point is that the real terms of trade are very much in our favour. Other nations desire a resource that I doubt we could use (to the same value) ourselves. In return, because the terms of trade have moved so far in our favour, we can enjoy a range of products that we cannot make ourselves.
The last word on the Cambridge Conference goes to Ann Pettifor:
The impression created is of an economics profession actively seeking to exclude any Keynesian challenge to an orthodoxy that has so patently failed society. As we seek solutions to rising unemployment, bank and business failures, debt-deflation and sovereign debt crises, the determination of a group of economists at an elite University – Keynes’s University – further to close down debate on alternatives should be a matter of the greatest possible concern to the public at large.
My profession has set up an elaborate set of checks and controls to suppress debate – journal editorships, grant body stacking, appointments bias, curriculum domination and more.
I guess the “Keynesian” group in Britain especially are miffed that they have been boycotted by this event.
But the Post Keynesians themselves have not been very productive in imposing themselves on the debate and if you examine the majority of the literature (with notable exceptions) you will see that it falls into the deficit dove category which I think leaves them open to being sidelined by the mainstream neo-liberals.
Too often the debate comes down to how large the “cuts” have to be, or “when” the fiscal consolidation has to take place, or “how large” is a safe public debt ratio. Once that debate begins the progressive agenda is lost.
But I agree with Pettifor it is a disgrace that this sort of conference was held under these terms.
Conclusion
This is what happens when volcanic ash strands you at an airport.
A tough day – chaos at the airport today with tens of thousands stranded because of the volcanic ash clouds. Luckily I got a flight home albeit later than scheduled.
That is enough for today!
A bit off topic . . . re Ann Pettifor, she has recently drawn attention to the latest gift made by Europe’s elite to European banks, paid for by taxpayers, of course. See:
http://www.debtonation.org/2011/06/eu-diverting-funds-from-taxpayers-to-bankers/
“Dynamic stochastic general equilibrium models are one of the latest fads of the mainstream ”
I love it when economists mention equilibrium. I refer readers to this excellent paper that was published in Physica A:
‘The Futility of Utility: how market dynamics marginalize Adam Smith’
A preprint can be found here:
http://arxiv.org/abs/cond-mat/9911291
Additionally a glaring error with these supply demand curves, in fact all supply demand curves, is that they are not continuous lines and are not 2 dimensional. They are discrete points that should be plotted in 3 dimensions (the relationship between supply an demand must change with time other wise the supply and demand curve for iPods would be the same today as it was in 2002 for example). The reason it is incorrect to draw these plots as lines, even in 2 dimensions when they should be 3 dimensional, is that the metrics being plots are quantized. You can only have integer numbers of employees, or if you measure labour in time worked rather than numbers of people, there is still a minimum time unit. Likewise with price there is a minimum unit. In other words on either axis you cannot infinitesimally divide the quantity — there is a minimum unit. Nothing exists between these points on the plot. Osborne wrote about this sort of stuff in the 50s:
http://www.amazon.com/Stock-Market-Finance-Physicists-Viewpoint/dp/0964629208/
You asked the other day about things you should stress at a conference you are to attend. I suggest that you stress what you stressed in your blog a few weeks back that spending equals income. I think of that every time I hear the chorus on CNBC singing the tune that those pampered greek workers should give up their lavish life styles and take cuts to their income and benefits. I wonder how those fat cat workers are going to increase their spending if their incomes fall.
Some time ago I’ve briefly read a similar paper from the ECB: “Potential output in DSGE models”. In this paper the authors talk instead of wage cuts about negative wage mark-up shocks. From a linguistic perspective I find these papers most interesting.
Dear Bill
When it comes to labor supply, I think that we should distinguish between necessary income and luxury income. The former is used to buy what are considered essentails and the latter to buy what are luxuries. Suppose that a man feels that he should make at least 40,000 a year. If his after-tax income is 20 dollars per hour, he will have to supply at least 2000 hours of work a year. Now supppose that his hourly return to work drops to 16 dolars. Then his labor supply will increase to 2500 hours a year. Since some income is necessary, lower wages mean greater supply of work until necessary income has been reached. There are many people who have more than one job. If you ask them why, they’ll invariably reply that they can’t make enough in one job. They supply a lot of labor because their hourly wage is low. If their hourly wage were to increase considerably, they would work less, not more. The implication of this analysis is that lower taxes, by increasing the hourly return on work, may actually lead to a decline in the supply of labor, contrary to what the supply-siders claim.
With luxury income, the situation is quite different. Suppose that Peter can reach his necessary income by working 40 hours of week. He can also work on Saturday. He would like to take a trip, which is of course a luxury. The trip costs 3000 dollar. If he can make 20 dollars an hour after tax on Saturdays, the cost of the trip is 150 hours of leisure. He may think that the trip is worth 150 hours of leisure, so he works on Saturdays. If his after-tax return of work on Saturdays drops to 12 dollars, the trip will cost him 250 hours.of leisure. He may think that 250 hours of leisure is too much for the trip and decide not to work on Saturdays. For luxury income, higher wages mean more work, not less. The trad-off between labor and leisure only exist at higher levels of income, where people’s necessities are already satisfied.
Regards. James
Right now, while US faces no operational constrains on spending, there certainly are political. Therefore I have to agree with Krugman that US would be better off if China would stop accumulating savings in US dollars.
Dear James,
Not sure of the importance of differentiating between necessary income and luxury income.
Imagine you are a public servant (ie a teacher, police man, admin, nurse, doctor) living in Spain or Greece where your income has been cut by 25% this year and your adult children live at home because there is 40% unemployment in the under 35s. You are not able to find work to compensate for this year’s 25% wage cut and you’d be struggling to find the time to work the additional hours. My understanding is that these countries don’t pay their public servants luxury incomes.
In Australia, the average income is about $58,000, the median income is closer to $30,000 – there are a lot of people in receipt of social payments. Only 20% of Australians earn less than $90,000 and less than 3% of people earn more than $150,000. This blog consistently states that a more realistic unemployment rate in Australia is about 15% – or to put it another way – there are 7 qualified applicants for every job vacancy.
It seems to me that most neoliberal academics would be better suited to writing children’s fiction, complete with fantastic monsters that are slain only by heroic knights in white armor. No doubt there would be some intial objections to this retasking, but I’m convinced that we could overcome these by simply telling our new writers that it was they who were the knights, and that the monsters were nothing more than demon labor itself.
_______
Question for Dr. Krugman: Were you aware in advance of your attendance and presentation at this conference that conference organizers had actively sought to shut out major segments of Keynesian and post-Keynesian academia from the debate on the future of Keynesianism?
[Left as a comment on his blog post on the conference.]
.
Mostly ?
.
http://www.abs.gov.au/ausstats/abs@.nsf/featurearticlesbytitle/2E5DC0CD8723CD0FCA2573AA001446E9?OpenDocument
says more Australian imports are invoiced in USD than AUD!
.
“Mostly” ?
.
Love doing this!
The point is that the AUD never leaves “Australia” no matter who is holding it. The same goes for the USD and all the fiat currencies.
Is that so? What about eurodollars? Clearly, there in plenty of US$ banknotes all round the world, but where are the US$ when people deposit their US$ in a bank in Argentina?
When Uruguay’s banking system collapsed in 2002, Uruguay didn’t default like Argentina but restructured its debt, against what the IMF was recommending at the time. Since the IMF didn’t want to give them a loan, the solution was to get a direct emergency loan from the US Treasury and then negotiate with the IMF. The loan was of 1.5 billion dollars, and they sent the money by plane.
Mammoth,
When MMTers say that (“no dollars leave”), they really mean to say that unlike a Gold-Standard like international monetary system, you won’t have foreigners selling things to residents and taking Gold back in ships or notions such as that.
Yes there’s lot of US dollar currency notes outside the US. Of the around $900b-$1T notes in circulation issued by the Federal Reserve, around $300b-$400b is held outside the United States.
“Eurodollars” is a slightly different.
Eurobanks are just banks outside the US which have US dollar deposits as liabilities.
Interesting fact about Uruguay.
Greenbacks are just bearer receipts for an entry on the computer at the Federal Reserve and Eurodollar deposits are just an asset denominated in USD.
So even though the greenbacks are kept in vaults in banks outside the US, the actual USD is still at the Fed (in the notes issued column). If the fed changed those receipts from greenbacks to bluebacks for whatever reason a lot of people would find themselves with worthless deposits.
Mammoth,
“outside the United States” (Thursday, June 23, 2011 at 2:55) as in physically outside the United States.
Ramanan: they really mean to say that unlike a Gold-Standard like international monetary system, you won’t have foreigners selling things to residents and taking Gold back in ships or notions such as that.
So in what sense is that difference relevant? What difference would it have mane if under a gold standard foreigner just got their gold deposits marked up in a domestic bank instead of shipping the gold to the foreign country?
“if under a gold standard foreigner just got their gold deposits marked up in a domestic bank instead of shipping the gold to the foreign country?”
Prior to 1971, when Nixon shut the gold window, gold kilo bars were shifted among cells labeled with the names of the various countries in the way-deep gold vault underneath the NY Fed. I actually witnessed this. A couple of guys wearing steel boots to protect their feet were loading bars onto a dolly and trucking them from one cell to another iaw the daily manifest. Some of the cells had lots of gold bars in them, others very few.
Tom, that’s what I thought. But I would says it does not make any difference, it’s just logistically more efficient. (of course it makes a difference when your gold gets confiscates, but that’s a different story.
So I think my question about Bill’s quote is two-fold:
The point is that the AUD never leaves “Australia” no matter who is holding it. The same goes for the USD and all the fiat currencies.
1) Is that so?
2) What difference does it make?
For instance when a third world country gets flooded with FDI in US$, they usually buy dollars to prevent their currency from appreciating too much, the issue debt to sterilize the operation. Why would they do that? I think it makes sense if those US$ were in their domestic banking system but not if they were in the US banking system. Or, in other words, whose money supply has been affected?
Dear Ramanan (at 2011/06/23 at 1:44)
You noted that the ABS:
Australian imports and exports are “invoiced” in a number of currencies but the USD clearly constitutes the largest proportion. Australia is largely a price taker in international trade. But that doesn’t change the point that was made – the flow of funds has to be converted into AUD – the workers do not get paid in USD and local operating costs are in AUD. The invoicing arrangements do not determine the final currency of the transaction.
The reference to “mostly” was not as you interpreted. It was a recognition that some Australian exporters keep overseas offices and pay their “local” costs at those offices in non-AUD currencies.
best wishes
bill
Here’s a link to the current US BEA Reporting Instructions for US Direct Investment Abroad:
http://www.bea.gov/surveys/pdf/be10i_web.pdf
Section IV.B. Page 9 Addresses “Translation of foreign currency financial and operating data into U.S. dollars”
Excerpt: “”Revenue and expense transactions shall be
translated in a manner that produces approximately the
same dollar amounts that would have resulted had the
underlying transactions been translated into dollars on
the dates they occurred.” Since separate translation of
each transaction is usually impracticable, the specific
results can be achieved by using an average rate for the
period.”
So in the US, the BEA reports foreign transactions that actually occur in foreign currencies, in the translated USD amounts in their US ITA reports, such as the Current Account/Capital Account/Financial Account flow reports.
Transactions that actually take place in foreign currencies are reported in USD.
Resp,
Ramanan,
Any info on the currency composition of the gross international investment position (i.e. liability side)?
A little off-topic, for JKH or anyone else who can help with the debt creation process, and from:
“If age were the only thing that mattered, and if people were otherwise identical, and if everyone were age 35, debt would be zero. That’s because there would be nobody for the 35 year-olds to borrow from. It takes two to tango. A borrower and a lender. Dollars borrowed equals dollars lent.”
Comments:
“If age were the only thing that mattered, and if people were otherwise identical, and if everyone were age 35, debt would be zero. That’s because there would be nobody for the 35 year-olds to borrow from. It takes two to tango. A borrower and a lender. Dollars borrowed equals dollars lent.”
Doesn’t this break down if banks change their leverage ratios. IE they start lending the 65 year old’s savings out 30 times instead of 20 times?
Posted by: Al | June 22, 2011 at 01:37 PM
Al: Short answer: No. Banks are (approximately) irrelevant. With (say) 10% capital, a bank borrows $90 debt (including savings account + chequing account) plus $10 equity from the 65 year old, and lends $100 debt to the 35 year old.
Nick Rowe | June 22, 2011 at 01:53 PM
From what JKH and others have said I don’t believe nick is describing the debt creation process correctly. Can someone verify that? Thanks!
Sorry. Here is the link:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/06/debt-and-bi-modal-demographics.html
‘Mass unemployment’ comes only from monopoly as the classics insist, hence the search for sticky things
What the miss, and what Keynes described but did not recognize ‘by name,’ is that the currency itself is a (simple) public monopoly.
And as you state, when the currency monopolist restricts supply of his currency by not spending enough to cover the tax bill plus any savings desires, the evidence is your mass unemployment.
Warren Mosler
http://www.moslereconomics.com
Bill,
“The invoicing arrangements do not determine the final currency of the transaction.”
Don’t know what that means. To me MMT is naturally biased about describing the whole thing as if imports are purchased in the importer’s currency.
Its not straightforward. The exporter (to Australia) gets paid in US Dollars immediately. The importer pays in local currency. The financial system “accommodates” this via not so straightforward banking operations.
JKH,
Had seen this earlier – but haven’t looked in detail – maybe this is what you were looking for ?
http://www.rba.gov.au/publications/bulletin/2009/dec/1.html
http://www.ausstats.abs.gov.au/Ausstats/subscriber.nsf/0/65EC32E99BC6925ECA25765E0015A1D5/$File/53080_march%20quarter%202009.pdf
The conference title is misleadingly titled, that’s for sure, and the program quite narrow. Hopefully a conference for the 100th anniversary of the GT will be better designed and open to broader participation/contribution!
Nick,
There was a conference in Cambridge in 1983 .. on Keynes 100th birth anniversary…
Here’s the short link to a Google Books link to the book based on that. http://goo.gl/TlLtX
Ramanan,
Thanks for that link. That book looks interesting, particularly the part on rational expectations, with a comment by Pasinetti and samuelson. There’s also an article by Godley. My library doesn’t have a copy, so I’ll have to track down a copy
Dear Bill
I agree with everything what you said in your reply. However, I was making a micro-economic point. The relation between the supply of labor and wages is not linear. At some level, higher wages mean more willingness to work, and at another level, they mean less willingness.
As you pointed ut, running trade deficits usually presupposes a willingness of foreigners to invest in or lend to the country that runs the deficit. However, sometimes it is possible for a country to run a trade deficit because it has accumulated so much capital abroad that the repatriated profits on that capital can finance a trade deficit. Suppose that Ruritania has 200 billion invested abroad, while foreigners have invested nothing in Ruritania, and suppose that the return on that is 4%, then Ruritania could run a trade deficit of 8 billion, without borrowing or receiving investment from abroad.
Before WWI, Britain was in such a situation. For years, Britain had invested abroad. The return on those investment allowed the Brits to run a trade deficit.
Regards. James
Regards. James
Warren, the monopoly currency supplier view simply cuts right through to the core of the problem; a money/demand famine “money’s too tight to mention”.
I’ve dug out and am now re-reading Sterling by Douglas Jay.
He mentions the idea of total costs along with total money demand and total output and the problems there were in the 80s deflation that people/businesses had with fixed debts and costs around 15% higher than the available money to pay them with and the economic destruction, nay vandalism fundamentalist monetarism wrought on the UK economy.
Bill,
I’m a bit late to commenting, but hopefully you’re still reading.
“In return, because the terms of trade have moved so far in our favour, we can enjoy a range of products that we cannot make ourselves.”
While MMT’s description of exports as costs and imports as benefits does make sense within the theory’s context, it sits very poorly with me. I understand that being able to enjoy products that you cannot make yourself does leave you better off, especially when you’re exporting raw materials or what I would call “lower value-add” products (I’m not an economist, but hopefully that term makes sense here). But long-term I believe this leaves a nation in a precarious position.
I believe that technological advancements tend to occur in those places where manufacturing, research, and development are most active. You need a labor force composed of skilled people who work with advanced technologies on a daily basis and who have the practical knowledge to improve upon them or design new ones. Nations such as Germany, Japan, and China are export powerhouses and are among the more likely sites for continued development of advanced technologies because they maintain such a base of workers and use the global market as the place to send their national overproduction. The exports are a cost to them, but they receive a more abstract benefit by maintaining a skilled labor force and increasing the chance that they will be the site of the next major tech boom. A nation that does not produce any of its cars is not likely to develop the hydrogen powered electric car engine.
Nations with economies like Australia benefit from their position as net importers, but only insofar as they have valuable resources to offer to other nations. When those resource demands diminish, they have less to fall back on. The example I know best is Uruguay after WWII–in the early 1900s it was referred to as the Switzerland of South America and had a very generous social welfare state with high incomes, standards of living, etc. It imported most advanced goods and exported agricultural products (mainly beef, if I recall correctly). In the 1950s, global demand for ag products decreased and Uruguay had very little other industry to fall back on. This, I believe, is the plight of overly import-dependent, resource-oriented economies in the longer run.
Essentially, I’m arguing that MMT’s position on imports and exports may be overlooking issues relating to technological development and economic vulnerability and, as a consequence, its stance on imports/exports comes across as incomplete. I believe that exports, especially of high technology products, are a cost that is paid to develop a nation’s productive capacity when the domestic market is not large enough and, consequently, are paid to maintain the benefit of economic flexibility and complexity in the face of variable global market demands. The standard MMT presentation reads as if exports are a nonsensical cost based on outdated thinking–perhaps I’m reading that wrong though?
I’d be curious to hear your thoughts on this!
@ Ramanan,
“not so straightforward banking operations”
It looks like for instance at least one Australian bank has been finding sources and places to deploy excess USD balances:
http://www.thenewspaper.com/news/34/3409.asp
Resp,
“First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost.”
Maybe I’m missing something here, but I think Krugman’s argument is that exports do create real benefits in terms of employment. Obviously if we had a full employment program in operation this would be less of an issue, but since we don’t we can surely see imports as essentially taking away potential jobs from the domestic private sector, right?
I’m not saying which is really better or worse. But can we not safely say that there are costs and benefits to trade deficits/surpluses and evaluate their existence relative to these costs and benefits?
Ramanan – thanks.
Fed Up – he’s got the banking causality backwards, but apart from that, no problem.
“Maybe I’m missing something here, but I think Krugman’s argument is that exports do create real benefits in terms of employment”
It’s undoubtedly the case that exports create employment.
However that is the problem. The government sector is shirking its responsibility to maintain the economy at full operating capacity and trying to get the rest of the world to step in and prop their economy up. That causes imbalances in the rest of the world.
Arguably that is exactly what is happening in the Eurozone. Germany has got the peripheral countries to prop up their economy because there is insufficient domestic demand for goods and services. The fixed exchange rate has allowed them to do that and they’ve destroyed several economies with their actions. They even lent those economies the rope to hang themselves with.
Japan is doing the same, but it is less pronounced due to the floating exchange rate mechanism, which they clearly game to their benefit.
The first country to realise that imports are purchased essentially with exports of currency that are then stocked by foreigners will gain the advantage, since the production of currency is trivial. They would have a huge standard of living boost until the exchange rates moved to sort out the imbalance.
@ Neil Wilson
You’re absolutely right. But the point still stands. Krugman’s main point is that the exports create jobs because when he advocates stimulus he advocates pump-priming — not JG.
One other thing that was raised above. I agree with one commentator that institutional factors might also play a part in large trade deficits. In short, I have some sympathy with the commonplace idea that economies with massive deficits are lazy consumer societies that watch too much TV and eat too many Twinkys.
Take Ireland in this regard. Back in the day highly educated people had to emigrate — even though they didn’t want to. When we started churning out the exports scientists and the like were able to stay in the country and get jobs in chemicals and pharmaceuticals and the like. Even after the crash this continues to be the case. One saving grace of the boom years. But without a thriving export sector this would almost certainly not be the case — and, to play on another semi-accurate stereotype, they’d all just be sitting in the pub waiting for the ferry.
JKH said: “Fed Up – he’s got the banking causality backwards, but apart from that, no problem.”
Here is this from the thread:
“Al: Short answer: No. Banks are (approximately) irrelevant. With (say) 10% capital, a bank borrows $90 debt (including savings account + chequing account) plus $10 equity from the 65 year old, and lends $100 debt to the 35 year old.”
Here is what I think I have picked up about accounting from JKH, Billy Blog, and others.
Same scenario.
Asset side:
$100 NEW loan
$10 Capital requirement
Liability side:
$100 NEW demand deposit
$10 Equity (Net Worth)
The new loan gets a capital requirement. The new demand deposit gets a reserve requirement. I skipped the reserve requirement. The demand deposit is new, and if it becomes a means of payment, is new medium of exchange.
The key is the demand deposit is new (new/more medium of exchange, capital multiplier), and whoever holds the liability (demand deposit) is a “lender” ex-post.”
Is that right? Thanks!
Fed Up,
Simple example:
Start of period 1:
Loans 1000
Deposits 900
Equity capital 100
Capital fully allocated to risk taking in lending
(Capital is only on the right hand side of the balance sheet)
Period 1 activity:
Profit comes from interest margin, which is interest paid on loans less interest paid on deposits
Borrowers pay interest from their own deposits
Depositors collect interest paid into their own deposits
Suppose interest margin = profit = 10
Then deposits have net declined by 10 (borrowers pay more than depositors collect)
Offset is retained profit
Retained profit is an addition to equity capital – increases by 10
End of period 1:
Loans 1000
Deposits 890
Equity capital 110, including “excess capital” of 10
Excess capital = capital not yet used to back loans
Period 2:
New loans 100
Loans create deposits = 100
Backed by new capital of 10 already in place
End of period 2:
Loans 1100
Deposits 990
Equity capital 110
No “excess capital”; capital now fully allocated to risk taken in lending
P.S.
Steve Keen has written volumes on this type of stuff, trying to show what Marx couldn’t figure out apparently
But its just double entry accounting
P.S.
left out profit cycle in period 2 for clarity, but its similar to period 1
i.e. “end of period 2” above is effectively beginning of period 2, when new loans are made, before start of period 2 profit cycle
JKH said: “End of period 1:
Loans 1000
Deposits 890
Equity capital 110, including “excess capital” of 10
Excess capital = capital not yet used to back loans
Period 2:
New loans 100
Loans create deposits = 100
Backed by new capital of 10 already in place
End of period 2:
Loans 1100
Deposits 990
Equity capital 110
No “excess capital”; capital now fully allocated to risk taken in lending”
I get the loans create deposits part. I’m a little confused about the beginning and the drop in deposits. I think it is because I’m thinking in terms of budgets and medium of exchange. Let me try to explain.
I start a bank with my savings.
Asset side:
$10 in medium of exchange
Liability side:
$10 equity capital (new worth)
Someone gets a mortgage (10% capital requirement) for $100 with monthly payments of $11 for principal and interest for 10 months (total payments $110). The person has no savings, no down payment but a good job (keeping it simple), and does no other saving. To keep it simple the demand deposit gets put in a checking account earning no interest (meaning net interest to the bank is $1). I’m also skipping the reserve requirement.
Asset side:
$10 in medium of exchange
$100 NEW loan
Liability side:
$10 equity capital (net worth)
$100 NEW demand deposit (serving as NEW medium of exchange)
At the end of 1st payment:
Asset side:
$21 in medium of exchange
$90 loan
Liability side:
$100 in demand deposits
$11 in equity capital (net worth)
At the end of the loan term:
Asset side:
$120 in medium of exchange ($110 plus $10 at the beginning)
Liability side:
$100 in demand deposits
$20 equity capital (net worth)
Is that correct?
At the end of the first payment when the loan goes to $90, does the capital requirement go to $9 from $10 freeing up $1 of capital?
If my scenario is correct, isn’t it incorrect to say a bank borrows $90 debt (including savings account + chequing account) plus $10 equity from the 65 year old, and lends $100 debt to the 35 year old?
Thanks again!!!!
Fed Up,
The key to getting lost is that the deposit initially created ex nihilo on the account of the borrower is instantly transferred to the account of the guy who sells the house who just happened to be that 65 years old individual. So the net result of the BOTH transactions is that the deposit belongs to the saver – while the house belongs to the borrower who also owes money to the bank. If we manage to forget about the sale of the real asset then we may fall into an illusion that the saver had had to deposit money before the loan could have been extended. But who went to the bank first? Of course the borrower not the lender. I know that for sure because this is exactly what happened when I applied for a mortgage. Your example is perfectly valid but if we want to close the circuit then the young hard working guy has to keep selling his labour to someone possibly that 65-er in order to earn money to repay the loan and the interests accrued – so somebody’s account will be debited for the same amount as the debt which is repaid. Whether his debt is repaid with the high-powered money or just all the transactions occur within the same bank it is not so relevant. If we want to introduce the government money we have to speak about the position of the government there. Either the 65-er has to spend all his deposit and the bank dividend coming from the interests or the government has to spend to pay for the labour of our worker what is exactly the Chartalist position. Otherwise the net effect of all the transactions will be labour sold for the house.
Please be very careful in checking out the Steve’s blog as there is one thing there most of us don’t agree – Steve thinks that the “money” is not destroyed once the loan is repaid. My brain was infused with enough SQL code to think purely in terms of database transactions – I don’t really care about the hidden meanings of money as credit or whatever. To me the transaction where debt is repaid is a reversal of the transaction when debt is created.
I think that the best description of the working of the monetary circuit can be found in papers of a French economist Bernard Vallageas (one of them was mentioned recently by Randal Wray in his paper). If you Google for the “Knoxville Paper” you’ll find balance sheets for each stage of the process – without any “paradoxes of profits”.
Fed Up,
Regarding your example, I see one error, one dilemma, and (at least one) interesting and important insight, at least in my opinion.
First, the error:
The “medium of exchange” for a bank is not the same as the medium of exchange for a bank customer. What you’ve called the medium of exchange for the bank is really bank reserves.
The bank’s customers use bank deposit liabilities for their transactions and their medium of exchange.
So my advice would be to steer clear of “medium of exchange” terminology to make things more precise for different economic actors using different types of money.
Accordingly, your starting balance sheet might be:
10 reserves
100 loan
100 deposit (loan creates deposit)
10 equity capital
Second, the dilemma I see is that Rowe’s characterization of the demographic distribution of bank deposits is simply not possible in the real world – not even in theory in the real world. 65 year old individuals could not hold all the bank deposits, even in theory. That’s because all economic actors, including 35 year old individuals as well as all businesses and institutions, require bank deposits at some point, in order to complete normal banking transactions such as writing cheques and transferring funds – transactions that are essential to all actors for exchanging value in a monetary economy. So it is futile to attempt to connect Rowe’s extreme formulation of the demography of banks deposits to anything that is related to the real world, even in theory. And that means it’s futile to attempt to match the logic of balance sheet accounting entries as an entirely closed system to Rowe’s demographic formulation.
What can be done instead in my view is some reasonable intuition about how such a trending demographic distribution of deposits could impact at the margin, in a reasonably substantial way.
E.g. there’s no reason in theory why 65 year olds couldn’t end up owning a large chunk of bank deposits (not all of them though), and a large chunk of bank equity, as savers.
There’s no reason why 35 year olds couldn’t be receiving a large chunk of loans.
35 year olds spend to consume, which corresponds to a slice of GDP. That generates GDI (income). Since the 35 year olds have already bought the product without earning the income (they borrowed), somebody else by logical construction must have earned that income and saved it. That could happen in the form of interest on bank deposits and earnings on bank equity accruing to 65 year olds.
I’ve already shown you how internally generated capital (the internal addition to equity) can be funded by a decline in bank deposits. (That’s another reason why the 35 year olds must have at least some of the deposits along the way – they pay their interest and principal from them.)
Note that it’s also possible in theory to start a brand new bank by selling newly issued equity to 65 year olds. They will pay for that with deposits from another bank. The new bank will end up with a starting balance sheet looking something like the lower half of the revised one above – 10 in reserves and 10 in equity. (The bank can always swap the reserves for t bills or something.) And then the new bank drives on with lending to 35 year olds, which generates new deposits, which effectively circulate and start to end up mostly with the 65 year olds through saving.
Third, your insight that I quite liked:
“At the end of the first payment when the loan goes to $90, does the capital requirement go to $9 from $10 freeing up $1 of capital?”
Yes, that’s quite right, and important in understanding bank capital management. Moreover, the retained profit of 1 adds further to that, so at the end of year 1 you have $ 9 of allocated capital and $ 2 of excess capital.
I get that by deriving the following balance sheet at the end of period 1:
10 reserves
90 loan
89 deposit (loan creates deposit)
11 equity capital
(The deposit is 89 because the 35 year old has paid both principal and interest from his deposit. Again, the 35 year olds require “working capital” in the form of deposits to repay their loans. The 65 year olds can’t have all the deposits, as per Rowe’s world.)
Adam (ak) & JKH, thanks to both of you. I have some other questions.
JKH said: “Accordingly, your starting balance sheet might be:
10 reserves
100 loan
100 deposit (loan creates deposit)
10 equity capital”
I believe you mean loan loss reserves, but I think a lot of people would think central bank reserves for the reserve requirement (or maybe I’m mixing things up). The other thing is let’s say my savings to start the bank was a demand deposit from another bank for $10 plus $11 in a demand deposit for the first payment.
I said: “At the end of 1st payment:
Asset side:
$21 in medium of exchange ( $9 loan loss reserves)
$90 loan
Liability side:
$100 in demand deposits
$11 in equity capital (net worth)”
First, don’t loan loss reserves have to be currency, demand deposit(s), or some other liquid asset? Second, the demand deposit holder comes in and wants $100 in currency. I sell the loan for $90 in currency, and then I go to cash in the demand deposit from the other bank. Oops, it has gone bankrupt with no deposit insurance. Now I’m in trouble meeting the withdrawal request. There is one difference between currency and demand deposits.
JKH said: “E.g. there’s no reason in theory why 65 year olds couldn’t end up owning a large chunk of bank deposits (not all of them though), and a large chunk of bank equity, as savers.
There’s no reason why 35 year olds couldn’t be receiving a large chunk of loans.”
I’d rather put wealth/income inequality in there that eventually throws off the retirement market.
I said: “At the end of the loan term:
Asset side:
$120 in medium of exchange ($110 plus $10 at the beginning)
Liability side:
$100 in demand deposits
$20 equity capital (net worth)”
Adam (ak) said: “Your example is perfectly valid but if we want to close the circuit then the young hard working guy has to keep selling his labour to someone possibly that 65-er in order to earn money to repay the loan and the interests accrued – so somebody’s account will be debited for the same amount as the debt which is repaid.”
JKH said: “I’ve already shown you how internally generated capital (the internal addition to equity) can be funded by a decline in bank deposits. (That’s another reason why the 35 year olds must have at least some of the deposits along the way – they pay their interest and principal from them.)”
If I’m understanding you both correctly and no new loans/debt are created, then the $110 the worker earned to pay his/her mortgage means someone else’s demand deposit account got marked down somewhere? Is that correct?
What I am really trying to get at is how the amount of medium of exchange (currency plus demand deposits) can go both UP AND DOWN bringing up the concept of too much debt. Demand deposits from debt can be defaulted on if the loan losses are higher than the loan loss reserves set aside for them and demand deposits can be paid off. Both of those can lower the amount of medium of exchange throwing off the economy (it will probably spiral backwards in time just like the increasing amount of medium of exchange from demand deposits from debt caused it to spiral forwards in time). If more currency/demand deposits no with bond/loan attached are created, that eliminates the debt default and debt payoff problem.
The reserves are central bank reserves.
I think I’m confused.
I thought central bank reserves were only for the reserve requirement.
They can be used for the capital requirement too?
Adam (ak) said: “I think that the best description of the working of the monetary circuit can be found in papers of a French economist Bernard Vallageas (one of them was mentioned recently by Randal Wray in his paper). If you Google for the “Knoxville Paper” you’ll find balance sheets for each stage of the process – without any “paradoxes of profits”.”
I tried googling. I get stuff from the Knoxville, TN paper. What else should I add?
Fed Up,
Reserve balances held at the central bank are on the left hand side of the commercial bank balance sheet, as are loans.
Equity capital is on the right hand side, as are customer deposits.
Reserve balances at the CB and equity capital are entirely different, and for different purposes.
Reserve balances are for settlement of payments.
Capital is for absorption of unexpected losses.
Fed Up,
I came across B. Vallegeas papers on the monetary circuit when I was reading:
Working Paper No. 647 Money by L. Randall Wray
Levy Economics Institute of Bard College
One is mentioned in that paper (available in the usual place for download).
Adam (ak), I’ll try to look that up.
JKH, “JKH said: “Accordingly, your starting balance sheet might be:
10 reserves
100 loan
100 deposit (loan creates deposit)
10 equity capital”
That is one reason I left out the reserve requirement. I wanted to focus on the capital requirement. If 10 reserves means 10 central bank reserves, then I assume the $10 in currency or the $10 demand deposit was swapped at the central bank (correct?). If the only focus is the capital requirement, then why can’t my bank just hold the $10 in currency or the $10 demand deposit in the bank vault and skip the central bank reserves?
I believe this comes down to what asset the equity capital (net worth) gets invested in.
JKH said: “Fed Up,
Reserve balances held at the central bank are on the left hand side of the commercial bank balance sheet, as are loans.”
Assets, OK.
“Equity capital is on the right hand side, as are customer deposits.”
Liabilities, OK.
“Reserve balances at the CB and equity capital are entirely different, and for different purposes.
Reserve balances are for settlement of payments.
Capital is for absorption of unexpected losses.”
Somehow I think there is a cross there. It seems the capital got invested in central bank reserves (see above).
“Al: Short answer: No. Banks are (approximately) irrelevant. With (say) 10% capital, a bank borrows $90 debt (including savings account + chequing account) plus $10 equity from the 65 year old, and lends $100 debt to the 35 year old.”
Back to the 35 year old and the 65 year old, it seems as if the 65 year old lend $10 in capital and $100 in deposits (after the fact, ex-post). Is that correct?
Fed Up,
I assumed 10 in central bank reserves as a corrective modification to your starting balance sheet, as I already explained. It’s got nothing to do with a reserve “requirement”.
Let’s start over.
Suppose you create a new bank.
You issue 10 in capital (shares).
New investors pay for their shares that by writing cheques on their deposits at other banks.
That brings central bank reserves into your bank (as settlement for the cheques). The role of reserves in this case is their use as settlement balances, not because of a “reserve requirement”.
Your starting balance sheet is:
Assets:
10 central bank reserves
Capital:
10 capital
At that point, you have no loans and no deposits.
Suppose you buy t-bills from other banks to get an interest earning asset. That moves central bank reserves to other banks (settlement in payment for the t-bills) and your balance sheet is now:
Assets:
10 t bills
Capital:
10 capital
You still have no loans and no deposits.
T bills are considered “risk free”.
That means all of your capital is excess to any requirement to support risk, because none of it is allocated to risk taking.
Now you make 100 loans and credit your borrowers with 100 in their deposit accounts. (Loans create deposits.)
Your balance sheet now is:
Assets:
10 t bills
100 loans
Liabilities and Capital:
100 deposits
10 capital
Your capital now backstops the risk on 100 loans, and is considered fully allocated to risk.
There’s a fundamental difference between liquidity management and capital management. In this case, the cash that was brought in with the initial capital issue ended up being invested in risk free treasury bills. But the primary purpose of the capital is to backstop the risk subsequently taken in the loans.
As an alternative, you could sell the t bills and use the money to pay down 10 in deposits, in which case your balance sheet is:
Assets
100 loans
Liabilities and Capital
90 deposits
10 capital
That’s a more conventional picture of how capital fits in vis a vis corresponding assets. But this version is only a variation of the first, because of liquidity management. The capital in either case is allocated to 100 loans for risk purposes.
JKH,
Isn’t that last section only valid if you sell the T-bills to depositors in your bank – otherwise you bring in central bank reserves again.
JKH, I think I have it now. The “powers that be” want to make central bank reserves, demand deposits, and t-bills equivalent to currency. That means they are liquid, don’t go down in value, and are not defaulted on. That allows a lot of 1 to 1 swapping to go on in the present and near future so that the equity capital is maintained or increased if the t-bill yields much.
JKH said: “New investors pay for their shares that by writing cheques on their deposits at other banks.
That brings central bank reserves into your bank (as settlement for the cheques).”
I think you skipped a step, but I believe it is important. I get the demand deposit from the new investors. Then I swap the demand deposit at the central bank for central bank reserves thereby removing my default risk from the bank of the new investors. Is that correct?
I said: “Al: Short answer: No. Banks are (approximately) irrelevant. With (say) 10% capital, a bank borrows $90 debt (including savings account + chequing account) plus $10 equity from the 65 year old, and lends $100 debt to the 35 year old.”
Back to the 35 year old and the 65 year old, it seems as if the 65 year old lend $10 in capital and $100 in deposits (after the fact, ex-post). Is that correct?
Let me expand on that and hope this gets interesting.
65 old year’s demand deposit (DD) account gets marked down by $10. Equity capital of the bank gets marked up by $10.
NEW demand deposit of the 35 year old MUST be backed by a loan. 35 year old’s demand deposit account gets marked up by $100. Bank has a loan asset for $100. 35 year old buys the 65 year old’s house who accepts the $100 demand deposit thereby becoming a “lender” ex-post. 35 year old’s demand deposit account gets marked down by $100, and 65 year old’s demand deposit account gets marked up by $100.
We’ll stop here for a second. The 65 year old’s DD account at the beginning showed $10 and now has $100. The amount of medium of exchange has gone up $90. The 35 year old’s DD account was zero(0) and is still zero(0), but now he/she owns the house. Is that correct?
On we go. The 65 year old pays the 35 year old $11 per month for labor. On to the next to last month:
Assets:
$10 central bank reserves
$10 loan
Liabilities:
$ 1 demand deposit
$19 equity capital
The 65 year old gets his initial capital ($10) back.
Liabilities become:
$11 demand deposit
$ 9 equity capital
At the end of the loan term:
Assets:
$10 central bank reserves
Liabilities:
$10 equity capital
65 year old gets a $5 dividend
Assets:
$10 central bank reserves
Liabilities:
$5 demand deposit
$5 equity capital (now the bank’s)
The 35 year old had no DD at the beginning or end, but has the house.
The 65 year old is now down to $5 DD with no house but got some labor.
The bank is $5 equity capital richer.
If no else goes into debt (increasing DD’s and therefore medium of exchange) then the $90 spike in DD’s because of the loan goes down every month until it completely goes away, and the house falls in value.
Is all that correct? Thanks!
Back to my other point.
If more currency/demand deposits with no bond/loan attached are created (increasing the amount of medium of exchange), that eliminates the debt default and debt payoff options. Correct?
How about these comments from:
http://macromarketmusings.blogspot.com/2011/06/monetary-policy-efficacy-during-balance.html
Jazzbumpa said…
Sure about this:
Yes, deleveraging is a drag on the economy, but for every debtor deleveraging there is a creditor getting more payments… (And if the debtor is not making payments and defaulting then the debtor still has funds to spend.)
The parenthetic finesse is an off-point distraction, or worse. The debtor cannot both pay debt and spend because is is broke, and the creditor is NOT getting the payments. Overall spending declines, whether you will have it that way or not. This has NOTHING to do with uncertainty, and everything to do with a lack of cash.
The creditor cannot increase spending because he doesn’t have the money that, if you will recall, he didn’t receive. Your argument is an abstraction, unrelated to reality.
What is uncertainly compared to a decline in rent receipts?
QE failed because the money is sitting, useless, in excess reserves.
Cheers!
JzB
Cheers!
JzB
June 26, 2011 9:48 AM
Anonymous said…
The point of deleverging is that both loans AND deposits collapse. It’s what MMT describes as the collapse of horizontal money. For every dollar of loans repaid, a dollar of deposits disappears.
Taxes collapse vertical money. The severe collapse in horizontal money through bankruptcy is replaced by vertical money through government bailouts.
June 26, 2011 11:41 AM
Anonymous said…
Anonymous above:
Deleveraging that leads to collapse of loans and deposits means that the medium of exchange has fallen. For a given money demand this reduction in the money supply by the banking system means that there is an is a new excess money demand problem. That is the point being made above: creditors are creating an excess money demand problem that the Fed could address. Of course, it is not just banks, but all creditors.
June 26, 2011 12:20 PM
Ralph Musgrave said…
I’m pretty sure I agree with Anon just above. To put Anon’s point in my own words, David Beckworth is not quite correct to say that “for every debtor deleveraging there is a creditor getting more payments”.
That is true where the creditor being repaid is not a bank. But where someone who has borrowed from a bank repays the bank, the bank just extinguishes the money, or to use Anon’s phraseology, horizontal money collapses.
June 27, 2011 8:43 AM
Thoughts?
JKH, do you or do you someone who does the accounting for FDR going off the gold standard? Thanks again!
EDIT: “do you someone” TO “do you know someone”
Neil Wilson,
Right – you can sell bills internally to depositors, in which case there’s no net reserve effect.
But there’s also the case where depositors move their money externally, which shows up as a loss in the bank’s reserve account, de facto. The bank’s liquidity/cash manager can then respond to that by selling bills externally, which offsets the reserve loss from the depositors.
Everything in bank cash management is at the margin. The cash manager adjusts iteratively to all exogenous events that affect the reserve position (including those that might have, but don’t), in order to steer the reserve position endogenously.
Fed Up,
That concludes my explanation for now, thanks.
JKH, thanks for your time. It helped A LOT!