Saturday Quiz – August 27, 2011

This Post Has 19 Comments

1. bill, would you be willing to discuss my “in the present” vs. “in the future” argument about Q2? I assume that the gov’t budget is set up to pay both interest and principal so that the gov’t bond is paid off at maturity (meaning no rollover risk). Thanks!

2. Hey, I got all five! Does that mean I’m in the know?

3. Dear Bill et al,

   The following quote from Steve Keen’s latest post defines aggregate demand:

   “Aggregate demand is the sum of income plus the change in debt, and this is spent on both goods and services and assets. There is thus a link between the change in debt and the level of asset prices (and the fraction sold, and the quantity produced, but I’ll focus just on just house prices for now).
   Going one step further, the change in aggregate demand is the change in income plus the acceleration of debt. There is thus a link between the acceleration of debt and the rate of change of house prices. If this relationship is strong, then rising house prices require that the rate of growth of debt rises over time.”

   Could anybody comment on what MMT would have to say about this definition of aggregate demand?

   Thanks,
   jrbarch

4. jrb,

   I’ve been pondering the same point this morning funnily enough, trying to marry the two.

   I suspect it is down to each model’s definition of ‘income’ and what is included in that. Within MMT the endogenous expansion of credit boosts income directly because spending = income. So if somebody pulls tomorrow’s income to today by borrowing for consumption then that necessarily increases income in the second order spending.

   And of course you’ve got a neutered government at the moment who has tied its hands so much that it can’t counter stabilise that credit expansion and contraction – other than via the increasingly weakened automatic stabilisers.

   So I can sympathize with Steve’s view that the change in private debt matters because it increases spending. Certainly his simulations model what has happened pretty closely. But if he’s double counting then the model needs something else in it to balance things out and get it consistent with accounting.

   It would be useful to find a common ground between MMT’s model and Steve’s private debt models. And to do that we need to understand what the areas of disagreement are. Anybody got a concise list of those?

5. “If the central bank regulated that banks have to hold reserve equivalent to their outstanding loans this would restrict lending.”

   I’m going to query this and watch my argument be demolished. Because this is one area I’m not clear about.

   It surely must restrict lending if the central bank refused to issue more reserves and essentially let the interest rate go where it will. In other words it targets a quantity rather than a price. Then in that context the private banks know that the central bank won’t accommodate them and they will have to obtain reserves a-priori before lending or risk being short at clearance and being put into administration.

   Therefore the question is based upon the assumption that the central bank is targeting an interest rate price and not a quantity of credit. If the central bank operates this policy then the private banks know that the central bank has no choice but to hand out reserves on demand and the private banks can continue to obtain reserves after the fact.

   So the question is if the central bank targets a quantity of reserves and lets the interest rate go where it will, with a 100% reserve requirement, what happens?

6. @Neil Wilson: The central bank also acts as a lender of last resort, to provide reserves to banks as long as their balance sheets are in order. My understanding is that as long as this lender of last resort property is maintained, the central bank cannot target the quantity of reserves even if it were prepared to let interest rates go wherever – because at some point, banks would just go to the central bank to obtain the required reserves.

   Or, if you want to look at it from the other end of the implication, if you really wanted the central bank to be able to target the quantity of reserves, it seems like you would have to disable this lender of last resort function, which would mean changing the system much more than just setting required reserves to 100%.

7. ” which would mean changing the system much more than just setting required reserves to 100%.”

   But doesn’t changing to 100% reserves mean that you have disabled the lender of last resort function? There should be no need for extra reserves unless the bank is breaking the rules – in which case the bank is insolvent.

8. Neil: “I suspect it is down to each model’s definition of ‘income’ and what is included in that.”

   Consumption in current period:
   Present income – revenue over a period gets spent or current consumption
   Past income – savings get drawn down and assets sold for current consumption
   Future income – borrow against expectation of future revenue to finance current consumption

   Neil: “But doesn’t changing to 100% reserves mean that you have disabled the lender of last resort function? There should be no need for extra reserves unless the bank is breaking the rules – in which case the bank is insolvent.”

   Neil, why couldn’t there be a 100% RR and also ELR to provide RR as needed? This would just make lending more expensive for the bank than a lower RR due to increased borrowing cost from the cb, so this would have the effect of raising the rates at which the bank would lend, thereby restricting loan demand. Seems that Nicholas is correct that a separate rule eliminating ELR would be needed to fix the amount of reserves?

9. I don’t see any problem with Steve’s definition except that it’s a bit sloppy. We like to say that AD is about net saving desired by non-govt sector relative to the govt’s deficit. That definition includes (a) the fact that non-govt sector spending is a function of income and not necessarily equal to it, (b) non-govt spending is a function of borrowing (debt) to finance non-govt sector spending beyond its income, and (c) the govt’s deficit relative to these. This seems a lot more comprehensive, clear, and (as Neil pointed out) avoids double counting if that is in fact occurring.

10. jrbarch’s post said: “Aggregate demand is the sum of income plus the change in debt …”

    And, “Could anybody comment on what MMT would have to say about this definition of aggregate demand?”

    Does that definition of aggregate demand include or exclude financial assets?

11. Neil Wilson said: “But doesn’t changing to 100% reserves mean that you have disabled the lender of last resort function? There should be no need for extra reserves unless the bank is breaking the rules – in which case the bank is insolvent.”

    Is it insolvent or illiquid?

12. @NeilWilson

    I think there is an unstated assumption that policies external to the question remain as they are in the real world. So I would assume that the CB would continue to provide reserves on demand. I don’t think the policy rate wouldn’t have to be zero unless the CB wanted it to be. In other words, the CB could still elect to pay interest on reserves.

13. ScottF Aug28 0:51 – “AD is about net saving desired by non-govt sector relative to the govt’s deficit”

    Thanks for your answer Scott. Has there ever been a point in any country’s history where the government’s deficit was too large relative to AD – i don’t quite know how the newspapers would write that one up!!

14. “Is it insolvent or illiquid?”

    It’s insolvent under the rules. Regulations require that you have 100% reserves to cover loans. You haven’t. Therefore you have breached your ‘banking covenants’ and should be foreclosed by the regulators. (Because you are ‘cheating’ – which is what brought about fractional reserve in the first place).

15. “Neil, why couldn’t there be a 100% RR and also ELR to provide RR as needed?”

    You could but that’s just targeting a price again rather than a quantity, which means that the private bank doesn’t alter its fundamental behaviour – which we all know is to make the loan and find the reserves later. The result is exactly as the question implies – 100% reserves in a targeted rate environment have precisely the same effect as 0% reserves.

    ISTM that you need to target a fixed quantity of reserves and threaten ‘resolution’ if they go beyond that before a bank will make absolutely certain it has the reserves before lending. And you probably need to require maturity matching as well.

    Then you end up with a hard cut off point because reserves have a strange function. If there is $1 more reserves than required then the interest rate drops to zero and if there is $1 less than required the interest rate rushes to infinity or until somebody goes bust (whichever comes first).

    The question then is what effect a quantity limit has on the stability of the banking system from the public’s point of view?

16. @Dale,

    Agree entirely. The assumption in the question is just that the reserve requirement changes – which of course make no difference at all.

    Which is why, when debating with 100%ers, you need to establish first whether they propose closing the discount window.

17. Hello jrbarch,

    “Has there ever been a point in any country’s history where the government’s deficit was too large relative to AD ”

    If there’s ever been a case where there is demand pull inflation, then you have a case of the deficit too large relative to net saving desires of the non-govt sector.

18. Neil Wilson’s post said: “”Is it insolvent or illiquid?”

    It’s insolvent under the rules. Regulations require that you have 100% reserves to cover loans. You haven’t. Therefore you have breached your ‘banking covenants’ and should be foreclosed by the regulators. (Because you are ‘cheating’ – which is what brought about fractional reserve in the first place).”

    My point was about whether the loans are still performing or not.

19. @ ScottF Aug 28 23:51

    Right! So the propensity to save is overcome by the propensity to consume (competition to consume). The desire to be content is a powerful engine!! I doubt the world’s best consumer is content. (lol) You would think people would come up with a new formula … thanks Scott.