As I noted yesterday, last evening I accepted an invitation to speak on a panel…
MMT and the external sector – redux
This blog post is written for a workshop I am participating in Germany on Saturday, October 13, 2018. The panel I am part of is focusing on external trade and currency issues. In this post, I bring together the basic arguments I will be presenting. One of the issues that is often brought up in relation to Modern Monetary Theory (MMT) relates to the foreign exchange markets and the external accounts of nations (particularly the Current Account). Even progressive-minded economists seem to reach an impasse when the question of whether a current account should be in surplus or deficit and if it is in deficit does this somehow constrains the capacity of currency-issuing governments to use its fiscal policy instruments (spending and taxation) to maintain full employment. in this post I address those issues and discuss nuances of the MMT perspective on the external sector.
What we can agree on
There is now widespread understanding among those who have been introduced to MMT that:
1. There is a fundamental difference between the currency-issuer and the currency-user, such that the former has no intrinsic financial constraints on its spending. Such a government can always meet any liabilities that are denominated in the currency it issues.
This also means that such a government can purchase anything that is for sale in the currency it issues, including all idle labour.
Which means that the government chooses the unemployment rate. An elevated unemployment rate is always a political decision rather than anything that is forced on a nation by ‘market forces’ or the choice of individuals/households.
2. The governments ability to spend is prior to any revenue it might receive in the form of taxation. Taxation revenue comes from funds that the government has already spent into existence.
3. Central banks are monopoly creators of ‘central bank money’, while commercial banks create ‘bank money’ out of thin air – through “balance sheet extension”.
Central banks set the interest rate but cannot control the broad money supply or the volume of ‘central bank money’ in circulation.
This is because the central bank has no choice but to ensure there are enough bank reserves available given its charter is to maintain financial stability.
If cheques start bouncing because of a shortage of reserves then financial panic would follow.
This also means that the mainstream economics idea of ‘crowding out’, which posits that government borrowing absorbs scarce funds that would otherwise be available for private firms, is erroneous. Commercial banks will make loans to any credit-worthy borrower on demand. There is no scarcity of credit (loanable funds).
4. The National Accounts tell us that a government deficit (surplus) is exactly equal to the non-government surplus (deficit).
The non-government sector is comprised of the external and private domestic sectors. If the external sector is in deficit and the private domestic sector desires to save overall, then the government sector has to be in deficit and national income changes will ensure that occurs.
Which means that fiscal surpluses squeeze non-government wealth.
Further, the mainstream concept that fiscal surpluses represent ‘national saving’ is erroneous. A currency-user, such as a household saves (foregoes current consumption) in order to enjoy higher future consumption possibilities (via interest income on the saving).
A currency-issuing government never has to store up money in order to spend in the future. They can always purchase whatever is for sale in that currency at any time they choose.
5. The aim of fiscal policy is not to deliver a particular fiscal outcome (surplus or deficit). Rather, it is to ensure that the discretionary government policy position is sufficient to ensure full employment and price stability, given the spending and saving decisions of the non-government sector.
If from a particular level of national income, the private domestic sector, for example, desires to save more overall and cuts its spending accordingly, then unless there is more net export spending coming in, the government will have to increase its deficit to avoid rising unemployment and a recession.
There is no particular significance in any fiscal outcome. Context is everything.
Even mainstream economists are starting to accept many of these propositions in the sense they now claim there is nothing new in MMT.
The external sector and sustainable policy space
However, there are still disputes about whether the external sector presents a terminal constraint on the government’s ability to maintain full employment and price stability.
MMT indicates that a flexible exchange rate regime maximises the policy space for government to pursue domestic objectives. Once a nation adopts a currency peg of any description (fixed exchange rate, dollarisation, currency board, etc) it loses its full currency sovereignty and compromises domestic policy aspirations.
Thus, the MMT preference for floating exchange rates is about removing constraints on policy that compromise the capacity of government to maintain full employment and price stability and deliver equitable outcomes to all.
To understand that, we must first develop a concept of sustainable policy space.
The well-known sectoral balances framework, which is derived from the national accounting framework can be depicted graphically (we develop this in detail in our forthcoming macroeconomics textbook).
The sectoral balances accounting statement is written:
(1) (S – I) = (G – T) + CAB
where S is household saving, I is private capital formation, G is government spending, T is taxation revenue and CAB is the Current Account balance (which is the sum of exports (X) minus imports (M) plus net external income flows (FNI)).
Equation (1) is interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAB > 0) generate national income and net financial assets for the private domestic sector, which must be saving overall (S > I).
Conversely, government surpluses (G – T < 0) and current account deficits (CAB < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.
Consider the following four-quadrant diagram.
All points above zero on the vertical axis represent a government fiscal surplus (T > G) and all points on the vertical axis below the origin denote government fiscal deficits (G > T).
Similarly, all points to the right of the origin on the horizontal axis denote external surpluses (X + FNI > M) and all points to the left of the origin on the horizontal axis represent external deficits (X + FNI < M). While we shall refer to surpluses and deficits with respect to the sectoral balances, these balances should be understood as being expressed as shares of GDP.
Clearly, the origin of both axes denotes a position where all balances are equal to zero.
From Equation (1), we also know that when the private domestic balance is zero (S = I), then the government fiscal deficit (surplus) will equal the external deficit (surplus).
Thus, the diagonal 45-degree line shows all combinations of government fiscal balances and external balances where the private domestic balance is zero (S = I). We will refer to this as the SI line.
When is the private domestic sector in surplus or deficit?
At points A and C, there is a private domestic balance. Point B corresponds to a fiscal deficit (G > T) and an external surplus (CAB > 0). Thus the private sector must be engaging in positive net saving (S > I). Then between points B and A, and also B and C, net saving by the private sector is falling until private domestic balance is achieved at points A and C respectively.
Similarly, it can be readily shown that at D, the private domestic sector is net spending (S <I). Between points D and C and D and A, net spending by the private sector declines until private domestic balance is achieved at points A and C respectively.
We can generalise this knowledge and conclude that all points above the 45-degree line on each side of the vertical axis correspond to private domestic sector deficits and all points below the 45 degree line on each side of the vertical axis correspond to private domestic sector surpluses.
How would we use this graphical depiction of the sectoral balances to determine the feasible and sustainable policy space for a currency-issuing government?
First, for a sovereign, currency-issuing government, all combinations of the sectoral balances represented by the points in the four quadrants are permissible. With private sector spending and saving decisions combining with the flows of income arising from trade with the external sector driving national income, the government sector can allow its balance to adjust to whatever magnitude is required to maintain full employment and price stability.
For example, if the external account is in deficit and the private domestic sector is saving overall, then the drain on aggregate demand would require the government to run a deficit of sufficient size to ensure that total spending is sufficient to absorb the real productive capacity available in the economy.
Alternatively, the external account might be in surplus, which would add to aggregate demand, while the private domestic sector might be spending more than it is earning, that is, in deficit overall. In these situations the government would have to ensure it ran a surplus of sufficient size to ensure that the economy did not overheat and exhaust its productive capacity. The strong economy would be associated with robust tax revenue growth, which would help the government achieve its surplus. Discretionary adjustments in spending and taxation rates might also be required.
However, while these combinations of sectoral balances are permissible, we know that the private domestic sector cannot sustain deficits permanently. This is because the flows of spending which deliver deficits must be funded. Private domestic deficits ultimately manifest in an increasing stock of debt being held on the private domestic sector’s balance sheet.
This process of debt accumulation is limited because at some point the susceptibility of the balance sheet to cyclical movements (for example, rising unemployment) increases and the risk of default rises.
In the long term, the only sustainable position is for the private domestic sector to be in surplus. An economy can absorb deviations from that position but only for short periods.
Thus, it is only the area ABC (the blue-shaded area) that can be considered to be the sustainable policy space available to governments that issue their own currency.
If we were to impose fiscal rules on such a government (such as the 3 per cent threshold in the EMU Stability and Growth Pact) the sustainable fiscal space would shrink significantly.
Why is this important? An unconstrained government can always utilise the available space to ensure aggregate demand is sufficient to maintain full employment and price stability.
By definition, not every nation can run an external surplus because an external surplus in one nation has to be matched by external deficit(s) in other nations. While the external surplus nations have more policy flexibility when operating under a fiscal rule than external deficit nations, the fact remains that the allowable fiscal deficits may be insufficient to maintain the aggregate demand necessary to sustain full employment.
The policy inflexibility facing nations which run external deficits and simultaneously have to operate under fiscal rules becomes even more restrictive. When such an economy experiences a negative economic shock significant enough to drive the private domestic sector to reduce its spending and target a sectoral surplus, the extent to which the fiscal deficit can be used to absorb the loss of overall aggregate demand is very limited.
It is highly likely that such an economy will experience enduring recessions as a result of the artificial fiscal rules (restrictions) that are placed on its government.
The ‘Balance of Payments’ constraint and fixed exchange rates
I have dealt extensively with questions of the exchange rate and the open economy in relation to MMT previously. For example:
1. The capacity of the state and the open economy – Part 1 (February 8, 2016).
2. Is exchange rate depreciation inflationary? (February 9, 2016).
3. Balance of payments constraints (February 10, 2016).
4. Ultimately, real resource availability constrains prosperity (February 11, 2016).
The issues raised by MMT critics usually relate to the inflationary effects of exchange rate depreciation including the erosion of living standards via rising import prices and the destabilising impacts of currency speculation. Critics recognise that the depreciation may enhance trade competitiveness but then present elaborate formulae to show why that might not be the case (debates about Marshall-Lerner conditions, etc).
In effect, they argue that the sustainable policy space is much less than the previous diagram might suggest.
Taken together these concerns are bundled under a heading – balance of payments constraints.
So, while MMT proponents argue that the currency-issuing state has no financial constraints, critics argue that the capacity of a nation to increase domestic employment using fiscal deficits is limited by the external sector.
And they argue that these constraints have become more severe in this age of multinational firms with their global supply chains and the increased volume of global capital flows.
These critics also, often, erroneously believe that fixed exchange rate regimes provide financial stability and insulate nations from imported inflation, while flexible exchange rates undermine stability. History doesn’t support this preference for fixed exchange rates.
The Post World War 2, fixed exchange rate system restricted fiscal policy options because monetary policy had to target agreed exchange parities. If the currency was under downward pressure, perhaps because of a balance of payments deficit would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).
This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of US dollar reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.
If fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion. Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.
This period was characterised by the so-called “stop-go” growth where fiscal policy would stimulate the domestic economy, drive up imports, put pressure on the exchange rate, which would necessitate a monetary contraction and stifle economic growth.
While the ‘stop-go’ terminology was really born in the period of fixed exchange rates (Bretton Woods period), it is survived into the flexible exchange rate era (post August 1971).
Ultimately, Bretton Woods collapsed in 1971 because it was politically unsustainable. It was under pressure in the 1960s with a series of “competitive devaluations” by the UK and other countries who were facing chronically high unemployment due to persistent trading problems.
The fixed exchange rate history of the European Community, in various guises is illustrative of the problems encountered.
After the inevitable failure of the Bretton Woods system of fixed exchange rates in 1973, most of the rest of the world decided that floating exchange rates were more desirable as it freed monetary policy from having to defend the agreed parities.
However, the EEC Member States persisted with various dysfunctional fixed exchange rate arrangements – the Snake in the Tunnel, the Snake, the EMS and then the ultimate ‘fixed exchange rate’ system – the common currency, in no small part due to their decision to introduce the Common Agricultural Policy in 1962.
The CAP introduced a complex system of cross border price fixes that would have been administratively impossible to manage without relative currency stability. As it was, the currency variations within the Bretton Woods system led the European Commission to introduce a complex system of so-called ‘green exchange rates’ or simply ‘green rates’, which sat underneath the official exchange rates.
Each one of these arrangements proved to be unworkable in the sense of allowing the governments to unambiguously advance the well-being of their people.
The Bundesbank historically ran a tight monetary policy because of its obsession with low inflation and this forced its trading partners to endure higher unemployment than they desired because they had to defend weaker currencies.
The weaker currency EEC nations – France, Italy, the United Kingdom (after 1971) – were forced to accept the restrictive Bundesbank monetary policy settings or else face major capital outflows. But they were continually up against currency pressures to devalue (under the fixed arrangements and with the Bundesbank more or less refusing to intervene symmetrically), so at times they had to push interest rates up well above the German rates to head of impending currency crises.
The history of the EEC is littered with these episodes.
The consequences were obvious – a recession bias, elevated levels of unemployment, and ultimately, increased speculative attacks on their currencies necessitating period devaluations following a currency crisis.
None of that tension has really gone away under the common currency. It is just that ‘internal devaluation’ has replaced the discretionary realignments pre-euro and central bank can no longer control capital flows in the way they did when their governments were sovereign.
Flexible exchange rates
After the breakdown of the Bretton Woods system, most nations moved to a system of flexible exchange rates, with varying degrees of ‘management’ (dirty floats etc).
A flexible exchange rate frees monetary policy from having to defend some fixed exchange rate parity. This, in turn, means that fiscal policy can solely target the spending gap to maintain high levels of employment and other desirable policy objectives. External sector imbalances are then adjusted for by daily variations in the exchange rate.
While there is no such thing as a balance of payments growth constraint in a flexible exchange economy in the same way as exists in a fixed exchange rate world, the external balance still has implications for foreign reserve holdings via the level of external debt held by the public and private sector.
It is also advisable that a nation facing continual current account deficits, for example, foster conditions that will reduce its dependence on imports. However, the mainstream solution to such deficits actually makes this adjustment process more difficult.
Indeed, IMF lending and the accompanying conditions that are typically imposed on the debtor nation almost always reduce the capacity of the government to engineer a solution to the problems of inflation and falling foreign currency reserves without increasing unemployment and undermining public services, including health and education.
Targets to reduce fiscal deficits may help lower inflation, but only because the ‘fiscal drag’ acts as a deflationary mechanism that forces the economy to operate under conditions of excess capacity and unemployment.
This type of deflationary strategy does not build productive capacity and the related supporting infrastructure and offers no ‘growth solution’. And fiscal restraint may not be successful in lowering fiscal deficits for the simple reason that tax revenue can fall as the taxable base shrinks because economic activity is curtailed.
Moreover, the lessons of how the international crises of the 1990s and early 2000s were dealt with should not be forgotten: fiscal discipline has not helped developing countries to deal with financial crises, unemployment, or poverty even if they have reduced inflation pressures.
There are also inherent conflicts between maintaining a strong currency and promoting exports – a conflict that can only be temporarily resolved by reducing domestic wages, often through fiscal and monetary austerity measures that keep unemployment high.
The best way to stabilise the exchange rate is, within a stable political environment and well-functioning legal system, to build sustainable growth through high employment with stable prices and appropriate productivity improvements.
A low wage, export-led growth strategy sacrifices domestic policy independence to the exchange rate – a policy stance that at best favours a small segment of the population.
Flexible exchange rates and inflation
Critics argue that a nation with flexible exchange rates can ‘import’ inflation from other nations, which negate real income gains made through domestic expansionary policy. In other words, this is a revised version of the ‘balance of payments constraint’ on growth.
Through its impact on import prices, the exchange rate does influence the real value of the nominal incomes that are produced. The purchasing value of nominal incomes is the volume of real goods and services that an income recipient can purchase with those incomes. That depends on the prices of goods and services, some of which will be more influenced by movements in exchange rates than others.
Non-tradable goods and services will be much less influenced by exchange rate movements than direct imports. In many cases, these goods and services will have negligible exposure to exchange rate movements. The provision of many services, for example, will have little variability to exchange rate fluctuations.
The extent to which those movements in domestic prices are influenced by shifts in import prices arising from exchange rate movements depends on the degree of ‘pass through’ and the importance of imported goods and services to the overall basket that determines the workers’ material living standards.
The research evidence is clear – ‘pass through’ estimates are highly variable and depend on many factors including how much spare capacity there is in the economy, the degree of import competition, etc.
But that isn’t the end of the matter.
The second impact depends on how changes in overall consumer price inflation respond to changes in import prices. So ‘pass through’ might be high and rapid but the second impact low and drawn out, making the overall impact inconsequential.
So if imports are a relatively small proportion of goods and services included in the inflation measure, even if the ‘pass through’ is high, the overall impact on the domestic inflation rate will be small.
There is also the question of time lags – how long these separate effects take to impact. In many studies, the sum of the two impacts can take years to manifest.
It is also very difficult to come up with unambiguous estimates of these separate effects.
The coherent empirical research on this question suggests that ‘pass through’ effects are weak in most nations for which coherent empirical research has been conducted.
This blog post – Is exchange rate depreciation inflationary? (February 9, 2016) – discusses ‘pass through’ and the impact of exchange rate changes on inflation rates in more detail.
Estimates for Australia, which is a small, open economy highly exposed to exchange rate shifts, indicate that these exchange rate effects are very small and drawn out over time (Source).
Australia has historically endured large swings in its exchange rate. Between February 29. 1984 and July 31, 1986, the Australian dollar depreciated by 36 per cent against the US dollar.
By January 31, 1989, the exchange rate had appreciated by 48.6 per cent against the US dollar, a large shift in the opposite direction. This is a familiar pattern to citizens of Australia, a primary commodity producer.
Over the first period, Real net national disposable income rose just 3.3 per cent (per capita measure fell by 0.2 per cent), while real GDP rose 8.4 per cent and GDP per capita rose 4.7 per cent.
So even with a massive exchange rate depreciation, which followed major declines in Australia’s terms of trade, real per capita living standards barely fell using the Real net national disposable income measure and rose using the GDP per capita measure.
Three years later, Real net national disposable income had risen by 17 per cent (per capita measure rose by 12.2 per cent), while real GDP rose 12.6 per cent and GDP per capita rose 8.1 per cent.
It is also the case that the distributional impacts of those shifts are uneven. Buyers of expensive imported (luxury) cars suffer more than those who purchase the lower-margin cars. Those who take overseas ski holidays at expensive resorts face higher costs.
Australia regularly goes through these sorts of exchange rate swings but manages to be classified as among the richest per capita nations in the world. It is simply untrue that a flexible exchange rate system severely compromises the material living standards of workers.
Second, it is false to think that a flexible exchange rate regime is more prone to speculative attacks on a nation’s currency. If anything, the reverse is true.
When currency traders form the view that a government will have to eventually devalue a fixed peg parity to stem the consequences that accompany a chronic current account deficit they can easily hasten that decision by short-selling. It becomes a self-fulfilling inevitability.
And, in this context, the nation state has the capacity to impose capital controls if there are destabilising financial flows present. Iceland has demonstrated the effectiveness of using capital controls to stop the financial sector undermining currency stability through speculative capital outflows. Similarly, unproductive capital inflows can be subjected to direct legislative controls.
Moreover, the history of fixed exchange rates tell us that costs of defending the exchange parities (the recession-bias) tend to dwarf all other costs including fluctuations in price levels that might be sourced in exchange rate variability.
This is not to deny that a nation may have to take some hard decisions in relation to its external sector when it experiences a depletion of foreign exchange reserves or its currency depreciates against foreign currencies that it requires to purchase essential imports.
This is especially so if it the nation is reliant on imported fuel and food products. In these situations, a burgeoning external deficit will threaten the dwindling international currency reserves.
In some cases, given the particular composition of exports and imports, currency depreciation is unlikely to resolve the external deficit without additional measures.
As noted above, the depreciation may impart an inflationary bias to the economy. Moreover, depreciation leads to expectations of further depreciation and fuels the run out of the currency. There may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default.
The reality is that a nation facing a lack of ability to purchase imports, for whatever reason, has to either increase its exports or reduce its imports.
For less developed countries faced with currency crises, there is probably no short-run alternative but to urgently restore reserves of foreign currency either through renegotiation of foreign debt obligations, international donor assistance or default.
For an advanced nation, similar constraints might apply and a sudden shift in international sentiment against the nation or other financial assets denominated in that currency are no longer deemed as desirable, then adjustments in the flow of real goods and services sourced from foreigners are required.
And, as I explain in this blog – Ultimately, real resource availability constrains prosperity – the limits for a nation are clear – if it cannot command access to real resources owned by foreigners the it must rely on the resource wealth it has for sale in its own currency.
But none of that reduces the financial capacity of the currency-issuing government to purchase whatever is for sale in that currency.
Further, it introduces a valid role for an international agency to replace the International Monetary Fund. A new agency could ensure that weak nations were always able to purchase essential energy and food imports.
Are current account deficits a problem?
We continually read claims that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings.
In MMT, this sort of claim would never make any sense. A CAD 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 CAD. 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 CAD, which, in turn, enjoys a net benefit (imports greater than exports). A CAD means that real benefits (imports) exceed real costs (exports) for the nation in question.
Giving some real thing away is a cost. Getting some real thing is a benefit. Exports, by definition, involve sacrificing real resources and depriving a nation of their use. Imports on the other hand clearly involve receiving final goods and services where the real resource sacrifice has been made by the exporting nation.
In a world where we produce to consume receiving goods and services is better (real terms) than sending them elsewhere.
The only reason a nation would want to export and incur the costs involved is to generate a higher rate of return. Which means that the cost is best considered as an investment in generating benefits, which in this case, might be an increased capacity to purchase imports.
As noted above, being able to export is clearly particularly important for a nation that cannot feed itself or run electricity systems with the resources it has at its disposal without trade.
But there is another perspective.
Nations that export may desire to accumulate financial claims in the currency of the importing nation. A CAD also 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 CAD) on its head in recognition of the true nature of exports and imports.
Subsequently, a CAD will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the CAD 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 in evaluating whether we should prevent that exposure by minimising CADs, we should understand 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.
Welfare is evaluated on the basis of consumption not production. This ties in with the view that external deficits automatically lead to a hollowing out of the industrial sector and the nation ends up a consumer rather than a producer.
The logic of the market is that consumers will demand what they think is best. It is true that if local production is lost to foreign nations as a result of trade competition, the consequences can be heart-wrenching for the dying manufacturing towns – as it was as agriculture waned some decades earlier and communities vanished.
While real living standards are based on access to real goods and services, and, at the macroeconomic level, a nation enjoys a material advantage if its real terms of trade are favourable (exports less than imports), a worker in a rust belt region who has endured unemployment as a result of cheaper imports coming from nations with lower labour costs is unlikely to be among those who benefit.
But there doesn’t appear to be a valid case to reintroduce widespread industrial protection where the rest of a nation’s consumers subsidise the jobs of a few who can no longer produce attractive enough products in their own right.
The challenge for nations entering a post-industrial phase is to implement what are called Just Transition frameworks to minimise the costs for the losers of industrial change and build pathways for workers in the declining areas into sectors that are growing. This is a fundamental responsibility for government and the evidence is, that in the neoliberal era, governments are abandoning that responsibility.
There are also nominal consequences of running CADs that need to be considered.
Foreigners (surplus nations) build up financial claims in the currency of the deficit nation. They might, for example, drive up local real estate prices or other strategic assets. Governments introduce foreign investment rules to militate against this propensity, although in many nations, these constraints are weak.
But the point is that the nation state can legislate whatever restrictions they like in this respect.
Alternatively, foreigners might sell all their currency holdings in one fell swoop and destroy the currency. They might. But then they would be deliberately creating massive losses for themselves, and history shows that this sort of behaviour is rare.
And if these funds end up in the hands of speculators the nation state can lock them with capital controls if it so chooses. Even the IMF supports that strategy these days and acknowledges it is effective. We noted above the way in which Iceland invoked effective capital controls during the GFC.
More problematic is that foreign interests may seek to use their financial clout to manipulate the political system and the public narrative view media domination etc.
Again, regulations can militate against that sort of trend. Strict campaign funding rules, media ownership rules etc are required to prevent these sorts of complications.
There is an additional consideration relating to nation-building. CADs tend to reflect underlying economic trends, which may be desirable for a country at a particular point in its development. 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 current account 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’.
Conclusion
A national government should always aim to to design its fiscal policy with a view to the economic effects desired, rather than with a deficit or surplus target in mind.
While fiscal deficits are likely to raise living standards which will increase the CAD it should always be noted that all open economies are susceptible to balance of payments fluctuations. These fluctuations were terminal during the gold standard for deficit countries because they meant the government had to permanently keep the domestic economy is a depressed state to keep the imports down. For a flexible exchange rate economy, the exchange rate does the adjustment.
Is there evidence that fiscal deficits create catastrophic exchange rate depreciations in flexible exchange rate countries? None at all. There is no clear relationship in the research literature that has been established. If you are worried that rising net spending will push up imports then this worry would apply to any spending that underpins growth including private investment spending. The latter in fact will probably be more ‘import intensive’ because most LDCs import capital.
Indeed, well targetted government spending can create domestic activity which replaces imports.
Moreover, a fully employed economy with skill development structures, first-class health and education systems, and political stability, is likely to attract FDI in search of productive labour. So while the current account might move into deficit as the economy grows (which is good because it means the nation is giving less real resources away in return for real imports from abroad) the capital account would move into surplus. The overall net effect is not clear and a surplus is as likely as a deficit.
Even if ultimately the higher growth is consistent with a lower exchange rate this is not something that we should worry about. Lower currency parities stimulate local employment (via the terms of trade effect) and the distributional consequences tend to be more onerous for higher income earners.
These exchange rate movements also tend to be once off adjustments to the higher growth path and need not be a source of on-going inflationary pressure.
Finally, where a dependence on imported food or other essentials exists – then the role of the international agencies should be to buy the local currency to ensure the exchange rate does not price the poor nations out of these goods and services. This is preferable to the current practice of forcing these nations to run austerity campaigns just to keep their exchange rate higher.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.
Bill,
In your 4-quadrant diagram, the “45 deg. line” is not actually at 45 deg.
.
To be 45 deg. the 4 quadrants would need to be squares, and they are rectangles.
Steve_American
Dear Bill
A country has an interest in avoiding wild swings in its exchange rate. Every time that the exchange rises rapidly and drastically, the export industries have to shrink and the import-competing industries can expand. When it falls rapidly and drastically, the export industries can expand but the import-competing industries have to shrink. This is destabilizing.
A country has therefore an interest in combining a flexible exchange rate with controls on short-term capital flows. If a country has very one-sided exports, for instance 90% of its exports consist of oil, and if the price of its export fluctuates wildly, then it has an interest in setting up a stabilization fund.
Regards. James
I’ve been reading about MMT for a few years, primarily via your essays, your intro text and your book ‘Reclaiming the State.’ And this essay is instructive. That said, can you write more about
applied MMT economics? I think I get the general drift of what MMT is all about, compared to the mainstream economics, but I tend to think in terms of its application. For example, what of Trump’s tariff efforts? And poor Venezuela! You do a pretty thorough job critiquing the EU, so props to you there. I think your study of ‘framing’ the narrative for MMT would be helped by an approach that explains benefits created by applied MMT economics.
You write: “Taxation revenue comes from funds that the government has already spent into existence.”
I understand, however, that the largest amount of money is created by commercial banks in the process of extending credit/loans. I assume further that it is from this money that most taxes are paid/most tax revenue stems.
Why, then, do you not write:
“Taxation revenue comes from funds that the government has already spent into existence as well as funds that commercial banks have lent into existence?”
Why do MMT-texts tend to suggest that only money created by government provides the money that flows back to government as tax revenues?
Am I overlooking something?
Dear Steve_American (2018/09/26 at 6:19 pm)
Sure enough. It just goes to show I am a poor diagram maker!
Just imagine.
best wishes
bill
“If the external sector is in deficit and the private domestic sector desires to save overall, then the government sector has to be in deficit and national income changes will ensure that occurs.”
It seems to me that this statement is not strictly correct. If the private sector desires to save overall, it does not necessarily achieve savings.
Lector,
The commercial banks can create ‘money’ (liquidity) by creating loans (credit). But they cannot create new net financial assets because the asset (loan) is offset within the non-government sector by the liability (debtor).
Only transactions between the government and non-government sector can create or destroy net financial assets.
The government is also the monopoly issuer of the currency (notes and coins). The commercial banks can get access to that and distribute it (vault cash) but only by sacrificing bank reserves held at the central bank.
“…the largest amount of money is created by commercial banks in the process of extending credit/loans.”
By what metric? I see this claim made repeatedly but it’s only ever backed up by some central banker’s opinion.
Sounds like another myth promoted by Monetarists in my view.
If you compare the US outstanding credit balance to US federal spending over history you will find that substantially more spending at origination occurred from federal spending than bank lending.
Couple that with the fact that taxes only accrue against federal spending in the budget and that most of the $ remaining in the system are owed to the banking system it’s easy to come to the wrong conclusion relating to the origination of funds.
“This is preferable to the current practice of forcing these nations to run austerity campaigns just to keep their exchange rate higher.”
The current practice is the blueprint of neoliberal globalisation as the banks and financial elites cry for balanced budgets. Then brainwash the population that it all works like a household budget.
So the banks can allocate resources and the banks can be the main issuer of the currency. “We don’t want the government to fund public infrastructure. We want it to be privatised in a way that will generate profits for the new owners, along with interest for the bondholders and the banks that fund it; and also, management fees. Most of all, the privatised enterprises should generate capital gains for the stockholders as they jack up prices for hitherto public services.
This idea that governments should not create money from thin air implies that they shouldn’t act like governments. Instead, the de facto government should be Wall Street and the City of london. Instead of governments allocating resources to help the economy grow, the commercial banks should be the allocator of resources – and should starve the government to save the wealthy. Starve the government to a point where it can be drowned in the bathtub and which is what austerity and neoliberalism is really all about.
Allowing the commercial banks to control the money supply they then proceed to privatise the economy, they can turn the whole public sector into a monopoly. They can treat what used to be the government sector as a financial monopoly. Instead of providing free or subsidised schooling, they can make people pay for it to get a college education. They can turn the roads into toll roads. They can charge people for water, and they can charge for what used to be given for free under the old style of Roosevelt capitalism and social democracy.
The commercial banks can create ‘money’ (liquidity) by creating loans (credit). But they cannot create new net financial assets because the asset (loan) is offset within the non-government sector by the liability (debtor).
Only transactions between the government and non-government sector can create or destroy net financial assets.
The government is also the monopoly issuer of the currency (notes and coins). The commercial banks can get access to that and distribute it (vault cash) but only by sacrificing bank reserves held at the central bank.
This is the model that has failed and why Brexit happened and the rise of populism everywhere.
Free movement of capital.
Dear Derek Henry,
Thank you for your reply.
Unfortunately, I do not see how your points explain/prove that only government created money is capable of returning in the form of tax revenue.
Again, I may be overlooking something.
Can you spell out explicitly which facts and factors determine that all tax revenue must of necessity be money previously spent by government and cannot be money created by any other agent?
Thank you for your patience.
Dear paulmeli,
I refer to McLeay et al, who write
“Of the two types of broad money, bank deposits
make up the vast majority – 97% of the amount currently in
circulation.(6) And in the modern economy, those bank
deposits are mostly created by commercial banks
themselves.”
(Source: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf)
As for my principal question above, please be patient with me.
I do not see how your points explain or prove that only government created money is capable of returning in the form of tax revenue.
Again, I may be overlooking something.
Can you spell out explicitly which facts and factors determine that all tax revenue must of necessity be money previously spent by government and cannot be money created by any other agent?
Thank you for your patience.
Dear paulmeli,
I refer to McLeay et al, who write
“Of the two types of broad money, bank deposits
make up the vast majority – 97% of the amount currently in
circulation.(6) And in the modern economy, those bank
deposits are mostly created by commercial banks
themselves.”
(Source: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf)
As for my principal question above, can you demonstrate why tax revenue must necessarily be money previously spent by government and why it cannot be money created by any other agent?
Lector, here is my understanding of your question. The currency issuing government probably could decide what it will accept for payments of taxes. It might decide that gold or cows or labor would fulfill a tax obligation. It might decide that a promise to pay the government’s currency in the future, or upon demand, which is what bank created money is, would be acceptable. But usually in the present time, taxes get paid through the banking payments system and obligations between parties (various commercial banks and the government) are settled by transferring reserve balances at the central bank. Since the central bank is really an arm of the government, and is the only source of these reserves, central bank reserves really are ‘government created money’.
lector, perhaps I can help with this thought experiment. Let us suppose that we have a set of social groups that wish to amalgamate into a federal union, not unlike the 13 American colonies did in the 18th century. Each social group will have had its own currency. After the federal government has been set up, this currency will be worthless because it will be replaced by a national currency. There are two ways to deal with this. One is to set the value of the old currency to zero or to set it at a nominal value in relation to the new now national currency. The government can also spend directly to individuals and organizations in order to get projects it is interested in under way, such as bridges, schools, etc. Either way, the government has to be the first spender. This is because once the old currency is rendered valueless, no one has any money. Once these actions are done, the monetary curcuit is operational.
However, just because the government has created a new monetary system, it has to motivate organizations and individuals to use it. It does this by enacting fees and taxes which can be redeemed only in the national currency. This currency must be collected in order to pay said taxes or fees. Taxation could be said to be the initial driver of the national monetary circuit.
When it is said that the banking system is the greatest creator of credit/money, two things are sometimes conflated. One is the amount of credit/money created in a given time frame; the other is the number of instances of credit/money creation. Leaving out the issue of reserves, it could be said that there are more instances of direct credit creation by the retail banking system than there are by the central bank. This is simply because there are more of them. I left out the reserve system because each instance of credit/money creation by a retail bank is associated with an action by the central bank. They work together in this respect, so the picture of credit/money creation becomes quite complicated.
I don’t know if this is clear or answers your query.
@lector
“…I do not see how your points explain/prove that only government created money is capable of returning in the form of tax revenue”.
Income tax liability can and does accrue due to income from bank lending/spending but the tax cannot be subtracted from the credit balance, which can be reduced only through amortization.
One can’t, after borrowing funds to buy their house, go back to the bank and borrow the funds to make the payments, and in so doing reduce their outstanding balance. Nor can any other borrower reduce overall liabilities by providing you with the income to make your payments. Total outstanding liabilities increase no matter what.
Income taxes can only be subtracted from federal spending. There is no way to subtract them from the outstanding credit balance.
The funds necessary to extinguish credit liabilities can therefore only come from federal spending.
“”…the largest amount of money is created by commercial banks in the process of extending credit/loans.”
By what metric?”
Just looking in Wikipedia, the ratio of the M2 (cash and money waiting to be spent in current accounts) outweighs the Monetary Base (cash and bank reserves) in the U.S. now by a factor of 10+ to 3. This is less than I thought. I’ve repeated the 97% line, but I’m not sure now what basis I have.
“The challenge for nations entering a post-industrial phase is to implement what are called Just Transition frameworks to minimize the costs for the losers of industrial change and build pathways for workers in the declining areas into sectors that are growing. This is a fundamental responsibility for government and the evidence is, that in the neo-liberal era, governments are abandoning that responsibility.”
How do we calculate the total cost to the citizens of sovereign currency issuing nations, where successive neo-liberal infused governments have refused to apply a “Just Transition framework” based on their ideological principals?
It would be interesting to know how much of the household and business debt the world is swimming can be attributed to the abandonment of governments duty of care in this area.
As Michael Hudson points out even massive job creation won’t save some economies from that debt, and the cumulative loss of savings, which resulted from unreasonably long periods being deprived of expected personal income. Only a massive debt forgiveness to a level reflecting ability to pay can restore some normalcy.
Couldn’t a federal government use such a calculation to determine the size of the check it ought to send as relief of private debt that has that has accrued because of such misguided and improper behavior?
The central bank interest rate could then be taken to zero, or less, if needed to incentivize economic activity via commercial bank business lending shepherded by a government lead Just Transition Framework .
“[Why not] “Taxation revenue comes from funds that the government has already spent into existence as well as funds that commercial banks have lent into existence?””
Another angle, or maybe the same angle but spelled differently:
That’s not how lending works.
When I bought my last car, the bank arranged a 5-year loan. They did NOT go to the dealer and say “It’s being payed with a 5-year loan; you’ll get the money over the next 5 years.” They paid the dealer right away, with their money. I’m paying the bank over 5 years.
Similarly, if you borrow money to pay your taxes, the bank will cover your check to the Tax Authority right away, with money from their reserves. The loan deal between you and the bank stays between you and the bank.
“This is because the central bank has no choice but to ensure there are enough bank reserves available given its charter is to maintain financial stability.”
I may not agree on MMT in that aspect, if I could interpret it right. In my understanding, that statement may be valid for some countries but are not be valid to all.
I don’t agree because, in some countries, the central bank would supply reserves only in exchange for government bonds (direct transactions or repos) and nothing else, and it is not obliged to lend to banks in any other form, be it unsecured, collateralized by credit portfolios, or via bail outs or anything else.
Hence, in that countries, the only way the private sector can earn bank reserves is by working to the government and receiving a bank reserves transfer from the Treasury (or from other government agencies, depending on the institutional arrangements) or by selling government bonds (or giving it as collateral in repos) to the central bank (or to the Treasury itself, if it opts to buy back some government bonds). And by earning interest on governments bonds, repos and reserves, of course.
In that countries, if a bank faces a bank run and suddenly run out of bank reserves, checks would start to bounce, and it would go broke – and the central bank would not save it. What the central bank would probably do was trying to solve the problem as smoothly as possible, maybe by trying to find or facilitate a buyer for such broken bank or arranging its smooth liquidation – but not supplying bank reserves somehow.
On the other hand, I agree that, if the central bank controls the interest rates, it has no direct control over bank reserves balances, government bonds amounts, or any other monetary aggregate. If it controls the interest rates, the central bank has to option but to accommodate the level of bank reserves / gov bonds / repos / etc that the private sector wants at the interest rate. The exact way the central bank will do it depends on the institutional arrangements of the country (but usually central banks employ either repos or remunerated bank reserves for that purpose).
@Mel
I guess my point was how would one even do such a calculation? Funds are introduced through spending. By that metric, origination weighs heavily in favor of money creation by the state. From there, since all income taxes must subtract from G, most of what remains must be what is owed to the banking system. Simple enough arithmetic.
We can make a back-of-an-envelope calculation:
The sum of all deficits over history less Debt Held by the Public leaves maybe a couple trillion net $. I’m assuming bonds are not considered part of the official money supply. I did the arithmetic some years ago and maybe the difference has changed somewhat since.
Still, The ASTDSL series puts total liabilities (TCMDO) less government debt at around $44T.
2/(44+2) ==> 96% bank liabilities i.e. bank money remaining in the system.
I can see where they (central bankers/economists) may come up with that number but does it have any real world meaning or importance? I find it highly misleading as it promotes monetarist thinking over the capacity of the state to invest in our futures, and comparing spending to liquidity seems like a purposeful obfuscation.
Like the public debt/GDP ratio that has nothing to say of importance re the real world, it’s central bank/economist gas-lighting.
It seems that most of what we “know” is BS.
Bill. I’m glad you returned to this topic. I like and admire you guys. I consider Warren a genius. And I try to go along with, bring your thinking into my conceptualizations. But this external sector stuff, trade, current accounts – it always catches in my throat. I might say that in some ways it must run against my life experience. Here’s something at the center, for a closed economy, the world:
Total consumption + Total investment = gdp (production side)
gdp = Total consumption + Total Savings (income side)
So Total Consumption = Total Savings (I’ve seen this in your on-line book so it’s not just my idea)
A static situation where yearly, the amount of savings just satisfies desired investment.
Now suppose in a sector of the economy a higher level of savings is imposed, the portion of gdp allotted to consumption falls. Resources are freed. But we have a problem – desired investment has not increased and so investment does not increase. And this means that total savings have not increased – so in another area of the economy savings must decrease. And they will. Somewhere people will lose employment and productive facilities will slow or shut down. And so someone must spend. And as the govenrment spends the debt will rise. The only way it can not rise is if it’s productive investment. And how can that be assured?
Beggar thy neighbor. Trade war. I was listening to a conversation on public radio and the so-called experts, journalists and soybean council reps, and none of them could define trade war.
To me, large persistent trade deficits almost always indicate injustice and disease. Let me ask a few questions:
Large, Long term exporters can only do this by subjugation and subordination – people are denied the enjoyment of their efforts, aren’t allowed to work for themselves, so that the wealthy and powerful and gain more wealth and power in another arena. How do you make peace with injustice, the injustice of the exploiters when they use their leverage and power to take. The enjoyment of lower cost products isn’t enough for me. I don’t want to support slavery or bondage or exploitation.
It’s pretty obvious that the savings decisions elsewhere in the world impact, impose upon the savings decisions here. It has an impact on the liberty of people here. Some people are naturally inclined to build, manufacture. Why place them in competition with labor held in bondage? Don’t they have a right to use their natural talents and inclinations without undue pressures from outside.
You say “The logic of the market is that consumers will demand what they think is best. It is true that if local production is lost to foreign nations as a result of competition,…” Yes there has been a hollowing out. I follow the spot raw industrial price index. IN the US the economy has been growing while industrial production has been falling. We’ve lost a lot.
Markets, Competition. It’s funny you resort to neo-liberal thinking here. Yea there’s competition, but it’s raw power against raw power, looking for position and advantage. The wealthy and the powerful maneuver.
Persistent trade deficits can be imposed from the outside. All the chinese, or anyone need do is take their money here, take whatever discount necessary to acquire dollars, enlighten others about the good deals to be taken from their people in bondage, and buy or loan the dollars here. Trade flows determined by capital flows.
Well I’m tired out, like you. I hope I didn’t bruise your nose.
If cheques start bouncing because of a shortage of reserves then financial panic would follow. Bill
Otoh, if citizens could have accounts at the Central Bank itself, alongside those of banks, then a cheque drawn on an account there would only bounce if THAT account had insufficient funds.
So we could have TWO payment systems (besides physical fiat, coins and bills): An inherently risk-free, always liquid payment system consisting of individual, business, State and local government, etc. accounts at the Central Bank itself and the existing payment which must work through banks.
Jerry Brown, larry, paulmeli, Mel and Derek Henry – I want to thank you for taking up my question.
I can’t pursue your much appreciated contributions in this thread today or tomorrow, as I’m off on a business trip. But I shall certainly mull over your attempts at helping me.
In the past, I’ve had a number of issues when I thought MMT has got it wrong, while it actually was right. In every case, it turned out that I had not fully grasped or inadvertently distorted the MMT position. Frequently, the problem is that I tend to smuggle in assumptions that I’m not aware of myself and that are not part of the MMT take.
@ lector,
It really comes down to operation impossibility. Banks create bank money by creating bank liabilities (bank deposits). When a government initially sells a government security (bond) it only is for sale in the government’s currency (or equivalent central bank deposit). Whoever wishes to buy the government security must first therefore acquire the necessary government currency which can only come from the government via prior government spending (or from the central bank).
As Warren (and I’m sure Bill) has said… reserve drains (tax collection & government security sales) can only happen after reserve adds (government spending or central bank lending/purchasing/direct adds).
Lector: This may be the problem. You or I can pay taxes with bank money, by writing a check on our bank account. As far as you or I see, there is no difference between bank money and government money here. (Say that this tax check exhausts, closes our bank account, for simplicity) But that is not the end of the matter, which I think may be your assumption. After the federal government has accepted our tax check, the bank now owes the government.
It is as if the government now has our account at the bank. The government wants to be paid now, wants to close this account. The only thing it will accept from the bank as payment when it closes this account is federal money, reserves that it has earlier issued. If the bank does not have the reserves to pay up immediately, it will be in debt to the government, and the discount rate – determined by the government – is the rate that the bank will be paying the federal government on its “account”. If the bank can never pay this debt, it is eventually declared insolvent by the government.
Always, the government want’s its own money back. Rendered unto Caesar, as an ancient economist said.
lector, have a successful trip.
Some Guy, thanks to you, too, for your helpful explanation. I sense the penny is about to drop.
A very good summary.
I like the four quadrant graph and the 45 degree line representation of s=i. Helps a lot to understand the various combinations.
One concept I often struggle with is ‘investment’ and how one should conceptualise it in the sectoral balances. To what extent is is a build up of inventories when consumers stop spending leading to a contraction eventually as demand drops? To what extent is it productive investment, fixed capital formation etc? In what sense is it the other side of savings – does borrowing to invest create the savings or does the parsimonious act of saving provide the funds for investment? A blog on this would be helpful….
cs:
If we spend without purchasing consumption goods, that is presumably investment. Similarly, saving is income that is not spent consuming. As a matter of algebra, investment and savings are identical. Yet, this is an accounting identity and does not directly tell us causality. According to the mainstream theory, savings is the constraint on investment, akin to loanable funds thought. Accordingly, if the marginal propensity to save increases, more savings can be lent out. The main fallacy in this belief is that it confuses an increase in the marginal propensity to save with an increase in the volume of savings. If I save more money (increase my marginal propensity to save), I necessarily spend less money, which necessarily generates less income for those who would otherwise have been the recipients of my expenditures. Rather than savings increasing in total, this is a redistribution.
At an individual level, although it may appear that my saving has been a constraint on my decision to invest (suppose I buy capital goods), this ultimately raises the question of where I received my savings to “finance” my investment decision. It will be found to have been the prior result of investment decisions. If I work in the construction sector and investments are made in equipment, my income will be the product of that investment spending, which simultaneously generates an equivalent amount of savings until I decide to spend part of my income, but this then generates the multiplier effect and a dynamic change in leakages that eventually match the initial injections.
It is similar to the total spending = total income identity. Which causes which? While at the individual level it appears that I spend out of my income, I can theoretically choose how much I spend out of this income. But irrespective of my discretion, whenever I spend money I necessarily generate an equivalent income in the form of receipts. Hence, it is spending that determines income and not the other way around.
Bill,
In the long term, the only sustainable position is for the private domestic sector to be in surplus. An economy can absorb deviations from that position but only for short periods.
The above claim is illogical. Except for short periods when cyclical factors prevent it, private debt can rise for ever. Because as a long term trend, the amount the private domestic sector can afford to borrow will increase as long as one of three conditions are met:
1) Productivity increases
2) Interest rates fall
3) The inflation rate is positive.
Some businesses and individuals will desire to save, but in the long term it’s unlikely the private domestic sector will desire to net save unless the central bank uses usury to force it to.
In relation to Lector’s useful question and Some Guy’s excellent response can we say:
All money is ultimately Government money because when we pay for things, reserves move around so we are, in fact, using reserves all the time.
When a bank creates a loan, it later looks for reserves which are Government money (usually backed by repos-also a Government issued financial asset).
So maybe this distinction between loans and Government money is otiose? The main difference being, as Derek pointed out, that one is a net asset and the other a simultaneous asset and liability but all the payments are the movement of reserves, hence Government money.
I only appreciated this more recently when my friend Nigel Hargreaves pointed out to me that we are using reserves all the time and the ‘financial asset’ in ‘my’ account is not something parallel or separate from the reserves but ‘permission’ to use reserves.
Keyne’s seems to say this in his Treatise on Money:
‘The State-Money held by the central bank constitutes its “reserve” against its deposits. These deposits we may term Central Bank-Money. It is convenient to assume that all the Central Bank-Money is held by the Member Banks – in so far as it may be held by the public, it may be on the same footing as State-Money or as Member Bank-Money, according to circumstances. This Central Bank-Money plus the state money held by the Member Banks makes up the Reserves of the Member Banks, which they, in turn, hold against their Deposits. These Deposits constitute the Member Bank-Money in the hands of the Public, and make up, together with the State-Money (and Central Bank-Money, if any) held by the Public, the aggregate of Current Money. (Keynes, 1930 pp. 9-10) ‘
Not sure I quite get Keyne’s terminology here but he seems to support the point.
So maybe the artificial separation of this putative 97% from 3% cash is all unfounded?
This process of debt accumulation is limited because at some point the susceptibility of the balance sheet to cyclical movements (for example, rising unemployment) increases and the risk of default rises. Bill
I thought it was more fundamental than this in that bank “loans” (actually new bank liabilities for fiat*) only create aggregate principal and not the required aggregate interest thus guaranteeing at least some loan defaults.
And before anyone says that principal is a stock and interest is a flow, what if all interest income is not recycled into the economy as consumption and investment but instead some interest income is itself lent for even more interest?
*Since, except from their vault cash, banks can not lend their reserves to the non-bank private sector since the non-bank private sector may not have accounts at the Central Bank with which to receive fiat.
Hi Bill
I am just forwarding a comment from Warren Mosler.
If a bank doesn’t have ‘enough’ its Fed account is overdrawn, and an overdraft *is* a loan and booked as a loan if the bank does nothing. So it can be said that loans create both deposits and reserves as needed, all as a matter of accounting. There is no CB act of ‘accommodation’ anywhere in this process.
“If a bank doesn’t have ‘enough’ its Fed account is overdrawn, and an overdraft *is* a loan and booked as a loan if the bank does nothing.”
Well, there are many cases in which the account is simply not overdrawn. The bank will default in its payments and probably go broke (or at least face a severe stress period).
For example, Lehman Brothers account was not magically overdrawn.
So I have trouble in understanding what Mosler is trying to say.
Lehman Brothers was a real estate hedge fund disguised as a bank, so I’m not certain they even had an account with the central bank?
Matt B,
My point is that: The fact is that a bank always has some easy ways to invest in the government and earn the risk free rate (be it through remunerated bank reserves, repos or government bonds), but borrowing from the treasury, central bank or any other bank is another very different story.
If the bank doesn’t have good collateral (or sometimes even if it has) it will not be able to borrow. It may go broke. So, it is not symmetrical. It is easy to invest at the risk free rate, but not so easy to borrow at the risk free rate (or even the risk free rate plus a penalty).
I believe that Warren Mosler and Bill Mitchell are entirely aware of that…
Andrew Anderson,
“And before anyone says that principal is a stock and interest is a flow, what if all interest income is not recycled into the economy as consumption and investment but instead some interest income is itself lent for even more interest?”
Lending it out effectively recycles it into the economy. Indeed the flow of interest can be expected to increase the bank’s stock of capital which (because of the Basel requirements) is a constraint on how much it can lend (though usually just a secondary constraint; finding profitable customers to lend to tends to be the primary constraint).
Banks lending out money puts more of it into the economy; the flow of interest doesn’t alter that fact.
By definition, not every nation can run an external surplus because an external surplus in one nation has to be matched by external deficit(s) in other nations. Bill
What if the fiat given to foreigners in exchange for imports could ONLY be used to buy exports and labor from the importing nation or else be eaten away by negative interest at the importing nation’s Central Bank?
Then wouldn’t we strongly tend to have balanced trade for every nation that implemented that policy?
In other words, “Use our fiat to buy our exports and labor or lose it anyway.”
With Overt Monetary Finance, it might then only be necessary to implement negative interest on foreign owned reserves at the Central Bank to strongly encourage balanced trade?
Andrew Anderson,
Why would you want world trade obstructed by pointless (and probably unworkable) bureaucracy?
Do you see anything wrong with the situation where Australia net exports to China, China net exports to Europe and Europe net exports to Australia?
Why would you want world trade obstructed by pointless (and probably unworkable) bureaucracy? Aidan Stanger
What I’ve described would require no bureaucracy; just Overt Monetary Finance, which Bill favors anyway, and negative interest on foreign owned reserves at the Central Bank to encourage them to use those reserves or lose them. Where’s the bureaucracy?
As for my motivation, since exports need only pay for imports, and since it is controversial whether a trade deficit is good or bad, I was wondering why no one was advocating for balanced trade? Since every nation, in theory, can have balanced trade with every other nation? I supposed the answer would be like you said, that it could be a bureaucratic nightmare, and I sought an elegant solution instead.
And besides, it can be argued that only individual citizens have an inherent right to use* a Nation’s fiat for free, up to reasonable limits on account size and transactions per month, so negative interest on foreign accounts is a natural anyway,
*that is, in account form at the Central Bank or perhaps Treasury.
Aidan Stanger says:
Friday, September 28, 2018 at 11:04
If it turned out a country did not want to spend all its export earnings from a particular country on imports from that country, then it could swap its unused fiat for a more desirable fiat(s) rather than necessarily lose it to negative interest. And it could be assumed that roughly balanced trade would still be the result since the same negative interest rate would apply, only to a different account(s).
Since every nation, in theory, can have balanced trade with every other nation? aa
Informed by your question, make that rather: Since every nation, in theory, can have balanced trade with the rest of the world?
Matt, Andre- Lehman was an investment bank, not a bank. (Isn’t it wonderful how humanity comes up with such lucid terminology that makes all explanation superfluous? 😉 ) It did not have an account with the Fed, like a real bank. Goldman Sachs for instance, only became a bank with discount window access during the crisis.
Warren Mosler is often terse. I think the point is “this process” loans–>deposits–>reserves is (quasi)-automatic. If some bank were genuinely dedicated to insolvency – holding parties to burn its vault cash, say, eventually authorities might intervene and stop the fun. But it might take a while, it would require real regulatory intervention in the quasi-automatic process.
@ can people pay taxes with dollars created by banks?
IStM that “a dollar is a dollar is a dollar’. That is, there are 2 sources of dollars that make up the money supply; dollars deficit spent by the US Gov. in the past and dollars created out of thin air by banks making loans.
Dollars are fungible. They are the most fungible thing in the world. To me, the pool of dollars is like a pool of water. The water molecules can come from many reactions [burning H2, burning gasoline, burning methane, etc.]. In the pool they all get mixed together. It is IMPOSSIBLE to tell them apart. In the same way, dollars in bank accounts are a mix of the 2 kinds of dollars. It is impossible to tell them apart.
. . Further, the banking system increases the amount of reserves it must pay to the Fed. Res. when it makes loans. The source of the dollars it uses to make the deposits into its Res. acc. at the Fed. that are then required is dollars deposited by customers. These dollars are a mix of the 2 kinds of dollars. This mix of dollars does not become all US issued dollars just because it is now in a bank’s account at the Fed. Res. and are then paid to the US gov. acc. to clear those checks that were written by the banks customers to pay their taxes.
.
This is a little similar to my side of an argument I had with a Neo-liberal lay-economist. He said that the US Gov. can ONLY make interest payments [on the federal debt] with dollars from tax revenues. I said that even making most of your/his assumptions [i.e. dollars are not destroyed when paid as taxes], even then, he is wrong because the dollars in the US Gov. account at the Fed. Res. are a mix of dollars paid/collected as taxes and dollars borrowed by selling bonds. In that account they all get mixed together and become one sort of dollars. So, when the US Gov. makes an interest payment it does so with that mix of dollars. We [that is people] can think it is one kind or the other or a mix. It is impossible to prove what sort the are. I like to think that the Gov. is borrowing the dollars to pay the interest because [to me] that is closer to the truth that interest payments don’t increase anyone’s tax liability.
Dear Bill,
I agree in principle with what you are saying about how external sector limitations work and how governments can overcome them through various measures, as well as how depreciations generally are over exaggerated in their effects.
Yet empirically there is something which doesn’t seem to add up. Why is it countries such as Indonesia – which as I understand ensure their financial system and government is completely independent of foreign currency debt post the humiliation of the Asian financial crisis – continue to have explicit central bank policy intervention to defend the currency against depreciation, despite having floating exchange rates? Is this some sort of political preference? Or is there some sort of economic factor that is compelling the central bank of Indonesian to defend against depreciation using rate hikes?
The Indonesian example seems to be a perfect case study where these MMT insights should be applied, and yet for some reason the conventional neo-liberal thinking appears to dominate the policy making.
https://tradingeconomics.com/indonesia/interest-rate
“Bank Indonesia raised its 7-day reverse repurchase rate by 25 bps to 5.50 percent on September 27th, matching expectations. It was the fifth hike in six meetings, in an attempt to support the country’s falling currency. The rupiah already weakened nearly 10 percent against the USD since the beginning of the year, reaching its lowest since 1998, amid a higher than expected current account deficit and a continued strengthening of the dollar. The deposit and lending facility rates were also increased by 25 bps to 5 percent and 6.5 percent respectively.
Excerpts from the Bank Indonesia Press Release:
“The decision is consistent with ongoing efforts to lower the current account deficit within a manageable threshold while maintaining the attractiveness of the domestic financial markets, thus further strengthens Indonesia’s external resilience despite widespread global uncertainty. The Government’s seriousness and concrete measures, with Bank Indonesia, to stimulate exports and reduce imports is expected to lower the current account deficit, specifically in 2019, to around 2.5% of GDP. Furthermore, Bank Indonesia will continue to strengthen coordination with the Government and other relevant authorities to maintain economic stability and bolster external resilience. Moving forward, Bank Indonesia will monitor prevailing economic developments, such as the current account deficit, exchange rates, financial system stability and inflation, as follow-up measures to maintain macroeconomic and financial system stability.
The Rupiah has continued to lean against depreciatory pressures, while mitigating volatility. Rupiah depreciation is in line with the currencies of peer countries, spurred by broad US dollar appreciation. Therefore, the Rupiah depreciated by an average of 1.05% in August 2018 but defied pressures in September to close at a level of Rp14,905/USD on 26th September 2018. Year-to-date (ytd), therefore, the Rupiah has lost 8.97% in value against the US dollar as of 26th September 2018, faring better, however, than the Indian rupee, South African rand, Brazilian real and Turkish lira. Moving forward, Bank Indonesia will continue to implement exchange rate stabilisation measures in line with the currency’s fundamental value, while maintaining market mechanisms and financial market deepening efforts. Such policy is aimed to contain Rupiah volatility and liquidity adequacy in the market, to prevent risks on macroeconomic stability and financial system.”
Inflation forecasts remain unchanged at 3.5±1 percent for 2018; and Bank Indonesia projects economic growth in the 5.0-5.4% (yoy) range, subsequently accelerating to 5.1-5.5% (yoy) in 2019.”
Hi Lector
Government spending adds to the non-government sector’s net financial assets.
Taxation reduces the non-government sector’s net financial assets.
The non-government sector comprises the domestic non-government sector and the external sector (the rest of the world).
The non-government sector’s net financial assets (denominated in the government’s currency) comprise three things: reserve balances, government securities, and physical cash on issue (i.e. physical cash that is held by banks, households, firms, sub-national governments, foreign governments – any entity that is not the issuer of the currency that we are talking about).
Note that we are only talking about financial wealth, not real wealth (land, buildings, factories, equipment, tools, cars, art works – anything tangible).
Retail bank deposits are NOT part of the net financial assets of the non-government sector.
Why?
Because retail bank IOUs are offset dollar for dollar by other IOUs within the non-government sector.
When a retail bank issues its IOU (a bank deposit), a household or a firm is issuing its own IOU to the bank. The IOUs net to zero. They cancel each other out.
Therefore ultimately households and firms pay their taxes with reserves, not with retail bank deposits.
The government always taxes by writing down reserve balances.
The government always spends by writing up reserve balances.
Hi Steve_American
Sure, monetary units are fungible. We don’t know which particular dollar originated as government spending or as credit creation by a retail bank. And we don’t need to know.
What matters is that only government spending can increase the net financial wealth of the non-government sector and only taxation can reduce the net financial wealth of the non-government sector.
The government ALWAYS spends by crediting reserve accounts.
The government ALWAYS taxes by debiting reserve accounts.
“1. Such a government can always meet any liabilities that are denominated in the currency it issues. This also means that such a government can purchase anything that is for sale in the currency it issues, including all idle labour
5. The aim of fiscal policy is not to deliver a particular fiscal outcome (surplus or deficit). Rather, it is to ensure that the discretionary government policy position is sufficient to ensure full employment and price stability, given the spending and saving decisions of the non-government sector.”
I have some questions I would like to pose based on the above and this particular statement in context of the JG program (buying up idle labour)
“Given the spending and saving decisions of the non-government sector”
Why would any household need to save or even own property if their income could be guaranteed, such as through a JG program?
For myself and a lot of people I speak to, the only reason I have ever saved is because of any uncertainty I have about future income, which is almost always ‘uncertain’.
If I knew my income was guaranteed by government because it was offering a job through a JG program, then I see absolutely no reason to save; I also see no reason to own my own home but rather it would be easier to simply rent or have government own the house. I see no reason to own my own car but to simply lease it or even have government own it. I would also see no reason to save for retirement because if the government was willing to guarantee an income whilst I am able to work a job, there is no reason why it can’t pay me a pension when I am too old to work – it would make more sense to do it this way than to rather risk my retirement by speculating with it in the markets. In other words, with a guaranteed income I see no reason to insure against anything.
In fact, if government was able to guarantee an income, then I see no reason why it can’t guarantee all my human needs. Which means, if it can guarantee all my human needs, then why bother with an ‘income’ at all? If I am working for government under a JG program, then at the end of each week or month I simply tell government what I need to live and it buys it for me – this is in theory of course as logistically it would be different. But the point is there would be absolutely no reason for me to have any money ‘left-over’ after all my bills are paid. The only thing which may be additional to my human needs is maybe a holiday for 4 weeks of the year, but I also see no reason why I would need to save for it – government could just hold a portion of my guaranteed income and by the end of 48 weeks, put it in my bank so I can enjoy a holiday.
This then begs a further question. If government can guarantee a job, an income, all my human needs, a 4 week holiday every year etc, then it should be able to guarantee a ‘productive process’. In other words, why work ‘for’ government as a labourer, why not work ‘with’ government under a partnership where government invests in the capital (real capital such as tools etc) and the partnership is based on producing some need of society and which is operating under a non-profit model? Then I can actually be creative and productive as a human being, without having to worry about all those things which businesses have to worry about (including having to obtain credit and the risks involved etc).
Do you see where I am going with this?
In other words, if government can guarantee an income, it can guarantee absolutely everything I need to function as a human being which includes my need to be creative and productive (provided I have no desire to become financially wealthy), which means why bother with simply an income when it can go the whole hog and form a non-profit partnership with me for purposes of enabling me to be creative and productive and where the government becomes the shared owner of my production (less what I need for myself), and it can also guarantee all my needs such as housing, a car, furniture etc (obviously the government would own these as I would have no need to own them). It can also keep all purchases, including tools etc, local as it would have no need to import anything.
An example would be a small time farming operation, but other examples abound. The production process does not need to be confined to tangible things like producing food, but could include non-tangible things like research; I mean the list of things which could be done under such a program is endless even just from the perspective of things produced which lessen the burdens of government.
I ask these questions because I have posed this type of program to lots of people who are showing interest in it for themselves, in other words, some of these people are long time unemployed, others are just sick of the rat-race, others are not equipped to compete in the private sector etc. The question I have, is from an MMT perspective, is there any reason why this program could not be implemented by some people? Based on what I have read from MMT, the answer seems clearly to be NO – there is no reason why such a program could not be implemented.
If any of the questions are not making sense, can you please ask me to clarify.
@ Nicholas,
So basically, you are asserting that if I borrow by getting a 2nd mortgage and therefore get bank created dollars; and then pay my taxes with them, that those dollars are magically converted into reserve dollars during the process of clearing the check.
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I guess you and I will have to disagree about that. I don’t believe in that magic.
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On a different note — I want to ask Bill and you-all this question.
If I borrow $100K against the value of my house and create an exactly balancing IOU [which makes the net change in everyone’s assets be zero], what happens if/when I declare bankruptcy?
. . IStM that after the bank writes off the debt that there must have been some residual dollars that were spent some time ago and now no longer have an offsetting IOU that make the net assets still be zero. So, are those dollars now adding to someone’s net assets and therefore to everyone’s net assets? That is, are those dollars exactly the same as US Gov. deficit spent dollars?
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@ lector
I hope others responses help explain it, but I found most of them to be too complicated.
In simplicity, all bank created money are liabilities to convert on demand into notes and coins (which are government issued money) – which is why all banks fear bank runs. When you see it from this perspective, when you pay taxes in bank created money, you are paying the government a promise of the bank to convert into notes and coins – which once in the hands of the government becomes both its asset and its liability – which by the law of merger extinguishes the liability (taxation is the right to destroy).
If you or I had the charter or legal power to issue promises to convert into notes and coins, our IOUs too could be used to pay taxes
Dingo says:
Saturday, September 29, 2018 at 13:45
Notes and coins are the physical form of fiat, the remaining form of fiat is inherently risk-free account balances at the Central Bank, aka “reserves” when the account holder is a bank – which all private sector account holders are currently since the non-bank private sector may not use fiat except physical fiat, i.e. mere coins and bills.
But imagine if all citizens could also have inherently risk-free accounts at the Central Bank. Why not? Should not all citizens be able to use their Nation’s fiat in inherently risk-free, convenient account form via checks and debit cards?
Besides, our current two-tiered money system whereby only the banks may use fiat and the public may not (except for coins and bills) but instead must use bank deposits was designed or evolved for the Gold Standard when fiat was too expensive for everyone to use but only the banks in the private sector.
So the major reason we have so many problems with the banks is that we are using a money system suited for a Gold Standard, not for inexpensive fiat.
@ Andrew Anderson
valid points worth talking about, but my purpose was just to try to answer lectors questions
My apologies, Dingo.
“But imagine if all citizens could also have inherently risk-free accounts at the Central Bank. Why not? Should not all citizens be able to use their Nation’s fiat in inherently risk-free, convenient account form via checks and debit cards?”
According to some Acts of some countries which legislate the central bank, there is in fact no law against this idea, meaning private relations between individuals and the central bank could be set up for this purpose….as for everyone in society doing it then this would require nationalizing the banks wouldn’t it? I’d prefer the first option as it doesn’t involve politics
It isn’t magic, it’s just how the monetary system works. The government only accepts payments in its own IOUs. The government does not directly accept your retail bank deposit as payment of your tax liability. Your bank writes down your transaction account, and your bank instructs the central bank to write down its reserve account and to write up the Treasury’s reserve account. That’s how your taxes get paid.
…and into reserves as well.
The retail bank’s IOU is a promise to convert your bank deposit on demand into any of the two forms of high-powered money (reserves and physical currency).
If you want to use your demand deposit to make a payment, your bank must honour its promise to convert your demand deposit into reserves. Your bank will write down your demand deposit, instruct the central bank to write down its reserve account and write up the reserve account of the recipient’s bank, and the recipient’s bank will write up the transaction account of the recipient.
You can invoke this process to pay your taxes to the Treasury, make payments to individuals and businesses and organizations, move your demand deposit to a transaction account that you hold with a different bank.
Dingo:If you or I had the charter or legal power to issue promises to convert into notes and coins, our IOUs too could be used to pay taxes
That isn’t right. For you or I do have the legal power to issue promises …. . Free speech! As Minsky said, anyone can create money, the problem is getting other people to accept it. In modern societies like the USA or UK or Australia, that you can always use bank money to pay taxes with is a basic factor that makes it trade 1-1 with government money. If you or I had that relationship with the government, then our promises would trade 1-1 also. The problem is not making promises, it is in carrying them out!
Also, once in the hands of the government, the bank money is still a just a liability of the bank and an asset of the government, that has to be canceled against the bank’s reserve account – asset/liabilities the other way.
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Nicholas & Steve: Not entirely sure of your meanings – but Bank dollars and government dollars are NOT intrinsically interchangeable. They can be told apart. Bank accounts dollars are bank money, bank liabilities ONLY. The only place bank dollars and government dollars can be “mixed” are on a person’s balance sheet. You can have a bank account and change in your pocket.
The absolutely most important thing in money and finance to distinguish is “whose money is it?”. In Both senses – first, who is the Holder, the creditor? Nobody but pickpockets, con men and financial wizards have trouble with that – but ALSO the sense of who issued the money? Whose liability? Where is the account with? Bank X or Bank Y or Person Z or firm W … or the Government.
Current institutions and practices can make the conversion of one money to another quasi-automatic, as above in loans–>deposits–>reserves. But there is no intrinsic, legal and logical equivalence.
Also, if you are bankrupt and have debts erased, the “extra money” will be in the form of debt/money of whoever you had owed, whether firm, bank or government. They will book it as a loss, just the same result as if they sent you a check for whatever you owed and you repaid them with that check. Only is government deficit spending if the government is the one who forgave your loan.
Dean:
In other words, why work ‘for’ government as a labourer, why not work ‘with’ government under a partnership where government invests in the capital (real capital such as tools etc) and the partnership is based on producing some need of society and which is operating under a non-profit model?
IMHO, this is making a distinction without a real difference. A JG worker working for the government as a labourer already is a partner etc operating under a non-profit model. Long enough term leasing is also essentially equivalent to ownership. IMHO the pre- (& post-?) modern wider conception of property as including things like my life, my labor, my human rights, common rights to public property etc fits better with MMT than narrower, more rigid, individual and physical – and logically inadequate – conceptions of the last centuries. MMT and the JG (& your proposals) are then about expanding, clarifying, rationalizing and defending property rights. 😉
The idea is that a real JG already does what these other structures and institutions do, but likely with less muss and fuss. No problem in having them, but most people will probably not want to live on communes and will want to have pin money to buy random stuff with. Again, to me the really important thing is to see the major commonality of such co-ops and your proposals with a JG, not the trivial differences. A JG is nothing but economically organizing the worker’s co-op called “A Nation” in a non-psychotic way. Of its Government becoming a sane Custodian of the Nation.
“Given the spending and saving decisions of the non-government sector”
Why would any household need to save or even own property if their income could be guaranteed, such as through a JG program?
It’s not a question of needing to save, but a question of wanting to save.
There will always be some domestic households that want to net save in order to accumulate spending power that they can use in the future.
Remember too that the non-government sector includes domestic firms, domestic banks, and the external sector, not just domestic households.
If we added three words the phrase would be “given the spending and saving decisions of the non-government sector as a whole .”
Of course there will be plenty of individual entities within the non-government sector that choose to balance their income and spending or to be net spenders. There can only be privately issued IOUs if there are private savings. Every dollar of privately issued IOUs has to matched by a dollar of saving somewhere else within the private sector. This is the concept of inside wealth. Inside wealth does not change the net financial position of the non-government sector as a whole. How inside wealth is distributed is an important question of social equity. In general, households that are headed by older people are net creditors (savers), while households that are headed by younger people are net debtors (borrowers). Inside wealth might be unevenly distributed by race. Inside wealth needs to be monitored in case it is unevenly distributed.
The non-government sector as a whole (domestic non-government sector and external sector) can only net save if the government net spends. This is the concept of outside wealth.
The domestic non-government sector as a whole can only net save if one or both of the other two sectors (government sector, external sector) are net spending. If there is unemployment, this means that the domestic non-government sector does not have enough outside wealth to meet its overall savings desires and use all of its available labour. The additional outside wealth that is needed can only come from the external sector or the government sector or both. Since the government cannot directly control what the rest of the world does, the correct policy move is for the government to increase its net spending into the domestic non-government sector. The government can do this directly, precisely, and quickly. The government can target its spending by geographic location, by income level, by wealth level, by occupation, by industry, by household type. Fiscal policy can be targeted with a high degree of precision. It’s much smarter for the government to use fiscal policy to eliminate unemployment than to muck around with monetary policy (interest rate adjustment) to try to push and prod the private sector to spend down its savings, or to muck around with trade policy to try to push and prod the external sector to buy more of our output. The government can only indirectly and imprecisely influence the spending decisions of the domestic private sector and the external sector. The government has direct and precise control over its own spending decisions.
You can read about inside wealth and outside wealth on pages 10 to 13 of the 2015 edition of Randall Wray’s Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems.
Yeah sure but some of the demand deposit dollars originated as fiscal policy decisions of the government whereas some of them originated as loan issuance decisions by retail banks.
Whenever the government spends, of course it mostly ends up as demand deposits held by households and firms (only a small percentage like 3% ends up as physical currency held by households and firms).
I think the point that Steve was making is that when households and firms are transacting in demand deposits, we don’t know where particular units of those demand deposits originated i.e. were they driven by government spending or by loan issuance. They are all thoroughly mixed in with each other and indistinguishable. That was Steve’s fungibility point. If you fill your petrol tank with petrol from several different petrol pumps, you don’t know which molecules of petrol came from which pump. Petrol is fungible.
When your bank issues you a loan you get a deposit, and you can use that deposit to make a transfer to your plumber’s bank account. This is a horizontal financial transaction (it occurs completely within the non-government sector; the non-government sector’s overall financial worth has not changed). Your plumber doesn’t know that the demand deposit that they got originated as a bank loan and it doesn’t matter to them. For all your plumber knows, the government may have paid you a wage or a contractor’s fee or an income support payment, and you used the demand deposit generated by that vertical financial transaction (government sector to non-government sector) to make the payment. The non-government sector’s overall financial wealth has increased.
How does the plumber know whether the demand deposit that they received was generated by a horizontal financial transaction or whether it was generated by a vertical financial transaction? They don’t know, they have no way of knowing, and it doesn’t matter to them.
“It’s not a question of needing to save, but a question of wanting to save.
There will always be some domestic households that want to net save in order to accumulate spending power that they can use in the future.”
Sorry, but it makes no sense to save when my income is guaranteed; if I know that each week or month I am guaranteed a fixed amount of money then why would I want to save anything, for what purpose? Why would I need to accumulate spending power when I am guaranteed the power to spend every payday? Can you give me a reason?
“Remember too that the non-government sector includes domestic firms, domestic banks, and the external sector, not just domestic households.”
I already know this, but my questions are not related to this group. Were you able to read my whole post?
Not everybody will be satisfied with the material standard of living provided by a basic income. Many people will want a higher standard of living than that.
“Not everybody will be satisfied with the material standard of living provided by a basic income. Many people will want a higher standard of living than that.”
I am not talking of a basic income, and I am unable to see how you came to that conclusion. Again, have you read my whole post?
You got to use the bank’s IOU but the bank had to write off your IOU. Therefore the bank takes a loss of $100K of wealth. The net financial wealth of the non-government sector falls by $100K.
That is why widespread bankruptcies cause recessions unless the government increases its net spending to offset the losses of non-government sector wealth. If the non-government sector’s net wealth falls, so too do spending, income, output, and employment.
“Again, to me the really important thing is to see the major commonality of such co-ops and your proposals with a JG, not the trivial differences.”
I don’t see the JG program as having ‘differences’ to my proposal. What I am trying to point out is that the principles behind the JG program extend far beyond ‘income’ and ‘jobs’…can you see what I am trying to point out? If a government can guarantee a job, and therefore an income, then on what grounds can it not guarantee other things…those other ‘things’ I have already pointed out in my original post
Thank you to every one.
1] So, when I go bankrupt the people who have the actual dollars I borrowed and spent are totally un-effected, but the bank [or the then holder of the mortgage] will have to lose some of the money of that asset. And this will exactly match what I borrowed. That is the total of what they still have as the value of the house they now own when the bank sells it + what they must right off is exactly equal to what I borrowed minus the total of the payments that I had made. Forgive me if I say that I’m not convinced. The house changed in value and this might change things.
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2] When people are designing games there is this thing they should avoid — making a distinction without a difference. IStM that maybe that is what is happening with the distinction between bank dollars and US created dollars. So, I ask you-all — What is the difference between them? Some real difference that actually matters in a real sense. I’m not saying one doesn’t exist, I’m asking you to point one out to me.
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But your income is not guaranteed by a Job Guarantee. Only a job is guaranteed. You still need to work to a satisfactory standard if you want to get paid. If you don’t do the work, you don’t get paid.
A monetary economy consists of a government that imposes a tax liability that can only be extinguished in a currency of which it is the monopoly issuer.
The tax liability creates unemployment (people offering labour, goods, services in exchange for the currency that they need to extinguish their tax liabilities and avoid the penalties for non-compliance). The penalties could include fines, confiscation of property, prison.
The tax liability ensures that some real output is produced by the non-government sector and supplied to the government. The government needs the output to provision itself and provide public infrastructure and public services.
So the non-government sector supplies the government with real stuff. In exchange, the government supplies the non-government sector with currency.
It is the threat of penalties for non-compliance with the tax obligation that ensures that there are always enough people offering labour, goods, and services that the government wants.
In your scenario, the government guarantees everybody all of the income that they need to buy the living standard that they want and meet their tax obligations. This scenario is incompatible with a monetary economy. It would defeat the entire purpose of state money. If everyone were given that guarantee, nobody would have to supply labour, goods, and services to the government. The government wouldn’t be able to provision itself and perform the functions of a government (provide public goods and public infrastructure). Production would fall, inflation would erode the living standard that could be bought with people’s guaranteed incomes, public goods and infrastructure would not be provided.
In effect, what you are proposing is the abolition of a monetary economy. Production of output and the provision of public goods and infrastructure would have to be organized by some other mechanism.
“But your income is not guaranteed by a Job Guarantee. Only a job is guaranteed. You still need to work to a satisfactory standard if you want to get paid. If you don’t do the work, you don’t get paid.”
You are missing my point. Like I said to another on this blog, “If a government can guarantee a job, and therefore an income, then on what grounds can it not guarantee other things…those other ‘things’ I have already pointed out in my original post”…whether one ‘deserves’ it or not is beside the point
what I have also noticed is that no one has actually answered my questions? instead, they have taken my posts as a reason to express their own beliefs about economics….does anyone want to actually answer my questions?
“In your scenario, the government guarantees everybody”
No, I did not say this…where have I said that ‘everybody’ should enter this program? Your implication is like saying that everyone should participate in a JG program…you are not reading my questions properly
Hi Steve,
Where does taxation fit in your scenario?
What functions do taxes serve in the society that you have outlined?
You ideas seem to assume the existence of a government sector, a non-government sector, and money, so I presume that you are talking about a monetary economy rather than some form of non-monetary economy (for instance a subsistence economy, a gift exchange economy, a communist economy in which the state directs all production and distributes all goods and services to everybody).
Dean, I am just a lay-MMTer who is an American.
So, the standard MMT stuff.
Taxes are to mainly give dollars a real value for many people who need them and to take dollars out of the economy to avoid inflation.
Oh yes, to take dollars from the super rich so they are just rich.
Does that answer your questions?
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Hi Steve! Sorry, I meant to address my previous post to Dean!
Hi Dean
It isn’t compulsory for people to save. If you personally want to spend all of your income, you are free to do that now. You would retain that freedom if you were working in a Job Guarantee.
Given that this is a blog about macroeconomics, I thought that you were objecting to aggregate saving by the non-government sector. You were responding to Bill Mitchell’s comment about the net savings desires of the non-government sector in aggregate. So that was a reasonable assumption for me to make.
If you are talking about your own personal preferences, then of course you don’t have to save.
In a monetary economy a lot of people will choose to spend less than they earn (i.e. save). That is not a problem in itself. If the government decided that the distribution of savings was creating an undesirable degree of inequality, it could take measures to fix that (e.g. it could tax savings away, or it could apply a negative interest rate to savings above a certain level to induce high savers to spend down their savings).
I agree with you that a monetarily sovereign government can and should provide a wide range of public goods without requiring a user fee. All forms of health care, all levels of education and training, public transport, child care, aged care, and disability support services can and should be available to everyone for free. The government can and should create a large supply of high quality public housing and subsidized social housing. It would be good for the government to provide people with secure long-term lease arrangements such as those involved in the ACT’s Land Rent Scheme (check out Cameron Murray’s recent report entitled Unspoken Alternatives To Expensive Housing). The government can own and operate a public retail bank that provides people with access to the payments system at zero cost, and that provides loans to creditworthy borrowers at the lowest possible cost that is consistent with the government’s employment, price stability, income and wealth distribution, and environmental objectives. The government can provide energy and telecommunications services to people at the lowest possible costs that are consistent with its policy objectives. There is no need for the profit motive to be involved in the provision of public goods. That is a standard ideological preference among economists who work from an MMT framework.
A JG can be designed to accommodate cooperatives.
I’m not sure what difference it makes whether you or the government owns your furniture and other personal effects. If you have a conscientious objection to owning furniture individually, your cooperative could make furniture collectively and designate it as a form of common property within your cooperative.
Hi Steve
The difference is that government IOUs are at the top of the money pyramid. The second level is retail bank IOUs. Third level is non-bank financial institution IOUs. Fourth level is corporate firm IOUs. Fifth level is household IOUs.
The ranking reflects how much demand there is for each type of monetary instrument.
Randall Wray discusses the money pyramid on page 5 of the 2015 edition of Modern Money Theory: A Primer On Macroeconomics For Sovereign Money Systems.
I agree with you that retail bank IOUs are nearly as good as government IOUs. This is because the retail banks are committed to converting our demand deposits into government IOUs whenever we want, and the central bank is committed to ensuring that the banking system as a whole always has enough reserves for payments to clear. Those two commitments add up to near rock solid guarantee that we can get our retail bank IOUs converted into government IOUs on demand.
Conceptually, however, they are different things. Operationally, they are different because government spending is done with a view to promoting the government’s policy objectives, whereas retail bank credit creation is done with a view to upholding good underwriting standards (ideally!), and unfortunately at the moment it is done with a view to making easy profits for the bank (which could be fixed by setting up a public bank that does not make profits). I support a public option for retail banking.
On page 7 of the book that I cited above, Randall Wray expresses his view that for-profit private retail banks have a valuable role to play in a large, complex, monetized economy. He believes that although there is a role for public banks, it is not feasible for public banks alone to do all of the financing. His argument seems to be that a network of privately owned banks can operate in a more flexible, decentralized, and responsive way than a public bank ever could. At the same time, however, he advocates much stricter regulation of privately owned banks to shrink the size of the banking sector as a whole, minimize inequality of income and wealth, uphold strong underwriting standards (assessments of credit-worthiness), and prevent speculative financial activity that is not necessary for productive activity.
Bill Mitchell goes a lot further than Randall Wray. Bill Michell advocates nationalizing the banks.
Hi Simon
This is a very helpful way of thinking about the relationship between demand deposits and reserves. Thank you.
Nicholas,
I have another thought, if I may.
You say that bank dollars are converted into US created dollars when they are deposited at the Fed. Res. as “reserves”, right?
Isn’t it also true that if I get an auto-payment of US created dollars from Soc. Sec. directly into my bank account that as soon as it is in my bank account it becomes just bank dollars, right?
Well, I’m totally sorry but this distinction makes zero sense to me. The dollars convert back and forth from one form to the other depending only on the type of account they happen to be sitting in at a given time. This is clearly a distinction without a difference.
Perhaps there is some benefit in keeping track of how much of each sort of dollars constitutes the total money supply. But, this doesn’t mean the dollars are in any *real sense* different.
Just like it is a good idea to track how many dollars are destroyed by taxation or for that matter selling bonds.
.
PS — If you are coming from the place that MMT says this so I must be wrong, then I don’t care. I’m right until someone can show me an *actual real difference*.
.
Bill,
I see the the diagram has not been changed. The 45 deg. line is not at 45 deg.
However, you can just change the words. Don’t call it the 45 deg. line.
Call it the “diagonal 1 to 1 line”.
Steve_American,
I don’t know if it may help, but I will give you a simplified, didatic example.
Let’s suppose you are a public employee that works for the federal government and do not have a bank account. You want to recieve your wages in dollar notes and coins, and let’s suppose you have the right to do it (in some countries this may not be the case anymore).
So you work for a period and then go to a government agency or its designated bank, show them your id and recieve your wage in dollar notes.
Those dollar notes were issued by the government, not the bank. They represent an IOU you have against the government, a tax credit, earned because you have worked for the government. It is your asset and the government’s liability.
Then you decide to open a deposit account in Bank A. You go there and deposit your money, by giving them your notes and coins. They receive your dollar notes, and keep it, and then they go to their internal system and register that Steve_American has now $x in its account. This registry is nothing more than the formalization of a promise that Bank A has made to you, that it is “in debt” to you, that if you go there and demand your money they have the obligation to somehow give back you dollar notes. Of course, because it is a promise, it may be defaulted. That promise is an IOU called “bank deposit” and it is an asset to you and a liability to the bank.
The dollar notes you gave to the bank will not be kept in a safe with your name in it. The bank will use it for a lot of purposes. Maybe it will pay staff with it, maybe make transfers to other banks etc. It is hard to tell and it doesn’t really matter where exactly the dollar notes went to, but the fact is that banks do not keep enough currency to cover all its deposit liabilities. If every customer wanted to withdraw their currency at the same time, the bank would not be able to fulfill its promises. Banks manage their leverage, and usually keep just a small fraction of currency or high liquid assets.
If you borrow money from the bank, it will first assess whether you are going to repay the loan back. If they believe there is just a small probability you don’t and/or if you have good collateral, they lend money to you – they simply credit your bank account, creating bank money out of thin air. Then you may want to withdraw it (in dollar coins and notes) so the bank has to always keep some amount of [government] dollar notes stored for customer withdrawals.
So, answering your first question: If you don’t repay your loan, the bank will seize your collateral and try to sell it. It may sell for a low price and not recover all the currency it lent. It is a loss. That happens. Banks may decide to close or even go broke if they start losing too much money.
Answering the second question: You can use your dollar notes to pay taxes. You can’t use bank money to pay taxes. If you order your bank to pay your taxes, a lot of things will happen in the background. The bank will first debit your bank account, because you are using the IOUs you have against the bank. Then the bank will need to have some US government currency (dollar notes, coins and bank reserves) and transfer it to the government, to pay your taxes. The government is not interested in Bank A’s deposit accounts. It will accept only US currency to settle taxes. Most people don’t know how that background operations work and because of that they may wrongly assume that private bank deposits were used to settle taxes.
Don’t know if I answered your questions, but I tried…
Steve_American,
Maybe by differentiating the consequences of reserves x bank deposits things may get clearer, I don’t know.
So supposte that there is a private bank with $ 100 billions in assets.
Its balance sheet is like this in the asset side: $1 in bank reserves (a kind of US government currency), $4 in government bonds, and $95 in long-term retail loans. The liabilities side is like this: $80 in demand deposits (to retail customers), $20 in shareholders’ equity.
Then one day all of its customers decide that they want to pay taxes. It means that suddenly the bank has to pay $80 in taxes to the government, in the name of its customers.
The bank will use the $1 bank reserves to pay the first $1 of taxes. Then it will sell the government bonds (to other banks, institutional investors, the government itself, etc), hence “transforming” them into $4 in bank reserves, and then pay the taxes. There still $75 remaining.
Now the bank is in trouble. It doesn’t have $75 in reserves to fullfil the order of its customers. All it has are the long-term loans credit, which, in spite of being profitable, will be recived only in the long-term.
The first thing the bank would probably do was to send the following message to its customers: “service temporary unavailable. please try again later”. It would try to decieve its customers in believing that there is some kind of operational issue, not a lack of currency.
Then the bank would try to borrow some money from anyone willing to lend (retail, wholesale, corporate customers, institutional investors, the government, etc). The problem is that, when a bank is facing trouble, there is a chance that investors would not lend much money, not even by receiving high interest rates.
Another thing it would do was trying to sell its credit portfolio or giving it as collateral to borrow currency.
Nonetheless, such bank would face the possibility of going broke.
Something that would never work was the bank calling the government and saying “hey, look, instead of paying you bank reserves directly, why don’t you open an account with us? we credit it in $75, and then you withdraw the currency slowly along the month”. The government would not agree or allow this arrangement. Bank deposits are not the samething as reserves. Taxes need to be paid with reserves, not bank deposits.
Dear Steve_American (at 2018/09/29 at 11:14 pm)
Please give up on the pedantry. It is a diagram in a blog post.
best wishes
bill
“If a government can guarantee a job, and therefore an income, then on what grounds can it not guarantee other things…those other ‘things’ I have already pointed out in my original post.”
Dean, the government really cannot provide unlimited real goods and services the way it can provide an unlimited nominal income in the currency it creates. The currency is easy to create- it is mostly key strokes into a computer- the amount that could be created is all but unlimited. Houses, tools, food, land are all ‘real’ goods- the amount of each that can be provided is finite. Usually their creation depends on the availability of other ‘real’ resources such as labor and raw materials.
The government can promise to provide ‘an income’ to everyone and could keep that promise. It cannot promise as credibly that the currency that income consists of can always buy any certain amount of real goods and services. That is the distinction that needs to be made here in order to answer your question.
Nicholas: Yeah sure but some of the demand deposit dollars originated as fiscal policy decisions of the government whereas some of them originated as loan issuance decisions by retail banks.
I don’t believe thinking about things that way – the origin of demand deposit dollars – is very useful. It can amount to double counting. The reserve dollars that the bank has after you deposit fiscal policy cash can more reasonably be seen as originating in fiscal policy decisions, while I think it is better to only ever think of the bank dollars as only coming from the bank, period.
For Dean,
I read the first 3 or 4 exchanges between you and Nicholas. Then I just quickly skimmed through the rest or your exchanges. So forgive me if I am am now going to attempt to clarify something that was clarified earlier. I think that what Nicholas was trying to say is that with a persons basic income that s/he earmed for the year at the end of the year there might be enough left over to buy a kayak that the person could use to paddle around his nearby lake, river, or coastline. But if that person defers spending the money on the kayak they could buy a boat with a motor that could pull two waterskiers at the end of ten years. To have money for a rainy day fund is not the only reason that people save money.
Then Jerry Brown with his comment on Sunday at 2:17 gets in to the guaranteein an income does not guarantee everything. But what governments can do is to implement a progressive income tax policy that would insure that the wealthy can not obtain so much money that they have enough to buy an appartment in Sydney (New York, London. Toronto) and in Perth (Los Angelas, Rome, Vancouver) and in Melborne (Chicago, Frankfurt, Winnipeg) for example. Because, when too many people have to much money they tend to use it ways that is disruptive to the sustainability of the planet which will eventually cause runaway inflation based upon real resource shortages. (OK technological innovation can push the days of real resource shortages in to the future. Keep in mind though no one can predict what the effectiveness of future innovations will be)
If you know people that think that the free market is a reliable mechanism for effectively useing the planets resources I would refer you to the website colddarkstars or collapseofindustrialcivilization.
Dean: What I am trying to point out is that the principles behind the JG program extend far beyond ‘income’ and ‘jobs’…can you see what I am trying to point out?
Yes, since I have been trying to point it out myself for years, and others for centuries.
If a government can guarantee a job, and therefore an income, then on what grounds can it not guarantee other things …
It can not-guarantee things that it is unable to guarantee as Jerry Brown notes, or that people do not think appropriate to guarantee. The richer the community, the more it can guarantee.
but I also see no reason why I would need to save for it – government could just hold a portion of my guaranteed income and by the end of 48 weeks, put it in my bank so I can enjoy a holiday.
This is by definition, saving. So you are asserting that people will desire to save, answering you own question and contradicting your other statements, like “it makes no sense to save when my income is guaranteed.”
This sort of question has been explored for a long time. Yes, guaranteed income can and has diminished savings desires, but it does not completely eradicate them. For instance many economists feared the return of the Great Depression in the USA after WWII. But some, more correctly, pointed out that the Social Security system would diminish the savings desires that could have refueled the Great Depression. People might save if they want something too expensive to be paid out of one period’s income, want to give gifts to their friends and children, want a cushion against some unforeseen expense, whatever. It’s their business, and that people save for many reasons is simply a behavioral fact. Only if one knows the future completely and can plan spending until death is it irrational to save, as Keynes more or less observed.
Hi Steve
No. Bank IOUs are never deposited at the central bank. The central bank only deals in the government’s IOUs (three money things: reserves, physical currency, government securities).
When you tell your bank that you want to pay your taxes, your bank honours its promise to use its reserves to pay the government. Your bank’s reserve account is debited. The Treasury department’s reserve account is credited. This is the record of you fulfilling your tax obligation to the government.
Nicolas said”
“Where does taxation fit in your scenario?
What functions do taxes serve in the society that you have outlined?
You ideas seem to assume the existence of a government sector, a non-government sector, and money, so I presume that you are talking about a monetary economy rather than some form of non-monetary economy (for instance a subsistence economy, a gift exchange economy, a communist economy in which the state directs all production and distributes all goods and services to everybody).”
I said nothing about a ‘society’. You are making the classic case most people make and assuming that I am trying to describe some whole ‘society’. The questions I have posed are based on around 5-10% of the population (an NO, it is not some commune either).
Jerry Brown said
“Dean, the government really cannot provide unlimited real goods and services the way it can provide an unlimited nominal income in the currency it creates. The currency is easy to create- it is mostly key strokes into a computer- the amount that could be created is all but unlimited. Houses, tools, food, land are all ‘real’ goods- the amount of each that can be provided is finite. Usually their creation depends on the availability of other ‘real’ resources such as labor and raw materials.
The government can promise to provide ‘an income’ to everyone and could keep that promise. It cannot promise as credibly that the currency that income consists of can always buy any certain amount of real goods and services. That is the distinction that needs to be made here in order to answer your question.”
Now we are starting to get somewhere. Jerry is pointing out, governments can guarantee things like income, jobs, but not real goods (lets use widgets as an example) – but of course, this makes no difference whether the government wants to buy widgets or the individuals who have been paid the guaranteed income wants to buy widgets – if no one in the private sector has produced widgets, no one can buy them irrespective of how much money one has.
But if you read the whole of my post you will also notice that I speak of the government investing in a ‘productive process’ under a non-profit model also. Let’s use the widgets as an example.
An individual (like me) sees that no one is producing widgets, but that there is a demand for them. But, also this individual does not wish to take the risks involved in starting a for-profit business making widgets in the private sector. So this individual walks up to government and says “There is a demand for widgets, no one is making widgets locally, I am good at making widgets, but what I am *not* good at is being a businessman; also, I have no desire to become financially wealthy, so rather than me taking the risk of trying to form my own business, I want to do this as a non-profit partnership with government – how about you the government, and me, forming a partnership where you the government invest in the all the tools I need to produce widgets – you the government will own all the capital, and all the widgets produced (less what I need to take for my own living). In exchange for me producing the widgets, you provide for all my living expenses; because government can guarantee the ability to fund any productive process, then provided I can produce something whilst I am fit and able, I have no need to save. When I use the term ‘save’, I am not really referring to wanting to buy a kayak – I am more referring to the need to put money away or invest in stocks etc because of the insecurity of the future. But if government can guarantee to always be my partner, then I should have no fear of the future other than if the government itself collapsed.
Does this make sense what I am asking?
In other words, if government can guarantee an income and a job, it can also guarantee the money needed to invest in a productive process, such as making widgets, and to maintain this productive process, provided the productive process is not done for profit. And this further implies that even if all of a sudden widgets fall out of demand, the productive process can be changed to suit some other demand of society.
I am NOT suggesting that *everyone* in society go down this road. Based on my research, I believe there would be around 5% of the population that would prefer to operate this way, and I can prove this if people want me to. I can introduce you all to people who have a real desire to do this if you want.
Dean, there is nothing wrong with your proposal as outlined @8:59. It is actually similar in some ways to parts of the MMT job guarantee proposal (especially as to how various projects would be decided upon). Yes the government can always provide funds for new investment. Prior Savings are not required for future government investment. They are not required for future private investment funded through bank loans either.
I like your idea.
MMT-informed JG proposals describe a JG that employs people for socially valuable, environmentally sustainable,
. For-profit employers would be excluded from a JG.
As an individual participant in a JG, you would be free to use your income as you like. You can save some of it, or you can spend all of it. It is up to you.
MMT-informed JG proposals describe a JG that employs people for socially valuable, environmentally sustainable, not-for-profit production. For-profit employers would be excluded from a JG. A JG is not designed to be a wage subsidy scheme.
As an individual participant in a JG, you would be free to use your income as you like. You can save some of it, or you can spend all of it. It is up to you.
“Dean, there is nothing wrong with your proposal as outlined @8:59. It is actually similar in some ways to parts of the MMT job guarantee proposal (especially as to how various projects would be decided upon). Yes the government can always provide funds for new investment. Prior Savings are not required for future government investment. They are not required for future private investment funded through bank loans either.
I like your idea.”
Thanks Jerry – whilst it took a while to get here, this answer is what I suspected based on what I have read and studied over the last few years. Interestingly, this exchange involving people on this blog has demonstrated that it is extremely difficult to explain an idea without people invoking images in their minds and making presumptions, which means trying to explain the idea to government is going to be difficult unless it is done face to face. Now the ultimate question – who in government to approach with it?
Thank you everyone,
I live in SE Asia. I slept on it and I think I see where I went wrong.
Perhaps “reserve dollars” never actually leave the Fed/ Res. Bank. They move from account to account inside the bank but never leave it. Every bank in the US has a separate acc. at the Fed. Not sure about foreign banks, they may all work thru their own central bank [or have an acc. at the Fed. also].
. . So, bank dollars and reserve dollars never are in the same account and so are actually never mixed together. When my Soc. Sec. payment goes into my bank, it doesn’t really ever reach the bank. It stays in the bank’s reserve acc. at the Fed. The same for every check I deposit. My bank gets the money by presenting it to the Fed. Res. Bk. for payment; the Fed. transfers reserve dollars from the bank it is drawn on from it to my bank’s acc. at the Fed.
. . When I take out a loan the bank simply credits my acc. there with some magic dollars. They do not come thru the Fed. Res. system. However, whenever I spend them with a check the are transferred thru the Fed. Res. system and are converted in the process into reserve dollars . This happens every time because the bank already has a supply of reserve dollars that it uses to do it. There is no magic at all.
.
I was led astray by 2 things I heard or read from authoritative sources.
1] A Prof. MMTer said that banks are not limited when they make loans because the act of making the loan provides it with the dollars necessary for it to meet its new reserve requirement. At least, that is what I thought he/she said. Now I think I got confused.
. . The fact is the world is awash in dollars that can be reserve dollars. All $21T in US Bonds can be converted into reserve dollars if the banking system needs more reserve dollars. The US Gov. deficit spends every year and this adds reserve dollars into the US banking system’s accounts at the Fed. Res. Because the reserve requirement is 10% it follows that just the deficit spending provides enough reserve dollars to fund loans totaling 10 times the Gov. deficit.
2] For another argument I had to look at the Fed. Res. Bank’s official web page on how reserve requirements are calculated. There it said that “bank deposits” were a source of dollars for meeting the reserve requirement. Perhaps what that meant was that all deposits transferred thru the Fed. Res. system provide reserve dollars. I thought it meant bank loan deposits *also* [see above #1]. Perhaps it meant just those deposits made thru the Fed. Res. system.
I hope I got it right this time.
.
“Perhaps ‘reserve dollars’ never actually leave the Fed/ Res. Bank. They move from account to account inside the bank but never leave it”
Well, I feel that you are understanding the workings of reserves, but “leave” would not be a good word for it. I don’t even know what it means.
In a sense, bank reserves are electronic registries in Fed’s internal systems and databases, and such database never “leaves” Fed. Is that what you were talking about?
“So, bank dollars and reserve dollars never are in the same account and so are actually never mixed together”
Correct. One thing is bank reserve accounts registered at the central bank, an another distinct thing are bank deposits registered at a bank’s internal systems. They are separate things that don’t mix.
“When my Soc. Sec. payment goes into my bank, it doesn’t really ever reach the bank. It stays in the bank’s reserve acc. at the Fed.”
Don’t know what you mean by “doesn’t reach the bank”. That wording seems awkward to me, don’t know. The Sec Soc payment do reach the bank in the sense that its bank reserve account registered at Fed will be credit, and that, after the bank recurving the confirmation and details of the credit, it will probably credit the deposit account of its customers.
“Fed transfers reserve dollars from the bank it is drawn on from it to my bank’s acc. at the Fed”
Yes, I guess it is true. There are some details there (like, usually the transfer is not automatic, the banks need to order the transfer to Fed), but it is more or less like that.
“A Prof. MMTer said that banks are not limited when they make loans because the act of making the loan provides it with the dollars necessary for it to meet its new reserve requirement. At least, that is what I thought he/she said. Now I think I got confused”
I share the same opinion with you that MMTers, even the most renewed ones (Bill Mitchell, Warren Mosler, Randall Wray, etc) sometimes say confusing things. I think that’s the price they pay for being so open and so keen to spread MMT word. I believe sometimes the communication is not so clear as it could be, but I think that overall they are doing a great job. If you really pay attention to what they say, you will understand that banks are somehow limited by bank reserves (but not the way mainstream economists usually think about it).
“There it said that “bank deposits” were a source of dollars for meeting the reserve requirement”
Well, I think there is some confusion there. Legislation obliges banks to hold reserves to an equivalent amount of 10% of last week’s demand deposits average. That rule doesn’t mean that deposits somehow originates reserves out of thin air or anything like that.
” “There it said that “bank deposits” were a source of dollars for meeting the reserve requirement”
“Well, I think there is some confusion there. Legislation obliges banks to hold reserves to an equivalent amount of 10% of last week’s demand deposits average. That rule doesn’t mean that deposits somehow originates reserves out of thin air or anything like that.” ”
.
Andre’, now you got confused.
What I tried to say was — whenever a deposit to a bank is made using a check, that bank’s reserve account at the Fed. gets that amount of reserve dollars as a transfer from the bank the check was drawn on. So, those deposits do give the bank reserve dollars. And 10 times more than it needs to meet its requirement [set as you said by last week’s average of total deposits].
Yes – bank deposits from other banks.
A bank can’t use its own IOU to meet the reserve requirement. Loan issuance doesn’t automatically increase the bank’s reserves. If it is short of the reserves it needs for payments for clear it will need to borrow them from other banks in the interbank overnight money market, or borrow them from the central bank (through the discount window or an intra-day repo facility), or sell government securities that it owns, or by sell other assets.
When the Commonwealth bank transfers its IOU to ANZ bank, the Commonwealth Bank’s reserve account is debited and ANZ’s reserve account is credited.
When a bank receives another bank’s IOU, it is receiving a claim on that other bank’s reserves.
Steve, you’re on the right track with reserves being deposits at the Fed, only moving from one account to another.
The larger question, what is the difference between government dollars and bank dollars, is, I believe, best explained this way: Both government dollars and bank dollars are promissory notes denominated in currency units. They count the same way and spend the same way (unless something has gone horribly wrong). Government dollars are promissory notes created by the government out of thin air that the government promises can be used to cancel tax liabilities. Bank dollars are promissory notes created by banks out of thin air, in the form of deposits, payable in government dollars.
Government dollars create public debt, which can never default (the government can always keep its promise). Bank dollars create private debt, which can result in default; the bank may not be able to acquire the necessary government dollars to keep their promise. Generally because the people who owe the bank are unable or unwilling to keep their promises to pay the bank with government dollars.
Yes Steve. That is my understanding. AUD financial assets never leave the Reserve Bank of Australia. They just shift from account to account. It doesn’t matter if the account is held by a resident or a foreigner. The asset always stays within Australia’s banking system.
AUD never go “offshore”. The owner can be offshore but the account is always a reserve account at the RBA.
Well it seems to be problem in Turkey
Jake: I think Turkey has a lot of foreign denominated debt. That of course is a game changer as Bill and others have made very clear. What’s the point of having a sovereign currency if you don’t employ a fiscal policy that puts it to good use?
Seriously Bill, here you are arguing that as a trading nation its ridiculous for government to prop up industry that can no longer compete with imports, there are just a couple of things off the top of my head I would say about this. There are other benefits to producing goods locally rather than importing them than just the financial cost of them. (within reason). The sovereign country might want to have controls over the quality of certain products, the environmental effects of producing certain products, the retention of skills relating to the production of certain products,the option to have those local products available to the local population for national security reasons etc etc. You say that countries should just move on into the post industrial phase then go on to say that a job guarantee should be introduced where your personal opinion is that people who do not participate should not receive welfare payments? . There are so many reasons to retain certain local industry’s for national benefit, that benefit is not only real jobs but more importantly things like food and energy security.If I have misunderstood you then by all means point it out.
Gia, everything you say about this I agree with. There definitely seem to be many benefits for producing goods and having, or getting, or retaining an industry within your country. And I think a lot of economists underestimate those benefits. Including MMT economists.
But, to be fair, Bill Mitchell has addressed many of your concerns in his previous writings. A good one to look at is https://billmitchell.org/blog/?p=39420 “A surplus of trade discussions” . It even has the advantage of being relatively brief.
Economists including David Ricardo and Adam Smith recognized the point that you make Gia. They understood that the ability to import from foreign markets meant that those with purchasing power could benefit in real terms from the offerings of foreign markets, but at the expense of the overall health of the home economy, which can lose productive capabilities over time.
Smith’s famous “invisible hand” was in fact a hoped for but unrealized “home bias” or preference for locally produced goods. In the neoliberal era we have at times seen motions to eliminate the origin of manufacture labels from products altogether so we can’t even know we’re not purchasing local goods.
The term Trade itself is quite misleading in today’s world where the ‘deals’ are mostly about further consolidation of the power of transnational corporations to exploit various global inequalities.
As Bill has pointed out however, MMT is not really about trade and the job guarantee is not a politically derived suggestion but a proposal for maximizing human resource potential while helping to achieve price stability using the buffer stock concepts.