In the spirit of debate … my reply Part 2

Today, I offer Part 2 of my responses to the comments raised in the debate so far. I am still about 40 comments shy of the total. In general, I thank Scott, JKH, Ramanan, Sean and others who have provided excellent interventions into this debate based on their knowledge of how the monetary system actually works rather than a stylised representation of it which leaves out the government sector and is liberal with the accounting conventions applied to account for asset and liability flows and flow to stock relations. But there still appears to be major confusions which I will try to address here.

So let me pick up the thread from the commentary that has been made in the last two days (since I last considered them). Please also accept my apologies if I haven’t got to your comment yet and you were talking about things other than “debt cancer” and/or the “descent into communism”. It is just a matter of how much time I have on any given day even though I type very quickly these days.

ak, who regularly provides thoughtful interventions to my blog and posted this comment on both billy blog and Steve’s debate page:

… I think that I can explain the root cause of inconsistency between Steve’s model and accounting rules mentioned on your blog … the issue is simply too important to leave is not reconciled properly as it will keep confusing readers forever … The main difference between Steve and Bill is the definition of money I believe … The discrepancy can be explained in my opinion in the following way: the term “money” is used by Steve in the same sense as in the infamous
“money multiplier” model – as credit money.

The comments by Scott and JKH are very valuable in this regard.

Modern monetary theory does not use the term “money” in the same way as the mainstream because it creates instant confusion. As Scott said “Money is always someone’s liability, so better to be precise about whose liabilities we are talking about than saying money.” That is why we emphasis fully understanding the asset-liability matches that occur in monetary systems. And that leads you to realise that transactions between government and non-government create or destroy net financial assets denominated in the currency of issue whereas transactions within the non-government sector cannot create net financial positions.

That distinction is very important. For example, it allows you to understand why budget deficits put downward pressure on overnight interest rates contrary to everything that mainstream economics (via its fallacious crowding out theory) tells you. The fact that the commercial banks cannot via the interbank market eliminate a system-wide surplus cash position (excess reserves) by lending to/borrowing from each other is the reason that rates fall when there are excess reserves.

If the non-government sector could change net positions then this would not occur. But then we would not be describing the actual operations of the monetary system we live in or else we would be inventing accounting rules to suit.

The fact that modern monetary theory develops these insights separates it from mainstream macroeconomics and provides a coherent and consistent basis for understanding how our monetary system operates.

So modern monetary theorists prefer to concentrate on what is going on with balance sheets after certain flows have occured rather than narrowly defining some financial assets as money and others not.

Then we can easily understand the statement made by Scott that “if the government increases its liabilities, this is a net increase in financial assets for the non-government sector.”

There is no doubt that the non-government institutions can increase credit. Some slack analysts call this an increase in money. But the accurate statement is that, as a matter of accounting it increases the (in Scott’s words) “the quantity of financial assets and financial liabilities 1 for 1 in the non-govt sector. So, with private credit, there is BY DEFINITION no NET increase in private sector financial assets created.”

Once we understand that and note that typically the non-government sector seeks to net save in the currency of issue then modern monetary theory tells you that the public sector must run a deficit to underwrite this desired net saving or else see an output gap widen.

Continuing, there was an interesting comment posted on both our blogs which said:

… Am a lay-reader wanting to understand more about the nexus … between the vertical transactions of the government and non-government sectors which appear on a balance sheet as surplus (deficit) or assets (liabilities) – and the horizontal creation of credit by authorised participants in the non-government sector through loans, which on the balance sheet sum to zero … 1) Can the non-government sector authorised participants create loans if they have a zero balance or deficit with the government (or only if their balance is positive)? Or is their vertical balance immaterial to their credit creating power? 2) Is not the horizontal zero balance of loans and deposits immaterial: currently I am wondering why the material concern should not be that (obviously?) horizontal credit has the power to appropriate, perhaps even force the creation of vertical assets or a government deficit, overriding whatever vertical constraints may exist? Banks go down, the government deficit goes up? Who is in control? …

The commercial banks have to maintain at least positive reserve balances with the central bank at all times (allowing for differing accounting conventions around the world as to when these balances are measured). The same banks can always initiate loans without prior recourse to their reserve positions on a particular day.

I think reading this blog – Money multiplier and other myths – will help you understand this point.

Who is in control is an interesting question. Clearly, the government cannot directly control the money supply which renders much of the analysis in mainstream macroeconomics textbooks as being irrelevant. The Monetarists via Milton Friedman persuaded central banks to adopt monetary targetting in the 1980s and it failed a few years later – miserably.

So in that respect, the commercial banks call the shots via their credit creation. The non-government sector can also render a government’s plans to run surpluses, for example, futile. This is the paradox of thrift argument. If the non-government sector sets into place a plan to increase their saving ratio and stop spending then the income adjustments will clearly plunge the economy into a downturn if nothing else happens.

But we know that the automatic stabilisers that are built into the budget kick in (tax revenue falls and welfare spending rises) even without any discretionary changes to fiscal policy. The income adjustments will ultimately drive the public budget balance into deficit whether the government likes it or not.

This is why I talk about “good deficits” (that are designed to support the saving desires of the non-government sector) and “bad deficits” (which arise from a government not taking responsibility for filling the spending gap). If the non-government sector wants to net save in the currency of issue then the government will be in deficit – one way or another.

Then you might like to consider it from the other angle – a government which accepts responsibility for full employment can “finance” the saving desires of the non-government sector by increasing its deficit up to the level warranted by the spending gap (left by the full employment non-government savings). So in that sense, the government is in control because the paradox of thrift tells us that the desire to increase saving by the non-government sector will be thwarted by the income adjustments unless the government acts to “finance” the plans.

The vertical-horizontal framework allows you to understand all of this.

One commentator concluded:

Mitchell is smoking something. The idea that the government is acquiring private goods with currency or credit we were swindled into taking in the first place is nonsense.

Sorry, I am a fitness fanatic and do not smoke. I also can’t recall anyone not agreeing to accept cheques from the government or not being pleased when their bank accounts have been credited with public spending. If I am wrong let me know. I guess this commentator hands back all government spending.

Then I read that:

The problem with Mitchells theories is that there are always hidden consequences and he ignores them. If we can create money through debt, why not just let the government do it. Simply that people will always try to grab the easiest money and that is the stuff handed out by government. Make more of it and people try harder rather than doing anything useful. Unfortunately economies that don’t make anything don’t have a lot to sell. So then we get pricing controls etc, as governments run around fixing things and it all looks a lot like Russia in the seventies.

We seem to have a fixation with falling into communism. Modern monetary theory doesn’t tell you anything about that so I cannot help you with your fears.

But it is true, every action has a consequence, and in the millions of words I have written as an academic I have never resiled from teasing out what I think are the consequences of this policy option against that policy option. I think this person should read more of my work.

I might also conduct a poll of people who work on government contracts to deliver the US military machine; those who run all the US border security systems; those who fight in far-off lands on behalf of “freedom” whether they have been grabbing the easiest money. The proposition is, of-course, without substance. The government and the non-government sectors do useful things and they do stupid things. The system that the commentator now uses to communicate (the Internet) was conceived and implemented initially by government.

I think the comment by ak was very telling also in relation to several other responses along these lines that modern monetary theory is about communisn:

Chartalism has nothing to do with nationalising your company or getting rid of the markets. However chartalism discovers tools which can (but don’t have to) be used to lower unemployment or to prevent a depression … [quoting one of the manic commentators] … We have seen the economic and human hardships endured by Communist Eastern Europe, Russia and China.” What has it to do with chartalism? Whoever doesn’t believe in absolute property rights and money as a tool to preserve wealth is a communist – isn’t he?

That had salutory value even though I might have written it a little differently.

The same person to whom ak had previously responded to, came back with this:

… Chartalism is a trojan horse for Bigger. more Interventionist and controlling Govt, no matter how you care to spin the economic argument. Who would benefit most from a chartalist economy?

Oh dear … don’t you realise that if you live in Australia, the UK, China, Japan, the US and most nearly everywhere else that you are already living in a “chartalist economy” (dude)? It is not some new system that is being proposed – it is the system. Modern monetary theory seeks to educate us on how that system actually operates rather than the way abstract economic models that count angels on the end of a pinhead say it operates.

Information is freedom. A better informed public has a better chance of keeping things in check. Since when has improving the level of education been a one-way route to communism?

Then an accounting commentator waded in to show why the non-government sector can create net asset positions (which of-course it cannot):

… For exampe, in a medieval setting, I hand over some of my savings to the miller to upgrade his watermill, because I expect that that will result in higher profits to him out of which he will repay the loan of my savings plus interest … There has to be net negative assets in this situation, because I have handed some of my savings to him and, being a loan, there is a risk that the debt will not be repaid. E.g. if the Vandals raid our village and burn the mill, the money I loaned him will be wasted and gone, so I can’t count that loan to the miller as a current asset until it is repaid.

Well, I am not sure why we are back in a feudal system but lets assume this is a fiat monetary system of the type we live in today and which modern monetary theory seeks to explain.

So the person provides a loan to a miller. Accounting: person increases his/her assets (loan) and writes down an asset by the same amount (cash at hand). The miller has an asset (the cash) and an equal liability (the loan). No net position changes. Assets created equal liabilities created.

If the Vandals invade and burn the mill the following accounting occurs with respect to this transaction (ignoring asset changes with respect to the burnt mill): If the miller defaults, the person eventually writes off asset (bad loan) by crediting the miller’s loan account and simultaneously debit (decrease) the allowance for doubtful debt account (which is typically a contra account in the current asset section of the balance sheet). The miller would make a similar contra entry when he writes the loan (liability) off.

So sorry, no net financial assets are created in this transaction.

But I was very surprised when Steve Keen responded to this comment as such:

No analogy is perfect (witness the medico reaction to my Alternative Medicine analogy!), but I generally agree with yours …

This further confirms my view that Steve’s accounting is not conventional and it is that deviation from the accepted rules that generates some of his analytical results. The challenge to Steve is to integrate his credit economy into a properly specified modern monetary framework which has a complete sectoral specification and obeys accepted accounting conventions and produces perfect stock-flow consistency. Then we would be able to really have a debate. I think the interventions by JKH – here and here have been of tremendous value to the debate in this regard.

One commentator (and I am splitting the comment for presentation purposes) said:

The Chartalist say that they understand the system in that all equation balance. Fine but to better the system means upholding the law and limiting government power which indeed is what the system was pre tearing up the rule book. Nowhere do Chartalist say that government power should be limited by way of a constitution or otherwise. Instead they continually talk about the use of government power as if its a necessary or natural event … Please allow the system to correct and remove yourselves from advocating government interferrence. My advice to the Chartalist is read some of Jefferson and Madision’s writing; read some history – become educated on what absolute power does – it corrupts absolutely.

When in doubt quote some old tome! In a lateral way this column from 2005 is of excellent use in considering this question (thanks to Peter Martin for digging this up).

Modern monetary theory will also not put the peanut butter on your toast in the morning. Matters of constitutional law and referenda and the like are not the realm of modern monetary theory. I presume we all agree that citizens and institutions should be governed by the rule of law and that that law be decided in transparent and equitable ways.

But I would also note that whether you like it or not, there is a government sector; in most countries it is the monopoly issuer of the currency; what it does will have significant influence on the economic outcomes that emerge; and even if it is minimalist the national accounting rules and other insights that modern monetary theory provides will rule! Sorry to disappoint you.

Bolting down the government will have consequences in a fiat currency system and I sense the way you want to bolt it down (for example, not running deficits as a matter of course) will lead to other ambitions you have (like less private debt) not being realisable. Get used to it.

Someone made a comment about my statement that toxic debt today was good debt yesterday. I was wanting to make the point that you cannot consider the debt position in an absolute sense independent of the state of the economy. The capacity to service debt is always dependent on the capacity to earn income and that mostly varies with employment. Those who see debt as “cancer” fail to grasp this point.

So in terms of the current economic crisis which began in the US as a financial crisis and then spread out rather quickly, I have this to say.

It is not difficult to pin point the triggers for the current crisis. The dynamics began in the US with the collapse of their real estate boom. Since 2000, the US financial engineers had loaned massive amounts to drive the boom. To increase their profits further, they penetrated into the riskier segments of the market – the so-called sub-prime loans. The bet was that even high risk borrowers would be able to re-finance on higher property values and avoid default. This bet turned out to be very unsound. As the housing price bubble burst and increasing numbers of borrowers faced negative equity, defaults and foreclosures rose dramatically.

The extent of the exposure was at first unknown but we now know that many investment banks had borrowed huge amounts to purchase the mortgage-backed securities which were derived from the initial unsound loans.

It is also clear that the US mortgage giants Freddie Max and Fannie Mae, which together own or guarantee around three-quarters of the total US mortgage market, led the lending frenzy without sufficient due diligence.

Another factor has been the so-called credit-default swaps which are akin to insurance contracts. They are totally unregulated and provide the holder with a guarantee against loan default. Trillions of dollars of these swaps were written against risky mortgage loans. The problem was that once the loans soured, and the holder of the swaps started to seek their “insurance payment”, the many financial institutions that had issued them could not honour their obligations.

But the crisis became seriously disruptive to the real economy when the interbank market dried up. Banks struggled to fund their exposed positions. Investors, who in more normal times underwrote the capital of these financial institutions, became extremely risk-averse fearing that the sub-prime exposure was the tip of the iceberg. Once the credit markets became crippled, firms in the real economy started to struggle to finance their working capital.

Institutional trends in financial markets have also been problematic. Over the last two decades banks have moved away from operating as intermediaries between household depositors and firm borrowers to banks acting as brokers, the potential for a disastrous disconnection becomes enormous. This is because the markets do not function rationally, making efficient use of available information.

There are profound gaps in the information flows between the banks, investors, firm and household borrowers, providers of securitized assets to be used as collateral, providers of insurance for these assets, the credit rating agencies assessing levels of risk in relation to these assets (which include credit default swaps), and the parties in the “real sector” who are generating the actual IOU’s that eventually become securitised. It is these interactions between the real and the financial sectors that must be grasped to fully understand modern financial crises. The role of fiscal policy, however, in both a positive and a negative sense, must be understood.

I do not concur with the widespread view that the crisis can be attributed to “irrational exuberance” in US real estate markets. It is clear that the securitised sub-prime loans experienced default rates that were unexpectedly high. This led to a liquidity crisis because holders of the securities could not refinance their positions with short-term debt. Because of high leverage and interconnected balance sheets of financial institutions all over the world, problems quickly spread to other asset classes (in a classic case of a Minsky-Fisher debt deflation) and the crisis became global. We now know that the problem loans were by no means limited to sub-primes – rather, low underwriting standards plus insufficient risk spreads were common throughout all types of lending in the US and abroad.

The financial crisis plus other factors (high debt service, high energy costs, and a fiscal squeeze in the US all reduced consumption-lowering US imports and thus impacting exporting nations) generated a recession that then impeded ability to service debt in a vicious recursive cycle. Because much of the world relied on US imports to drive growth, the US slowdown hurt even those nations that were not substantially linked to global financial markets.

You might also like to read the blog – Origins of the economic crisis – where I develop the argument in greater detail.

At any rate, I hope that resolves the approach I have to the debt question.

But crucially, you cannot understand the debt situation in isolation from what was happening with fiscal policy.

Any growth strategy predicated on fiscal surpluses and increasing levels of private debt are inherently unstable and ultimately unsustainable. First, the rising levels of debt clearly rendered private agents increasingly susceptible to small changes in external conditions including policy changes.

For example, the increasing fuel prices in recent years endangered the solvency of highly geared households. In turn, debt defaults would be less confined than in the past because of the size of financial derivatives market which has grown to drive the proliferation of credit. Second, private agents eventually had to increase their saving to reduce the precariousness of their balance sheets.

Both sources of instability mean that aggregate demand would fail resulting in unsold inventories, reductions in production levels, job loss and rising unemployment.

The resulting unemployment is involuntary in nature by which we mean labour unable to find a buyer at the current money wage. It also invokes the idea of a systemic macroeconomic constraint that renders an individual powerless to improve their employment circumstances.

Orthodox macroeconomic theory struggles with the idea of involuntary unemployment and typically tries to fudge the explanation by appealing to market rigidities (typically nominal wage inflexibility). However, in general, the orthodox framework cannot convincingly explain systemic constraints that comprehensively negate individual volition.

The modern monetary framework clearly explicates how involuntary unemployment arises. The private sector, in aggregate, may desire to spend less of the monetary unit of account than it earns. In this case, if this gap in spending is not met by government, then unemployment will occur. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending.

The non-government sector depends on government to provide funds for both its desired net savings and its tax obligations. The private sector cannot by itself “net save” in the currency of issue because saving is a signal to lend and so savers are always in an accounting sense matched by a borrower

To obtain these funds, non-government agents offer real goods and services for sale in exchange for the needed currency units. This includes, of-course, offers of labour by the unemployed. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

The same commentator that wants us to read Jefferson and Madison said (this is part of the comment I split):

Can I ask what is wrong with unemployment. Were the government to uphold the law and allow business to fail then recession would occur, people would become unemployed. This is great because they would then need to reskill into areas that produce things that people need/want. Instead we have this sick attitude that everyone is entitled to work without first trying to determine what they should do. In otherwords: here I am world – give me a job or else. Thus instead of a self correcting system we have big bother leading us straight off the cliff into a centrally controlled command economy.

As soon as I read statements about falling off cliffs into a centrally controlled command economy (excusing the tautology) I realise there is no debate possible here. But let me say that modern monetary theory has nothing to say about how resources should be allocated. It just points out the consequences for the economic system if you choose certain paths against others.

It shows what opportunities a national government has – and leaves it to the political process to determine how they use those opportunities. That is a lot better than theories that tell us nothing about what the consequences of different government fiscal positions are (for example, pure credit economy analysis) or that tell us lies about these policy choices (for example, the entire edifice of mainstream neoclassical theory).

Further, you might think that this is a desirable socio-economic goal for government to aspire to. For those who worry about resource allocation and efficiency (the typical mainstream economist) it always surprises me how they can advocate policies that create persistent unemployment. The daily loss of GDP that arises when there is high unemployment is staggering and dwarfs the so-called microeconomic inefficiencies (like ports not loading quite as fast as they might, or transport systems not being very well coordinated).

Yet the mainstream seems obsessed with deregulation and privatisation to address these alleged microeconomic malfunctions while closing their eyes to the massive loseses arising from unemployment.

Unemployment is also the single-most significant cause of poverty among workers. A business that collapses typically does not generate poverty for its owners. Why someone would think it reasonable to tolerate unemployment in this context is beyond me. But then the whole “trickle-down” mentality can only work as long as there are impoverished souls who want to claw their way up. So given this is mainstream thinking I suppose it makes sense to them to maintain an underclass.

The wider social issues also have to be considered – family breakdown, increased strain on the criminal justice system, increased substance abuse, increased incidence of mental health disorders, increasing incidence of general health issues and more. But mainstream economists make it an artform to ignore all of those costs (probably until they are implicated personally).

My perspective says that we should evaluate decisions in terms of broad social costs and benefits (which include everything in addition to private costs and benefits). That is, the natural environment costs are included along with the mental and happiness type costs. While mainstream economics has a few paragraphs in the standard textbooks about externalities the matter is usually dismissed as a failure to specify property rights correctly and enforce them in the market. This misses the boat entirely.

Anyway, what all this means is that to maintain high levels of employment and given that the public generally desire to hold some reserves of fiat money, the government balance will normally have to be in deficit.

I find the concept of a budget surplus to be often misunderstood. Deficits are popularly constructed as “gaping holes in the fiscal bucket”. The problem is that there is no hole because there is no bucket. To explain this we need to understand what happens when the sovereign government runs a budget surplus.

One of the themes I have picked up throughout the comments is that we need less debt! Public or private. Steve, himself, is on the public record as saying this. My public position is that we need less private debt at present and the household saving ratio has to rise back to where it typically has been after being squeezed for years by budget surpluses and the financial engineering “miracles”. But that will require expanding fiscal deficits.

As long as our governments hang onto these irrational and totally futile rules (some legal and some just imposed by choice – although the legal constraints can also be amended) – that it has to issue debt $-for-$ to match net spending – as if it was still operating in a gold standard convertible currency world – then the rising fiscal deficits will be accompanied by rising public debt.

I don’t see that as a problem. The problem I see is that they are so stupid to be doing it – driven by blind neo-liberal ideology only. That is the debating question – not the solvency of the position. Public debt is not akin to private debt in any way and so I reject the hysterical comments that invoke terminology like “cancer”, “invasions of our freedom” and manic statements along those lines.

For these commentators to be advocating the reduction of public debt, under current institutional arrangements, then they must also be advocating that national governments will have to run budget surpluses.

What modern monetary theory tells you – $-for-$ – is that if the government tried to do that and succeeded – then the non-government sector would be running increased deficits (building debt).

Debt-deflationists cannot escape that fundamental national accounting rule. It is not my opinion. Let me repeat that: whenever you argue that you want public debt to fall (under current institutional arrangements) you must be advocating the increase in non-government debt – or total stagnation. One or the other.

It would be a much better and consistent position to recognise as modern monetary theory demonstrates that if you want the non-government sector to net save in the currency of issue (which would be required to reduce private debt) then net public spending has to match (and finance) that saving. If you also do not want public debt to rise, then you would have to support at least some of the operational guidelines I outlined in this blog – Operational design arising from modern monetary theory . There I show why it would be better if we abandoned these voluntary, ideologically-driven rules and stopped issuing any government debt at all (at a national level).

The debt-deflationists should be happy with that although I am sure many of those on the right will then challenge the notion of any net public spending at all. Then they are just in a losing position unless they can discover a very valuable resource/product to export and keep the economy afloat via massive net exports. But not all countries can do that by definition and so it cannot be a general solution to their concerns.

I also detect a thorough misunderstanding out there about what budget surpluses actually constitute. It is often argued that the surplus represents “public saving”, which can be used to fund future public expenditure.

With the current decline in government revenue and the need for a dramatic fiscal injection to underpin aggregate demand, many commentators are erroneously claiming that the Government will run out of funds and will have to postpone or abandon its much-touted infrastructure development plans, including the upgrade of the broadband network.

This spurious assertion is rehearsed across TV, radio and written media all over world. I picked up a similar sentiment in many of the comments on Steve’s blog, all of which were from readers who probably do not regularly read my blog.

In rejecting the notion that public surpluses create a cache of money that can be spent later, I note that government spends by crediting a reserve account. That balance doesn’t “come from anywhere”, as, for example, gold coins would have had to come from somewhere. It is accounted for but that is a different issue. Likewise, payments to government reduce reserve balances.

Those payments do not “go anywhere” but are merely accounted for. In the USA, for example, when tax payments are made to the government in actual cash, the Federal Reserve generally burns the currency notes. If it really needed the money per se surely it would not destroy it. A budget surplus exists only because private income or wealth is reduced.

In an accounting sense, when there is a budget surplus then either base money is destroyed and/or private wealth is destroyed (government runs down debt).

The budget surplus may be applied to running down debt (that is, forcing the private sector to liquidate its wealth to get cash) but this strategy is finite.

In recent years the Australian government followed the pattern of several sovereign governments and established the Futures Fund. This amounts to the Treasury competing in the private equity market to fuel speculation in financial assets and distort allocations of capital.

However, this behaviour has been grossly misrepresented as providing future savings. Say the sovereign government ran a $15 billion surplus in the last financial year. It could then purchase that amount of financial assets in the domestic and international capital markets. But from an accounting perspective the Government would no longer have run that surplus because the $15 billion would be recorded as spending and the budget would break even.

In these situations, the public debate should be focused on whether this is the best use of public funds. It would be hard to justify this sort of spending when basic infrastructure provision and employment creation has been ignored for many years by neo-liberal governments.

The alternative when a surplus is generated is to destroy liquidity (debiting reserve accounts) which is deflationary. The weaker demand conditions would force producers to reduce output and layoff workers with rapid increases in joblessness. Investment irreversibilities driven by uncertainty of future demand conditions then retard capacity growth and prolong the downturn.

So I wonder how many people really understand that the pursuit of public surpluses necessitates an increase in the net flow of credit to the private sector and increasing private debt to income ratios.

The current financial crisis is now evident that a threshold has been reached where the private sector, by circumstance or choice, becomes unwilling to maintain these deficits? It also means that reliance on rising indebtednesses to underwrite private spending is now unsustainable and an alternative growth strategy, based on fiscal expansion has to be introduced.

In terms of fiscal policy, there are only real resource restrictions on its capacity to increase spending and hence output and employment. If there are slack resources available to purchase then a fiscal stimulus has the capacity to ensure they are fully employed. While the size of the impact of the financial crisis may be significant, a fiscal injection can be appropriately scaled to meet the challenge.

This is why a modern monetary theorist will have no unease in saying that there is no financial crisis so deep that cannot be dealt with by public spending.

Another commentator raised the distributional struggle issues (Kalecki) among other things:

… how does the government to differentiate private sector demand for savings to pay for costs of production or purchase of assets (investments) to private sector demand for savings to pay for speculative motives. In my ignorance I fail to see how the latter is not unsustainable and furthermore what effect would increases of government currency have upon the demand for that currency, particularly when taxes stay at a static level?

On an aside point, how do Chartalists propose to overcome the barriers to full employment as raised by kalecki?

The government doesn’t have to make that distinction in designing fiscal policy. Modern monetary theory tells us that if the government wants to maintain high levels of output and employment then its net spending has to close the spending gap left by non-government spending decisions. Simple as that. What the private sector, for example, does with its non-consumption is another matter – not unimportant but separable from the fiscal policy issue.

On the Kalecki point – which is that the “captains of industry” hate full employment because it undermines their power if everyone has a job I would suggest you read this paper that I wrote in 2000. It has been subsequently published in Journal form but you will get it for free this way.

The relevant Kalecki reference is Michal Kalecki, ‘Political Aspects of Full Employment’, In Selected Essays on the Dynamics of the Capitalist Economy, by Michal Kalecki, pages 138-145. Cambridge University Press, 1971. The original paper was written in 1943s.

Note that the analysis advocates a Job Guarantee rather than the government creating full employment by competing against private firms for labour at market prices.

In that context, I offer the following. Michal Kalecki’s 1943 paper published as the “Political Aspects of Full Employment”, in the Political Quarterly, laid out the blueprint for socialist opposition to Keynesian-style employment policy. The criticisms would be equally applicable to a Job Guarantee policy. Kalecki (1971: 138) said, “the assumption that a Government will maintain full employment in a capitalist economy if it knows how to do it is fallacious. In this connection the misgivings of big business about maintenance of full employment by Government spending are of paramount importance.” The alleged opposition by big business to full employment mystified Kalecki because the higher output and employment would seemingly be of benefit to workers and capital alike.

Kalecki (1971: 139) lists three reasons why the industrial leaders would be opposed to full employment “achieved by Government spending.” The first is an assertion that the private sector opposes government employment per se. The second is an assertion that the private sector does not like public sector infrastructure development or any subsidy of consumption. The third is more general and involves a dislike by the private sector “of the social and political changes resulting from the maintenance of full employment”.

One is tempted to respond to Kalecki with the reference to the long period of growth and full employment from the end of WWII up until the first oil shock (excluding the Korean War). Most economies experienced strong employment growth, full employment and price stability, and strong private sector investment over that period under the guidance of interventionist government fiscal and monetary policy. This period of relative stability was only broken by a massive supply shock, which then led to ill advised policy changes that provoked the beginning of the malaise we are still facing after 25 years. In Kalecki’s defense it might be argued in reply that it took 30 odd years of the Welfare State to generate the inflationary biases that were observed in the 1970s (Cornwall, 1983).

Kalecki (1971: 139-140 explains how the dislike by business leaders of government spending “grows even more acute when they come to consider the objects on which the money would be spent: public investment and subsidising mass consumption.” If public spending overlaps with private spending (the classic example is toothpaste) then “the profitability of private investment might be impaired and the positive effect of public investment upon employment offset by the negative effect of the decline in private investment.” (Kalecki, 1971: 140). Business leaders will be very well suited according to Kalecki if there is no such overlap. But ultimately the government will want to move towards nationalisation of industries to broaden the scope for investment. This criticism is inapplicable to a buffer stock route to full employment. JG jobs are most needed in areas that have been neglected or harmed by capitalist growth. The chance of overlap and therefore substitution is minimal. Of-course, I am not arguing that as an industry policy the government may deliberately target an overlap to drive inefficient private capital out.

Kalecki (1971: 140) acknowledges that the “pressure of the masses” in democratic systems may thwart the capitalists and allow the government to engage in job creation. His principle objection then seems to be that “the maintenance of full employment would cause social and political changes which would give a new impetus to the opposition of the business leaders.” The issue at stake is the relationship between the threat of dismissal and the level of employment. Kalecki (1971: 140-41) says:

Indeed, under a regime of permanent full employment, ‘the sack’ would cease to play its role as a disciplinary measure. The social position of the boss would be undermined and the self assurance and class consciousness of the working class would grow.

Kalecki is really considering a fully employed private sector that is prone to inflation rather than a mixed private-Job Guarantee economy. The Job Guarantee creates loose full employment rather than tight full employment because the buffer stock wage is fixed (growing with national productivity). The issue comes down to whether the JG pool is a greater or lesser threat to those in employment than the unemployed when wage bargaining is underway. This is particularly relevant when we consider the significance of the long-term unemployed in total unemployment. It can be argued that the long-term unemployed exert very little downward pressure on wages growth because they are not a credible substitute. The JG workers, however, do comprise a credible threat to the current private sector employees for reasons noted above.

The Job Guarantee pool provides business with a fixed-price stock of skilled labour to recruit from. In an inflationary episode, business is more likely to resist wage demands from its existing workforce because it can achieve cost control. In this way, longer term planning with cost control is achievable. So in this sense, the inflation restraint exerted via the the Job Guarantee is likely to be more effective than using a NAIRU strategy.

The International Labour Organisation (1996/97) says, “prolonged mass unemployment transforms a proportion of the unemployed into a permanently excluded class.” As these people lose their skills, warns the ILO, they are no longer considered as candidates for employment and “cease to exert any pressure on wage negotiations and real wages.” The result is that “the competitive functioning of the labour market is eroded and the influence of unemployment on real wages is reduced.”

In what form does Kalecki see the opposition by capitalists coming? I am leaving aside the political rationale where presumably funds directed to sympathetic political parties and control of the media could all be effective means to oppose an incumbent government. He is very vague about what might transpire. Kalecki (1971: 142-143) outlines that counter-stabilisation policy is not a concern of business as long as the “businessman remains the medium through which the intervention is conducted.” Such intervention should aim to stimulate private investment and should not “involve the Government either in – (public) investment or – subsiding consumption.” Kalecki (1971: 144) says if attempts are made to “maintain the high level of employment reached in the subsequent boom a strong opposition of ‘business leaders’ is likely to be encountered. As has already been argued, lasting full employment is not at all to their liking. The workers would ‘get out of hand’ and the ‘captains of industry’ would be anxious to teach them a lesson.”

But how would they do this? Kalecki seems to imply that the reaction would work via business and rentier interests pressuring the government to cut its budget deficit. Presumably, corporate investors could threaten to withdraw investment. An examination of the investment to income ratio in Australia over the period since the 1960s is instructive. History tells us that the investment ratio moves as a mirror image to the unemployment rate, which reinforces the demand deficiency explanation for the swings in unemployment. The rapid rise in the unemployment rate in the early 1970s followed a significant decline in the investment ratio. The mirrored relationship between the two resumed albeit the unemployment rate never returned to its 1960s levels. Far from being a reason to avoid active government intervention, the Job Guarantee is needed to insulate the economy from these investment swings, whether they are motivated by political factors or technical profit-oriented factors.

Another factor bearing on the way we might view Kalecki’s analysis is the move to increasingly deregulated and globalised systems. Many countries have dismantled their welfare states and enacted harsh labour legislation aimed at controlling trade union bargaining power. Trade union membership has declined substantially in many countries as the traditional manufacturing sector has declined and the service sector has grown. Trade unions have traditionally found it hard to organise or cover the service sector due to its heavy reliance on casual work and gender bias towards women. It is now much harder for trade unions to impose costs on the employer. Far from being a threat to employers, the JG policy becomes essential for restoring some security in the system for workers.

There have been major reductions in barriers to international trade and global investment over the last 20 years. While globalisation may still not have as large an impact on depressing wages as say the effects of declining union membership, anti-labour legislation and corporate restructuring, there is still concern about the destruction of jobs in manufacturing and the downward pressure on wages.

Models – dynamic, differences, differential and otherwise

There seems to be a lot of worship of formal modelling among the commentators. I agree that formal modelling has a place and as Steve knows my work gets technical at times.

But there was an undercurrent in the comments that sometime emerged as absolute assertions that modern monetary theory is not based on any formality. In this regard, I thought the observation by regular billy blog commentator, Ramanan was excellent:

… In the work of Wynne Godley and Marc Lavoie, they have indeed modeled the world dynamically. They use difference equations instead of differential equation but seems fine by me. In their text “Monetary Economics”, the model in Chap 11, there is no equilibrium and of course they never make a profit maximising assumption. They have good features such as the future being path dependent. The various “experiments” they do in their text seems very connected to the real world to me.

Then Steve’s response interested me:

Yes, but there are problems with their difference equation approach that I discuss in this paper. There are three basic problems: (1) difference equations should have different lags for different variables (a 2 week lag for consumption, a 52 week lag for investment for example) but because it’s so difficult to do that, everyone uses the same lag (one period) for variables that change at very different frequencies; (2) artificial lags are sometimes needed for variables that don’t require them to avoid algebraic loops …; and (3) it introduces false dynamics from the synchronicity it imposes on unsynchronised variables.

That’s why I’m campaigning to introduce economists to differential equations. There are many other good reasons too which I’m sure the engineers here could detail.

The problem with using differential equations in an economic setting is that the economic world is not continuous. Neo-classical models also use continuous time and that violates our understanding that time is an important aspect of uncertainty. This is one of the essential starting elements of Post Keynesian thought which condition the underlying approach of modern monetary theory.

In the words of John Archibald Wheeler:

Time is nature’s way of keeping everything from happening at once. Space is what prevents everything from happening to me.

Further, differential equations ignore the reality that things happen at discrete intervals and that intervention effects occur. For example, once you add government policy interventions, unless you are going to assert Ricardian type responses that are underpinned by rational expectations then you have to realise the these intervention effects are significant and cannot be fully grasped in continuous time.

But moreover, I find it quite curious that the commentators regularly applauded the formality of Steve’s work as something that gives it insights over modern monetary theory when I assume the vast majority of the them would have very little inkling of the underlying mathematics, computational algorithms and economics being modelled. This is not a criticism of Steve’s approach per se. Just a reflection.

It is interesting because the appeal to formality is also the way the mainstream neo-classical economists claim authority even though the vast majority of their analysis is of a garbage in-garbage out variety.

Further an abstract pure credit economy model is very incomplete no matter how well it is modelled and I find it curious that many commentators appear happy to accept that the conclusions from a model of that type and think they are applicable to the real world we live in. I think Steve has agreed he has a stylised model.

I think his challenge is as I noted above – is to integrate his credit economy into a properly specified modern monetary framework which has a complete sectoral specification and obeys accepted accounting conventions and produces perfect stock-flow consistency. I agree with JKH, I think that will be difficult unless major changes in the accounting approach are to be made.

But finally I would offer this on the modelling front and regular readers of my blog will have read my view on this before.

If we could find a real-world laboratory to “test” the extremes of modern monetary theory then that would be superior to a Mathcad (Steve), Matlab (Bill) modelling environment where for tractability reasons alone the models are simplified. We would overcome all the difference versus differential arguments. We would not be debating whether one accounting rule was preferred when everyone else uses another.

So a real-world example would allow us to view a true fully-specified dynamic model that encompasses the entire set of processes and their feedbacks.

We have such a real-world example which provides us with the ultimate non-linear “dynamic model”. I encourage readers to become closely acquainted with the last 20 years of history in Japan.

This real world demonstration of how a fiat monetary system behaves should guide all of us because it demonstrates the veracity of a number of fundamental elements of modern monetary theory and debunks all of the fundamental elements of mainstream macroeconomics.

If the debt deflationists are eschewing public debt issuance (Japan had this at very significant levels) and also consider on-going budget deficits to be inflationary (Japan had huge daily deficits over this period) then they are closer to the halls of orthodoxy than they would like to think.

They have clearly not embraced the logic and operational reality of modern monetary theory that the historical experience of Japan demonstrates. Huge deficits, huge public debt, zero overnight interest rates, very lower longer-duration interest rates, and zero and sometimes negative inflation.

You will find some of my detailed analysis of Japan in this blog – The impact of government on reserve dynamics ….


That should be enough to go on with. I still have to respond to the comments about employment guarantees. I may or may not respond to them given that many are not really comments but rants against the government etc.

To all those who have revealed they are living in daily fear of a command-economy coming down on them like a tonne of bricks I offer this advice – go out in the sunshine and do some sport or something. The fears will pass.

Thanks also to the constructive contributions that have been received. I think the debate idea is sound.

And Sean – I will definitely respond to you on asset bubbles. Think tax policy though not monetary policy.


When reading about modern monetary theory I suggest the following procedure:

  • Forget who you are.
  • Forget what you think of government – good or bad – unless you are going to be able to get rid of government (that is, establish pure communism) you are stuck with it.
  • Forget what you think of social policy – you may hate the unemployed or you may feel compassion – forget all emotions.
  • Forget what nation you live in – it doesn’t matter.
  • Forget all prior economic concepts and training (if any).
  • Then just try to understand what you read.

This Post Has 22 Comments

  1. Bill,
    if the JG pool is to provide industry with workers at a fixed wage, what I’m failing to understand despite the outlines above is why private industry cannot arbitrage that. Consider two cases:

    For example, a recession happens and a skilled and highly paid engineer gets laid off. Without the JG and fiscal stabiliser, this guy is going to find it very hard to get back into work. Then along comes the JG, and offers this individual to private industry at a very low cost, which instantly threatens his currently employed peers, and leaves his former bosses rubbing their hand with glee.

    Now, if an 18 year old school leaver with one year experience of washing windows gets laid off, this guy is hardly a threat to any employed individual in the window washing business firstly because the wage differential between experienced and novice window washers is less than the differential between experienced and novice engineers, and secondly because window washer wages were already closer to the JG wage than the engineer wage was in the first place.

    THis objection seems so obvious that I feel I must be missing some essential aspect of the JG scheme porposal.

  2. Scepticus . . . the JG offers a job at a fixed wage; it doesn’t “offer this individual to private industry at a very low cost.” The basic point is that instead of having a 0 wage offer for the unemployed, they automatically have the fixed wage offer.


  3. Dear Bill,

    I’ve been lurking for a while on Steve Keen’s blog, attempting to understand the GFC as an economic layman. I applaud both of you for your full and frank exchange of views, as there is an obvious risk for an academic of being caught saying something stupid in public.

    I’ve only just started reading the material on your blog, so maybe I shouldn’t be saying anything, but I have two comments on your most recent post.

    1. Although I can see arguments for against differential vs difference equations, I don’t understand the assertion that “differential equations ignore the reality that things happen at discrete intervals and that intervention effects occur.” Free variables (inputs) in a system of differential equations can change discretely and instantaneously. An example might be the interest rate set by a central bank.

    2. Although consistency (and hence in this case double-entry book keeping) is a necessary prerequisite of a correct model, it is equally true that a tautology can’t tell us anything new. To be more specific, if I enforce consistency on the wrong parameters, my results may not be valid. The particular case I’m thinking of is your explanation of the mediaeval miller example: “If the miller defaults, the person eventually writes off asset (bad loan) by crediting the miller’s loan account and simultaneously debit (decrease) the allowance for doubtful debt account (which is typically a contra account in the current asset section of the balance sheet).”

    Notice that the loan is ‘eventually’ not instaneously written off. So what should we consider here, the situation given by the official accounts, or that “on the ground”? The latter may have real effects, but it is not measured in a timely fashion in the statistics. The obvious example real-world would be banks refusing to lend, while hiding loan losses off-balance-sheet. If you enforce consistency based on published statistics, you risk hiding real and important phenomena.

  4. Bill/Scott: from the paper by bill at:


    “The JG wage sets a
    floor in the economy’s cost structure for given productivity levels. The dynamics of the
    economy change significantly. The elimination of all but wait unemployment in Sector A
    and frictional unemployment does not distort the relative wage structure so that the wagewage
    pressures that were prominent previously are now reduced. But the rising demand
    softens the product market, and demand for labor rises in Sector A. There are no new
    problems faced by employers who wish to hire labor to meet the higher sales levels. They
    must pay the going rate, which is still preferable, to appropriately skilled workers, than
    the JG wage level. The rising demand per se does not invoke inflationary pressures as
    firms increase capacity utilization to meet the higher sales volumes.”

    I think the issue with this is that firms who employ significant numbers of workers at wages near the sector B fixed wage, they will find it harder to discpline those workers, because there is a significant indifference factor for the sector A worker near the sector B wage level. For example, a pushy boss could tip the balance if the salary differential between A and B is minimal for this worker. Or it may be preferable to work out of doors on forrestry projects for a B wage than work in a chicken factory for a B+ wage.

    I’d anticipate in this case some kind of ‘gap’ between A and B wages in which private employers can’t be sure of the loyalty of their employees. This gap would fluctuate with the household saving rate.

    My point has been on this subject that the JG wage represents an arbitrage in the labout market, and that this will always manifst itself in some for or another, leading to unintended consequences. Perhaps this oculd possibly be smoothed with welfare payments designed to eliminate this arb somehow?

  5. Hi bill,

    in this article you say…..”The capacity to service debt is always dependent on the capacity to earn income and that mostly varies with employment. Those who see debt as “cancer” fail to grasp this point.”

    In the chartilist or modern monetary economy we live under, does the govt not have the power to ensure that people are always able to service default and don’t ever have to default ? I use the example of govt. schemes to protect borrowers who fall behind with mortgage payments and more pointedly govt. zero interest rate policy, and by extension govt guarantees to insure banks against loan losses. therefore for the borrower and lender govt. act as a not so invisble hand to save them from themselves. Are any lessons learned from such ‘bailouts’ ? surely it’s better in some respects to have this neoliberal boom-bust cycle because it clears out a lot of the excess buildup of hubris from periods such as the current age of moderation and the taming of interest rate period. these periods lull those into a false since of security, and i would have to say irrational exuberance.

    make no mistake, i don’t wish for high levels of unemployment and bankruptcies, but neither is govt. intervention exactly a level playing field ? here we go back to savers as losers, variable rate highly leveraged mortgage holders as winners. Plus banks as winners.

    Doesn’t the govts. ability to act in this way, by not being revenue constrained, leave us in a tricky situation. A govt. could chose to ‘bailout’ or ‘intervene’ during difficult periods as is the case during this recession, but not actually address any of the fundamental challenges that exist that create private debt buildup and eventual recession. In other words, the very matter of fact national accounting rules are used/abused by partisan politicians. that i find scary.

    i think what’s best for the global economy is we get a japan situation for the next decade. But such is the desperation to return to ‘normal’ to return to supposed neutral rates of interest, to address the fiscal budget balance……that eventually we’ll be lulled back into the situation that existed in the early part of the decade and a private sector debt fallout which will require even greater ingenuity from govt. to deal with. And next time they’ll be even more confident in being able to address any situation with fiscal and monetary policy.

  6. “So, with private credit, there is BY DEFINITION no NET increase in private sector financial assets created.” The explanation provided is straightforward and understandable. It seems important to clarify that by “net” you mean assets minus liabilities (which fits with your strong focus on accounting technique). There are other meanings of net asset change that to most of us are equally important (and not contradictory) to your angle on net asset change. Perhaps the most critical in real economic events is the net change in a set of (or in aggregate) assets (and their matching liabilities) over time. This seems so basic and obvious as a central factor in issues like credit growth or contraction, production and consumption growth or contraction, and its effect on inflation, disinflation, or deflation. If total assets and liabilites have increased (or decreased) over a given period of time by a factor of 5 or 10, that is possibly much more important to the analysis of these issues than simply reasserting that the assets and liabilities balance. Perhaps you could discuss this “net change in assets over time” as it relates both to modern monetary assertions about “net asset change in private sector finance” and as it relates to the major business cycle and secular credit and money patterns that are observed to occur.

  7. “Say the sovereign government ran a $15 billion surplus in the last financial year. It could then purchase that amount of financial assets in the domestic and international capital markets. But from an accounting perspective the Government would no longer have run that surplus because the $15 billion would be recorded as spending and the budget would break even.” This reasoning appears to contradict all the (accurate) statements you make that if X amount of an asset (and cash receipts are an asset in accounting) is exchanged for X amount of another asset (and financial assets in the domestic and international capital markets are an asset in accounting), there is NO net change in assets. Now you’re calling that exchange “spending” and stating that the surplus (in the form of an asset) has suddenly disappeared. I’m confused!!

  8. Michael at 9:26

    You are referring to the horizontal expansion of credit, which is undoubtedly extremely important. We haven’t neglected it whatsoever or tried to minimize its importance . . . Bill linked to some posts on this topic in this piece. But Steve already models this and discusses it at length on his blog; the chartalist focus was integrating this with the government/central bank sector, or the “vertical component,” which has generally been neglected by everyone but us, in our view. The total literature is wide ranging and it’s essentially impossible to touch on everything in a 1000 word summary or even a few follow up posts. That some things haven’t been our focus the past few days doesn’t mean we haven’t addressed them at perhaps even great length in the past.


  9. Let me put it another way: In accounting, if you take in $15 billion in cash from taxes (or any other revenue source) that you then “spend” on $15 billion in financial assets (or any other asset), your bottom line is zero WITHIN THE CONFINES OF THE INCOME STATEMENT. But, the explicit function of a reserve fund is to save, not spend (at the moment). On your BALANCE SHEET you have added an asset of $15 billion with no offsetting liability, which gives you a net asset balance of +$15 billion. Those assets can be sold when you you need that reserve for spending purposes, zeroing out the balance sheet at that time. When you liquidate the asset (reverting it to cash) and spend the cash, the income statement will again net to zero. At that point, both income statement and balance sheet will be net zero – but the balance sheet will have been positive until that point, non-trivially giving you the option you were seeking, which is to set aside cash received today for future use We’ll ignore the possibility that you may earn interest or capital gains on your initial investment of your asset and thus have more asset (convertible to cash) at the end of the reserve funding period than you did at the beginning, which seems to matter to the Chinese, Norwegians, Gulf States, Social Security Trust Fund, and others. Now, one can state that, because it’s the government who prints currency, and all currency is a liability of the government, any assets accumulated by the government which are denominated in the currency are also liabilities. But if you go there you are not only skirting with tautology, you are then stating that one set of accounting rules applies to the private sector and a separate set of accounting rules applies to the government, and that would be disastrous for your theoretical approach, so I don’t think that’s what you mean. Please explain.

  10. Michael

    The Treasury’s balances at the Fed or in correspondent bank accounts (an asset) were debited $15B, and the $15B in financial assets was credited. Net change to asset side =0. Net change to liability/equity side =0.


  11. “Notice that the loan is ‘eventually’ not instaneously written off.”

    Don’t confuse the REAL asset and the FINANCIAL asset. The financial asset is the promise to pay in the future. WHETHER OR NOT the loss in the ability to meet that promise is accounted for promptly, the first financial loss is realized with the first promised payment that is no made.

    And there is ALWAYS some degree of intrinsic uncertainty whether there shall be an ACTUAL ability by a private party to meet the promise when it falls due – the only certain payment is the one that has already been made. So even if a future promise is accounted for PRO FORMA as certain to be paid, it is in actuality always contingent until the payment has been made.

    Indeed, take the Viking Invasion scenario out of the way and say that a new canal has been opened which allows farmers in the region to go to get their grain milled at a large Windmill which buys wheat at a higher price and sells flour at a lower price than the local miller can compete with. The loss of INCOME by the local miller can just as easily make for an inability to repay the loan.

    Because such losses will occur, there has to be a means of managing the handling of those losses, but whatever the means, whatever credit has been lost by one side will be a liability that has been removed from another side.

    And, indeed, consider the Viking Invasion scenario where the Vikings have stolen the gold for the miller, but in the next village over the miller who had not gold to hand over had his mill destroyed. The Miller with the operating mill and the local monopoly may well be in a better position to generate income to meet his liability, even though the money lent for improvements or to enable the miller to engage in lucrative grain speculation was stolen before it could be put to use. Provided the loan is repaid, the fact that the income opportunity that the money was to buy has been lost and the new income comes from a different income opportunity is immaterial for the value of the financial asset of the promise of the miller to repay the loan.

  12. Micheal, Thursday, October 1, 2009 at 12:50

    “but the balance sheet will have been positive until that point, non-trivially giving you the option you were seeking, which is to set aside cash received today for future use”

    So on the one hand, the government “gains” the ability to retire cash today and generate the cash in the future by swapping cash for financial assets with private holders of financial assets, and then swapping the financial assets for an uncertain amount of cash at some time in the future by selling to private holders of cash.

    Except when it is the government doing it, it can simply retire the cash today, and generate the cash in the future, removing speculation on whether the government will be buying or selling a particular variety of financial asset at some time in the future from the system, and accomplishing precisely the same thing it was going to accomplish with the cash at the future date.

    Now, from the perspective of traders in financial assets who gain transactions income from selling the assets to the government on behalf of clients and transactions income from buying the assets from the government on behalf of clients – the appeal is obvious. From the perspective of speculators, who gain from increases in volatility of prices of primary financial assets because of the resulting demand for hedging of that risk – the appeal is obvious.

    What is less obvious is what the public gains from the government doing by such a round-about method what it can accomplish directly.

  13. Dear Michael

    You said:

    Say the sovereign government ran a $15 billion surplus in the last financial year. It could then purchase that amount of financial assets in the domestic and international capital markets. But from an accounting perspective the Government would no longer have run that surplus because the $15 billion would be recorded as spending and the budget would break even.” This reasoning appears to contradict all the (accurate) statements you make that if X amount of an asset (and cash receipts are an asset in accounting) is exchanged for X amount of another asset (and financial assets in the domestic and international capital markets are an asset in accounting), there is NO net change in assets. Now you’re calling that exchange “spending” and stating that the surplus (in the form of an asset) has suddenly disappeared. I’m confused!!

    Assume today the government ran a surplus. It would do the same tomorrow but instead it builds a much need public hospital and spends more than it gets back in taxes. The result – budget deficit and much needed public
    asset. Private sector builds the hospital enjoy the injection of aggregate demand and employment rises.

    Now the third day, instead of spending on a public good or running a surplus, it buys a share in a company. The result – budget deficit and the ownership of a speculative asset with no public good value. Perhaps some private asset inflation to the benefit of the shareholders.

    Neither decision (day 2 or day 3) provide the government with any more or less capacity to spend more than they tax (or less) on day 4. On both days 2 and 3 new net financial assets have been created and on day 2 turned into a hospital.

    A sovereign fund is just the stock that results from government spending. It provides no extra capacity for the government to spend in the future. The debate then should be about which option – day 2 or day 3 – is the preferred strategy for government spending.

    best wishes

  14. Dear Tricky

    Another good contribution. In financial terms, it is true that the national government has the capacity to reduce all nominal financial losses as a result of this crisis to zero. They could easily top up all the superannuation funds, pay the default payments on the bad debts with one or more computer entries. The cheques (bank credits) would all be 100 per cent sound and apart from the huge redistributions that would going on – life would go on.

    But to recognise that is one thing, another thing is to think it is desirable social policy (remember I think governments should only advance public purpose and if private benefits coincide then all the better).

    So then it comes down to debating the particular form in which the government fiscal powers should manifest. I would argue (and I suspect you would agree) that the policies chosen to date (particularly in the US) have redistributed massive volumes of public spending to the top end of town at the expense of the poor. When real wages are static and unemployment and poverty is rising while at the same time the big investment banks are resuming their profit bonanza, safely contoured by the government bailouts then I think something is very wrong. This is poorly targetted and designed policy.

    So being a modern money supporter does not then automatically mean you agree with the composition of the spending. Far from it. I would allow some of the banks to disappear and many of the high-cost, low-productivity operations to die. But I would take this opportunity to use the government fiscal capacity to restore some of the degraded public goods which have suffered under the neo-liberal cutbacks. I would invest heavily in people – education, skills development, research.

    I would invest heavily in job creation in renewable energy production etc. I would have a Job Guarantee so lowest paid workers who have lost their jobs have recourse to meaningful public sector work and can therefore avoid poverty. This work would be in a range of personal care, community development and environmental care services. There is a huge need for those activities to be resourced.

    I don’t consider it to be the role of government to bailout failed industries and underpin their lack of investment and risk management.

    So I don’t think we are that far away from each other.

    best wishes

  15. Dear DNM

    You are correct in pointing out that differential (continuous-time) equation models can cope with policy interventions. The point I was making is that when the data you are trying to describe is discrete, and the economic behaviour is influenced by the announcement and intervention effects involved in that discreteness then differential equation models are problematic in several ways. The so-called passing problem – trying to render the continuous time discrete to allow one to generate discrete time data (that is, to comment on the real world) is on such issue.

    I am not against differential equation modelling. But both types of dynamic modelling have their advantages and disadvantages. But when you are trying to bring insights to bear on real-world data which is very discrete and there is an institutional structure (of expectations and behaviours) built up around that periodicity then I prefer to use difference equations.

    On your second point, I think Scott and Bruce have addressed it adequately.

    best wishes

  16. hi bill

    thanks for the reply. I don’t think we are that far way in viewpoint certainly, your ideas sound perfectly reasonable to me.

    but can i ask…… you approve of the so-called ‘cash for clunkers’ type schemes that exist in the US and UK and elsewhere, where a struggling auto industry is given a shot in the arm via a govt. subsidised scrappage scheme. So owner of old vehicle gets a x thousand dollar rebate toward the price of a new car in return for scrappng an $800 10-year old motor ?

    On the one hand i see the benefits, or purpoted benefits. Although it’s clearly about supporting auto industry sales with the environmental issues secondary. But can this type of scheme not also be viewed as a bailout of a failed industry, or rather an industry with an outdated business model in many instances which above all else relies on the cheap and easy access to credit availablilty to it’s customers.

    that’s not to mention the market distortion of the second hand car market that can be created by taking thousands of old cars off the road…., and the inevitable extension of these schemes to cover ‘nearly new’ vehicles and non-dealerships.

    playing devils advocate, would it not be better to not have an industry wide prop such as this, and to provide incentive to viable car manufactuerers but allow the weak car manufacturers to fail or force them to make the necessary changes to stay afloat. Many of the major economies are moving away from this type of mass production production line jobs anyway, and any unemployed can be reskilled back into true demand areas of the economy. It seems keeping auto industry jobs is the last nod to the traditional manufacturing sector job dominance which the politicians want to hold on to becuase of the negative press reaction.

    ofcourse finding other jobs for thousands of redudandant auto workers would require the dreaded ‘retraining’ but if the govt. was doing it’s job properly, it would satisfty the need or create the demand for jobs in areas in public infrastructure or public services. so making people redundant from faltering companies/industries needn’t necessarily mean leaving people on the scrap heap of un.employment.

    it’s striking a balance between what the market is deciding, what intervention to take as a result and the most benefiial social programs to invest in.

  17. “I think reading this blog – Money multiplier and other myths – will help you understand this point.”

    Thanks Bill – I will; and follow up on other links you have provided above. Have since read ‘Operational design arising from modern monetary theory’ and Parts 1~3 of ‘Deficit Spending 101’. Are there other papers in the get a basic understanding kitbag that you would recommend? Or authors?

    Thanks heaps for everybody’s efforts in this blog. Cheers …


  18. In the words of John Archibald Wheeler: Time is nature’s way of keeping everything from happening at once. Space is what prevents everything from happening to me.

    Good quote. Wheeler also said that Time is defined so that motion looks simple.

    Another physics analogy supports this. Kenneth Wilson, another physicist championed the technique where we look at physics scale by scale. The description of the macroscopic world such as footballs, planets do not depend much on the microscopic details. Even though I am used to studying things using differential equations, in my opinion, the marginal utility of studying Macroeconomics at infinitesimal intervals (i.e., using differential equations) is not much. Unlike the financial markets, the real economic world does not move so rapidly. Hence there is hardly an issue in studying it using the technique of difference equations. Also, difference equations have the advantage of being intuitive all the time.

    Having said that, I should add that my analogy with Physics ends there. In my opinion, Econophysicists should go take a walk.

  19. I should add that one advantage of differential equations in this context is that they look neater.

  20. Dear Ramanan

    Good points. I noted on Steve’s blog yesterday a comment that said that his model was not a pure credit model because there was “fiat money” (presumably dropped by a helicopter) as starting endowments. I didn’t explicitly comment on it (ran out of time) but the relevant issue is to ask how have these net financial assets embodied in this “fiat money” been created and accumulated? Vertical transactions have cumulative effects on the non-government sector which have to be taken into account. Merely dropping some money at some point in time on a world is not remotely akin to tracking in a stock-flow consistent way the interaction between the fiscal balance (or central bank monetary operations) and the non-government balance (decomposed into its parts). Helicopter drops are what Milton Friedman and co did in their models to motivate “money” entering their stylised world but they paid no attention to the stock-flow impacts.

    best wishes

  21. Bill,

    I think Steve seems to believe that “money” appears dynamically. This is just my speculation of what goes on in his mind – based on looking at some of his papers on his website. It is said that equities is not a zero sum game because a day trader can take a position in a stock in the morning and close it out at the last half hour of trading on the same day for a profit and a pension fund can buy it from the day trader and can also make money after selling the stocks after six months. However, even though, it is a good example, the content of the previous statement is just that much. One cannot extrapolate it for the whole monetary system.

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