It is at the pointy end of my blogs and won’t appeal to all. But if you really want to start understanding the quality of modern monetary theory then stock-flow accounting is a good place to start.<\/p>\n
What this framework allows you to understand is why the prevailing orthodoxy in macroeconomics has failed. The framework shows you that the mainstream belief that markets self-equilibrate at levels that are remotely socially acceptable is erroneous. Markets do not self-regulate in ways that avoid major financial upheavals and these crises have profound impacts on the real economy.<\/p>\n
In particular, the body of literature that is built upon the belief that fiscal policy should only be a passive support to an inflation targeting monetary policy is shown to be highly damaging to the long-term growth prospects of modern monetary economies.<\/p>\n
The current crisis confirms that the only way that the non-government sector can save is for the government sector to run continual budget deficits. The stock-flow framework allows you to understand why this fiscal conduct is non-inflationary and, if managed properly, exerts downwards pressure on nominal interest rates and underpins full employment.<\/p>\n
To understand how the modern monetary economy operates we need to take a step back into national accounting. First, a modern monetary system has three essential features:<\/p>\n
- \n
- A floating exchange rate, which frees monetary policy from the need to defend foreign exchange reserves).<\/li>\n
- A sovereign government which has a monopoly over the provision its own, fiat currency.<\/li>\n
- Under a fiat currency system, the monetary unit defined by the government has no intrinsic worth. It cannot be legally converted by government, for example, into gold as it was under the gold standard. The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.<\/li>\n<\/ul>\n
Within a modern monetary economy, as a matter of national accounting, the sovereign government deficit (surplus) equals the non-government surplus (deficit). The failure to recognise this relationship is the major oversight of neo-liberal (and Austrian) analysis.<\/p>\n
In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. The sovereign government via net spending (deficits) is the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save and hence eliminate unemployment.<\/p>\n
Additionally, and contrary to neo-liberal (and Austrian) rhetoric, the systematic pursuit of government budget surpluses is necessarily manifested as systematic declines in private sector savings.<\/p>\n
The decreasing levels of net private savings which are manifest in the public surpluses increasingly leverage the private sector. The deteriorating debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity. So you have to trace the private indebtedness back to the conduct of the government sector.<\/p>\n
The analogy neo-liberals (and Austrians) draw between private household budgets and the government budget is false. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.<\/p>\n
With that in mind, modern monetary theorists develop a theory of unemployment based on the conduct of fiscal policy (compare that the Austrians who emphasise excessive real wages). In a fiat monetary system, unemployment occurs when net government spending is too low. As a matter of accounting, for aggregate output to be sold, total spending must equal total income. Involuntary unemployment is idle labour unable to find a buyer at the current money wage.<\/p>\n
In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns.<\/p>\n
Nominal (or real) wage cuts per se<\/em> do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save. This is a fundamental mistake that neo-liberals (and Austrians make).<\/p>\n
For example, if you read the classic Austrians, such as Murray Rothbard, you will get this sort of claim in his Power and Market<\/a> (pages 204-205):<\/p>\n
\nUnemployment is caused by unions or government keeping wage rates above the free-market level.\n<\/p><\/blockquote>\n
And this gem from America’s Great Depression<\/a> (pages 43-44):<\/p>\n
\nGenerally, wage rates can only be kept above full-employment rates through coercion by governments, unions, or both. Occasionally, however, the wage rates are maintained by voluntary choice (although the choice is usually ignorant of the consequences) or by coercion supplemented by voluntary choice. It may happen, for example, that either business firms or the workers themselves may become persuaded that maintaining wage rates artificially high is their bounden duty. Such persuasion has actually been at the root of much of the unemployment of our time, and this was particularly true in the 1929 depression.\n<\/p><\/blockquote>\n
In a fiat monetary system where the government has currency sovereignty this analysis couldn’t possibly be true. More on this will appear in another blog.<\/p>\n
All of the modern monetary propositions can be understood within a flow of funds<\/em> framework which renders the underlying accounting between flows and stocks consistent. Mainstream economic models do not have stock-flow consistency and therefore fail to understand how the spending relations tie in with the wealth and other stock relations.<\/p>\n
Definitions<\/strong><\/p>\n
To understand the difference between a stock and a flow think of a bath-tub. The water in the bath is a stock – it is measured at a point in time. The water that comes into the bath (via the taps) and\/or out of the bath (via the sink) are flows and you measure them as a rate of water flow per unit of time. So many litres per minute.<\/p>\n
If the inflows are stronger than the outflows the water level in the bath will rise and vice-versa. In other words, flows add to and subtract from stocks.<\/p>\n
In economics, this distinction is very important and most students fail to really understand it. I think that is because mainstream macroeconomics then doesn’t go onto to use the distinction properly, especially in the area of fiscal relations.<\/p>\n
So the level of bank reserves is a stock – measured at some point each day. Government spending and taxation, consumer spending, saving, investment, exports, imports, etc are all flows of dollars per unit of time. Government spending adds to bank reserves and taxation reduces (drains) the stock of reserves.<\/p>\n
Clearly, a theory of the economy that doesn’t recognise the intrinsic relations between the flows and stocks is missing the boat. Given that modern monetary theory is ground out of the operational accounting of the monetary system, its stock-flow consistency is impeccable and unique (a major strength).<\/p>\n
A Flow of funds view of modern monetary macroeconomics<\/strong><\/p>\n
A Flow-of-funds approach to the analysis of monetary transactions highlights both the importance of the distinction between and vertical and horizontal transactions and the fundamental accounting nature of the budget constraint identity.<\/p>\n
It shows categorically that the Government Budget Constraint (GBC) is an ex post<\/em> accounting identity rather than an ex ante<\/em> financial constraint. You will recall that mainstream macroeconomics (and the Austrians) all believe the GBC somehow represents a financial constraint on government prior to it spending.<\/p>\n
It doesn’t and cannot in a fiat monetary system unless the government adopts, voluntarily, a framework that replicates the operations of the ex ante<\/em> GBC. In doing so it reduces its fiscal authority and bows to the pressure of those who oppose government intervention at a sufficient level to generate full employment.<\/p>\n
A Flow-of-funds approach also shows that if the sovereign government runs cumulative surpluses which destroy net financial assets then the non-government must accumulate deficits in the form of increasing indebtedness which are unsustainable.<\/p>\n
The distinction between vertical and horizontal transactions can be clearly demonstrated by examining the current transactions matrix for a simplified economy.<\/p>\n
The last row of the current transactions matrix affords a crucial insight into the nature of (vertical) transactions between the government and non-government sectors. <\/p>\n
These transactions must be clearly distinguished from their (horizontal) counterparts: those between banks, households, and firms. The basis for this distinction is that only vertical transactions give rise to net financial assets or increases in real wealth, whereas horizontal transactions net out to zero.<\/p>\n
While transaction accounts (or T-accounts) are helpful for distinguishing between such things as high powered money and other forms of money, and for explaining why it makes theoretical sense to consolidate the central banking and treasury functions of government, they are not very helpful when it comes to establishing the difference between vertical and horizontal transactions.<\/p>\n
However, this difference can easily be justified by examining a current transactions matrix for the economy, which depicts flows of goods and services and flows of monetary payments between institutions (households, banks, firms, and the government sector). <\/p>\n
The following figure is what we call a current transactions matrix<\/em> and is a highly simplified stock-flow consistent macroeconomic model. I recommend you print the figure by clicking on it and then using the print out it to follow the discussion. Note the -1<\/sub> or t-1<\/sub> just means last period’s value.<\/p>\n
Here, consumption spending by households, C<\/em>, comprises wages after tax, W-Tw<\/sub><\/em>, plus a fixed share a<\/em>, of (lagged) household wealth, Vh<\/sup><\/em>.<\/p>\n
Household wealth increases both through savings out of income, the latter including (lagged) interest receipts on deposits, ib<\/sup><\/em>, and dividends received from banks, Fb<\/sub><\/em>, and firms, Fd<\/sub><\/em>, inclusive of the capital gain on equities (a component subject to minor degree of simplification).<\/p>\n
Firm investment is pDK<\/em> (the D is the greek delta meaning change in), il<\/sup><\/em> is the loan rate of interest, and Tl<\/sub><\/em> is the tax rate on firm income. It is further assumed that the government chooses the bill rate of interest, ib<\/sup><\/em>, tax parameters and government spending as proportion of total capital.<\/p>\n
![\"Table_1_current_transactions_matrix\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2009\/09\/Table_1_current_transactions_matrix.jpg\" "\\"Table_1_current_transactions_matrix\\"")
<\/a><\/p>\n![\"Table_2_current_transactions_matrix_open_economy\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2009\/09\/Table_2_current_transactions_matrix_open_economy.jpg\" "\\"Table_2_current_transactions_matrix_open_economy\\"")
<\/a><\/p>\n