Monthly Archives: November 2013

Three Sector Balances Haven’t Gone Unnoticed by the Economic Mainstream

MMT incorporates the concept and emphasises the importance of the sector financial balances model of aggregate demand. It is a simple concept. The public sector, the private sector and foreign sector surpluses/deficits net to zero in any measured time period.

It causes neo-liberal types some problems. They probably do not like the idea of a public sector deficit being a necessary condition for a private sector surplus. They would like to pretend that the public account and private sector can be in strong surplus simultaneously. That’s impossible except for those countries who export much more than they import. So I wouldn’t expect to see three sector graphs offered up for public consumption by the mainstream media any time soon.

They are pretty good indicators of how the share market might perform though so naturally they can’t be totally ignored!

For what it’s worth I would agree that its a good time to buy shares. Watch that black line (the private sector) in the first graph. When it bottoms out, it will be a good time to sell!

If previous experience is anything to go by, the indicators will be completely misinterpreted for popular consumption. The reduced future public sector deficit will be hailed as a great success by various western  governments.  There won’t be any mention that this will mean the private sector will be overstretched. There won’t be any warnings of the next slump to come. The experts will be telling investors not to panic and prophesising soft landings etc.  You’ll know what I mean. You’ve heard it all before!

PS If anyone does really well from this advice I’m not too proud to accept tokens of appreciation!

Can commercial banks create money out of thin air?

If the title of this posting is Googled there will be many hits suggesting that banks are able to do just this.

For instance according to Michael Kumhof Deputy Division Chief, Modeling Unit, Research Department, International Monetary Fund “The key function of banks is money creation, not intermediation.”

Some banks are also able to issue their own banknotes (or bills in the US). For instance Scottish banknotes, designated in £ sterling,  can be issued by several of their commercial banks and are readily accepted there.  But, maybe less so in England!  Normally UK banknotes are issued by the Bank of England. The Bank of England is the reserve bank of the UK,  part of the UK government and the issuer of the £ sterling currency.

When commercial banks issue loans they credit the bank accounts of the borrower and but they don’t debit their own reserves. The bank has the asset to the amount of the loan, and the borrower assumes the liability of repayment.

Of course, there are rules, which vary from country to country, which govern the lending practices, and ability to print banknotes, of the commercial banks. There is often, but not always, a requirement for the commercial bank to maintain a certain level of reserves. However, subject to these rules, the commercial banks can borrow as they need to provide commercial loans. They borrow at a low rate of interest, either from the reserve bank or their depositors, and lend out at a higher rate. The difference between the two rates provides the banks with their profit margin and also acts as an insurance against a default on the loan.

But if they feel they don’t need to borrow anything they don’t. They just write out an IOU which we all tend to think of as if it were the same as a government IOU.

Government, or their reserve banks, set interest rates as a matter of policy to regulate lending. The conventional, but erroneous, wisdom,  is that money can be created by the Reserve bank,  in printed  form or by keystroke,  and lent out via  the commercial banks  to regulate the level of activity in an economy.   It is is not considered that this should be done to directly fund additional government spending though. That needs to be done via the process of printing or creating treasury bonds. Somehow, for reasons which don’t appear to be quite logical, the economic mainstream don’t consider printing bonds to be the same as printing money.

Swapping money for bonds, or vice versa, doesn’t really change anything much at all , as has been recently seen through the so-called process of Quantitative Easing so maybe something of a rethink is called for on this point.

However, regardless of any inconsistency, the process works reasonably well in normal times but less well when interest rates are deliberately reduced to ultra low levels. The control knob can’t be turned any further.

Does this mean the commercial banks,  too,  are also acting as currency issuers rather than users? Are the Scottish banks assuming the role of a currency issuer when they print banknotes?

No, they aren’t.  Apart from being able to borrow directly from the reserve bank, individuals can do the same thing. They can issue IOUs as they please which in principle can be traded by a third party. Casinos can issue £5 chips, which are their IOUs, for use on , say, a roulette table. They, too, in principle could be traded on an open market. Of course, if the casino were considered a credit risk the chips would lose their value. Scottish banknotes could lose their value too if the issuing bank was considered to be in risk of default. Similarly, any bank customer with a bank account full of newly created credits would need to have all payments cleared using those credits. It is possible that they would be refused, by another bank, if the issuing bank were considered to be at risk of default.

It’s the financial viability of the issuing institution which guarantees any written IOU. Conventional theories involving banking multipliers are bunk! That’s not how it works.

So, in conclusion,  the “thin air” expression is somewhat misleading. Commercial banks aren’t doing anything special at all. The only issuer of a currency is the government, or governments in the case of the Euro,  via their Reserve bank. Everyone else is a user, and cannot , unless they are in the counterfeiting business, create their own extra units of that currency.

Further reading:


PS This posting has generated more heat than any other with 23 comments so far. I think I now understand the  problem better than I first did, so I’d like to thank everyone for their contributions. It seems to me that there needs to be a recognition that what we see in our bank accounts, at the commercial banks, isn’t quite the same thing as money. The figures actually do refer to bank IOUs which can of course be always swapped for government printed banknotes, which are certainly money,  providing the bank is solvent.
Similarly what the bank creates isn’t quite money. They generate their own IOUs or asset/liability pairs in the same way as anyone else can.  Should they be prevented from doing this? I’d have to say no. Anyone has the right to issue an IOU.  But, that of course is a political and not an economic question.

One (or maybe slightly more) Line Responses to Common Neo-liberal Arguments

We’ve must all, at times, have been in conversation with friends and acquaintances,  when we have heard wrong-headed neo-liberal  type remarks which have required some response, but not too much of a response. We need something quick, snappy, and easy to understand. After all, we probably do want to keep those friends. We’d like to encourage them to think about what they are saying but not bore them rigid with long-winded explanations.

Hopefully, we’ll get more contributions but these are a few, which immediately spring to mind:

  • Governments shouldn’t spend more than they earn
    I’m pleased they do. Otherwise, none of us would have any money. I work 40 hours a week to re-fill my bank account with government IOUs. I don’t know about you, but I need that Government debt!
  • It’s wrong for Governments to print money
    ALL money, except loose change, is either printed or created by keystroke. It would be much less convenient to have to carry around gold bullion to pay the grocery bills.
  • A government is like a household etc etc
    I don’t have a currency printing press in my household! If I don’t pay the mortgage it’s my problem. If a government defaults on its debt it’s everyone’s problem. The government is an issuer not just a user of the currency. That is a key difference.
  • The government will have to default on its debts if it carries on spending like a drunken sailor.
    Only if its printing presses break down or if the computers malfunction!  Governments with sovereign currencies can create whatever they need to settle their bills. Government cheques need never bounce.
  • So you are advocating we copy the economic policies of Zimbabwe?
    No I’m saying we learn from Goldilocks. The porridge should neither be too hot nor too cold. She liked it just right.
    (Note: It is important to emphasise the need to avoid inflation)
  • There are too many inefficient civil servants. The government sector is too large etc etc
    Workers emptying the bins, driving buses, teaching children, or whatever, don’t become any more productive if they work for the private sector. In any case that’s a secondary issue. Real inefficiency is having workers do nothing when they could be making a useful contribution to society.
  • People should save more to help the Government pay off its debts.
    It’s the other way around. For every saver (lender) there has to be a borrower, and vice versa. Higher savings mean higher government borrowings and therefore higher debts
  • The private sector has had to tighten its belt since the GFC. It is only fair the government should do the same.
    That’s was the accepted conventional wisdom in the 1930’s. The depression only really ended when governments were forced to tear up their neo-liberal text books when the war started. Do we have to have another war to re-learn the same lesson?
  • Who is going to pay for it all? We can’t afford it.
    It can actually be done at a profit. Higher employment levels means more taxation revenue and less spending on social benefits. In addition the streets could be cleaner, the parks tidier and the environment better for all. There would be less crime. Everyone would benefit from reduced economic inefficiency not just those who gained a job. It is not Utopianism. It has been done before and can be done again.

Warren Moslers 7 Seven Deadly Frauds of Economic Policy #6

Deadly Innocent Fraud #6:

We need savings to provide the funds for investment.

Investment adds to savings.

This fallacy, or fraud, maybe requires a little more thought than some of the others. I did have to read Warren Mosler’s explanation more than a couple of times to fully understand his observation.The idea that we need savings to provide the funds for investment derives from initially thinking in microeconomic terms and then applying that reasoning at the macroeconomic level. That trap can be quite difficult to avoid. On the microeconomic level, it of course, makes perfect sense to initially put some funds aside then invest them later, say in a business venture or whatever.

So how does that differ at the macroeconomic level? This is how I would explain Deadly Innocent Fraud #6:

Say a particular country wished to build a broadband data network at a cost of $30 billion dollars and which would be a significant percentage of their GNP. There would be kilometers of optical fibre cables to lay, maybe new satellite stations and terrestrial microwave links would need to be constructed etc.

If the government were in charge of funding the project it wouldn’t make any sense to save $10 billion for two years from taxation and then spend $30 billion in one go in the third year. There is a paradox of thrift involved here. There would be a loss of purchasing power of $10 billion in each of the first two years which will mean that items will not be sold, or sold at a loss, and the economy will fall into recession as production is scaled back. When the $30 billion is released in one go in the third year it would be highly inflationary. It would be even more inflationary than if the extra $20 billion had been printed in the first place. Many of the industries may well have closed down in the meantime.

It wouldn’t change matters if a consortium of citizens saved their money on a voluntary basis to do the same thing. In a free society, it would not be possible for governments to stop them doing this, of course, but a responsible government would spend and tax in a compenastory manner, and adjust monetary policy too, to smooth out the effect on the economy.

If the economy was initially running close to full capacity, extra spending on the project, either by Government or the private sector, would be inflationary, unless Government removed some spending power from the economy through taxation. In that case, it might be argued that investment would not add to savings.We aren’t in that position now though! Government can control its own spending as a matter of decision, and the spending of the private sector indirectly, either by taxation or by the level of interest rates in the economy. The commercial banks have the power to create money ‘out of thin air’ as is often said! If there was an amount of spare capacity in the economy, that could be utilised over a period of time without causing inflation. Whether the project was funded directly from government spending or through commercial loans to private companies, the effect of the investment would be just the same in macroeconomic terms. In the initial stages of the project, that is before there is any data to buy from the operators of the data network, there would be an increase in the so-called national debt and an increase in the wealth of the private sector as the work got underway. The levels of dollars in the workers’ bank accounts, and in those who in turn receive payments from companies and workers, would inevitably increase too.

So it can be seen that Warren Mosler is right. Investment does add to savings. Usually at least!

Why do they lie to you?

“When President Obama tells you we are running out of money, that the piggy bank is empty, that is just not true. All economists know that is not true so the question is why do they lie to you?”

Professor L Randall Wray (Sept 2012) (time =3.40)

Of course President Obama is far from alone in giving out the same false message. We hear these kind of comments all the time from politicians, even supposedly liberal and socialist politicians.

Not just in America, but in the UK and other countries too. “Running out of money” is a justification for austerity economics. The UK, Australia, NZ , Japan etc all have sovereign currencies so they can’t run out of money either.

Is it possible that politicians themselves, are not actually lying, but they don’t understand the economic systems they are supposed to be in charge of? Or is it more likely that they do understand them but prefer not to explain them?

Which would be worse?

PS The only justification for not spending more would be if employment was as high as it could possibly be. If all industrial plant and machinery was working at full capacity. In that case spending more could generate  inflation. If that’s their worry then the politicians and their economist advisors should say so

What Is A Government Bond?

This primer from Bond Economics is a very good and well worth a cross posting!

This primer answers the question “What is a government bond?” is in terms of defining what a bond does. The answer is that a government bond is an instrument that drains reserves from the banking system. This is not the standard way of looking at government bonds, but I believe it is the key ingredient explaining…..