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…..

Money, Government Bonds, and Quantitative Easing

Quantitative Easing is considered, by many, to be a euphemism for printing money. Is there just possibly a germ of truth in that statement? Why is it done?What exactly does it mean?

In normal times, central banks try to increase the amount of lending and activity in the economy  by cutting interest rates which encourages people to spend, not save. However, when interest rates are close to zero and can go no lower, another  option for a central bank is to lend money into the economy, by which they usually mean the commercial banks, directly. That is  supposed to be the motivation for quantitative easing (QE).

The way the central bank does this is by buying assets – usually government bonds – using money it has simply created “out of thin air” .The institutions selling those bonds , either commercial banks or other financial institutions, will then have extra money in their accounts, so boosting the money supply. That is the mainstream theory

It was used first by  in Japan to help it out of a period of deflation following an asset bubble collapse in the 1990s.

Let us just go through the steps of what happens when a government issues, say, $1 billion of new bonds and then re-purchases them. That in a nutshell is QE – although usually just the last step is considered. A government issues (prints!) the bonds. They are sold for $1 billion at auction. The government can then claim, somewhat dubiously as we will see, their $1 billion is real and hasn’t been printed. The financial institutions have their bonds. The government decides to buy them back. There would be no point in using the original $1 billion so
Government prints another $1 billion. The government gets back the bonds. As they are an IOU all they can do is tear them up. The financial institutions then have back their $1 billion, plus no doubt a little extra to keep them
sweet, so there’s no net change as far as they are concerned. The bonds no longer exist and all that is apparent is the government, somewhat to their embarrassment, have funded their deficit by printing money after all!

But is all what it seems?

Let’s start from the beginning with our understanding of what money is. Nearly all modern money is fiat based. It is not backed by anything tangible like Gold or silver. It isn’t pegged to any foreign currency and can be worth more or less against other currencies one day than the next. It has a value because of the power of governments to impose taxation and insist on payment in that currency.

All money is printed. Or, it is an electronic version of that. So the term ‘printed’ can mean either one or the other. Look in your wallet and you’ll possible have a $100 dollars or so of printed government money. They are just IOUs. You’ll maybe have a thousand dollars or so in your bank account. They are just electronic government IOUs. Basically they are the same thing.

So what is a bond? Anyone can issue a bond which is just an IOU with interest included. If the issuer sells a bond, there will be a promise to pay a certain amount at some future date. Depending on the credit worthiness of the issuer and the prevailing, and anticipated future,level of interest rates at the time, the bond will have some value which is less than the face value of the bond.For instance, I could issue a ten year bond for $200 and maybe expect to sell it for $100. That would give my creditors approximately a 7% return on their investment. That bond would be trade able during its lifetime and at some intermediate point will have a value of $150.

Governments too issue bonds. The more credit worthy the government, the less risk of their defaulting on their commitment and so the higher price they can expect to receive on issue. These are usually decided by a process of auction. When governments are in full control of their own sovereign currencies there is zero risk of involuntary default. There isn’t zero risk of inflation though, and so the issue price will probably still be less than the face value of the bond. Although there have been instances of that not being the case. It is possible to have negative interest rates. In that case investors are effectively paying a fee for someone else to look after their money.

Government bonds are still known as ‘Gilt-edged securities’ in the UK. At one time they were printed pieces of paper with golden edges. On some bonds, coupons were attached which could be handed in for the payment of interest.
The term coupon is still used for payment of interest on a bond.

The conventional wisdom is that it would be highly irresponsible for Governments to finance their budget deficits by printing money. It is not considered acceptable for Governments to spend new money into existence. There is a different argument when it comes to lending money into existence. That’s different of course! We may come back to how commercial banks by arrangement with reserve banks can create money ‘out of thin air’ in a later posting.

That argument does, of course, depend on whether bonds are not just another form of money. If we look at one piece of paper which is a bond, we have to ask if it is really different from another piece which is in the form of a banknote. One will have an interest rate associated with it but what if that interest rate is very low as would be the case presently? What if that interest rate were so close to zero that it hardly mattered? In that case it can be seen there is no functional difference between a bond and a banknote.If one is printed money then they are both printed money. The level of interest is just a detail.

Quantitative easing, the buying of bonds, and other securities by Government, is just an exchange of one form of money for another. Its all done in bank accounts in reality. There are probably no pieces of paper involved. A customer of a central bank has money in bonds when it is in one type of bank account. The process of QE means shifting out the money to another account which is currency based. The process will tend to reduce the level of interest rates but if they are near zero to start with, probably not by much. The overall effect on the economy will be small. Especially when the financial institutions choose to sit on their assets, rather than lend them out,  as they previously decided to do. Contrary to initial fears QE has not led to runaway inflation in countries where it is being used.

Yes, printing money has occurred: it happened when the bonds were first issued, which is considered quite normal, not when they are being re-bought.

Warren Moslers 7 Seven Deadly Frauds of Economic Policy #5

Deadly Innocent Fraud #5: The trade deficit is an unsustainable imbalance that takes away jobs and output. Facts: Imports are real benefits and exports are real costs. Trade deficits directly improve our standard of living. Jobs are lost because taxes are too high for a given level of government spending, not because of imports. By now you might suspect that, once again, the mainstream has it all backwards, including the trade issue. To get on track with the trade issue, always remember this: In economics, it’s better to receive than to give. Therefore, as taught in 1st year economics classes: Imports are real benefits. Exports are real costs. Hopefully if everyone has grasped the fundamentals of MMT so far, Warren Mosler’s arguments won’t need any further explanation. It is difficult to disagree with them per se but the advocates of  MMT may lose many of those who should be friends and allies if they are pressed  in too insensitive a fashion. At the time of writing, 300 Qantas workers are reported to be about to lose their jobs in Melbourne. Due to the strength of the A$ it makes sense for Qantas to service their planes overseas rather than in Australia which is likely to turn out be the real, if not the stated, reason given by Qantas management. IMO . It is a typical case of an imported product replacing a local product. It is doubtful  Qantas workers will be too receptive to an argument of  “Imports are real benefits. Exports are real costs”. They may well be real benefits to Australia as a whole in terms of increased profits to Qantas and even in lower fares for Qantas passengers. Increased government spending could help find extra jobs for Qantas workers but they might be forgiven for thinking that to be extremely unlikely in the current political climate. The new jobs may well be less skilled and less well paid if if they are created. WM seems to be aware of potential problems in pushing this argument too far. Later in his book he allows that “Industries with Strategic Purpose” shouldn’t be totally exposed to the mechanisms of a free market. The example given is the US Steel industry. Steel would not be the only strategic industry. Just about any industry can be considered to be strategic, to a greater or lesser extent, even the operation of a commercial airline. So some care is probably in order  with this argument, and maybe extra thought too on just what constitutes a ‘strategic industry’.

A Simple Four Sector Model of an Economy

MMT incorporates sector models, which date back to Keynes and play a role in neo- and post-Keynesianism, of the economy which gives, IMO, a key insight into the way a typical sovereign economy may function. The  model usually used is one of a three-sector model, government, the private sector and a foreign sector as ‘rest of world’.

There is an aggregation of individual accounts into overall national accounts. According to the principles of double-entry bookkeeping, all financial assets are another’s financial liabilities. All accounts together – private, public, foreign – sum to be  zero. In a three sector model at least one of the three has run a net surplus, while at least one of the other two has to run a deficit.

In principle the division can be of any number from two upwards. This model divides the private sector into the active economy where the money supplied to it changes hands at least once in the course of an arbitrary time period, say a month, and stored private money where money doesn’t change hands, or  if it does, moves from one account to another in a way that does not affect the active economy.

The active economy is where people earn their living, by selling their labour power, and buy  commodities which are the necessities of life. It is the one that matters to most people but  of course does not exist in isolation.
Stored private money would normally be tied up in savings accounts, long term investments such as government bonds, but equally it could be stored as cash under a proverbial mattress or even in a child’s piggy bank. Active money is the sort normally held in our current, or checking, accounts, and in our purses and wallets.

economy2The model shows that Government Spending, Withdrawals and Loans and Exports payments all will add currency units CUs to the active economy and can be considered inflationary

Taxation, Savings, and Import payments will remove money and can be considered to be deflationary.

For illustrative purposes only, the left side table show CU levels at time period t. The right side table shows CU movements.
Starting at time t=0 we can assume zero levels. Further we assume a’ready to go’ economy.
At time t=1 we can conceptualise the ‘kick-starting’ of the economy by a government expenditure of 13 CUs. Simultaneously taxation (3 CUs) is required to establish the value of these CUs. This leaves 10 CUs of fast moving money in the active economy. 10 CUs is the set target.
At time t=2 Government spends an extra 6 CUs, taxes 3 CUs. The private sector saves 2 CUs. There are 1 Cus of exports and 2 Cus of imports.
The position  is still 10 CUs of active money in the economy.
At t=3 Government spends 5 CUs and taxes at 3 CUs. Savings andwithdrawals are both 1 CUs. Exports are 2 and Imports are 3,
This leaves 11 CU’s in the economy. One higher than the target. This can be corrected later or left as is of course.

There are several important things to note from this simple model:

  • Government has a strong influence on the workings of an economy but it is not in total control. Except in special times  like wartime, it would not be able or willing to sufficiently control the savings and desire for loans of the private sector.
  • As stores of money are built up by the private  and overseas sectors,  so too does the level of Government debt. One is the inverse of the other.
  • Wealthier  members of the private sector, and the thrifty members too,  contribute more to Government debt than the less wealthy and less thrifty .
  • Running a continuous trade deficit  increases levels of government debt and/or reduces the stored money of the private sector.
  • Government debt is necessary to create private wealth.

Implications for Real economies
1) The USA

The USA has a total government debt of around $17 trillion.

Of this ~$5 trillion was owned by the overseas sector. ~$5 trillion is owned by intragovernmental organisations ~$7 trillion by the US private sector.

The argument is often made in MMT circles that no matter  what the size of any government deficit, or debt, the government can never involuntarily default. It is the ‘government checks never bounce’ argument’ which is now  well established.

But, if the US doesn’t have a debts problem, could it have an assets problem? Could the size of assets (stored money)  held by the private and overseas sectors ever become so large they threaten to destabilise the US economy? The owners of these assets are could well consider that what we argue are necessary fiscal measures to reduce unemployment levels,  to be highly inflationary. They may well be wrong in thinking that, but is it possible they could bring about that inflation by spending wildly, on anything and everything,  outside of government control, before the $ lost too much of its purchasing power?

A little extra inflation would probably be a good thing but could it get out of hand?

To be continued.