I present a simple macro model and use it as a vehicle to explore the idea that it matters how monetary policy is framed. One framing leads to a deflationary spiral, which an alternate framing can avoid or escape. The model is an otherwise bog-standard New Keynesian/Neo-Wicksellian model, but with a minor modification in the financial sector.
Phillips Curve: p = 0.25(y-y*) + 0.5p(t-1) + 0.5E(p)
Lower case p is inflation between this period and the next (sorry, but I can't do Greek), y is real output, y* the natural rate of output, and E(p) expected inflation. There's a 50-50 mix of forward- and backward-looking elements. There's a whole literature on the backward-looking elements, which are needed empirically to give inflation inertia. I need the backward-looking element to slow things down so we can see deflationary spirals evolving slowly when monetary policy makes a mistake under the wrong framing. Otherwise they would happen instantly.
IS curve: y-y* = n-r
Where r is the real rate of interest, and n the (time-varying) natural rate of interest. I am tempted to replace y* with expected future y. This would be better theoretically (the IS curve then has the standard Euler equation interpretation). It would also give more interesting results, because a deflationary spiral would then have an additional channel of positive feedback, since a fall in expected future output would mean the real interest rate would have to fall even further to break the cycle. But it's not needed to illustrate my point, and makes the maths a little harder.
Substituting the IS into the Phillips Curve gives us the IS-PC equation:
p = 0.25(n-r) + 0.5p(t-1) + 0.5E(p)
It is important that the coefficient on the real interest rate be small relative to the coefficient on lagged inflation, if we want to see the deflationary spiral evolve slowly. Otherwise it would happen instantly.
Financial sector. There are two financial assets: nominal bills and "real bills". Firms/households issue both to fund their spending. (As in all Neo-Wicksellian models, there's really a third financial asset, the medium of exchange, that is implicit in the model, because the violation of Say's Law makes no logical sense otherwise.)
A nominal bill is a promise to pay $1 in the next period. If B is the nominal price of a nominal bill, we can define the nominal interest rate i as
B=1/(1+i)
A "real bill" is a promise to pay 1 unit of real output in the next period (or its monetary equivalent). If R is the nominal price of a real bill, and P the current price level, we can define the (ex ante) real interest rate r as
R=P(1+E(p))/(1+r)
(I hate using the term "real bill" in this context, when it already has two different and contradictory meanings in the history of monetary thought. I would rather replace my "real bills" with shares in a stock price index mutual fund, but doing so would complicate the model. I still think of them as representing shares nevertheless.)
People are risk neutral, so in equilibrium the two financial assets give the same inflation-adjusted expected rates of return
(1+i)=(1+r)(1+E(p))
I approximate this as i=r+E(p) when I need to.
Monetary Policy.The central bank wants zero inflation and a constant price level (where P = $1). (I know there's an important distinction between inflation targeting and price level path targeting, but I will largely ignore it, because it doesn't matter for my purposes). The only time-varying parameter in the model is the natural rate of interest, n. Assume the central bank observes n contemporaneously.
If the central bank gets what it wants, we can describe the equilibrium as:
1. P=1 (or p=0 and E(p)=0).
2. B=1/(1+n) (or i=n)
3. R=1/(1+n) (or r=n)
[Update: typos fixed in 2 and 3, thanks to himaginary]
An outside observer, who saw the evolution of data for this economy, would be unable to distinguish between three different ways of "framing", or social constructions of monetary policy: 1. "The central bank is targeting inflation"; 2. "the central bank is targeting the price of nominal bills"; 3. "the central bank is targeting the price of real bills". All three are observationally equivalent, even if the observer knows the structural equations, and observes the natural rate of interest n. And there are many more ways he could describe monetary policy, including complex ways of describing it, like: 4. "targeting the nominal interest rate in order to target inflation".
Suppose the outside observer is a sociologist, who wishes to discover how people in this economy themselves construct reality. He induces a breach in the equilibrium. Suppose there is a temporary drop in the natural rate, n, by one percentage point, but the sociologist hides this fact from the central bank, by falsifying the bank's data. What happens?
What happens next depends on how the population and central bank frame monetary policy. And it is precisely because what happens depends on the framing that the sociologist's experiment succeeds in revealing that framing.
Suppose that people believe the central bank targets inflation, so E(p) stays at zero. And they maintain this belief in inflation targeting, despite temporary evidence that the central bank has failed to hit its target. But the central bank does not target inflation directly, and instead frames monetary policy as targeting the price of nominal bills (equivalent to the nominal interest rate), in order to hit its ultimate target, zero inflation.
In period 1, the natural rate drops, but the bank doesn't see it, so the price of nominal bills stays the same. The real and nominal rates of interest stay the same, and are now above the natural rate. So output drops below the natural rate y*, which means that actual inflation drops below zero.
In period 2, the bank learns that the sociologist has falsified the data, and takes the necessary steps to bring inflation immediately back to target. Because lagged inflation appears in the Phillips Curve, this requires the bank to engineer a boom, with output above y*. This in turn requires setting the nominal interest rate on nominal bills below the natural rate.
In period 3, everything returns to normal, except that the price level is lower than before the sociologist's experiment.
Now suppose people believe the central bank targets the price of nominal bills (the nominal interest rate). (Or they originally believed the bank targets inflation, but lose faith in this framing when they see the bank fail to hit its target.)
In period 1 the results are exactly the same as above, because people don't see what the sociologist is doing, and so continue to expect zero inflation.
In period 2, suppose people expect the bank to set the nominal rate equal to the natural rate. What would they expect to happen? (What would happen if the bank did what people expect it to do?). Substituting the IS into the Phillips Curve, setting i=n, and imposing rational expectations we get
p = 0.25(n-i+E(p)) + 0.5p(t-1) + 0.5E(p) = 0.5p(t-1) + 0.75E(p) = 2p(t-1)
So if the population stops framing monetary policy as targeting inflation, and instead frames it as setting the nominal rate of interest, then they expect a deflationary death-spiral with deflation doubling every period, the real interest rate rising continuously relative to the natural rate, and output falling continuously with the output gap doubling every period.
Central banks are aware of this danger, of course, which is why they don't frame nominal interest rate targeting as setting
i=n+p*, where p* is target inflation.
The above interest rate rule fails to obey the "Taylor Principle". If the population ever loses the frame of monetary policy as targeting inflation, so that expected inflation differs from target, the central bank needs to frame monetary policy as setting:
i = n + E(p) + a(E(p)-p*), where a is some strictly positive number.
But if our central bank (with a target of zero inflation) cannot observe expected inflation, and can only observe lagged actual inflation, it would need to frame monetary policy as:
i = n + (2+2a)p(t-1)
[minor math mistake fixed, thanks to himaginary]
If the inflation target is credible, so that expected inflation never deviates from target, an outside observer would be unaware of the existence of the (2+a)p(t-1) term. It's rather like police reserves. As long as the crowd knows they are there, even if hidden, the crowd obeys the social rules, and we never see the reserves deployed. But if the crowd ever did start to riot, would the reserves be big enough to restore the original social reality — the mutual expectations of following the rules?
If the central bank ever lost control of expected inflation on the upside, there is no limit on how high it could raise the nominal rate of interest to restore order. But if it ever lost control on the downside, the zero lower bound on nominal interest rates does impose a limit on the bank's ability to restore order. The police have limited reserves, and if too many in the crowd run riot, there won't be enough reserves to restore order; and the crowd knows this. With deflation and expected deflation doubling every period, a central bank that waited too long to call in the reserves would lose control of the inflation target.
Now suppose we change the way monetary policy is framed. Suppose people believe that the central bank targets the price of real bills, rather than nominal bills, in order to maintain its inflation target. Let's re-run the sociologist's experiment.
In period 1 exactly the same thing happens as before. The central bank doesn't learn that the natural rate of interest has decreased, and so sets the price of real bills too low, and the real rate of interest is therefore above the natural rate. Output falls below y*, and inflation is negative.
In period 2 and thereafter the central bank once again learns the correct value of the natural rate of interest, and is expected to set the nominal price of real bills at R=1/(1+n) thereafter. This framing of monetary policy rules out the possibility of a deflationary spiral as a rational expectation. To see why this is so, substitute R=1/(1+n) into the definition of the (ex ante) real rate of interest to get
(1+r) = (1+n)P(1+E(p))
In a deflationary spiral, the price level P would fall without limit, and expected inflation E(p) would fall without limit. If the real interest rate were constant, this would mean the nominal price of real bills would fall without limit too. But if monetary policy were framed as holding the nominal price of real bills constant, a falling price level and falling inflation would mean the real interest rate would fall without limit too, so output would rise without limit, and that rising level of output would put ever-increasing upward pressure on inflation.
My math isn't good enough to solve for the time-path explicitly (though any competent graduate student could probably solve it), but it is easier to show that deflation cannot accelerate into a spiral. Suppose E(p)=p(t-1), and the IS-PC equation yields:
p = 0.25(n-r) + p(t-1)
Since P<1, and E(p)<0, we know that r<n, so there will be less deflation in period 2 than in period 1. With rational expectations, people will know this, which reinforces the brake on deflation. Inflation must eventually turn positive, and the price level must eventually return to its original level. Setting the nominal price of real bills anchors the long run equilibrium price level in a way that setting the nominal price of nominal bills can never do.
[Update: himaginary in comments provides the solution:
"I'm not good either, but here is some try:
p = 0.25(n-r) + 0.5p(t-1) + 0.5E(p)
= 0.25(1+n){1-P(1+E(p))} + 0.5p(t-1) + 0.5E(p)
= 0.25(1+n)(1-P) + {0.5-0.25P(1+n)}E(p) + 0.5p(t-1)
Assuming E(p)=p by rational expectation, it becomes
p={0.25(1+n)(1-P)+0.5p(t-1)} / {0.5+0.25P(1+n)}
The coefficient of p(t-1) is 1/{1+0.5P(1+n)}, which is less than 1. So deflation-spiral surely doesn't happen in this case."]
This result shows that framing monetary policy as targeting the price of real rather than nominal bills can prevent a deflationary spiral from ever getting started. Even if the central bank were permanently ignorant of the natural rate, and set R too low permanently, the cumulative fall in the price level, and rising expected deflation, would eventually mean the real rate would fall below the natural rate, ending the deflationary spiral.
Suppose nevertheless that a deflationary spiral did begin, perhaps because monetary policy had initially been framed in terms of targeting the nominal interest rate. Could a re-framing of monetary policy in terms of targeting the price of real bills break the spiral? Could it do this even if the zero lower bound on nominal interest rates were binding? If the re-framing were successful, and if the central bank can credibly commit to a future price of real bills, the answer is yes.
To see why this is so, remember that the price of real bills anchors the long-run equilibrium price level. By promising a high enough future price of real bills, the central bank can promise a future price level that is high enough to make current expected inflation positive. If monetary policy were framed as targeting the nominal interest rate, there is no way the bank can make this promise. People just wouldn't understand the language in which the promise were made, so it could not be credible.
To repeat what I said in a previous post: it's the framing of what central banks do that caused the mess, not anything central banks are actually doing. (The bank does exactly the same thing in period 1, whether monetary policy is framed as targeting the price of nominal bills or of real bills.) The social construction of reality is what dunnit!
Addendum: if you make two small changes in the model (replace y* with E(y(t+1)) in the IS curve), and change my "real bills" (which I think of as shares) into "nominal GDP futures contracts", my model would come close to what Scott Sumner is talking about. The small change in the IS curve would mean that the level of current output would depend on i-n plus the expected growth rate of nominal GDP (as opposed to the expected rate of inflation). But I can never remember the difference between a forward and a futures contract; the ones I want are where you pay $R this period, in return for a fixed percentage of nominal GDP next period, so a change in R for given expectations affects the real interest rate.
Worthwhile Canadian Initiative 
Hi Nick
Winterspeak is presuming a situation in which the private sector is desiring to increase its NET saving. The only way it can actually achieve this is for the govt deficit to increase (in the closed model).
You are assuming the fall in the interest rate reduces the desire to net save. This certainly could be true, though I would suggest (and I think Winterspeak agrees) it might not be, and it might actually increase the desire to net save as interest income is reduced. But regardless, you are assuming away the situation Winterspeak was presenting.
Best,
Scott
Scott,
I’m wondering, do you think there is any difference between the following two statements:
a) The non government sector desires to increase its net saving. The only it way can achieve this is through net saving with the government sector.
versus:
b) The non government sector desires to increase its saving. The only way it can achieve this is through net saving with the government sector.
FYI, I think there is a subtle (or maybe not so subtle) difference between the two, and that the second is more accurate. But the first seems to be more common among MMT adherents.
Interesting question, JKH.
Yes, the two are different. Regarding accuracy, how are you defining “saving”?
Best,
Scott
Hi Scott: By NET saving I presume you (and Winterspeak) mean “Saving minus investment”? That’s what I figured he meant, but wasn’t sure, so I just assumed investment = 0 always, to remove any ambiguity between saving and net saving.
(In economics, “saving” normally means “income minus taxes minus consumption”, and “investment” means production/purchases of newly-produced capital goods (plus increase in inventory). (And “net saving” means saving minus depreciation of capital goods, just to confuse us all further.)
Yes, I am assuming that a fall in real interest rates causes desired savings to fall and desired investment to increase. To an economist, this is like assuming that demand curves slope down. But our reasons for assuming this have nothing whatsoever to do with any purported effect of interest rates on income. It’s a substitution effect, not an income effect. To a first-order approximation, there are no income effects from relative price changes in macro.
And if demand curves don’t slope down, and supply curves don’t slope up (i.e. if “net” demand curves don’t slope down), then there’s no reason to believe that the market for apples will ever reach equilibrium, where desired net demand for apples = 0. No different for the desired net savings = 0
Scott,
I define saving as income that is not spent on consumption.
And just to add some colour to my question:
The “demand for net saving” version troubles me a bit because it suggests that the non government sector actually targets net saving with the government sector as a form of saving. It’s not clear to me that the non government sector has the capacity itself to differentiate the best channel for the expansion of its own saving in this way. For one thing, it seems to contradict the operative causality in all cases, which is that expenditure of some type is first required in order to generate income and saving from income. With respect to non government saving, that expenditure could either be government expenditure or investment expenditure.
And noticing Nick’s comment, saving should also exclude taxes paid, of course.
Hi Nick
There’s no problem with a demand for investment sloping down with respect to interest. The point is regarding an aggregate spending curve sloping down with respect to interest . . . assumptions have to be made there. Take Japan, for instance . . . reduce interest rates (real or nominal) and you could very well reduce aggregate spending as savers’ incomes fall.
Best,
Scott
Scott,
Yet another follow up thought:
It’s always seemed to me that the most natural explanation is that non government “net saving” with the government sector “falls out” as a consequence of its demand for saving of some type, followed by the fact that the government comes to the rescue in supplying saving to meet that demand in the more specific form of net saving.
Notwithstanding that, it’s also occurred to me that the non government sector does have a very specific demand for saving with the government, but not because it is in the form of net saving. Rather it’s because such saving is in the form of government credit risk, which is a very attractive risk attribute in the kind of environment that leads to the excess demand for saving in the first place.
Supply/demand cross currents.
Scott: for every $100 lent there’s $100 borrowed. For every 1% drop in interest rates, lenders’ disposable income falls by $1, but borrowers’ disposable income rises by $1. Unless lenders and borrowers have different mpc’s, it’s a wash.
Nick . . . yes, that’s one of the assumptions that is made. Another is that the lender/borrower relation you note doesn’t apply to govt debt service. And the cb could take the further step of QE and eliminate still more coupon income to the non-govt sector.
JKH . . .agree with your follow-up thoughts.
Hi JKH
Regarding your comment at 441
I agree with regard to your point about what troubles you about “demand for net saving.” I usually consider it a demand by the non-govt sector to save (or leverage) on balance, with the result of net saving (or net dissaving). Much of this is via automatic stabilizers, as you noted in your follow up.
That’s probably something that could be clarified/explicated a bit more carefully, say, in the description and labeling of the desired private sector financial balance schedule in my sector financial balances model posted to the KC blog back in late July.
thanks Scott
Nick, I’ve never liked the terminology in monetary economics–terms like “target” are too vague. I know that it would make no sense to rigidly target stock prices, the price level would be unstable. I assumed you meant something like an intermediate target, something to help one avoid liquidity traps.
Scott: yes, using stock prices as an intermediate target would be more sensible, I think. But I still find it interesting to think about what would happen if stock prices were rigidly targeted. Would the equity premium disappear? What would be the consequences for investment, growth, and financial stability, if all the people who now clamour for safe bonds held stocks instead, because their nominal rate of return were fixed?
ANON: I’ll tell you what. If you can show me a series of t-table transactions that result in a sector increasing its equity (net financial assets) I’ll change my mind and say you were right. Conditions: 1) has to be within a single sector, cannot have gold mines or some external sector capitalizing the sector under consideration. 2) has to be financial assets, not real assets. So improved land, piles of apples from an abundant orchard etc. do not count. 3) has to be a sector wide improvement. One actor within a sector increasing its equity as another actor loses it does not count. OK?
NICK: I’m trying to be precise and consistent in my use of the terms “savings”, “investment” etc. I am pulling directly from the standard accounting identities, Y = I + C + G (ignoring NX). The entity I am talking about is G-T, which equals the deficit, which equals Y – I – C – T, or income minus investment minus consumption minus taxes. I believe the standard identity term for this is Net Private Savings. The direct translation for this into balance sheet terms (where I am also being absolutely strict and correct and using standard financial definitions) is the financial assets recorded in the equity section on the liability side of the balance sheet. You can also think of it as money in your bank account, which is a very straightforward common sense notion of “savings”. I don’t count investment as a form of savings for the simple reason that it is not, not in an accounting sense, and I hope not in an economic sense (although I find economists are incredibly sloppy about terminology when talking about finance, usually this is because they don’t know any better though). Savings is no one else’s income. It is an increase in savings that causes velocity to fall. Every other entity counts as income to one actor or another. This is all very straightforward, and if economics treats the same transaction as income from one side, and savings from the other, well, GIGO I guess.
“Not necessarily. That’s the simple Keynesian mechanism by which desired savings adjusts to actual savings (income falls until they are equal).” Not if you nominal debt in the picture, which is when you get Fisher Debt Deflation (I assume you are familiar with that given the title of your post). Ultimately, it leads to all private debt being written off or paid down, leaving the sector with just the financial assets paid-in by Govt (equal to the National Debt). All prices fall to the price willing to be paid by the unlevered buyer. This would be greater than the Great Depression.
“1. The main effect of real interest rates on desired savings (and investment) is a substitution effect, not an income effect. And I’m not sure if you understand that that’s my reason why r affects S and I.”
I understand the model, and I am pointing out that it’s a crap model because household savings desires are impacted by balance sheet considerations as well as time preference. My discount rate can stay the same, but other changes can make me want a different balance sheet. Imagine that you lose your job — does that make you a short term thinker? Might you change your spending decisions?
“2. In a closed economy, no government, there is NO income effect from a change in interest rates (though there may be a distribution effect if opposing income effects on different people do not wash out in aggregate, because of different marginal propensities to consume across different people). For every borrower who is better off when interest rates fall, there is a lender who is worse off. It washes out, unless they have different mpc’s. Some economists don’t understand that. But I do, and have done so for several decades.”
By “closed economy” I thought you meant no imports/exports, not no Govt. Sorry for misunderstanding that. I am looking at our economy, which has a Govt, which once-up-a-time paid interest on bank deposits, interest which used to support aggregate demand via spending and saving, but is no longer around to do so. Govt interest payments are a fiscal measure, and so directly change (increase) the net financial assets held by the private sector.
“If you can show me a series of t-table transactions that result in a sector increasing its equity (net financial assets) I’ll change…”
That’s not the correct definition of equity… equity is investment PLUS net financial assets.
Your “conditions” contradict the definition of equity. That’s the whole point. The t-table is trivial … nfa and investment as assets, equity on the right hand side
… equity defined properly is the same thing as saving. That’s where you’re making the mistake.
Nick,
The interest rate dependence of investment on interest rates is weak in my opinion. Entrepreneurs borrow not because it is cheap but because it will be profitable. We are in a situation where the aggregate demand is low. The US households want to save a lot and this means that the sales of the production sector will also go down. This further reduces the wages paid and/or layoffs and reduces the households savings and consumption in the next period. Its a feedback effect and the GDP will keep reducing unless automatic stabilizers come in. The terminology should actually be changed to “delayed stabilizers” In a downfall scenario, increased government spending and lesser taxes paid because of less activity stabilizes an economy but the new level of GDP will be less than the level it started from unless the size of the fiscal stimulus is reasonably high. For the new level of the GDP to be the same as the present, both the size and the timing of consumption and investments should match a fiscal austerity measure.
Of course the bottom is not really a bottom because increased deficits in the downfall period leads to higher interest payments from the government sector and hence it is a bit cyclical and uncertain. There is however no guarantee that the GDP will come back to its high. There is also an uncertainty about how long it will take.
A bit about investments – if you look at the Flows Of Funds data of the United States, you will see that investments are funded not just by bank loans and issuance of corporate debt but also undistributed profits. Firms typically not only have retained earnings to fund investments, they also use it to buy financial assets. The ratio of internal funds to investments is typically more than 1!! This is at the aggregate level but you can see what I mean.
At a more general level imagine two countries – country A wants to save twice the proportion of income as country B. The citizens of both countries are the same when it comes to ability and hard work opportunities etc. The only way countries A and B can have identical standards of living is by having the government of country A take on higher public debt than B.
Winterspeak: ” I don’t count investment as a form of savings for the simple reason that it is not, not in an accounting sense, and I hope not in an economic sense (although I find economists are incredibly sloppy about terminology when talking about finance, usually this is because they don’t know any better though).”
Economists do define saving differently. Economists define “private saving” as Y-T-C, not as (Y-T-C-I). Standard economics textbook definition. So investment certainly is one of the things I can do with my saving, in the economic sense. (And NET savings to us usually means Y-T-C, but where Y is Net domestic product, not Gross domestic product. I.e. it’s net of depreciation.)
Now, economists certainly do tend to be sloppy, but this is not one of those cases. We have deliberately chosen to define saving this way. If accountants want to define it differently, that’s fine, but we are going to stick to our definition. Our definition works better for us, given our behavioural theories.
To show what I mean by this, consider Y=C+I+G+X-M. Why do we divide output up this way? Why don’t we divide it up into Y=goods+services? Or Y=organic goods + inorganic goods? Or Y=red stuff+blue stuff+ yellow stuff+ other stuff? Because our behavioural theories (or some behavioural theories) say this is the most useful way, because each element is determined in a different way. The other ways to divide up Y don’t divide it up into any useful way (though they might be useful from a very different theoretical perspective).
“By “closed economy” I thought you meant no imports/exports, not no Govt. Sorry for misunderstanding that.” No, you understood me right the first time. “Closed economy” means no exports and imports. When I wrote “In a closed economy, no government,…” I meant “In an economy which is closed and also has no government..” My writing wasn’t clear.
Now, in a closed economy, but with a government and government debt, does a fall in interest rates have a negative income effect on AD? That depends. The private sector is better off, but the government sector is worse off. If the government has the same marginal propensity to spend as the private sector, it’s a wash. Or if the private sector internalises the government budget constraint, because the private sector realises it’s ultimately on the hook for all government finances (Ricardian Equivalence), it’s a wash.
Ramanan: “The interest rate dependence of investment on interest rates is weak in my opinion. Entrepreneurs borrow not because it is cheap but because it will be profitable.”
That’s like saying “Costs don’t matter for the level of a firm’s output. Firms expand output when it’s profitable to do so, not because costs are low.” Profits are the difference between revenues and costs. An investment that is profitable at a low rate of interest may not be profitable at a higher rate of interest.
Sure, expected AD matters too, as well as the rate of interest. If firms can’t sell the extra output, other things equal, they are less likely to invest. But if a fall in the rate of interest causes some increased investment directly, that will induce an increase in AD and expected AD and have additional multiplier/accelerator effects.
“At a more general level imagine two countries – country A wants to save twice the proportion of income as country B. The citizens of both countries are the same when it comes to ability and hard work opportunities etc. The only way countries A and B can have identical standards of living is by having the government of country A take on higher public debt than B.”
Assume both A and B are closed. If the people in A want to save twice as much as people in B, then interest rates need to be lower in A than B, so that A will want to invest more and want to save less, and B will want to save more and invest less, until desired S=desired I in both countries at “full employment”.
“So investment certainly is one of the things I can do with my saving, in the economic sense.”
this is precisely correct, of course … consistent with the correct definition of both saving and equity… I wonder who’s being sloppy here?
re: flow of funds info: it uses correct definitions … investments are real, as per normal economics … financial assets are not “investments”…
Anon: re:flows of funds .. I know! Please check table F.102 of FoF! Plus good to be non-anon even if you have a nickname
The point about being “sloppy” is with respect to accounting. Economists can define things however they want, but they are always talking about transactions that affect financial statements, so the accounting is important and defining things differently from the accounting is being sloppy. Winterspeak’s defintion of equity is the CORRECT one for financial accounting.
If the term “net saving” is confusing here given different definitions in use, then let’s use the term “net acquisition of financial assets” or “NAFA,” to describe Y-C-T-I, as in this paper . . . http://www.levy.org/pubs/wp_569.pdf (discussion of these terms begins on page 10)
The point of NAFA is not to describe how much investment spending can occur (as that operationally never depends on the ex ante flow of saving), but rather to understand the changes in the financial status of different sectors of the economy.
“Winterspeak’s defintion of equity is the CORRECT one for financial accounting.”
a firm that spends retained earnings on real investment hasn’t saved and hasn’t increased it’s equity?
– that’s not correct financial accounting
“re:flows of funds .. I know!”
sorry, you’re right … although there are sub-category distinctions
Retained earnings from profits are an increase in equity and they are an increase in NAFA if they are held as financial assets. I didn’t see where Winterspeak suggested differently, but perhaps I missed something.
he suggested and stated the only way to increase equity is by increasing NAFA … which is incorrect
Winterspeak’s talking about the aggregate for the private sector. An individual firm can increase it’s NAFA, but the private sector as a whole cannot unless there is (in our closed model) an increase in G-T.
right … but any unit or any aggregate can increase equity with saving and real investment … point being that increasing NAFA, either unit or aggregate, is not the only way to increase equity
It’s the only way to increase aggregate net financial assets for the sector. Net financial assets is a measure of net financial wealth, which is a measure of “net” equity.
ANON: There is one subtle and one not-so-subtle point about equity. Not sure which one you are making. The subtle point is that a stock claim is accounted for as an asset, but it is still held by one entity and issued by another, so still follows the asset/liability rule that, within the sector, nets out to zero. JKH pointed this out originally.
The not-so-subtle point refers to “paid-in capital and retained earnings” in the equity form. “Paid-in capital” is capital that come from another source, and so is a redistribution of financial assets within the sector, but not a net increase or decrease. “Retained earnings” had to originally come from payments from some other source, so it decreased their financial assets, and those payments were not all paid out, so some were retained within the corporation. Again, this is a redistribution of financial assets and not a net increase or decrease.
I specified I was talking about sector level increases in financial assets in a single sector model. Your opportunity to change my mind still stands.
(Another way for you to think about this is: whenever you create a financial asset you must also create a liability. Therefore, within a sector, all assets and liabilities must sum to zero. For there to be a net positive amount, there must be some other sector creating financial assets and liabilities and then giving those assets to the original sector. There is simply no way for a sector, within itself, to increase its net financial assets).
SCOTT: You are correct, “An individual firm can increase it’s NAFA, but the private sector as a whole cannot unless there is (in our closed model) an increase in G-T.” I am happy to call NPS NAFA, but it’s harder to get someone to go through a t-table exercise with NAFA.
NICK: “Now, in a closed economy, but with a government and government debt, does a fall in interest rates have a negative income effect on AD? That depends. The private sector is better off, but the government sector is worse off.”
The Government is no longer on a gold standard and is unconstrained in its spending. It has no need for income.
Also, I final note on whether “investment” is savings or not. I’m on the same page as JKH here, I save whatever I do not spend. I can spend on consumption, or I can spend on investment, but either way, my spending decision is creating income for someone else. Maybe I expect to be paid back in the future, or maybe I don’t. And even if I expect to get paid back, maybe I won’t.
When I buy a stock, if I count that as “savings” for me, it triggers “income” for the seller of that stock. Isn’t that weird to you? When I want my money back from my stock, I need to find a buyer, in order for me to get my “savings” back as “income”. And yet, if I buy an antique, is that really “saving”?
When I put my money in a bank however, or under a mattress, no one else gets income from my action. That money is effectively taken out of circulation. These two things are profoundly different, and are fundamental to understanding NAFA, savings, V etc. Understanding what actions take money in and out of circulation is critical to understanding how the financial system works, and if economics is muddying this by classifying the same transaction as both 1) being savings and 2) producing income it isn’t going to get stuff right.
Winterspeak you said: “When I put my money in a bank however, …, no one else gets income from my action. That money is effectively taken out of circulation. ”
No, is is a pretty bad misunderstanding about the economy works. Putting it under a mattress would be as you say, putting in a bank is not.
Putting it in a bank doesn’t help the bank’s operational ability to make a loan. It might improve the profitability of the loan (which could then help capital) compared to holding other, interest bearing liabilities, but the loan can be made, regardless.
However, if in the aggregate households are making the decision to put $$ in the bank instead of spending, then this reduced spending could actually reduce the likelihood of loans being made as it could reduce firm’s expectations of profits and potentially the banks’ perceptions of the credit risk of the borrower.
“Net financial assets is a measure of net financial wealth, which is a measure of “net” equity.” OK … but a bit of a dance in the invention of new terms … “net equity”… although with that the original error of using “equity” is crystallized
“The subtle point is that a stock claim is accounted for as an asset” … equity = saving … e.g. retained earnings … NOT = common or preferred stock …”Retained earnings” had to originally come from payments from some other source, so it decreased their financial assets” … retained earnings = equity = saving … NOT a financial asset … accounting 101 … “Your opportunity to change my mind still stands.” accuracy here is independent of that. “Another way for you to think about this is” good, but trivial … you’ve missed the point about the potential sources and uses of equity.
Winterspeak,
However you want to define the letters s-a-v-i-n-g, I wonder if you still agree that the behavior you exclude from conventional savings in your definition (i.e. investment) can still be economically interesting. So, if I decide to forgo my annual $200K birthday party and instead hire some people to build a house (maybe to rent out, maybe to live in sometime in the future), I have not engaged in your “savings” but I have nonetheless furthered my preference for future consumption over current consumption. And even though my behavior results in income to someone else (workers and supppliers), it also still has interesting sector-wide effects. In world A, I throw my party and provide income to others, with the resources disappearing into entropy. In world B, I build my house with the same income to others, but almost certainly end up with more resources for myself and the private sector as a whole. You focus on the fact that the private sector’s additional resources don’t reflect additional net financial assets. They also don’t represent more money. Nor do they represent more government debt. But they do represent something, and that something is related to the time preference expressed by people choosing to consume or not-consume. You apparently find that distinction between consuming and not-consuming uninteresting (since you leave it out of your dictionary), whereas other people find it much more interesting. Or, if you do find it interesting, do you have a name for “not-consuming,” i.e. in your language, investment plus savings?
Instead of caring about consuming versus not-consuming, you focus on either consuming or investing versus not consuming or investing. Other people care about this, too. Instead of calling it “savings” they call it “demand for money” and they talk about it a lot (though they still have a use for conventional definitions of savings). But I can guess that this doesn’t work for you, because you believe it is more useful to group money together with government debt when the government issues a fiat currency. So when you talk about savings, you aren’t primarily talking about time preferences, nor are you even talking about the acquisition of financial assets (because the “net” and the sectors are so important to your perspective). You are really just talking about an expanded version of the demand for money: Demand for money or government debt. My guess is that this issue — whether we should talk about demand and supply of money or money plus government debt when we talk about shocks like the one we’ve just had – is where you’d be having your most interesting discussions with traditional monetary disequilibrium people if the conversation didn’t get bogged down in savings semantics. If I have this right, I can’t help but think you’ve chosen a clunky way to express your perspective. It almost seems like you had a big revelation based on changing your terminology, and assume that this is the only way that other people will be able to see your point. In my experience, when one person has some kind of epiphany based on changing their vocabulary, one of the hardest ways explain that epiphany to most people is to start by redefining terms.
accounting 101 – corporate retained earnings is not a financial asset…it is a financial accounting entry … it is one of two basic financial accounting equity entries…the other equity entry is capital paid in when equity is issued…both are equity accounting entries … neither are financial assets…the financial asset is the stock that’s issued, which takes on a life and value of its own… financial accounting entries are not financial assets…when a corporation has stock outstanding, the financial asset is the stock and its market value, not the retained earnings accounting entry… corporate retained earnings is no more a financial asset than household net worth … both are accounting entries…you’re very confused on financial accounting versus financial claims … which is why you’re missing the basic point on the nature of equity
ADAM P: There were two things I learned that totally changed my understanding of the financial system and converted me away from monetarism. These were:
1. The private sector can only increase its holdings of net financial assets (NAFA, or NPS, or whatever) if the Govt funds it. Public deficits fund private savings.
2. Bank lending is not reserve constrained. My deposits in the bank do NOT fund that bank’s ability to make new loans. In fact, bank loans create the deposits.
It was very hard to understand these two points, and it is very hard to get others to understand them as well. I’ve found that if you can get people to see 1), it is easier to get them to see 2), but 1) and 2) together is too much and causes overload. But my success at communicating any of this has been terrible, so who knows.
ANON: If you believe that the private sector’s incapacity to increase its net financial assets is trivial, that’s fine. That is the number that private leverage is built up on, though, and I think it’s pretty obvious that it’s having profound consequences today. I have still to see t-tables, but you aren’t the first person who has gone from “impossible!” to “obvious and trivial”. I guess you can return to arguing about interest rates, but my offer stands.
dlr.myopenid.com: Thinking correctly about savings is extremely interesting. Nevertheless, to understand money you have to be consistent with how you count it, and conflating activities that do not count as income with those that do is, frankly, garbage. It is obvious why this is the case.
I find the distinction between consumption and non-consumption to be something you only know in hindsight. Your $200K house — was it consumption, or investment? Suppose there is a housing collapse (I know, impossible to imagine) and the house is now worth just $100K. How do you classify the $100K you’ve lost? Or suppose you bought a lottery ticket and got lucky — did that act of consumption suddenly become a shrewd investment?
Either way, in your example, your $200K is someone’s income, either a catering company, or a home builder. In the former case, it’s pure consumption. In the latter case, you get a real asset out of it, which you can live in, which may or may not go up or down in value. It’s a mix of consumption and investment, even in the good case where the value goes up, because by living in its you are foregoing rent. I don’t like housing as an investment example because it’s a mixed-use good, and thus often causes confusion. Also, you have to keep real assets separate from financial assets. I’ve repeated this, but it’s easy for it to get lost.
You are correct in that govt debt and money are close substitutes. When the Govt issues debt, the reserves to buy that debt must already exist, so you’re just moving the money from one container (“reserves”) to another (“treasury bills”). The Govt isn’t really borrowing money, it does not need to, it’s just changing the term structure of the money out there because that’s the mechanism it’s chosen to set interest rates.
I don’t know enough about the “demand for money” literature to say whether it’s what I’m talking about or not. I instinctively don’t like it because it does not seem to distinguish between privately issued debt, and Govt deficit spending. The private sector is free to create, or uncreate, as much internal debt as it chooses. But it cannot change the amount of NAFA, or NPS, or NFA, or net financial equity, or whatever it has, that can only come from some external sector.
Time preference is one element in savings, but not the only one. Balance sheet considerations matter too. They may even matter more. At a sector level that is almost certainly true.
I have yet to find a good term for the money the Govt injects into the non-Govt sector when it deficit spends, that people can then take a model out in t-tables. My batting average in this is zero, so I know I need help and am open to suggestions.
Let’s try a different route rather than regurgitating lectures for classes I already teach . . . back to Winterspeak’s original question:
How does a sector, within itself (no transactions with outside sectors), increase its net financial assets?
“How does a sector, within itself (no transactions with outside sectors), increase its net financial assets?”
That’s trivial. It can’t. Never said it could. That’s never been in question, and hasn’t been the point of my objection. Where have I said it could?
“you aren’t the first person who has gone from “impossible!” to “obvious and trivial”
that’s it; change the subject and distort the record when you can’t understand or answer the question
Winterspeak, when GE issues a bond that doesn’t create a net financial asset? I suppose that you’ll respond that since it’s paid in money on the net they haven’t created a new financial asset, they’ve just repackaged government debt.
Fine, what about a bond that is paid in goods? There is in fact a precedent for this. During the civil war the South issued bonds that actually paid sugar cane. Russia has suggested issuing debt redeeemable for oil.
But anyway the question is a hypothetical. Suppose GE issued a bond that pays in some basket of GE produced goods. Would that increase total net financial assets?
“when GE issues a bond that doesn’t create a net financial asset?”
every financial asset is also a financial liability; net zero; that’s why that part of the subject is trivial
“what about a bond that is paid in goods”
that’s not a financial asset
“Never said it could.” OK!
“that’s why that part of the subject is trivial”
meaning from an accounting perspective … the economics are profound … never said otherwise
ADAM P: Anon is correct in his description of what happens when GE issues a bond, and in what happens when the bond is payable in real goods.
ANON: Help me out here. It seems like you understand that the private sector cannot increase its “increase its net financial assets” by itself. Great. So, suppose all all private sector credit was paid down or written down, all loans were paid down or written down, all stocks issued were bought back, every receivable was received, or written off, etc. etc. All the financial assets created in the private sector were uncreated
The balance sheets would not be zero. You would have something like “cash” on the asset side, and an equity entry on the liability side, that would be called something like “paid-in equity” or “retained earnings”. That is the entry that I’m trying to name.
What would you have left, and how would that be represented on a balance sheet? (Again, I’m focused on financial assets, no real assets).
…unusual question … only makes sense on consolidation because you’re eliminating almost all inter-unit claims … I’ll answer it in the context of net financial assets but you can’t ignore real assets in the real world so… you would be left with real investment (corporate and household) as assets, with a combination of corporate retained earnings and household net worth (i.e. household equity) as offsetting equity … no private debt in the economy at all…. no common stock in the economy at all … consolidated result: real investment offset by equity … good illustration of my first point … PLUS net financial assets with the government sector offset by the same amount of additional equity … all equity represents cumulative saving … to my point total equity or saving splits between real investment, and net financial assets with the government … if you want to ignore real assets, your “net equity” entry would still be a combination of corporate retained earnings and household net worth, depending on who owns the government debt … small detail in the banking system – allow for reserves and equal offsetting deposits for that part of net financial assets plus currency – everything else eliminated by supposition … also, have excluded external sector here to keep it simple … my first take on a wild question
P.S.
external sector adjustment – a foreign current account surplus is net foreign saving which is a piece of net foreign equity – chase down the micro accounting entries at origin in the foreign country – note that the foreign surplus is a surplus with the combination of all domestic sectors, not with the government sector directly or only… then bundle in foreign sector with domestic non government sectors and proceed to net financial assets with government, etc. … a little complicated in untangling it all …
P.P.S.
Mr. Fullwiler coined the term “net equity”… suggest a high level balance sheet terminology consisting of net financial assets offset by “net financial equity” (as opposed to “real equity”.) Net financial equity then breaks down to some combination of retained earnings and household net worth…depending on who owns the government debt and currency and reserves.
My use of “net equity” (and I used quotation marks because I knew it was not the standard use of the term) was only an attempt to explain the same thing Winterspeak is asking about, not an attempt at redefining.
Also, we are quite aware that you can’t abstract from real assets. We don’t want to do that at all. The point, though, is that we are in this case describing the changes to financial statements due (at least mostly) to financial transactions.