To paraphrase Churchill, accountants and economists are divided by a common language. We seem to be using the same words to talk about the same things, but we don't understand what the other is saying. This is my attempt to provide an economist's perspective on the relation between accounting and economics.
What I say here will not I think be new or controversial for economists (until I start talking about money). Accountants may find it hilariously wrong, like locals hearing tales from a traveller who can't speak the local dialect and gets everything muddled. Let's see.
Like most economists, I don't think about accounting much. Normally I only think about it when I teach the ECON 1000 bits on national income accounting and money and banking, and try to remember if assets go on the left or right side of a balance sheet (I rely on my students to remind me). I decided to write this after an interesting exchange with Winterspeak, both here and on his blog.
So, here's my take on accounting:
There are two fundamental accounting identities. Here's the first:
1. stuff bought = stuff sold
If some people bought 100 apples, some (other) people must have sold 100 apples. The "stuff" in question can be a flow or a stock, measured in monetary or real units, or whatever. If it's a flow we call it income accounting. If it's an accumulated flow, or stock, we call it balance sheet accounting. The stuff could be real goods and services, or it could be financial stuff. All accounting consists of dividing and subdividing stuff into different categories, trying to keep your head straight when doing it, so that the RHS and LHS both capture mutually exclusive and jointly exhaustive ways of dividing the same stuff. Don't miss anything out, and don't double-count.
This is an identity; not just an equation. it's true by definition of what we mean by "bought" and "sold". It's not something we could go out and test empirically. If we did test it empirically, and found the numbers weren't equal, we would figure we must have made some sort of mistake in the test, like adding things up wrong, forgetting something, defining "stuff" inconsistently, or somebody lied to us, or whatever. And because of that, it doesn't tell us anything about the world, only about how we must use words in a logically consistent manner if we are to think about the world without internal contradictions.
The equivalent sentence in economics has three different variants:
2a. stuff demanded = stuff bought = stuff sold = stuff supplied
is the complete version, though it's often shortened to:
2b. stuff demanded = stuff traded = stuff supplied
And sometimes we shorten it further still, to:
2c. stuff demanded = stuff supplied
First, 2a and 2b are logically equivalent, since the middle "=" is an identity, so that "stuff bought" and "stuff sold" are just two ways of saying the same thing.
Second, "stuff demanded" means the amount of stuff buyers want to buy, and would buy if it were available to buy. It doesn't mean "stuff bought". Same with "stuff supplied".
Third, the other two "=" are equalities, not identities. They can be empirically false, and are empirically false when there is excess demand or supply. They are only both true in full market-clearing equilibrium.
Fourth, 2b reveals that there are really two "=" in market equilibrium, where buyers get to buy what they want to buy, and sellers get to sell what they want to sell. Normally we impose the "short side rule" so that quantity traded is whichever is less, quantity demanded or quantity supplied. This means that if 2c is true, both sides of 2b will be true as well. But the short side rule is an empirical fact about markets: that exchange is voluntary. I can at least imagine cases where 2c is true, but both buyers and sellers are forced to trade either more or less than they want, so 2b is false.
By common stereotype, accountants are careful people; economists are usually sloppy people. We often get really sloppy in speaking to distinguish between 1 and 2, and between 2a or 2b, and 2c. That might be the problem. Or it might be that accountants just don't understand the difference between demand and buy, and supply and sell.
Let's take a specific example of 1. In national income accounting, we define "stuff" to be a flow of newly-produced goods. And we divide the stuff up according to who does the buying: households, firms, government, or foreigners (though we aren't altogether consistent here, because we often fudge investment, and imports are a weird category – more a subtraction from C, I, and G).
3. C+I+G+X-M = Y
(Newly-produced) goods bought = (newly-produced) goods sold.
We don't have to divide the stuff up in this way; we could divide it between goods and services; or stuff made on Mondays, Tuesdays, etc. We divide it this way if we think (or some economists think) it's useful to divide it up this way, because, for example, households, firms, and foreigners are influenced by very different things in deciding how much they want to buy. And it's economists, not accountants, who must ultimately decide what categories are useful to us. But already I'm starting to talk about stuff demanded, and economics, not stuff bought, and accounting.
The important point is this: economists can and should decide on their own ways to define the "stuff" that is bought and sold, and how to divide it into sub-categories of "stuff". We decide on a conceptual scheme that is useful to us, not to accountants. And it is useful to us if it matches our behavioural theories of how the world works. We don't have to follow the accountants' conceptual scheme, and shouldn't follow the accountants, if we have a different scheme that is more useful to us. Ultimately, we economists have to be our own accountants.
The second fundamental accounting identity is this:
4. The value of the stuff I buy = the value of the stuff I sell.
We have to be really careful with this one.
Think about a barter exchange: I swap my 10 apples for someone's 5 bananas. The price of a bananas is 2 apples. So I sell 10 apples and buy 10 apples' worth of bananas in exchange. Those "values" are the prices at which the transactions are made, even if the bananas turn out to be rotten. Unlike the first fundamental accounting identity, which can be expressed in physical units if you want, this one can't; it must be expressed in values. (Maybe this is why accountants have so much difficulty dealing with inflation? Dunno. Maybe not.)
What about monetary exchange? If I sell 10 apples at $1 each I "buy" $10 in the medium of exchange – money. That's what causes misunderstandings, because we don't normally talk about "buying" or "selling" money. But we have to in this case.
Now let's consider the economist's version of 4:
5. The value of the stuff I demand = the value of the stuff I supply.
In other words, when I go into any particular transaction, at any price, deciding how much I want to transact at that price, I get the maths right. I don't demand $20 and supply 10 apples at a price of $1 per apple. That makes sense. The only thing that could make it false would be if people made math mistakes. It's close to an identity, but isn't quite, because empirically people do make math mistakes.
Now, what happens when I aggregate up over all transactions I make? You get: the sum of the values of my excess demands must equal zero. Aggregate over all people (and firms and governments): you get Walras' Law. The sum of the values of excess demands must equal zero. [Update for clarity: an equivalent statement of Walras' Law is: the sum of the values of goods demanded must equal the sum of the values of the goods supplied. Excess demand=demand minus supply.] If you forget to include money as one of the goods, you get (one version of) Say's Law (and it's not a version necessarily believed by Say himself, but let that pass).
Now, many (most?) economists believe in Walras' Law (or think they do). But I don't. I think it's fine to aggregate over all transactions in the accountant's version 4 (the sum of the value of excess purchases is identically equal to zero). But I don't think it's fine to aggregate over all transactions in the economists' version 5, even if everyone has perfect math, and is perfectly rational.
If we make all our purchases and sales at the same time in one big market for all goods, then Walras' Law would be right (unless somebody got the math wrong). But in a monetary exchange economy, with n-1 [typo fixed] goods plus money, there are n-1 markets. In each of those n-1 markets we make a separate decision to transact in that market, subject to any constraints we expect we might face on how much we are actually able to buy and sell in each of the other n-2 markets, if any of those markets are in disequilibrium. Clower/Leijonhuvfud/Bennassy etc..
That means n-1 separate maximisation problems, in principle. Each one of those maximisation problems will satisfy Walras' Law, but the only way we can add them all up consistently is if we recognise that there are n-1 separate excess demands for money, coming from each of those separate decisions.
So the only generally correct aggregate economist's version of the second fundamental principle of accounting is this:
6. The sum of the values of the n-1 excess demands for non-money goods, plus the sum of the n-1 excess demands for money, is identically equal to zero, provided the people doing the demanding and supplying can do math.
I have no idea what the accountants will make of 6.
Worthwhile Canadian Initiative 
Winterspeak @ 6:00 p.m.
The answer to that is beyond obvious.
Why are you asking that question?
JKH: With respect, your responses are, in general, pretty dense. It’s easy to get lost as you work through them. Always worth the effort though, so please do not take this the wrong way! Strangely enough, I understand you more easily when your posts are very short.
As I move through your response, I’d love to get feedback on whether I am on the right path or not. Thus I asked the obvious question.
Clearly, you and I are not on the same page wrt to non-govt equity. You don’t always specific whether you mean net non-govt equity, or non-Govt financial equity, or net non-govt financial equity. Are those omissions intentional, or just to improve readability? Just wanted to be sure.
If your point is that there are enough real assets in the non-Govt sector that they contribute a meaningful equity base to leverage on top of, and thus are a meaningful addition to NFA equity from deficit spending, that’s certainly an interesting point. You would be saying that, although we cannot ascribe an exact price to them, they have SOME value, maybe even a lot. Maybe even enough to swamp the value of NFA equity.
But I don’t know if that’s what you mean.
Winterspeak @ 6 p.m. # 2
By obvious, I meant the following:
First, you specified in your question the elimination of all non government financial assets. And then you ask what non government financial assets would remain. You answered that in the question – zero.
Then you ask for what remains, but you’re not interested in real assets. I’m sorry, but you can’t understand the world if you’re going to impose such overwhelming constraints on the examination of it. It’s infuriating. Believe or not, MMT is not the world in its entirety. It has a context. That’s much of my point. Given the elimination of all financial assets, is it likely that a sensible answer to the question excludes at least a reference to real assets?
So here’s the answer:
What remains is that the non government sector has real assets offset by balance sheet equity. In addition, the non government sector has net financial assets with the government sector, offset by the same amount of additional balance sheet equity.
I was interested in knowing where that would get you, which is why I asked why you were asking the question.
Now I’ll have a go at your 7:47 p.m. question.
Winterspeak @ 7:47 p.m.
I mean non government equity. I mean what’s on the right hand side of the consolidated non government balance sheet.
The right hand side is a gross equity position.
The left hand side consists of financial assets with the government and real assets, when everything is consolidated, as per the previous question.
The only time I’ve used the phrase net in connection with equity is with respect to what I termed NFA equity, which corresponds to the piece of equity that offsets the net financial asset position with the government.
The reason what I write is “dense” is that I tend to take the time to define and explain things.
I don’t know what those various terms you’ve used above mean. You’d have to explain that to me, not vice versa.
Your other comments suggest you’ve barely absorbed what I’ve written to date, and I’ve written a lot, including many references to the various numerical quantities involved. It appears you taken little note of the relative magnitude of these numbers, since they refer precisely to the magnitudes you’re wondering about.
“The only time I’ve used the phrase net in connection with equity is with respect to what I termed NFA equity”
Correction. I may have used it in the sense of sector positions. E.g. the foreign sector (i.e. foreign sector to the US) has a net financial asset position with the counter party combination of the domestic private sector and the government sector. That position constitutes cumulative saving, marked to market, through cumulative US current account deficits. I may have used the phrase net equity to describe such foreign sector cumulative saving or wealth with respect to its position with the US; I don’t recall. But its consistent usage of the term net. It’s just that its not net with respect to only the government.
JKH: Yes, real assets were something that I had not paid any attention to.
As far as the magnitudes, I honestly do not know what to make of them. Even if (and I realize this is not the case) NFA equity was the only sliver of the capital base that private sector credit was heaped upon, I honestly do not know what is the “right” amount, and if a given amount of leverage is too much, or not. V has, and can, change pretty dramatically. How much of that is tied to the NFA equity leverage number, I really honestly do not know. The Federal Govt right now is trying to re-ignite private credit extension, while that sector de-leverages after a credit binge. Is that a viable strategy? Again, I do not know.
I do know that the price of real assets depends on the amount of credit available. The cash buyer has a very different willingness to pay than the leveraged buyer. Inflation/deflation price adjustments become really important when real assets come into play, which is one reason why I was setting them aside. You don’t need to worry about that kind of thing when everything is nominal.
You really shouldn’t get infuriated with me. There are better targets for you to vent your wrath at.
Winterspeak,
This was a post about the relationship between economics and accounting. The “Modern Monetary Theory” or MMT brand is built on a foundation that includes the accurate presentation of a particular area of accounting focus – that of central bank reserves, deficits, and the banking system. The MMT brand is also associated with a style where its proponents generally rebuke the neoclassical thinking of those economists who simply don’t understand operations and the accounting for the monetary system. This is very understandable. The way I think about it is that it’s very unlikely that an area of economic thinking will hold much interest for me if I happen to know that its premise is riddled with misunderstanding as to how existing modern monetary systems actually work. And I believe MMT is very accurate in its understanding of the accounting issues that are relevant to its focus. But this also sets a higher bar for MMT proponents, of which you are clearly one, in terms of their own understanding of the accounting issues. The particular accounting focus of MMT is in fact a small subset of accounting as it applies to economics more broadly. To the degree that MMT proponents begin to make more sweeping statements about accounting interpretation, it should be incumbent among them to ensure that such statements accord with the facts of accounting outside of the MMT focus. If such statements are inaccurate or misleading, it becomes a case of the pot calling the kettle black. That warrants strong push back.
JKH: I get your point and I accept it. I genuinely don’t know how to handle real assets because of the valuation issues I raised in an earlier post. The amount of leverage you extend against a real asset depends on the value of that asset, and the value of that asset depends on the amount of leverage available to be extended against it. It’s very circular, as anyone who has lived through the past 10 years can attest.
So, if you close out all private sector credit, you’ll be left with a consolidated balance sheet that includes whatever NFA equity paid-out by the Govt, plus real assets. I absolutely do not know how to guess at the $ value of those assets, but I would start by valuing them at what the non-leveraged buyer would pay. And that, at least in part, would be driven by discount rates, so I see a clear role for monetary policy in private sector credit extension (and I have no idea if MMT adherents would agree). It would also be driven, in part, by the quantity of NFA equity in the private sector.
I don’t know to what degree accounting can help here, as there are lots of accounting models that deal with precisely this issue, and all have their pros and cons. I am open to suggestions.
Winterspeak,
Let’s stick with the accounting first.
The Fed flow of funds report Z1 handles corporate real assets by passing them through the lens of financial assets. The non-corporate sectors hold financial claims on corporations, including their real assets. So the direct valuation of corporate real assets is avoided. The value of real assets is reflected through the liability and equity claims side of corporate balance sheets. That’s how non government equity is ultimately valued in such a way that it takes into account the effect of real assets held by corporations. As far as household real assets are concerned, that is captured directly as the value of residential real estate and consumer durables.
So if you assume a closed economy with a net zero foreign sector, non government equity includes:
a) Household real assets such as real estate and consumer durables
b) Net household financial assets such as stocks, bonds, mutual funds, pension and insurance values, less any liabilities such as mortgages and consumer credit.
Note importantly that the definition of net household financial assets as in b) automatically embeds as a subset the net financial asset position of the non government sector with the government sector. E.g. household direct holdings of government bonds are included. E.g. pension fund holdings of government bonds are included by virtue of the indirect reflection of that value through a household financial asset equal to the pension fund obligation to that household
When you add in the foreign sector, note that the foreign sector is itself a net financial asset position, but again in the more general sense like households. And again, any non government net financial asset position with the government is embedded in that more general net financial asset position. E.g. China’s holdings of government bonds are part of that foreign sector net financial asset position.
So that’s the larger, global accounting context for the handling of real assets and everything else as I see it.
Beyond the accounting, you get into judgements about leverage strategies, which I’d prefer to leave as a separate discussion until we’re on steadier ground with respect to the global accounting, in which MMT accounting is embedded. The proper global accounting is as essential a prerequisite to that integrated leverage discussion as is MMT focused accounting to the proper discussion of government deficits.
I guess I’m saying I’d like to see your question put in the context of a more mutual understanding of a global accounting framework that is bigger than MMT (I mean global conceptually rather than geographically, although that too). That said, your question may disappear in a sense, because the original issue of contention was the interpretation of MMT NFA equity versus equity in the larger global context as I’ve defined it. That larger global equity position includes the reflection of real corporate assets through a financial asset lens. This has essentially been an accounting issue that impedes better discussions about strategies such as leverage. If that obstacle can be removed, the discussions about strategy flow much easier I’m sure.
Nick,
This is quite good.
http://blog.andyharless.com/2009/11/investment-makes-saving-possible.html
You’re on his favorite blogs list, so I find the topic a little more than coincidental, including a haircut example.
JKH and winterspeak, IMO people need to look at the situation like this. There is a domestic lower and middle class, a domestic gov’t, and domestic rich. There is also a foreign lower and middle class, a foreign gov’t, and foreign rich. Now add in retirement and its economics.
Here is one question. How should retirement be accounted for?
Ah yes, I was about to post the link to Andy Harless. It seems pretty likely he must have been reading this conversation or at least some of Nick’s previous posts (and the comments).
Fascinating discussion, though I’ll need to set aside some time to read all of it.
In the meantime a note on Krugman: he does indeed state that the deficit enables private saving rather than vice versa. It’s implied in:
http://krugman.blogs.nytimes.com/2009/07/07/the-paradox-of-thrift-for-real/
and in:
http://krugman.blogs.nytimes.com/2009/07/15/deficits-saved-the-world/
and stated fairly explicitly (with a link to Brad Setser) in:
http://krugman.blogs.nytimes.com/2009/06/06/wheres-the-money-coming-from/
I believe Krugman is a closet or un-selfdiscovered MMT’er, and a potential valuable ally to their cause.
But Warren Mosler, who is as out front an MMT’er and leader of their cause as there is, doesn’t:
http://www.moslereconomics.com/2009/11/24/krugman-on-the-phantom-menace/
Leigh Caldwell, I had a look at the 3 posts.
I would be interested to know what the graphs would look like in the second link ( http://krugman.blogs.nytimes.com/2009/07/15/deficits-saved-the-world/ ) if the private sector “surplus” was broken down into the rich and the lower and middle class.
JKH: Yes, I had read Andy’s post. But this is well-trodden ground in macro. Nothing I said about S=I is original with me. I stick close to the mainstream on this topic, except I depart a bit when I start talking about money.
Paul Krugman is writing about S-I=G-T within the context of an economy in a recession with the rate of interest stuck exogenously. He would almost certainly say very different things about causation in a different (normal) context. He might sound a bit “MMT-ish” in that context, but there is no way he would say the same things otherwise.
Semi 0ff-topic. I just realised where I had heard the name “Warren Mosler” before. He’s the guy that makes really neat cars! I had read about him on car blogs, “PistonHeads” I think. I wonder how he’s getting on with GM (not General Motors)?
“Paul Krugman is writing about S-I=G-T within the context of an economy in a recession with the rate of interest stuck exogenously.”
How about is this correct?
(S-I) of the rich = (G-T) minus (S-I) of the lower and middle class
Too much Fed: Yes, that’s correct. So is:
(S-I) of men + (S-I) of women = G-T
(S-I) of right-handed people + (S-I) of left-handed people = G-T
Which illustrates my point: the accounting identities that are useful to you depend on your theoretical perspective.
Nick,
Apart from making good cars, Warren Mosler also writes well. You may want to look at “Seven Deadly Innocent Frauds” http://mosler2012.com/wp-content/uploads/2009/03/7deadly.pdf
Ha! As I pasted this link, I got reminded.. he is also running for the President for 2012.
Nick,
Re Krugman, I was agreeing with Leigh’s comment.
Also, the following:
http://neweconomicperspectives.blogspot.com/2009/07/employing-krugmans-cross-farewell-mr.html
http://neweconomicperspectives.blogspot.com/2009/07/krugmans-new-cross-confirms-it-job.html
Nick,
Thanks for hosting this discussion. I hate to “put you under the microscope”, as it were, but I find your inability to “get it” fascinating (and somewhat disheartening). I mean, you’re not as arrogant as someone like Krugman or Delong, and you seem genuinely to want to engage with new ideas. But I am forced to conclude that an early exposure to neoclassical thinking leads to economic brain damage (it’s like learning BASIC as your first computer language…)
Thanks Jim! I can’t afford to be as arrogant as PK or BDL; I’m not as good as them!
As you get older and more out-of-date, it’s actually easier to be less hostile to new ideas. It’s the young bright guys, fresh out of grad skool, who have most to lose if a new idea makes worthless all their highly specialised theory-specific human capital. All we old guys have left is our general human capital, because all our specialised knowledge got blown out of the water decades ago. (I got that idea, which I think is brilliant, from an even older guy – John Chant.)
I DID learn BASIC as my first (and only) computer language. How did you guess? Funnily enough though, my earliest exposure to economics was very Keynesian.
Given the topic of this post, I can’t resist commenting on the following. It’s a staggering example of a very well known economist who hasn’t a clue as to the basics of financial accounting. Here’s Mark Thoma on excess reserves:
“the Fed has injected liquidity into the system by increasing bank reserves substantially — massively is a better description — and the result is that a very large quantity of excess reserves has accumulated within the banking system. Reserves sitting idle within the banking system, as they are now, are not much of a problem and they provide insurance against unexpected losses in other areas of a bank’s balance sheet.”
In this case, we have one of the most widely read economists in the blogosphere not understanding that profit and loss flow through the income statement and the capital account – not central bank reserves, for goodness sakes. This is a truly mind boggling error.
The rest of his diagnosis of excess reserves is wrong as well, in a way that extends beyond the accounting alone. It’s the usual stuff. I don’t have the patience to go into it.
Here’s the complete mess:
http://moneywatch.bnet.com/economic-news/blog/maximum-utility/worries-about-budget-deficits-and-inflation-lets-avoid-repeating-our-mistakes/262/
JKH . . . all I can say is, wow!
Frightening, Scott.
OK, I confess. I don’t get what’s wrong with what Mark Thoma said either, in that paragraph you quote.
Nick,
It’s because “excess reserves” just change around the content of the banking system’s balance sheet, they don’t provide “insurance” against losses. Let’s say you owe $100000, have $50000 in a savings account, and $60000 in a checking account. If I transfered $10000 from the savings to the checking, would you say you were “better insured against losses”?
The other problem in Thoma’s presentation is that he implicitly clings to this fractional reserve nonsense, implying somehow that these reserves affect lending decisions by a bank. A bank will make a loan (and create a deposit) if it finds a good credit risk. That means the borrower is “creditworthy”. The whole top down premise that somehow you shove enough money at the banks and build up their reserve positions and force them to lend is based on a completely wrongheaded paradigm.
Trying to get anyone to understand that Treasury “borrowing” is just re-arranging assets has been near impossible, in my experience.
And that’s a very simple transaction compared to loans creating deposits, for example! Or deficit spending funding NFA equity.
Thoma has no clue, and is in excellent company.
My post said: “(S-I) of the rich = (G-T) minus (S-I) of the lower and middle class”
Nick’s post said: “Too much Fed: Yes, that’s correct. So is:
(S-I) of men + (S-I) of women = G-T
(S-I) of right-handed people + (S-I) of left-handed people = G-T
Which illustrates my point: the accounting identities that are useful to you depend on your theoretical perspective.”
I am trying to approach this from a “what’s happening in the real world” perspective.
Can you see that when the lower and middle class stopped going into currency denominated debt to the rich/politically connected domestic/foreigners (and some even tried to default) that the rich/politically connected domestic/foreigners got the gov’t to bailout them out of some of the bad currency denominated debt and got the gov’t to go further into currency denominated debt for the lower and middle class so the rich/politically connected domestic/foreigners could maintain their excess savings?
I am going to post this and see what everyone thinks.
Jim Baird said: “It’s because “excess reserves” just change around the content of the banking system’s balance sheet, they don’t provide “insurance” against losses.”
It seems to me that bank reserves are debt instruments (let’s say fed debt) and that the U.S. gov’t won’t allow the fed to default/fail. If so, does swapping bank reserves for bad debt just mean that the fed is trying to “hide” the bad debt until more can be created to offset the losses?
Plus, if the gov’t won’t allow the fed to default/fail, are bank reserves actually gov’t debt (possbily future gov’t debt) in disguise and is “insurance” because the gov’t debt “socializes” the losses on taxpayers?
Marshall Auerback, so do you think Steve Keen is right? and from:
http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/
“In the real world, banks extend credit, creating deposits in the process, and look for reserves later.”
And, “Thus loans come first—simultaneously creating deposits—and at a later stage the reserves are found. The main mechanism behind this are the “lines of credit” that major corporations have arranged with banks that enable them to expand their loans from whatever they are now up to a specified limit.
If a firm accesses its line of credit to, for example, buy a new piece of machinery, then its debt to the bank rises by the price of the machine, and the deposit account of the machine’s manufacturer rises by the same amount. If the bank that issued the line of credit was already at its own limit in terms of its reserve requirements, then it will borrow that amount, either from the Federal Reserve or from other sources.
If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:
refuse to issue new reserves and cause a credit crunch;
create new reserves; or
relax the reserve ratio.
Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.
Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail.”
Marshall Auerback said: “A bank will make a loan (and create a deposit) if it finds a good credit risk. That means the borrower is “creditworthy”. The whole top down premise that somehow you shove enough money at the banks and build up their reserve positions and force them to lend is based on a completely wrongheaded paradigm.”
It seems to me we are headed to a two tier credit system. If a bank is politically connected and does what the fed wants, the gov’t/the fed will bail you out of bad debt. If a bank is not one of the two, it is on its own.
Nick,
I agree with the comments of Marshall Auerbach, Jim Baird, and Winterspeak. They’ve emphasized the general theme of reserves, also noted many times in comments throughout your Chartalism and Accounting posts. Jim Baird also hits on the salient accounting point. Thoma’s errors are not that surprising; it’s a recurring pattern with him.
I quoted the part with the insurance reference because it was so apocalyptically egregious from the perspective of the theme of your post, which as I saw it opened up the question of appropriate integration of economic and accounting analysis.
To the degree that that Thoma’s insurance analogy is invoked, its correct application is very different in the case of each of central bank reserves and bank capital.
The insurance concept with respect to central bank reserves has to do with liquidity risk. From a systemic point of view, the central bank supplies a sufficient amount of reserves in order for the overnight rate to trade at or near the policy target rate. In times of crisis, this may require more reserves, because banks may be hoarding reserves. The reason they’re hoarding is due to an abundance of caution with respect to their own ability to attract sufficient funds in order to maintain their reserve accounts at required levels. This was a big factor in the early days of the crisis. To the degree that banks were cautious in such hoarding, they could be said to be “self-insuring” their own liquidity risk. To the degree that the central bank responded, it could be said to be the “insurer” of that risk for the system as a whole. As the crisis progressed, and as additional central bank initiatives took effect, that liquidity insurance motive took on less importance.
As the crisis evolved, the Fed increased excess reserves as a natural consequence of its initiatives on the asset side of its balance sheet. It created new money through its own credit expansion. That money came back to its liability side as reserves. The Fed chose to leave those reserves in place and pay interest on them. Thus the excess reserve strategy was eventually associated more the balance sheet requirements of central bank asset management, than those of commercial bank asset management.
On the other hand, the insurance concept with respect to bank capital has to do with risks other than liquidity. The purpose of capital, literally, is to absorb unexpected financial losses. These losses have to do directly with risks other than liquidity – credit risk, interest rate risk, foreign exchange risk, etc. Insurance against losses is equivalent to a put option, with a financial payoff in response to a certain event. The event in this case is a financial loss due to risks such as those noted. The payoff is the charge to capital (allowing for the effect on capital position of any current period net income).
Thus, there are two broad categories of banking risk – liquidity risk, and a group of risks that have to do directly with financial loss. That second group is sometimes rolled up into the terminology of capital or solvency risk. Liquidity and capital risk can display interactive dynamics, particularly in financial crises, but they are distinct risks. To say that this is a huge topic on its own would be an understatement.
Capital and liquidity are distinct also from an accounting perspective. Accounting statements are in a sense the ex post representation of realized risk. You can’t think properly about risk in the future, unless you can project conceptually the ex post accounting representation of various possible outcomes of that risk.
Capital risk, and the risks that underlie it, are represented ex post in the income statement and balance sheet. Any financial loss will be entered as a charge to income and/or capital.
Liquidity risk is represented ex post in the balance sheet and the sources and uses of funds statement. E.g. a bank that has accumulated excess reserves through deliberate hoarding, or through relatively passive participation in a systemic excess reserve environment will show its share of reserves as a balance sheet asset. The change in that “stock” or asset will be reflected as a “flow” in the sources and uses of funds statement for the relevant accounting period. The principal amount of such flows will never be recorded on the income statement. The only related aspect that touches the income statement is the interest income paid on reserves.
That brings us back to Thoma, who said that “reserves sitting idle … provide insurance against unexpected losses in other areas of a bank’s balance sheet.” In addition to the fundamental background errors noted by the commenters above, and following from Jim Baird’s more specific comment, this statement by Thoma is an almost inconceivably incorrect conflation of entirely distinct accounting measures. To use his insurance analogy, the insurance functions pertaining to each of central bank reserves (i.e. liquidity) and capital should be entirely different, as described above. Central bank reserves are not some repository of net worth to be used as a cushion against losses. Thoma’s confusion on how to read a balance sheet correlates strongly with his misinterpretation of excess reserves. That seems quite relevant to the topic of your post.
The following should be of interest regarding the Thoma piece:
And, Too Much Fed, that quote from Keen is correct.
Regarding Winterspeak’s point, I just did a post this week on that precise issue with the accounting operations (they’re quite simple, but most don’t know how to do them) and it was posted at various places around the web. A number of commenters claimed it was “dangerous” or “irresponsible” for me to explain this.
Saw your post, Scott, which I thought was very good. Some interesting subtleties there about bank versus non-bank purchases of bonds.
That’s an odd reaction from those commenters.
Thanks for noting Bill Mitchell’s piece. Hadn’t seen it yet.
Scott: Somehow I missed all your posts. Can you point me to one? Thanks!
Happy Thanksgiving everyone
The original post from this week is here:
http://neweconomicperspectives.blogspot.com/2009/11/what-if-government-just-prints-money.html
That was my first one since July, actually.
With a thumbs up from “Flow5”.
Now that’s a compliment!
Some here will be interested in the “discussion” going on at:
http://economistsview.typepad.com/economistsview/2009/11/worries-about-budget-deficits-and-inflation-lets-avoid-repeating-our-mistakes.html#comments
Thoma appears more defensive than normal. I’m collecting quotes from big name economists who have said things that are quite embarrassing if an understanding of reserve accounting ever becomes widespread. Thoma should have his own page on my list after the past few days.
Commercial bank reserves at the central bank are the most liquid form of asset they can hold. And also the safest (except for the inflation risk, but since their liabilities are subject to that same inflation risk, that’s probably a good thing). So an individual bank is safer (with respect to both liquidity shocks and shocks to the value of its risky assets) if it has a higher proportion of its assets held as reserves than if it lent them out in some sort of risky and illiquid loan. Isn’t that what Mark Thoma meant?
OK, to say they are “insurance” against other risks isn’t strictly accurate. If I have a safe asset, equal in value to my house, that isn’t the same as having insurance against my house burning down. But I will accept the word “insurance” as a metaphor here.
Where I might disagree with Mark Thoma is that this might be true for an individual bank, but I am less sure if it is true for the commercial banks as a whole. (If they all expanded loans, would this make economic recovery stronger and reduce risk?) But that’s a different argument.
“So an individual bank is safer (with respect to both liquidity shocks and shocks to the value of its risky assets) if it has a higher proportion of its assets held as reserves than if it lent them out in some sort of risky and illiquid loan. Isn’t that what Mark Thoma meant?”
On an individual bank basis, that may have been what he meant, but it’s wrong relative to the non-liquidity risks that involve financial losses, as I discussed above. Reserves are zero risk weighting, and require no capital underpinning on a risk weighted basis. They are neutral in the sense of both risk taking and associated capital requirements.
The same bank with risky assets instead of reserves would require additional capital. So the choice between the two asset alternatives as presented is a false one, because one of them requires additional capital.
The correct comparison is between two different banks (effectively) with two different risk asset portfolios and two different capital requirements. The fact that they have two different reserve positions is irrelevant to the assessment of non-liquidity financial risks, which is the relationship to which Thoma was referring.
Let’s call a spade a spade. To say reserves are insurance against other assets is strictly inaccurate. The insurance metaphor is wasted if used nonsensically.
OK. I’ve now read the whole of Mark Thoma’s post. It looks OK to me. (I might have a little less faith than him in fiscal policy, and more in monetary policy, but that’s a separate argument).
But on the argument in the comments, with R. Winslow, I think they are talking past each other. At root of the misunderstanding is the accounting/economics distinction between quantity sold and quantity supplied. In this case the quantity in question is reserves. R. Winslow (who must be one of you guys, under a different nom de plume?) is talking about reserves sold by the banking system; Mark is talking about reserves supplied by the banking system. And YES, they are different. If (like the French) we used the word “offer” instead of “supply”, (and if economists were more careful with their language in making this distinction), the misunderstanding would disappear. And it’s compounded in this case by the distinction between an individual bank, which can lose reserves, and the banking system as a whole, which cannot (unless there’s a cash drain or an OMO, or something).
Oh god, I expect I should do a post on this, to let you accountants and MMT’ers have another go!
Scott Fullwiler, I thought that “In the real world, banks extend credit, creating deposits in the process, and look for reserves later.” was correct.
I scanned your post “What If the Government Just Prints Money?”
http://neweconomicperspectives.blogspot.com/2009/11/what-if-government-just-prints-money.html
First, I don’t believe anyone should say the phrase “prints money”. It is not specific about what is happening. I believe it should be what if the gov’t prints currency, what if the gov’t attempts to sell gov’t debt denominated in currency, and what if the gov’t allows the fed to “print” bank reserves to attempt to produce private debt denominated in currency.
Since the fed can’t print its own currency and IMO the gov’t won’t allow the fed to default/fail, bank reserves are actually gov’t debt in disguise.
Also, “As such, this post considers whether a given deficit resulting in more reserves in circulation and fewer bonds held by the non-government sector raises the likelihood of spiraling inflation, …”
Do more bank reserves (IMO fed debt, which is gov’t debt in disguise) and fewer bonds mean the fed itself is becoming “riskier”?
Mark Thoma said in his post: “When someone starts from perspectives such as that (and with notions such as reserves don’t matter for loans and there is no money multiplier), there is nothing for people to learn from shining a light on these beliefs.”
How about in certain situations there can be no money multiplier (as in the money multiplier is zero)? Or, is it more like there CAN BE no debt multiplier?
“More nonsense. I usually let Winslow’s silliness go, but not this time. On the last point, in a liquidity trap, the interest rate can’t fall to clear the market (so quantity is demand determined). How hard is that to understand?”
How about there is a problem in a different market besides the “interest rate” market?
St. Louis Fed Series: MULT, M1 Money Multiplier
http://research.stlouisfed.org/fred2/series/MULT
Nick,
I’m not sure what point you are making in responding to the MMT related criticism of his Thoma’s piece, either above or on his blog. But he likes it.
I can only comment additionally about his 5.1 per cent example, which you referenced. It is wrong as an illustration of what it purports to illustrate. I don’t know whether you or he actually understand that the Fed sets the floor for the policy rate using the interest rate on reserves (in today’s excess reserve environment). I can’t decipher the exchange there. I think you probably do. But in either case, that’s not where he’s really wrong in that example.
Again, he doesn’t acknowledge issues related to capital or risk, which are fundamental to understanding the limited role of reserves. And as a result, he presents false choices about bank lending.
The choice is not between leaving reserves at the Fed at 5 or 5.1 per cent versus lending money to a business or consumer at, or below that rate, which is the example he portrays.
The only legitimate choice using an example with those kinds of rates is between leaving reserves at the Fed or lending them overnight in the interbank market – i.e. the choice is between receiving interest on reserves or receiving the fed funds rate. That’s the choice for comparable risk, and it’s the only choice where a bank has alternatives for transacting directly in reserve funds. Banks don’t lend reserves to non-bank customers. That’s a factual observation from MMT and one of the aspects of the monetary system that Thoma ignores or doesn’t know about.
So the choice he does present is completely false. Banks don’t lend to businesses and consumers at rates that are comparable to either the interest rate paid on reserves or the fed funds rate. They lend at rates that reflect risk – at rates that reflect credit risk premiums, maturity risk premiums, and liquidity risk premiums. They lend at a spread.
Mostly importantly, banks lend or acquire risk assets based on the availability of capital to support that risk. That’s why they charge the interest rate premiums they do.
And that’s why banks don’t undertake risk lending as a function of reserves. Banks are capital constrained but not reserve constrained in taking on risky assets.
I.e. banks don’t make decisions on risk lending by looking for arbitrage opportunities between interest on reserves and the Fed funds rate, as Thoma portrays it. That’s an absurd argument.
Again, for the nth time unfortunately, MMT detractors don’t acknowledge the difference between central bank reserves and bank capital (i.e. risk lending according to credit standards). In short, they don’t acknowledge or understand the topic of risk. The relative uselessness of reserves in the function of lending to acquire assets with credit risk (and other risks) is a fundamental point made by MMT.
Nick, I’m not seeing a connection between your comments here (or at Thoma’s) and the MMT related points on Thoma’s piece. And I’m not sure declaring victory over Winslow resolves it. I’d be interested if Scott F. or some of the earlier commenters here can add to this.
JKH:
” I don’t know whether you or he actually understand that the Fed sets the floor for the policy rate using the interest rate on reserves (in today’s excess reserve environment). I can’t decipher the exchange there. I think you probably do.”
Yes. I understand that. The Fed’s (now) just like the BoC.
Sure, there’s a spread. Mark ignored that spread for simplicity. Economists often talk like that. Add in a spread, and it doesn’t affect what he said, in terms of the directions of change.
Suppose banks are capital constrained, and that’s an absolutely hard constraint (as opposed to a trade-off). They can’t lend a single $1 more without more capital. OK, if the profit opportunities are there, they get more capital. That’s like saying an increase in the price of apples won’t cause orchards to want to sell more apples, because they don’t have the trucks to take the extra apples to market. Buy/rent more trucks. If the price of apples is high enough, it’s profitable to do that.
Must go to work.
JKH,
If I may, I’ll throw in my 2 pence.
I think the issue that is hanging everyone up is that Nick and Thoma have in the back of their minds a sort of gold standard analogy. Under the gold standard exchange was facillitated by notes with a promise of gold convertability but only fractional backing. Nick and Thoma are trying to make an analogy where reserves play the role of gold and credit plays the role of the notes.
I think that the reason they keep gravitating to this conceptual framework is that everyone wants the government to have a nominal budget constraint, for some reason people don’t like the idea that governments can have real constraints but no nominal constraint (which is how I like to phrase the issue). It’s their insistence on this conceptual framework that leads them to continue to insist that the quantity theory makes any sense.
This brings up two points:
1) Their is NO direct analogy between a fiat money system and a commodity backed system. (With a commodity backed numeraire the government’s real constraint shows up in nominal terms, this doesn’t happen in the fiat system no matter what numeraire you actually use to express things).
2) Keeping point 1 firmly in the front of our minds, if you put a gun to my head and force me to make the best gold standard analogy I can then it’s capital that plays the role of gold. The reason for this is that capital is the real side quantity, it is in positive and limited net supply. Reserves are zero net supply, that’s why they don’t constrain anything.
I’m trying here to translate JKH and friends’ point into a language more natural for economists (these MMTers annoy me to no end by insisting on putting everything in accounting terms), I’m quite certain they’ll (all) tell me if they disagree.
Adam P.,
That’s an amazingly insightful comment, IMO. You’ve put all the pieces together in a unique way.
I’ve not yet seen that analogy between the gold standard and capital. I’d have to think about it a bit more, but my initial take is that it’s brilliant, IMO. I’ll come back on that.
On the accounting issue, it pains me in a way. I’m not an accountant, but logical accounting is a critical input for the MMT story. The reason it gets in the way so much is that MMT critics (proactive or de facto) inevitably don’t understand the accounting that’s necessary to understand MMT. And they don’t understand the degree to which their failure to understand the accounting for the monetary system has contaminated their paradigm for economics. One of the reflexive defences is to dismiss the importance of the accounting by resorting to the use of the term “accountant” in the pejorative sense. That’s extremely unhelpful and ill advised. You’re not doing that, but I can understand your frustration with the recurrence.
Accounting is the mechanical under body of MMT. The really important ideas are those that you’ve summarized so well.