Anyone who has taken ECON1000 has probably seen the simple model of how banks create money in a fractional-reserve banking system, and how an increase in reserves creates a multiple expansion of loans and the money supply. An alternative approach, cogently argued in comments here by JKH, says that it is bank capital, not reserves, that plays the crucial role. I think there may be some truth in what JKH says, especially at present, but it is not the whole truth. I'm going to lay out what i believe. Others can either learn from what I say, or try to help me learn where I might be wrong (or maybe even both).
Let's start with the simplest textbook story.
Bank deposits are money, by assumption. Each bank desires to keep (say) 10% reserves against deposits, either to cover liquidity risks, or because it is required to by law, or a bit of both. Bank capital is irrelevant. Start in equilibrium, where reserves are 10% of deposits at every bank. Now assume the central bank does something that causes each bank's reserves to increase by $10. Each bank now has $10 excess (undesired) reserves. In the first round, each bank increases the supply of loans and deposits by $10. It does not increase loans and deposits by $100 immediately, because it anticipates that when the deposit is spent, it will be re-deposited in another bank, so it will lose $10 in reserves. (The textbook story implicitly assumes that each bank is small relative to the whole banking system, and is looking for the Nash equilibrium.) But in aggregate, of course, there is no loss of reserves. If all banks are doing the same thing, each bank finds it gains as many reserves and deposits as it loses (absent a currency drain, of course). So with deposits and reserves both $10 higher than in the original equilibrium, each bank now has $9 excess desired reserves, so it increases loans and deposits again…
In the new equilibrium, deposits (the money supply) expands by 10 times (1/10%) the increase in reserves. That's the simplest textbook story. (OK, I've told it slightly differently from the textbook, by assuming all banks get the extra $10 reserves, rather than just one bank. That helps me think about the symmetric Nash equilibrium.)
Now let me give a totally different theory. It's one I just thought up this morning. Initially it was just a thought-experiment to help get my head clear. But then I wondered if there might be some truth to it after all. I call it the "Loan Officer Theory of Money Supply".
Forget reserves. Banks don't need reserves to make loans; they need loan officers to manage those loans. The desired reserve ratio is probably zero anyway, and doesn't matter. What matters is the ratio of loans to the loan officers who are needed to manage those loans. Assume, given an average turnover and complexity of loans, that one loan officer can manage a $10 million loan portfolio.
Start in equilibrium, with the desired ratio of loans to loan officers. If the central bank increases the supply of reserves, that does nothing to the money supply. The extra reserves just sit there. Banks won't increase loans with the same number of loan officers. But an increase in the number of loan officers, one per bank, would increase loans by $10 million per bank, and would also increase the money supply by $10 million per bank.
It's the supply of loan officers, and the desired ratio of loans to loan officers, that determine the supply of loans and money.
What's wrong with the loan officer theory? Absolutely nothing, provided we make explicit some assumptions. The first assumption is that the banking technology has fixed proportions between loans (the output good) and loan officers (one of the inputs). There is zero substitution between loan officers and other inputs. This means that banks' demand curves for composite other inputs, holding the quantity of loan officers fixed, is perfectly inelastic when loan officers are fully employed. The second assumption is that the market supply curve of loan officers is perfectly inelastic. Given these two assumptions, and change in the price or availability of any other input (like reserves, or capital) will have no effect on the quantity of loans, and so no effect on the money supply.
But if we relax either of those two assumptions, the supply of loan officers to the industry will no longer be the sole determinant of the supply of loans and money. A fall in the price (or increased availability) of other inputs will cause banks to expand loans by using more other inputs per loan officer, or hire more loan officers (pushing up wages along their supply curve) to make more loans.
You can see where I'm going with this. Here's the Bank Capital Theory of Money Supply.
Forget reserves and loan officers. What matters is the ratio of capital to loans. Assume banks desire (or are required by law, or both) to have capital equal to 10% of their loans. Then the money supply is 10 times bank capital. A fall in the price, or increased availability, of reserves (or loan officers) will have no effect on the money supply. But an increase in banks' capital will cause a tenfold increase in loans and the money supply.
Again, this assumes that there are fixed proportions between loans and capital. And it assumes the supply curve of bank capital is perfectly inelastic. Relax either of those two assumptions, and a fall in price or increased availability of other inputs will cause an increase in the supply of loans and money. If banks can vary the loan/capital ratio, by varying the average riskiness of their loan portfolio (at the expense of lower returns or greater loan management costs of course) then the model fails. Or, if banks can all raise more capital, perhaps at a higher price, the model fails.
The Loan Officer and Bank Capital models fail except under extreme assumptions. But that's not surprising. All simple models fail. That doesn't mean they contain no truth. The supply of bank capital, and the supply of loan officers, will affect the supply of loans and the supply of money, other things equal. And perhaps their effect is more important in the current recession than normally. Bank capital is certainly important now, but has been discussed by others. But maybe, just maybe, my Loan Officer model contains more truth than normal as well. If there have been large structural changes in the demand for loans, so that loan management is now much harder to do, and in greater demand than normal, then perhaps the supply of experiences loan officers does matter much more than normal. (Sound plausible, bankers?)
But, but, but. Why all the emphasis on the supply of reserves, if reserves are just one of many inputs? And more importantly, are reserves really an input?
Let me tackle the second question first. Are reserves really an input in the production by banks of loans and money?
Yes, and no. At the level of the individual bank, reserves are certainly an input at the margin; and rational individuals and banks make choices at the margin. At the level of the banking system as a whole, reserves aren't an input (or, are only r% of an input with an r% desired reserve ratio, and I am quite happy to let r go to zero).
Suppose the desired reserve ratio is zero, for simplicity. An individual bank that makes a new $100 loan, by crediting the borrower's chequing account $100, knows that the borrower will spend the loan, and if his cheque is cashed at another bank, the first bank will lose $100 reserves. If it doesn't have $100, it will need to borrow $100 reserves. That's a required input, and that input has a cost. The cost is the interest rate at which it could borrow reserves, or, in an opportunity cost sense, the interest rate at which it could have lent its own reserves. So the interest rate on reserves is a marginal cost of an input to the individual bank, and affects its supply of loans in exactly the same way that the marginal cost of capital and the marginal cost of loan officers affects its supply of loans.
It simply does not matter to the individual bank's decision, in Nash equilibrium, where it chooses its own quantity of loans taking other banks' quantities of loans as given, that there is no loss of reserves to the banking system as a whole. It's maximising its own profits, not those of the whole banking system. It does not internalise the externality of the fact that its reserve loss is another bank's reserve gain.
So the price and availability of reserves matters, at the margin, for an individual bank's decision, in exactly the same way that the cost of loan officers and bank capital matters.
So why do economists concentrate so much on reserves, and downplay or ignore other inputs in the money supply process?
Because reserves can be influenced by policymakers. Other things equal, the price and availability of reserves, capital, loan officers, etc., all influence the money supply and loan supply process. But a central bank's job, when it determines the price and availability of reserves, is to make sure those other things aren't equal. The slope and position of the market supply curves of bank capital and loan officers are what they are. The slope and position of the market supply curve of reserves is whatever the central bank wants it to be. It can make it horizontal, or vertical, or anything in between. It can make it shift left, right, up, down, back and forth, to try to attain whatever objective it wants to attain.
Worthwhile Canadian Initiative 
And of course, by extension, all interaction between banks and the Govt are completely trivial (except those which remove or undermine the first-loss position of private capital)
Good point, Too Much fed.
I should modify that statement to –
All transactions in which banks operate as principals.
Banks act as agents in clearing customer’s deposits with each other. That obviously doesn’t create or destroy money.
And banks act as agents for the government in distributing and redeeming currency. The banks have no direct role in creating or destroy money there – they’re just passing it through.
Very good point, Too Much Fed. Thank you.
Sorry if this is a repeat.
JKH said: “ALL transactions of ALL type between banks and non-banks create or destroy money at the margin.”
Should that be create or destroy currency denominated debt at the margin?
If not, how is currency destroyed?
The commercial banking system is the endogenous system.
The government/central bank is the exogenous system.
At some level, a bank is a bank.
Just that the exogenous system is not revenue constrained.
The endogenous system is – where revenue hits capital constraints (credit revenue; credit equity).
According to MMT, only a sovereign government as currency issuer is able to influence the net financial assets of non-government, which it does through fiscal operations. Government “deficit spending” ( as distinct from non-government expenditure) increases non-government net financial assets, taxation reduces net financial assets.
Government borrowing simply reduces reserves. The CB only controls the overnight interbank rate, e.g., through OMO that manage the cost to banks of borrowing reserves as a required liquidity provision. However, when governments run large deficits, the CB cannot absorb enough of the reserves being generated by deficit spending through OMO alone, since its balance sheet is finite and it cannot issue government debt. Therefore, the CB coordinates with Treasury regarding its needs, and Treasury issues debt as required to remove reserves through bank purchases that exchange interest-free or low interest reserves for interest-bearing Treasuries. This is simply a neutral asset switch, other then for the interest that is injected into the non-government sector, which also increases non-government net financial assets. This is pretty much a daily operation, in which the Fed and Treasury communicate closely. For all practical purposes the Treasury and CB act as a single entity in this regard, since Treasury simply accommodates the CB in its setting the target rate.
Commercial banks control the money supply but cannot increase or decrease non-government. Their activity cannot increase or decrease non-government net financial assets because their operations net to zero.
The sovereign government is the monopoly provider of its currency of issue, which is called high power money (HPM), base money and M0 (zero). Bank money is only involved in M1, M2, and M3. How the non-government system works is the subject of Circuitism. The relation between government and non-government is the subject of Chartalism.
This is the basis of MMT, as I understand it. Hope I got it all correct.
Oops. “Commercial banks control the money supply but cannot increase or decrease non-government” should read, “Commercial banks control the money supply but cannot increase or decrease non-government NFA.”
tjfxh: You are correct. JKH’s point is that expenditure by the bank (on its own behalf) has an equivalent impact on horizontal money as if it had made a loan, and is subject to the same constraints.
In my mind, I see parallels between this and how the Govt creates (and destroys) NFA equity via spending (and taxation)
tjfxh | December 01, 2009 at 06:30 PM
Looks good to me.
Winterspeak: “In my mind, I see parallels between this and how the Govt creates (and destroys) NFA equity via spending (and taxation)” Herein lies the problem is the horizontal operations of commercial banks are not distinguished from the vertical operations of the government as currency-issuer in relation to non-government as currency-user. The great contribution of MMT lies in providing understanding now the monetary system actually works. This is not theoretical. It is descriptive of fact (financial operations and how they are accounted for).
The term “money” invites confusion in this regard because it has a number of different meanings that are significant to financial operations and national accounting. In modern economies, the currency of issue provides the numeraire. Because the “money” in use is generally a single, universal and exclusive numeraire in modern economies, “money” applies to both government money (M0) and bank money. These are usually not thought of separately other than for professional reasons. But failing to keep the differences straight results in confusion.
Incidentally, “non-government” means domestic or “private,” plus foreign operations in the domestic economy, e.g., trade, capital flows, and foreign purchases of government and non-government financial instruments. Foreign transactions generally go through the same clearing procedure as domestic, so it is not usually necessary to distinguish them or treat them separately in general discussions. So it all gets lumped in as “non-government” in contrast to government as a vertical relationship.
An important point that MMT makes is that the government as currency issuer is providing a public service by providing “moneyness.” In this sense, government money (currency issuance and management) is a public utility. This is important because many people tend to think that money is generated by the private sector, so that government borrowing competes for loanable funds and crowds out investment, and taxation siphons off money produced by the domestic economy for “redistribution,” thereby disadvantaging the “rightful owners.” The reality is that deficit spending adds to net financial assets and taxation subtracts from them. It is really only necessary to subtract net financial assets when additions threaten inflation. Otherwise, the government needs to spend in order to balance the public’s desire to save, or there will be an output gap and unemployment will rise. It might be argued that S=I, but this only applies “in the long run.” The fact is that firms may not to choose to invest all available saving in a timely way, so that these funds do not contribute to aggregate demand. I suspect that this is what someone (Winterspeak?) previously referred to as “dead money.” Moreover, a lot of what counts as saving in times like these is being committed to paying down debt as previous consumption.
The basic MMT principle is that government deficits increase non-government surpluses, and vice versa. Therefore, government surpluses lead to the necessity for domestic borrowing if there is a desire to spend, because incomes will not be sufficient to purchase all available goods and services for sale, and this will lead to an output gap, unless the debt load is increased sufficiently to compensate. Increasing debt load is, of course, unsustainable in the long run.
When the government spends into the economy, the Treasury writes checks as currency issuer. It does not depend on prior “saving” nor does it have to borrow or tax to raise the funds. When these checks are cashed in commercial banks, bank reserves increase. This is an increase in M0 (HPM). This how the government creates money as a financial asset of non-government. Physical currency (cash) enters the economy by banks exchanging reserves for Federal Reserve notes and coins minted by the Treasury and provided to the Fed for this purpose, since the Fed doesn’t mint coin.
This is really irnonic. Quoting myself, from the 3rd Canadian edition of Mankiw, Kneebone, McKenzie and Rowe (I wrote this bit):
“Central banks can increase the supply of money in circulation by buying something. They can decrease the supply of money by selling something. It really doesn’t matter what the Bank of Canada buys or sells. For example, if the Bank of Canada buys a new computer for its researchers with $1,000 of newly-printed currency, the firm that sold the computer to the Bank of Canada now holds an extra $1,000 cash, so the money supply increases by $1,000 immediately.” (** added)
I also used the computer market operation as the example. JKH would object that the BoC doesn’t normally pay cash, which is a legit objection, but it comes to the same thing.
Now JKH is saying that what holds for the BoC, also holds for BMO, which sounds right to me, provided we define “money supply” as M1, not monetary base, of course.
BUT, how does this follow, Winterspeak: “Talking about underlining, in triplicate, the unimportance of reserves!”?
The supply curve of reserves, and hence the price of reserves, will affect whether or not BMO is willing to buy something, whether it be computers or bonds or IOU’s.
Winterspeak:
Here’s an analogy for the issue of money:
A landowner collects rent of 50 ounces of silver per year. At a market rate of interest of 5%, that makes his land worth 1000 oz. When he buys groceries, he pays with his own IOU, which says “IOU 1 oz.” Call them shekels. He accepts his own shekels in payment of rent, so lots of people accept his shekels as money. Since his land is worth 1000 oz., he can issue up to 1000 shekels without fear of them losing value, but after issuing 1000 shekels his net worth will have fallen to zero.
Now he wants to buy more land, worth 2000 oz. He writes up a bond worth 2000 oz and trades it for the land. The land yields rent of 100 oz./ year, which he uses to service the interest on his bond. His net worth is still zero.
Next, he designates a room in his house as his central bank. His central bank prints 2000 more of his shekels and uses them to buy his 2000 oz. bond (which he can now tear up if he wants). His net worth is still zero, and he could, if he wanted, buy back all 3000 of his shekels by selling his 3000 oz. worth of land and canceling his 2000 oz. bond.
Change ‘landowner’ to ‘government’ and ‘rent’ to ‘taxes’, and you have a pretty good picture of how green paper dollars are issued.
Next, private banks accept 100 of his shekels on deposit, issuing their own IOU’s in the form of 100 checking account shekels. Finally, the private banks create 400 additional checking account shekels, which they lend to a customer who offers collateral worth 400 oz in exchange. In spite of all this money-issue by both central and private banks, the shekel is still worth 1 oz. The shekels issued by the landowner are adequately backed by his land, and the shekels issued by the private bank are adequately backed by the private bank’s assets.
Note that banks are not all that powerful, that reserves and capital barely matter, and that bank spending is equivalent to bank lending.
tjxfh: “The term “money” invites confusion in this regard because it has a number of different meanings that are significant to financial operations and national accounting. In modern economies, the currency of issue provides the numeraire.”
Buer the numeraire. “Numeraire” is something economists use, and it’s totally arbitrary. We could use “Venus dust” as numeraire; it would make no difference. What you mean is “medium of account” which is the medium in which real people (as opposed to economists and accountants) quote prices. That matters when prices are sticky. But buer the medium of account too; what really matters is the medium of exchange. A general glut of goods (such as we have now) is an excess demand for the medium of exchange. To talk of a “general glut” in an economy without a medium of exchange is economic nonsense.
And until you understand the importance of the medium of exchange (and the distinction between a monetary exchange economy vs a barter economy), as well as the distinction between desired and actual S and I, (and the equivalent distinction between economics and accounting) you wont get your following two paragraphs right either.
For example: “The basic MMT principle is that government deficits increase non-government surpluses, and vice versa. Therefore, government surpluses lead to the necessity for domestic borrowing if there is a desire to spend, because incomes will not be sufficient to purchase all available goods and services for sale, and this will lead to an output gap, unless the debt load is increased sufficiently to compensate. Increasing debt load is, of course, unsustainable in the long run.”
No, no, no!
Winterspeak:
I know how banks make loans. If you really think that this is a great insight that pokes holes in the monetarist theory, then you just don’t understand.
Think about alternative monetary arrangements. 100% reserves for transactions accounts. A frozen quantity of base money. Develop an understanding that covers those possibilities as well as something closer to the status quo.
You asserted that banks must make loans by crediting deposit accounts. Well, that is a very narrow view of what it means to be a bank. That is one way it can happen.
My examples all involved offsetting changes in bank balance sheets that allowed the quantity of monetary liabilities to change in a way different than the quantity of bank loans. None of its was inconsistent with bank loans being created by having funds credited to deposit accounts or having them repaid by debits to deposit accounts.
I teach all of this in introductory macro and then more so in money and banking.
tjxfh: and I would love to take you on with the philosophy of language too 😉
(Off-topic: where where you when I was doing posts on the Principle of Charity, and needed a philosopher of language?)
Each theory creates its own semantic net, depending on the distinctions it thinks are relevant and irrelevant. Sure, I am misusing language from the perspective of accountants’ and finance guys’ dictionaries. But who gave those guys the authority to write the dictionary?
In this theoretical context, bonds and promissary notes are theoretically equivalent. So are IBM computers, for that matter. They are all just “stuff that banks buy”.
(Off-topic again: do you understand what I was trying to say in my posts on “churches and central banks”, and “interest rate targeting as a social construction”? Because hardly anybody else did.)
Nick, I’m certainly not going to argue with you about the meaning of numeraire. You are the economist, not me. But I’ll explain my thinking.
Investopedia: “Numeraire: An economic term that represents a unit of account. In French, the term means “money”, “coinage” or “face value”…. An example of a numeraire arises when we look at how currencies were valued under the Bretton Woods system during the mid-twentieth century. The U.S. dollar was priced as one-thirty-fifth the price of an ounce of gold. All other currencies were then priced as either a multiple or a fraction of the dollar. In this situation, the U.S. dollar acted as the numeraire because it was fixed to the price of gold.”
My thinking is that the old notion of numeraire was in terms of the fixed relationship of the dollar in relation to gold. I assume that now that convertibility is thing of the past, that the dollar itself becomes the numeraire as the reserve currency. I should also say that I’ve seen it said that in some economies (Scotland) different bank monies acted as multiple numeraires. If I have this wrong, please set me straight.
Nick’s post said: “A general glut of goods (such as we have now) is an excess demand for the medium of exchange.”
Can it be a shortage of the medium of exchange?
Care to differentiate between currency and currency denominated debt here?
tjfxh: Sorry, I’m getting overly excited this evening. Too many comments coming too fast!
But yes, investopedia isn’t quite right. At least, this is not how economists use those words.
When an economist is building a model, he chooses some good to use as numeraire, sets its price equal to 1, and measures all other prices in terms of that good. The economist’s choice is arbitrary. It doesn’t matter what he chooses (except it may make the math simpler or harder). The good the economist chooses as numeraire need not even exist in his model (hence “Venus dust”.
Then there is the good in which people in the real world quote prices. That’s the medium of account. The economist often uses the medium of account (if it is defined in his model) as his own numeraire, but only because it leads to less confusion. he could choose anything.
(The unit of account is a particular quantity of the medium of account. If gold is the medium of account, one troy ounce of gold might be the unit of account, for example. Only really prissy economists insist on distinguishing between the medium of account and unit of account.)
But the good which people use to buy or sell all other goods, the medium of exchange, is what is really important. It’s what I call “money”. It’s normally convenient for real people to use the same good as medium of account and medium of exchange, but in some (rare) cases prices are quoted in one good, and payment is made in another.
In Scotland (I used to live there), there was one unit of account (the pound) but multiple media of exchange. But since the Royal Bank of Scotland notes, and Bank of Scotland notes, etc, were all redeemable into bank of England notes, at par, all media of exchange functioned equivalently in Scotland (all were equally acceptable north of the border, but not too far south of the border).
One of the big failures of “MMT” is that it implicitly assumes (quite correctly) a monetary exchange economy (as opposed to a barter economy, or an economy with one centralised auction market), but insists on defining “money” as the medium of account, thereby missing the essential importance of the medium of exchange role of money, even within “MMT”. Without a medium of exchange, “MMT” would be theoretically nonsense.
For example, in a barter economy, there cannot be a general excess supply of goods. In a barter economy, an offer to sell one good is an offer to buy another good.
But that criticism of MMT would lead me totally off-topic.
Off-topic again: the HG221 shelves of any library are stacked full of dusty tomes with titles including the words “modern” and “money”.
Nick, here is a quote from Bill Mitchell that summarizes what I was trying to say, however naively:
The only way the private domestic sector can save if there is a current account deficit is for the government sector to run deficits up to the desired private saving. Government deficits “finance” private saving by ensuring that aggregate spending is sufficient to generate the level of output and income that will bring forth the private desired saving levels.
“Unemployment occurs when net government spending is too low. As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour unable to find a buyer at the current money wage. In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.”
“How large should the deficit be? To achieve full employment net government spending has to be equal to the non-government desire to net save to ensure there is no aggregate demand gap.”
tjfxh:
The only way for me to handle Bill’s quote is to fisk it:
“Unemployment occurs when net government spending is too low.”
Only if you define “too low” in that way. If the price level and rate of interest can and do adjust, you can have a fall in government spending and no change in unemployment. And you can have unemployment that cannot be cured by fiscal policy 9or monetary too).
“As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period).”
No. As a matter of accounting, total spending equals total income regardless of whether aggregate output is sold, whether there is mass unemployment, or excess demand for labour.
“Involuntary unemployment is idle labour unable to find a buyer at the current money wage.”
OK. Not the same as Keynes’ definition, but I can live with it nevertheless.
“In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns.”
No. He has confused medium of exchange with unit of account. And he ignores other possible causes of unemployment (such as efficiency wage theories) that have nothing to do with insufficient aggregate demand.
“Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending.”
This assumes that the unemployment is due to deficient aggregate demand. It also ignores investment (unless it defines “net saving” as “saving minus investment”).
“Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.”
But this ignores the role of the price level and rate of interest etc in affecting desired saving and investment.
Look. In short, this is basically a mix of accounting identities and the macroeconomics I learned in high school.
Too much Fed:
“Can it be a shortage of the medium of exchange?”
‘Excess demand’ is economist’s speak for ‘shortage’.
“Care to differentiate between currency and currency denominated debt here?”
Nope. The key distinction is between ‘medium of exchange’, which includes currency but also includes chequing accounts; and stuff that isn’t medium of exchange.
NIck, thanks for advancing the debate for me. Without clearly understanding all sides, the matter reduces to ideological preference. I’m just in the process of acquiring economic literacy, so have to think about this.
Perhaps if Scott F. is around, he will take up the MMT side in response.
tjfxh: As a first year undergrad I had a slight misadventure and developed a rash over my whole body that kept me from sleeping one night. So I read Lipsey’s first year economics text cover to cover. By dawn I was economically literate. I would recommend the same to any intelligent person (just skip the girl, bathtub, and large bottle of herbal shampoo). Any university intro text will do.
“Care to differentiate between currency and currency denominated debt here?”
Nope. The key distinction is between ‘medium of exchange’, which includes currency but also includes chequing accounts; and stuff that isn’t medium of exchange.
So, what about a mortgage when buying a house?
Nick wrote: ” And you can have unemployment that cannot be cured by fiscal policy”
Could you give an example?
Too much Fed: a mortgage is not a medium of exchange.
Winslow R.: Efficiency wage models (lots of different models under that heading); minimum wages; monopoly unions; search models; hiring cost models; adverse selection models; probably lots more I’ve forgotten.
Question for Winterspeak and JKH about whether a change in the price of reserves constitute a supply issue. If I understand correctly, you’ve argued that higher interest rates (FFRs as the benchmark) merely result in higher loan offer rates, and whether this affects the market for bank loans then depends on how these higher rates affect demand from borrowers. Banks remain capable of producing any quantity of loans they desire, subject only to demand at a given price. Thus, reserves are only a demand side issue.
Does your terminology preference here apply outside of the bank loan market? Let’s say there was a terrible wheat harvest, down 50%. But that farmers had an available alternative. At a much higher cost than traditional growing, they can make up for the bad weather and produce enough to match (or exceed) the prior year’s quantity, but at a much higher cost (more labor hours and technology inputs). But the only way quantity sold will match last year’s is if demand was perfectly inelastic or the demand curve shifts, since prices will have to be much higher. Are you okay with calling this change in the pricing curve of wheat a supply issue, or do you also see this as only a demand issue because supply is not physically or legally constrained?
Nick wrote: “Efficiency wage models ”
It seems you might consider fiscal policy “counter-productive to an employer’s employment goals” rather than deciding it “wouldn’t work” to reduce unemployment.
Winslow R.: If you have an efficiency wage model of unemployment, then fiscal policy (or monetary policy) can shift the Aggregate Demand curve, but that will not reduce unemployment. It just creates inflation. It’s not that the effect is undesirable to employers. It means there is no effect on unemployment. Zero. And the unemployment in these models is “involuntary” in the normal sense of the word. Some workers are employed, and other identical workers would like to work at that same wage, but are unemployed.
Nick: “If you have an efficiency wage model of unemployment”
After the big “if”
“fiscal policy (or monetary policy) can shift the Aggregate Demand curve,”
yes, but fiscal policy can also directly target the unemployed through an ELR (employer of last resort) another part of MMT avoiding the inflationary consequences of inefficiently shifting the Aggregate Demand curve while still reducing unemployment.
Combination of posts said: “A general glut of goods (such as we have now) is an excess demand for the medium of exchange.
Can it be a shortage of the medium of exchange?
‘Excess demand’ is economist’s speak for ‘shortage’.
Care to differentiate between currency and currency denominated debt here?
Nope. The key distinction is between ‘medium of exchange’, which includes currency but also includes chequing accounts; and stuff that isn’t medium of exchange.”
I think I’m not asking it right. Let’s try it this way. If excess savers don’t spend now because they don’t need to and other people don’t have enough debt free money to spend now and can’t afford to borrow more from their credit cards, borrow more against their house, or borrow to spend on a house, what should happen?
I’m thinking about Calculated Risk’s post(s) saying housing (mortgage debt and I believe new homes) and retail sales (probably credit card debt) have led the economy out of the past few recessions.
The US Fed is very clear: reserve requirements are irrelevant (basically zero). The mechanism is through clearing balance requirements.
Capital constraints are irrelevant because 1) banks are rarely capital constrained in the short-run and 2) bank capital is endogenous and is supplied by the market as needed.
Banks can have as much capital as they want, but capital cannot meet clearing balance requirements, only reserves can. Therefore, only the monetary base affects the rate-of-interest in the reserves market.
I think the real question you’re all dancing around is whether the rate of interest in the reserves market is related to the broader economy.
tjfxh: I quite understand how the banking system works, and the difference between horizontal and vertical money. I was just reacting to the fact that all bank expenditures (when they are acting as principal) increase increase horizontal money just as credit extension does. Wild. I used the term “parallel” for that reason.
NR:”The supply curve of reserves, and hence the price of reserves, will affect whether or not BMO is willing to buy something, whether it be computers or bonds or IOU’s.”
I knew reserves had no effect on bank’s ability to lend, and now I learn they have no impact on any kind of principal spending. And yes they impact whether a bank is willing to buy something, but so do about 1000 other factors.
Bill: “You asserted that banks must make loans by crediting deposit accounts. Well, that is a very narrow view of what it means to be a bank”
Great point! Just last Friday I went down to my local bank to take out a mortgage, and they gave me 300 lbs of freshly slaughtered goat meat in honor of Eid al Adha; ) You are right, my focus on bank loans ending up as credits in a deposit account was far to short sighted!
“2) bank capital is endogenous and is supplied by the market as needed. ”
and why did we had some 150 bank failures?
“net save”, as I understand it, is equivalent to stuffing cash into a mattress though holding treasury securities also qualifies. Basically storing financial wealth in government created financial assets.
I guess Nick could be right about income = spending if spending on treasury securities, or ‘government income’, is included which I don’t think Bill does.
Kind of complicates things if the government starts selling debt for no other reason than to soak up short-term reserves and increase ‘spending’ to meet the population’s desire to ‘net save’ 🙂
Winslow: If you added ELR fiscal policy (money-financed), with a money-wage W, to an efficiency wage model, then this is what would happen.
There would be Kurt E Vonnegut jr “Player Piano” jobs paying W that would give workers exactly the same real wage as unemployment insurance pays today. Nominal wages and prices would rise in the private sector until you had exactly the same excess supply of labour to private sector “real” jobs that you have now. The previously unemployed would be working for the government, but would be equally as miserable as the unemployed are now.
Essentially, it would be like a Dickensian workhouse, just financed by printing money.
That’s just the logic of the Shapiro/Stiglitz model.
Winterspeak, I was quite aware that you know all this, and I wasn’t writing with you in mind, other than in the first sentence. I was just pointing out that folks often equate similarity with sameness, so that is quite usual to overlook the vertical relationship of government to non-government. Sorry about my lack of clarity of intent if you took the entire comment as directed at you personally.
Winslow:
“”net save”, as I understand it, is equivalent to stuffing cash into a mattress though holding treasury securities also qualifies. Basically storing financial wealth in government created financial assets.”
Yes, I think that’s how Bill defines it. Same as “savings minus investment” (for a closed economy).
“I guess Nick could be right about income = spending if spending on treasury securities, or ‘government income’, is included which I don’t think Bill does.”
No. I’m adopting the same income=spending that’s standard in national income accounting, and that Bill must be adopting too, or else he would be wrong for other reasons.
“Essentially, it would be like a Dickensian workhouse, just financed by printing money.”
Wow, that gives me a pretty good understanding of where you stand on the WPA.
Winslow: what’s WPA?
And no, it doesn’t give you any understanding of where I stand on anything at all.
All you should understand from this exchange is that you are arguing with someone who actually does understand efficiency wage models of unemployment, and how your ELR policy would work if the efficiency wage model were true. Someone, in other words, you has actually made the investment to understand this stuff, and is not just BSing.
Nick wrote: “what’s WPA?”
http://en.wikipedia.org/wiki/Works_Progress_Administration
Nick, good night!
If you think I need to review effiency wage models, “if the efficiency wage model were true”, please point me in the right direction. I think I understand it pretty well, but I could be wrong.
Morning Winslow! Yes, i should have gone to bed earlier!
At a theoretical level, i really like the ELR policy. Deficient-demand unemployment is caused by a shortage of medium of exchange in the right hands. The ELR automatically puts it in the right hands. It creates a perfectly elastic AD curve, with an immediate and very direct transmission mechanism for what I call monetary policy (and you call fiscal policy, though it’s really both). The monetarist helicopter flies over the unemployed. Practical problems, but leave them aside.
But if you match it with an efficiency wage model, you get very weird results. That model implies that there is an equilibrium wage differential over the “outside opportunity”. Normally we think of that as unemployment insurance, but with an ELR, it would be replaced by those “Last Resort” jobs.
Now, the government fixes the nominal wage on those last resort jobs, and prints money accordingly. The efficiency wage model determines the real wage, not the nominal wage. That means the price level must rise sufficiently, and the real wage on last resort jobs must fall sufficiently, until the original real wage differential of “good jobs” over last resort jobs returns to what it was originally, as a differential over unemployment insurance. So in the new equilibrium, real wages in last resort jobs must make workers in last resort jobs as miserable as the unemployed were before the ELR program was instituted.
Which is why my “Dickensian workhouse” comment.
With that Shapiro/Stiglitz efficiency wage model, unless there is some policy that can tackle the original cause, there is a sort of “iron law of constant misery” of those not in good jobs. Anything you do to reduce the misery of a worker not in a good job, just causes a proportionate increase in the number not in good jobs. The total misery stays the same.
FYI, from a paper by Randy Wray in 2000 at http://www.cfeps.org/pubs/wp/wp9.html
The first component of the proposal is relatively simple: the government acts as the employer of last resort, offering to hire all the labor that cannot find private sector employment. The government simply announces the wage at which it will hire anyone who wants to work, and then hires all who seek employment at that wage. A package of benefits could include healthcare, childcare, sick leave, vacations, and contributions to Social Security so that years spent in ELR would count toward retirement. Of course, there will still remain many (non-ELR jobs) jobs in the public sector that are not a component of the ELR and that could pay wages above the ELR wage. This policy will as a matter of logic eliminate all unemployment, defined as workers ready, willing and able to work at the going wage but unable to find a job even after looking. Certainly there will still exist many individuals—even those in the labor force—who will be voluntarily unemployed; there will be those who are unwilling to work for the government (perhaps at any wage!—survivalists and the like), those who are unwilling to work for the government’s announced wage (for example, because their reservation wage is too high), those who are between jobs and who would prefer to look for a better job while unemployed, and so on.
The ELR will eliminate the need for a minimum wage, as the ELR wage will become an effective minimum wage. It could also establish the base package of benefits that private employers would have to supply. It could replace unemployment compensation, although it could be simply added on to give workers who have lost their jobs more choices. In the US well under half of the officially unemployed even qualify for unemployment compensation. The point is that no matter what social safety net exists, ELR can be added to allow people to choose to work over whatever package of benefits might be made available to those who choose not to work. Obviously, generous benefits to those who do not work can affect willingness to work. The ELR benefit and wage package should be set higher than the benefit package given to similar individuals who do not work, but even this is not absolutely necessary. If ELR enhances one’s access to desirable private and public sector (non-ELR) jobs, then some individuals will choose to work in the ELR program even if this means taking a benefit cut. However, if society values work, it seems far more reasonable to reward ELR workers with a better compensation package than they would receive if they did not work.
NR: “One of the big failures of “MMT” is that it implicitly assumes (quite correctly) a monetary exchange economy (as opposed to a barter economy, or an economy with one centralised auction market), but insists on defining “money” as the medium of account, thereby missing the essential importance of the medium of exchange role of money, even within “MMT”. Without a medium of exchange, “MMT” would be theoretically nonsense.”
No. MMT is very clear about where it applies and where it does not, and it would not claim to apply to a barter economy. If only monetary theory was as clear and would exclude itself from current reality! There are economies in the world where the Govt is not a currency issuer, and monetarists could make themselves useful limiting their inquiry (and recommendations!) to those.
“and why did we had some 150 bank failures?”
But that misses the point. Just because capital is supplied as needed does not explain which institutions receive the capital. This process depends upon a notion of the return earned on the capital. Once the CBs of the world committed to steady inflation, the risk to capital declined, but certain bank managers show themselves to be a risk… ergo, the capital goes to the other banks (and so does everthing else) and naturally equilibrates to maintain a fair return.
I have a real problem identifying distributed actions as the independent variable. Bank capital allocation is a distributed process driven by the ‘price system’ and thus must be endogenous in any discussion of the way monetary policy works.
The exogenous variables must be those arising from centralized action because those are the only factors that can plausibly be set arbitrarily.
“With that Shapiro/Stiglitz efficiency wage model, unless there is some policy that can tackle the original cause, there is a sort of “iron law of constant misery” of those not in good jobs. Anything you do to reduce the misery of a worker not in a good job, just causes a proportionate increase in the number not in good jobs. The total misery stays the same.”
I don’t see how the idea of a “iron law of constant misery” is justified.
As you say, “The ELR automatically puts it[money] in the right hands.”
Unless you see that ‘misery’ comes from earning the lowest wage on the economic ladder or from working for the government, I don’t see the allocation or even the quantity of ‘misery’ remaining unchanged.
The current U.S. system doesn’t provide unemployment benefits (or any other benefits for that matter) to the long-term unemployed and are therefore in deep ‘misery’.
I’d propose the ‘iron law of constant misery’, if considered true, would then have a compliment called the ‘iron law of constant nirvana’. Taking a bit from those in a state of ‘nirvana’, using a government transfer, to negate some ‘misery’ seems to be the crux of the ELR program.
Total misery/nirvana would remain the same, just nirvana wouldn’t be as good and misery wouldn’t be as bad. Seems a lot like an argument about the efficient allocation of resources without regard to the benefits of a more egalitarian society.
Would you argue that an egalitarian society is inherently inefficient?
If the floor on misery is raised, does the overall societal benefit more than exceed the cost of raising the floor?
Are there ‘benefits’ to raising the floor?
“Bank capital allocation is a distributed process driven by the ‘price system’ and thus must be endogenous in any discussion of the way monetary policy works.
The exogenous variables must be those arising from centralized action because those are the only factors that can plausibly be set arbitrarily.”
The ratio of bank capital to loans can be set ‘exogenously’.
Winslow R: Yes, capital requirements can be set exogenously. TARP in effect relaxed them.
Winterspeak: “No. MMT is very clear about where it applies and where it does not, and it would not claim to apply to a barter economy.”
Agreed. But then for consistency they ought to define money as medium of exchange. But, the criticism I am making here of MMT I would also make of many other macroeconomic approaches. MMT is in good (bad) company!
Jon and Winslow: on bank capital. I think you can perhaps make a good argument that the supply curve of bank capital has been vertical (or close to it) recently (during the crisis). That’s because bank capital is sort of “locked in”. Banks’ shareholders can’t, in aggregate, pull their capital out of banks. If the price at which the banks could raise new capital would imply a low price at which new shares would be issued, then the supply curve of bank capital would be vertical up to some point, and only then start sloping up. And right now, banks may very well be on the vertical portion of that supply curve. I don’t know if that’s making sense.
Winslow: “I don’t see how the idea of a “iron law of constant misery” is justified.”
It’s not justified. It is predicted by the model.
The “No shirking condition” in Shapiro/Stiglitz says that the expected benefits from shirking are equal to the expected cost of being caught shirking. That latter is the probability of detection, times the “misery” of being fired if you are caught. So, for given expected benefits, and given probability of detection, that “misery” is a constant. You can think of that “misery” as “misery per week times number of weeks until you get a good job again”.
If a nice person does some policy that halves the relative misery per week (give bigger transfers to the unemployed), you just double the number of weeks of misery. If a sadistic person did something to double the misery per week of the unemployed (flogging them), he too would be disappointed to find that the weeks in misery would halve.
Yes, the predictions of that model are indeed miserable.
Bank capital: having another go to explain this clearly:
Since banks can issue new shares, but shareholders can’t in aggregate, redeem old shares, the supply curve of bank capital look like a hockey stick, standing upright. A vertical shaft, then an upward sloping blade. In normal times, banks are on the point where the stick curves. A drop in the value of banks’ assets shifts the stick horizontally left. A fall in bank share prices shifts the stick vertically up. We have just had both. So that has put banks on the vertical portion of their capital supply curves. That’s why JKH’s model starts to work in these special circumstances.
MMT has a medium of exchange, it’s that which is used to settle a tax liability.
Inquiring minds are asking how, if the existing models that were used recently are so good, what happened. We now have a global financial crisis that has turned into a real crisis of historical proportions. This situation seems to be nowhere near resolved since many economists are increasing the odds for a double dip, with even higher unemployment coming. Even relatively rosy assumptions foresee a new normal with higher unemployment than previously experienced post recovery, coupled with weak growth.
When asked why this wasn’t foreseen, the orthodox answer seems to be, “No one could have seen it coming.” Needless to say, this is infuriating to a whole lot of people down here in the US, many of whom are suffering, and many of those not suffering yet are getting scared that this things are spinning out of control because the folks running things don’t really have a handle on what is happening and are just bailing out their buddies. As a result the political scene here is turning somewhat ugly.
What say?