I'm going to put forward two perspectives on why bad banks might be important in understanding the recession: an orthodox perspective; and a heterodox perspective.
Banks are financial intermediaries. A financial intermediary is a firm whose (primary) business is borrowing and lending. (They intermediate between the ultimate borrowers and the ultimate lenders). That's an important job. The ultimate lenders could lend directly to the ultimate borrowers. But then each ultimate lender would have to collect information on the creditworthiness or profitability of the ultimate lenders. Information is a non-rival good. There is no point in several ultimate lenders duplicating the costs of collecting that same information. A financial intermediary can collect the same information just once, and act as agent to the ultimate lenders' principal. To ensure the agent acts more or less in the principals' interest, banks act as residual claimant, and for this they need capital, so banks' capital can take the first hit when their loans go bad.
If banks go bad, because a lot of bad loans caused a loss of banks' capital, they must raise new capital, or shift to less risky loans, or contract their balance sheets in proportion to their loss of capital. Raising new capital generally means banks must issue new shares. The same financial crisis that caused banks' loan losses may also cause a fall in banks' share prices. People's uncertainty over the value of banks' assets may further lower banks' share prices. If banks believe that their share prices are below their fundamental value, they will be unwilling to issue new shares to raise new capital.
I'm not 100% sure my above story makes sense, either theoretically or empirically. But let's suppose it does. So we have "bad" banks, that have only their remaining capital, are unable or unwilling to issue shares to raise more capital, and so face a perfectly inelastic supply curve of capital — they have what they already have, and cannot get more, at any "reasonable" price. They cannot expand their balance sheets to take advantage of what would otherwise be profitable opportunities, because each individual bank is capital-constrained. A fall in the interest rate on reserves at the central bank, which would normally give each individual bank the incentive to expand its balance sheet, even if it meant raising more capital by issuing new shares, will now have no effect. Because banks' balance sheets are capital-constrained. (See my previous post.)
So what. Why does this matter? That's what I'm trying to understand. If someone says "we can't get a recovery until bad banks get fixed", why is that?
If we view banks merely as financial intermediaries, then I find it hard to see why bad banks would really matter much, under present circumstances.
Sure, good financial intermediaries are important for the efficient allocation of the flows of savings between competing borrowers. They will make sure savings flow to the places where they earn the highest (risk-adjusted) return. A country with good financial intermediaries, doing this job well, will have a Long Run Aggregate Supply curve moving rightwards more quickly than an otherwise identical country with bad financial intermediaries, because the (risk-adjusted) return on savings and investment will be higher.
But the current economic crisis does not exhibit the symptoms of a problem with the AS curve. We have symptoms of excess supply of goods and labour, and falling prices. That suggests a fall in Aggregate demand, relative to Aggregate Supply. So even if bad banks have caused to LRAS curve to shift left (or move rightwards at a slower pace), that is not the current problem. We have a fall in AD, and current output and employment is demand-constrained, not supply constrained. We have a general glut.
Why should bad banks cause AD to fall?
Banks borrow short, safe, and liquid; and lend long, risky, and illiquid. And they earn their income on the spread between the interest rates. Bad banks will mean higher spreads, because capital-constrained banks are unwilling to expand their balance sheets to exploit and hence reduce those spreads.
Different people and firms face different costs of funds, or opportunity costs of funds. The whole 3D picture of the yield curve (across time, risk, and liquidity) will affect consumption and investment demand. "The" interest rate that determines consumption plus investment demand will be some sort of weighted average of the whole 3D curve. For a given interest rate set by the central bank, at the short, safe, liquid, end of the spectrum, the greater the spread(s) the higher will be "the" rate of interest which determines consumption plus investment demand. So bad banks increase the spread between the central bank rate and "the" interest rate, and so reduce Aggregate Demand, for any given rate set by the central bank. Bad banks could force the central bank rate down to zero, and still leave insufficient AD.
The above represents my best attempt to represent the "orthodox" view of why bad banks are (partially) responsible for the current recession. I think there is some truth in that orthodox view. I have proposed it myself in a previous blog post. And by "orthodoxy" here I mean the Neo-Wicksellian consensus that prevails in central banks, as well as academia, and views the monetary policy transmission mechanism as operating solely via interest rates. [And yes, Post-Keynesians, you are absolutely orthodox in that regard: horizontalist Neo-Wicksellians minus microfoundations. Sorry. I couldn't resist a little dig at your heterodox self-image ;-)].
But is that orthodox consensus the whole truth?
Financial intermediaries are useful (to reduce information costs) but not essential. A lot of lending and borrowing is direct, via stock and bond markets, and does not go through financial intermediaries. And banks aren't the only financial intermediaries either. I have often been a financial intermediary myself, when I both borrow and lend at the same time. (OK, sure, I miss on the technical definition of "financial intermediary" because my primary business is being an economics professor, but so what?).
The textbook definition of a bank is: a financial intermediary, some of whose liabilities are media of exchange. Banks create money, in that outdated viewpoint. The fact that people have chequing accounts at banks, and those chequing accounts are the most important means for people to buy and sell everything else, is what makes banks special, and important. Currency is the only alternative. And it's an outdated viewpoint because in the current orthodoxy the quantity of money is demand-determined. Monetary policy is interest rates, and interest rates cause aggregate demand, and if they also cause money, that is just as an aside.
Against that orthodoxy, the heterodox view argues that general gluts are always and everywhere a monetary phenomenon; the proximate cause of an excess supply of goods is always an excess demand for the medium of exchange. And the quantity of money (qua medium of exchange) is supply-determined, in a way that is quite distinct from any other good. It's a view arising from the confluence of disequilibrium monetarist and Keynesian streams.
Money is an asset (and usually a liability too), but is different from every other asset because everybody regularly both buys and sells money whenever they sell and buy anything else. That's what it means when we say that money is the medium of exchange. There is only one way to hold more land than you are holding now, and that is to buy more land. There are two ways to hold more money than you are holding now. One way is to buy more money (i.e. sell more other things); the second way is to sell less money (i.e. buy less other things).
An excess demand for land cannot cause a general glut of newly-produced goods, even though a desire to spend part of your income to buy land counts as desired "saving" according to standard definition. If everyone is trying to save in the form of land, so everyone wants to buy land, and nobody wants to sell, what happens? They fail, of course. Unable to spend their income on land, unless people decide to save their income in the form of money, they must decide to spend it on something else instead. Absent an excess demand for money, an excess demand for anything other than newly-produced goods must be frustrated, and people change their plans and decide to buy newly-produced goods instead. The inexorable logic of Say's Law dictates there cannot be a general glut that way, unless people desire to save in the form of money.
If people decide to save more, and save in the form of money, they might try to buy more money (i.e. sell more other things, like labour). They will fail of course, in a general glut, where all goods (like labour) are in excess supply. But an individual can never fail to to sell less money (i.e. buy less goods) and get more money that way. Each individual can succeed, but in aggregate they must fail (if the total stock of money is not increased). But the result is a fall in goods bought, and a fall in goods produced, and a fall in labour demanded.
A general glut is caused not by an excess desire to save, but by an excess desire to save in the form of the medium of exchange.
So where do banks come in? Banks create money. Sure, the central bank creates currency, but most people buy most things not with currency, but with the money created by commercial banks. We pay by cheque, or debit card, or ATM from our chequing account.
Forget currency (mainly, I admit, because I can't really get my head around where it fits in). Assume that all money is bank money. The commercial banks are the central bank's agents for creating money. Normally, when the central bank wants to create more money, it shifts the supply curve of reserves (shifts a horizontal supply curve down, or shifts a vertical supply curve right, or anything in between), and individual banks respond to this incentive of a lowered supply-price of reserves to expand their balance sheets, supplying more money on the liability side (and supplying more loans, buying more bonds, computers, whatever, on the asset side).
But even if banks want to supply more money, how can the actual stock of money increase, unless people want to hold more money? For any other asset, you cannot sell more unless people demand to hold more. If banks were land banks, they could not sell more land unless they persuaded people to want to own more land, by lowering the price of land, or raising rents, or whatever. But money is different. And it's different because it is the medium of exchange.
When a bank makes a loan, it does so by crediting the borrower's chequing account $100 in return for an IOU for $100. The borrower may ask about the interest rate on the loan. But he will not ask about the interest rate on his chequing account. Nearly all borrowers borrow money because they want to spend it, not because they want to keep it in their chequing accounts. Individual banks increase the interest rate on chequing accounts not because they want to persuade people to accept more loans, but only because they want to attract more deposits so they don't have to borrow as much from the central bank.
If the central bank increases the supply of reserves, and banks respond by increasing the supply of loans, the money supply expands, regardless of whether those borrowing from the bank demand a greater quantity of money. Banks really are like helicopters, in that they can increase the quantity of money held without needing to creating a demand to hold more money. For any other asset, if you wanted people to hold more, without getting them to want to hold more, you would have to give the asset away, for free. Throw it out of a helicopter.
Now commercial banks certainly don't give away money for free. But they can "force" people to hold more money even when people don't want to hold more money. Each individual borrower accepts money in exchange for his IOU, because he can get rid of that money by buying something. But in aggregate they can't get rid of the money they don't want to hold. One person's spending of money is another person's receipt of money. But their attempts to get rid of that money are what gets us out of the recession, by eliminating the general glut of other goods.
Central banks got rid of their fleet of helicopters when currency got replaced by demand deposits as the primary medium of exchange (again, I admit, I'm unclear on where currency fits into my picture). They contracted out helicopter operations to the commercial banks. They wanted the commercial banks to create the excess supply of money at current levels of income, leading people to want to spend that excess so we can escape any general glut. But now the banks' helicopters won't fly, because banks lack the capital to expand loans.
It ain't the loans what matter; it's the money creation that goes along with loan creation what matters. That's why (bad) banks matter. Bad banks won't create money.
Update: I wrote this post partly as a follow-up to my previous post on banks, and partly as a response to a post by Scott Sumner that was sort of a response to that post.
Worthwhile Canadian Initiative 
Bill: thinking about interest rates on deposits some more, let’s assume there are no admin costs on demand deposits (or that banks charge separate fees for each cheque, etc., to cover those admin costs). Then each individual bank has two equivalent ways of getting more reserves: borrow them from other banks, including the central bank; attract more demand deposits. With a competitive banking system, with x% desired reserve ratio, the interest rate on demand deposits would always equal (1-x) the interest rate on reserves. With x=0%, the interest rates would be the same.
So if we start in equilibrium, then the central bank increases the supply of reserves, the interest rate on reserves falls, loans and deposits expand, and the interest rate on deposits FALLS TOO. So it will not increase to eliminate the excess supply of deposits.
Nick. . . regarding land and net financial assets, you said what I would have in your response to David.
Bill: I thought your “banks make loans in something other than money” comment was priceless, but I think your “negative nominal interest rates on cash currency” is even better. I’m eager to hear how this will be implemented. I hope it involves flamethrowers.
NICK: Yes, your explanation was the orthodox one, and the orthodox one is wrong. It’s wrong because it looks upon banks as financial intermediaries who somehow “loan out deposits”. If banks were financial intermediaries who loan out deposits, the other stuff would be right.
Hi Nick,
“I can run exactly the same argument against RSJ and Scott, if people desire to save in the form of financial assets (except money), instead of land, or antiques. Either the price (interest rate) on financial assets adjusts, until desired savings equals investment again, or it doesn’t adjust.”
I hate to say this, but this dispute may be about stock-flow confusion. Please forgive my wordiness — I’m too busy to be brief 🙂
Money as the medium of exchange means that all income flows are in terms of money. But the desire to accumulate financial assets is expressed as a desire to increase your total stock of financial holdings. In other words, I agree that everyone desires to earn money, but they do not desire to hold money per se. Bonds, stocks, or other financial claims are just as good. So let’s separate out two desires:
1. (flows) the desire to increase your holdings of financial assets by earning financial surpluses, defined as earning more money than you consume by purchasing real goods/services whether for consumption or investment
2. (stocks) allocating those holdings among stocks, bonds, etc.
For 2., I claim that portfolio shifts do not affect aggregate demand. Suppose a company borrows money to retire bonds, or sells bonds to retire debt. None of that affects purchases of real goods or services, and none of that will cause a glut, even though it will shift some of the monetary aggregates.
Moreover, if everyone is happy with their current level of profitability, but is unhappy with their portfolio holdings, you may see a stock market crash or yield divergences, but this will not translate into layoffs or changes in output. 1987 is a good example. But that is a rare, as all that people really care about is the total value of their portfolio, and the only way to increase their financial holdings in aggregate is to increase your financial surpluses, or #1. That is what causes gluts.
For #1, the amount of financial surpluses earned, by identity is exactly the amount financial deficits. Everyone who earns money but does not spend it on goods is withdrawing from demand in the goods market — they are a sink, in terms of cash-flows. A sink can only exist if there is an offsetting source somewhere else in the economy. The source is funded by borrowing or issuing liabilities (here we need to include someone drawing down their own stock of financial assets as borrowing from themselves).
There is no shortage of willing sinks — everyone wants to be as profitable as possible. The system is constrained by the number of willing sources. Moreover, as Scott pointed out, the issuance of liabilities is not constrained by the desire to accumulate assets, whereas the reverse is true.
This is why if people stop borrowing on real estate in Florida, then the profits of General Mills decrease. Government better step in and deficit spend, or you hope to get people to borrow on real estate in Ohio, etc. When a source disappears, the size of the pie of gross financial surpluses shrinks by an equivalent amount.
When businesses stop being profitable, they liquidate capital and lay off workers. Everyone has a certain cost of capital, below which it is not profitable for them to create output in the first place. That is how output decreases as a result of a decline in the issuance of liabilities. If you are talking about flows, you can characterize this as the desire to earn money profits that are not re-invested in goods, in excess of willingness to dissave money, as flows occur with money. If you are talking about stocks, you can characterize this as the desire to accumulate financial assets in excess of the desire by others to incur financial liabilities.
“Wrong. Many (most, even) lenders do not use any funds to create a loan”
Good point, Scott.
The same happens when you buy claims in the credit market (even new issues). Imagine a company selling bonds to an investor. The investor liquidates his money market holdings to buy the bond, and the company takes the cash proceeds of the bond sale and puts them into a money market fund. Even though many sales and purchases may have been triggered, effectively all that happened was a swap of a money market asset for a newly issued bond.
Just as with a bank creating a loan, the result of the operation is that the new asset matching the new liability is first assigned to the borrower, as the investor’s financial net worth is unchanged as a result of buying the bond.
To the degree that the borrower then spends that money by making purchases, they are adding to demand and more importantly, they allow the rest of the sector to earn financial savings. This is the only way that financial savings can occur.
“Only if the government monopolized the issue of currency, keeps its nominal yield at zero, and makes it the medium of redemption for all the rest of the economy, do problems develop…But the notion that the government must create more financial assets because the private sector wants to hold more is mistaken.”
It’s true that in theory, you might be able to convince people not to accumulate nominal financial assets and to re-invest all their money profits in tangible assets. That would prevent gluts. Trying to eliminate the desire of the private sector to accumulate financial assets all so that the government need not issue liabilities is a hopeless fight against human nature.
RSJ:
“1. (flows) the desire to increase your holdings of financial assets by earning financial surpluses, defined as earning more money than you consume by purchasing real goods/services whether for consumption or investment”.
This isn’t right. A deficient demand recession is when people are earning more money (from producing new goods/services) than they want to spend by purchasing NEWLY-PRODUCED real goods/services whether for consumption or investment.
And this can mean “the desire to increase your holdings of financial assets”, but it can also mean the desire to accumulate real assets like land, or accumulate goods produced in the past like antique furniture.
So if an excess desire to accumulate financial assets can cause a recession, why can’t an excess desire to accumulate land, or antique furniture, also cause a recession? In all three cases, some income from the production of new goods is desired to be diverted away from being spent on newly-produced goods.
I have explained why I believe that an excess desire to accumulate land and antiques cannot cause a recession, and I can make the same argument for financial assets (except the medium of exchange) too.
RSJ @12.59. But when the company that holds $100 in the money market fund withdraws $100 to spend it, what happens to the money market fund? It needs to raise $100 from somewhere else.
“why necessary to assume there’s not a market clearing price for the money price of land? why can’t there be a market clearing price for excess demand for existing assets? agree if you assume not, then the money alternative becomes the source of the glut – but why assume that? … Agreed. We are on the same page”
conditionally on the same page, yes, but only if you assume no market clearing price – but still why do you assume not? why assume an excess demand for money due to a goods and services glut can’t be cleared by pricing for existing assets? this holds the entire market for existing assets inflexible apart from a glut assumption about the market for goods and services – why? if sellers of existing assets like the price they’re getting, there’s no reason to assume the excess demand for money doesn’t get absorbed
RSJ,
When a company borrows $100 and puts in into a money market fund, the fund must then do something with the investment it receives. Normally, it would purchase some security (commercial paper, treasuries, etc.) from another investor. And then that investor must do something with the money. The chain doesn’t end for purposes of Aggregate Demand analysis until (1) someone increases their demand for money (2) someone spends it on goods and services.
This is why it is a bit frustrating to see Scott F’s recent one-line response to Nick’s question, which I thought finally had a chance at getting to the heart of a genuine non-semantic Rowe versus MMT difference after all this time. Normally the MMT camp applies so much operational fervor in showing how step 1 causes step 2. So Nick is asking how step 1 (an increase in demand for financial assets) turns into step 2 (decreased aggregate demand) without step 1a (an excess demand for money, as in the medium of exchange) happens in between.
Your MMF story is not different than where a Corporation borrows money and uses it to invest in a standard mutual fund. The mutual fund then must do something with the money (buy stocks) and so on. Only if the fund (so someone in the chain) decides to increase its actual money holdings does the chain stop and allow for a general glut, because money is special.
Horizontal expansions can go on a long time until debt structure/asset prices become unstable due to low ratio of vertical money (currency/reserves) to horizontal money (what Nick calls bank money or dlr may call money).
dlr wrote: “without step 1a (an excess demand for money, as in the medium of exchange)”
Perhaps the role of government is what you are looking for?
A small withdrawal of vertical money due to government surplus (excess taxation) then leads to deleveraging of the horizontal debt/asset structure as borrows scramble to payoff loans while asset prices collapse.
anonTDH: I am making the standard assumption that the price of goods is sticky in the short run.
Suppose we have an increased demand to save in the form of money (people desire to save part of their income and add a flow of money to accumulate a greater stock of real balances M/P). If the price of goods P falls, that solves the problem, by increasing M/P and satisfying the demand to hold more money. (Unless of course it causes expected deflation which exacerbates the problem by increasing the demand for money).
Is that what you were asking?
Suppose the price of new goods and services is sticky. Prices don’t drop, people don’t buy, which means they save. But instead of saving in the form of money, they buy existing assets, driving up their price… then there has been a glut of new goods and services, but people haven’t saved in the form of money. Sellers of existing assets are happy with the higher price they receive, so you can’t really blame the glut in new goods and services on their excess demand for money, can you? Also, those sellers haven’t “saved”; they’ve just exchanged one asset for another … e.g. a glut of new houses; people bid up the price of existing houses; no resulting saving in the form of excess demand for money.
anonTDH: But has there been a glut in new goods?
Take a simple example. Suppose people currently are holding their target value of financial assets (excluding money). Suppose they decide they are all going to live twice as long in retirement, and want to double their target value of financial assets. So each individual decides to save a little bit more, and slowly increase his financial assets over time. But if the price of financial assets responds instantly to excess demand, the price of financial assets relative to goods doubles instantly, to eliminate the excess demand for financial assets. Having hit their target immediately, they stop saving immediately, and the excess supply of goods disappears immediately. There was only an incipient excess supply of goods.
(All this assumes that the doubling of the prices of financial assets has no effect on the demand for money, of course.)
Nick @6:57
“But if the price of financial assets responds instantly to excess demand, the price of financial assets relative to goods doubles instantly”
No, it doesn’t.
The price of financial assets is determined by estimates of future returns over a given time horizon. Prices will not adjust upward unless either prospects for overall returns increase, or unless all other prospects (e.g. investment in tangible capital, rental property, and finally the overall growth rate of the economy) diminish so that you are willing to accept a lower yield as you have no other options. Obviously in the short run, there are frictions and dislocations, cognitive biases, etc, but the price of financial assets is not determined by a desire to have your overall portfolio increase in value — such a desire is infinite.
In terms of your model, you demonstrated that if everyone wants to hold a good, then transactions will stop. That is true. It holds for bonds, money, land, antiques, and anything else you want to accumulate. No one will succeed if everyone is on the same side of each trade, and everyone has the same list of second and third best preferences. They will all move down this list together at the same time. If they are trying to accumulate land — everyone will just keep the land they already have and no one will get more. If they try to accumulate money — everyone will just keep the money that they have and no one will earn any more. You go on down the list and the end result is that no transactions occur. But I don’t think this is enlightening, or is an argument that can be used “against” my model.
re: new vs. pre-existing goods
I agree that only purchase of new output counts, but I don’t think that purchase of pre-existing output leads to gluts. Whether someone buys a new or used car can lead prices to adjust between new and used cars, or between cars and real estate, but as long as they are spending all of their income on goods or tangible assets, then there will not be a glut.
The person who receives the proceeds will turn around and spend them on something else (again, we are assuming that they are not saving in the form of financial assets). It is only when they do not turn around spend but take that money out of the goods market can there be a glut. Whether they leave the money passively in a bank account, or whether they exchange their bank account for a bond is beside the point. They will allocate their financial assets in such a way as to maximize their returns, but regardless of that allocation, demand for output is decreased.
If this demand to earn more than you spend is not offset by people who spend more than they earn (by incurring liabilities), then the market will not clear and you will have a glut. This does assume that prices do not just adjust downward, but of course network effects and debt service prevent prices from adjusting downward. Contracts and cost of capital effects cause business to liquidate capital rather than instantly re-negotiate all debts/wages/vendor relationships/prices downward simultaneously by some all-knowing auctioneer.
RSJ: “No, it doesn’t. The price of financial assets is determined by estimates of future returns over a given time horizon.”
In my very simple model, where people wanted to double the value of financial assets they held, regardless of expected rates of return, the prices of financial assets would double. You are moving to a more complex, admittedly realistic model. But it doesn’t affect my point. If an excess supply of goods is matched by an excess demand for financial assets, and the price of those assets is perfectly flexible, they adjust instantly to eliminate the excess demand for financial assets and the excess supply of goods (as long as there’s no excess demand for money).
“In terms of your model, you demonstrated that if everyone wants to hold a good, then transactions will stop. …… If they try to accumulate money — everyone will just keep the money that they have and no one will earn any more. You go on down the list and the end result is that no transactions occur. But I don’t think this is enlightening, or is an argument that can be used “against” my model.”
Good. You have understood my main argument. I just need to convince you that it doesn’t apply to money. Money, as medium of exchange, is weird. It’s different.
All the other goods have a market of their own. Money doesn’t have a market of it’s own. Money (as medium of exchange) appears on one side of all the markets. In a monetary exchange economy, if there are n goods, including money, there are n-1 markets, one for each of the non-money goods. And money is bought and sold in each of those n-1 markets.
And money circulates. Every person has a flow of money coming in, and a flow of money going out, and so there are two ways to increase the stock of money you hold: increase the flow coming in; or reduce the flow going out. If one of those ways is blocked, because there’s an excess demand for money, you just switch to the other way. If there’s an excess demand for money, you can’t sell more goods to increase the flow of money coming in; but you can buy fewer goods to reduce the flow of money going out. And that’s what causes the recession.
Hi dlr, Nick @4:58
“When a company borrows $100 and puts in into a money market fund, the fund must then do something with the investment it receives.”
In my example, a company sold a bond to an investor. The investor had $100 in a MM fund. The investor sells his MM holdings and buys the bond, and the company sells the bond and buys the MM holdings. So everything is closed. The MM fund assets are unchanged. Obviously many other transactions can happen, but these portfolio shifts are not important.
The company now has a liability (bond), and an asset (MM holdings). The investors in the economy do not have more or less financial assets then they started with. The only role of investors in this process was to price the bond in terms of their MM holdings.
Next, suppose that company sells the MM holdings to buy some capital equipment. You can assume the seller of the capital equipment receives MM holdings as proceeds of the sale. If you draw a line about the initial company and the rest of the private sector, when the company buys the capital equipment with the MM holdings, the net financial savings of the rest of the sector increased by $100. That is because the liability stayed with the company, but the asset jumped ship to the rest of the sector.
And this is the only way that financial savings can increase.
“This is why it is a bit frustrating to see Scott F’s recent one-line response to Nick’s question, which I thought finally had a chance at getting to the heart of a genuine non-semantic Rowe versus MMT difference after all this time.”
OK, here is my shot at it:
My view:
Borrower creates asset and liability and spends the asset into the economy, causing someone else to end up with a financial asset. In terms of rates, a flow of borrowing causes a flow of financial asset accumulation, which is defined as surplus profits, or profits not re-invested in the goods/labor markets. The nominal yield does not equilibrate between the supply and demand for financial assets, but merely reflects risk-adjusted nominal growth expectations (although obviously the amount borrowed depends on changing growth prospects and risk tolerances).
My characterization of the orthodox view:
Businesses/Individuals choose to save in the form of financial assets. Interest rates equilibrate the amount borrowed with the amount saved, so that a businesses decides to save $100 and then keeps lowering the interest rate up until $100 is borrowed and spent, funding the $100 in savings ex-post.
I think, operationally, the orthodox view is not consistent with accounting, or observed economic behavior.
“Normally the MMT camp applies so much operational fervor in showing how step 1 causes step 2. So Nick is asking how step 1 (an increase in demand for financial assets) turns into step 2 (decreased aggregate demand) without step 1a (an excess demand for money, as in the medium of exchange) happens in between.”
My point is that no one holds money as a stock, they only hold claims (e.g. deposits, savings accounts, bonds, money market funds, stocks). Money circulates to settle transactions, but there is no special desire to hold cash in your mattress. There is a special desire to obtain a flow of cash profits that are not re-invested in goods/labor.
But the terminus of this flow is some financial claim, whether a bank account, bond holding, etc, and the market prices of one claim vs. another is such that indifference is achieved between holding one or the other (once time horizons are taken into account).
RSJ @12.18: Kudos to you for a good attempt to explain the MMF transactions. But I’m afraid my brain is not up to following it. Just too many transactions to try to keep my head straight. Sorry.
But I do want to take issue with you on this bit:
“My point is that no one holds money as a stock, ….. Money circulates to settle transactions, but there is no special desire to hold cash in your mattress.”
But they do. There is a stock of currency and demand deposits that people hold. I agree that money circulates, and that it’s like an inventory. But at any given time there is a stock that can be seen in a snapshot. And people can change the stock that they desire to keep on average. (And if they held each dollar for some fixed period of time, and never changed their minds about how long they wanted to keep each dollar in their pockets, then that says desired velocity of circulation is fixed, and we get into a very monetarist MV=PT sort of model.)
” Every person has a flow of money coming in, and a flow of money going out, and so there are two ways to increase the stock of money you hold: increase the flow coming in; or reduce the flow going out. If one of those ways is blocked, because there’s an excess demand for money, you just switch to the other way. If there’s an excess demand for money, you can’t sell more goods to increase the flow of money coming in; but you can buy fewer goods to reduce the flow of money going out. And that’s what causes the recession.”
I agree! And I would add the following caveat: Any retained earnings immediately become a financial asset. Remember that both currency and demand deposits are financial assets backed by financial liabilities (of the central bank and private banks, respectively).
If desire to hold financial assets is not matched by a growth of financial liabilities, then markets don’t clear and you have a glut. I think we agree on this point. Moreover, we would both agree that if you have $10,000 in money market funds, and I have $10,000 in bonds, and Joe Potato has $10,000 under his mattresses, then it doesn’t matter whether we all switch our holdings, in terms of purchases in the real economy. Moreover, if in aggregate, businesses shift their capital structure to fund themselves more with equity than debt, or more with bank debt than bonds, then none of these shifts in monetary aggregates affect demand or the real economy.
“But they do. There is a stock of currency and demand deposits that people hold.”
I agree that both demand deposits and currency have transactional utility that causes people to hold them above and beyond the return provided. But this is just a buffer stock to help settle transactions — it’s a cache.
Who says to themselves “I want to spend $100 less than I make and store it as currency.”?
My claim is they say “I want to save $100”, and then there is a separate decision of whether to buy a stock or bond, or hold that money in a deposit account, or withdraw cash and keep it under your mattress.
And I claim that decision #1 affects the real economy whereas decision #2 does not — at least for an economy with the current banking framework (e.g. the CB would add currency to the economy as people put more under their mattress, if such an event caused overnight rates to spike).
RSJ:
“If desire to hold financial assets is not matched by a growth of financial liabilities, then markets don’t clear and you have a glut. I think we agree on this point.”
No we disagree there (for financial liabilities that are no media of exchange). Either the price (rate of return) on those liabilities adjusts, eliminating the excess demand for both them and for newly-produced goods, or it doesn’t, and people can’t buy financial liabilities and have to buy something else with their income instead (or add to their stocks of money).
“Moreover, we would both agree that if you have $10,000 in money market funds, and I have $10,000 in bonds, and Joe Potato has $10,000 under his mattresses, then it doesn’t matter whether we all switch our holdings, in terms of purchases in the real economy.”
Yes, we agree.
“I agree that both demand deposits and currency have transactional utility that causes people to hold them above and beyond the return provided. But this is just a buffer stock to help settle transactions — it’s a cache.”
Take out the word “just”, and we agree.
“Who says to themselves “I want to spend $100 less than I make and store it as currency.”? ”
I did! As a baby I held no currency, and now I hold $100 on average. So I must have done this.
“My claim is they say “I want to save $100”, and then there is a separate decision of whether to buy a stock or bond, or hold that money in a deposit account, or withdraw cash and keep it under your mattress.”
My claim is that some economists may find it useful to think of there being two separate decisions, but this way of framing the problem is a consequence of the economist’s theoretical perspective; it is not a fact about the world. We can take the time derivative of the second budget constraint, and substitute it into the first budget constraint, and get a unified budget constraint. But what both these approaches miss is the structure of markets in a monetary exchange economy. In an economy with n goods, including money, there are n-1 markets, and really n-1 separate decisions, because each of those n-1 decisions is to maximise utility subject to any quantity constraints in the other n-2 markets (Clower, Benassy).
You have a “2-decision” way of looking at the world; I have an “n-1 decision” way of looking at the world. And that is radically different. When markets are not clearing, then monetary exchange matters. If the transactions costs of barter were not (usually) prohibitive, then unemployed workers would swap the goods they produce directly with each other, and would circumvent the excess supplies of goods and get to full employment. There could never be deficient demand unemployment if barter were possible at low transactions costs.
“….– at least for an economy with the current banking framework (e.g. the CB would add currency to the economy as people put more under their mattress, if such an event caused overnight rates to spike).”
Agreed, sort of. If the CB did add currency and/or demand deposits to eliminate any excess demand for money then we wouldn’t get a glut of newly-produced goods. But I don’t think the spike in the overnight rate would necessarily be a good indicator of whether or not there was an excess demand for money. Remember there are n-1 markets, and so n-1 separate excess demands for money, in principle.
Nick,
Nick,
We have grammar to clarify meaning. Yours does. I won’t fix what ain’t broke.
Ex-post, you are right about the uniqueness of money. But in a world with sticky pay rates and other prices, it is expectations that do the heavy hauling of adjusting PQ to MV. So ex-ante looks the way to think.
If I think there is a 0.001% chance of your converting your house into money, that belongs in my estimate of the expected MV. If I reckon that chance has increased to 0.002%, that is probably a large change in my estimate of expected MV.
Nick:
I haven’t been following these comments.
I don’t believe that interest rates on deposits will change to clear up excess supplies or demands for money.
I see no plausible market prices by which an excess supply of money will lead banks to raise deposit rates. Or an excess demand for money will cause them to lower rates.
The Black and Fama parts of BFH and some of Greenfield and Yeager’s early arguments made that sort of false claim.
I think deposit interest rates are often sticky in the short run, which allows changes in the prices of nonmonetary assets to generate the liquidity effect. So, you get some kind of short run “equlibrium” with deviations of the market and natural interest rates.
On the other hand, if there aren’t sticky, then I think deposit rates will move in proportion to other rates. That might happen in the short run and will happen in the long run. And so, no liquidity effect.
However, when that happens, there is no problem with a zero nominal bound.
That is why having a yield on them is important. It can be negative and so there is never a problem with the zero nominal bound.
The zero nominal bound is solely an artifact of currency. And deposits get tied up in it because of redeemability into currency.
Bill: “I don’t believe that interest rates on deposits will change to clear up excess supplies or demands for money.”
I’m glad to see your intuition is coming to the same answer as mine.
Nick:
I agree that not all the n-1 goods are perfectly substitutable — I don’t think this is a source of gluts. It’s a source of badness which may or may not reach general glut badness levels.
“My claim is that some economists may find it useful to think of there being two separate decisions, but this way of framing the problem is a consequence of the economist’s theoretical perspective; it is not a fact about the world”
It is a fact about the world, because yields on financial assets (and hence their price) are not determined by the quantity of borrowing demanded intersecting with the quantity of “lending” supplied, but by the expectation of return. This is a prediction market, and you cannot use the same supply and demand arguments to combine a prediction market with goods markets. There is real world economic behavior driving this distinction.
Prices of securities in liquid markets are not set by the marginal purchaser — anyone can short a security if they think it is too expensive, and all cash-flows with similar return characteristics are perfectly substitutable: A second or third cash-flow with the same return characteristics is not priced lower than the first. Therefore the “supply” of lending is horizontal with respect to quantity demanded.
A good mental model is to imagine a line of borrowers standing in front of you, the lender. Each borrower asks “how much is my obligation worth?”, and you say “X”, trading X of your existing financial assets for the borrower’s new issue. And the next borrower asks “how much is my obligation worth?” and you say “Y”, swapping again. You as the lender can “lend” many multiples of your financial holdings in a single trading session, because each time you swap some of your existing assets for a new issue, you are enabling a borrower’s balance sheet to expand, even as your own balance sheet is unchanged.
And you are not going to start increasing the yield if the line is long or short. The rate of turnover does not boost the price, but you will appraise each claim individually, regardless of the quantity borrowed.
This is unlike the Walrassian n-1 goods markets, in which the buyer and seller must come to an agreement on the quantity of goods purchased, with any excess demands resulting in purchases in some other market in which people also agree on quantity. The net result is a full overall agreement on quantity within the barter model.
When you introduce money, then there is no agreement on quantity in the money markets. The level of financial savings is a one-way decision set by borrowers. You can call this an “excess desire for money savings” if you want, but the key point is that it is excess of whatever the borrowers say it will be, and there is no reason to believe that the increase in liabilities will be sufficient to meet the financial savings needs of the private sector.
Nick, do you agree with what is said here about currency?
http://www.treas.gov/education/faq/currency/legal-tender.shtml
I thought this might interest JKH and others about capital requirements.
Nick’s post said: “Too much: “When someone buys a house, does he/she get the mortgage and eventually and usually pay with a check (demand deposit)?” Yes.
“Think about an economy with all currency and NO currency denominated debt. What would it look like?” Horrible. No pension plans. But OFF-TOPIC!
“Is it more accurate to say “The commercial banks are the central bank’s agents for creating currency denominated debt with an interest rate attached and repayment terms attached.”?” No.
“Is it the central bank increases the supply of reserves, interest rates come down, and demand for currency denominated debt (a loan) goes up (they are hoping for that)?” Quantity demanded of loans goes up. Yes.
“With legal tender laws, is currency used to make the interest payments on currency denominated debt whether gov’t (thru taxes) or private?” No. We usually pay by cheque.
Now, back off a little please. Let someone else attack me!”
If the builder redeposits the check, I don’t see any currency created.
If there is an all currency economy, are there any currency denominated debt defaults? If no, are there any bad banks?
Could you expand on the no pension plans part?
I don’t believe commercial banks can create currency, so what do they create?
In a lot of cases, the Quantity demanded of loans goes up. I think we need to discuss the demand side like when it might not go up.
Aside from some form of check default, is it really a good idea to make the interest payments on currency denominated debt with currency denominated debt? (I believe we agree that a check is currency denominated debt [see the treas.gov link/post])
@Bill, Nick
“‘Bill: “I don’t believe that interest rates on deposits will change to clear up excess supplies or demands for money.”
I’m glad to see your intuition is coming to the same answer as mine.'”
I agree with this as well, the imbalance will continue as the information moves though the market. Eventually a catastrophic shift will happen to correct the imbalance. I believe this is what Hayek’s trade cycle is.
Its a bit heterodox, but I don’t think that markets are efficient, but that they are efficiency seeking.
@Too Much:
“Aside from some form of check default, is it really a good idea to make the interest payments on currency denominated debt with currency denominated debt?”
Yes; it allows you to not have to adjust for price changes due to supply side shocks in what ever you are making the interest payments in. For example say you have a silver denominated currency (like US dollars during bimetallism) suddenly new technology allows for much better silver mining and the price of silver plummets (Like it did). Now you have severe inflation.
“It ain’t the loans what matter; it’s the money creation that goes along with loan creation what matters. That’s why (bad) banks matter. Bad banks won’t create money.”
So the major credit card issuers are bad banks, right? I suspected as much. 😉
I think that what the US government (and other governments that have followed in their footsteps) has been doing to do to attempt to “improve” the economy is very irresponsible and wreckless. It has wasted trillions of dollars bailing out creditors and shareholders of failed institutions with broken business models rather than addressing the structural flaws in the system of too much debt. And this is going to lead to massive problems down the road with regard to our currency and interest rates, in my opinion. And I think that the gold price breaking out to a new high is a strong indication of the reduction in faith and confidence that people have in governments and their fiat currencies. I recently read a good article on this at Gold Price Cheaper Now than at $300 – Hathaway that discusses the Federal Reserve’s easy monetary policies in order to try to prevent any sort of deflation from occurring and to try to reflate assets prices. There are also many more articles here that I think are very helpful for any investor to read because they help to explain the investment implications for the dollar, the gold price, and gold mining companies who I believe will continue to benefit from central banks’ inflationary programs.
Nick’s post said: “Too much: “When someone buys a house, does he/she get the mortgage and eventually and usually pay with a check (demand deposit)?” Yes.
So if I can buy a house with all currency, all “check” (demand deposit and therefore currency denominated debt), or a combination of the two, are you sure that there are not n-2 markets?
Nick said: “We have a fall in AD, and current output and employment is demand-constrained, not supply constrained. We have a general glut.”
I agree (believe it or not) about being demand-constrained.
That sounds like an output gap. If so, how should it filled?
RSJ said: “Who says to themselves “I want to spend $100 less than I make and store it as currency.”?
My claim is they say “I want to save $100”, and then there is a separate decision of whether to buy a stock or bond, or hold that money in a deposit account, or withdraw cash and keep it under your mattress.”
I agree. People are trying to maximize the return on their savings.
“And I claim that decision #1 affects the real economy whereas decision #2 does not — at least for an economy with the current banking framework (e.g. the CB would add currency to the economy as people put more under their mattress, if such an event caused overnight rates to spike).”
Add currency??? It seems to me the fed is about adding reserves NOT currency. Why is that?
Nick said: “Here’s why I think the orthodox view is wrong. Suppose we start in equilibrium, then suddenly everyone wants to cut consumption of newly-produced goods and buy land.”
What if the cut in consumption is forced by currency denominated debt defaults, the collateral seized, and the collateral resold as a used good?
Are the reselling of technology goods around 2001 and the reselling of housing good examples?
Doc merlin, I assume that is why there is a legal tender law and a need for an entity to limit currency printing.
Now if there was only a good way to limit currency denominated debt creation!?!
Hi Nick, I know you’ve moved on from the topic, but could you offer, a summary of what just went on here these past couple of months, maybe reference back to the “what makes a central bank a central bank.”
Did anything happen? I’ve read a ton of words, some used by the same people with different meanings. People getting exercised. And all that sticks out was JKH saying something about viewing ownership as access, to real rents, disagreeing with winterspeak. You trying to convince the MMT’s of shifting the curve to the left. And a whole lot of “reserves don’t cause lending!” It’s just that I’m going through my chemistry exams and realizing they would have been easier with more studying during the term. Economics is like falling through the rabbit hole, but I really appreciated you stating that economists could use whatever variables they like.
This is more a backhanded compliment then anything, thank you and the commenters for the knowledge, there is a lot of dense material.
Hi edeast: yes, it all got pretty dense!
If I were doing it again, I would change the title of my earlier post, because people (understandably) misunderstood the question I was addressing. Instead of “What makes central banks central?” I should have called it “What gives central banks the power to control monetary policy?” Or “Why is the Bank of Canada more powerful than the Bank of Montreal?” My answer would stay the same.
In this post, and the post on “capital, reserves, and loan officers”, I would insist that “an increase in the supply of reserves (or loans)” means “a shift in the supply curve of reserves (or loans)”. That is what economists (should) mean by “supply”. Otherwise, I would stick to what I said originally. A shift in the supply curve of reserves does cause a shift in the supply of loans and of money. Except perhaps in special circumstances when the supply curve of bank capital is (locally) vertical, so banks are capital-constrained.
An awful lot of confusion is due to people thinking that “an increase in supply” means “an increase in quantity sold”, as opposed to “a shift in the supply curve”.
ok, thanks.