Like physics, modern macroeconomic theory predicts the possibility of "black holes". The analogy with physics is close, but not exact. Because unlike physics, where it's not easy to see a black hole, there should be no difficulty in macroeconomists seeing a black hole, if one exists. At the very least, we should certainly see any economy being sucked into one. So where are they? Why don't we ever see any?
If the economy gets too close to a black hole, it can't escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation…and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it.
Theory does not predict that black holes will happen. But it does predict that they can happen. And commonsense (backed up by Murphy's Law, in this case) says that, sooner or later, anything that can happen will happen.
So where are they? Why can't we see them? We sure have sailed our macroeconomic spaceships close enough to the boundaries of predicted black holes plenty of times. Why didn't any economy ever get sucked into one, and collapse into an infinitely valuable pinpoint?
Either somebody up there likes us. Or there's something wrong with macroeconomic theory.
Worthwhile Canadian Initiative 
After Keynes and Industrial Revolution there is always the option to junk existing financial obligations and I’d guess this behaviourally (psychology not economics) becomes more and more likely the longer you are out of work and noting the hoarding of the means of production. I guess you could use propoganda (education) or 22nd century policing powers to reduce this return-to-Keynes political demand, or you could lose the ability to mine coal or something….it doesn’t seem too likely.
“If the economy gets too close to a black hole, it can’t escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation…and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it.”
I don’t think that is right. Think about an all currency economy with no currency denominated debt defaults.
If you are thinking about the situation today in the USA, you might be able to apply some of that to lower and middle class currency denominated debt. And, someday you might be able to apply some of that to gov’t currency denominated debt.
Why is it so hard to distinguish between currency and currency denominated debt???
Or, what is the “price” of currency, and what is the “price” of currency denominated debt?
Extending the analogy to an ‘event horizon’, Wikipedia states that “any object that approaches the horizon from the observer’s side appears to slow down and never quite pass through the horizon, with its image becoming more and more redshifted as time elapses. The traveling object, however, experiences no strange effects and does, in fact, pass through the horizon in a finite amount of proper time.”
Maybe some economies are already in the event horizon but since we’re all part of the travelling object, we do not experience the effects (or recognize it for what it is), but everything has actually been slowing down. As in an event horizon where time slows but objects stretch,we do not experience the deflation because something has been stretching to make up for it, money perhaps?
” If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation…and so on. ”
Hmm — I look at things a little differently:
reduction in net borrowing –> reduction in demand –> reduction in output + prices –> reduction in expectations of growth –> reduction in net borrowing.
Of course, as a loop, you could start with reduction in growth expectations (which you call (risk-free) interest rates — sorry for the dig :P).
But counteracting this trend is that wages are more sticky than prices (and people have the ability to default on debt). Therefore the worse things get, the higher real incomes are, up until people start spending again via a form of Pigou effect (but for the discounted income stream, not necessarily for stored wealth), growth improves, return prospects improve, and borrowing increases.
Merry Christmas
You’re just asking for abuse aren’t you Nick? “Or there’s something wrong with macroeconomic theory” Gee…. I wonder….
More seriously, if as a non-macro question I might make a couple of suggestions. First it seems to me your black hole analogy fits best to the private economy, not really anticipating government as a sort of super actor on the side ready to push us away the other way. I think to some extent that’s why we haven’t slipped into the vortex in the past, as government actions (intelligently planning to do so or unintentionally blundering that way) have saved us by not following the logic of the black hole.
I think the second problem I see is the inability or the limited ability of individuals to follow the same logic. Even though there may be a compelling reason not to, we usually need to buy something – we can’t reduce our consumption to zero. Nor do I think people follow the logic of the forces you describe so tightly – they aren’t that rational if that’s the right word. If macro assumes they do, then yes, there’s something wrong with macro.
Stars only collapse into black holes if their mass is over a certain limit. Below this, electromagnetic forces or strong nuclear forces (and the Pauli exclusion principle) keep the individual particles at a non-zero distance, leading to a white dwarf or neutron star respectively.
An economy entering this kind of death spiral would presumably be prevented from total collapse by the analogous “interatomic” forces: subsistence and barter.
Now technically I’m talking about singularities, and a black hole doesn’t need to be a singularity. A non-singularity black hole is simply a large enough mass in a small enough space to have an event horizon. Perhaps this equates to a subsistence economy with so many people that it can never achieve sufficient coordination to return to a monetary exchange system (see Krugman’s paper on relativistic interest rates for ideas on how this could happen).
The singularity case is, of course, more interesting and more tantalising. Although we have never observed it, the hypothesis is that at some point (from memory, between 10 and 50 suns) gravitational force is greater than neutron pressure and even a neutron star cannot exist. The Pauli exclusion principle is somehow violated, or else each particle exists in some quantum gravitational state for which we currently have no accepted theory; or indeed the particles themselves may no longer have any identity. In an economic system, this may mean that all the agents in the economy begin to fetishise money and assign infinite value to it, in which case they’d spend all their time worshipping their paper currency, stop feeding themselves and die. Despite the rumours, this is not what happened at RBS.
However, the problem with the whole analogy is that unlike the other three forces, gravity has no repulsive mode and thus can never reach equilibrium once it has broken through the barrier of the strong nuclear force. Money is different. If it gains sufficient value through deflation, surely the issuer of the currency – no matter how virtuous – will eventually give in and start printing more. If not at CA$1 = US$1000, surely at CA$1 = US$1 billion?
Who says economists have physics envy?
WW2? About as black as they get.
EDIT: “… Think about an all ‘non-fixed’ currency economy …”
Leigh: Wow! You do really know some physics! (or are impressively good at faking it!)
“Perhaps this equates to a subsistence economy with so many people that it can never achieve sufficient coordination to return to a monetary exchange system…”
I think the predicted outcome would be a return to barter, which isn’t quite the same as subsistence, but might be close enough in practice.
“Money is different. If it gains sufficient value through deflation, surely the issuer of the currency – no matter how virtuous – will eventually give in and start printing more. If not at CA$1 = US$1000, surely at CA$1 = US$1 billion?”
But modern macro theory says that monetary policy is powerless in a liquidity trap! (At least, the sort of modern macro theory i am implicitly criticising says it is.)
Jim: “Even though there may be a compelling reason not to, we usually need to buy something – we can’t reduce our consumption to zero.”
If we followed the logic of the theory, the real rate of interest would keep on rising, plus people would expect declining real incomes, so would spend less and less, both because of the incentive of high real interest rates, and because they expected to be even closer to starvation in the future. I expect when they hit the point of starvation they would say “well, I’m going to die anyway, so I might as well eat today and die tomorrow” and the economy would hit bottom.
” “Or there’s something wrong with macroeconomic theory” Gee…. I wonder….”
You missed the whole point of my post ;-). Since there can’t be anything wrong with macro theory, it must be that somebody up there likes us! I was making a theological argument, not a macro one. Can’t you tell the difference??
RSJ: Merry Christmas!
“But counteracting this trend is that wages are more sticky than prices (and people have the ability to default on debt). Therefore the worse things get, the higher real incomes are, up until people start spending again…”
You have to be careful here. If P falls more quickly than W, real wages will rise, and wage income will rise as a percentage of total income, but real income (= real output = real aggregate demand) still falls. If the marginal propensity to consume out of wage income is higher than out of non-wage income, that might be a stabilising force though.
Rogue: Neat physics! But I think you are putting more weight on the physics analogy than it can bear. I think Statistics Canada would still be reporting accurate figures on deflation and GDP even when the economy went into a black hole. (At least until we got to total economic collapse, and by that time it would be so bad we wouldn’t need StatsCan to tell us how bad it was.)
Too much Fed: “Or, what is the “price” of currency, and what is the “price” of currency denominated debt?”
It’s 1 divided by the price of goods. 1/CPI, if you like.
Phillip: The escape valve would be a resort to barter. But we don’t see it. Well, we do see it a bit in recessions, but not a total switch to barter.
So, “modern” macroeconomic theory says that real expenditure can only be influenced by increases in real balances (even as they approach infinity) if they lower the real interest rate?
I would say that real balances rise, saving falls, consumption rises, real expenditure begins to rise. The natural interest will rise to meet the real interest rate.
Is there something nonmodern about this?
Is the problem that current deflation rates are always projected into the future? No one spends their infinite wealth on current consumption because they will have more than infinite wealth if they just wait for prices to fall further?
I think all it takes is for people to believe that somebody will spend some infinitely small fraction of their infinite real balances to buy enough real goods and services, that they won’t project current deflation to the future and instead may even expect inflation. Has the price level undershot?
By the way, suspending currency payments would be a good idea if this was happening. Then the interest rates on money can be more negative than deflation rates.
Bill: “Is there something nonmodern about this?”
Yes! It’s definitely non-Neo-Wicksellian! Monetary policy IS interest rates, doncha know?
OK. What I’m trying to do is force a contradiction, or at least a paradox. If there exists no mechanism whereby an increase in M/P via increasing M can rescue the economy from a liquidity trap, then there can be no mechanism whereby an increase in M/P via falling P can rescue the economy from a black hole. But we don’t observe black holes. Ergo..
Matt: WW2 was certainly bad, but not a deflationary black hole. Mild repressed inflation.
Even more sticky than wages is debt. Those with substantial liquid assets, particularly in risk free assets, would get wealthier. While they could continue to hold out for even greater wealth in the future, they are frequently near or in retirement with shorter time horizons. Those with secure incomes such as government jobs and pensions would also experience something similar. Those with bonds would have to trade off increased real income or accelerated repayment against default. Creditors would prosper while debtors would struggle up to default. Wealth unleashes the liberal impulse. Still, while this provides a floor, it doesn’t necessarily turn things around.
There have been a number of examples of reversion to local script to assist in barter under hardship conditions.
“If the economy gets too close to a black hole, it can’t escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation…and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it.”
You have described a positive feedback cycle informally. The existence of one does not imply runaway feedback (death spiral), unless the cycle accelerates. It might approach a limit.
“Theory does not predict that black holes will happen. But it does predict that they can happen. And commonsense (backed up by Murphy’s Law, in this case) says that, sooner or later, anything that can happen will happen.”
That depends upon what you mean by “might”. If we think that something might happen because we do not know whether it will or not, that is not enough to say that it will happen sooner or later. Argument from ignorance is invalid.
“So where are they? Why can’t we see them? We sure have sailed our macroeconomic spaceships close enough to the boundaries of predicted black holes plenty of times.”
We have? I have some questions about that below.
“Why didn’t any economy ever get sucked into one, and collapse into an infinitely valuable pinpoint?
“Either somebody up there likes us. Or there’s something wrong with macroeconomic theory.”
Or it might simply be that macroeconomic theory is incomplete. There is nothing intrinsically wrong with an incomplete theory. It simply means that there are some things that we are ignorant about, and ignorance is our natural state. 🙂
Now, we have certainly seen runaway inflation, where the value of money has a lower limit (zero). One thing that stops it is the human impossibility of creating money fast enough. Neither printing presses nor loans can keep up the pace. I suppose that that human limitation is not part of normal macroeconomic theory, because it is irrelevant to most situations. Besides, the government can stop printing money, and people can stop lending it, when no terms of interest make sense.
What would runaway deflation look like? Stores mark down prices twice a day, but nobody comes to spend any money? Nobody bakes bread to sell, because they would pay more for the ingredients than the would get for the loaf?
I don’t think so. After all, economic activity is almost always a non-zero sum game, with advantages to all or most parties: a win-win. Money facilitates it, but is not necessary.
Wouldn’t runaway deflation end in barter? There would be no banks. Money might be a store of value, but it would have ceased to be a medium of exchange. (Like those huge circular stones we read about as children.)
Suppose that we were on a gold standard. In a barter economy gold would still retain some value, which would provide a floor for deflation of a gold-denominated currency. The positive feedback cycle would have a limit. This why I question the statement that we have seen close many close calls to runaway deflation. Hasn’t most money been backed by something physical? Something that would retain value in a barter economy?
A fiat currency would have no such limit. However, as long as money has a value at any given point in time, it would occasionally be used in a barter economy. For instance, I might pay $1 for one year’s rent. In fact, the theoretical limit for runaway deflation might be a situation where I could pay rent forever for $2: $1 the first year, $0.50 the next, $0.25 the next, etc., etc.
Now, since we would not have any banks, the only money would be physical notes and coins. In the situation I have just described, the value of that money would double each year, without human needs increasing at that rate, nor with economic activity increasing at such a rate. The extra money would be superfluous. Why in the world would everybody be twice as rich in real terms? (Since very little money is changing hands, everybody hangs on to nearly all of it, as a store of increasing value.) This picture does not add up, since the physical supply of money is not halved each year.
Years ago I saw Milton Friedman on TV, saying that during the U. S. Civil War confederate money experienced rapid inflation, except for a period of a few weeks when the printing presses were not in operation. This suggests that in the extremes, inflation and deflation of fiat currency come down to the printing press.
If that is indeed the case, then, rather than allowing the role of money as a medium of exchange to cease, wouldn’t the government print more money to stabilize its value? Or even to cause some inflation? Of course, people would have to believe in the government for that to happen, but if they did not, how could you have deflation of fiat currency in the first place?
“You missed the whole point of my post ;-). Since there can’t be anything wrong with macro theory, it must be that somebody up there likes us! I was making a theological argument, not a macro one.”
Thanks, Nick! That’s the best proof of the existence of God that I have heard today. 😉
Wait till Thomas Aquinas hears this!
Isn’t a black hole just a special cases of a permanent bubble, where the bubble asset happens to be money? In theory, permanent bubbles can happen, but at some point they reach the limits of the theory. People can keep buying tulips for higher and higher prices in the expectation that someone else will be willing to pay an even higher price, but the process becomes more and more unstable as the difference between the market value and the fundamental value increases, as the severity of potential bubble-collapse event increases and makes participation more and more risky.
The same thing should be true for money. As money becomes more and more valuable, and as people accumulate more and more of it, the prospect that it will move toward its fundamental value becomes more and more frightening, and eventually the bubble pops. At least that’s what would happen if central banks used price level targets. On the other hand, if a central bank is constantly promising to cushion the inflationary crash by bidding the value of money up to a slow downward path, then….I suppose a black hole isn’t too far-fetched. But presumably we still won’t observe it, because central banks will eventually learn the error of their ways, or else some cataclysmic event (e.g. WWII) will give them an excuse to suspend their policy.
Nick’s post said: “Too much Fed: “Or, what is the “price” of currency, and what is the “price” of currency denominated debt?”
It’s 1 divided by the price of goods. 1/CPI, if you like.”
For currency, at first glance I don’t believe that is correct.
For currency denominated debt, why isn’t it the interest rate or maybe the interest payment?
I’m with Leigh – Maybe black holes don’t exist (or are exceedingly rare), but economic supernovae certainly exist (e.g. Easter Island, Rome). I’d add ‘this sucks, I’m leaving’ to subsistence and barter. The civilization dies, but the people don’t. They just re-group and try again.
Min said: “If that is indeed the case, then, rather than allowing the role of money as a medium of exchange to cease, wouldn’t the government print more money to stabilize its value? Or even to cause some inflation?”
Do you mean print more currency or attempt to create more currency denominated debt?
Nick and Leigh’s post said: “‘Money is different. If it gains sufficient value through deflation, surely the issuer of the currency – no matter how virtuous – will eventually give in and start printing more. If not at CA$1 = US$1000, surely at CA$1 = US$1 billion?’
But modern macro theory says that monetary policy is powerless in a liquidity trap! (At least, the sort of modern macro theory i am implicitly criticising says it is.)”
Notice Leigh said print more currency, while monetary policy involves interest rates and therefore currency denominated debt. See the difference???
Hi Nick,
No my argument does not assume differing propensities to consume, but derives them.
For each dollar you save, you get an expected (financial) return. I claim that people desire to accumulate wealth not just to spend it, but because they obtain satisfaction from having wealth just as much as they obtain satisfaction from eating an apple. Wealth represents things like “success”, freedom, security, etc, and is an end in and of itself, beyond any considerations of consumption smoothing. And many people desire to accumulate wealth with absolutely no intention of ever spending it.
But in a deflationary environment, the expected investment returns fall, whereas the amount you can consume per dollar increases. The statement that prices adjust more than wages means that even taking into consideration the inflation-adjusted wealth, still the marginal financial returns are lower from investing than from consuming, and this gap continues to widen the deeper inflation gets. At some point, the various trade-offs for enough of the population are such that it is better to spend than to save. So the net result is that deflation will eventually increase people’s marginal propensity to spend once the returns on investing diverge sufficiently from the returns on consumption. At that point, prices stop falling, outlook improves, borrowing increases, and you start reflating again.
If I have time, I will write up a simple model for this, and you can then poke holes in utility functions 🙂
Too Much Fed: “Min said: “If that is indeed the case, then, rather than allowing the role of money as a medium of exchange to cease, wouldn’t the government print more money to stabilize its value? Or even to cause some inflation?”
“Do you mean print more currency or attempt to create more currency denominated debt?”
I was basing that comment on Friedman’s remark about printing presses, so I had actual printing in mind. I would think that lending would have virtually ceased. Why lend $100 to get paid back $90?
Wasn’t the Great Depression close enough?
There are two issues here:
1. The “economy” is not partly a command economy and the black hole only applies to the market economy part.
2. People got to eat (so there is a floor at the bottom of the hole.
oops
… 1. The “economy” is partly a command economy ….
No black holes, just multiple equilibria.
A lot of good comments here. I’m not sure I can do justice to all of them.
Lord. I ignored debt for simplicity. But if we add in nominal debt, then as you say, deflation redistributes wealth from debtors to creditors. But I would follow Irving Fisher’s Debt-Deflation theory at this point: I don’t see that putting a floor under the price level; I see it exacerbating the deflation.
Min: “You have described a positive feedback cycle informally. The existence of one does not imply runaway feedback (death spiral), unless the cycle accelerates. It might approach a limit.”
Agreed. But it should accelerate in this case, according to theory, provided expectations catch up to reality. That’s because the positive feedback exceeds one.
Unemployment is an increasing function of expected deflation.
Expected deflation eventually adjusts to equal actual deflation.
Deflation equals expected deflation plus an increasing function of unemployment.
“That depends upon what you mean by “might”. If we think that something might happen because we do not know whether it will or not, that is not enough to say that it will happen sooner or later. Argument from ignorance is invalid.”
Agreed. But in this case, theory says they will happen under certain conditions. The precise nature of those conditions depends on the particular parameters of a model. But once we hit the lower bound on nominal interest rates, and there is deflation, and expected deflation, we meet those conditions, unless some lucky shock comes along that is big enough to break the cycle. And the longer we wait, the bigger that lucky shock has to be.
I think you are correct, or at least onto something, when you say that resort to barter will eventually break the cycle. I would then re-write my AD function as:
“Unemployment is an increasing function of expected deflation and a decreasing function of barter”. And add that “barter is an increasing function of unemployment”.
Even though barter would put a floor under the spiral, we don’t see economies hitting that floor. I think. I’ve not got my head 100% clear on this.
“In the situation I have just described, the value of that money would double each year, without human needs increasing at that rate, nor with economic activity increasing at such a rate. The extra money would be superfluous. Why in the world would everybody be twice as rich in real terms? (Since very little money is changing hands, everybody hangs on to nearly all of it, as a store of increasing value.) This picture does not add up, since the physical supply of money is not halved each year.”
Then you are saying that M/P matters, regardless of real interest rates. In which case the standard Neo-Wicksellian macro model (in which money only matters via interest rates) is wrong. In which case, we can escape a liquidity trap with monetary policy.
Andy: “Isn’t a black hole just a special cases of a permanent bubble, where the bubble asset happens to be money?” That’s an interesting way of looking at it. “Yes” would be my first reaction.
” But presumably we still won’t observe it, because central banks will eventually learn the error of their ways,..”
But ‘theory’ says there is nothing central banks can do, if nominal interest rates hit their lower bound!
RSJ: I think I am following you. But I don’t think you can escape a black hole that way. Suppose that when AD hits some lower level, increasing real interest rates don’t have any effect on AD thereafter. That puts a floor on output and employment. But we are still left with excess supply of output and labour. So if the standard Phillips Curve is correct, deflation should continue to accelerate.
And I think that applies to reason’s comment too.
Jason: but why don’t we observe some of those equilibria?
Nick Rowe: “I think you are correct, or at least onto something, when you say that resort to barter will eventually break the cycle. I would then re-write my AD function as:
“Unemployment is an increasing function of expected deflation and a decreasing function of barter”. And add that “barter is an increasing function of unemployment”.
“Even though barter would put a floor under the spiral, we don’t see economies hitting that floor. I think.”
As Lord and others pointed out, we do see barter increase under deflationary conditions. My grandfather was a country doctor during the Great Depression, and often got paid in chickens.
The state government, perhaps unconstitutionally in the U. S., created money in the form of tokens worth less than a penny.
Moi: “In the situation I have just described, the value of that money would double each year, without human needs increasing at that rate, nor with economic activity increasing at such a rate. The extra money would be superfluous. Why in the world would everybody be twice as rich in real terms? (Since very little money is changing hands, everybody hangs on to nearly all of it, as a store of increasing value.) This picture does not add up, since the physical supply of money is not halved each year.”
Nick: “Then you are saying that M/P matters, regardless of real interest rates. In which case the standard Neo-Wicksellian macro model (in which money only matters via interest rates) is wrong. In which case, we can escape a liquidity trap with monetary policy.”
I did not know that I was challenging any theory. 😉 Anyway, here was my idea. Does not the main value of fiat currency rest upon its being a medium of exchange? (Not entirely so, witness the huge circular stones.) If money is not really being used as a medium of exchange, but is occasionally bartered, like everything else, two questions arise. First, if you have more paper dollars than I do, why should I agree that you are richer than I? OC, the government says so, and it will take that money in payment of taxes. Also, the same could have been said of the stones, but they retained their value, anyway. People are funny. Second, why should the value of those dollars increase, if they are just sitting there? Again, most people may be a little richer, but why should they agree than people with more money than they are even richer? We are not just talking about nominal values. Why should the rich get richer for no reason at all? Sure, the value of dollars would increase if the government agreed to accept fewer of them in taxes next year in return for the same services. But why should the government do that? In fact, why should the government not print enough money so that it becomes a medium of exchange again?
The value of money is a social construct. In extremes of inflation and deflation, the social contract threatens to come apart, and the normal assumptions do not apply. Other forms of positive feedback can threaten the social fabric. Escalating conflict can lead to the dissolution of partnerships and families, to long lasting feuds and wars. Even if these conflicts eventually cease, they do not do so under the rules of the old understandings, which may contain most conflicts. There is no particular reason to expect theories that describe the normal workings of society to hold in extremis. The assumptions upon which they rest are unlikely to hold.
Fiscal
Why expect economists to see a black hole when they don’t understand the reserve system yet?
There’s definitely a black hole somewhere around here ; )
best line: “Either somebody up there likes us. Or there’s something wrong with macroeconomic theory.”
JKH: btw. not just economists. Check out this thread where we have Michael S, a bank owner, saying that his bank lends out deposits.
https://www.blogger.com/comment.g?blogID=7958140996781104565&postID=4627007655494567487
Now, the conversation is ongoing, and maybe he hasn’t thought through things in this way, or maybe there is some misunderstanding over terminology. Or maybe I’m misunderstanding.
winterspeak,
You may be referring to:
“Let’s suppose our bank has picked up $100 million in new deposits and has to decide what to do with the money.”
That’s generally not the way or is at least a gross simplification of the way banks or bank treasury functions work, particularly larger banks. Banks are particularly liability management sensitive in terms of the effect of deposit inflows on reserve positions. If for some reason a deposit inflow was unanticipated, it’s almost certainly a short term money market flow. Bank money market desks deal with balancing inflows and outflows of this type all the time. The important point is that the focus of balancing is on the reserve account (or settlement account if you like, where reserve requirements are zero, as in Canada.) E.g. short term wholesale deposit inflow boosts reserve account by $ 100 million; purchase of $ 100 million in treasury bills produces outflow; reserve account net flat. That sort of short term management is quite separate from banking lending into longer term risk assets, which requires capital. Drawdown is accompanied by notification to the money market desk which just throws the expected reserve effect into the pot of everything else it has to deal with.
But I think your point on banks not lending deposits may be subtler than that. The fact is that the effect on micro reserves of deposit inflows and outflows has a vague similarity operationally to the effect on macro reserves of government expenditures and taxes, respectively. Deposit inflows increase reserves. Outflows reduce them. This is akin to creation and destruction from the micro world perspective of an individual bank.
The moldbug thread looks interesting. I’ll have a longer gander.
Justin Fox points to a serious deflation that occurred when the Romans de3parted Britain in 400 AD.
http://curiouscapitalist.blogs.time.com/2009/12/23/the-latest-economic-indicators-were-doing-better-than-5th-century-britain/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+timeblogs%2Fcurious_capitalist+%28TIME%3A+The+Curious+Capitalist%29
Did the British rebels know how much of their economy depended on Roman terms of trade for Europe?
winterspeak,
Looking at the conversation between Michael S. and zanon more closely, zanon is more correct than Michael, but not entirely correct.
He’s correct in the sense that lending requires no pre-existing reserves or deposits in either a macro or micro sense. As noted above, a large bank facing a draw down of $ 100 million on a new lending facility will simply notify its treasury desk that the draw down is coming. (This assumes immediate disbursement of the loaned funds by the borrower into the rest of the system.) Treasury can then handle the expected reserve outflow effect by offsetting it entirely through liability management if it wants to. This can be related to the “loans creates deposits” theme in the sense that new money will be created at the macro level on the day of the draw down, and the lending bank simply has to go into the market, after the fact of the draw down, to source an offsetting reserve inflow by attracting new deposits through the wholesale money market. The cause is the loan, the effect is the deposit.
As Michael S. says, that could be handled by selling liquid assets also. But the point is it doesn’t have to be.
Where zanon is wrong is in his assumption that the required offsetting reserve inflow must be attracted directly from another bank. (btw, this is a common error made by PK readers.) In fact it normally isn’t. The normal operation is to attract non-bank deposits where the source of the money coming in is drawn from non-bank accounts with other banks. The reserve inflow is attracted indirectly rather than directly.
It’s all consistent with PK causality.
Nick: I’m posting in a hurry and just scanned the other comments, but how about Pigou’s solution? M/P and consumption?
Debt is a variant of the government response as it relies on government behaving differently than the rest of society. While government can counter deflation though, I see no reason it has to. I can readily imagine if Hoover had a longer term we would have had even more deflation during the depression. While barter, subsistence, and in kind services may be an explanation for the real economy, it wouldn’t explain the absence of a black hole in the measured economy, why all debt wasn’t repaid or repudiated and all transactions didn’t cease. Can money retain its transaction value even as it ceases to be transacted? It’s a mystery.
I am not sure what theory you refer to? I guess textbook Keynesianism. I think standard theory, at least since Patinkin, would not the real balance effect, which would cause real wealth to rise when prices fall and restores equilibrium.
I suppose you could argue that deflation also causes bankruptcies ala Fisher, but that is not really standard theory. Standard theory models do not predict what you say they do.
The moldbug post is a mix of Austrians and computer scientists, with zanon and Michael S thrown into the mix. Beware the site in general, it’s ridiculous.
Michael S obviously has some operational experience. I don’t think that he’s PK though, although if he thinks about his operations more closely, he may get there.
Thank you for your note on how “The normal operation is to attract non-bank deposits where the source of the money coming in is drawn from non-bank accounts with other banks. The reserve inflow is attracted indirectly rather than directly.”
Can you help me understand what a non-bank deposit, or non-bank account with another bank?
By non-bank deposit I just mean the deposit of a non-bank (e.g. Microsoft) with a bank. By non-bank account I mean a chequing or operating account of Microsoft with its bank.
In my example, suppose JP Morgan is the lender and Exxon is the borrower. Exxon draws down funds to pay for some project, disbursing funds away from JPM immediately. JPM’s loan officer apprises it’s treasury of the loan drawdown and JPM treasury issues a 1 month CD to Microsoft. Microsoft pays for the CD by writing a cheque on its chequing/operating account with Wells Fargo. Wells pays JPM in the reserve clearings/settlement process.
(Sorry. I do tend to be vague as well as dense in my writing. It’s a powerful combination :))
There is no such thing as a deflationary spiral. I have never ever seen it happen, never watched it, never seen it talked about in history. However, we have seen multiple times, INFLATIONARY death spirals.
Deflation is its own cure, because as prices drop, people will naturally want to consume more.
“Is the problem that current deflation rates are always projected into the future? No one spends their infinite wealth on current consumption because they will have more than infinite wealth if they just wait for prices to fall further?”
Thats baloney because of discounting. People would rather have stuff now than later.
Anyway, I can’t accept Keynsian economics because it has these absurd a-physical results. Like having no inflationary death spiral, but it does have a deflationary death spiral.
Be clear that the operational issuance of the CD occurs following the approval of and even the draw down of the loan.
Kevin Quinn and Barry Ickes both come up with the “theoretically correct” answer.
Here’s Kevin: “..how about Pigou’s solution? M/P and consumption?”
Here’s Barry: “..standard theory, at least since Patinkin, would not the real balance effect, which would cause real wealth to rise when prices fall and restores equilibrium.”
Both are referring to the Pigou effect, the effect of a lower price level on raising the real quantity of base (outside) money, thereby increasing wealth, and thereby increasing consumption.
BUT:
1. We have been told that the Pigou effect is trivially small, and of no empirical significance, and we should ignore it.
2. What I am calling “modern” macro theory, the Neo-Wicksellian approach that central banks use to describe their own behaviour, and as taught in New-Keynesian grad skools, has no role for M/P in its models. Monetary aggregates play no causal role. Monetary policy can be described by interest rates alone. (And this same feature is shared by Post-Keynesian macro too.)
JKH: I see what you mean. Can’t speak for zanon, but I think (s)he meant what you said. I don’t think PKs are careful in their terminology when they say a bank borrows reserves from another bank. They may mean from a bank’s own account, or a non-bank account at a bank. Either way, it all happens “behind the scenes”.
When the loan is created, a deposit has to be create SOMEWHERE. That then has to feed into the reserve system SOMEHOW (unless it’s held as cash). Once in the reserve system, it has to get to banks short reserves SOMEHOW. The number and structure of bank intermediaries in his process gets abstracted away. I don’t know if anything important is lost there.
winterspeak,
I see what you’re saying as a useful abstraction. But there is an operational distinction. The only direct MARKET for reserves is the interbank fed funds market, which is definitely not “behind the scenes”. It’s the only direct access to reserve “trading”. That’s different than the role of reserves when used as the means of settlement in the payment system, which is the clearing of reserves between banks in net settlement of customer payments. PK MMT is operationally oriented after all.
I think this applies here.
Titled “Conducting Monetary Policy when Interest Rates Are Near Zero”
http://www.clevelandfed.org/research/commentary/2009/1009.cfm
From the link above:
“It is important to stress that the extreme version of this scenario—the black hole Krugman refers to—is unlikely to occur, partly because firms anticipating a drop in demand will eventually cut production enough to stop excess supply. Nevertheless, our inability to offset a deflationary shock could conceivably prolong a period of deflation and falling output.”
Productivity growth could go negative too?
Might be other reasons?
JKH: Help me understand the operational distinction.
I bank at bank A and write a check which gets deposited at bank B. When the check clears, bank A gets a liability debit and a reserve debit. Bank B gets a liability credit and a reserve credit. Bank A now may be short reserves, while bank B is long.
No new credit extension here, just a transfer.
I assumed that the reserves could balance in exactly the same ways as if there was a loan, ie. either through other non-bank account to non-bank account transfers, or via trading on the interbank market. Am I wrong?
Doc: “Anyway, I can’t accept Keynsian economics because it has these absurd a-physical results. Like having no inflationary death spiral, but it does have a deflationary death spiral.”
That’s an interesting point.
If we take the standard Neo-Wicksellian model, then inflationary spirals are possible, but it is always possible for monetary policy to stop an inflationary spiral, just by raising nominal interest rates sufficiently. According to the same model, it is not possible for monetary policy to stop a deflationary spiral, once nominal interest rates hit the lower bound. So we would expect deflationary spirals to be more common that inflationary spirals.
But, as you say, we observe inflationary death-spirals (Zimbabwe etc), but we do not observe deflationary death-spirals.
Min: I like your comment, and tend to agree. But it’s probably too much to ask of a merely macroeconomic theory that it incorporate a breakdown of the legal-political system endogenously.
Too much Fed: Yes, it was exactly reading that post http://www.clevelandfed.org/research/commentary/2009/1009.cfm
that inspired me to write this post.
I really ought to do a follow-up post to draw out explicitly the relation between the non-existence of black holes and the use of monetary policy to escape a liquidity trap.
But I’m not quite yet ready to tackle that task.
Winterspeak,
You’re right that the reserves could balance in exactly the same way as if you drew down a loan at bank A in the form of a cheque or bank draft or something (i.e. without a deposit account) and presented the cheque/bank draft as payment to somebody else who deposited it with their bank B. That too is a “behind the scenes” clearing of reserves to use your phrase above.
Now compare that with the inter-bank fed funds market. Again you’re right that reserves could balance in exactly the same way.
But the fed funds market is no longer “behind the scenes”. It is accessed directly by banks that clear through the fed. There is a direct transfer of reserve account funds from Bank A to Bank B. That is the operational difference.
In other words, the fed funds market is a PRINCIPAL market in reserves; the cheque and other instrument clearing market is an AGENCY market in reserves.
The Fed funds market is the ONLY market where participants have direct access to reserve account transactions. And banks that clear with the Fed are the ONLY participants as principals that can transact in that market. This is an illustration of why it is incorrect to say that banks “lend reserves” in their normal day to day operations. They only do that with each other through the fed funds market and there they are sometimes described as buying and selling reserves as terminology (rather than borrow and lend).
There is also a real time information and control advantage in the fed funds market. Banks know exactly what the net reserve effect is at the time. Conversely, it’s not always feasible to predict where Exxon is going to end up directing its money. Exxon may well be paying somebody who also banks with the lending bank, but even that’s no guarantee that the funds don’t have an additional way to go through the money market. Predicting and tracking agency clearings is no trivial task.
Finally, to make things interesting, banks can also transact in the interbank Eurodollar market, which is distinct from the Fed funds market. It is again one step removed from direct transfer of reserves. Payments through the Eurodollar market will ultimately be settled in Fed funds, but only as an additional step in the process. And New York banks run “offshore” Euro books in addition to their domestic fed funds books. Very circuitous stuff.
too much fed / Nick / winterspeak
I trashed the Cleveland Fed report at Mosler’s and Billy’s.
Cleveland Fed staffers don’t understand the operation of the reserve system.