The Fed is the loan placement officer for the world's central banks. The US government is the Fed's borrower of last resort. The forced loans can be called in at any time the lender wishes.
People are different; that's why they trade. Sometimes that trade will take place between people who live in the same country, and sometimes it won't. There is intranational trade and international trade. Some of that trade is intertemporal. Some people will want to lend and others will want to borrow. Again, sometimes the borrowers and lenders will live in the same country, and sometimes they won't.
Why is international intertemporal trade ("global financial imbalances") seen as a special problem? So what if people in one country are net borrowers and people in another country are net lenders? It would be a total fluke if it didn't turn out that way. Countries are not identical. We don't expect a country's imports of apples to exactly balance its exports of apples. We don't see it as a problem if net imports of apples are balanced by net exports of bananas. Why should we expect imports of all goods today to exactly balance exports of all goods today? Why is it a problem if net imports of goods today are balanced by net exports of goods in the future?
What's the policy problem of global financial "imbalances"?
One answer is that there is a global paradox of thrift. There is a global excess of desired saving over desired investment, and so global output falls to equalise the two. Saving may be good for the individual, or individual country, but bad for the world as a whole. There is a global shortage of aggregate demand, and like a common property resource, some people and countries are hogging too much of that scarce aggregate demand for themselves, and not returning it to the common pool by spending.
That answer begs the question: why is there a global shortage of aggregate demand? Why not just print money? It's like a library, where some selfish people are hogging all the books and not returning them to the library so they can go back into circulation. Except: in this case the library can simply print more books for free. And that is what the US Fed seems to have decided to do.
What's the problem?
Pre-Keynesian monetary economists had the concept of "forced savings". When the central bank decides to print money, it forces people to save. I'm going to turn that concept on its head. When people decide to save money, it forces the issuer of money to dissave.
Nobody can force me to borrow from them. Adverts come in the mail every day offering me loans, but I don't have to accept any of them.
But it's different for a central bank. If there's an increased demand to hold Bank of Canada money, the Bank of Canada has to satisfy that demand by printing more money. If it doesn't satisfy that demand, there will be a recession and disinflation in Canada. Given that the Bank of Canada must prevent a recession and disinflation, we are forcing the Bank of Canada to print money. And if next year the demand for money falls back to normal, the Bank of Canada is forced to buy back that extra money it had previously printed, to avoid an inflationary boom.
In effect, we have forced the Bank of Canada to borrow from us. We have forced the Bank of Canada to take an interest free loan. We bought the Bank of Canada's IOUs, and next year the Bank of Canada bought back those IOUs. And it's an interest-free loan to the Bank of Canada, because Bank of Canada IOUs, at least in the form of paper currency, don't pay any interest. It's a forced loan, and the amount and duration of the loan are decided by us, not the borrower. We decide how much the Bank of Canada has to borrow from us; and we decide when the Bank of Canada must pay it back. We don't give the Bank of Canada any advance warning when we want our loan repaid.
Maybe the Bank of Canada should not be worried if we force it to borrow from us. It can use the proceeds of the forced loan to buy Canadian government bonds, and earn interest. Next year it sells the bonds again, uses the proceeds to retire the now unwanted currency, and keeps the interest as profits (which it hands over to its owner, the Government of Canada).
We may have forced to Bank of Canada to borrow from us, but we haven't yet forced it to dissave. It may turn around and buy Government of Canada bonds. Does this mean the Bank of Canada is making a loan to the Government of Canada? Only if the Government of Canada issues new bonds. Otherwise, the Bank of Canada must go out into the open market and buy already existing bonds from the people who hold them, which means that the Bank of Canada is making a loan to the people who sell it those bonds. And, ultimately, the people who sell the Bank of Canada those bonds might be the very same people who wanted to hold more Bank of Canada money. They didn't want to save more; they just wanted to hold their existing stock of savings in a different form: money rather than bonds.
Nevertheless, by demanding more money, and forcing the Bank of Canada to issue more, the immediate effect is to force the Bank of Canada to dissave. The Bank of Canada can only escape being forced to dissave if it can persuade someone else voluntarily to borrow from the Bank of Canada. Unlike me, the Bank of Canada is forced to accept the offer of a loan that comes in the mail. And if it doesn't want to dissave, it must try to find someone else who is willing to borrow from it. The Bank of Canada, in other words, is forced to act as a loan placement officer, with a quota of loans it must place. And if it fails to place the loans with willing borrowers, it must borrow and dissave itself.
Canada is a small country (in terms of the world economy), and the Canadian dollar is not (very much) a reserve currency. The US economy is large, and the US dollar is a reserve currency. The Bank of Canada is the loan placement officer for Canada, and is forced to place a quota of loans the size of which is determined by Canadians. The Fed is the loan placement officer for the world monetary system, and is forced to place a quota of loans the size of which is determined not just by US holders of currency, but by anyone in the world, including world central banks. If it fails in its attempt to place those loans, it must dissave itself, or else accept a US recession and disinflation.
Now, it's true that world central banks do not hold (much) US currency. Instead, they hold US government bonds. But that doesn't change the story. If the central banks in the rest of the world decide to save $1b more and hold S1b more US dollars (currency) in reserves, the Fed is forced to issue those dollars to prevent a recession and disinflation in the US. The Fed is forced to accept the offer of a loan. The immediate effect is to force the Fed to dissave. The Fed must then place those loans if it wishes to offset its own dissaving by lending to someone else. The Fed, as the world's loan officer, must meet its quota. And it must do whatever it takes to persuade someone to borrow from it, by selling US bonds to the Fed. And if central banks in the rest of the world subsequently switch from holding US dollars to holding US bonds, that reduces the size of the Fed's sales quota by $1b, but at the same time takes away $1b of the Fed's potential customers' demand for loans. The fact that central banks in the rest of the world decide to hold an extra $1b in US bonds rather than an extra $1b in currency doesn't make it any easier for the Fed to meet its quota for placing loans.
When central banks in the rest of the world decide to hold more reserves, and so save more, they force someone else to dissave. The Fed has the responsibility of finding a willing dissaver, or must dissave itself. The Fed is the world's loan placement officer, and must meet a monthly quota of loans determined by the world demand for US dollars. If it fails in its task of placing its quota of loans, it must borrow itself, or allow disinflation and recession. And the US government acts as the Fed's borrower of last resort, if it cannot place the loans elsewhere. And the loans don't have a fixed term. The lender can demand repayment any time, with no advance warning.
[I'm not sure this is 100% right, but I'm posting it anyway.
Is "loan placement officer" the right job title? The person at the bank who is told "your job is to get out there and find people who will borrow $10 million from us this month".]
Worthwhile Canadian Initiative 
vjk, this notion of coercion is the premise of Nick’s piece. It is uncontroversial, as you can gauge from the run of the comments.
Phil:
If the notion of coercing the bank into selling its 10 year T-bond holding is uncontroversial, it should be easy for you to describe the procedure of extracting such a bond from an unwilling bank.
What is the procedure of making the unwilling bank comply with the Fed wish to extract the bond ?
VJK,
The bank doesn’t need to sell the bond to the CB, it sells to “the market” just as the CB buys from the market. But the effect of the sale is that the financial sector balance sheet changes. It loses an interest bearing asset and gains cash.
This could be because they incur a short position in an interest bearing asset that is matched by a long position in cash, or because they reduce a long position in an interest bearing asset and replace that with cash — it doesn’t matter; the financial sector balance sheet is hit, rather than households or firms.
Assuming that the CB sale does not change household or firm preferences for the types of assets that they wish to hold — e.g., that the act of selling a treasury does not cause households to want to hold more deposits, then the financial sector liability side will remain unchanged. This means that effectively the financial sector has relinquished an interest bearing asset and replaced it with cash, regardless who the CB bought the bond from.
The specific asset(s) relinquished by the financial sector need not be the ones that the CB purchased — the specific assets trade at indifference prices and diffuse throughout the entire system.
So, for example, the CB buys a treasury form PIMCO, who rolls the proceeds over to the purchase of an agency from a bank. Or the CB buys a treasury from a pension fund, that pays out the proceeds to a household that repays a bank loan. The possibilities are endless, and each transaction triggers a chain of many other transactions, but the net effect is that the financial sector loses an interest bearing asset and gains non-interest bearing cash.
The net effect is not that the CB purchases a bond and the proceeds are spent on goods. The proceeds are spent on some other asset, and at the end of the day, that is all that happens — an asset swap between the CB and the financial sector, with no goods purchases involved.
vjk,
You are right; when dealing in a market economy, the central bank cannot force the private sector to do anything. It has to find terms which INDUCE the private sector to do the transaction desired by the central bank. Arbitrage ensures that those terms propagate from the institution that the central bank actually deals with, so there is no sharp divide between the financial sector and the rest. Those terms will depend on the expected return on base money as well as its (expected) utility to meet reserve requirements and for facilitating transactions. This expected return will depend on interest paid on reserves as well as the likelihood that an inflexible buyer of base money – ie the central bank – will come to market before long.
Again, academic economists tend to tie themselves in knots trying to analyse events in terms of their “standard toolkit” instead of investigating how the economy actually works in practical detail.
Suppose Fred decides he wants to save more.
Barter economy: the onus is on Fred to induce someone to borrow from Fred, by offering favourable enough terms that someone wants to borrow from Fred. If Fred can’t find someone willing to borrow from him, he can’t save (unless of course he directly invests himself in real assets).
Monetary exchange economy. Fred just stops spending, and starts to hoard cash. He can save without needing to induce someone to borrow from him. The central bank has to increase the supply of cash to prevent a recession. The onus is on the central bank to induce someone to borrow from it. The central bank has to find someone willing to borrow from it (unless of course the central bank itself, or it’s owner the government, directly invests in real assets).
Metaphor: in a monetary exchange economy, the central bank is Fred’s loan placement officer, that is forced to find a willing borrower for Fred to lend to.
Take an extreme case: suppose nobody wanted to borrow from Fred? In a barter economy, Fred would be unable to lend. In a monetary exchange economy, Fred would always be able to lend. The central bank is forced to borrow from him, and then pass that loan on to someone else.
RebelEconmist:
when dealing in a market economy, the central bank cannot force the private sector to do anything.
That was my simple point, thanks.
I was rather interested in the non-bank sector’s, mainly households’ I’d imagine, motivation to swap 10 year T-bonds for cash. The non-bank financial sector(mutual/pension funds, brokerages, etc) can be considered in the first approximation as a households’ proxy for such dealings.
Rebel: “vjk, You are right; when dealing in a market economy, the central bank cannot force the private sector to do anything. It has to find terms which INDUCE the private sector to do the transaction desired by the central bank.”
Not quite right. The central bank can force people to hold more money, even if nobody wants to. Money is different. Sure, the central bank has to induce someone to accept cash in exchange for some asset. But just because someone willingly accepts money doesn’t mean they want to hold more. Each individual accepts more money even if he doesn’t want to hold more money because he can always pass it on to another individual. Each individual can get rid of it, but in aggregate they can’t.
RSJ:
at the end of the day, that is all that happens — an asset swap between the CB and the financial sector, with no goods purchases involved
Right, the word “forcing” was what I found amusing, as well as the implied bank sector pain and suffering of being unable to extract even more rent in addition to what the Feds are already paying for “forcing” the bank hold excess cash.
Spot on, Nick. It is the Fed which is forced, by virtue of its function (although of course the authorities always have powers to force the market if they really want, such as by changing reserve requirements).
Maybe you can build from this to the effect of Chinese intervention, although I cannot see how, because that intervention is money-neutral (I should have said “money” not “currency” in my comment above). The Chinese are basically swapping goods for (dollar denominated) IOUs.
I just willingly sold my labour to Carleton University in exchange for money. But I had absolutely no desire to hold a bigger stock of money.
Nick:
The central bank has to increase the supply of cash to prevent a recession
I am not sure if supply of freshly printed cash has anything to do with preventing a recession — witness $1 trillion of cash in “excess” that is already there.
Perhaps you mean direct give-away’s to households and firms rather than mindless swaps of government paper of different tenors ? The Feds unfortunately (or fortunately) are prevented from engaging into that sort of activity by law, the helicopter Ben metaphor notwithstanding.
vjk: I don’t know. This whole post started out with a vision, and I’m trying to articulate that vision, explore its implications, and get my head straight on it, by reading and arguing with you guys.
Nick (at 08.18),
Now you are stretching it. I don’t think it matters whether the central bank counterparty does want to hold whatever the central bank is offering. They may value it because they expect they can trade it for something else that they do want to hold. Besides its transactional utility as the medium of exchange, I don’t see that money is so different (okay, okay, you can force people to take money using legal tender laws, but I doubt whether that is ever a binding constraint).
vjk,
there is no need for helicopter drops. Just lend more money to the private sector…
vjk at 08.29,
Now here I am with Nick. As you know, demand for base money derives both from its role as the medium of exchange and as an unbeatably safe, liquid store of value. Briefly, in a panic, the store of value demand increases greatly, and if the central bank does not accommodate it, the shortfall of supply to serve the medium of exchange purpose gums up the economy. So I think it was reasonable for the Fed to allow a dramatic expansion of base money in 2008. More recently, however, the purpose of QE has become to drive down longer term interest rates by an asset swap of interest-bearing reserves for long term bonds. I would question whether that is appropriate, and, as you say, it does not seem to have been effective either.
RebelEconomist:
Briefly, in a panic, the store of value demand increases greatly,
That’s a good point, I think, cash as sort of gold for those who cannot afford real stuff. Irrational, perhaps. Would you speculate that the panicky mood still persists thus assuring “success” of the apparently forthcoming QE2 ?
It would be interesting to know who(commercial banks, actual households, their financial proxies, etc) made specific choices with respect to government paper maturity distribution in their portfolios. That would allow one to try and quantify, as it were, behavioral aspects of cash biased portfolio composition in our turbulent times. I assume such information is not readily available if at all.
and if the central bank does not accommodate it, the shortfall of supply to serve the medium of exchange purpose gums up the economy.
That, I am not so sure of unless one assumes a totally broken interbank market which it was for a while. I believe it recovered at least partially before QE1. Has the ib market fully recovered by now (judging by the bank I am associated with it has, but one sample is statistically meaningless) ?
the purpose of QE has become to drive down longer term interest rates
Well, I am sceptical about the Fed having enough paper power to accomplish that regardless of desirability of lowering long-term rates in principle.
Cash is a subset of reserves. Maybe the demand for notes and coin has risen during this recession but it can hardly be a driving factor. Perhaps its better to think of the CB as supplying liquidity rather than “printing money” as its too easy to mistake printing money with something different–supplying saving, for instance. Wouldn’t a more realistic story be something like the demand for liquid assets (demand for a particular type of savings) has risen alongside a demand for increased net worth (demand for increased saving)? The former the CB can help with directly but the latter requires somebody else as well at the very least.
vimothy:
CB as supplying liquidity
I do not know what the above means because the CB supplies “cash” or FRNs that can be exchanged for government obligations, not some nameless “liquidity”. Different people mean different things by “liquidity” thereby making the word rather meaningless without providing context.
I do know what “cash”, “coins”, “currency, i.e. Federal Reserve Notes” are.
Clearly, “base money” == “cash” + FRNs — that’s a trivial and unimportant point.
“Coins”, by the way, are not issued by the Feds and therefore are not their liability, but that’s unimportant too for trying to understand why one would prefer to hoard cash or FRNs rather than differently colored government paper.
Hahaha.
Its not fair to poke holes like that. Lets correct vjk’s argument: They traded goods for government bonds. The mystery here is not about a stock of money (which they do not have). Its about their choice to acquire government bonds rather than investment goods.
That’s why the trade is unbalanced. In so much as the Chinese have a propensity to save, it’s in yuan not dollars. Direct dollar holdings are negligible.
Nick:
I just willingly sold my labour to Carleton University in exchange for money. But I had absolutely no desire to hold a bigger stock of money.
That’s your personal preference that only you can rationalize 😉
Perhaps, one can consider your case statistically insignificant.
vjk–sorry for the confusion, my comment was directed at Nick in response to “The central bank has to increase the supply of cash to prevent a recession”.
You responded with: “I am not sure if supply of freshly printed cash has anything to do with preventing a recession — witness $1 trillion of cash in “excess” that is already there.”
I agree with that. Just saying that demand for cash is probably irrelevant, and the CB’s “cash” to the bank sector is just an asset swap, to make existing stock of savings more liquid, not a flow of new saving. Probably just ignore it as it’s old news and not phrased particularly well in any case.
Actually, I’m not sure that I do agree with that. Anyway…
vjk,
It was the seizure of the inter-bank market in 2008 that I had in mind. After that, I doubt whether there has been a shortage of base money. I know Nick takes the view that the present recession is due to a paradox of thrift style shortage of the medium of exchange, but, while I can see that that can happen in theory, I have not seen any empirical evidence that that is what is happening in practice.
I have no doubt that the Fed has the power to lower long term interest rates if that is what they want to do and they are not deterred by the prospect of hyperinflation or taking big losses when the time comes to unwind the expansion.
By the way, “cash” means different things in different fields (eg including t-bills in asset allocation literature). As you define it above, cash is always “reserves” (as in a bank current account balance at the central bank, to avoid confusion with foreign exchange reserves!).
including t-bills in asset allocation
That’s odd as you can repo t-bills, they are indistinguishable from zero-coupon bonds, and you cannot buy shoes or gas for them.
In fact, t-bills is the Fed’s favorite toy in OMOs. Or used to be.
Repo’ing cash for cash sounds of odd, but, if that’s the accepted terminology in asset allocation, who am I to argue 😉 ?
Nick:
“I just willingly sold my labour to Carleton University in exchange for money. But I had absolutely no desire to hold a bigger stock of money.”
How is that different from any other kind of inventory? You may have some ideally preferred stock of money, but you’re willing to let your stock fluctuate with inflows and outflows, just as a fruit stand is willing to let its stock of apples fluctuate. “The orchard guy came by this morning, and I willingly purchased a bushel of apples. I had absolutely no desire to hold a bigger stock of apples, but I figured I could probably unload them within a day or two.”
If there’s a bumper crop of apples, we don’t say that it forces people to hold (or eat) more apples. Rather, it temporarily swells inventories above the ideal level and then (or simultaneously) changes the price of apples (and the prices and quantities of other goods like pears and cupcakes) until people are satisfied with their new level of apple consumption. Same way with money. A bumper crop of OMO’s temporarily swells money balances above the ideal level and then (or simultaneously) changes asset prices (and goods prices and the quantity of aggregate output) until people are satisfied with their new money holdings.
Nick, you believe that
1) “money” is simultaneously the medium of exchange and the unit of account
2) the central bank controls the size of this money stock (although it may be “forced” to adjust it based on changing preferences)
3) Unless the CB intervenes, the stock of money is fixed, and therefore households are not able, in aggregate, to increase or decrease their stock of money. That is where the paradox comes in.
4) Households have a demand for money, or for M/P.
The problem is that there is no “money” that satisfies all of the above. So you need a different definition that makes 1) hold, but then makes 3) false. Or if 4) is true, then 2) is false. Etc. So you are thrashing about. And each time someone points out that whatever definition you use to support argument #X makes argument #Y false, you then change the definition to make Y true, but then X becomes false.
All of this work, just to keep the flawed model going.
1) and 2) are only true if money is cash. All goods and services are bought and sold for cash. The cash settlement period may be a few days after, but it is a cash settlement unless the parties specifically agree to a swap. And even in that case, cash is always valid for the settlement of debts. Deposit accounts are not a medium of exchange, only cash is. And the CB only controls the amount of cash in the private sector as a whole. It does not control the stock of deposit accounts, bonds, or anything else. And you are right, in that “control” is misleading, as the CB reacts to the needs of the financial sector.
But 3) is false if money is cash.
First, households are able, both on an individual level, and in aggregate, to increase or decrease their cash holdings. They can withdraw cash from banks or deposit cash into banks. The private sector is not households, but households, firms, and the financial sector. The private sector as a whole has no demand or utility for anything. There is no “representative private sector”. There are representative households and firms, that interact with banks and the government. Households can change their asset allocations both individually and in aggregate, by engaging in transactions with the financial sector. That is why when the CB reduces bonds and increases cash, it is not households that have their bond and cash holdings changed, but the financial sector has its balance sheet changed. 3) is only true if you define “money” as all financial assets. Then, a portfolio shift wont help. But as long as you define money as one type of asset, then households can, in aggregate, do a portfolio shift to hold less of that asset and more of some other asset, and they will succeed in the shift. These shifts happen all the time.
So if you want to define money that way, you have to accept the limitations of the quantity based view of monetary policy. The only quantities changing are of one form of money with another, and the only economic actors who see this change are the financial actors. That leaves only the short term interest rate mechanism, which isn’t a very good mechanism in general, but is impotent in a zero rate world.
And 4) is true for financial assets but irrelevant for cash. Walking around money is not significant in any sense, and has no place in a simple economic model. Pollution is more likely to be a cause of our recession than a sudden desire to hold more precautionary cash. Just make the model cash-less, and abandon the cash in advance constraint that is causing so many problems. If you could abandon that constraint, then you would also be abandoning the budget constraints in your walrassian model, and so there would be no paradox of excess demand. And I would argue that a true “monetary” model would assume that the economy is cash-less and view both the unit of account and the medium of exchange as debt instruments. That allows investment to be self-funding and there can be “bubbles”. If I create a debt instrument, I just created money. No one needed to save. By accounting identity, someone did save, but that savings could have been forced. All that happened was that I convinced the other market participants to sell their own debt instruments for my newly created one. That is a balance sheet operation that leaves the net worth of the participants unchanged, and so does not require any savings. There is no cash in advance constraint here.
If debt instruments are both the unit of account and the medium of exchange, then firms and households are creating debt instruments, and then paying for goods with them, so that you cannot argue that the sum of excess demands must be zero, but the sum of excess demands will be equal to zero plus the sum of net new debt instruments created. Therefore during a period of credit contraction, you must see an overall deficiency of demand. Now we can argue whether this simple model is true or not, or whether it is more true than the cash-in-advance hoarding explanation — but at least if you are going to defend the old model, then make a commitment, define what you mean by “money”, and then simultaneously defend all of the suppositions using the same definition.
So far, the Bank of Canada has said nothing about the possibility of quantitative easing on this side of the border. Barring some sudden and ridiculous spike in the loonie, the Bank is unlikely to intervene. The loonie may fly higher yet.
“Forced savings” was language introduced by Hayek.
It meant changes in the price and availability of money and credit that changed the level and structure of investment in production processes — i.e. more was invested for longer periods, i.e. “savings” in the sense of building stuff creating output for consumption on down the road.
The expression wasn’t about stuffing money under the matress for future use.
The real economy made up of real stuff matters — and is at the heart of “forced savings”.
“It meant changes in the price and availability of money and credit that changed the level and structure of investment in production processes ”
that’s not what it meant, not even close.
Adam, read Hayek on Bentham and others on forced savings here:
Click to access profits_interest_hayek.pdf
Read Hayek’s original discussion of forced savings here:
Click to access pricesproduction.pdf
Educate yourself, Adam.
I think Hayek attributes the “forced savings” concept to Bentham, at the end of the 18th century, and it refers to someone creating money and then bidding away goods from others with it, therefore forcing the others to spend less (and consequently save more) than they wanted. The main targets for scorn by the Austrians was bank money creation via lending, but you can also blame monarchs who debase the currency, etc. I.e., this is a crowding out of consumption goods story.
In all cases in order to have forced savings you need someone to violate their cash in advance constraint. The government can violate it because they make their own cash, banks violate it because they lend first and then get any required reserves later, and it can be violated in the credit markets by the following transaction:
A sells a bond to B in order to buy goods from C. B sells his own bond, say a government bond to C, and uses the proceeds to buy A’s bond. C uses the proceeds of A’s purchase to buy the bond from B.
All three transactions occur simultaneously, or at least settle simultaneously.
Here, B prices the bonds but neither saves nor dissaves — he is shifting his portfolio. A dissaves and C saves, but C obtains the income necessary to save from the borrower. A funds C, not the other way around — investment is self-funding.
If C doesn’t want to save, then he will, effectively, sell his bond to X, use the proceeds to buy goods from X, and X will use the proceeds to buy the bond that C sold.
The bonds are just tokens that can be passed around in exchange for goods. The IOUs are money.
If everyone rushes to dispose of the bond, then goods prices rise up until savings is forced. If demand curves slope down, then this can be stimulative to some degree and you have a boom, with prices rising and real interest rates falling, up until the market begins to reprice the IOUs and/or there is a financial crisis in which the IOUs stop being liquid assets. Then, it is as if the money supply suddenly shrank. The central bank, by purchasing the safe assets that everyone is rushing to buy is not going to cause the money supply to increase. They would need to restore the value of the junk assets to the excess exuberance levels in order to restore the effective money supply to the boom period. Even then, there is no guarantee that the level of dissaving will be the same, as expectations will be different.
The idea that IOUs can be used for payment, and that therefore investors do not require a pre-existing pool of financial savings from which to borrow is not new. Also at the end of the 18th century, Alexander Hamilton, argued that the new constitutional government should consolidate on its books the states’ revolutionary war debt, creating a large federal debt, and one of his arguments was that
“..there is a consequence of this, less obvious, though not less true, in which every other citizen is interested. It is a well known fact, that in countries in which the national debt is properly funded, and an object of established confidence, it answers most of the purposes of money. Transfers of stock or public debt are therefore equivalent to payments in specie; or in other words, stock, in the principal transactions of business, passes current as specie. The same thing would, in all probability happen here, under the like circumstances.”
And it need not be only government debt. Confidence and/or the institutional arrangements determine when and what types of IOUs become liquid assets. Do banks turn away borrowers and/or raise the interest rate charged to borrowers while they wait to acquire enough reserves in advance, or do they lend first and then worry about reserves later? Do households, after receiving income, store it in the form of currency in advance of their expenditures or are the proceeds of sales automatically used to purchase deposit accounts or money market fund shares, which are really claims on longer maturity assets?
To the degree that the latter case is true, then transfers of stocks of IOUs do pass as payment in specie, and you need a different way of thinking about what equilibrates planned savings and planned investment if investments, or a large subset of investments, are self-funding.
Strangely this was known 200 years ago, but when economics bothered to introduce money into the model at all, they did it in the obvious way, in which money is only specie that is needed in advance for payment, and not in the “less obvious” way, in which promises to pay specie could also pass for payment in specie. To my mind, any model that enforces a cash-in-advance constraint is not really a monetary model, or at least, it is a non-financial model.
Interesting comment RSJ. Out of curiosity, did you read up on this in response to this post and comments?
But I think you are too hard on the CIA constraint. It was seen as a crude way to prevent barter exchanges in economic models; not as a final word on all monetary exchange.
“it refers to someone creating money and then bidding away goods from others with it, therefore forcing the others to spend less (and consequently save more) than they wanted.”
yes, that’s basically correct. I would have said it operates through inflation, if their is a leverage financed spending boom this causes inflation that expropriates some of the real purchasing power of money holders. This forces them to consume less in real terms.
For the term “savings” to be appropriate it should refer credit financed investment that causes the inflation. Since investment must be matched by savings somewhere else. In this case the investment spending causes inflation and the expropriation of the real wealth of money holders is the savings that funds the investment. Of course these people aren’t willing savers in this case, they were holding the money to finance their consumption, if they wanted to fund investment they’d have bought bonds.
Nothing at all to do with the structure of investment or investment for longer periods, everything to do with inflation. The only part Greg got right was that it is related to an increase in credit availability so I guess saying “not even close” was too strong.
I agree, Adam, that inflation is the most common driver, but then you have Michael Pettis’ critique of the asian development model, in which you don’t necessarily see consumer price inflation, but a transfer of income from households to state owned enterprises, via forced household subsidies to the banking sector. Maybe you can split that up into a forced savings component and an inflation fighting component.
Nick,
Mostly yes, although the treatise on credit has been a favorite read of mine for some time. Hamilton also goes on to argue that the creation of government debt and subsequent increase in broader money will drive up asset prices, specifically real estate, which had fallen significantly during the revolutionary war.
I think the endogenous money view is a very attractive alternative. All of the “fringe” groups from the Austrians to the PKers agree on this, and it has the added advantage of being the mainstream view of central bankers and others on the front lines when the industrial revolution was taking off and these financial crises as well as depressions were more common.
There is no a priori reason why you can’t incorporate this view in a model that includes intertemporal utility maximization, and I’ve been puzzling about that, but there are other people here who could really do it right more quickly. I was actually hoping that you would do it 🙂
But the main thing is that a medium of exchange by itself should not make a real difference to the model. If you go from transactions of the form A is sold for B to A is sold for M and then M is sold for B, then the situation is isomorphic. M is unnecessary, except for changing the transactional overhead, and the model should not rely on this overhead to get fundamentally new effects from the A B model.
In order to get a model with different outcomes, you need to allow for fundamentally different transactions, not isomorphic transactions. The tri-party transactions are an example. If you combine that with a financial sector that does maturity transformation, then effectively you can issue long term bonds to an intermediary, use the proceeds to buy goods, and the seller of the goods, who does not want to save, ends up purchasing a transactional account from the same intermediary that is backed by the bond that you issued. He is not purchasing a long term investment because the financial sector does the maturity transformation, so he is just receiving “money” for his good. But now you’ve introduced a non-isomorphic transaction, so the model can have different outcomes.
And the same argument goes for “why don’t firms just pay their workers in the goods that they produce”? Again, it shouldn’t because of M, since that model, apart from the frictions, is isomorphic. But if you allow for investment that does not immediately produce consumption output, then workers producing capital goods can’t be paid in what they produce, since they demand consumption goods in the present period. At best the firm can pay them in IOUs for the future consumption goods that their present labor is producing, and these IOUs will be sold for present consumption. But now if the long term cost of capital does not fall, then everyone agrees that the IOUs are not worth much, and there is less demand in the economy as a whole — less demand for labor, less demand for capital goods, and less demand for consumption. It was as if a large part of the economy had decided that it’s current efforts were uneconomic and not worth doing, and as a result there are idle resources. And it seems reasonable to assume that long term rates will not adjust as quickly as short term rates, or that they can remain “too high” for a very long time before it is realized that they are too high. Here, too, I would prefer to look to a non-isomorphic model to explain the new effect, in this case, the introduction of investment that does not produce consumption during the present period.
So all of this is part of a program to try to find better models that are still very simple. I hope the program does not come across as a warpath, but I think that everything — from sticky prices to demand failures, should be explainable in real terms, and in relatively simple terms, and you should not turn to frictions such as menu costs or ad hoc external constraints such as Calvo mechanisms to hammer the observed results out of your model. Anyways, I find these discussions very enjoyable.
Damn! It ate my comment!
Trying again:
RSJ: “But if you allow for investment that does not immediately produce consumption output, then workers producing capital goods can’t be paid in what they produce, since they demand consumption goods in the present period.”
Workers producing capital goods don’t want to be paid in capital goods, because they would then have the hassle of swapping those goods for the consumption goods they do want. Agreed. But workers producing apples also don’t want to be paid in apples, because they then have the hassle of swapping 99.9% of those apples for other consumption goods.
In both cases, it’s more efficient for the firm to specialise in selling its goods for money, and giving the workers money.
adam, it’s clear you didn’t read hayek or Bentham.
In other words, your comments are comming out of the back of your pants.
Greg, it’s equally clear you didn’t understand Hayek or Bentham and as such it’s unknown where your comments are coming from.
Nick, no that was not my argument. You argued that Keynesian economics makes no sense in a non-monetary world because “workers want goods but don’t have the money, firms would hire the workers if they could sell the goods — why not pay the workers in goods”.
Whereas Keynes always, or primarily, argued in real terms — “wage units” — and he argued that investment was independent of savings and a determinant of it. Therefore the interest rate did not necessarily equilibrate planned savings and planned investment. It has nothing to do with the convenience or inconvenience of paying workers in goods. The workers paid in capital goods IOUs find those heavily discounted, and so overall demand declines because the investment rate of interest is too high for the markets to clear.
I invite you to actually read some Hayek — and the Bentham quoted by Hayek.
There is no evidence that you have any knowledge of Hayek’s work — or Bentham’s for that matter.
But your behavior does fit the definition of a “troll” to a T.