>
> (email exchange)
>
> On Wed, Nov 10, 2010 at 10:29 PM, Mark wrote:
>
> One more thing I dont get. You say there isn’t more money
> in the system, but there is more “cash”. For instance, If
> I have $10 in t-bonds before QE and you have $10 in cash
> and the government comes and buys my bond from me then we
> both have $20 in cash combined.
>
Right, because as an investor, yields are such where you now favor cash over t bonds.
>
> If we both want to buy a pair of socks the next day we will
> bid up the price of those socks because now there is more
> cash in the system, right? Before I couldn’t buy the socks
> because I owned a bond. Is that wrong?
>
Not wrong, but probably not realistic.
If you wanted socks you could have sold your t bonds the day before, just at a slightly higher yield/lower price.
QE is predominately about yields adjusting to levels where investors in aggregate make investment decisions decide to hold cash rather than longer term securities.
To your point, the question is whether lower rates in general cause what were investors to become consumers.
There isn’t much evidence of this happening anywhere, including Japan, so the next question is why not.
My guess is the interest income channel- lower rates mean less income for the economy in general because the govt sector is a net payer of interest. And QE directly reduces govt interest payments as the Fed earns the interest on the securities it buys, rather than the private sector.
So rates are lower, which might encourage consumption, and might encourage borrowing to consume, but income over all is lower as well.
And, of course, without real asset prices rising lenders are less inclined to lend as they don’t have rising collateral values to bail them out. A 70,000 mtg on a 100,000 condo or house can easily turn into a loss if the borrower defaults, for example, just from fees, commissions, closing costs, depreciation due to neglect.
This might relate to the minutiae of monetary ops, but are the PDs obligated to sell their bonds to the Fed for QE?
In other words, if the Fed pursues QE and attempts to swap bonds for cash, can the banks simply keep their interest-bearing assets?
If not, then wouldn’t the Fed bid these bonds to such a high price as to create a profit for the banks?
Joe,
For some reason there has been a lot of focus recently (on various blogs) on the Fed buying treasuries (via QE) that are held directly by the banks. I think people keep using this scenario so they don’t have to deal with readers worried about increases in broad money supply if the Fed buys from non-banks. But as I understand it the primary dealers often act on behalf of clients (who are outside the banking sector) and thus it’s not just banks/PDs who sell their treasuries. So the Fed’s bid should be just like any other bid in the private-sector-wide treasury market.
it’s all done by price. the fed pays high enough prices to attract the bonds it wants. and, in fact, that’s the point- to get price up/yields down.
Another reason why QE won’t turn investors into consumers to any great extent is as follows. Assume for the sake of simplicity that prior to QE investors have the volume or value of savings that they want. Converting a chunk of their wealth from bonds to cash has no effect on their total wealth, thus they are not going to turn into big time consumers all of a sudden (i.e. dissave).
And that is the really daft aspect of QE: it involves handing out new money to precisely the portion of the population which is least likely to spend it. In contrast, a payroll tax reduction hands money to a portion of the population which is MORE likely to spend it.
Also I have more faith in the above wealth effect than in WM’s income effect (last three paragraphs above). WM argues that QE reduces the private sector’s income from interest, which is deflationary. But this depends on what the Fed does with the INCREASED income it gets from its newly acquired Treasuries. If the Fed simply extinguishes this money, then WM is right. Alternatively, if the Fed passes this increased income on to the Treasury at the end of the year, and the Treasury / Congress spends it on roads, schools, etc then there is no effect on aggregate demand.
The only way of getting a definitive answer to the latter question is to actually ask the Fed what they do with that above additional income.
Ralph,
“if the Fed passes this increased income on to the Treasury at the end of the year, and the Treasury / Congress spends it on roads, schools, etc then there is no effect on aggregate demand.”
Remember here the Treasury doesnt necessarily collect balances to be able to authorize expenditures. Fiscal Policy is pretty much set with the appropriations with the exception of non-discretionary/automatic stabilizers which are to are large extent dictated by the non-govt sectors savings desires.
If Congress were to look at it as a Fed provided windfall and thus the deficit wasnt as big as they predicted and then would quickly do a supplemental, then yes I would think there would be no change in AD…but Congress looks like it would rather take credit for the ‘savings’ the way it looks politically right now…
the fed passes the funds to the tsy, but the tsy spends only what congress budgets.
and i don’t see the congress adding to spending because there was more interest income than anticipated. they’re just out of paradigminly thankful the deficit wasn’t that much higher, as they work on cutting social security.
Why doesn’t the Fed just announce a target rate for each maturity and then offer to buy/sell to match that rate. This is what they do for the FFR. Just making the announcement has the effect of driving the rate there because banks know the Fed has the power to get the rate there.
They still think it is about quantity. That’s why its called “quantitative easing” and not “price fixing.” 🙂
exactly our point here!
it’s about price, not quantity
Even it that were how QE worked, how could two people buying socks at the same time cause inflation when there are 25 million unemployed sock makers and a 74% capacity utilization rate?
no, hyperinflation according to the fear mongerers
Brother Beck had his small sample of goods on yesterday’s show and was demonstrating what the prices will soon be as the Soros/Obama gang debases the dollar. Small can of coffee – expect that to go to $77.00.
Get your wheelbarrows ready.
Or you can get a big sack of BS from Glenn for free.
Besides, coffee is brown and Nazis wore brown shirts, so coffee obviously was a secret Nazi invention, which, by the way, HAS taken over almost the entire world! Think about THAT!
For all,
Link to the FRBNY UST purchase schedule for the first month. Complete with dates, amounts and maturities:
http://www.newyorkfed.org/markets/tot_operation_schedule.html
Starts tomorrow.
Resp,
Matt,
Thanks to such crazy stuff with little effect, amounts such as 7-8 billion dollars look like a small amount.
Hi,
Here’s what I posted elsewhere:
Something else was bothering me regarding QE2.
1. Let’s say Paul buys a 5 year T-note at an auction.
2. The Treasury spends the proceeds by mailing a check to Peter.
3. The Feds QE2 Paul’s note.
4. Paul buys another 5 year T-note at the next auction.
5. The Treasury spends the proceeds by mailing a check to Mary/crediting her bank account.
6.The Feds QE2 Paul’s note.
et cetera ad infinitum.
With Paul being a conduit between the Treasury and the Feds, does not QE2 reduce to a de facto fiscal policy with the Fed financing government spending ? I know it is a simplistic scenario but still (Paul of course represents a collection of bondholders)…
I am sure I must be missing some subtlety.
Yes you can think of the Fed financing the government spending, though some MMT purists may object to the wordings.
So, QE2 is an easy detour around the prohibition of the Feds directly financing government spending ? Kind of MMT come true ? Forgetting the complication of the Congress budget approval. But that’s an unimportant detail.
I expected to be explained how silly I am in missing this or that.
Ramanan, I am disappointed 😉
One can look at it like that but it doesn’t matter. Even if the Fed hadn’t been involved in these purchases, the US government would have had no issues with financing its deficit.
The holding of these assets provides the Fed more income, which would have else gone to the private sector and one can say that it reduces demand, but low interest rates are good for aggregate demand. Also reduces income payments to the rest of the world. It has caused capital gains on assets.
On the other hand, fiscal policy is the need of the hour. Higher deficits do not crowd out anything and QE just digresses everyone’s attention.
By the way sometime back I read somewhere that the no overdraft rule is just an agreement between the Fed and the Treasury, not the Congress and hence not a constitutional law.
Ramanan, to my knowledge no one has yet come up with citations of the relevant US legislation regarding the political restraints imposed by Congress. Anyone here have anything?
Yes we should collect some info .. Of course Beowulf’s discovery of platinum coin creation powers overrules all rules.
But lets assume that its not there for a moment.
If one finds out that there is no superlaw which prevents no overdrafts and/or direct purchases of Treasuries by the Fed, then the debt ceiling is meaningless because the latter just means amount of Treasuries issued is $xTrillion nothing more. Plus there is no rule I guess that Treasuries have to be issued.
There’s a GAO report on the topic, Tsy hasn’t had overdraft rights (what the GAO calls “draw authority”) since 1981.
In the past, Treasury had access to both a cash and securities draw authority. Intermittently between 1942 and 1981, Treasury was able to directly sell (and purchase) certain short-term obligations to (and from) the Federal Reserve in exchange for cash… In the years Treasury used this authority, it borrowed on average about 11 days per year. Use of this authority was concentrated mostly in times of war or armed conflict… The most Treasury borrowed on a single day throughout the period was $2.6 billion in 1979. (/i>.(p.41 of pdf)
http://www.gao.gov/new.items/d061007.pdf
Federal Reserve Act, Section 15:
1. Federal Reserve Banks as Depositaries and Fiscal Agents of United States
The moneys held in the general fund of the Treasury, except the five per centum fund for the redemption of outstanding national-bank notes may, upon the direction of the Secretary of the Treasury, be deposited in Federal reserve banks, which banks, when required by the Secretary of the Treasury, shall act as fiscal agents of the United States; and the revenues of the Government or any part thereof may be deposited in such banks, and disbursements may be made by checks drawn against such deposits.
… reads like “disbursements may be made by checks drawn against such deposits” does not provide authority for disbursement without deposit cover – i.e. does not allow overdrafts
Well, the above quoted document does not leave any ambiguity as to whether overdraft is allowed:
”
After the expiration of the authorities [1981], the Federal Reserve was and still is limited to purchasing and selling obligations of the United States only in the open market.
”
and
”
Finally, a direct draw from the Federal Reserve would require a change in the law to allow the Federal Reserve to directly lend to Treasury.
“
“Well, the above quoted document does not leave any ambiguity as to whether overdraft is allowed”
There’s lots of ambiguity, actually. First, the discussions on this blog focus almost entirely on the potential for structural overdrafts of the type that would occur without issuing bonds under current institutional arrangements. That sort of overdraft logically would not be associated with specific term credit requiring repayment, clearing the deposit account ASAP back to a positive balance – that sort of reparation is simply not consistent with the nature of the discussions here (and elsewhere in the MMT realm). Second, and more generally, a normal overdraft arrangement is sufficient to drive a credit obligation as a result. But it’s not a necessary precondition for a credit obligation. The type of lending restriction noted in the FRA doesn’t require overdrafts as the precipitating event. So it’s not clear that an overdraft situation is clearly covered by the part of the Act that references lending. That’s why I referred to the deposit section.
(With apologies to Scott)
I’m still not understanding why anyone cares about the overdraft issue. It simply doesn’t matter.
By the way, the part of the FRA where the Fed is prohibited from lending to the Tsy except in the open market is here:
US Code Title 12, Ch. 3, section 355
Also, thanks, Beowulf, for the link. My sources on that were getting old, so it’s nice to see a more recent one.
Seems to be an account of unflagging interest here, Scott; Auerback chanelling winterspeak as well:
http://www.levyinstitute.org/pubs/pn_10_04.pdf
Yes, I know. Meanwhile, the MMT case is so much stronger if we focus on the interest rate on the debt. That is, after all, what really does matter. Sigh.
Scott, you’re right, interest rate on the debt are what count economically, but politically the statutory debt limit is a royal pain.
The trouble is, the debt limit vote is an annual excuse for Congressman to give brave, stern speeches against the deficit before voting to increase the debt limit. By the terms of their own logic, its like declaring they were against axe murderers and and on the side of naive coeds, before reluctantly agreeing to vote in favor of buying chainsaws for the criminally insane.
I get where the Tea Party is coming from, they’re telling their congressmen to stop talking a good game and then caving, if debt is bad, then vote against more debt. Economically its crazy talk, but even crazy people dislike politicians who talk out of both sides of their mouth (which is to say, all of them).
The optimal solution is what Hyman Minsky and a monetary reform committee suggested to President Kennedy, just abolish the debt limit.*
http://en.wikipedia.org/wiki/Commission_on_Money_and_Credit
Not sure how far that will ever go politically, I think the second best solution accomplishes the Tea Party goal of no more debt without standing in the way of functional finance; replace bond sales with coin seigniorage. GSE and, I suppose, municipal bonds (that may require congressional approval) could be given Tsy loan guarantees to satisfy investor demand for risk-free securities, federal loan guarantees don’t count against the statutory debt limit.
Yes, Beowulf, but overdrafts are debt, too, last I checked, and wouldn’t help get under the debt ceiling. The debt ceiling applies to all debt, not just that held by private investors. Debt govt owes itself is included in the debt ceiling. Otherwise, the Fed’s purchases of Tsy’s under QE would be providing additional space under the debt ceiling–I haven’t heard anyone say such a thing.
Scott, I agree with you on all points, I only walked in to drop off the GAO report. :o)
Is not the overdraft prohibition will be circumvented at least partially with the ongoing QE2 anyway ?
The 2-5 year T-notes auctions are scheduled on about weekly basis which is easy to coordinate with the Feds acquisitions of the securities of the same tenor.
I’m not familiar with how closely they’ll be coordinating that sort of thing, or how much they want to be perceived to be doing it.
But apart from issuance/purchase coordination, the cumulative effect of QE2 on commercial bank and non-bank balance sheets is similar (i.e. reserves and deposits) to what would happen if they’d not issued bonds for the same amount or if they ran an overdraft for the same amount.
The important thing is the effect on the duration of the net vertical position (reserves, currency, bonds) (shorter) and the average interest rate paid on it (lower).
Overdraft protection only matters if there are no more Tsy auctions, and the only reason Tsy would stop the auctions if Congress didn’t raise the debt limit. Congress requires even Fed-held debt to be under the statutory debt limit.
Beo,
The draw authority was one kind of arrangement which expired. The author interprets it as overdrafts are no longer possible. However it just means draw authority is no longer possible.
Plus there is a rule which says that the Federal reserve must have 30% gold or something. Obviously that is violated.
Scott,
US Code Title 12, Ch. 3, section 355 is violated regularly because the Fed participates in auctions when Treasuries it holds mature.
The reason there is unflagging interest at least from me, is the simply interesting independent of other things.
The overdraft seems just like a rule like “sleep early” or “have breakfast only after a bath”
Ramanan,
“The author interprets it as overdrafts are no longer possible”
can you please point to where that document references overdrafts explicitly (as opposed to direct lending)
“US Code Title 12, Ch. 3, section 355 is violated regularly because the Fed participates in auctions when Treasuries it holds mature”
What part of the section does the Fed abide by at 1 second before midnight on the day of maturity, but that it violates at 1 second after midnight?
JKH,
What I am saying is that in that GAO article, the focus is on draw authority and the authors say that overdrafts is not possible if the draw authority is not available. On the other hand, there is no law quoted about the overdraft itself.
Of course, what you quoted can be interpreted as no overdraft possible by law.
“What part of the section does the Fed abide by at 1 second before midnight on the day of maturity, but that it violates at 1 second after midnight?”
When the Fed has some of its Treasuries holds expire, it has to bid along with others in the upcoming auction. If it’s successful in the bidding, it means it has bought Treasury securities directly from the Treasury in violation of the law. So either there is a law with such an exception or the rule is not applicable.
(Don’t interpret it as I am taking a stand that the Fed is doing something wrong etc)
Ramanan,
Just asking:
“the authors say that overdrafts is not possible if the draw authority is not available”
Where do they say that explicitly?
“When the Fed has some of its Treasuries holds expire, it has to bid along with others in the upcoming auction.”
Not familiar with that. What’s your source?
Ramanan,
BTW, thanks for linking to that Lavoie chapter on hbl’s site. I’ve seen it before, but looked closely at it for the first time there. Interesting modularization of the monetary system there – a bit different.
Also, Keen refers to himself as a renegade post Keynesian, but he sure uses circuitist stuff a lot in his presentations. Refers to Graziani a lot (but not to Lavoie).
“The Federal Reserve is prohibited by law from adding to its net position by direct purchases of securities from the Treasury—that is, the Federal Reserve has no authority for direct lending to the Treasury. As a consequence, at most the Desk’s acquisition at Treasury auctions can equal maturing holdings.”
Understanding Open Market Operations, MA Akthar, p37
http://research.stlouisfed.org/aggreg/meeks.pdf
The thing is everyone says there is a law. Scott actually referred to the law but the law doesn’t seem to allow the above.
Yes the GAO doesn’t seem to talk about overdrafts itself but the authors are worried about a backup plan so are implicitly assuming no overdrafts.
Thanks, re maturities. Didn’t notice that before.
Yes I think the term PKE is a bit general. Samuelson also referred to himself as a PKEist!
Marc Lavoie is not exactly a circuitist but is fairly active in using the circuitists ideas in his work and developing it further. More generally he may be called an Horizontalist. He really writes well and I have a good collection of his books authored by him and books he has a chapter in.
Steve Keen on the other hand seems to be fairly preoccupied with the paradox of monetary profits – and I haven’t understood till date what the issue is. I like him till the point he actually starts writing his equations.
“US Code Title 12, Ch. 3, section 355 is violated regularly because the Fed participates in auctions when Treasuries it holds mature.”
Obviously it’s not being violated, since everyone knows they are doing it, including people that know the FRA better than anyone.
Yes I should have used some other word than “violated”.
Do you know of the law which allows participation for substituting maturing holdings ?
What I am trying to get at is that if JKH’s quote at #8 is interpreted as no overdrafts are allowed, then Treasuries have to issued. (assuming Platinum coins of any denomination are not created) If on the hand, it is interpreted as “doesn’t mean overdrafts as not allowed”, the Treasury can simply run unlimited overdrafts 🙂 or am I saying something silly ?
Ramanan,
Not silly at all. I haven’t found anything to answer the question, though I interpreted that quote as referring to the Fed as a fiscal agent, not overdrafts. The section I quoted has a title specifically related to liabilities of the Treasury.
That said, in regulatory and operating manuals by the Treasury, one would expect the details to be spelled out. That’s why for years I’ve wanted to get my hands on the part of the Treasury’s financial manual that relates to its account at the Fed. Unfortunately, I’ve been completely stonewalled by the Tsy when I’ve requested it–and the emails have been, shall we say, a bit “strange,” leading me and others who have seen them to think they may be hiding something (though, I don’t know for sure, obviously).
That’s why for years I’ve wanted to get my hands on the part of the Treasury’s financial manual that relates to its account at the Fed.
Scott, you should get in touch with Ron Paul’s staff, (detailing your efforts and why the “strange” emails lead you to suspect Tsy’s hiding something). Paul is the incoming chairman of the House Subcommittee for Domestic Monetary Policy and Technology.
The Treasury and the Fed have many items to manipulate at a practical level. The Treasury used to keep $5b for cash management and to avoid overdrafts. Now -after whats happened – it looks so low.
Its possible purely because of uncertainty that the Treasury balances can go below zero. Most countries have an overdraft and the Treasury needs to take a draft because of wrong forecasts (didn’t mean “wrong” because it is difficult anyway). However, in that case, the Treasury could sell some foreign assets to the Fed to bring the balances to a comfortable level and wait till the next auction.
Ramanan:
”
US Code Title 12, Ch. 3, section 355 is violated regularly because the Fed participates in auctions when Treasuries it holds mature.
”
You are looking at a wrong section.
You should be looking at:
”
Section 270.4(c)(1) “Transactions in obligations.”
To buy and sell Government securities and U.S. agency securities in the open market for the System Open Market Account, and to exchange maturing securities with the issuer
”
The maturing issues exchange option was present in FRA probably since 1913, in a mumbly way (Section 13).
Ramanan:
”
Steve Keen on the other hand seems to be fairly preoccupied with the paradox of monetary profits – and I haven’t understood till date what the issue is.
”
The issue is that there is no satisfactory explanation of profit monetization in a production circuit.
Here’s what, for example, Louis-Philippe Rochon, Marc Lavoie’s fellow circuitist, said:
“The existence of monetary profits at the macroeconomic (aggregate) level has always been a conundrum for theoreticians of the monetary circuit. If money is created from bank credit, how can we explain profits if firms borrow just enough to cover wages that are simply spent on consumption goods and returned to firms to extinguish their initial debt. Indeed, not only are firms unable to create profits, they also cannot raise sufficient funds to cover the payment of interest. In other words, how can M become M’?”
M-C-M’ is Marx’s formula, of course.
right, it requires that all income be spent, including interest earned by the banks.
unspent income creates a lack of agg demand, etc.
I’ve known them for a while and last I knew they no longer had a problem with this.
Thanks for both of those, VJK.
Regarding the Circuit, the “conundrum” as stated in the quote you provide would seem to be rather easily solved if one considers a typical project expected to be NPV positive (or at least NPV=0) rather than working capital as the core example to build the model around. Even with working capital, it should (obviously) only be a subset of the funds obtained to finance the business. Now, if you did that, and you still had a conundrum, that would be worth trying to think through.
In other words, the firms borrow enough to create deposit balances sufficient to pay interest to banks and dividends to consumers (100 per cent earnings payout), in addition to wages. All interest flows through to consumers via the banks in the form of interest paid on deposit balances as well as bank interest margin paid to consumers as earnings dividends (100 per cent payout).
Consumers then purchase all of the output of the firms with the deposit balances they’ve received from wages, interest, and dividends.
The firms then repay their loans to the banks, extinguishing both deposit balances and loans.
The borrowing/production/consumption cycle then starts again.
It’s just double entry bookkeeping.
(In the case with no dividend payouts, firms retain deposits equal to firm retained earnings, banks extinguish firm deposits equal to bank retained earnings, and consumers borrow sufficient to compensate for their missing dividends, collateralizing their debt with stock in the firms and the banks.)
Long term investment and saving can be added as an afterthought.
Keen’s explanation is that the Circuitists didn’t understand the difference between stocks and flows. It appears they didn’t understand DEB as well. If DEB logically and empirically allows for the monetization of profit, it’s pretty crazy to suggest that economics doesn’t.
VJK,
I am aware of the problem. I am also aware that it doesn’t go away even after careful analysis even though the circuit theorists are insightful in their analysis.
However, it goes away using Wynne Godley’s methodology because all previous analysis miss out some term or the other and Wynne’s method makes sure that everything is taken care of at the same time.
I remember talking to you once on this either here or somewhere. Didn’t follow it up but I had referred you to Gennaro Zezza and your mistook him for someone called Zazzaro! (don’t know who the latter is).
I am quite a fan of circuit theory by the way.
JKH@2:28 . . . EXACTLY!
Scott:
A lot gaps can be filled out by reading the following book:
Allan H. Meltzer: A History of the Federal Reserve vol 1/2
His book contains data and references that are impossible to find easily elsewhere.
Unfortunately, someone “borrowed” my copy, and I could not verify if he talks about that specific issue of maturing vs. other kinds of securities – it’s been a while since I skimmed through the book.
As far as I remember, he divides the Feds history into three periods roughly: 1913-1940 hands-off/non-interference, 1940-1960 the Feds controlled by treasury, 1960-onward: an independent Feds. I may be wrong on dates and exact wording.
Warren: right, it requires that all income be spent, including interest earned by the banks. unspent income creates a lack of agg demand, etc.
h/t Fred Bethune
seems he underestimated the influence taxation has on the human psyche.
in fact, best I can tell he never did get into taxation all that much, or recognize the central role it played in the monetary system?
As far as I can tell, Circuitism is essentially an economic “model” of double entry bookkeeping, although I’m not sure Circuitists understand that. Anybody who understands double entry bookkeeping will relate to Circuitism as a literary/logical exposition of DEB. It looks to me like Keen has taken Circuitism and adapted his own structure of accounts to it, to come up with a rather unusual model that is at odds with the conventional DEB account structure. He claims to have seen through the “paradox of monetary profits” (and he has) as an error in confusing stocks and flows. But at the same time, that error should be self-evident to anybody who understands DEB. It’s rather weird that this apparently has been a legitimate historical debate, going back to Marx. As per MMT, it’s all a matter of understanding the accounting and the economic logic that gets forced out as a result of it.
keen does not undesstans that public debt is private saving. he does realize loan create deposit.
nuff said
http://moslereconomics.com/mandatory-readings/a-general-analytical-framework-for-the-analysis-of-currencies-and-other-commodities/
A General Analytical Framework for the Analysis of Currencies and Other Commodities
Warren Mosler
Director of Economic Analysis
Adams, Viner, and Mosler
West Palm Beach, FL. USA
Mathew Forstater
Professor of Economics
Visiting Scholar
Levy Institute
Keynes lashed out against neoclassical theory for treating capitalism as a barter or “real-exchange” economy, and offered his “monetary theory of production” as an alternative to the traditional approach based on the “Classical dichotomy.” This aspect of Keynes’s work has been developed by two traditions, the Post Keynesian and the Circulation Approaches (Deleplace and Nell, 1996). Post Keynesians have elaborated, among other topics, the relation of money (and money contracts), uncertainty, and historical time (Davidson), asset pricing and financial instability (Minsky), and endogenous money and credit creation (Moore, Wray). While Post Keynesians have generally emphasized money as a stock of wealth, circuit theory (Graziani, Parguez, Schmitt) has highlighted the importance of a rigorous analysis of the circulation of money for understanding the operation of capitalist economies, including the principle of effective demand.
Both Post Keynesian and Circulation Approaches accept the widely held view that modern money is not commodity money but rather token (or fiat) money (see, e.g., Moore, 1988; Graziani, 1988). But they criticize conventional theory for continuing to utilize a framework that treats modern money as though it were still a commodity money. This paper begins with two comments on this fundamental point. First, while modern money does not derive its value from its status as a commodity, once a token is declared necessary for the payment of taxes it can be analyzed like any other commodity. Second, absent from most Post Keynesian and Circuit analyses is the institutional process by which a token obtains its value (becomes money). Many analyses “add in” government spending and taxation, and the central bank, after an initial investigation of the operation of a private money-using economy (see, e.g., Lavoie, 1992, pp. 151-69).
Analyses of the circuit that begin with banks financing firms’ production (or households’ purchases) and end with firms (or households) paying back their loans leave unanswered the question of why anyone would initially sell real goods or services for the unit of account. The “common-sense” reply, “because they can use the funds to buy other goods and services” is not a satisfying one, for the further ‘infinite regress’ question remains the same: “why do those sellers want the unit of account?” What is missing is the process by which the unit of account is endowed with value.
This paper takes the position that the question remains unanswered because it cannot be (adequately) answered unless the State is incorporated from the very beginning of the analysis. “Money is a Creature of the State” (Lerner), and thus a “monetary” analysis cannot be conducted prior to the introduction of the State. Interestingly, the Chartalist view of a tax driven currency can be found in the writings of Keynes (not to mention Adam Smith!), the Post Keynesians, and the Circulation theorists, yet it is almost always presented as an aside, with the implications remaining unexplored (see Wray, 1998, on Smith, Keynes, and Post Keynesians such as Minsky; for the Circulationists, see Graziani, 1988).
In the Chartalist view, the State, desirous of moving various goods and services from the private sector to the public domain, first levies a tax. The State currency unit is defined as that which is acceptable for the payment of taxes. The imperative to pay taxes thus becomes the force driving the monetary circuit. The present paper seeks to refine the concept of the monetary circuit using a multidimensional model designed to reveal and illuminate the workings of a tax- driven currency. It will also be shown that this same model lends itself to the analysis of any commodity. In an adaptation of Moore’s (1988) terminology, the model includes “horizontal” and “vertical” components of the monetary circuit. Following outline and discussion of the model, it will be utilized to dispel the myth that deficits imply future taxation, as well as to briefly analyze the 1997 Asian Financial Crisis.
I found your “General Analytical Framework” to be the most difficult of the required readings, requiring several goes over time. The notion of a farmer deficit spending in corn isn’t immediately intuitive, although the corn/money vertical inventory analogy is more so, along with the commodity futures/horizontal debt comparison. In any event, it’s all powerful stuff, including the vertical/horizontal integration. Keen of course isn’t interested in Chartalism or MMT; he’s more bent on massive horizontal debt write offs than the possibility of vertical assistance (if he understood it). I’ll stick to my characterization of Circuitism and Keen’s application of it until convinced otherwise.
“the model includes “horizontal” and “vertical” components of the monetary circuit.
Not sure why you look at it that way. Basil Moore’s usage of horizontal, vertical etc were for supply demand diagrams. His 1988 book was to show that the money supply diagram is horizontal and there is nothing called money supply function – its all demand-led.
Your usage of horizontal and vertical is related to the diagrams you may placing the central bank and the treasury on top and other things in the bottom – nothing to do with supply-demand curves.
no supply/demand curves because the monetary system being described is a simple (and notional) public monopoly where the monopolist sets notional demand (taxes) and controls supply (govt. spending) as well.
curves and functions come into play with ‘savings desires’ (as well as with the real economy)
Ramanan,
That use of the term horizontal is sufficiently standardized that even Nick Rowe uses it – when he refers to “horizontalists” – i.e. no reference to the MMT usage.
Yes I have seen him use that. I know what Verticalist is and what Horizontalist is.
The “Vertical” in Moore’s terminology has nothing to do with government’s transactions. When Moore refers to something as “Vertical” that something is a curve in the supply-demand diagram, not a transaction.
Yes, I know that as well. My point is that his usage is most likely not original, and is definitely not related to the unique value that MMT must have derived from his work. Completely different use of the same terms.
Yes yes thats what I was trying to point out – his usage is completely different – contrary to whats written here:
“In an adaptation of Moore’s (1988) terminology, the model includes “horizontal” and “vertical” components of the monetary circuit. ”
The terms Horizontalists/Verticalists is Moore’s own invention. The conjecture that the money supply is horizontal and hence there is no “function” is due to Nicholas Kaldor.
I had always thought that Basil had been describing the verticalists as taking the position- the Fed adds reserves, and the banks lend them out, with the expansion a function of the reserve requirement, etc.
no?
(And I fondly recall when he asked me whether I was a horizontalist or a verticalist and I said ‘both.’ Quite the discussion followed!)
OK, thanks.
“I had always thought that Basil had been describing the verticalists …”
Yes of course.
My point was that his usage of Vertical was related to supply demand diagrams not based on a schematic of a monetary system like where the central bank sitting on top.
So he may be wondering why you are a Verticalist because in his description, government stimulus keeps the money supply horizontal and shifts the demand curve to the right.
I recall being a verticalist meant believing in the money multiplier model- that ‘money’ originates from the Fed, and the banks ‘multiply’ it?
(If you go to Paul Davidson’s post keynesian discussion group archives a lot of this is probably all still there.)
Anyway, I said you can’t horizontally expand nothing. You at least need a concept. There are no gold futures without gold.
There are no dollar loans creating dollar deposits without dollars. The concept of dollars has to come from somewhere first, even though no actual dollars are used in the horizontal expansion. Then they started asserting scholarly sacred cow rhetoric I of course already knew- like ‘banks create dollars ex nihilo’- to which I’d say, ‘not completely, as there had to at least be a thing called the dollar for banks to create dollar deposits.’
That was all pretty steamy stuff for the PK’s to follow at the time. Randy Wray was accused by another colleague (not Basil) of supporting my positions because I was paying him to do so. In academia, it doesn’t get much worse than that.
And that’s where the concept of net financial assets came in, which only come from the vertical component, as a point of logic.
The idea that net financial assets and income exerted influence over the horizontal expansion was problematic for the pk’s as well.
They all believed that interest rates could do it all. Basil pretty much still did last I spoke with him a few years back. He still couldn’t understand why Japan, with 0 rates, doesn’t have run away asset prices. So the PK’s were/are what we today monetarists more than what we now call Keynesians. But back then a monetarist was a verticalist who believed the quantity of money somehow coming from the fed somehow was a factor, and a pk was a horizontalist who believed the fed set rates, and rates controlled the monetary aggregates/quantities of bank deposits, and not the fed. But they still believed in a limited role for fiscal adjustment due to most all the deficit myths, and a major role for interest rate adjustment.
This was before anyone knew what Wynne Godley was actually doing. I’d never even heard of him. Some of them had probably seen his spread sheets but from what I later saw at conference presentations, and the questions that followed, no one seemed to care what he was doing.
Wray describes it here as Moore’s horizontalism (horizontal reserve supply) leading directly to endogenous money interpreted as the “horizontal leveraging” of reserves. Two different horizontals connected at the hip?
Of course, Soft Currency Economics is included in the references:
http://www.cfeps.org/pubs/wp-pdf/WP17-Wray.pdf
“I recall being a verticalist meant believing in the money multiplier model- that ‘money’ originates from the Fed, and the banks ‘multiply’ it?”
Of course.
“say, ‘not completely, as there had to at least be a thing called the dollar for banks to create dollar deposits.’ ”
Yes they believe money was privately created long before government had control on money. So governments never spent first and taxed/borrowed later.
“because I was paying him to do so. In academia, it doesn’t get much worse than that.”
He he … politics … but same everywhere and in all fields
“This was before anyone knew what Wynne Godley was actually doing. I’d never even heard of him. Some of them had probably seen his spread sheets but from what I later saw at conference presentations, and the questions that followed, no one seemed to care what he was doing.”
He had been doing that since his days in Cambridge and most of his ideas – sectoral balances, fiscal stance, stock-flow consistency, government debt as a mirror of private sector wealth etc. He had written it up in his 1983 text “Macroeconomics”. Its quoted quite a lot in the Circuit literature.
JKH:
”
In other words, the firms borrow enough to create deposit balances sufficient to pay interest to banks
”
Setting aside the unrealistic assumption that the firm would borrow more money than necessary to realize the production cycle, the firm that borrows x would need to repay x + x*i where ‘i’ is the interest rate; the firm that borrows x*(1+i) would need to repay x*(1+i)^2, etc.
What am I missing ? Where would x+x*i come from if the firm can recover x at most assuming that x was paid in wages and recuperated in sales (simplifying away raw matirials and such) ?
Ramanan:
”
I had referred you to Gennaro Zezza and your mistook him for someone called Zazzaro! .
”
I doubt I did.
”
(don’t know who the latter is)
”
Another circuitist.
”
it goes away
”
If it does, you should be able to reproduce the transaction flow easily. 😉
Yes I just meant I haven’t read Zezzaro, heard of him.
I suggest you read G&L Chapter 9. There is absolutely no issues there. Its difficult writing it in words. Firms in the model in Chapter 9, are able to make profits and there is no paradox.
Zezza, Zazzaro, Zezzaro– I’m confused if you guys are talking about one, two (or even possibly) three different people.
Let’s get back on track… G&L Chapter 9 model… there’s a couple of charts and Eview Macros for that here (the name of the eponymous site owner is, of course, purely coincidental) :o)
http://gennaro.zezza.it/software/eviews/glch09.php
Ramanan:
OK, you’ve motivated me enough to take a look at the chapter.
Here’s what it says:
“As with nonfinancial firms, we assume that banks distribute all their profits to households immediately.
”
That’s quite an assumption !
It makes the notion of profit/interest earnings quite meaningless — the households could have received the money as wages from the very beginning, without the unnecessary detour through the “profits”.
the trouble with their models is that the number of equations keep increasing as you add more features. The statement you quoted means they are assuming that retained earnings are zero – a condition which is relaxed in other more complicated models later in the book.
Vjk @ November 15th, 2010 at 1:09 pm
The market clears ultimately because interest income, including compounding, accrues in discrete time rather than continuous time.
Illustration:
The firm borrows from the bank the interest due to the bank on its principal borrowing on the final day of the period. The bank credits the firm’s deposit account with the amount of interest due. The bank then debits the firm’s deposit account for interest it owes, and credits the deposit accounts of those to whom the bank owes interest on deposits and those to whom the bank pays dividends (as a payout of earnings derived from its net interest margin). Those two income recipient groups have incorporated the time lag on their expected payments into their purchasing expectations, and immediately purchase their share of output based on their receipt of the funds that in total amount to the interest paid by the firm to the bank. At that point, the entire principal amount that the firm has borrowed as well as the interest it has borrowed has been paid out to the factors and used by the factors to purchase the firm’s output. The firm has also built the full principal and interest amount of the loan into the pricing of its output, so it earns sales revenue corresponding to the factor payments in total, which tops up its deposit accounts in such a way as to allow full repayment of principal and interest by the end of the final day of the period.
If the market clears properly on the final day of the period, the borrowing of interest described is essentially a daylight overdraft facility – which is a de facto facility when scheduled payments can be matched up as planned. There is no additional interest on interest because there is no overnight overdraft. In fact, the interest doesn’t really have to be considered as having being borrowed explicitly- to the degree that it becomes part of the normal payments clearing process that nets to zero in the deposit account. I referred to borrowing per se, but there is no compounding interest charge assuming the market clears properly intra-day on the final day of the period and all the principal and interest has been repaid.
The example is simple, but illustrates the principle involved, and more elaborate cases can be extrapolated from there. As a theoretical matter, the compounding dilemma is superseded when the limit on interest compounding frequency is approached and reached – daily being the normal limit. That allows the market to clear without an infinite regress of compounding as a mathematical complication. And, as a practical matter, we know that DEB (double entry bookkeeping) clears the market empirically every day, according to real world cash flow patterns, which are different in degree of complication – but not fundamentally different in nature from what is described above.
JKH:
”
At that point, the entire principal amount that the firm has borrowed as well as the interest it has borrowed has been paid out to the factors and used by the factors to purchase the firm’s output.
”
You assume that the interest has been fully transferred to the workers. The consequences:
1. The banks have no retained profits — the earned interest was paid to the workers.
2. The firm has no profits — it re-paid loan+interest which was funded by sales to the factors whose consumption, in its turn, was made possible through their wages and earned interest.
”
we know that DEB (double entry bookkeeping) clears the market empirically every day,
”
We do, we just don’t know how 😉
I covered all that @ November 15th, 2010 at 2:28 am:
“In the case with no dividend payouts, firms retain deposits equal to firm retained earnings, banks extinguish firm deposits equal to bank retained earnings, and consumers borrow sufficient to compensate for their missing dividends, collateralizing their debt with stock in the firms and the banks.”
And the interest doesn’t pay for firm profits, retained or not – that comes out of the principal borrowed.
JKH:
“And the interest doesn’t pay for firm profits, retained or not – that comes out of the principal borrowed.”
The firm, in you description of November 15th, 2010 at 8:15 pm, pays wages to the factors in the amount of the principal, the factors also receive the interest from banks and buy the firm output which allows the firm to repay the principal and the interest without any profits, retained or otherwise:
Sales = Wages + Interest from/to the bank
Loan = Wages + Interest from/to the bank
Profit = Sales – Wages -Interest from/to the bank == 0
It would be helpful if you demonstrated my error with transactions and numbers.
Thanks.
The 8:15 was a response to your question on the interest specifically. The firm does not pay wages in the amount of the principal, and I never said that in any of my comments. You have to combine my 8:15 comment on interest with the earlier one. The earlier one specifically covered firm profits, as I just explained for the second time at 11:16. Based on the nature of your feedback, I have no intention of constructing a numerical example for you at this particular juncture. You are free to believe what you want, including the view that everything I’ve written is rubbish. Thanks for your input.
JKH:
”
Based on the nature of your feedback, I have no intention of constructing a numerical example for you at this particular juncture.
”
If you are unable to grasp the gist of the problem or state clearly your solution, there no need to get pissy !
”
everything I’ve written is rubbish
”
Regrettably, it appears to be the case.
Good stuff. Have a nice day.
At that point, the entire principal amount that the firm has borrowed as well as the interest it has borrowed has been paid out to the factors and used by the factors to purchase the firm’s output.
”
You assume that the interest has been fully transferred to the workers.
As I understand it, JKH includes the firm itself and the bank as factors, receiving profits and interest respectively, both of which are spent on output. Whether this happens directly or via dividends doesn’t matter. That just determines who owns the output. The only thing that does matter is that it is all spent so there is no monetary residual because that translates as a lack of aggregate demand in absence of a vertical component.
Sales = Wages + Interest + Profit = Loan
Oliver:
”
The only thing that does matter is that it is all spent so there is no monetary residual because that translates as a lack of aggregate demand in absence of a vertical component.
”
That’s the point — there is no monetary residual even if you assume that the firm borrows not only to cover production, but also to include future profits and interest.
No firm does that in real life. But, even when one makes that unrealistic assumption, the source of residual remains unexplained.
Additionally, the firm or the bank cannot retain anything. Otherwise, there will be unsold inventory, and the firm will be unable to repay the loan (if Sales < Loan).
That’s the point — there is no monetary residual even if you assume that the firm borrows not only to cover production, but also to include future profits and interest.
Future profits? Not profits of the current cycle?
No firm does that in real life. But, even when one makes that unrealistic assumption, the source of residual remains unexplained.
I think the consumer borrowing against retained earnings, as JKH explains above (and below), could go on indefinitely if it doesn’t grow faster than output. That might be one relationship to look at as an indicator of instability.
Additionally, the firm or the bank cannot retain anything. Otherwise, there will be unsold inventory, and the firm will be unable to repay the loan (if Sales < Loan).
In The Case With No Dividend Payouts, Firms Retain Deposits Equal To Firm Retained Earnings, Banks Extinguish Firm Deposits Equal To Bank Retained Earnings, And Consumers Borrow Sufficient To Compensate For Their Missing Dividends, Collateralizing Their Debt With Stock In The Firms And The Banks.
I guess there’s a time problem between you and JKH. Does rolling over debt from one cycle to the next (is that what you call it?), which certainly happens in reality, make it count as closed cycle? Does it matter?
Disclaimer: my accounting skills are very basic, I’m not even sure I use terms correctly since everything I ever did learn formally (not much) was in German.
and re if sales < loan
Less profit = smaller loan at equal sales?
”
Future profits? Not profits of the current cycle?
”
“future” in the sense of the current cycle profits, yes.
”
the consumer borrowing against retained earnings
”
I do not know what the above means. To make sense of it, I’d like to see a hypothetical transaction flow. Moreover, retained earnings, for the firm, are not even possible assuming the loan has to be repaid at the end of the cycle.
”
Does rolling over debt from one cycle to the next (is that what you call it?), which certainly happens in reality,
”
It certainly does, but the ‘residual’ money is still nowhere to be found in the multi-cycle arrangement either.
”
Less profit = smaller loan at equal sales
”
When the firm borrows so much as to include future profits and the interest to repay, the firm can repay Loan = Wages + Interest + Profit only by remitting Profit to the bank as part of the Loan repayment, hence, no retained profit is possible for the firm.
I am still not sure, without seeing an actual transaction flow example, how the hocus-pocus with pre-borrowing interest is possible, but that’s unimportant since the firm still cannot retain profits as I described above.
You’re looking for an accounting entry (retained earnings) on only one side of the balance sheet – an imbalance sheet, so to speak :-). That’s against the rules. So, in the horizontal case, retained earnings necessarily translate into a bank loan somewhere down the road with corresponding interest payments attached to it.
In the vertical case, the entry to the bank’s balance sheet is exchanged for one on the government’s with the difference for the asset holder being that no nominal interest is due. On the other hand, there is a mechanism for paying back the principal, depending on what you do with it and what the current arrangements are: taxes.
Or am I as lost as VJK there, JKH?
Oliver,
The factor payments would be:
– Wages paid to all labour (firms and banks)
– Interest paid from banks to households
– Bank net interest margin = profit earned by banks (assumed fully paid out to households as dividends, but with an option to retain as per note in my first response)
– Profits earned by firms (similarly assumed as fully paid out to households as dividends, but with an option to retain as per note in my first response)
The clearest approach is to assume 100 per cent profit payouts as dividends. This loses no generality, as the retained earnings option is an easy adjustment as I indicated.
Assuming full payout of profits:
Wages earned by households, interest paid to households, and dividends paid to households should account for all factor payments, and the sum equals GDP and GDI.
The firm and the bank are not factors per se. Their wage earners, shareholders, and in the case of the banks their depositors are the factors that receive the income payments that sum to GDP/GDI.
“The firm and the bank are not factors per se.”
I.e. except where I indicated, payments in and out net to zero in terms of GDP contribution.
E.g. most of the interest paid to the bank is then paid by the bank to households, netting to zero as a bank contribution to GDP/GDI, but netting to interest received by households as a positive contribution. The rest becomes net interest margin or profit, again netting to zero as a bank contribution but to dividends received by households as a positive contribution.
In the case with no dividend payouts, firms retain deposits equal to firm retained earnings, banks extinguish firm deposits equal to bank retained earnings, and consumers borrow sufficient to compensate for their missing dividends, collateralizing their debt with stock in the firms and the banks.
Missed that first time round, sorry.
that’s the one
JKH@November 16th, 2010 at 1:56 am
“Wray describes it here as Moore’s horizontalism (horizontal reserve supply) leading directly to endogenous money interpreted as the “horizontal leveraging” of reserves. Two different horizontals connected at the hip?”
The use of “leveraging” there confused some horizontalists. They interpreted it as a sort of money multiplier relationship. Keen interpreted it that way, too, as did Febrero in that horrific paper critiquing Chartalism that gets trotted out frequently on the internet.
It’s a bit of a mine field of terminology – to be treaded carefully. That includes leveraging of net financial assets up to the banking system balance sheet (plus other horizontal residuals), versus leveraging of bank capital up to the banking system balance sheet. I’m guessing that’s where Warren views bank capital as smoothly endogenous rather than a constraint (unlike reserves), which is the way I’ve tended to view bank capital. Maybe I should change my mind, or at least look at NFA as superseding the capital constraint in terms of the leveraging dynamic.
for one thing all horizontal expansion leverages something. corn futures lever corn. loans/deposits lever dollars. etc.
and yes, bank capital is always infinitely available for all practical purposes, with price varying to clear market conditions.
Oliver,
In case you’re interested, here is a numerical example that corresponds to my earlier generic description of double entry accounting as a Circuitist type construction. It’s just an example. There are many ways of constructing this sort of thing.
It is a 2 day model of market clearing. Some of the numbers are unrealistically outsized (e.g. interest of 10 on 100 principal), but only for illustration and ease of following the numbers. For simplicity, there is no investment or net saving for the period, so that all wage and capital income distributions are used for consumption. No generality is lost due to any of the simplifications; it’s all structural logic and accounting. The example is easy to tweak for additional detail. E.g. it assumes 100 per cent profit distribution; the adjustment for 100 per cent retained earnings is easy, as described in my earlier comment.
Day 1
Firm borrows 100 from bank.
Firm has 100 loan liability and 100 deposit.
Interest rate is 10 per day.
Workers create the product.
The firm values the product inventory on the balance sheet at 110.
Firm pays workers 90 for the day’s work. This transfers ownership of 90 in deposits from the firm to the workers.
Firm assets now consist of 10 in deposits and 110 of product inventory.
The firm records interest payable of 10. This is the cost of the loan for day 1, payable to the bank on day 2.
Firm funding now consists of 10 interest payable, 100 principal loan, and 10 in equity. The equity entry derives from the fair value of the inventory.
Firm pays dividends of 10. This transfers ownership of 10 in deposits from the firm to the workers.
Firm balance sheet equity is now zero.
The firm balance sheet consists of 110 in inventory, 10 interest payable, and 100 loan.
Note – Dividend payments are a cash transaction that doesn’t necessarily depend on how earnings are recorded. E.g. firms can pay dividends in a particular quarter with quarterly losses. There is a difference in the type of accounting decision that records a cash transaction, versus one that reports valuation adjustment based on non-cash accounting event. Accountants are constantly making judgements on balance sheet valuations and their effect on reported earnings. I’ve shown such a balance sheet adjustment in this example by including an equity entry of 10 due to inventory valuation. This is a simplification for purposes of illustration. Such a valuation could change depending on actual sales. The precise forensic accounting rules aren’t important to the illustration here. The important thing is that accounting forces decisions on such balancing entries. In this example, if expected sales and earnings didn’t materialize, it would be up to the accountants as to how to report equity and earnings based on the (re)valuation of the inventory on Day 2. For this example, we are going to assume that sales will be actually be made on Day 2, and that the market clears as per expectations reflected in Day 1 accounts.
Although money has been moving around between depositors, the nominal bank balance sheet has remained static, consisting of 100 loans and 100 deposits.
The starting balance sheet equity positions for the firm and the bank are immaterial to the point of the illustration. The operational execution of these transactions doesn’t depend on starting equity.
Day 2
The firm owes the bank 100 in principal and 10 in interest, due by the end of the day.
The bank makes the following distributions, with (temporary intra-day) adjustment to its equity account. (It is still owed 10 in interest from the firm by the end of the day):
– Bank debits bank equity 3 and credits bank workers with wages of 3
– Bank debits bank equity 2 and credits depositors with interest of 2 (for Day 1 balances)
– Bank debits bank equity 5 and credits shareholders with dividend of 5. The dividend corresponds to what will clear in the accounts by the end of the day as the bank’s net interest margin, i.e. the bank’s earnings. There is 100 per cent payout by assumption.
(Again, it makes no difference whether there is starting equity or not – the equity debit is an intra-day entry only until the market clears.)
Firm sells 110 in product (GDP).
The source of the 110 spent by consumers is as follows:
– firm wages 90
– firm dividends 10
– bank wages 3
– bank interest 2
– bank dividends 5
With actual sales, firm’s deposit increases by 110.
Firm repays bank principal of 100.
Firm pays bank interest of 10.
Bank eliminates principal amount of loan.
Bank debits firm deposit 10 for the interest payment, and increases bank equity 10, returning the equity level to zero following the earlier intra-day debit.
All markets have cleared and settled. GDP and GDI for the period are both 110.
This example corresponds to my earlier generic description of the DEB-Circuitist equivalence. My first description is reproduced below (Scott Fullwiler concurred with it), along with the follow up comment.
By comparison with the following comment, I added bank wages in the numerical example.
November 15th, 2010 at 2:28 am
“In other words, the firms borrow enough to create deposit balances sufficient to pay interest to banks and dividends to consumers (100 per cent earnings payout), in addition to wages. All interest flows through to consumers via the banks in the form of interest paid on deposit balances as well as bank interest margin paid to consumers as earnings dividends (100 per cent payout).
Consumers then purchase all of the output of the firms with the deposit balances they’ve received from wages, interest, and dividends.
The firms then repay their loans to the banks, extinguishing both deposit balances and loans.
The borrowing/production/consumption cycle then starts again.
It’s just double entry bookkeeping.
(In the case with no dividend payouts, firms retain deposits equal to firm retained earnings, banks extinguish firm deposits equal to bank retained earnings, and consumers borrow sufficient to compensate for their missing dividends, collateralizing their debt with stock in the firms and the banks.)
Long term investment and saving can be added as an afterthought.
Keen’s explanation is that the Circuitists didn’t understand the difference between stocks and flows. It appears they didn’t understand DEB as well. If DEB logically and empirically allows for the monetization of profit, it’s pretty crazy to suggest that economics doesn’t.”
By comparison with the following comment, I used accounting entries for the firm of an inventory valuation, along with an interest payable entry. The interest payable replaces what I described in the following as an intra-day loan of interest from the bank to the firm with an effective daylight overdraft position. The interest payable used in the example amounts to the same thing economically, in addition to being more correct in an accounting sense. The entire story is the same in economic terms as the numerical accounting example.
November 15th, 2010 at 8:15 pm
“The market clears ultimately because interest income, including compounding, accrues in discrete time rather than continuous time.
Illustration:
The firm borrows from the bank the interest due to the bank on its principal borrowing on the final day of the period. The bank credits the firm’s deposit account with the amount of interest due. The bank then debits the firm’s deposit account for interest it owes, and credits the deposit accounts of those to whom the bank owes interest on deposits and those to whom the bank pays dividends (as a payout of earnings derived from its net interest margin). Those two income recipient groups have incorporated the time lag on their expected payments into their purchasing expectations, and immediately purchase their share of output based on their receipt of the funds that in total amount to the interest paid by the firm to the bank. At that point, the entire principal amount that the firm has borrowed as well as the interest it has borrowed has been paid out to the factors and used by the factors to purchase the firm’s output. The firm has also built the full principal and interest amount of the loan into the pricing of its output, so it earns sales revenue corresponding to the factor payments in total, which tops up its deposit accounts in such a way as to allow full repayment of principal and interest by the end of the final day of the period.
If the market clears properly on the final day of the period, the borrowing of interest described is essentially a daylight overdraft facility – which is a de facto facility when scheduled payments can be matched up as planned. There is no additional interest on interest because there is no overnight overdraft. In fact, the interest doesn’t really have to be considered as having being borrowed explicitly- to the degree that it becomes part of the normal payments clearing process that nets to zero in the deposit account. I referred to borrowing per se, but there is no compounding interest charge assuming the market clears properly intra-day on the final day of the period and all the principal and interest has been repaid.
The example is simple, but illustrates the principle involved, and more elaborate cases can be extrapolated from there. As a theoretical matter, the compounding dilemma is superseded when the limit on interest compounding frequency is approached and reached – daily being the normal limit. That allows the market to clear without an infinite regress of compounding as a mathematical complication. And, as a practical matter, we know that DEB (double entry bookkeeping) clears the market empirically every day, according to real world cash flow patterns, which are different in degree of complication – but not fundamentally different in nature from what is described above.”
Thanks, greatly appreciated! I’m working my way through it :-).
cheers, Oliver
In the numerical example provided, neither the firm nor the bank retain any earnings. They are forced distribute all the dividends just to make the production circuit work, so there is no profits in any meaningful sense of the word.
That’s the very point circuitists make.
There is no ‘residual’ money created and hence no monetary growth.
In Marxian terms, M->C->M+, M+ cannot not exceed M.
Oliver,
You highlighted my earlier comment pertaining to the dividend/retained earnings issue:
“In the case with no dividend payouts, firms retain deposits equal to firm retained earnings, banks extinguish firm deposits equal to bank retained earnings, and consumers borrow sufficient to compensate for their missing dividends, collateralizing their debt with stock in the firms and the banks.”
I’ve noted the nature of this adjustment several times. Here is how the dividend example is transformed to a retained earnings scenario, without impediment:
From the dividend example,
“The source of the 110 spent by consumers is as follows:
– firm wages 90
– firm dividends 10
– bank wages 3
– bank interest 2
– bank dividends 5
…”
So in the dividend case, the firm pays out 10, and the bank pays out 5. In doing so, the firm loses deposits of 10 and the firm’s shareholders gain deposits of 10. The bank reduces its equity by 5 and credits bank shareholders’ deposits by 5.
Here is the comparable case of no dividend payout:
Day 1
Because no dividend is paid, the firm balance sheet now includes increases of 10 in deposits and 10 in equity, compared to the dividend payout scenario.
(The firm records interest due from the bank on its (new) 10 in deposits. The bank records interest payable. Reflecting the effect of these interest accruals, the firm’s shareholders experience equity value accrual and the bank’s shareholders experience equity value decline. The combined effect on all shareholders is that the total value of equity held in the firm and the bank is unaffected by these accruals. Also, there is zero net effect on system income, GDP and equity.)
Day 2
With no dividend payout, the bank’s equity is higher by 5 and its deposits are lower by 5, compared to the dividend payout scenario.
(The bank records less interest payable starting on Day 2, and bank shareholders record less interest receivable than the dividend case (they have no deposit now). The bank records more equity value accrual and shareholders do the same. There is zero net effect on system income, GDP and equity. There is also zero net effect on the equity value of shareholder’s own balance sheets at the end of Day 2. However, the value of bank shares has actually increased marginally as a component of shareholders’ own balance sheet equity.)
We set aside now the parenthetical interest and equity accruals noted, since they have no net effect on GDP or income or equity in aggregate.
The effect of not paying dividends then is that shareholders in the firm and bank combined have an additional 15 in equity (plus the minor adjustment for the Day 2 equity accrual for the bank), and shareholders have 15 fewer deposits, compared to the dividend payout situation.
Shareholders in total now borrow 15 from the bank, using their additional 15 + equity value as collateral. The new bank loan of 15 provides the shareholders with a new deposit of 15, which is what they need to make up the deposit shortfall compared to the dividend scenario. The result is that households in total now have the same money as before to purchase the same level of GDP of 110. All GDP is purchased by the end of Day 2, as before.
(Final accrual note: shareholders record an interest payable on the (new) 15 loan starting on Day 2, and the bank records an interest receivable. The bank records more equity value accrual and shareholders do the same. The net effect is that there is zero net effect on system income, GDP and equity. There is also zero net effect on the equity value of shareholder’s own balance sheets at the end of Day 2. None of this changes the GDP transactions that clear the system on Day 2.)
In summary, the described asset and liability adjustments reflecting the difference between dividend and retained earnings scenarios have no net effect on GDP or income or equity over the 2 day period. GDP transactions clear fully as described under either scenario. The firm and the bank make profits under either scenario. One scenario distributes earnings as dividends; the other retains earnings without dividend distribution.
In the modified numeric example, the bank and the firm retained earning of 15 are exactly offset by the household debt of 15.
At the end of the production circuit, the households have no funds to repay the debt.
Thus, the profits are made possible at the expense of ever growing household indebtedness growing ad infinitum, an unlikely scenario.
in a horizontalist model, every household financial asset must by definition be offset by the equal amount of debt to a bank. that’s double entry book keeping. it couldn’t be any different and nobody claimed it was.
the difference between the 2 scenarios is whether both bank and household books close with a 0 or with 15 on both sides of their respective ledgers at the end of a ‘hypothetical’ cycle. sustainability of the process depends on the congruence of growth of real asset values and gross debt, i would say.
Oliver :
So, your statement is that without the Central bank(horizontalist model) retained monetary earnings are impossible without offsetting household debt ?
If that is your statement, how did firms managed retain earning in the US before 1913 without households running ever increasing debt ?
i would guess that, before 1913, there was actual gold in circulation. that is asset with no offset liability, therefore can be held as net savings by non-govt sector
Two key features of the model as described factor prominently into the resolution of the question of profits. These are the assumption of no investment/saving, and the (optional) scenario of no dividends. Although such constraints are reasonable in examining economic activity at the margin and in the short run, they are unrealistic as the representation of a functioning real economy in total. In that sense, the model tests the question of profits under a particularly onerous combination of structural restrictions on investment and dividends. But even with that, the question of profits is resolvable. And from there, it is easy to free up the model from that worst case, so that it becomes a more reasonable approximation for a real world functioning economy. And the resolution of the profit question becomes increasingly obvious and natural.
The two constraints in question are the assumption of no investment/saving, and the scenario choice of no dividends. The combination of the two affects the asset liability adjustments required to resolve the profit question. In this fully constrained mode, it is true that “at the end of the production circuit, the households have no funds to repay the debt.” Indeed, this is built into the design of the 2 day model. Day 2 concludes with households being indebted. That scenario is deliberate, since there is no intention that the debt be repaid by the end of Day 2.
“The profits are made possible at the expense of ever growing household indebtedness growing ad infinitum, an unlikely scenario”. That is true also in the context of an indefinite extrapolation of the model. And that’s fine as a conclusion of what would be the case with such an extrapolation. But both the assumption and the conclusion warrant a number of qualifying observations that themselves suggest likelier outcomes in the context of the model viewed as a marginal, short run piece of a larger, more realistic economy.
First, at a pure level, the idea that the model might theoretically go on ad infinitum as an extrapolation isn’t in itself a denial of the existence of profits or the ability to borrow against them. The idea of indefinite debt growth is as equally likely or unlikely as the idea of indefinite retained earnings growth, given the fact of matched income flows of interest paid and equity accrual in the model. It is this matching of income flows that qualifies stock held by households as good collateral for debt as it grows over time. The premise is quite feasible at the theoretical level.
Second, the indefinite extrapolation of the 2 day model is an unlikely scenario, not because it is not mathematically possible, but because the combined constraints of the model for specific reasons are an unlikely representation of a real economy in total, and over time. The model depicts finance adjustments in a highly constrained situation. This situation is more reasonably and realistically interpreted as a short term subset of broader activity in a realistic economy – activity that includes investment especially, which has a major impact on the context for profit. The unlikely nature of such concentrated household debt growth has to do more with the restrictive scope and constraints of the model than with the mathematics of the extrapolation.
It is the combination of no investment and no dividends that complicates the issue of profit resolution in the context of concentrated household debt growth. When one widens the scope and lengthens the horizon of the economic activity, it makes little sense to impose this particular concentration of combined constraints. The model was deliberately limited to the no investment scope, with a no dividend option, under a 2 day time horizon to illustrate double entry accounting under onerous finance conditions. With that starting point, it’s easy to relax those constraints more realistically and observe the natural relief it provides to the household debt concentration exhibited in the 2 day model.
With the introduction of investment, the business sector in total purchases its own output of investment goods. When investment falls closer in line with the chosen policy for retained earnings, the question of profit viability resolves without the issue of such concentrated household debt. The accounting entries are a fairly simple transformation of the constrained case already illustrated. It should be obvious that as investment increases toward the level of retained earnings, there is less by way of complication due to the absence of the dividend or the need for households to borrow against their stock in order to purchase the economic output. That purchasing function is now split between business and households. If investment equals retained earnings, the consolidated household sector doesn’t have to borrow at all.
Moreover, it makes little sense to assume that even a 2 day model economy with no investment and no dividends would function indefinitely without adjustment in the dividend policy. A theoretical model that includes no investment and no dividends depends on the assumption of economic behaviour that if carried on without change could only be construed as pathological. If there is no investment as a permanent structural assumption, it becomes dysfunctional for the business sector not to distribute dividends. When the business sector is producing only consumer goods by assumption, it is only rational that it distribute dividends so that is shareholders can buy the entire GDP output without being forced by nonsensical dividend policy to borrow from the bank against the value of their stock. Business with no investment has absolutely no good use for retained earnings. Such pathological hoarding deliberately puts the household sector in an artificial financial straight jacket, in terms of its arrangements for purchasing the economic output that is intended exclusively to meet household consumption needs. Since the shareholders are also consumers, this pathology is nonsensical. This point of policy is further to the observation that even such an irrational policy structure is mathematically sustainable, as noted, as interest income flows create the equity value that is required as collateral to sustain the borrowing. It is the restrictive dividend policy in the context of an investment free model that forces the household sector to borrow in order to buy the output. Even under these conditions the business sector continues to generate profit, despite the fact that the resulting household debt concentration is the result of irrational dividend policy. And dividend policy is likely to change due to the blatant irrationality of the existing policy under the assumption of no investment.
In summary, it is both the unrealistic nature of an economy without investment and the compounding dysfunction of such an economy without dividends that suggests the simplified model as illustrated is best interpreted as a marginal, albeit mathematically feasible, piece of the total puzzle. The simple 2 day model illustrates the nature of the double entry accounting that allows profit capacity, starting with the most onerous set of structural, policy, and financing assumptions.
Very eloquent and detailed, as usual, thanks. I can sort of reconstruct, without explicitly understanding of the maths involved, how the addition of complexity would generate more stability than the simple model suggests. I suppose the time lagged superposition of a large number of such models creates a de facto buffer that ‘solves’ the conundrum of profits without violating DEB or the necessity of buying all output. I’m working at wrapping my head around it more thoroughly :-).