Monthly Archives: March 2014

The Phrase Money Multiplier Itself Is Inaccurate And Misleading

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Some people point out that the critique “there is no money multiplier” is wrong because it is a ratio whatever said. No! The phrase “money multiplier” itself is wrong because the phrase itself captures a wrong causal story. A phrase is a small group of words standing together as a conceptual unit and hence the phrase “money multiplier” is inaccurate and misleading.

So take the textbook Keynesian multiplier first. It suggests that a rise in government expenditure leads to a rise in output more than the increase in the expenditure. The ratio of rise in output to the rise in expenditure is the multiplier.

But this is not the case with the “money multiplier”. There is no direction of causality from a rise in bank settlement balances to the rise in the money stock. This is true even if the central bank is doing QE/LSAP, i.e., purchasing assets on a large scale. So if the central bank purchases government bonds in the open market, it leads to a rise in banks’ settlement balances at the central bank and also a rise in the money stock. But the rise in the settlement balances could not have been said to have caused the rise in broad monetary aggregates such as M1, M2 etc. It is the act of the central bank purchase which leads to a rise in the stock of both narrow and broad monetary aggregates.

Now to the case of no QE.

Same story: the rise in banks’ settlement balances could not have been said to have caused a rise in broad monetary aggregates. The more appropriate phrase is “credit divisor”. Here’s Marc Lavoie from his 1984 paper The Endogenous Flow Of Credit And The Post Keynesian Theory Of Money

The Credit “Divisor”

To sum up the monetarist point of view, which, for causality purposes, is similar to the view endorsed by the great majority of economists, one can use equation (2):

M = m B          (2)

where m is the monetary multiplier, and where causality is read from right to left, B being the independent variable while M is the dependent one.

On the other hand, the post Keynesian view can be summarized by equation (3):

B = (1/m) M          (3)

where 1/m is the so-called credit divisor; B is the dependent variable and M is the independent variable. As a matter of fact, this equation cannot be found explicitly in any of the post Keynesian writings, but it is clear that such a relationship is implied by a large segment of the post Keynesian literature.

The choice between the multiplier and the divisor is a function of the opinions one has about general equilibrium. If one believes that money appears as the result of production processes, that is, as a consequence of the flow of credit created for entrepreneurs by commercial banks, then the multiplier is unacceptable since money becomes a sort of residue, which is incompatible with general equilibrium theorizing. Furthermore, central banks are generally engaged in “defensive” operations, that is, they act according to equation (3).

Another paper of Marc Lavoie informs us that the phrase credit divisor was first used by Louis Levy-Garboua and Vivien Levy-Garboua in a paper in 1972.

Thomas Palley’s Nice Critique Of Steve Keen’s Models

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Thomas Palley has a new paper Effective Demand, Endogenous Money, And Debt: A Keynesian Critique Of Keen And An Alternative Theoretical Framework, which can be found on his blog.

In the abstract, among other things, Palley points out that Steve Keen’s treatment of endogenous money “falls into the theoretical morass regarding the black box of velocity of money via its adoption of a form of Fisher equation to determine AD.”

The part I found most interesting was that Keen’s new equation suggests that “changes in income are … driven exclusively by borrowing and loan repayment” and Palley illustrates the inaccuracy by considering cases where expenditure can be changed without borrowing:

The assumption that only borrowing and loan repayment can change AD is implausible. Households and firms can change their propensities to spend without borrowing or repaying loans. A central insight of Keynesian economics concerns the role of money which can act as a sink for purchasing power. Spending can be reduced by adding to idle balances, and it can be increased by activating existing idle balances. In the US, firms currently hold massive cash hoards. Those hoards can be activated to finance investment spending that increases AD. Export levels can change, and households and firms may also change the composition of their spending between domestic output and imports. Changes in the distribution of income, at both the functional and personal levels, can affect AD because of different propensities to spend out of income among agents. All of these changes can be accomplished independently of new borrowing or debt repayment. Moreover, borrowing in prior periods creates debt service transfers from debtors to creditors and these transfers will affect the pattern of leakages to the extent debtors and creditors have different propensities to save. Given all of that, there is no reason why this period’s aggregate demand should equal last period’s income or last period’s aggregate demand.

The paper is available in pdf at Thomas Palley’s blog post.

Nicholas Kaldor On Rational Expectations

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I was recently re-reading an article by Nicholas Kaldor and J. Trevithick [1] and I came across this fine description of rational expectations:

The main plank of the monetarist school has hitherto been that inflation is invariably ‘demand induced’: it can result only from an excessive demand for goods which, however, can manifest itself in the prevalence of excess demand in the labour market [footnote i]. In either case, any consequential increase in output or any fall in unemployment below its natural rate can occur only temporarily.

This latter view, which was shared until recently by the great majority of monetarist economists, is now contradicted by a more radical group of monetarists who developed the notion of ‘rational expectations’ and applied it to the study of inflationary processes. Their position is an extension of the argument that the increase in employment induced by monetary and fiscal policy is the result of some form of ‘cheating’ since workers had expected higher real wages than they actually received, whereas employers had expected to pay a lower real wage than they ultimately had to pay.

It is now claimed by this group of American monetarists that the above theory assumes that expectations are formed on an irrational basis, whereas it is in the interests of all economic agents to form a ‘correct model’ of how the economy functions. The proper cognition of the economy enables rational expectations to be formed which will prevent all but ‘surprise’ departures from an equilibrium path and will, therefore, render nugatory any attempt to reduce unemployment below its ‘natural’ level even in the short run. The centrepiece of this argument is that both workers and employers realise that the quantity theory of money is correct and that wages and prices must rise in the same proportion as the money supply. As a result, it is argued that increased expenditure will cause increases in wages and prices directly without affecting real variables such as output, employment or the real wage rate. They contend that they will base their expectations not on a projection of past trends in the price level or one of its time derivatives (such a procedure would usually be ‘irrational’) but on the ‘correct’ understanding of the economy which takes changing trends into account. Although the mechanism through which prices and wages rise is unclear, this school by-passes the traditional mechanism by which they rise under the pull of excess demand only. The corollary of this hypothesis is that inflation can be reduced far more painlessly than was thought by early monetarists, for, provided that the government can convince the public that it has a firm intention to get the money supply under control, the price level and the level of money wages will respond with only a very short lag: it does not require appreciable restriction of demand in real terms or any abnormal fall in employment even for a temporary period. [footnote ii]

This rational expectations theory goes beyond the untestable basic axioms of the theory of value, such as the utility-maximising rational man whose existence can be confirmed only by individual introspection. The assumption of rational expectations which presupposes the correct understanding of the workings of the economy by all economic agents—the trade unionists, the ordinary employer, or even the ordinary housewife—to a degree which is beyond the grasp of professional economists is not science, nor even moral philosophy, but at best a branch of metaphysics.

[emphasis added]

[footnote i: Harry G. Johnson, ‘What is Right with Monetarism’, Lloyds Bank Review, April 1976]

[footnote ii: It is well known that in the last five years, many Western countries have experienced the phenomenon of rising unemployment coupled with accelerating inflation. This appears to undermine the validity of the traditional natural rate hypothesis and, a fortiori, the rational expectations version. Professor Friedman (‘Inflation and Unemployment’, Institute of Economic Affairs, 1977), has acknowledged this divergence between monetarist theory and empirical observation, but he is hard-pressed to explain it.]

In this recent video, Marc Lavoie (at 28:00) quotes Philip Mirowski saying the same thing:

… orthodox macroeconomists came to conflate ‘being rational’ with thinking like an orthodox economist. What this implied was that agents knew the one and only ‘true model’ of the economy (which conveniently was stipulated as identical with neoclassical microeconomics) …

[1] Kaldor N. and Trevithick J. 1981. A Keynesian Perspective On Money, Lloyd’s Bank Review. (reprinted in Collected Economic Essays, Vol. 9)

Paradox Of Profits?, Part 2

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In the previous post Paradox of Profits?, I mentioned how I view the paradox of profits as the confusion between production firms’ operating surplus (as defined in the SNA such as the 2008 SNA or earlier versions) and surplus on the financial account of the system of national accounts.

The paradox is highlighted by saying that at the beginning of the monetary ‘circuit’, firms inject an amount of money M and can only recover a maximum of M.

So let us think of an economy in which there is no money or banks initially and suddenly someone producers find a way to make cakes and the banking system opens simultaneously. This is admittedly an oversimplification but nonetheless useful.

Initially firms decide to make 100 cakes and price it $1 per cake. They hire labour and pay $60 as wages. For this, they borrow $60 from banks. Households is a mix of both labour and entrepreneurs.

Now households consume cakes worth $55.

Before proceeding, it is important to note that inventories will be valued at current costs. So even though firms have initially paid households $60 and recovered $55, they have still made a profit of $22. This is because 55 cakes were sold and cost $55 × 0.6 = $33.

So:

Profits = $22

I am neglecting the interest costs on loans but this is minor in comparison to the income generated by production so as to matter crucially.

That profits are $22 can be seen from the profits formula of the previous post:

Ff  = C + ΔIN − WB − rlL

Having sold 55 units of cakes, firms have 45 units left in their inventory. But since inventories are valued at current costs, the multiplicative factor here is 0.6, so ΔIN  = $27. So,

$22 ≈ $55 + $27 − $60 − ε

After having paid their employees, firms started out with no bank balance but soon have $55 in bank deposits. They then pay back $33 of loans, leaving them with $22 of bank deposits. At this stage household hold $5 of deposits: they received $60 and consumed $55.

So total bank deposits is $27. This is equal to the value of inventories. This is also equal to the initial loan of $60 minus the repayment of $33. So firms’ inventories are backing the loan amount.

Firms are now in a situation to distribute dividends. It is clear that they don’t have trouble paying interest to banks. (In this example but not always the case).

Another production cycle starts. Dividends will buy more cakes and make more profits for firms. Fixed capital formation can also be added in the story without any problem.

Paradox Of Profits?

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Post-Keynesians unnecessarily worry a lot about the paradox of profits. This post is on my thoughts on the paradox. In my view, there is no paradox at all. It is simply the case of not looking at all the parts of the system of national accounts/flow of funds.

Although Post-Keynesians use Kalecki’s profit equation in which the government deficit adds to profits, the statement of the paradox is for a pure credit economy. But in any case, there is none.

Let us assume that at the beginning of the ‘circuit’, production firms need an initial loan to pay the wage bill WB in advance. Households receive the wages and consume C and allocate their saving in financial assets (households don’t buy houses). The two financial assets are money and equities so:

WB − C = ΔM + ΔE

Production firms’ profits Ff  is:

Ff  = C + I – WB − rlL

Here, I is the gross fixed capital formation of production firms or investment, L is the outstanding loan of firms from the banking system and rl is the rate of interest on these loans.

Now assume all investment is financed by issuing equities (i.e., ΔE = I). With a small amount of algebra:

Ff  = − ΔM  − rlL

So this is the “paradox”.

Now there are several things wrong with this. The simplest is that profits are actually paid to households and there’s a term for change in inventories missing in the right hand side. If profits are not paid, they are retained and investment is then financed by both issuing equities and retained earnings. So ΔE ≠ I. 

There is an alternative way of stating the “paradox” which says: if firms inject money at the start of the production process, how do they recover more money at the end of the process? This seems to confuse what is known as operating surplus in the system of national accounts (such as in the 2008 SNA or earlier versions) with the surplus on the financial account.

So let us redo this. Here is the transactions flow matrix for the economy (assuming away banks’ undistributed profits):

Paradox Of Profits - Transactions Flow Matrix

First assume all profits are distributed (i.e., FUf = 0 and FDf = Ff).

So:

 WB + rmM + Ff  + Fb − C = ΔM + ΔE

Ff  = C + I + ΔIN − WB − rlL

Then assuming ΔE = I and a bit of algebra,

ΔIN = ΔM

In other words, there is no paradox at all. Ff  has simply dropped out. All this means is that if households wish to hold more of their assets in deposits instead of equities, firms will be left with more inventories.

Of course, you might ask, “how have you assumed that profits are distributed when there is a paradox?”. The answer is that I haven’t done anything self-inconsistent. More consistency checks would be via constructing a dynamic model and check if it solves but assuming it does, the above static analysis is good enough. There is no paradox to begin with.

So in the above, although there was no paradox of profits, there was still a pressure on output and hence profits—if households wished to hold more of their wealth in deposits and reduce their preference to buy equities, firms will be left with more inventories and will have to reduce investment. This reduction in investment happens because of two reasons – a fall in equity prices and a fall in output leading to a fall in firms’ expectations of sales. Of course, this can be seen via writing dynamic models, and one shouldn’t rely on identities. But bank loans will be useful here and so higher preference for ‘money’ needn’t necessarily lead to a fall in output. If households wish to hold more money instead of other assets, firms may switch to bank loans and this process creates deposits.

But let’s for the moment still assume that investment is not financed via bank loans but via issuance of equities and retained earning. In this case,

WB + rmM + FDf  + Fb − C = ΔM + ΔE

Ff  = C + I + ΔIN − WB − rlL

but also,

ΔE = I − FUf 

and with some algebra,

ΔIN = ΔM

Again, no paradox. At all!

Now in the final case, assume that production firms use bank loans to finance investment in addition to financing it via equities. The equations are:

WB + rmM + FDf  + Fb − C = ΔM + ΔE

Ff  = C + I + ΔIN − WB − rlL

ΔE = I − ζΔL − FUf 

where 0 < ζ < 1 is that part of ΔL used for investment expenditure. In this case,

ΔIN + ζΔL = ΔM

So if households wish to hold more deposits, firms will switch to bank loans without any drop in inventories, output or expectations, with the qualification of course that bank credit is available.

Some have suggested (via Kalecki’s profit equation) that the paradox can be resolved only because of government deficits. This is not needed at all because there is no paradox. So around the turn of the millennium, the US government had its budget balance in surplus and the nation’s current account balance of international payments was in deficit over many quarters. Yet US firms made profits and were able to distribute them.

See the data below: the first one highlights in yellow the current account balance (line 42) and the budget balance (line 49) and also the fact that the financial balances of other sectors (lines 47/48) were low negative compared to profits numbers in question (source Z.1):

Flow of Funds, Table F.8

 (click to expand and click again)

the second one shows the net undistributed profits (undistributed profits less depreciation) (line 24), distributed profits (line 17) and depreciation (line 2) from which profits can be calculated, implying budget deficit and/or positive current account balance of payments is not needed to resolve the paradox of profits (because there is none to begin with).

Flow of Funds, Table S.5.a

 (click to expand and click again)

Of course, fiscal policy was tight around the time (although the budget balance is a poor measure of this) and this led to a fall in output soon, but that issue shouldn’t be confused with the paradox of profits.

Conclusion

One does not simply confuse operating surplus and surplus on the financial account of the system of national accounts. There is no resolution of the paradox of profits because there is none to begin with.

Reconciliation Of The Supply And Demand For Money

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What brings the supply and demand for money into equivalence?

It is interesting that the recent Bank of England quarterly bulletin referred to an article of Peter Howells, a Post-Keynesian (also available here), although I don’t think the authors appreciate why the paper is interesting.

The title of my blog post is flicked from a paper by Basil Moore which is in reply to Howells.

Howells sets up the problem:

[B]anks set up their collateral standard and lending rates … and then meet all loan requests forthcoming. The demand for loans is determined by other variables in the economic system … making the loan volume exogenous from the banks’ point of view and the resulting quantity of deposits endogenous … Notice, crucially that in this view, increases in the money supply are demand-determined but the demand in question is the demand for loans … the question then is what reconciles the demand resulting from this lending with peoples’ willingness to hold money? … What is it that ensures that the supply of new deposits created by the flow of net new lending is just equal to the quantity demanded?

Let me present it in another way. To be clear let us assume the economy is closed. Output is determined by domestic demand or by private expenditure and government expenditure. Output is equal to the national income and is distributed to various economic units such as households who among other things allocate a part of their wealth into deposits. So there is a money demand. Of course expenditure is partly from income and sale of existing assets and by borrowing from other economic units and in particular from banks which lend by creating deposits in this process. So there is a change in the money supply. So there are two pictures with overlapping stories but not exactly so the question is – what processes ensure that

Ms = Md

is valid at every instant of time?

Does the rise in income and higher demand for money (because of a rise in wealth) alone ensure this? Is there a price clearance? Prices of what? Goods and services? Or prices in financial markets? (‘price’ includes interest rates such as deposit rates, loan rates, bond yields, equity prices and so on).

Also note this is in nominal variables. So is the rise in income purely due to a rise in prices or purely a rise in real output or a mix of the two? What causes inflation?

Where does QE fit into this? Does it raise output? Real/nominal? Raise prices – of goods and services or asset prices or both?

It is important to appreciate the formulation of the question. In case you don’t yet appreciate the question, more from Howells:

The starting point is that the demand for the loans that create the deposits originates in the desire of deficit units to spend in exceess of income. It is a question of financing an income-expenditure discrepancy. Furthermore, it is a decision made by a subset of the community since not everyone is involved in demanding an increase in their indebtedness to banks. (Indeed it is not even the case that everyone holds a stock of bank debt…). By contrast, the decision to hold (i.e., not spend) the newly created deposits is a portfolio decision. Furthermore, it is a decision made by different people (“the community as a whole”) from those concerned with borrowing it… the fact remains that so long as we are dealing with two groups of agents, with different motives, an ex ante coincidence of preferences is quite implausible. The question, then, is how are these ex ante preferences to be reconciled, ex post.

Back to Moore’s paper. Moore summarizes possible solutions suggested by Howells:

… Howells considers four responses that have been proposed to his conundrum:

  1. Kaldor and Trevithic[k] – any excess money is automatically extinguished as a result of the repayment of bank debt.
  2. Chick – the income multiplier process will automatically increase the demand for active balances.
  3. Laidler – the buffer stock demand for money is a demand “on average” over a period of time, rather than a demand for a fixed stock at a moment of time.
  4. Moore – “convenience lending,” the rejection of an independent money demand curve, rooted in a “full-blooded rejection of the idea of equilibrium”: In a non-ergodic world, no meaning can be attached to the notion of a unique general equilibrium stock of  money demanded.

Howells maintains that the above list offers “promising solutions” to the mechanism that reconciles net new lending to borrowers with the change in the demand for money for the wealth holders. But he concludes that “each … on its own is almost insufficient” for the “reconciliation. As a result, he proposes that variations in relative interest rates, “which can and do occur continuously, provide the key to the fine-tuning required by the balance-sheet identity” …

Frequently in such discussions the accommodative behaviour of the banking system is forgotten. So there is another mechanism as highlighted by Nicholas Kaldor in his book The Scourge Of Monetarism (Oxford University Press, 1982):

As it is, a highly developed banking system already provides such facilities on an ample scale, since it is prepared to accommodate the public’s changing demand between different types or financial assets by altering the composition of the banks’ assets or liabilities in a reverse direction. If the non-banking public wishes to switch its holding of gilts for interest-bearing bank deposits, the banks are ready to supply such deposits at the minimum of inconvenience, and at the same time to place their surplus funds into the gilts which were previously held by the public. Similarly the banks provide easy facilities to their customers for switching balances on current accounts into interest-bearing deposit accounts, or vice versa.

In general banks not only hold government bonds but also other kinds of securities such as mortgage-backed securities, agency debt and so on. In olden days, there was no securitization and banks would hold more government bonds which got substituted. (See the Fed’s H.8 weekly release for data on banks’ assets) [There’s a Geithner ppt which mentions this in one slide, anyone has a link?]

This point is an important one because here the reconciliation happens via changes in quantities. Remember it is not just loans which create deposits but also banks buying bonds from the non-banking system which create deposits.

The answers to these questions can be found systematically by using James Tobin’s asset allocation theory.

Let me mention some positions. At one end are Monetarists for whom the direction of causality is from money to other things. So there may be an excess of money and if so leads to higher expenditure and a hot potato process in which money supply and demand are brought into equivalence by rise in prices of goods and services. It can also lead to a rise in real output but the Monetarists emphasize the price aspect more. In addition they also distinguish between government expenditure and private expenditure and try to point out that the latter is more efficient and so on.

Looking at an economy as a moving picture, as expenditures increase, output rises and there is a rise in prices of goods and services and a rise in the stock of money. Monetarists look at coincident events and assign some strange causalities.

Moving beyond Monetarism, there’s also a view that the reconciliation of the supply and demand for money necessarily happens via a rise in interest rates on everything including bank loans leading to a crisis. Of course that it not true because beyond a point banks will reduce lending instead of offering loans at higher interest rates. Banks have their own animal spirits but this is via tightening credit standards, quality of collateral etc. Also this is not the only outcome because the process of lending and borrowing increases output and income and can stabilize debt ratios. Nonetheless, debts can move into unsustainable territories and financial crisis do happen, and when it happens, there’s a high demand for money and the reconciliation may happen via bankruptcies of firms and the central bank may need to accommodate the rise in demand for money by lending at a large scale since bankruptcies threaten a fall in output.

Of course there are many more mechanisms for the reconciliation which I have avoided. It may happen that due to changes in portfolio preferences, there is a stock market boom and firms will go IPO instead of borrowing from the banking system. So we have economic units who wish to hold less money and more equities and firms borrowing less from the banking system leading to a reconciliation. (A more careful analysis is needed because firms have deposits after having raised funds through an IPO).

Now consider convenience lending. There is of course some truth to it. If you receive you salary on a Friday evening, you are not rushing to allocate newly held deposits into the stock market because it is already closed (unless you have an international brokerage account). So you are holding the deposits non-volitionally. However, subscribing to convenience lending alone is a bit extreme. 

Now to QE/LSAP. When the central bank purchases financial assets such as government bonds from the markets, it creates bank settlement balances and deposits in the process. Wealth holders will then purchase other assets and the reconciliation happens via changes in prices of financial assets.

This post is far from any complete analysis of the interesting questions but hopefully I have got readers interested in something. The question on reconciliation asks what reconciliates the demand and supply of money – income, prices (of goods and services or prices in financial markets), quantities and so on.  Also, some seem to think that “price clearing” has to do with some notions about an equilibrium. I don’t think these two are the same things. One can have price changes and clearances without appealing to the notion of any “equilibrium”.

Money Stock Determination

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The recent Bank of England quarterly bulletin has interested blogosphere into what goes on to determine the stock of money.

Money can mean various things and here I restrict to the the monetary aggregates as defined by central banks – as in the referred publication. But whoever is interested in “money creation” also becomes interested in the creation of assets and liabilities, so the right question is more general.

As I had pointed out in my previous post, the Bank of England articles seriously ignore the role of fiscal policy. Winterspeak also mentions this.

So what is the answer? In my view the most systematic way of saying this via Tobin’s theory asset allocation, improved drastically by stock-flow consistent models of Godley and Lavoie.

Also there are two things – influence and determination. For example, something can have an influence on the stock of money but may not determine it.

Since economies are highly dynamic it is not easy to answer this in a single sentence but it can perhaps be said that fiscal policy, private expenditure and QE influence the stock of money but it is ultimately determined by the holders of wealth.

Of course since people generally have a Monetarist intuition, the right notion that fiscal policy, private expenditure and QE influencing the determination of the stock of money is incorrectly taken by people to mean that QE has the same effect as a fiscal expansion. Which of course QE does not.

First take private expenditure. Since we know that “loans create deposits” it can be suspected that bank credit has an influence on money. Of course this process is more dynamic as the expenditure has its own multiplier effect (not to be confused with the money mulplier!) on output and income. But bank credit determining the stock of money is stretching too much. For example, while a bank makes a house loan and creates deposits in the process, the process of securitization reduces the stock of money as ultimate buyers of the securized products exchange money with the mortgage-backed securities (MBS). And of course there’s the reflux mechanism via which economic units may reduce their debts toward the banking system.

Now take fiscal policy.  Like private expenditure, government expenditure and taxes also influence the level of aggregate demand. This has an influential effect on credit creation via effect of increased output and income on private expenditure and via the process highlighted in the previous paragraph this has an influence on the determination of the stock of money.

Also, while economic units are earning and making decisions on spending, they are also accumulating financial and non-financial assets. So they have a preference on how much of their wealth they allocate into each asset. A Monetarist would talk of an excess supply of money and this raising prices of goods and services and bringing the demand and supply of money into equivalence. But there is no need for this from an endogenous money perspective. One can have the equivalence brought about by adjustments of prices of financial assets and also adjustment of quantities of assets and liabilities held by various economic units such as banks. This is where the importance of the work of Tobin’s theory of asset allocation comes in.

Now let’s discuss QE. Large scale purchases of financial assets by the central bank – although influences the stock of money, doesn’t determine it. Also QE doesn’t have a direct influence on aggregate demand like private or public expenditure. It has indirect effects via raising prices of financial assets (which can be described by Tobin’s theory of asset allocation) and inducing capital gains and a wealth effect on consumption. The Monetarist intuition highly exaggerates the effect.

The point of my writing the post was to show that fiscal policy has a strong effect on influencing the stock of money. This happens via the strong effect of fiscal policy on output and income inducing private expenditure. Of course private expenditure needn’t be only induced and has an autonomous nature as well, so both fiscal policy and private expenditure have an effect. The effect is via a rise in output and income and this leading to a rise in wealth and economic units allocating a fraction of their increased wealth into ‘money’ (as in currency notes and deposits).

So Winterspeak is right in pointing out the incorrect statement of the Bank of England paper:

The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates.

The above quote is suggestive of a very strong influence of interest rates on private expenditure, ignores the autonomous nature of private expenditure and the role of fiscal policy.

Nick Rowe defends textbook economics over his blog and suggests some influence of QE on prices via the Monetarist hot potato process where there is an excess supply of money and via a non-equilibrium process leads to a rise in prices of good and services! But in this he mixes asset allocation decisions with expenditure decisions, as if the two can be treated as the same. In the market for goods and services, producers set the price based on costs and their markups. So it is hard to see the influence. The supplies and demands of assets are actually brought into equivalence in the financial markets rather than the market for goods and services. He may have a point but the degree to which this has an effect is low. So holders of wealth may allocate some of their portfolio into commodity funds (after having sold their bonds to the central bank) which may buy commodities in exchanges and expectations due to a price rise and speculation and myths may cause a price rise but this is quite different from his suggested dynamics. Or it may have an effect via a depreciation of the currency and change in the consumer price index due to a change in prices of foreign goods.  The question then is to what extent do what economists stress are important are actually important. 

Needless to say, the usual story from money to other things is misleading. The point however is that “how money is created” is a good starting point to understand macroeconomics.

Evan Soltas Is The Future Greg Mankiw

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A recent post of Paul Krugman points out to a “worrisome campaign against full employment”:

Paul Krugman Recent Posts

The leader of this movement is an economics student named Evan Soltas, although Krugman doesn’t name him, maybe because Soltas is just a student.

If you go over to Soltas’ blog, you will find the vaguest interpretations of data claiming the labour market has become “tight” and that “it’s about time” the Federal Reserve raises interest rates. One of his replies to Dean Baker also brings in some vague statement about the Federal funds futures markets!

I won’t go into an analysis of how completely vague Soltas’ campaign is because Krugman has already done a nice analysis. But in case you weren’t following, let me also point out his Bloomberg article where he tells a story of how labour unions have died in the United States, making it look like such a thing was natural. This is poor rewriting of history because via policy, power has been slowly sucked out of unions.

Soltas also features in Mankiw’s latest book, where Mankiw quotes his argument that there is something wrong about universities having a differential fee structure.

Back to labour market versus policy. Such strong claims disadvantage the opponents who are trying to convince policy makers to expand fiscal policy. It makes a good strategy: shift the debate into something else – monetary policy in this case – and divert attention from fiscal policy even more.

Evan Soltas will be the future Greg Mankiw.

Bank Of England On Money Creation

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In the natural sciences, controversies are settled in a few months, or at a time of crisis, in a year or two, but in the social so-called sciences, absurd misunderstandings can continue for sixty or a hundred years without being cleared up.

– Joan Robinson, 1981 (1979), What Are The Questions And Other Essays – Further Contributions To Modern Economics, M.E. Sharpe

The latest Bank of England Quarterly Bulletin (2014 Q1) will be released on the 14th. It has pre-released two articles which go into money creation and the myths associated with it. 

The report is here. The second article Money creation in the modern economy may interest you more but the first is also readable.

Interestingly, the second pape refers to Post-Keynesians : Tom Palley’s 1996 book , Basil Moore’s 1988 book, a JPKE paper by Peter Howells and a 1981 paper by Nicholas Kaldor and J. Trevithick which discusses the reflux mechanism (reprinted in Kaldor’s Collected Economic Essays, Vol. 9). It also refers to James Tobin’s 1963 paper Commercial Banks As Creators Of “Money”. 

One negative is the omission of fiscal policy from the discussion altogether and emphasising monetary policy. This underplay of fiscal policy and overemphasis of monetary policy is one deep bias of the profession. The paper also has a slightly different emphasis on what determines the quantity of lending than emphasized by Post-Keynesians but I won’t go into it now. Still the page is worth a look. 

Massive Overstatement Of Profits?

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In an article, The Profits’ Conundrum, Marshall Auerback uses Kalecki’s profit equation analysis (which is just a simple rearrangement of terms of the sectoral balances equation) to claim that corporate profits have been overstated in the United States.

Now consider the US deficit and explain how on earth we can still have profits as a record percentage of GDP.  There is no way that we can have had a fall in the fiscal deficit to GDP ratio from ten percent to three percent (we are in the middle of fiscal yr 2014 remember) without some kind of significant decline in the profit share of GDP.

But NIPA says there is no such fall.   All the people who use this sectoral balance analysis keep saying that the profit decline is coming which of course is nonsense.  If it is to be it is here and now; we are dealing with an identity.  This cannot be ignored, but it is by virtually every single Wall Street analyst.

This does pose the real possibility that we have a massive overstatement of profits.

While it is possible this is the case, I don’t see how this follows from the usage of Kalecki’s profit equation or the sectoral balances equation without any dynamical analysis thrown in.

While the government deficit has fallen, the household sector saving has fallen too and there has been a big rise in firms’ investment expenditure in recent times. So let us look at the data but before that derive the profit equation.

From sectoral balances we know that net lending (in the language of the U.S. Z.1 Flow of Funds report) of all sectors should add to zero.

Firms’ undistributed profits FU is the sector’s saving. So firms’ net lending is:

FU − If

where If is firms’ investment expenditure.

This should be the sum of net borrowing of all the other sectors – households, government and the rest of the world: Household net borrowing + Government net borrowing + Rest of the World net borrowing

Or, in the more usual language,

FU = If  + Government deficit − Household Net Lending + CAB

where CAB is the current account balance of international payments.

Each term is a flow and has a time subscript such as −1 or 0 or 1 but I will avoid it. Now let’s compare 2013 and 2009.

We need the numbers highlighted in yellow to check what’s going on from the Fed’s Z.1 report:

Table F.8, Z.1 Q4 2013 Highlighting Corrected

(click to expand and see clearly)

Government deficit is the negative of net lending and between 2009 and 2013 this has reduced by $776.5bn. However, private investment has increased by $704.4bn and household net lending fell by $216.2bn. The change in current account balance over the period is small (line 42). So the rise in private investment and the fall in household net lending (and change in the current account balance) more than offsets the fall in the government deficit.

Also remember, reported profits is the sum of undistributed profits and distributed income of corporations. Table S.1.a has data only till 2012 but it shouldn’t be difficult to get a feel for the numbers.

Table S.1.a, Z.1 Q4 2013

(click to expand)

So the change in distributed income also has been high.

And add complications of taxes to the numbers (pre-tax vs. post-tax), the difference in profits in the last few years is even higher.

Why this exercise if you can get the profits numbers directly? To show that things do add up except for small discrepancies which are always present.

So pure rearrangements of terms of sectoral balance identity doesn’t prove the overstatement of profits as claimed by Auerback. Of course it still leaves the possibility of dynamics which lead to a contraction of aggregate demand and hence profits but Auerback’s claim is that this is purely due to accounting identities and this claim is erroneous.