How Money Works

by Stubborn Mule on 11 December 2009 · 31 comments

Notes of the WorldOver the last couple of years as the global financial crisis unfolded, a subject I have spent a lot of time thinking about is the nature of money. I have been planning a blog post on the topic and the time has finally come.

The catalyst for finally writing this post was attending last week’s 16th national conference on unemployment at the University of Newcastle, hosted by the Centre of Full Employment and Equity (CofFEE). I found myself there because the centre’s director, Professor Bill Mitchell, is the author of billy blog, which I read regularly. Bill’s research and advocacy in the area of unemployment and underemployment is firmly rooted in a detailed understanding of how money works in a modern economy (hence the appeal for me) and the implications these mechanics have for government spending policy. This theme also underpinned many of the talks at the conference and the program included a panel discussion on the subject of “Modern Monetary Theory”. The panel comprised Bill Mitchell, Randy Wray and Warren Mosler, all strong advocates of what is sometimes referred to as “chartalism”. Along with another billy blog regular, Ramanan, I was invited to participate by providing a brief wrap-up at the end of the discussion.

But how hard can it really be to understand how money works? You earn it and you spend it or save it. Or, as the textbooks would have it, money serves as both a medium of exchange and a store of wealth. Is there anything more to say?

In fact there is. Most people and, indeed, many economists have not given very much thought to the mechanics of money and this leads to a number of misconceptions, all of which have made frequent appearances in the press and in political debate around the world over the course of the financial crisis. One example is the suggestion that the UK government could run out of money, an idea given further credence by the decision of rating agency Standard & Poor’s to put the UK’s rating on “negative outlook”. Even Barack Obama seems to be saying that the US is running out of money. The fact is, governments in many developed countries simply cannot run out of money. China could (but it is very unlikely) and so could member states of the European Monetary Union, but the US, UK, Japan and Australia could not. I will explain why here. In later posts I will continue the theme of the mechanics of money and will look at other misconceptions such as the idea that banks can “hoard” their reserves at central banks or that government deficits inexorably lead to high interest rates (the short answer to this one is: look at Japan).

In this post I will start with the basics of how money works and cover the following points:

  • how lending can “create” money
  • the limits to money creation
  • the difference between “fiat” money and money that is convertible on demand

A useful parallel to money in a real economy can be found in gaming chips in a casino. So, imagine a fairly standard sort of casino. You walk in, James Bond-style, hand over a thousand dollars to the cashier and get a pile of chips in return. The chips are marked with various denominations and total one thousand. This is an old-fashioned sort of casino: every game is played on a green felt table, there is not a poker machine in sight and, of course, you need your chips to play. To make your stay easy, you can also use your chips to buy drinks and snacks. When you have finished your evening’s play, you can redeem any chips you have not gambled away for cash.

There might be hundreds of thousands of dollars worth of chips circulating around the casino, but so far behind every chip is a corresponding amount of money sitting in the cashier’s safe. If we call this money the casino’s “reserves”, then the chip supply in circulation around the tables is equal to the casino’s dollar reserves. Of course, there might be a few cases of chips in the croupier’s office and even a chip-pressing machine in the basement, but these chips are not yet in circulation. They are just waiting to be handed over to the next patron who walks in the door with a full wallet. Under this regime, every gambler can be completely certain that they will be able to redeem their winnings at the end of the night.

While your thousand dollar stake might seem like a lot, there are a few high-rollers who frequent the place who like to play with much larger sums. Rather than producing chips with very high denominations, this casino has introduced convenient “smart chip cards”. High rollers can pay the cashier as much money as they like and the cashier will add it to the virtual chip balance on their smart cards. At every gaming table, the croupier has a card reader which can be used to debit the balance on the card in return for actual chips. This means that the total chip supply in circulation is the sum of actual chips and virtual chip balances on the smart cards. But still, this chip supply is matched by money in the cashier’s safe.

Now suppose you are a trusted regular at the casino and one night you turn up short of cash. No problem, the casino is happy to advance you your thousand dollars in return for a quickly scribbled IOU with your signature. Your credit is good. You take your $1,000-worth of chips and walk to the Blackjack table. But now something has changed. The total chip supply in the casino is $1,000 higher than the money in the cashier’s safe. In theory this could be a problem. You could immediately lose the $1,000 in chips and walk out. Then if everyone in the casino wanted to redeem their chips, there would not be enough money to go around. But, it isn’t likely to be a problem in practice. The casino operates 24 hours a day and so there are always far more than $1,000 in chips in circulation. On top of that, the house takes a decent cut on the tables, so it would not take very long for the casino to win back over $1,000-worth of chips and then $1,000 can be held back from the profits that the cashier regularly sends up to the manager’s office. In fact, the credit seems so safe, the casino decides to offer credit more widely. While they are at it, they introduce a few other innovations, like offering lucky door prizes in chips, which also adds to the supply of chips in circulation without a corresponding increase in money in the cashier’s safe.

These loans that the casino has introduced give it the ability to “create” an additional supply of chips. But not all lending creates new chips. If instead of borrowing from the house, you had offered your IOU to a high-rolling friend you would still get your $1,000 in chips for the evening, but you got them from your friend so the chip supply does not change.

The new lending arrangements are working well, but the system is limited by the fact that the cashier does not know all of the patrons very well, and is naturally being very cautious about who to lend chips to. To manage this bottleneck, the casino decides to allow senior croupiers to provide loans to gamblers they know well as long as they take responsibility for the credit-worthiness of the borrower. So now getting credit is simply a matter of providing an IOU to the senior croupier who knows you best and he or she will charge up your smart chip card. If you need actual chips, that is not a problem either as the senior croupier has a stash under the table borrowed from the cashier. Of course, the croupier is taking a bit of a risk providing you with this advance since the house expects him or her to make good any amounts you do not repay. So to make it worth their while, you give the croupier a few chips for their trouble each time you need an advance. This works so well that the cashier no longer offers loans directly to anyone other than the senior croupiers.

As successful as the new arrangements are, the casino does have to be very careful about putting strict limits on the number of chips that the senior croupiers can create through lending. Otherwise, the day may come when there are simply too many chips and not enough money in the safe and a successful gambler may walk up to the cashier to cash in their chips only to find that the cashier does not have enough money in the safe. Word will spread and everyone will want their money back, but the casino will be unable to oblige. It would be bankrupt. So while there may be no limit to the number of chips that the casino could physically manufacture (and of course it has complete control of smart chip card balances), there is a constraint on the number it can put into circulation. This constraint is a direct consequence of the fact that chips are redeemable for cash.

The analogy to the real economy should be clear here. The cashier operates like a central bank and government treasury combined. The senior croupiers are the banks. Chips are money and smart chip card balances correspond to bank account balances. In the same way that senior croupier lending effectively creates new chips, so bank lending adds to the money supply in an economy. But what is the analogy to the money in the cashier’s safe? While central banks around the world do maintain reserves of gold and foreign currencies (think of all the US dollars that the central bank of China has), for many countries the analogy breaks down in one important respect.

The casino made a commitment to redeem your chips for cash. Some central banks do make similar commitments. In the days of the gold standard, central banks in Australia, the US, the UK and elsewhere would exchange currency for gold. Of course there were times, as in war, when this convertibility was suspended, but in those days having something backing money was seen as just as important as having money backing chips in a casino. The gold standard system was abandoned after the second world war and instead, under the Bretton Woods system, domestic currencies could be exchanged at the central bank for a fixed number of US dollars. This system collapsed in turn in the 1970s. Today, some countries such as China do maintain currencies pegged to the US dollar (or some other currency) and so still make a commitment of convertibility. However, most countries have adopted so-called “fiat” money. The word fiat is Latin for “let it be” and fiat money does not derive its value from any form of backing. It is declared to be money, and so it is. Many people still assume that Australian dollars are in fact backed by something, but if you tried to take a $10 note to the Reserve Bank of Australia, you would be lucky to get two $5 notes in return. You could certainly not be assured of getting any particular amount of gold or US dollars.

Some people find the entire concept of fiat money deeply disturbing and pine for a return to the “real” money days of the gold standard. But fiat money is in fact an extremely powerful innovation. In the casino analogy, the cashier must always be careful about how many chips are put into circulation to avoid the crisis of being unable to convert chips back to cash. However, in a country with fiat money, the central bank makes no convertibility commitments, so this risk simply does not exist. It has monopoly power in the creation of currency. So, the government simply cannot run out of money. There may be very good reasons for a government to curb its spending. For example, it may not want to add too much to demand in the economy because it is concerned about inflation. But running out of money is not one of those reasons, whatever the president of the United States may think.

I will leave it there for now, as this post is long enough already. But, stay tuned for more on the macroeconomic implications of a modern fiat money system.

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{ 26 comments… read them below or add one }

1 Chris Gummer December 12, 2009 at 10:20 am

Thanks for the article mule – I think I was able to follow most of this. However, banks in Australia seem to commonly state that their cost of borrowing from the wholesale money markets has increased in order to justify interest rate rises. But if they can simply “create” money via lending why are they borrowing money themselves? Is it because their customers are demanding more money than their imposed creation limits can supply?

2 stubbornmule December 12, 2009 at 12:21 pm

Chris: Good question. Apart from a passing reference to paying the croupiers for providing loans, I did really address the issue of cost. It’s a good topic to pick up in a future post, but I’ll have a quick stab at it here.

While bank lending can effectively create money, they do not have the same monopoly power that the government has. In a way, each bank operates like the hypothetical casino. Balances at the bank are like chips at the casino, but they are convertible on demand either to physical currency or to deposits at another bank.

A good way to look at it is to think about what happens to the money created by a bank loan. Let’s say I get a personal loan of $1,000 from the bank. Initially they credit my transaction account with $1,000 and record my debt of $1,000 in my loan account. From the bank’s point of view they have a $1,000 asset (the loan) and a $1,000 liability (the deposit) but so far all they had to do was record numbers in accounts, with no need to borrow anything. The $1,000 in my deposit account is the newly created money. Now I spend the money. If I spend it at a shop that also banks with my bank, there is no problem: the bank just reduces my transaction account balance and increases the shop’s balance the corresponding amount. It is still all internal to the bank and no borrowing is required. But what if the shop banked elsewhere? My bank has to pay $1,000 to the shop’s bank and that requires more than shifting numbers around between accounts at my bank. Similarly, if I decide to take out $1,000 in physical cash, my bank needs to come up with the money just as the casino’s cashier does when a patron cashes in their chips. At this point, my bank may need to borrow, either directly from another bank or via the bond market or by enticing people to put their money on deposit with the bank. In the last resort, it can borrow from the central bank. Now all of these sources of money involve paying a rate of interest. Note that by paying interest on deposits to attract money, banks have ended up even paying interest on the money they “create”. As long as they charge a higher rate of interest on loans than they pay on these various sources of funds (both internal–deposits–and external), they can make a profit. Actually this difference has to be big enough to cover losses from loans that default too. Now all of the sources of money for banks have become more expensive and banks are trying to recoup the difference by increasing interest rates on loans. Whether they are overdoing it or not is, of course, another question. Westpac for one have certainly got themselves plenty of bad publicity by raising their rates so much more than other banks.

3 Chris Gummer December 12, 2009 at 2:58 pm

Great explanation – thanks!

4 Ramanan December 13, 2009 at 1:08 am

Good explanation Sean. People also think of money as a commodity and get into confusions. As Randy says money is an IOU and his advisor Hyman Minsky also said that anyone can create money – the trick is to get it accepted.

People also tend to think of the system as “fractional banking” and as you once pointed out in Billy Blog, you can confuse them by pointing out to countries which do not have a reserve requirement. Also, lot of headaches can be avoided by simple guaranteeing all bank deposits instead of having some upper limit and instead regulating the banks from taking higher risks for this.

5 Mark Ho December 13, 2009 at 2:40 am

Hi Sean,

THanks for the intro on Money.

I’m facinated by the topic. For me, I find it hard to reconcile the difference between money as I know it and money as the ‘big banks’ know it. I use it to trade for commodities like bread and water but to Forex traders, money is the commodity for speculation.

In the short space of time from which it enters my account to the time I dole it out for goods and service, its buying power is relatively static. In reality, its value fluctuates with the whims and fancies of the market.

For the middle class such as myself, with half an idea of money’s depreciable nature, our sole salvation seem to lie in some small value-retaining asset like a house (so long as the global economy keeps churning along and the bottom doesn’t fall out). People with less income are on the back foot as they are without the means to accumulate assets. Whereas the landed gentry with widely distributed risks ride the wave of speculation likened to the financial masters on Martin Place.

Please tell me how the simple man, who execute his work to the best of ability, earning a living through toil and satisfaction, can be paid a legal tender whose worth is not real but perceived and whose value is based on the promise but not the guarantee of purchasing ability?

How can money as a common form of exchange, be at once our life-blood and the subject of speculation that directly affects its worth? Why should we commoners prop up its value by its use when at the same time it is devalued through printing to cover the excess of others? And then to place us under its yoke by compulsory superannuation that feeds these gambling halls of speculative ventures? And yet to go further, that by creating a feeling of insecurity in this free market, we are driven to become investors ourselves, so that the speculation, acquisition and accumulation of assets and capital become the dominant thinking and distraction of our lives?

It seems however we strive, our lot is tied in with the perceived health of the national economy. For all too apparent, weak nations laden with debt, inefficiencies in industry, poor institutions of state and law and paralysed by unions are unremittingly punished on the global financial markets.

And since industry is the lifeblood of all nations, statesmen are at hand to remind us of our duty to work for king and country to support the artificial value of money. In truth, the ethics of work and worth are so closely entwined for all men*, I find it hard to imagine how anyone can see past this conditioning.

*Men as taken to mean both men and women.

6 stubbornmule December 13, 2009 at 8:19 pm

Mark: Saving always involves a decision about what form the saving should take, As you note, nothing holds its value in a perfectly stable way. Many people are attracted to the “bricks and mortar” nature of property, but as the experience with house prices in the US shows, property is not always an ideal form of saving. While there is no truly risk-free form of saving, the risk/volatility of assets does vary and in stable developed economies, cash is at the low end of the volatility spectrum. As for fears about devaluing through printing, if you look at the US which has resorted to significant government spending through the financial crisis, inflation shows little sign of emerging. Indeed, some are still worried about deflation. Japan through the 90s and beyond again shows that Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” misses something.

You ask about “a legal tender whose worth is not real but perceived”. This points to a very interesting aspect of money: why it is perceived to have value. One interesting idea is that, in a fiat money system tax is not a means of revenue-raising for the government (after all, as the monopoly issuer of money, it could spend regardless), but in fact underpins the value of money. The government levies taxes in its own currency and so members of society will have to obtain this currency to meet these tax payments. It is then convenient to use the currency for other transactions as well. It is an interesting idea, but my own view is that money is a social construction, but no less real for that. We believe it has value because other people believe it has value. While that may not be a rational basis for believing in, say, UFOs, it is rational when it comes to social constructs. It may be that there is something that ultimately underpins the currency (whether that is gold in a commodity currency or tax in a fiat currency), but it mutual confidence in the currency is the immediate and, I would argue, more important source of its value. So I would agree with you that money’s value is, in a sense, merely “perceived”, but it remains real. Try getting your weekly groceries with something other than money to see just how real it is!

Anyway, I hope there is some further food for thought there for you.

7 Ramanan December 13, 2009 at 9:22 pm

This is very useful: The chapter The Logic Of The Taxes-Drive-Money View from Randy Wray’s book Understanding Modern Money: The Key To Full Employment And Price Stability

8 Ramanan December 14, 2009 at 1:48 am

Sean,

Debated with myself on whether taxes drive money or whether it is a social construction. I have been confused which one to accept but I think I will go with the former now. Imagine people abandon bank deposits or cash as a form of payment. People exchange all sorts of things for getting what they want like groceries including bank deposits and/or cash. Whatever sequence of events happen, I would imagine that some select set of population will be left with plenty of them and the remaining with less of it. They will run out out of a way of paying taxes because it is accepted only in one way. This will create a lot of confusion and chaos and getting bank deposits will become an expensive thing. Somehow at the macro level, people know this likelihood.

9 Marco December 14, 2009 at 12:24 pm

Stubborn,

Finally this story of fiat money starts to make some sense to me. Very didactic post; many thanks for it.

Also, the explanation about interest rates was, as someone else already said, excellent.

I am looking forward to other posts in this series!

Now, let’s see if I really understand what’s going on so far:

(1) Before the casino issued loans to their patrons (backed by IOUs accepted by the head cashier, and materialized either as a bunch of chips or as smart-cards), could one say that the casino was operating according to the neo-classical ideas about money? I mean, as the supply of chips can be 100% redeemed in money?

I guess, in a more abstract, general context, what I am trying to ask here is whether the notions of money (and its management, supply, banking, etc) change over time? Was there a historical change after the Bretton Woods system collapsed?

(2) This is probably a premature question (and probably a confusing one, too), but let me try it anyway. If you consider it better to wait, no worries; just let me know.

One of the few things I think I have clear about this Modern Monetary Theory is that, bar cases like China and the Euro Zone (which voluntarily renounced these prerogatives), governments not only have the monopoly to issue their own currency, but they also demand taxes to be paid in it. Thus, it makes sense for, say, US-resident households and business, alike, to accept the government-issued currency: at least they will have to pay Uncle Sam taxes in USD, anyway.

But, what about US foreign creditors, like governments, or foreign businesses paying taxes overseas? Why should they be satisfied with receiving payment from the American Govt. in US dollars? Could they demand to be paid in yuan, or AUD, or euro?

Here I am trying to address this more general question: fiat is a Latin word that means “by decree”. Etymologically, fiat money means money that is accepted by decree. What happens if people don’t have to obey this decree? Or, equivalently, what happens if people don’t believe in the Modern Theory of Money?

I’m asking this, because, as you mentioned above, even President Obama seems to have doubts about this subject. And I have seen many more articles pointing to the same kind of doubt.

As I said before, I understand this may be a rather difficult question. And I don’t want you to feel under pressure to answer. If you prefer, you can answer this question later.

Anyway, thanks again for another excellent post. Keep the good work up!

Marco

PS. Thanks Rahman for the link. It appears very didactic, too.

10 stubbornmule December 14, 2009 at 6:57 pm

Marco: With regards to (1) it depends on what you mean by “can be 100% redeemed by money”. If you mean that the casino does not allow any lending and so every chip is backed by money in the cashier’s safe, then while this may be a scenario much desired by the more extreme opponents of fiat money, it is in fact far more stringent an arrangement than was in place in the gold standard era or the Bretton Woods era. Even in the days of the gold standard, lending did create money above and beyond the amounts of gold held in central bank vaults. However, just like the casino in my example, central banks had to exercise caution to make sure that this money expansion did not compromise their commitment to exchange currency for gold. It also meant that there was a tendency for central banks to raise interest rates (to attract additional gold from offshore) at precisely the wrong time in the economic cycle.

As for the question of whether notions of money change over time, I would say yes, but perhaps not enough! In many ways, economists and politicians are still thinking about questions of fiscal policy and sovereign default risk through a gold-standard or Bretton Woods prism not a fiat money prism. I would argue that the understanding of money has not kept up with the realities of change in money mechanics.

Question (2) is a good one and an important one. Why would other countries want our currency? If our imports and exports of goods and services balanced exactly, there would be nothing to explain: buyers of Australian goods, for example, would want to obtain Australian dollars to purchase these goods and, indirectly, they could obtain these Australian dollars from firms exporting goods to Australia who have received Australian dollars that they cannot use back home. Of course many countries, Australia included, do not have imports and exports in balance. China, for example, has been accumulating the currencies of many other countries, particularly the US. Working through some of the issues in relation to the international movements of currency will be a topic for a future post (the list is growing!).

11 Marco December 15, 2009 at 6:24 pm

Stubborn,

Thanks. Looking forward to more articles.

Marco

12 JamesGlover December 17, 2009 at 8:20 pm

Fiat money can also be an IOU but not with the central bank against gold but with the People of Australia redeemable for good and services to the value of, say, $10. Why is it an IOU? Because I originally provided the People of Australia with a good or service which we agreed to be that value. Not knowing what G&S I would redeem the IOU against we agreed to store the agreement in currency.

Foreigners holding Australian currency also have an IOU against the People of Australia for G&S to that value. If the amount of IOU which a particular good or service “costs” is known in advance (ie. the “price”) then there is no problem. This is in line with how “money” arises spontaneously out of a pure barter economy. Presumably the original IOU were stored in peoples memories – I give you some hides now and you will repay me with some wheat later. But then someone had the bright idea of using something, e.g. a shell, as a way of agreeing on the value of goods stored rather than rely on memory. Maybe.

13 stubbornmule December 18, 2009 at 1:44 pm

James: it’s funny you should bring up the concept of money as IOUs. I have just been reading this article by Warren Mosler which argues that traditional economic history overstates the importance of commodity-based money (including money backed by gold or silver) and instead argues that money emerged as transferable debts. This thesis is back up by the prevalence of tally-sticks and other debt records throughout history across different societies. The article is a good read.

14 Alex December 25, 2009 at 3:45 am

Dear Mule (lol!),

I have been doing a lot of reading recently trying to put together a model in my head of how economies work. Coming across MMT and Bill Mitchell’s blog has been a big help. I’ve enjoyed reading your post here and your post about reserves too. There is a great clarity to your words.

From how I see it there are two originators and extinguishers of money in the economy;

1) Government spending and taxation. If equal the original cash will be extinguished with no net financial assets created. If there is deficit spending this creates net financial assets. As far as I can see it this is the *only way* net financial assets can be created. If there is surplus taxation this destroys net financial assets.

2) Bank Lending. This creates ‘temporary money’ in the form of deposits that when repaid extinguish the original loan.

Now what I am trying to grasp in my mind is how these two interact to affect the economy as a whole. For example, where does the money come to repay interest? The banks are not creating the interest so does that not mean that it either has to come from other loans or out of the government spending?

If it comes from government spending then is this not a transfer of net financial assets to the financial sector? Will this not leave the government with a deficit that has to be plugged by the creation of further net financial assets?

Why is the money supply constantly increasing? Is it the result of constant deficit spending plus a constantly increasing level of debt within the economy? If this is so then I see doom in the coming years for 2 reasons;

1) Mainstream economists all consider the optimum to be a ‘balanced budget’ so there will be no net financial assets being created.
2) Private sector debt has reached its limit.

Is the constant siphoning off of net financial assets by the financial and corporate sectors not the cause of the government having to then create further net financial assets and thus increase the money supply further, in an ever-increasing loop?

In a given country, what proportion of the money supply are net financial assets that exist outside of the loan/deposit system? As in, if all loans were repaid how much money (or net financial assets) would still exist?

As almost all net financial assets created via deficit spending also have a corresponding bond in the private sector (except for those being held by the Central Bank via quantitative easing, a recent occurrence) does this not create the need for a constantly increasing number of bonds and thus government debt?

Without sustained deficit spending with no corresponding government debt will we not need a constantly increasing amount of private sector and government debt? Can this not only be sustained by an ever increasing amount of economic growth, thus exacerbating booms and busts (which is what we’re experiencing)?

What effect does saving actually have on the amount of credit in the economy in a fractional reserve (or indeed it seems some countries now have NO RESERVE!) system?

Is it primarily the capital requirements that restrict bank lending? Is this capital in fact the net financial assets that the government has created?

I apologize for asking so many questions. Whenever I start thinking about these things I seem to hit a threshold where my brain goes ‘kaput!’ and I can’t seem to resolve my thoughts any further! But these are the questions washing around at present :-)

I hope you’re have a Merry Christmas! Or happy Hanukkah :-) Or just a Happy Holidays :-)

All the best,

Alex

15 Alex December 25, 2009 at 4:30 am

Another train of thought I just had in the shower…

Let’s assume we agree that the government needs to run a deficit that is partially unmatched by the sale of bonds, creating new money. How can the size of this deficit be determined?

And let’s say we decide we want more nurses. There’s plenty of unemployed people in the economy. How does the government decide what to pay the nurses to train and then work? If people start thinking the government can create money to pay for things, won’t the public sector demand more and more money as they see the government no longer constrained by debt? And how would private companies that employ nurses react to the government competing with them like this?

Finally, I understand that an increase in the money supply does not necessarily cause inflation if there is spare capacity in the economy. However, this is a very broad way of thinking. For example, here in London there is not an excess of capacity of housing. Quite the contrary. I believe that is why an expansion of credit or govt spending always results in rising house prices here. So we now have more nurses who previously had very little disposable income now making more money. They decide to buy or rent property. The result of this would be an increase in property prices.

My point is that whilst I want to see full employment and no underemployment and believe this could be done via an increase in unfunded government spending it raises many, many questions about how do this.

I note that in the UK we have created £200 billion of new money via quantitative easing that remarkably matches up to the expected £200 billion deficit this year. It has almost all gone on buying government bonds. So essentially the government is funding the deficit by creating new money, or increasing net financial assets and reducing its own liabilities (as long as the central bank holds on to these bonds). By contrast many other countries like Greece are pushing through painful fiscal cuts and cutting back on stimulus (and going nowhere near quantitative easing). The IMF has a history of enforcing ‘Austerity Cuts’ and yet we seem to be exempt from this.

I find this all very intriguing. I can only conclude that the prevailing mainstream economic thought is in fact a ‘con job’ used to keep the public sector of countries subservient to the private sector and the dominant countries dominant over the weaker one’s. This would seem to be backed up by “Confessions of an Economic Hit Man’.

Alex

16 Ramanan December 25, 2009 at 9:41 pm

Alex,

(Same Alex from Billy Blog ?)

I think you are asking the same questions I was asking in early 2009. And what a nice year it has been !! When we fit together all the pieces, the kick we get is unparalleled!

A picture can say a thousand words. Have a look at Tables 4.1 and 4.2 at

http://books.google.com/books?id=Px6PfGXKPz8C&lpg=PA66&dq=tarik%20mouakil&pg=PA66#v=onepage&q=tarik%20mouakil&f=false

Its easy to get confused between a stock and a flow and that is what economists have been doing over the years. One of my favourite text (which goes into details of the chapter link above) starts with “I have found out what economics is; it is the science of confusing stocks with flows.” – a statement made by Michal Kalecki. That book is http://www.amazon.co.uk/Monetary-Economics-Integrated-Approach-Production/dp/0230500552 The book takes absolute care about what is a stock and what is a flow. Stock is something like an absolute number – an accumulated number if you like and a flow is something like a “rate”. http://bilbo.economicoutlook.net/blog/?p=4870

Here are answers to some of your questions. You got this right very early – taxes leaves the system instead of funding the government. Getting this right early is crucial. So a government spending injects financial assets to the system (the private sector). The spending need not go to the financial sector. It goes to firms who use it to build infrastructure etc. Firms also take loans from banks. They pay wages to households and get income from sales via consumption from housholds. Banks receive interest payments and this extinguishes their liabilities and we have a wonderful system of double entry book keeping where this can be written precisely.

So back to tables, the way to understand is 4.1 -> 4.2 -> 4,1 -> 4.2 ….
The great thing about the tables is that everything comes from somewhere and goes somewhere. Helps to track everything.

It will also lead you to understand how M2/M3 grows etc. You will find out that the monetary aggregates are actually irrelevant on the effect on an economy!

The Greece vs. UK comparison is not an apples to apples comparison. Greece has surrendered its sovereignity by accepting the Euro and this was a huge mistake. However, the politicians and economic advisors don’t get it! UK on the other hand can pull itself out of the recession by a good fiscal policy and just forgetting being obsessed with public debt/GDP. You are right – inflationary pressures have to be kept in mind so a good understanding of looking at economics is necessary but mainstream economists still live in the gold standard era and this has led to lots of misconception and procyclical growth.

17 Marco December 26, 2009 at 12:26 am

Hi Alex and Ramanan,

Alex said:

“(…) The IMF has a history of enforcing ‘Austerity Cuts’ and yet we [UK] seem to be exempt from this.

I find this all very intriguing. I can only conclude that the prevailing mainstream economic thought is in fact a ‘con job’ used to keep the public sector of countries subservient to the private sector and the dominant countries dominant over the weaker one’s”.

Maybe Alex’s comparison UK vs Greece wasn’t fortunate (as Ramanan explained), but I still agree with him.

What about the IMF and Latin America during the 80s and up to the 90s? During all those years the IMF enforced the Washington consensus, which among other things demanded “fiscal austherity” as a precondition for any IMF loan.

18 Marco December 26, 2009 at 12:32 am

Alex and Ramanan,

I forgot to add this at the end of the previous message (sorry for messing up!):

The situation of Latin America and the UK seem to be the same: both had their own sovereign currencies. And yet, the IMF seems to be acting differently, indeed.

19 Ramanan December 26, 2009 at 1:02 am

Hi Marco – yes UK has been behaving as if it were Greece and this is really unfortunate. They have the tools to achieve less pain but they are simply not doing. Agree completely with you points on the IMF.

20 Alex December 26, 2009 at 4:59 am

Hey Ramanan,

I am the same Alex if you mean the Alex who has started posting in the last day :-)

I am away on holiday and it’s Christmas day so I’ve only been able to take a quick look but thanks for the links! One problem I have is that I my only formal Economics education is A-Level Economics here in the UK which is barely better than no Economics education at all! Plus I haven’t done any maths since GCSE.

Still, I took a quick look at the Money, Distribution & Economic Policy excerpts you linked to and get what’s going on there. But would I understand “Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth”? Did you buy a copy of this book? Are there any more basic ‘foundation’ books you can recommend to get my basic knowledge to a superior level?

2 quick things I was wondering…

In one of your comments on the “Stock-flow consistent macro models” post on Bill’s site you state that total fiscal deficits over the years in the US are “$4.5T. The total public debt seems to be $9T or so…” How is this possible if bonds are issued to match deficits? Also, $4.5t sounds much lower than I would have thought?

Also, if a sovereign nation started creating new money with no matching debt to spend what would be the ideal procedure for draining excess reserves in the banking system? Would you have to? And what would happen to the currency of the country relative to others on a floating exchange rate system? I noticed a post about “Automatic Stabilisers” on Bill’s site… I get a feeling I need to read that. Will do ASAP :-)

With regards to Greece, of course you are right. Greece can no longer issue its currency. It makes me so glad the UK has not! But I fear it is only a matter of time… the conspiracy theorist in me thinks the UK could be purposefully being drowned (and the US) in order to push us into the Euro and America into an American equivalent (Amero?). I try not to let the conspiracy theorist side of me out too much but to take a recent example then how else to see things like EU Constitution being forced down our throats!

Hope you’re enjoying Christmas :-)

Alex

21 Ramanan December 26, 2009 at 7:38 am

Hi Alex,

Happy Christmas :-) Yes that book is a bit mathematical and formal and slow but yeah I do have a copy and its always with me! Bill Mitchell’s book which you can find on his site is good too. Very direct and to the point. Randall Wray’s Understanding Modern Money is another good one.

Re the $4.5T : That is just the sum of deficit of each year. The government would have issued the debt every year and interest keeps accumulating so we have around $9T of total debt.

Yes understanding reserve accounting /open market operations is very important. If the Treasury/CB does not drain them, then overnight rates would fall to zero and the central bank will not be able to achieve its interest rate targeting. One simple strategy is to just pay interest on them so that banks don’t lend them to other banks below the rate paid on them by the central bank. However reserves do not cause inflation.

22 Stubborn Mule December 26, 2009 at 9:19 pm

Alex: a lot of questions there! But that’s great. I’ll have a go at chipping away at them a bit at a time.

With regard to your question about interest payments, there is no need for new net financial asses to he created for interest to be paid. For any interest payment someone is paying and someone is receiving, so money is just moved around in the same way that it moves around for any buying/selling transaction. In fact, I would argue that you should not get too concerned about the notion of net financial assets. If one party in the private sector (eg a bank) lends to another party, then no net assets are created for the private sector (there is an asset for the first party offsetting the liability of the second party) but this loan can still serve an important purpose in generating economic activity that may not have otherwise occurred. The time that the net position becomes important is, as recently, the is such a significant decline in private sector demand and the private sector in aggregate wants to reduce debt. Then if the government sector tries to run a surplus too, major problems result.

On the topic of the comparison between the UK and Latin American countries, it is important to note that past debt crises in Latin America have occurred while the countries were attempting to manage a currency peg to the US dollar. Doing this loses the true flexibility that fiat currency otherwise provides.

Finally you asked the question about how a government can know when they have spent too much and moved into inflationary territory. This is an excellent question. I suspect that it is actually impossible until it is too late. For this reason, the smartest approach to government spending is to make it counter-cyclical. Much government spending is already like this, such as taxes which tend to diminish in economic downturns and vice-versa. Similarly welfare payments increase in economic downturns and vice versa. Even if you get the aggregate spending right, too much in one place can cause localized inflation, as in your housing example. Bill Mitchell is sensitive to this issue when he proposes his Job Guarantee. Because it would pay minimum wage it is designed to avoid government-induced wage inflation.

I will aim to respond to more soon!

23 Marco December 27, 2009 at 8:31 pm

Stubborn said:

“On the topic of the comparison between the UK and Latin American countries, it is important to note that past debt crises in Latin America have occurred while the countries were attempting to manage a currency peg to the US dollar”.

You’re right, Stubborn, about the exchange rate regimes in LatAm being based on pegging. I checked this for the 90s.

“Doing this loses the true flexibility that fiat currency otherwise provides”.

But why is it? I mean, Dani Rodrik and Joe Stiglitz are very critical of the IMF (and WTO and World Bank, for that matter) for many reasons, other than exchange rate considerations.

PS: Merry X-Mas!

24 Alex December 29, 2009 at 2:51 am

Hey Ramanan & Stubborn Mule,

Thanks for both writing back to me. I’ve actually pretty much decided to go back into education and get an Economics degree. I am frustrated at my lack of knowledge and desperately want to fully understand things so that I might help bring about some greater awareness of the nature of economics among others.

I was wondering what you both think about the system of unrestrained bank lending we operate under? Obviously there is logic (from a banks point of view) to banks restricting credit in a recession as they want to be paid back. So I find it greatly amusing whenever the politicians are berating the banks for not lending enough when it was their reckless lending of too much money that largely got us in this mess!

But in boom times it seems to me that the current system of centrally set interest rates and lack of restrictions on bank lending means that no one wants to ‘stop the booze flowing’ so to speak. Isn’t there a way that Interest Rates could naturally adapt to the prevailing economic conditions rather than being set by human beings with political motivations (even central bankers are not immune!). And isn’t there some fiscal policy that could be implemented to stop asset bubbles? It seems like all easy-money does is in fact constantly fuel them. For example in the last decade: The DotCom Bubble; the Housing Bubble; the mini Oil Bubble from last year; (arguably) the current Gold Bubble now.

Best wishes to all,

Alex

25 Mr Speaker August 3, 2011 at 3:15 am

This is a really good article. Thanks.

26 Ashishb Yadav August 1, 2012 at 7:04 pm

Thanks Stubborn,
Its really eye opener, keep posting what will be the future of cirrency

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