« Substituting Capital for Labour, Radio DJ Edition | Main | Thinking About Economics »

Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

Scott:

Thanks for chiming in on this post. I am hoping you can comment on some thoughts I had for you.

At one time I was an enthusiast of the balance sheet recession view, but have become more skeptical thanks in part to the influence of Nick Rowe and his views on excess money demand. Let me explain what I mean by responding to this comment you made above:

"But you have not received any income from this aside from debt service (interest), just a portfolio shift from a loan or bond to deposits. You would have to make an additional assumption that the creditor now spends more out of income (i.e., as a result of the portfolio shift now moves to spend instead of save), which I don't see any inherent reason for; the creditor could desire to continue saving and just convert to a time deposit or whatever... "

If the debtor starts deleveraging at a faster rate than the creditor expected, then this would be a shock to the creditor's portfolio. As you suggest, the creditor may now have more deposits and fewer bonds. But, given this was unexpected it is now not an optimal allocation of assets. The creditor, therefore, needs to rebalance his/her portfolio and this sets in motion a series of transactions that should to some extent lead to an offset in spending. For example, if the creditor buys more bonds and uses funds from the deposits to purchase them, now the seller of the bonds has more money. That seller now has extra money in his/her portfolio and must decide whether to save or spend it too. At some point, this hot potato effect should eventually lead to investment or consumption spending. The only reason it would not is that somewhere in this process someone decided to not to spend the money (i.e. they left it sitting as a deposit). I would call that an excess money demand problem, rather than a deleveraging problem.

Also, on the role banks play in the system you noted the following:
Further, if it is a bank that is the creditor, the payment to reduce debt has simply resulted in a debited deposit of the payor and a debited loan for the bank. There is clearly no reason for the bank to "spend" more out of income. I agree, but the problem here is that the bank allowed the money supply to fall for a given amount of money demand, creating an excess money demand problem.

Finally, if the debtor is defaulting then the problem is whether the debtor chooses to spend or hoard the funds they would have paid the creditor. If they spend it, no problem, If they hoard it, then the excess money demand problem arises again.

So what are your criticism of this view? I like this approach because, as Nick has pointed out many times here, money is the one asset on every other market. Disrupt it and you affect all markets. But I am sure you can offer up a MMT critique of this view, so please do.

"Can the firm that sells scrub-clearing services to farmers build up a stock of unsold inventory of land-clearing services? No. So that is an example of a newly-produced investment service where there are no inventories."

And my explanation was that scrub clearing is not an investment. The value improvement to the land is the investment. And the land is inventory in the longer term sense.

Because scrub clearing is not an investment in any sense, it can't be an investment in the inventory sense. So the argument again is moot.

"The whole economy is moving towards a service economy."

Not the part that remains investment, which is still substantial. And that's the only part that can generate macro saving.

"We end up with Eugene Fama insisting that a fiscal stimulus can't possibly be expansionary because the savings to finance it have to come from somewhere."

Yes, as Krugman pointed out in "Dark Age of Macro".

I would add that to Scott Fullwiler's earlier list, along with James Galbraith's disembowelment of CBO projections earlier this year.

I agree with Nick about the role of inventories. My own post makes its argument without using inventories, and it uses custom software as an example of investment. My argument that "investment makes saving possible" is complicated by the introduction of inventories, because then the investment that facilitates saving may have been investment that took place in the past. With respect to inventories, it might be more reasonable to say that "saving forces investment," in the sense that saving prevents intended disinvestment from taking place.

In the shower just now, I suddenly remembered (if my memory is correct) a published paper that did make an accounting mistake. Martin Weitzman once did a macro paper that showed a rather strange equilibrium result that he attributed to firms' having increasing returns to scale. But, IIRC, he had forgotten to include firms' profits in the household budget constraint. And that explains why, when he switched to the long run model with free entry, where profits went to zero, his equilibrium results became much more normal. It didn't matter if he had forgotten profit income, if profits were zero anyway.

A lot of post-keynesians went rather gaga over his results at the time, IIRC, because they liked his underemployment equilibrium and they liked his increasing returns to scale assumption too. But it all was based on forgetting to include profit.

Now, would someone who knew accounting have immediately spotted that mistake? I don't know. But I spotted it, and I never much thought about accounting, nor knew any past the basics of NIA.

(All the above based on very old memories, so don't trust its accuracy0.

Andy,

If you assume no inventories, then investment equals saving trivially, as you noted in your post.

If there is an inventory process, then saving may force investment, as you say here.

That’s the case in the flow sense of saving, as it corresponds to a change in inventories.

And it’s the case in the stock sense of accumulated saving (savings), as it corresponds to the level of inventory investment.

Andy: On Fama. OK. It was maybe lack of clarity rather than a mistake. Job to tell.

David: good to see you wading in here, with the Paradox of Hoarding (Md=Ms) view as opposed to the Paradox of Thrift (Sd=Id) view.

(Funnily enough, when I first had inklings of MMT I was rather hoping they might be more in tune with monetary disequilibrium analysis, because of the different way most of them talked about saving, which they often speak of as S' = S-I, and how they talked about "money". But on further reading I figured they weren't really. They tend to speak of "money" under a *very* broad definition. So I was a little disappointed. My current interpretation is that they are a bit more like Old Keynesians in their analysis of this sort of thing.)

JKH: "If you assume no inventories, then investment equals saving trivially, as you noted in your post."

If you mean actual saving and actual investment, then they are equal always, regardless of inventories.

If you mean desired saving and desired investment, then they can be unequal even if there are no inventories. Just take any example where there is a line-up of buyers who want to buy some good that's included in GDP, but can't. Id exceeds Sd.

And this would be really obvious if we stopped talking about S and I and talked about demand and supply instead. Is it possible to have a good that is in excess demand, where quantity demanded exceeds quantity bought-and-sold? Obviously, yes. Go to Cuba and you see it all the time.

This is all too complicated. The confusion becomes because people are not understanding what is in the national accounts. All the matters is that the national accounts reckons people get income from selling things (including services) and use that income to buy either buy goods and services that are either considered final consumption goods or investment goods (and net intermediate goods such as inventories). Since every income comes from selling something (here labour complicates things because it is netted as income to one group and a cost to another) what is not spent on consumption goods must be a sort of savings (for some participants it will actually be savings in a bank account - but that must be exactly offset by others who borrow and invest). The key is the exclusive categorisation of goods and services into consumption goods and services and investment goods and services.

Nick wrote: "Look, Scott understood what I was saying. Suppose I have a debt to you of $100. Suppose I drop my consumption by $100, pay you the $100, and you increase your consumption by $100. Then private gross debt has fallen, private consumption and saving have stayed the same in aggregate, and nothing changed with I,G,T,X, or M. If your accounting identities are stopping you understanding that, then you are being mislead by your own accounting identities.

*Part right, part wrong. 1) Private debt has fallen only if when you pay me the $100 in reference to the debt. For deleveraging you need to ask, does it extinguish debt? You understand you can give me the $100 bill, now I owe you $100 and you still owe me a $100 debt? 2) In your example, private savings have fallen only if private debt has also fallen.

Hi Bruce W.! Economistview is a lesser blog without you. I worked out a deal with Mark where he just deletes my posts that offend him, he no longer feels the need to email to explain why. Brad D. just blocks me (for good reason).


I'd suggest reading 'Understanding Modern Money' by Randall Wray for the real definitions.

My definition:

Horizontal money (bank money) is created by loans/deposits and extinguished by the repayment of loans.

Vertical money (fiat money) is created by government spending and extinguished by government taxation.

And is it possible to have cases without inventories where Id is less than Sd? No. Because that would mean quantity demanded is less than quantity bought-and-sold. Which doesn't make sense. Why would anyone buy more of a good than they wanted to? Is the mafia selling the good?

Winslow: OK. Agreed.

And there's one more important problem with S=I as a way of thinking about things, compared to demand and supply:

Do we define desired saving as *actual* income minus desired consumption Sd=Y-Cd ?

Or do we define it instead as *desired* income minus desired consumption Sd*=Yd-Cd.

It makes a big difference when we have an excess supply of newly-produced goods.

In Keynesian underemployment equilibrium:

1. Sd=Id, output demanded = output bought-and-sold.

2. But Sd* exceeds Id. Output supplied exceeds output bought-and-sold.

God, but S=I is a crappy way to look at the world. Qs=Q=Qd is so much better.

"If you mean desired saving and desired investment, then they can be unequal even if there are no inventories. Just take any example where there is a line-up of buyers who want to buy some good that's included in GDP, but can't. Id exceeds Sd."

No problem with that, Nick.

I suppose the point of my original comment related much to the area of economic forecasting, where economists need to make sure that their future scenarios are compatible with accounting logic. If you look at much of the MMT blogs recently (actually I'm thinking most of Marshall Auerback), a good deal of has to do with accounting integrity in terms of reasonable outcomes for sector financial balances as a result of government policy, particularly austerity versus stimulus policy. So the accounting again is a constraint on the outcomes that you forecast using your best judgement on supply/demand behavior. This may be obvious to you, but the fact is that a lot of MMT writing emphasizes it in policy analysis. The implication is that MMT thinks in general that there's a lot of economic analysis out there that isn't understanding the nature of contradictory sector accounting outcomes that are implied in their forecasts and policy assumptions.

S=I is a crappy because it assumes away the government and the foreign sector. S=I relies solely on deposits/loans to provide money for exchange.

Nick,

How about: if ACTUAL economic outcomes reflected perfect mathematical continuity, then there would be no supply and demand functions, because each point on the continuum would reflect an actual accounting event. Because economics reflects discrete mathematics, supply and demand functions fill in the gaps between actual accounting outcomes.

Really great discussion between Scott and Nick in the comments.

My primary quibble with Nick's post is this piece here, which is more of side point: "So "desired saving" means "that part of income that people do not desire to spend on (newly-produced) consumption goods". What do they want to do with it instead? It could be anything, except spend on (newly-produced) consumption goods."

That might be true from an accounting perspective, but from a behaviorial point of view, desired savings is not the part of income that I do not desire to spend; it is the part of income that I want to transfer to claims on future spending. If I was single and expected to die in a month, I have no doubt I could find newly produced goods and services to spend any and all income. But, I do not expect to die so soon and do have a child, so I 'save' income for my future consumption or investment balancing risk and return to the best of my quasi-rational ability. And that's why I am still in the DeLong camp.

JKH: I am with you on your 12.25, but I'm going to stab a guess at your 12.33:

It's the econometric problem, of how to estimate a supply and demand curve. (Stephen spends his life on questions like this. I'm just going to give the simple version, which is all I understand.)

Assume (just to keep it simple, because it's hard enough already) that the market for apples is always in equilibrium where the supply and demand curves cross.

If we have just one snapshot, at one time, all we see are P and Q. We do not see the demand curve or the supply curve. We just think they are out there somewhere. We only see the point where they cross

If we knew (somehow) that the demand curve never moved, but that the supply curve moved around a lot, and if we had a movie camera, we would be able to see the demand curve. As the supply curve moved back and forward the points we see (the Ps and Qs) would trace out the demand curve.

If we knew (somehow) that the supply curve never moved, but that the demand curve moved around a lot, and if we had a movie camera, we would be able to see the supply curve. As the demand curve moved back and forward the points we see (the Ps and Qs) would trace out the supply curve.

The job of econometricians like Stephen who do simultaneous equation estimation is to figure out that "somehow". They find some variable (the weather) that they are pretty sure shifts the supply curve and not the demand curve. Then they figure out another variable (doctors saying apples are good for you) that they are pretty sure shifts the demand curve and not the supply curve. Then they throw it all in the computer and the computer tries to figure out what the demand and supply curves look like from watching P, Q, the weather, and doctors, with a movie camera.

Hello David,

This would be my view on the points you've raised.

Best,
Scott

You said:
If the debtor starts deleveraging at a faster rate than the creditor expected, then this would be a shock to the creditor's portfolio. As you suggest, the creditor may now have more deposits and fewer bonds. But, given this was unexpected it is now not an optimal allocation of assets. The creditor, therefore, needs to rebalance his/her portfolio and this sets in motion a series of transactions that should to some extent lead to an offset in spending. For example, if the creditor buys more bonds and uses funds from the deposits to purchase them, now the seller of the bonds has more money. That seller now has extra money in his/her portfolio and must decide whether to save or spend it too. At some point, this hot potato effect should eventually lead to investment or consumption spending. The only reason it would not is that somewhere in this process someone decided to not to spend the money (i.e. they left it sitting as a deposit). I would call that an excess money demand problem, rather than a deleveraging problem.

My response:
There is always a virtually default risk-free asset that earns essentially the risk-free rate . . . time deposits. Further, converting to a time deposit does not affect relative asset prices, since it arbitrages with the cb’s target rate, and this ends the hot potato effect since the “cash” no longer exists but has simply been renamed a time deposit. (If we're talking about "cash" in the form of currency, then the conversion to a time deposit means the bank has more vault cash, which it can sell to the Fed for an interest earning reserve balance; or, without IOR, the Fed would drain the reserve balance via a reverse repo. Again, no hot potato effect.)

Further, this “decide whether to save or spend” conflates behavior related to “money” with that related to “income.” My mother on the verge of retirement doesn’t spend more simply because the Fed buys her Treasury and she now has a deposit (she goes to a time deposit or buys another Treasury from the Treasury’s online purchasing site, both of which again destroy the deposit), but if you increase her Social Security check, this raises money and income and probably induces her to spend. As I said in the original comment, you have to make an ADDITIONAL behavioral assumption to say that the creditor now with greater “money” balances spends them beyond the assumption you would make if the saver had an increase in income. These are different, but they are too often treated as if they are the same.

This is the same point JKH and RSJ are making with Nick regarding the difference between income and cash flow. Another analogy is that it’s like a business that earns more profit versus reducing accounts receivable because previous purchases are now paid in full—these aren’t the same from the perspective of the firm even though both increase cash balances.

You said:
"I agree, but the problem here is that the bank allowed the money supply to fall for a given amount of money demand, creating an excess money demand problem."

My response:
Where’s the excess money demand? The debtor was reducing debt, which reduced deposits (as deposits used to retire debt do not exist anymore) and reduced the bank’s assets. Increasing the money supply would require someone to desire to borrow so the bank would create a loan.

Further, this “money demand” argument conflates several points. First, there is the portfolio adjustment issue of “money demand,” which is holding non-cash assets but wanting to. There is never a problem here if the person desiring “money” is holding a liquid asset. There may be a capital loss selling the asset, but there are market makers in every liquid market that set bid/ask rates (that’s why it’s a liquid market).

Second, “money” demand can be on the part of people without wealth. This can take the form of desired borrowing to spend—in which case an “excess demand for money” simply means the lender doesn’t deem the borrower creditworthy—or desired “money” from an increased flow of income. Everyone has an unlimited demand for the latter, always, but that’s not interesting and not related. For the former, it’s simply a demand for credit. And this is the only way the bank can “increase the money supply to meet a given money demand”—by providing “money” balances through credit. And if we're talking about a balance sheet recession, this demand for credit is by definition reduced, not increased. Conflating demand for money with demand for credit is a big mistake, but it happens all the time.

You said:
Finally, if the debtor is defaulting then the problem is whether the debtor chooses to spend or hoard the funds they would have paid the creditor. If they spend it, no problem, If they hoard it, then the excess money demand problem arises again.

My response:
If the debtor is defaulting then they have no funds. That’s why they defaulted. The money borrowed was already spent. And when they default, they are no longer creditworthy, no matter how low you cut the interest rate, while the creditor now has reduced capital and thus reduced ability to expand the balance sheet (make loans, and thus money creation) while could also be a bit more skeptical of would-be borrowers (again, potentially reduced lending and reduced money creation).

OGT; Thanks. Yes, this has been a good discussion.

"That might be true from an accounting perspective, but from a behaviorial point of view, desired savings is not the part of income that I do not desire to spend; it is the part of income that I want to transfer to claims on future spending."

Most economists would agree with you. Most economic models assume the desire to save is based on the desire for future consumption (oneself or one's kids). Milton Friedman's permanent income hypothesis, and the New Keynesian consumption-euler approach, are explicitly based on your view. I would mostly agree with you. But it's not 100% true. If I buy antique furniture, that's "saving", as currently defined (because it's not newly-produced). Sure, I will be able to consume it now and in future, or sell it to finance my consumption when I'm old. But it's not purely a "claim" on future consumption. It's different from a bond.

But basically yes, apart from my quibble with your quibble, your view of why people save should be built into the behavioural functions that determine desired saving. And they typically are (though they weren't in the crude Old Keynesian model I used in the post, for illustration).

^Nick, see :).

Nick, that's an interesting visual.

So I think you're saying that supply and demand functions can be derived implicitly by observing actual (P,Q) changes and inferring the factors that are causing the changes.

Scott,

Thanks for the reply. I am still wrapping my brain around this, but here are some thoughts:

"There is always a virtually default risk-free asset that earns essentially the risk-free rate . . . time deposits. Further, converting to a time deposit does not affect relative asset prices, since it arbitrages with the cb’s target rate, and this ends the hot potato effect since the “cash” no longer exists but has simply been renamed a time deposit."

How does this change or nullify the non-bank creditors's desire to rebalance their portofolio? In the scenario above they are heavy money assets and need to reallocate into higher-yield assets. This could mean buying financial assets, physical assets, or ultimately even goods. This is the essence of the portfolio channel of monetary policy. (one that existed well before Bernanke promoted it with QE2.)

"Further, this “decide whether to save or spend” conflates behavior related to “money” with that related to “income.” My mother on the verge of retirement doesn’t spend more simply because the Fed buys her Treasury and she now has a deposit..but if you increase her Social Security check, this raises money and income and probably induces her to spend.'

But your mom or any investor will want to rebalance his/her portfolio of assets after that transaction. Again, the hot potato effect.

"Where’s the excess money demand? The debtor was reducing debt, which reduced deposits (as deposits used to retire debt do not exist anymore) and reduced the bank’s assets. Increasing the money supply would require someone to desire to borrow so the bank would create a loan.

That's a fair point that the demand for loans would need to increase for the banks to start creating more money assets. But, regardless, the destruction of money assets (i.e. deposits) through deleveraging has not been offset and for a given money demand there is now a shortage of money assets. Moreover, during an economic crisis it is fair to say money demand, if anything, has become elevated.

Yes, the excess demand for credit is different than the excess demand for money. I am focusing on the latter. Here is how I define it: given there is a determinant amount of wealth people want to hold in the form of money, it is possible for desired money balances to be less than actual money balances.


"If the debtor is defaulting then they have no funds. That’s why they defaulted. The money borrowed was already spent.

Just because one defaults does not mean they have no funds. For example, someone may decide it is a fools errand to keep paying a mortgage on a home that is underwater. They are keeping the money assets they would have paid to the creditor. Again, if they spend it no problem. If they don't because they are say, still uncertain about the future then there an excess money demand problem.

I wonder if we focus too much on banks. They, after all, are just the intermediaries for households and firms, which in the US have been acquiring and maintaining an inordinate amount of money assets (relative to their other assets). These are the creditors I think that should be spending their money balances. On the surface they are not spending their money balances because of the dire economic outlook. At a more fundamental level, I see them not spending the money because there is first-mover, coordination problem. That is, if all started spending their money simultaneously there would be a recovery, but no one wants to be the first one to move. This where I think the Fed could assist via a price level or nominal GDP level target.

Thanks for listening.

These ideas of being accounting consistent and acknowledging supply/demand influences/functions shouldn't be incompatible. There shouldn't be any conflict between them at all.

I get stuck on this debtor/creditor discussion, because anybody who holds a money balance with a bank is a creditor. Has to be to make it all consistent. But that includes just about everybody at different points in time. So how do you define creditor or debtor in that context - anybody who has a gross position - or is it somebody who has a net position, net somehow defined?

"It’s a bit like being accosted at airport terminals by people with a glow in their eyes repeating “apples sold equals apples bought”.

But at least that, as Henry Kissinger would say, has the added advantage of being true. The ones to worry about are the crazy people at the train station who mumble things that are manifestly not true like, say, ”inflation is always and everywhere a monetary phenomenon.”
:o)

" On the surface they are not spending their money balances because of the dire economic outlook. At a more fundamental level, I see them not spending the money because there is first-mover, coordination problem."


So China isn't buying our good and services because they are afraid we won't buy theirs?

Is this error in reasoning caused by assuming S=I, no foreign sector, no government?

I'm an amateur who's been thinking very hard about S=I for some years. (And reading: from Kuznets -- who created national accounts system -- to many textbooks plus Sumner Rowe Waldman MMTers and etc.) I don't have any pronouncements to make here, just some ongoing perplexities.

"2. S = Y - T - C This is a definition of Saving"
and
"If you start your theory with I=S as an accounting identity"

I feel like "definition" may be the key word here. An accounting identity is a definition of terms.

Kuznets decided that we would measure all the sales of real goods (explicitly excluding financial assets), and assume (reasonably, it seems) that it equals all the real production (adjusting for inventory and imports/exports). That's Y.

If we subtract measured consumption and taxes from Y we get something that is labeled, alternately, either "savings" or "investment."

Kuznets gave those two words the same accounting definition. So of course they're equal. (Worth noting: in calculation of the national accounts, Savings is a residual; it's not measured.)

It seems like this reveals a conflation that goes to the roots of classical economics: between real investment and financial "investment," between real capital (from plants and equipment to ideas, knowledge, and skills) and financial "capital." "Investment" and "capital" are used, constantly, without the modifiers "real" and "financial." But buying government bonds or even stock in a company has very different effects on the economy than building a house or a factory or training your workers.

Underlying that seems to be an assumption that any financial "investment" -- money used to purchase financial assets (including newly-created financial assets) -- recycles instantly, within the period or at least by the next period, into real investment (or at least consumption). That there's no financial "holding pool" where it just circulates, without being spent on real goods. That that pool does not expand and contract based on inflows and outflows, plus "animal spirits."

Related: the widely-bruited notion that one can "spend" out of "income" (except metaphorically). One can only spend out of a stock. (cf. Godley on Stock-Flow consistent modeling, and Steve Keen's downloadable and runnable stock-flow consistent model.)

It's also related to the failure of national accounts to include capital gains as part of income. Financial assets, and their changes in value, are basically ignored in the national accounts, as if the financial system was nothing more than a tally sheet that's external and unrelated to the real economy -- like the bank in Monopoly -- with no motive force of its own beyond the push and pull of interest rates. As if we really did live in a barter economy. (I know, I know -- neutrality of money -- but...)

This may be related to Steve Keen's key points about static vs. dynamic modeling -- how static equilibrium modeling (maybe showing period 1 and period 2, but not the endless iterations of dynamic modeling) is incapable of representing how a money economy actually works.

On a completely different note: under MMT thinking, it seems to me there is no such thing as government "saving," any more than a bowling alley or United Airlines can "save" points. This makes me even more confused about S=I.

Take this thinking far enough, and you might get to the crazy notion that S=I is essentially a political statement, a statement of economic world view, a definition by Kuznets and company (unconsciously?) designed to maintain the status quo of the financial system, i.e. to maintain the wealth of creditors.

The national accounts *are* an economic model. How accurate/representative/useful are the fundamental underpinnings of that model? I'm not sure they are, very.

I may just be displaying deep ignorance here, and the last is perhaps wild-eyed. But I thought it worth delving below the "given" (given by Kuznets on stone tablets) that S=I.

These equations
1. Y = C + I + G + X - M
2. S = Y - T - C

They are stock equations and do not tell us anything about flow. What causes Y to rise or fall? What causes S to rise or fall? We cannot infer flows from these equations and will need completely new ones to tell about flow and causation. Take for example: Nick: "if you like, you could define S as "national saving" to include both private saving plus government saving"

How did we know that national saving is government plus private saving? Doesn't a flow from one lead to an increase in stock of the other? I.e., 'Private saving' increases with more government spending, and 'government saving' increases with private dis-saving (greater taxation), and at an extreme (forgetting foreigners) adding both together results in zero.

The equations also do not tell us anything about what makes people desire more consumption or investment. All we know is what cleared, i.e., what goods were bought/sold.

Re: Y = Cd + Id and Sd = Y - Cd
I can tell you my Sd is a lot greater than my Y - Cd. My Sd and Cd alone is greater than my Y. For example, I desire to buy a fleet of Ferraris, and I desire to save a million dollars a year. But who cares about that? All that matters is how many Ferraris I actually bought (zero) and how much savings I set aside ( a little). So my non-consumption of Ferraris does not lead to added Y for Ferrari, though my savings does contribute to increased funds for my bank, which as Scott F says, does not necessarily lead my bank to lend it to someone like Ferrari (since Ferrari doesn't expect to increase Y anytime soon, and doesn't need the funds for expansion).

wh10: Yup!

JKH: "So I think you're saying that supply and demand functions can be derived implicitly by observing actual (P,Q) changes and inferring the factors that are causing the changes."

That's close. If you observe actual P and Q changes, and if you also observe changes in two other variables, X and Y, and if you can assume that X affects demand and not supply, and that Y affects supply and not demand, then you can empirically estimate (infer the shape of) the supply curve and the demand curve. (Well, Stephen could; I couldn't.)

Simple econometrics estimates one equation at a time. Plot Y against X, and fit a curve to the data. But that (usually) won't work for supply and demand, because there are two equations, and you have to estimate both equations at the same time. So econometricians figured out how to do simultaneous equation estimation.

JKH: "These ideas of being accounting consistent and acknowledging supply/demand influences/functions shouldn't be incompatible. There shouldn't be any conflict between them at all."

Agreed. And if they were inconsistent, something would be terribly wrong. Like if your equilibrium condition were: apples + bananas demanded = apples supplied.

JKH: "But that includes just about everybody at different points in time. So how do you define creditor or debtor in that context - anybody who has a gross position - or is it somebody who has a net position, net somehow defined?"

Dunno. Good question. It might depend what you wanted it for. If you are just looking at an individual's wealth, then net does the job. But if there's risk, and you are leveraged, net doesn't tell the whole story. (As of course you understand better than me, because just take that same statement and apply it to banks, instead of people).

Of course, it's not always possible; there are usually pretty thorny identification issues with simultaneous systems.

Steve: "I feel like "definition" may be the key word here. An accounting identity is a definition of terms."

Absolutely. Which means you have to define "saving" in a very special way, to make it true.

"Related: the widely-bruited notion that one can "spend" out of "income" (except metaphorically). One can only spend out of a stock. (cf. Godley on Stock-Flow consistent modeling, and Steve Keen's downloadable and runnable stock-flow consistent model.)"

That doesn't seem right to me. One can have a flow of money coming in, and a flow of money going out, as you spend it. Now, it is true, we very rarely have perfectly smooth flows in and out in practice, if you are looking at a very fine-grained time intervals. Our flows in and flows out tend to bunch up. On annual data they look like flows. On hourly data they look like stocks. We hold fluctuating inventories of stocks of money precisely because it is so difficult to arrange our buying and selling so that everything is a perfectly smooth flow, minute by minute.

"On a completely different note: under MMT thinking, it seems to me there is no such thing as government "saving," any more than a bowling alley or United Airlines can "save" points. This makes me even more confused about S=I."

I don't get that. Just define government "saving" as its income (from taxes) minus its spending on newly-produced goods (G). Now, you might object that doing so is stretching the metaphor a bit. OK. But private "saving" is a bit of a metaphor too.

"Take this thinking far enough, and you might get to the crazy notion that S=I is essentially a political statement, a statement of economic world view, a definition by Kuznets and company (unconsciously?) designed to maintain the status quo of the financial system, i.e. to maintain the wealth of creditors."

Nope. Too far there. A statement of an economic view, yep. Different models would have different ways of categorising the world. (Example: Y=F+M national income accounting by a radical feminist who wants to divide everything into expenditure by males M, and females F. It makes just as much sense as Y=C+I+G+X-M.)

rogue: "These equations
1. Y = C + I + G + X - M
2. S = Y - T - C

They are stock equations and do not tell us anything about flow. What causes Y to rise or fall?"

They are *flow* equations, not stocks.
But agreed, they tell us nothing about what causes Y (or S, or anything) to rise or fall.

"I don't get that. Just define government "saving" as ..."

MMT derives sector balance equations from the national income accounts.

Those equations are net of I, so the result is an equation of net financial balances (as flows, which can be accumulated to stocks).

(Nick, I think you've taken issue a few times that this is a fairly trivial exercise from a "mainstream" perspective, and have been critical of MMT followers who think they've stumbled on something "new' here.)

E.g.

Government balance + private sector balance + foreign sector balance = 0

as in for the US:

government deficit + private surplus + foreign surplus = 0

(where foreign surplus is the inward looking reverse of the current account deficit)

Or, government balance + non government balance = 0.

Or, government deficit = non government surplus

MMT defines the right hand side of that as non government "net financial assets" or "net saving", as a flow, which can be accumulated to a stock.

So, basically the government delivers "net saving" to the non government sector by running deficits.

MMT'ers tend to get used to speaking in terms of "net saving", and then drop the "net" out of habit, which gets confusing.

But once they derive the sector financial balances model, they never aggregate government with non government again. Because that would be counterproductive to the interpretation of government being the productive supplier of net saving. It would serve no purpose in telling the story of the government role in running deficits.

And because of this, they also don't like and in fact reject the term "national saving", where the government deficit would be aggregated up as a negative.

It's a different view of the world, where government/non government aggregation serves no purpose.

It is a government-centric view, which happens to be very much in synch with Chartalism as a government centric view of taxation driving the acceptance of currency.

If I've inadvertently trivialized the approach by trying to summarize it, that's not something I mean to do.

P.S.

"where foreign surplus is the inward looking reverse of the current account deficit"

i.e. it's the US capital account surplus that corresponds to the US current account deficit

(which happens to be the "rest of the world" capital account deficit with the US, as a source of funds for the US - terminology and perspective gets slightly mind bending here)

Steve wrote:"Take this thinking far enough, and you might get to the crazy notion that S=I is essentially a political statement, a statement of economic world view, a definition by Kuznets and company (unconsciously?) designed to maintain the status quo of the financial system, i.e. to maintain the wealth of creditors."

Nick wrote:Nope. Too far there. A statement of an economic view, yep. Different models would have different ways of categorising the world. (Example: Y=F+M national income accounting by a radical feminist who wants to divide everything into expenditure by males M, and females F. It makes just as much sense as Y=C+I+G+X-M.)"

I don't understand your response. You haven't just divided up the economy in different ways, you've abolished the government and foreign sector affects on the money supply.

Steve R.'s point had to do with S=I, a special case where G-T+X-M = 0 your assumptions in eq. 4,5,6.

I'm thoroughly confused.

Isn't it obvious your special case relies on banks generating all money horizontally and therefore all the profits? How does Steve get a response of 'Nope'? Shorter Nick, 'for simplicity's sake, lets accrue all the profits of seigniorage to the banks.

There are a few people (20 or 30?) that won't take seriously (or at least sufficiently confused by) a profession that insists on waving away the government and foreign sectors.

Nick

Thanks for the response and I definitely understand that the federal debt is not the totality of non govt saving.

It seems that it is certainly fair to say then that the national debt represents the minimum level that the non govt sector is saving. Its never lower than that although it is likely higher.

tom: "I don't understand your response. You haven't just divided up the economy in different ways, you've abolished the government and foreign sector affects on the money supply."

First off, none of this has anything to do with the money supply. Y=C+I+G+X-M would still be true in a barter economy, with no money at all. And none of these variables determines the supply of money, even in a monetary economy.

Second. All I was trying to illustrate with my (daft) Y=M+F example is that there are many possible ways to divide up sales of newly-produced goods Y into different categories. Here are some more (daft) examples:

Y = goods + services

Y = apples + bananas + carrots + dates + eggs etc.

Y = food + non-food goods

Third: when I assumed away the government and foreigners in the post that was *purely* for simplicity. It is simpler to explain the meaning of S=I under those simplifying assumptions than to explain S+T+M=I+G+X in the more general case. The explanation is exactly the same, but it uses a lot more words, and it's harder to understand.

Damn! You mean government and foreigners *do* exist??? Wow! I thought us Canadian anarchists were here all alone! (Sorry, couldn't resist).

Gizzard: yep. Unless the government borrowed from foreigners.

JKH: "It's a different view of the world, where government/non government aggregation serves no purpose."

Understood. One of the main reasons we divide Y up into the particular categories C+I+G+(X-M) is because we think they are determined in different ways. That the things that determine consumption are different from the things that determine investment, for example. (It would make no sense to distinguish goods bought by right-handed people from goods bought by left-handed people, unless we thought that righties and lefties had totally different behaviour).

And we separate out G precisely because we want to keep it separate as a policy lever.

Nick wrote: "First off, none of this has anything to do with the money supply. Y=C+I+G+X-M would still be true in a barter economy, with no money at all.And none of these variables determines the supply of money, even in a monetary economy."

Thanks for your response, I must have missed a lecture since now I'm even more confused.

In your framework, government spending (G) doesn't help determine the supply of money, even in a monetary economy?

Nick and JKH . . . for me, the most important reason for separating out the sector balances as is done is for analysis from a Minskyan perspective. The identity arranged as "national saving" is a non-starter for me since it gets the causality wrong. But rearranged as the "sector financial balances" we can have some indicator of how things are functioning within the context of Minskyan analysis. Granted, it's not the only measure you would look at for that, but it's an important one, and it helped us make accurate assessments and predictions since the late 1990s. Some MMT'ers also use it to refute financial crowding out--and this is seen better when one goes to the actual NIPAs and Flow of Funds to build the balances relative to other sectors for households, firms, govt, current account separately. The identity used in the post here is not entirely the same thing, actually, and I think does come across a quit a bit more trivial than doing the real world calculations for the sectors (this is not a criticism of Nick's post--MMT'ers do the same thing all the time for simplicity).

tom: "In your framework, government spending (G) doesn't help determine the supply of money, even in a monetary economy?"

I can *imagine* a world where it does. But it's not a country anything like Canada. Suppose the government pays for *all* spending with freshly-printed dollar bills, and when it collects taxes it does so in those same dollar bills, which it burns. And suppose there is no central bank, or banks of any kind. And so those dollar bills were the only form of money people used. In that case, G-T would tell us how much the stock supply of money increased each year (or decreased if T is bigger than G).

But in a country like Canada, the annual revenue the government gets from printing money (the profits of the Bank of Canada, which it owns) are about $2billion per year. Which is much smaller than the typical government deficit or surplus. Most deficits are financed by selling bonds, not money. And surpluses are used to buy back (pay off) those bonds. So there's no direct link between G-T and the printing of government money (which is controlled by the quasi-independent Bank of Canada anyway).

Plus, some money is also created by commercial banks (depends on exactly how narrowly or broadly you define "money", but most would include chequeing accounts as money).

So, unless the government (like Zimbabwe) cannot borrow (can't sell bonds) there really isn't any link between G-T and the change in the (stock) supply of money.

Scott: "The identity arranged as "national saving" is a non-starter for me since it gets the causality wrong."

Understood. Since you guys think of "government saving" (T-G) as one of the main determinants of private saving, you wouldn't want to simply add the two together.

In a different model (the New Keynesian for example), where monetary policy is used to adjust the rate of interest to keep output at potential and inflation on target, it would make sense to add private plus government saving together to get national saving. Desired national saving and desired investment (assuming closed economy) together determine the natural rate of interest. And the central bank would need to keep the actual rate of interest equal to that natural rate to keep output at potential and inflation at target.

An aggregation that works well for one theory does not work for another. We need to make our accounting categories fit our models, not vice versa. (Pax JKH, because this doesn't mean you can make up any sort of accounts you like; things still have to add up right, it's just you can add them together or split them apart differently.)

The big problem is that saying I is investment makes people think that I is how much money was converted into capital goods that might improve productivity or demand. It isn't. There are all sorts of investments that are simply ways of removing money from the economy so that Y = C + I simply results in a smaller C and falling living standards.

"So, unless the government (like Zimbabwe) cannot borrow (can't sell bonds) there really isn't any link between G-T and the change in the (stock) supply of money."

Woah, Nelly.

There is not only a link, but this is one of the strongest correlations we can observe in the macro data.

//research.stlouisfed.org/fred2/graph/?g=1HI

rsj: Wow! I have just learned how to do St Louis Fed graphs! (I think) I am VERY proud of myself.

I'm really a bit concerned about this MZM stuff, but since you chose it, I thought I would compare your MZM with NGDP, as opposed to your debt in public hands. NGDP works much better. Velocity looks much more stable:

https://research.stlouisfed.org//fred2/graph/?id=GDP,#

(Yes, look, what I should have said is that there is no *accounting* link between stock of money and G-T. But all you are picking up in your graph is that everything has been increasing over time. Money and debt. NGDP works much better.)

I'm off for a day or so.

Have fun, play nice.

Damn! I can see my graph, but my link just shows NGDP. It doesn't show MZM any more. I have screwed it up somewhere.

rsj: do me a favour please. Can you draw a graph showing your same MZM, but compared to nominal GDP (that's the first one in their GDP list). Thanks.

Nick, if you click on Fred link (e.g. MZM) and then edit the graph to get MZM/NGDP, the URL in your browser does not change as a result of your edit, so you if then cut and paste the URL, it will point to your original graph (MZM) not the modified one.

To get a link to your modified graph, there is a "link" link just above the graph you created. Click on it, and you will get a URL that will point to just the .PNG file, or the entire page.

Here is a graph of MZM/NGDP and Debt held by Public/NGDP.
http://research.stlouisfed.org/fred2/graph/?g=1HK

And yes, my graph was a behavioral, not an accounting relationship. Very much like velocity! And like velocity, the relationship can break down if you push it to the extreme -- e.g. attempting to issue a lot of debt in order to increase MZM will have the same non-result as engaging in QE to increase MZM.

Here MZM and the base:

http://research.stlouisfed.org/fred2/graph/?g=1HL

But the behavioral theory is that when the government deficit spends, it creates a deposit, so MZM goes up, but when the government sells a bond, the deposit does not go away, only the reserves backing the deposit go away.

So the deposit ends up "backed" (very loosely) by a bond, rather than by reserves. The seignorage income is transferred from the government to the banking system, but the private sector as a whole still demands to hold money roughly equal to the federal debt. Obviously, this relationship breaks down if the federal government were to issue too much or too little debt. But in the latter case, the deposit ends up backed by a mortgage (say), which is more fragile than a riskless treasury. Therefore when MZM went above federal debt, this could have been (and was, for my part) interpreted as a sign of financial sector fragility. And the rush to increase federal debt can be interpreted as allowing the deposits to be "backed" more by riskless bonds -- it strengthens the financial sector.

Nick,

“An aggregation that works well for one theory does not work for another. We need to make our accounting categories fit our models, not vice versa”

Two different ideas in juxtaposition there -

MMT and the New Keynesian model and any other model should be able to map into the same basic accounting framework, in order to be able to “talk to each other”.

And everybody should map to national income accounting and financial accounting in general, in order to be able to talk to the real world. MMT accounting DOES derive from and map to national income accounting. You should too, Nick.

This is like saying that the rest of mathematics should be friendly and communicable with the natural numbers (please don’t attempt an exception to that, Nick).

Aggregation is separate. Aggregation can be done differently across and within the same accounting framework. (C + I + G + X – M) across is one aggregation. (G u G’) across is another. G’ within is another. Etc.

Pax out.

Nick Rowe: "First off, none of this has anything to do with the money supply. Y=C+I+G+X-M would still be true in a barter economy, with no money at all."

You mean each of the variables would be vectors? I. e., not reduced to a single measure?

Nick Rowe: "And none of these variables determines the supply of money, even in a monetary economy."

A somewhat ambiguous statement. :) And one that appears to contradict MMT directly, which claims that the gov't deficit injects money into the economy, increasing the money supply dollar for dollar. The simplest explanation for the apparent contradiction is differing definitions of money. Could you address that question more? Thanks. :)

Nick,

Interesting discussion on aggregation.

As someone has pointed out here, national accounting itself is based on a model - a way of looking at the complex world around us. And that is Institutionalism. New Keynesian economics seems to be built on utility-maximizing individuals and says little about the role of institutions.

Someone named Peter Kenway provided a taxonomy of the various income/expenditure models in Britain in a nice book. The first time someone aggregated in the way we are talking here (in an accounting language) - "private sector" was during the early 70s - Cambridge. So they would talk of the private sector "Net Acquisition of Financial Assets" in their models and would also combine the private and public sectors' accounts stressing that the income less expenditure of a nation as a whole is the current balance of payments and this would lead to net incurrence of liabilities to foreigners and that process cannot go on forever.

The aggregation of all sectors of a nation as a whole exists independently - central banks have been maintaining the balance of payments and international investment position accounts since the World War - or maybe before (?). The numbers are also consolidated - so we have numbers such as *net* international investment (which combines the government and the domestic private sector into one) hitting the first page of an official press release.

Agree with you on the question you have posed here - what mechanism ensures that the accounting identities are maintained at all times ? I see you have commented that Y adjusts to keep the accounting identities intact, which nobody has appreciated so far!

Yes accounting identities don't mean much. Some Austrian economist pointed out recently that he can criticize deficits using G-T=S-I by saying deficits reduce I! (The correct model IMO is that a fiscal expansion increases demand and would also increase investment)

"..this would lead to net incurrence of liabilities to foreigners and that process cannot go on forever."

Sorry meant the other way - expenditure higher than income leading to net incurrence of liabilities to foreigners and that the process could become unsustainable.

"First, you need to stop talking about the "flow of *funds*". What the heck are "funds"? You need to talk instead about the flow of *money* -- the medium of exchange. Because it is money that we buy and sell stuff with. If we talk about demand and supply, and buying and selling, in a monetary exchange economy, we are talking about the flow of money."

Can you stick to medium of exchange? IMO, there are too many definitions of "money"?

So in MV = PY should M equal the medium of exchange amount?

"But someone who says that lower interest rates will increase borrowing and therefore debt (which you hear a lot), has forgotten the other side of the accounting identity. Borrowing = lending. And lower interest rates reduce desired lending."

What about banks and the capital requirement?

That sounds like the nominal interest rate(s) (I could be wrong about that). What about real interest rate(s)?

"You can eliminate C in 3, and rearrange terms to get:

4. I - S + G - T + X - M = 0"

That requires a medium of exchange supply that flows. Correct?

"Start with the standard national income accounting identity:

1. Y = C + I + G + X - M"

What if C, I, G, and/or (X-M) are coming from time periods outside of that measured by Y?

"For example, if the government imposes a binding price floor on apples it will be wrong. In that case, Intro Economics would replace it with a slightly modified theory: the quantity of apples traded is determined by the demand curve and the price the government sets; the supply curve plays no role. With the price fixed above where supply and demand curves cross, quantity demanded = quantity bought-and-sold < quantity supplied. In that "semi-equilibrium" actual purchases will be equal to and determined by the quantity of apples people want to buy (demand) at the fixed price. But the actual quantity sold will not be equal to nor determined by the quantity people want to sell (supply)."

Can that be applied to the medium of exchange amount and/or its composition?

I said: "You can eliminate C in 3, and rearrange terms to get:

4. I - S + G - T + X - M = 0

That requires a medium of exchange supply that flows. Correct?"

I see something about barter above. Skip that and replace "requires" with "usually has".

this whole thread is talking past each other for one simple reason: we aren't using the right terminology. Wynne godley's main complaint was that in the mainstream model it isn't clear who is a counterparty to each transaction, what form savings take and where the excess of spending over income actually goes. i think this 6 page sample from wynne godley's monetary economics may be of use. http://goo.gl/jr0eS

Nick

Well, "borrowing" from foreigners is inapplicable to the USA but its also true that foreigners are a part of the non govt sector. They are part of the savers who are measured in the national debt. The MMT statement has never been "The national debt= AMERICAN CITIZEN savings only". They have a demand to save in US dollars that is being "met" with the debt.

RSJ wrote:'"So the deposit ends up "backed" (very loosely) by a bond, rather than by reserves. The seignorage income is transferred from the government to the banking system, but the private sector as a whole still demands to hold money roughly equal to the federal debt. Obviously, this relationship breaks down if the federal government were to issue too much or too little debt. But in the latter case, the deposit ends up backed by a mortgage (say), which is more fragile than a riskless treasury. Therefore when MZM went above federal debt, this could have been (and was, for my part) interpreted as a sign of financial sector fragility. And the rush to increase federal debt can be interpreted as allowing the deposits to be "backed" more by riskless bonds -- it strengthens the financial sector."

Awesome! I've never seen the mechanics of government spending interacting with the banking sector explained that way. If I did, I wasn't ready to understand it at the time. Initially it looks like banks have a large amount of control over the correlation between MZM and fed debt held by pub but their flexibility is determined by how much debt government is willing to issue. Basically it is the government's choice to destabilize the banking system.

I've followed the amount of tsy secs held by commercial banks

http://research.stlouisfed.org/fred2/series/USGSEC?cid=99

and never had a good explanation for the recent step like nature to bank purchases of government debt. I never considered they might be due to supply issues. Interesting, thanks!

Or Winslow R., its their choice to stabilize it...anyway welcome to MMT

rsj said: "But the behavioral theory is that when the government deficit spends, it creates a deposit, so MZM goes up, but when the government sells a bond, the deposit does not go away, only the reserves backing the deposit go away."

But when the gov't sells a bond, does a different demand deposit that was saved also "go away" even if it was created by something bank-like?

So the deposit ends up "backed" (very loosely) by a bond, rather than by reserves.

So does that mean the new demand deposit (the new medium of exchange) was borrowed into existence?

"So the deposit ends up "backed" (very loosely) by a bond, rather than by reserves." above is a rsj quote.

Min: I'm going to take your 2 questions in reverse order:

1. " "Nick Rowe: "And none of these variables determines the supply of money, even in a monetary economy."

A somewhat ambiguous statement. :) And one that appears to contradict MMT directly, which claims that the gov't deficit injects money into the economy, increasing the money supply dollar for dollar. The simplest explanation for the apparent contradiction is differing definitions of money. Could you address that question more? Thanks. :)"

Suppose a government buys $1billion worth of newly-produced tanks, or schools, or roads. That's an increase in G. And suppose it finances this purchase by selling a national park for $1billion. That's not part of G, because the national park is not a newly-produced good. And it's not part of T either, by any standard definition. So G-T has increased by $1billion, but there's no change in the money supply. (OK, you might say the money supply in public hands decreased by $1 billion when the government sold the park, but it immediately increased again by $1 billion when the government bought the tanks.)

Now, you might say that sales of government assets like national parks are perhaps rare. But it is very common for governments to finance deficits by selling bonds.

There are many different ways to define the stock of "money". But most people, when they say "money", do not include either national parks or bonds.

The stuff that people do call "money" that is a direct liability of the government and that the government can finance part of its deficit by issuing, is "base money" (i.e.currency plus deposits at the Bank of Canada). The stock of base money is normally around 5% of GDP in Canada and similar countries, while the public debt (accumulated deficits G-T) is (usually) many times bigger than that.

2. "Nick Rowe: "First off, none of this has anything to do with the money supply. Y=C+I+G+X-M would still be true in a barter economy, with no money at all."

You mean each of the variables would be vectors? I. e., not reduced to a single measure?"

I'm going to make two responses to this:

2a. (This is the innocuous part, that most would agree with).

Suppose people used barter exchange. They traded goods for goods directly, without using a medium of exchange. But accountants, including national income accountants, might still use some common measure of market value to add up the values of apples and bananas. They might, for example, use kilograms of carrots as the unit of account. That doesn't mean people use carrots as the medium of exchange -- only buying and selling things for carrots -- it just means that accountants reduce everything to carrots as the common denominator.

2b (A wild, outrageous claim, that I only thought up while writing this post, and I still can't quite get my head around. I'm not even sure it doesn't violate all the normal rules of science. I made this claim in the post, but nobody has yet called me on it. So, I'm going to repeat this wild statement, then call myself on it.)

Here's the claim, made as provocatively as possible: National Income Accounts allow us to add kilograms of apples with kilowatt-hours of electricity.

Apples sold = apples bought. That's the same number, just looked at from two different sides. We might as well write it, A=A.

Same is true for bananas: B=B.

*Normally*, National Income Accountants add up the *monetary values* of goods. If Pa is the price of apples, and Pb the price of bananas, they will say that the total value of goods sold = the total value of goods bought: Pa.A + Pb.B = Pa.A + Pb.B (for an economy that produces only apples and bananas.

But look at the math. You can replace Pa and Pb with *any* pair of numbers (like 7 and 42), and the equation still holds true: 7A+42B=7A+42B

We could measure apples in kilograms, and bananas in pounds, and the equation would still hold true.

Now, replace bananas with electricity. We could measure apples in kilograms, and electricity in kilowatt hours, and it is still true that A+E=A+E. Even though A+E doesn't mean anything at all, because the units are just.....wrong!

Weird, huh? What I say *can't* be right! (But nobody called me on this when I wrote this in the post.)

I bet the Austrians will love this one! They always said that aggregation is meaningless (or something like that).

Ramanan: "Agree with you on the question you have posed here - what mechanism ensures that the accounting identities are maintained at all times ? I see you have commented that Y adjusts to keep the accounting identities intact, which nobody has appreciated so far!"

Hang on! That's not what I said. I said that *nothing* needs to adjust to keep the accounting identities intact. Accounting identities are true by definition. (OK, if somebody said that sometimes the *meanings of words* has to adjust to keep the accounting identities intact, I would not disagree.)

I said that *something* has to adjust to keep the *equilibrium conditions* (like desired saving = desired investment) intact. And I gave *an example* of one theory where Y alone did all the adjusting, just to illustrate the point. A different theory might say that r adjusts. Or maybe P. Or maybe some mixture of all 3. Or maybe a quite different theory says nothing can adjust, and desired saving never does adjust to equal desired investment.

"If Pa is the price of apples, and Pb the price of bananas, they will say that the total value of goods sold = the total value of goods bought"

Disagree.

They say the total value of goods sold/bought = total income earned.

The right hand side requires a homogeneous unit of measurement by construction.

It doesn't allow the nonsensical examples you construct simply by invoking bought = sold.

Here's the thing: there is no such thing as a theory derived from accounting identities; all you have done is re-written the accounting identities in a different way. Arranging things so that X is on the left-hand side and Y is on the right-hand side is not a demonstration that Y depends on X.

"Suppose a government buys $1billion worth of newly-produced tanks, or schools, or roads. That's an increase in G. And suppose it finances this purchase by selling a national park for $1billion. That's not part of G, because the national park is not a newly-produced good. And it's not part of T either, by any standard definition. So G-T has increased by $1billion, but there's no change in the money supply."

So has the velocity of the medium of exchange supply changed because the gov't has stopped saving?

I didn't rewrite anything. It's products on one side, and income on the other. Value of transactions (product side) equals income. Transactions, bought or sold, are stated on the product side. I said/inferred nothing about dependency or causality. It's just accounting, not theory.

Sorry Nick you have lost me.

RSJ's point (as I interpret).

1) 'bank loans create bank deposits'
2) 'government spending creates bank deposits and reserves'
3) 'government taxes destroys bank deposits and reserves'

RSJ's point regarding reserves and deposits can also address whether government bonds are purchased by banks or bank customers.

If the bank customer's purchase bonds, reserves and deposits are destroyed.

Simple xplanation: initially the bank customer has a $10 deposit from which he requests $10 bill. He takes the $10 bill and purchases a $10 bond. Both reserves and deposits are destroyed, while customer gains a bond.


If the bank purchases government bonds, reserves are destroyed but deposits remain.

Simple xplanation: initially the bank has excess reserves. It exchanges the reserves for bonds. The reserves are destroyed while the bank gains a bond.

I'll test RSJ's theory against real numbers when I get back to civilization, hard to do on a smart phone, even an iPhone :)

Initially I don't think the base money at 5% of GDP vs. Government debt being several times that is a concern because government does sell bonds which destroy reserves all the time and deposits almost all the time ( except when the bonds are sold to banks)

Winslow,

I am not saying that all government bonds are purchased by banks. But I am saying that the result of the behavior is that the system behaves *as if* the government is transacting directly with banks.

Each action -- e.g. the government selling a bond -- kicks off a chain of other actions -- many other people/sectors buy and sell bonds as well. Interest rates change, quantities change, etc. The result of all of these actions is (typically) that the household sector bond to deposit ratio changes only slightly even as the other sectors significantly shift their net supply of bonds.

Primarily, it is the financial sector that adjusts its net bond holdings, allowing households to maintain a target level of bond to deposits in line with their own bond/deposit demand.

We would expect that target ratio to change with the interest rate, and it does, but the target ratio as demanded by households is much less sensitive to changes in the interest rate than the quantity of bonds supplied by the financial sector. Or equivalently, the financial sector, because it is leveraged, is much more sensitive to interest rate changes than the household sector, so it is the one to bear the brunt of the quantity adjustment.

This is basically an elasticity argument, that I tried to outline here with some graphs:

http://windyanabasis.wordpress.com/2011/06/16/pushing-on-a-string-supply-demand-version/

The actual data has been that household bond/deposit ratio remain relatively constant even as the government and foreign sector's bond supply swing around, with the financial sector soaking up the difference. This data is available here:

http://windyanabasis.files.wordpress.com/2011/04/bonds.png
http://windyanabasis.files.wordpress.com/2011/04/bonds_recent.png

That last post was by me, not "m" :)

Winslow R. said: "RSJ's point regarding reserves and deposits can also address whether government bonds are purchased by banks or bank customers.

If the bank customer's purchase bonds, reserves and deposits are destroyed.

Simple xplanation: initially the bank customer has a $10 deposit from which he requests $10 bill. He takes the $10 bill and purchases a $10 bond. Both reserves and deposits are destroyed, while customer gains a bond.

If the bank purchases government bonds, reserves are destroyed but deposits remain.

Simple xplanation: initially the bank has excess reserves. It exchanges the reserves for bonds. The reserves are destroyed while the bank gains a bond."

Let me try to expand on the bank part. If the bank wants to purchase the gov't bond, it creates a demand deposit (medium of exchange) out of thin air and immediately saves it. Next, both (central bank) reserves and demand deposit(s) are destroyed, while the bank gains the bond (a savings vehicle). Sound good?

Winslow R. said: "Simple xplanation: initially the bank customer has a $10 deposit from which he requests $10 bill. He takes the $10 bill and purchases a $10 bond. Both reserves and deposits are destroyed, while customer gains a bond."

It seems to me you can skip the $10 bill part. Just markdown the customer's account by $10 of demand deposit(s) and markup the same person's account with $10 of a gov't bond that yields interest.

That's great stuff, RSJ. It fits quite well with the MMT view. I'm going to have to work with both posts a bit more (pushing on a string posts, that is) when I get some time to see how much of my own views I can fit in their and how much it clarifies/adjusts my own views. Thanks!

RSJ,

I took a quick look at your two posts for the first time. They look very interesting. A couple of first reactions:

a) Wouldn't you expect off the top that most CB or Treasury bond sales/issues would end up in the financial sector directly anyway, based on the size and historic trend holdings of the household sector? If I'm not mistaken, your posts seem to develop it as if it is households that are taking on some sort of temporary intermediary function which results in "diffusion" of bonds out into the financial sector. But I'll have a closer look at your posts when I get a chance.

b) I think your posts may be blending in and out of talking about banks versus the non-bank financial sector a bit. It's still noteworthy to track the first round effect on bank deposits versus non-bank non-deposit liabilities, and to do it for the banks and non-bank FIs in distinction.

c) You've "universalized" the analysis to bond deposit liabilities versus bond liabilities. The big non-bank financial liabilities other than bonds that may be intertwined with bond purchases include mutual fund liabilities, investment fund liabilities, insurance liabilities, pension fund liabilities, etc. The bank bank liabilities of course include time deposits as opposed to bonds.

d) Just a caveat on flow of funds data, which you're probably aware of. The household sector is a data residual, not directly collected data. As a quirk, it happens to include hedge funds, which have probably had a substantial impact on bond distribution since the QE programs started.

This is a quick response. Apologies if I've misrepresented anything you wrote.

meant bank deposit liabilities, not bond deposit liabilities, above

Final point, RSJ - it's not clear to me that the CB would have an objective of creating household deposits with QE, given what you would think they would know and expect about the end distribution of bonds among sectors.

That's another reason why the official explanations for QE motivation seem somewhat vague and ill-defined.

Winslow R.: "RSJ's point (as I interpret).

1) 'bank loans create bank deposits'
2) 'government spending creates bank deposits and reserves'
3) 'government taxes destroys bank deposits and reserves'"

Hang on. Isn't there a central bank in there somewhere? What's it doing?

Savings will NEVER be equal to investment, because their under-the-mattress portion cannot and will not be invested, NO MATTER WHAT YOUR ARITHMETIC SAYS.

Scott -- thanks! I'd be happy to hear any criticism or corrections. The post was my interpretation of the data, but it may not be the only interpretation.

JKH,

Thanks. Regarding your points:

A) In the first post, I assumed that all bonds were sold to households or purchased from household, for purposes of exposition, not because this is important. As long as there is a law of one price, then it doesn't matter who the government is transacting with. While the law of one of price is itself just an idealization, it's good enough for my purposes.

But in the second post (the supply-demand version), I didn't look at individual transactions at all, but merely asset demand -- specifically net bond bond demand coming from different sectors. I think this is a better way of trying to understand the relationship between changes in government bond supply and the resulting shifts in both quantity and price that occur in each sector.

B) Perhaps. I am often sloppy. If you see an error, then point it out. But for my purposes, I don't treat insurance/pension/mutual funds as "finance", but I called them an "investment" sector. The sector membership definitions were defined in the first post. For me, the relevant part about finance is leverage, since my hypothesis is that leverage is what makes this sector more sensitive to rates and therefore the interest elasticity of net bond supply should be higher for leveraged institutions rather than non-leverage.

In the second post, I grouped most of the sectors together, purely for pedagogical purposes -- there were enough lines in the drawing already! But again, in theory, if you have N different sectors, each with N different interest-elasticities, then you can calculate how quantities and interest rate shift as a result of one of the sectors (e.g. the central bank or foreign sector) changing their net bond demand, just by using the elasticities and sum of bond positions = 0. That is uncontroversial. It then becomes an econometric problem to estimate the elasticities using time series data or other data. My general argument about leverage increasing the elasticity is the low hanging fruit.

C) Yes. I ignored equity completely, as well as things like repo funding. The former was just too volatile, and I don't imagine equity as directly competing with deposits in a way that bonds do. But the latter is important since I am ultimately looking at instruments that households can purchase and specifically looking at the effects of CB and foreign sector bond purchases.

Btw, I actually think that the foreign sector bond acquisitions were much more devastating to both household and financial sector balance sheets than the Clinton surpluses, and I think the data bears that out.

D) Yeah, the hedge fund data complicates every measure of household asset holdings. I think for this reason, it's good to group the household and "investment" sectors (as I've defined it) together -- another good reason to split off insurance and the like from "finance" and insert it into the household sector. Both groups tend to have fairly stable bond holdings under a variety of interest rate regimes, particularly in comparison with the other sectors.

Nick,

The CB is controlling the short rate, and -- in the case of something like QE -- it is causing the consolidated government bond demand curve to shift. I was examining the effect of the second.

Specifically, I was trying to understand why the various rounds of QE failed to cause MZM to increase -- both here and previously in Japan.

I came to the conclusion that it boils down to the incidence of the CB purchases on overall bond holdings by each sector:

If the CB sells a bond to a household, and the household turns around and buys a bond from a bank. Then the result of both operations is that MZM remains unchanged. On the other hand, if the CB buys a bond from a household, and the household keeps the deposit, then MZM has increased. Of course there are many other possibilities in between, but the key aspect seemed to be how net bond holdings change among all the different sectors as a result of a shift in the bond demand curve of the government sector.

When looking at the historical time series, I noticed that households tend to keep their bond/deposit holdings constant, or at least the sensitivity of this ratio to changes in interest rates is quite low. However the opposite is true of the financial sector. This sector adjusts its bond holdings very rapidly, and it seems to make this adjustment in such a way as to keep household bond holdings roughly unchanged.

Then I hypothesized that because this sector is leveraged, its sensitivity to interest rates is much higher, and therefore leverage is the main reason why the CB has such difficulty affecting the size of MZM via quantity adjustments (e.g. OMO). Hope that makes sense.

"Specifically, I was trying to understand why the various rounds of QE failed to cause MZM to increase"

Without looking at the data as closely as you have, I've always just assumed its directly related to the impact of de-leveraging on the banking system: loans being paid down, which extinguishes deposits. And banking system losses leading to bank recapitalization, which moves money from deposits into capital. But maybe that's too simplified.

JKH,

These issues are clouded by the fact the government has been stepping in to supply more net bonds and a lower trade deficit meant that the foreign sector was purchasing fewer bonds. If you consolidate CB + foreign sector + government, there hasn't been a change in net bond supply by this consolidated sector.

If you are going to measure bond supply shocks on the household sector, it's better to look at the foreign sector prior to the crisis, or, in the case of Japan, look at their QE effort.

Total borrowing by financial sectors is lower than before (but it seems to be have stabilized), so that if we group all types of bank borrowing -- recapitalization as you put it, together with debt growth, then there has been less of it going on now that before the crisis.

Therefore deposits, in aggregate, have not been moved into more claims on banks. Rather household bond claims on banks have been replaced with bond claims on government and the foreign sector. Total household deposits and bonds haven't changed a whole lot throughout this crisis.

I was the one who annoyed Nick at Sumner’s site by claiming that S=I (in absence of govt) by accounting and that equilibrium has nothing to do with it.

Here is why more generally the equality S-I=G-T has nothing to do with any equilibrium, and everything to with with accounting.

In the presence of govt, there are only 4 types of transactions, examples of which are below:

1) A buys investment good from B for 40.
(note that different parties accrue income and invest here: B accrues income, A invests.)
2) C buys consumption good from D for 60. (D accrues income, C consumes).
3) Govt G taxes party E 10. (no private sector income here)
4) Govt spends by crediting F’s account 20. (F gets income, G doesn’t consume anything)

This covers all possible transactions types in a closed economy with govt.

(cont.) part 2
Let’s looks at accounting:

Y=(outlays)=C+I+G

Y=(spending sinks)=C+S+T

The second equality is the definition of S=Y-C-T : Saving (S)=income (Y), unconsumed (-C), after taxes (-T).

I will show below that with this definition all transactions 1-4 obey S-I=G-T.

Note, that for this “saving” S to occur, there has to be a transaction (we need income). A stash of money we have in the bank, although commonly called “savings”, is a stock, not a flow, as S is – this is the source of the confusion.

(cont. part 3)

Here is how S-I=G-T is preserved in each of the above transactions:

1) Transaction 1
A buys investment good from B for 40.

Income incurred by B is 40, it records A’s investment (not consumption):
dY=40=dC+dI+dG=0+40+0
dY=40=dC+dS+dT=0+40+0

dS=40 here, by definition, because this the unconsumed income (40) after taxes (0) that was recorded in this transaction.

dS-dI=40-40
dG-dT=0-0

d(S-I)=d(G-T) in this transaction.

2) Transaction 2
C buys consumption good from D for 60.

dY=60=dC+dI+dG=60+0+0
dY=60=dC+dS+dT=60+0+0

dS-dI=0-0
dG-dT=0-0

d(S-I)=d(G-T) in this transaction.

(cont part 4)

3) Transaction 3
Govt G taxes party E 10. No private sector income is created here:

dY=0=dC+dI+dG=0+0+0
dY=0=dC+dS+dT=0-10+10

Here we have S=unconsumed income (0), minus taxes (-10)=-10

dS-dI=-10-0
dG-dT=0-10

d(S-I)=d(G-T) in this transaction.

4) Transaction 4
Govt spends by crediting F’s account 20. This income is not recording G’s consumption (thus belongs in S).

dY=20=dC+dI+dG=0+0+20
dY=20=dC+dS+dT=0+20+0

Here we have income of 20, which the private sector didn’t consume = it belongs to unconsumed income after taxes (S).

dS-dI=20-0
dG-dT=20-0

d(S-I)=d(G-T) in this transaction.

(cont part 5)

If the period in question contains transactions 1-4, the GDP equation is:

Y =C+I+G=60+40+20=120=C+S+T=60+50+10

Total saving S in this period: unconsumed income (Y-C=60), minus taxes (10)=50. Or, summing dS(i) accrued in each transaction: S=dS(1)+dS(2)+dS(3)+dS(4)=40+0+(-10)+20=50.

In this period:
S-I=50-40=10
G-T=20-10=10

Each larger period contains many of these transactions, yet each and every one of these transactions obeys S-I=G-T, no matter the size of the transaction, the interest rates, equilibrium presence and whatnot.

Interest rates or the presence or absence of equilibrium would have impact on the size of these transactions or their taking place or not in the first place, but it would have no impact on the equality S-I=G-T being obeyed or not (it will be obeyed no matter what).

S-I=G-T is preserved in each transaction that takes place in the economy.

In the absence of the govt, the transaction types 3) and 4) don’t take place and we have S-I=0 preserved in every single transaction, and hence in each period, however long or short.

(appologies for so many parts and a long comment.)

RSJ,

I'll have to absorb that.

I'm being a bit lazy about this at this particular point, but one of the pieces of the puzzle here is what could be a somewhat stand-alone explanation about what's happened to the banking system balance sheet. We know that reserves are up to due to QE. So what I'm looking to summarize in a lazy way is what is the offset to that instead of MZM on the liability side. It has to be some combination of asset adjustment and liability/equity adjustment that plugs the absence of MZM growth. No doubt it's consistent with your explanation, but is there a way of summarizing the system balance sheet change in such a way as to explain that adjustment?

P.S.

And I expect not much of it at all is going to be explained by a decline in commercial bank holdings of government bonds.

P. Petropoulos: "Savings will NEVER be equal to investment, because their under-the-mattress portion cannot and will not be invested, NO MATTER WHAT YOUR ARITHMETIC SAYS."

Aha! A man after my own quasi-monetarist leanings! Presumably you are saying that *desired* saving will not be equal to *desired* investment, if there is an excess demand for the medium of exchange.

You might enjoy this old post of mine:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/10/the-paradox-of-thrift-vs-the-paradox-of-hoarding.html

The comments to this entry are closed.

Search this site

  • Google

    WWW
    worthwhile.typepad.com
Blog powered by Typepad