Collateral and the money supply

I sketch a simple model where a shortage of collateral reduces the money supply, and makes the Cash-In-Advance constraint binding in an otherwise New Keynesian model. This post is a followup on my previous post on "negative money".

Start with an economy where the central bank issues green paper currency, and all goods must be bought for that green paper currency. There is a Cash-In-Advance constraint in this economy. If you do not have any green notes you will miss out on buying opportunites. If you want to sell goods, and the buyer does not have any green notes, you will miss out on selling opportunities. The CIA constraint will be binding.

Now suppose every agent keeps all his currency in a box at the central bank. When he buys something, the central bank takes currency out of his box and puts it in the seller's box. Nothing has changed (except for muggers). The currency boxes are just a simple form of ledger. It wouldn't matter if all the currency was destroyed in a fire, provided the ledger was saved.

Now suppose the central bank pays interest Rg on holdings of that currency, and can vary that rate of interest. (If you hold 100 green notes, the central bank gives you Rg more green notes every year.) An increase in Rg increases the demand for currency, and if the supply of currency is fixed, and if prices are sticky, this excess demand for currency would cause a recession.

Now suppose we add a second form of central bank currency. Red currency has negative value. If you buy $10 worth of apples, either you give the seller 10 green notes, or the seller gives you 10 red notes, or some combination of the two. Red currency pays a rate of interest Rr. (If you hold 100 red notes, the central bank gives you Rr more red notes every year.) If you want to sell something, and you do not have any red notes, and the buyer does not have any green notes, you will miss out on selling opportunities, and the buyer will miss out on buying opportunites. The CIA constraint will be binding. The gross money supply (green notes plus red notes) matters.

If we assume: the total stock of green notes is always equal to the total stock of red notes (the net money supply is always zero); the central bank will always give you one green note and one red note if you ask (the gross money supply is unlimited); the central bank will always destroy one green note and one red note if you ask; (these last two assumptions ensure the exchange rate between red and green notes stays fixed at minus one); the central bank always sets Rg=Rr (call it "Rm", for "interest on holding money"); Standard Euler equation IS curve; standard Calvo Phillips curve; then we have the standard New Keynesian model.

These assumptions ensure the CIA constraint is never binding, provided the central bank sets Rm just right so that the demand for green notes equals the demand for red notes. Because if neither the buyer nor seller of $10 worth of apples has any money, each goes to the central bank and asks for 5 green and 5 red notes, the buyer gives 5 green notes to the seller, the seller gives 5 red notes to the buyer, and they do the deal.

But if the central bank sets Rm too high, there is an excess demand for green money, an excess supply of red money, and so an excess demand for net money, and a standard New Keynesian recession.

But there is a problem with this New Keynesian model: who ensures that each agent's intertemporal budget constraint is satisfied? Who prevents an individual from always buying goods, never selling goods, accumulating an infinitely large stock of red currency, and so having a debt to the central bank he can never pay back? ("The economist who wrote the model, and who imposed the no-ponzi-condition" is not a satisfactory answer to this question.)

The simplest answer is that the central bank requires each agent to post collateral, and puts a ceiling on his holding of red notes equal to the value of that collateral (minus a haircut). If you do not post collateral you can only hold green money.

If collateral is scarce, so that collateral puts a binding constraint on the central bank's issuance of red notes, and if the central bank refuses to issue more green notes than red notes, then the scarcity of collateral puts a binding constraint on the total stock of green plus red notes (gross money supply). The CIA constraint becomes binding. If there is an exogenous drop in the quantity of collateral, or an exogenous drop in the quality of collateral so that the central bank increases haircuts, and if the central bank holds Rm constant, the result will be an excess demand for gross money, and so the CIA constraint bites more deeply, which causes a recession.

If the central bank will not or can not reduce Rm, the solution is for the central bank to issue more green money, and break the New Keynesian "rule" which says that the total stock of green money must always equal the total stock of red money. The central bank increases the stock of green money by buying assets outright. We call this "QE".

I think the ECB has a rule which says the total stock of green money must equal the total stock of red money. (JKH?) In other words, the ECB is a New Keynesian central bank. That's a problem for the ECB.

I'm not sure if I have got this right, but my head hurts, so I am going to post it.

Comments

[louis]

Great post; I'd like to think a little bit more about the nature of "collateral". Maybe this ties to some of your other thought experiments.
The world is full of assets - ownership claims that entitle their holders to future income. Land and other claims to rent, physical/intellectual capital, loans to others (incl ponzi loans), even durable consumption goods.
All represent wealth to their holders. Virtually none are liquid enough to be accepted as a medium of exchange. So the supply of money matters independent of the stock of wealth/assets in allowing the economy to hum along at capacity.
As you sketch it out, only a subset of those assets is accepted as "collateral" by the central bank, and that puts a constraint on the supply of money. Collateral shocks can lead to real output drops.
Can I draw these conclusions?
1) The CB buying collateral outright when collateral is short increases the money supply, but only to extent of the size of the haircut, since it has re
2) The CB buying non-collateral assets has a bigger impact, as does expanding the definition of acceptable collateral.
3) Some (eg Izzy Kaminska) claim that the CB creating money to buy collateral is contractionary. This conclusion is impossible by your model.
4) Since private institutions can create CB money substitutes, their policies with regard to collateral bear scrutiny. To some degree the CB may need to offset their changes in collateral acceptance.

[Frank Restly]

Nick,

"Who prevents an individual from always buying goods, never selling goods, accumulating an infinitely large stock of red currency, and so having a debt to the central bank he can never pay back?"

The legal authority (government) - at least until government and the financial sector created a series of revolving doors.

[Majromax]

> The simplest answer is that the central bank requires each agent to post collateral, and puts a ceiling on his holding of red notes equal to the value of that collateral (minus a haircut).

Huh. So this is a two-currency system: green money is unbacked, fiat currency, whereas red money is backed by the net posted collateral.

> The central bank increases the stock of green money by buying assets outright. We call this "QE".

Or the central bank could decrease the stock of red money by buying assets outright with (taking in) that money and retiring the $Red. That's equivalent to calling in the collateral held against the issued red money.

The existence of that collateralization makes me wonder if your assumptions (plus no-ponzi) are overly constraining. Simply requiring collateral means that the central bank can't "always give you one green note and one red note if you ask." Allowing for the possibility of that collateral to be called in might then violate the even amounts of $Green and $Red, unless the Central Bank keeps the $Red in circulation.

Adding in price levels also does interesting things for inflation? If the central bank takes 100$Red worth of goods as collateral but then finds out the goods were only worth 50$Red (drop in quality of collateral), is it forced to redeem that collateral for the 100$Red it issued? (Repurchase agreement?)

If so, then the central bank *cannot* keep all of the $Red in circulation. It takes in the collateral and 100$Red, but then cannot sell the collateral on the open market except for 50$ (red or green).

If the bank sells the collateral on "with" 50$Red, then the market keeps a stock of 100$Green and 50$Red in circulation, and the central bank must hold on to 50$Red with no ability to put it into circulation through market actions.

If the bank sells the collateral "for" 50$Green, then the market keeps a stock of 50$Green and 0$Red in circulation; the central bank then still has a net 50$Red. Maybe this is an example of the "good" (Green) driving out the "bad" (-Red)?

Either way, private citizens would experience a change in the even exchange of $Green for -1$Red. The first example makes my head hurt on goods prices, the second is sensible in that everything gets exchanged for $Green.

[Nick Rowe]

louis: Thanks!

I'm basically in agreement with you on collateral.

1. I would say the size of the haircut is the lower bound on the size of the effect. Because only those who want red money will post collateral. The central bank could issue green money by buying assets from anyone.

2. Sounds right to me.

3. Yep.

4. Yep. Both central and commercial banks.

Frank: banks (both central and commercial) want some evidence of assets or earning potential.

Majromax:

" So this is a two-currency system: green money is unbacked, fiat currency, whereas red money is backed by the net posted collateral."

No, Neither money is backed (if the net money supply is zero). Or you could say the green money is backed by the red money, and vice versa.

Yep. The assumption that net money supply is zero is overly constraining. That is the New Keynesian assumption (many of them think it means there is no money or "cash" in the model, only "credit").

"Either way, private citizens would experience a change in the even exchange of $Green for -1$Red. The first example makes my head hurt on goods prices, the second is sensible in that everything gets exchanged for $Green."

I was also trying to figure out if I had anywhere violated the conditions needed to ensure the fixed exchange rate of minus one between red and green money. I don't think I have, but it made my head hurt too.

[Ralph Musgrave]

Loads of unnecessary complexity in Nick’s green/red currency hypothetical economy. Here’s the ultra-simple MMT version.

Government and central bank create and spend enough currency into the private sector such that employment reaches the maximum that is consistent with avoiding too much inflation. All problems solved. Period.

As to borrowing and paying interest, citizens are free to borrow and lend or set up banks. But what collateral those banks demand and what interest they charge is up to them. If I were “government” I wouldn’t give a toss what they charged.

Hope that cures Nick’s aching head.

[Frank Restly]

Nick,

"Frank: banks (both central and commercial) want some evidence of assets or earning potential."

But what happens when the line between commercial / investment banking is eliminated? Commercial / Investment bank is both a lender AND a borrower. Who prevents a commercial / investment bank from always buying goods, never selling goods, accumulating an infinitely large stock of red currency, and so having a debt to the central bank it can never pay back?

That used to be the government until the set of revolving doors were constructed by Rubin, Summers, and company.

[Anon]

Good post, Nick. Definitely bridging a great deal of the gap from quantity theory to the NK model.

I think you may be leaving something out of the competitive equilibrium, though. With the different Rr and Rg rates, it is not efficient for lending to be intermediated by creation of new red/green notes. It's pareto improving to make loans intermediated by commercial banks at some rate between Rr and Rb using the same collateral. Either the lender or the borrower or both can get a better rate that way.

Second, the improvement of QE vs lending at Rr is only by the amount of the haircut and only if lending is taking place at a rate above Rg. This only occurs if the demand for green notes is not satiated (i.e. it currently does nothing in the US). And no matter what, what matters is the market lending rate R, which is somewhere between Rr and Rg. Contingent on R, I don't see how either the net quantity of green minus red notes or the values of Rr or Rg make any significant difference to the real economy. It's R that's relevant to investment and intertemporal consumption choices. The other values have no impact on anybody's choices at the margin.

[Jamie]

Nick,

This is a fascinating insight into how your mind works. I’d like to offer a variant on your model which corresponds to my (non-economist) understanding of the world, and then ask you three questions.

1. Red and green money exist and add to zero
2. Two banks: central and commercial. Central bank can only transact with commercial bank. Commercial bank can transact with everyone. Everyone else can transact with each other and with commercial bank
3. Central bank sets interest rate R. This is the minimum rate which can be used by commercial bank
4. Commercial bank sets Rg and Rr. Rr is always greater than Rg as that is how commercial bank makes a profit. Also, it incentivises people to minimise their red money
5. Central bank can create or destroy green money at any time in exchange for assets from commercial bank
6. Commercial bank can create or destroy equal and opposite amounts of green and red money at any time. It can ask for collateral (e.g. mortgage) or not (e.g. credit card) at its discretion
7. No-one else can create or destroy either green or red money
8. All transactions for goods and services must be paid for with green money ONLY.

Let’s try out a transaction. Assume buyer B and seller S who both start with 100r and 0g. B wants to buy goods worth 50g from S. Three separate things happen in quick succession.

1. At the request of B, commercial bank creates 50g and 50r in B’s account. B now has 150r and 50g, and S still has 100r and 0g
2. B buys goods from S for 50g. B now has 150r and 0g, and S has 100r and 50g
3. (Optionally) at the request of S, commercial bank destroys 50r and 50g in S’s account. B now has 150r and 0g, and S has 50r and 0g.

B starts with 100r and 0g and ends with 150r and 0g. S starts with 100r and 0g and ends with 50r and 0g. Note that my model achieves the same result as yours but mine specifically separates actions by commercial bank from the exchange transaction between B and S.

In this model, the supply of money used for buying goods and services is the supply of green money. In normal circumstances, changes to the supply of green money take place only when commercial bank creates or destroys equal and opposite amounts of red and green money.

Now, remember that, in this model, people are incentivised to destroy their red money due to the interest rate charged by commercial bank. Nevertheless, at most times the amount of money creation and money destruction by commercial bank might be around equal so the money supply of green money remains fairly constant. Maybe even it slowly increases if the commercial bank is asked to create more money than it destroys. However, in some unforeseen circumstance, people become scared by the amount of red money they hold. Hence, in unison, they decide to use much of their green money to destroy their red money rather than to purchase goods and services, and they decline to ask the commercial bank to create any new money. The supply of green money plummets and we have a recession.

What should the central bank do? QE you say! It should create green money and swap that green money with commercial bank for some of commercial bank’s assets. OK, so commercial bank now has an excess of green money and there is an imbalance of red and green money in the overall economy.

So here are my questions to you. Why does your model not include a commercial bank? This makes no sense to a non-economist like me. What do you think my commercial bank should do with the excess supply of green money arising from QE - following only the rules set at the start of my post? How will that action cure the recession?

[Too Much Fed]

Jamie said: "Why does your model not include a commercial bank?"

Good question.

Jamie, if commercial banks are included, are there three "items" to consider? Are they currency, central bank reserves, and demand deposits?

[Too Much Fed]

Jamie, if commercial banks are included, can entities exchange demand deposits for goods/services without currency or central bank reserves being involved?

[Nick Rowe]

Anon: Thanks!

"Definitely bridging a great deal of the gap from quantity theory to the NK model."

Yep. That was very important to me. I could see the monetarist/QT vision, and I could see the NK vision, and it really bugged me that I could not reconcile the two visions. I think I now have a sketch of a general model, in which the simplest monetarist model and the simplest NK model are special cases. With only green money, and Rg=0, and the central bank setting Mg, you get the simplest monetarist model. With both red and green money, and the central bank setting Rg=Rr, and no binding colateral constraints, and Mg=Mr but otherwise unconstrained, you get the simplest NK model. And I wanted to make the point that there really is money in the NK model.

"I think you may be leaving something out of the competitive equilibrium, though. With the different Rr and Rg rates, it is not efficient for lending to be intermediated by creation of new red/green notes. It's pareto improving to make loans intermediated by commercial banks at some rate between Rr and Rb using the same collateral. Either the lender or the borrower or both can get a better rate that way."

I think you are right. If Rg=Rr and there are no constraints on Mg and Mr, the central bank will be the only bank, and there will be no borrowing or lending outside the central bank. Like in the simplest NK model. More generally, we will have Rg < Rb < Rr. People holding green money will lend to people holding red money at a rate Rb. Plus, as you say, commercial banks will spring up to create their own red and green monies, to make a profit on the spread between the central bank's Rr and Rg.

In the real world, ordinary people cannot hold the central bank's red money, and the central bank's green money pays Rg=0. But commercial banks can hold both red and green central bank money, with only a 50 basis point spread between Rg and Rr. Commercial banks issue some red money, but with colateral constraints. So it's a mix of the two, and more complicated than either.

I am not sure your second point is right. If Rg < Rb, the CIA constraint must be binding for people holding green money. People will not be satiated in green money if there is an opportunity cost to holding it. Similarly, if Rr > Rb, the CIA constraint must be binding for people holding red money. And if some people are colateral constrained, their shadow Rr will exceed the observed Rr.

But I'm still thinking about it. This is too hard for my old brain.

Jamie: good questions, but currently too hard for me. My brain has to work slowly. See my answer to Anon above, which goes part way there.

[Jamie]

Too Much Fed,

I have deliberately avoided using terms such as ‘currency’ and ‘demand deposits’ for several reasons.

First, my background is in helping businesses and government organisations solve problems. One technique in this is to separate out the logic of a system from the physical way it is implemented. Physical implementations just add complexity and jargon and mostly confuse people. The specific names of accounts at banks, or whether payments are made electronically or using a piece of paper, just add such complexity and obscure the underlying logic.

Second, I live in the UK. I’m not familiar with the term ‘demand deposit’. I assume it is what I would call an ‘instant access savings account’ but that adds more complexity. If I used the UK name for the type of account then North American readers might not understand my point. If I used the North American term then I might misunderstand the term and use it wrongly.

Third, when you say ‘currency’ I assume that you mean ‘notes and coins that can be used for buying things’. Not only is this a physical implementation (so falls foul of my first point) but also, in the UK the responsibility for issuing currency is split. In England, bank notes are produced by the Bank of England. In Scotland, bank notes are produced by commercial banks under licence from the Bank of England. Hence, talking about currency just adds further complexity to the underlying logic e.g. if I include currency, I may or may not have to include a transaction between Central Bank and Commercial Bank in order to get the currency to the Commercial Bank, depending on whether I am talking about England or Scotland. I also have no idea how this works in North America.

Fourth, the underlying logic is the same independent of the specific type of bank product e.g. I may have red money as part of a mortgage, or I may have red money as part of a smaller loan, or I may have red money as an overdraft on my current account (checking account?), or I may have red money because I have used my credit card. However, all of these products have their own jargon and account types.

Fifth, I am not an economist or a banking expert. Based on my professional experience, if I use jargon then I risk being faced with the one-upmanship that professionals of all types like to use to undermine non-experts. This is a major risk for any lay person venturing into a specialist area such as economics or banking.

[Nick Rowe]

Jamie: here's one important thing about how my mind is working:

You want me to add additional things to the model. I'm still worrying about whether I really understand my simple model as it is. For example:

1. Will it still be true that the exchange rate between red and green money will be fixed at minus one even if I drop the assumption that the central bank will create one red and one green for anyone who asks? Is the assumption that it will destroy one red and one green for anyone who asks sufficient to fix the exchange rate?

2. Is the sort of recession that you get when the central bank sets Rm too high the same as the sort of recession you get if the central bank sets Mg too low?

Is my model internally consistent, and do I really understand what is going on in that model?

Simply understanding that the standard New Keynesian model, which is the workhorse of economics graduate programs, is in fact a model of a monetary economy, and that the rate of interest in that model is the rate of interest paid to people who hold money, is a controversial statement. I am disagreeing with Woodford (who wrote the new macro bible), because he says that the NK model is the limiting case where the quantity of cash disappears in the limit, leaving only credit. Arguing that there is no fundamental difference between the monetarist "cash" model and the NK "credit" model, and that they are both "cash" models (but with important differences) is the important point here. Anon (who knows his macro) picked up on that right away, when he said I was bridging the gap.

Embarrassingly, for us economists, we still do not understand as well as we should even our simplest models. "Does the real simple NK model (the one we teach to all our grad students) have money in it, and do people in that model have to buy and sell goods with money?" sounds like a basic question with an obvious answer "Just look at the model!". But it isn't obvious.

[Nick Rowe]

Jamie: "One technique in this is to separate out the logic of a system from the physical way it is implemented. The specific names of accounts at banks, or whether payments are made electronically or using a piece of paper, just add such complexity and obscure the underlying logic."

Bingo! YES!

"Demand Deposit" is (roughly) jargon for "chequing account". A deposit that can be withdrawn on demand. Though, strictly speaking, a demand deposit might not be chequable (or debit cardable) and might not be usable to buy things with.

Canadian banks, like Scottish banks, used to issue paper currency. When the Bank of Canada was created, it was given a monopoly over issuing currency.

[Anon]

Nick,

"If Rg=Rr and there are no constraints on Mg and Mr, the central bank will be the only bank"

Exactly. It is because we don't want government to be making credit decisions that we keep Rg and Rr different and supply enough Mg so that Rb will will be below Rr. This causes interbank lending to be direct, rather than central bank intermediated.

"If Rg < Rb, the CIA constraint must be binding for people holding green money."

Agreed.

"People will not be satiated in green money if there is an opportunity cost to holding it."

Also agreed. The way we can tell if there is an opportunity cost is if Rg < Rb. Right now in the Fed Funds market Rg=Rb (Rb is actually slightly lower for complex reasons) and the spread isn't changing as a function of Mg.

"Similarly, if Rr > Rb, the CIA constraint must be binding for people holding red money.

Something has to be wrong if there is both red and green money in the economy. There must be borrowing constraints if the red holders can't borrow from the green holders.

"And if some people are colateral constrained, their shadow Rr will exceed the observed Rr."

Also agreed. Now we no longer have the standard NK model because we have broken the condition that everyone has equal and unlimited access to borrowing. The main thread of literature on borrowing constrained NK economies that I am aware of is:

Kiyotaki and Moore (2008)
Del Negro, Eggertsson, Ferrero and Kiyotaki (2011)
Eggertsson and Krugman (2012)
Kara and Sin (2013)

Del Negro et al focus on collateral constraints and Fed operations like TAF. Eggertsson and Krugman and Kara and Sin are looking the impact of credit (or collateral) constraints on fiscal multipliers in the liquidity trap. In most of the literature there is no impact from plain treasury bond QE, but buying illiquid assets can definitely help at times. Fiscal multipliers are much higher when there are borrowing constraints.

[Squeeky Wheel]

Nick,

I was thinking about Singapore's macro-prudential debt policies (aka property cooling measures) in context of red money. Would a government on borrowing be the same as limiting net balances? But more interestingly - would that mean that the gross monetary supply has been limited? Would that represent tightening?

I still think that all (green) cash is credit (and red cash is debt). All money depends on the promise of others to convert it to goods and services and hence is credit. Even with backing - Singapore CB promises me that all physical currency is backed by foreign reserves, but they aren't going to let me count it, so I still have to trust them.

[Nick Rowe]

Anon: if you use the < sign, you need to put a space each side of it, or Typepad goes all funny. I edited your comment to put the spaces in.

[anon]

"Will it still be true that the exchange rate between red and green money will be fixed at minus one even if I drop the assumption that the central bank will create one red and one green for anyone who asks?/"

Assuming that Rg = Rr for simplicity, then ISTM that agents will seek to destroy notes if red notes are worth more than green ones. So the central bank's commitment ensures that green notes will be worth "enough" compared to red notes, as long as agents have red notes to destroy (and green notes to offset them - noting that if some agents can't get ahold of green notes, the shadow value is what matters here. Nevertheless, agents flush with green notes will want to take on red notes as a way of paying for goods, in order to offset them via the central bank).

The converse is true if the central bank can create notes on demand, but not destroy them - then a red note will be worth as least as much as a green note, possibly more. If the interest paid on red and green notes is different and perhaps variable over time, then it gets more complicated; the exchange rate between green and red notes will be constrained by the kind of interest parity conditions that should be familiar from international finance.

[Anon]

Thanks for fixing my bad html, Nick. That last "anon" is not me BTW. That I suppose is the peril of not using pseudonyms. Alas, I don't want any other "identity" than the one I already got. Sorry about that.

[Nick Rowe]

Anon: "Something has to be wrong if there is both red and green money in the economy. There must be borrowing constraints if the red holders can't borrow from the green holders.

If Rg < Rb < Rr, there should be some sort of symmetry here, between red and green monies.

Why don't holders of green money lend at Rb?

Why don't holders of red money borrow at Rb?

If you had instantaneous and continuous and costless access to the bond market, desired stocks of both red and green money would approach zero. You would go to the bond market immediately before and immediately after any purchase or sale of goods, and hold money just for that split second. Standard story for rate of return dominance.

I have read Eggertsson and Krugman, but I don't think I've read any of the other papers. You know your literature!

[Nick Rowe]

Squeeky: "I still think that all (green) cash is credit (and red cash is debt). All money depends on the promise of others to convert it to goods and services and hence is credit."

If issue an IOU for $20, my IOU will not be used as money. I have created both a credit and a debit (debt), but I have not created any money. If I were the Bank of Canada, or the Bank of Montreal, it would be different. My IOU would be used as money, and I would have created money.

[Max]

If there were a shortage of collateral like you describe, then interest rates would rise above the central bank's target. That's extremely unlikely to ever happen.

The real issue is that in a liquidity crisis, the central bank can step in and supply liquidity - something that under normal conditions it leaves to the private sector. This really has nothing to do with *money*, since anyone can supply liquidity. If you bought stocks, or corporate bonds, or even TIPS, in 2008-2009, you were supplying liquidity. You don't have to be a central bank.

[Nick Rowe]

Max: "If there were a shortage of collateral like you describe, then interest rates would rise above the central bank's target. That's extremely unlikely to ever happen."

That happens all the time. Some people pay 20% on credit cards. Loan sharks even more. Simply because they don't have collateral.

"The real issue is that in a liquidity crisis, the central bank can step in and supply liquidity - something that under normal conditions it leaves to the private sector. This really has nothing to do with *money*, since anyone can supply liquidity."

Money has something to do with liquidity. Money is the most liquid asset. The liquidity of other assets is defined as how quick and easy it is to buy and sell them for money.

[Max]

"That happens all the time. Some people pay 20% on credit cards. Loan sharks even more. Simply because they don't have collateral."

That's not due to an economy-wide shortage of collateral. There's plenty of collateral to create all the money needed.

"Money has something to do with liquidity. Money is the most liquid asset. The liquidity of other assets is defined as how quick and easy it is to buy and sell them for money."

If people want to sell A and buy B, then supplying liquidity means selling B and buying A. Only if people want to sell everything (including the safest, most liquid, interest bearing assets) is supplying liquidity synonymous with supplying money.

[Anon]

Nick,

"Why don't holders of green money lend at Rb?"

I'd say because they think the collateral and the borrowers (red holders) are bad. The CB is giving loans at the discount window under conditions that don't clear the market. However, given borrowing constraints there is no guarantee that the competitive equilibrium is optimal, so it may be efficient for the CB to do this. Of course, that doesn't prevent it from being unfair and/or corrupt.

Since governments can interfere with credit risk premia by buying poor collateral or lending against it at non-market clearing terms, I think it's worthwhile to distinguish between QE (the buying of t-bills), and credit easing or targeted asset purchases. It helps us stay clear about our what we are trying to do and also, different policies can have very different distributional consequences.

"You would go to the bond market immediately before and immediately after any purchase or sale of goods, and hold money just for that split second."

Many of us do. I'd bet you never pay interest on your credit card. Card transactions could be processed instantaneously, the debits and credits being processed at the same instant. Not even a split second of difference required (just like when the CB creates red and green money at the same moment).

"Money has something to do with liquidity."

Yes, but not necessarily base money. I think the financial system would do fine creating all the money we need if government supplied t-bills alone. And even without t-bills, there are enough stocks in the world for banks to create any required deposits via stock collateralized loans. The problem, the way I see it, is that most of those assets are legally segregated into retirement vehicles where they aren't available for collateral thus creating an artificial shortage. Bad institutions.

[Too Much Fed]

Jamie, check back. Hopefully, tomorrow.

[Squeeky Wheel]

"If issue an IOU for $20, my IOU will not be used as money..... If I were the Bank of Canada, or the Bank of Montreal,... My IOU would be used as money, ..."

Completely agree. Not all credit is money, but all money is credit. Generally speaking, we only call government or central bank credit money.

Companies buying other companies with stock (and acquiring debt - red money - in the process) is an interesting case of non-money + red money being used for a purcahse.

[Jamie]

Nick said:

“You want me to add additional things to the model. I'm still worrying about whether I really understand my simple model as it is.”

“Embarrassingly, for us economists, we still do not understand as well as we should even our simplest models. ‘Does the real simple NK model (the one we teach to all our grad students) have money in it, and do people in that model have to buy and sell goods with money?’ sounds like a basic question with an obvious answer ‘Just look at the model!’. But it isn't obvious.”

That’s ok. I understand. Let me try and give you some thoughts about what I think is happening here.

I spent many years helping businesses and government departments solve problems. One of my most enduring lessons in this is that different people in any large system will give very different descriptions of that system and its problems. The variety of descriptions can be startling at first but it’s really quite obvious. Different people have different perspectives so they see different things; they don’t see other different things; they focus on different things; they ignore other different things; they think in different time frames, at different levels of granularity and at different levels of abstraction; and they have different management reports available to them.

If three people are looking at a house – one from the back, one from the front and one from inside – they will see different things. However, because all three share a common model of a house, they will all recognise that the three descriptions are different perspectives and they will relate those descriptions to the common model.

In any large human system such as a business, however, there is no common model. There are only perspectives, and there are many perspectives. What often happens is that people with a specific perspective decide that their perspective represents THE TRUTH. Next they decide that other perspectives are false. Next they decide that their perspective is so obviously THE TRUTH that the people who hold other perspectives must be either very stupid or are deliberately trying to sabotage the system.

When I read various economics blogs, I see a lot of this behaviour. Indeed, I often read posts indicating that one perspective or another is now dominant amongst mainstream economists, and that other perspectives have been cast out into the wilderness. The economists who write these posts think that this is a sign of progress. In fact, it is merely a sign that one faction of economists has mistaken their perspective for THE TRUTH – and it is a major weakness.

Economists self-identify as Keynesian, Monetarist etc. However, when I think about economists I try to split them by perspective. For example, here are two different ways of thinking about economics:

Type 1: Economics is the study of the decisions of economic agents.
Type 2: Economics is the study of exchanges between economic agents.

You might think this is trivial but here is a very simple example to show that it is not. I read a post on Noah Smith’s blog recently where he was talking about trend chasing in financial markets where ‘everyone’ chases the same trend. The post included the following sentence:

“As you can see, when people say they expect stocks to do well, they actually put money into stocks.”

Noah is a smart guy and he is a type 1 economist (as are most mainstream economists). He is saying that when a representative group of people expect the stock market to go up they put money into the market and when they expect the stock market to go down they take money out of the market.

A type 2 economist would say that rising stock prices are nothing to do with representative groups putting money into the market. If a representative group of people puts money into the market, they can do this only by buying shares. However, they can only buy shares if someone else sells those shares. If someone else sells those shares then another representative group of people is taking the same amount of money out of the stock market. The amount of money in the market doesn’t change. That is true whether the market is at its high, its low or anywhere else. The only time that money flows into the market is for new issues.

A type 1 economist who starts by thinking about decisions of economic agents will find it natural to think about a representative agent model and will then pursue a chain of logic to flesh out such a model, including the rules surrounding that agent.

A type 2 economist who starts by thinking about exchanges will find it natural to talk about flows of goods and flows of money. They will join up these flows to create circuits and other patterns. They will find it natural to talk about accounting. They may even use pictures to illustrate their models.

Note, however, that the two types will find each other’s approach unnatural. People who think about representative agents won’t be very comfortable with flows and accounting. People who think about flows and accounting won’t know where to begin with a representative agent. Who does the representative agent trade with? Where does he get his money? Etc.

I think that the problem you have in this series of posts is that you are a type 1 economist who is trying to think his way to a type 2 model. That’s why you say ‘my head hurts’. I am not an economist but, if I were, my natural style of thinking about large systems would make me a type 2. That’s why I suggested an enhancement to your model to include a commercial bank. It is a simple matter to add a commercial bank to a type 2 model. Indeed, it would be almost impossible to conceive of a type 2 model of the economy without a commercial bank. From your reaction, it is obviously very difficult to add one to a type 1 model. I still find it impossible to visualise a type 1 model so I can’t be of help.

From my perspective, economics would be much healthier with a more pluralist approach which taught different perspectives so that economists could think from these perspectives and compare what they saw from different perspectives. I always look out for economists who try to think in different perspectives. That’s why I like your current series of posts. However, it’s obviously more difficult for you to do this than I imagined. I naturally gravitate to blogs/articles of type 2 economists (although I read a few type 1 blogs/articles to try to understand that perspective). Unfortunately, the type 2 economists are mostly outside the mainstream so there is probably little chance of combining the strengths of types 1 and 2 in the profession. That’s a great shame. Different perspectives might also allow economists to communicate more effectively with the rest of us too. In my experience, lay people react well to type 2 models, at least at the level of a single business, and simple type 2 models could be used to teach basic economics to kids.

[Nick Rowe]

Jamie: interesting comment. good comment. I was with you until you introduced the Type 1 (praxeology) vs Type 2 (cattalactics) distinction. (Those are Austrian words, that I have spelled wrong).

An example. There are two ways to write the very simple monetarist model:

Type 1: M=kPY Supply of money M = demand for money, which is some parameter k times nominal income PY. In equilibrium, nominal income must be such that people want to hold the stock of money that exists.

Type 2: MV=PY. V is (desired) velocity of circulation of money.

They look like different ways of saying the same thing. V=1/k. But they give very different perspectives. In MV=PY, money must be circulating in exchange for goods.

But we would get that exact same type 1 vs type 2 distinction whether people were using central bank money or commercial bank money.

I'm insisting that the NK model, and all models of money, must be seen from a Type 2 perspective. If money did not circulate in exchange for goods, it would not be money. Land, and bonds, might be held forever; money can't.

[Too Much Fed]

Jamie said: "The specific names of accounts at banks, or whether payments are made electronically or using a piece of paper, just add such complexity and obscure the underlying logic."

The names of accounts at banks can change. That is OK. But, I believe how the payments will be made is important, relating to medium of account (MOA) and medium of exchange (MOE). Eventually, people will have to agree to terms to understand the logic.

And, "Fourth, the underlying logic is the same independent of the specific type of bank product e.g. I may have red money as part of a mortgage, or I may have red money as part of a smaller loan, or I may have red money as an overdraft on my current account (checking account?), or I may have red money because I have used my credit card. However, all of these products have their own jargon and account types.”

Out in the real world, I believe all “money” is actually green money.

And, “Fifth, I am not an economist or a banking expert. Based on my professional experience, if I use jargon then I risk being faced with the one-upmanship that professionals of all types like to use to undermine non-experts. This is a major risk for any lay person venturing into a specialist area such as economics or banking.”

Agreed. I have been a victim of that by economists at many places.

Nick said: "In the real world, ordinary people cannot hold the central bank's red money, and the central bank's green money pays Rg=0. But commercial banks can hold both red and green central bank money, with only a 50 basis point spread between Rg and Rr. Commercial banks issue some red money, but with colateral constraints. So it's a mix of the two, and more complicated than either."

Plus, "If collateral is scarce, so that collateral puts a binding constraint on the central bank's issuance of red notes, and if the central bank refuses to issue more green notes than red notes, then the scarcity of collateral puts a binding constraint on the total stock of green plus red notes (gross money supply). The CIA constraint becomes binding. If there is an exogenous drop in the quantity of collateral, or an exogenous drop in the quality of collateral so that the central bank increases haircuts, and if the central bank holds Rm constant, the result will be an excess demand for gross money, and so the CIA constraint bites more deeply, which causes a recession.

If the central bank will not or can not reduce Rm, the solution is for the central bank to issue more green money, and break the New Keynesian "rule" which says that the total stock of green money must always equal the total stock of red money. The central bank increases the stock of green money by buying assets outright. We call this "QE"."

Jamie, I'd be interested in how you interpret those.

[Too Much Fed]

Nick said: "Now suppose the central bank pays interest Rg on holdings of that currency, and can vary that rate of interest. (If you hold 100 green notes, the central bank gives you Rg more green notes every year.) An increase in Rg increases the demand for currency, and if the supply of currency is fixed, and if prices are sticky, this excess demand for currency would cause a recession."

That is how a monetarist would think. Someone who thinks about saving/dissaving and personal finance/budgeting could say this is possible. I save so much a month to buy a vehicle. If I keep the time at which I purchase the vehicle the same, raising the return on my savings could cause me to spend more in the present. Michael Pettis makes the flip point about China, lowering rates (lowering the return on savings) can make people save more in the present.

[Too Much Fed]

Nick said: "I think the ECB has a rule which says the total stock of green money must equal the total stock of red money. (JKH?) In other words, the ECB is a New Keynesian central bank. That's a problem for the ECB.

I'm not sure if I have got this right, but my head hurts, so I am going to post it."

I'm not guaranteeing this, but I doubt if that is right.

From: http://monetaryrealism.com/negative-money/

"There is an interesting analogy between the green/red world distinction and something else that Godley and Lavoie touched on. That is the existence of a particular type of distinction in central banking regimes – asset based systems versus overdraft systems. In an asset based system the central bank acquires financial assets such as Treasury bonds in order to provide the reserves to the banking system that ultimately enable commercial banks to pay for the central bank notes that they provide to their customers. In an overdraft system, the central bank lends to the banking system for the same purpose. Apart from all their other differences, the US Fed system is an asset based system (most clearly viewed as such on a pre-2008 footing) and the ECB system is an overdraft system."

To me, an overdraft system is about issuing some type of bond or bond-like instrument.

[Too Much Fed]

Nick said: "Now suppose every agent keeps all his currency in a box at the central bank. When he buys something, the central bank takes currency out of his box and puts it in the seller's box. Nothing has changed (except for muggers). The currency boxes are just a simple form of ledger. It wouldn't matter if all the currency was destroyed in a fire, provided the ledger was saved."

Jamie, I want to see commercial banks added because I think Nick's box story is not quite right.

[Too Much Fed]

Jamie, one thing I need to model an economy is the MOA.

[Too Much Fed]

Did I lose some posts to spam?

[No more comments please. NR.]

[Jamie]

Nick said:

“interesting comment. good comment. I was with you until you introduced the Type 1 (praxeology) vs Type 2 (cattalactics) distinction”

Thanks for the reply. You may have moved on to other posts by now but I thought I would reply anyway.

I had a look on Wikipedia for the Austrian terms. I am definitely not an Austrian. As I understand it, Austrians reject the scientific method. They develop a logical theory and then take that theory to the world and apply it universally. I am a pragmatist who observes a specific real world situation and then tries to develop a specific theory (often based on rules of thumb from past experience) which can resolve whatever specific problems are present. Even at the level of a single business, I don’t think that there are any useful universal theories. There are always many interacting causes corresponding to an observed effect, so specific solutions are always required.

From what I read on Wikipedia, the Austrian type 1 involves Robinson Crusoe trading with himself. I agree that is what I mean by type 1. To my type 2 brain, that’s not a useful model. For example, there is no exchange of goods and there is no money circulating. That is also what you are saying.

Where I am struggling is that when economists talk about representative agent models it appears to me that they are talking about a generic version of Robinson Crusoe and developing micro-foundations about how generic Robinson would behave. I am struggling to understand how a model like that is compatible with your comment about insisting on exchange of goods and money.

The first post I read on your blog was entitled something like ‘What Steve Keen is maybe trying to say’. That suggested to me that you find Steve difficult to understand. In my mind, one of the reasons for this is that you are a type 1, because you appear to use the generic Robinson model, while Steve is a type 2 who thinks in terms of exchanges.

The consistency of type 1 models appears to be maintained by micro-foundations which are required to ensure consistency in generic Robinson’s decision making. However, the consistency of type 2 models is maintained by accounting rules. Note that accounting rules are not relevant in a type 1 model precisely because there appears to be no exchange of goods or money. Once you introduce accounting rules you cannot omit any institution involved in a process. Hence, you can’t have a consistent type 2 model of an economy without a commercial bank.

What am I missing?

[Jamie]

Too Much Fed,

I have seen your comments. I will have a think and then post a reply later.

[Odie]

Interesting discussion; I am hoping for more. One quibble:

"If money did not circulate in exchange for goods, it would not be money. Land, and bonds, might be held forever; money can't."

Bonds mature, money does not. Money balances can be held forever (e. g. cash or deposits); bonds expire at the end of their term.

[Jamie]

Too Much Fed,

I am reluctant to get into debate on specific points on terminology. The reason is that the meaning of any term such as “money” MUST be defined in terms of how it is used in the model. Until we agree the model we don’t have a definition of “money”. This is a chicken and egg situation but I’m afraid that is the price you pay for insisting on consistency.

Here is a simple example. I saw a link in one of your comments to Cullen Roche’s Monetary Realism (MR) site. As you will know, MR is a breakaway from MMT. One of the reasons for the breakaway was a disagreement on how, where and by whom “money” is created and destroyed. Based on my understanding, a key issue in this was that that MR and MMT have different definitions of “government”. In MR, “government” and “central bank” are two different institutions. In MMT, “government” includes “central bank”. With different institutions, you end up with a different model. So, in MMT, it makes sense to say “the government spends money into existence” whereas in MR that does not make sense as the central bank would have to create the money before the government could spend it. Also, in MR most money is created by commercial banks whereas in MMT most money is created by the government, so it’s not at all clear that they mean the same thing by “money”. As a result, Twitter wars break out between MR and MMT on a regular basis.

I hope you can see that, if we want consistency then we have to be very pedantic. One of the issues in economics is that there is no agreed definition of even basic terms. Economists of all shades mis-communicate because of this. When you add in the authors of comments on blogs who may or may not have consistent definitions with the bloggers, you have a recipe for chaos.

[Nick Rowe]

Jamie: the "representative agent" is tricky. Suppose you have a model with agents who are identical in every way, except agent A can only produce apples, agent B can only produce bananas, etc. And every agent likes consuming a mix of all goods. But there is perfect symmetry in the model, so in equilibrium one apple has the same price as one banana, etc. So each agent sells the good he produces, and buys the goods the others produce. That is a (very standard New Keynesian) representative agent model. But it would be more accurate to say the agents are symmetrical, rather than identical. If they all swap positions in the model, nothing changes. It looks like a Robinson Crusoe model, and can be solved almost as easily as a Robinson Crusoe model, but it isn't. It's a type 2 model.

BTW: I have spent 5 years trying to explain things to TMF, and have gotten nowhere. His comments always seem to lead the discussion off into dead-end arguments, unrelated to the post. He is like an accidental troll, throwing out red herrings all along the comment trail.

Odie: OK. But there are bonds that are perpetuities (consuls) that never mature. And we could imagine someone rolling over maturing bonds forever.

[Jamie]

Nick said:

“An example. There are two ways to write the very simple monetarist model:
Type 1: M=kPY Supply of money M = demand for money, which is some parameter k times nominal income PY. In equilibrium, nominal income must be such that people want to hold the stock of money that exists.
Type 2: MV=PY. V is (desired) velocity of circulation of money.”

I am familiar with the Type 2 equation but not the type 1.

In my modelling world, you cannot use a term until you have defined it properly. None of these terms are defined.

Assume the definitions in my initial post.

I said that only green money could be used to buy goods and services, so, if I have understood the equation properly, I can define PY as the sum of the green-green transactions in my economy. I can also define the money supply M as the amount of green money in the economy.

I can then define V = PY/M as I have already defined both PY and M and so can calculate V.

I am not clear what you mean by either M or PY. In your economy, it seemed like goods and services could be purchased with either red or green money. Hence the money supply would be the sum of red and green money – which is 0. So your equation wouldn’t work.

Note also my last reply to Too Much Fed where I was similarly pedantic.

[Nick Rowe]

Jamie: "However, the consistency of type 2 models is maintained by accounting rules."

No. Accounting rules plus agent's decision rules (like demand and supply functions) and equilibrium conditions.

"Note that accounting rules are not relevant in a type 1 model precisely because there appears to be no exchange of goods or money."

No. Robinson Crusoe has accounting rules too. The change in his stock of apples = apples produced - apples consumed - apples that rot.

"Once you introduce accounting rules you cannot omit any institution involved in a process. Hence, you can’t have a consistent type 2 model of an economy without a commercial bank."

No. Are you saying that the existence of commercial banks is logically necessary? The ontological argument for the existence of commercial banks, like God?

You have been reading far too much MMT stuff!

[Nick Rowe]

All accounting identities are simply variants on "number of apples bought = number of apples sold". Yep. If someone buys an apple then someone must have sold that same apple. That's what the words "buy" and "sell" mean. Big deal. That tells us absolutely nothing about what determines the number of apples bought-and-sold (all-one-word).

[Nick Rowe]

k is defined as: fraction of annual nominal income (P.Y) that people *desire* to hold as money.

In the red green world, M in MV=PY would be the sum of green notes plus red notes. Call it "gross money". So not zero. As opposed to "net money", green notes minus red notes, which is zero. (Switch "plus" with "minus" in both cases if you want to.)

[Jamie]

Nick said:

“Are you saying that the existence of commercial banks is logically necessary? The ontological argument for the existence of commercial banks, like God?”

No, I’m saying that commercial banks exist in the world in which I live and are a central part of the system which needs to be explained. That’s my pragmatic approach – explain what you see. It is not me that is arguing for the existence of commercial banks. It’s you that is arguing for their non-existence in a model of the economy. I will probably visit a commercial bank in the next couple of days so I know they exist in a way that I could never know that God exists. My first intervention in this thread was to ask you why your model doesn’t include commercial banks. That question genuinely perplexes me as it’s not obvious to me why anyone would exclude commercial banks from a model of the economy. If there is a genuine reason then I’m happy for you to tell me what it is. However, your answer included the following:

‘Embarrassingly, for us economists, we still do not understand as well as we should even our simplest models. "Does the real simple NK model (the one we teach to all our grad students) have money in it, and do people in that model have to buy and sell goods with money?" sounds like a basic question with an obvious answer "Just look at the model!". But it isn't obvious’.

On the one hand we are agreeing that a type 2 model should include the concepts of exchange and money but the answer I have just quoted suggests that, for a reason I don’t understand, it isn’t obvious whether your model includes money or people who buy and sell goods with money. However, when I suggest that, if that’s not obvious, then your model is not type 2, you disagree. I’m confused!

The problem I have in understanding the points you are making here is that they appear inconsistent. It may be that you guys are much smarter than me and I’m missing something obvious, or maybe it is just too difficult for a non-economist to grasp, but it seems to me that you need a better answer.

Back at your ontological argument question, my modelling assumption is that I only include things that exist in the world. For example, some people believe in a ‘money multiplier’. I would never include that in a model because it doesn’t exist in the world. Your question would be appropriate if I were suggesting that ‘money multiplier’ should be included in the model because I would then be saying that it should be included just because I believed in it – like I might believe in God. That’s not what is going on here.

My MMT comment was related to an earlier comment by TMF including a link to the MR site. I don’t think that the MMTers have got it right when they say things like “the government spends money into existence”. Nevertheless, they are type 2 thinkers so I find it relatively easy to determine where I do and don’t agree with them. The point is NOT that I think that the MMTers are right and you are wrong. Rather it is that it is easy for me to judge for myself whether their model is convincing or not, but with your model I’m left confused.

A point about accounting. For some reason, economists seem to dismiss accounting as a triviality. However, accounting is central to any business or bank or government organisation – the accounts are the nearest thing to a common model of a business. The accounts are pored over by people in the markets for clues to a business’s future performance. Macro-economists must get much of their raw data from national accounts. GDP has no meaning outside of accounting. In sciences such as physics and chemistry the concept of conservation (i.e. accounting for everything ) is central to disciplined study. Economists seem to see accounting as just some high level identities. However, I would say that accounting is central to our understanding of the world. It’s the accountants who define the language that can be used for discussing the accounts and hence the economy. If you don’t see accounting as central to a type 2 model then we are not talking about the same thing. Note also that the accounts of a business do not include anything at all about the decision making criteria of either the business or any of the stakeholders with which it interacts i.e. there is no equivalent of micro-foundations.

Here is an example where you don’t seem to be taking accounting seriously. In your latest comment, you said:

‘In the red green world, M in MV=PY would be the sum of green notes plus red notes. Call it "gross money". So not zero. As opposed to "net money", green notes minus red notes, which is zero. (Switch "plus" with "minus" in both cases if you want to.)’

Earlier we said that red and green money were equal and opposite – like credit and debt. However, you now want to add them together as though they are both positive. When you add them together, what colour is the resultant money? We have only defined red and green money. Are you saying that we need another colour too? Or can red money and green money be used interchangeably? That’s not my understanding of our models.

I am conscious that I am taking up your time and you probably have better things to do. I am happy to continue the conversation but if you want to leave it there I will understand. I appreciate that you take the time to debate with non-economists. Not many economists do that and more should. If you could write a book about this stuff that answered the sort of questions I am asking in a way that people like me found convincing, I am pretty sure you would be one of the most famous economists in the world. Only economists who engage in conversations like this will ever be in a position to write such a book.

[Nick Rowe]

Jamie; lots of things exist in the world, that we leave out of our models. The whole point of a model is to leave things out. We try to leave out as much as we can, while still having a reasonable explanation of what we seek to explain. Which things we can leave out, and which things we must leave in, is not obvious. And the answer depends on what we want to do with the model.

In this case, what I wanted to do with the model is to encompass both the simple monetarist vision and the simple New Keynesian vision. What differentiates those two models is not the existence or non-existence of commercial banks. They are a wholly separate question.

I left out energy prices too. And I left out food. "How can you leave food out of a model? people would starve, and you would have no economy!"

Here are a couple of my old posts about commercial banks:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/09/teaching-notes-on-banks.html

http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/09/if-banks-bought-houses.html

There are lots more, if you put "banks" etc. in the search box top right.

I can't write a book. Blogging has ruined me! This blog is my book!

"It’s the accountants who define the language that can be used for discussing the accounts and hence the economy."

No! Absolutely not. I refuse to let accountants define my language. Concepts that are useful to accountants may not be useful to economists.

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/accounting-and-economics-and-money.html

[Nick Rowe]

More on accounting: http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/01/macroeconomics-and-the-celestial-emporium-of-benevolent-knowledge.html

[Jamie]

Nick,

I agree that lots of things can and should be left out of models. When my clients couldn’t focus on the important aspects of a problem, I used to challenge them to draw the essence of a model on a single piece of A4 paper. That ensured that there was room only for things that really mattered and it made them think hard.

We agreed that a key aspect of a type 2 model is the existence of money and the use of that money for exchanges. From my perspective, we therefore need to define how money is created, how it is destroyed and how it gets into the hands of the people who will use it for exchange. That is central to what we have been discussing. In the world which I observe, the commercial bank is vital to this as the central bank does not transact with the general public.

Energy prices and food are irrelevant to the discussion we have been having so I don’t understand why you are suggesting that I think they should be included.

I can see that while I am trying to link from the world I observe to a model, you are trying to link from one model to another. I guess that these objectives are not compatible.

This discussion reminds me of the type of discussion I used to observe between people such as head office planners and factory operations managers. The planner would always think that the operations manager wanted to discuss irrelevant detail, while the operations manager would always think that the planner didn’t appear to know how anything worked in the factory. Oh and the factory manager always cared about stock accounting while the planner didn’t care. Stock accounting is vital to, say, the operations manager of an oil refinery. If the accounting doesn’t check out then something might be seriously amiss – maybe a leak somewhere, with huge safety consequences. If the planning manager said that he didn't care about accounting .......... insert expletive.

I didn’t mean that you should write a book but rather that ‘some economist’ should write one. I can see that you put a huge amount of effort into the blog. It must be very annoying when new readers come along all the time and are not aware of material you have already covered. That’s why I think that ‘some economist’ should write a book where new readers could follow a coherent logical argument from beginning to end and at their own pace.

I'll have look at the other posts you have linked to.

Thanks for your time.

[Too Much Fed]

Jamie, I'd be interested in continuing our discussion at:

http://monetaryrealism.com/negative-money/

Would that be OK with you?

[Too Much Fed]

Jamie, I'd be interested in continuing our discussion at the MR link above about negative money.

Is that OK with you?

[Jamie]

Jamie said, "It’s the accountants who define the language that can be used for discussing the accounts and hence the economy."

Nick said: “No! Absolutely not. I refuse to let accountants define my language. Concepts that are useful to accountants may not be useful to economists.”

Nick,

I’ve just been out for a brisk walk and I have been thinking about this and how to make sense of our different perspectives on accounting.

Imagine that instead of talking about the economy we are talking about a car.

I am starting with the design of the car. The car is an accounting system as its operation is governed by the laws of physics e.g. conservation. It exchanges fuel for energy plus exhaust fumes, and then exchanges energy for motion etc.

You are starting with observations of the behaviour of the car e.g. acceleration, deceleration, skids, crashes. You are right to say that this requires a different language from the accounting system so my previous comment was too black and white.

As long as you are merely observing the car, you can use your own language exclusively and ignore mine. However, if you want to make changes to the car to alter its behaviour then you need to persuade me that you understand the design of the engine and your revised design must be compatible with good design e.g. all the required connections are in place, the laws of conservation are being followed, there are no leaks as per my previous oil refinery analogy.

We agreed that a type 2 model of the economy requires money and exchange. The equivalent in my car analogy is that money = fuel and exchange = the exchanges of materials/energy etc in the operation of the car engine.

The equivalent of our economy debate in this analogy is that your model of the engine doesn’t seem to have a connection between the fuel tank and the engine so I don’t see how the engine works without that connection. (As an aside, I am also suspicious that you are trying to make the car go faster by adding more and more fuel to the fuel tank via ‘QE for cars’ but I’m not sure how that will help the car go faster if the extra fuel can’t get to the engine).

I hope that makes clear how I am seeing the role of accounting in the ‘economic engine’. However, I can now see that you need a separate language about ‘economic behaviour’ and that our discussion has been about blending these two perspectives together.

That’s definitely my last word on this thread apart from replying to TMF’s most recent post. I’m going to cut and paste the thread into a document to save it and possibly rationalise its content into a single document that makes sense to me. I haven’t read your linked posts yet but will do that over the next week or so.

Thanks again.

[Jamie]

TMF,

OK as long as the debate sticks to the essence of what’s going on. I still don’t want to talk about details such as the names of specific bank accounts.

I will be away for a couple of days from tomorrow. If you post on the MR thread in the next 24 hours then I will read your post before going away and reply on my return.

Please include a sentence or two of background in your post i.e. that this post from Nick is his follow-up to the post being discussed on the MR thread. Also please include a link to this thread as I won’t have time to repeat the discussions I have been having with Nick for the MR gang. Also, of course, please indicate what you want me to think about.

[Jamie]

Nick,

I should have said in my last post that, in my car analogy, the reason why you can't just leave things out of your car engine model when you don't see them as being important to your thinking is that your intention is to change the engine of a REAL car - and that requires a full understanding of the car engine design or it won't work.

[JKH]

Nick,

Rough connection/analogy with the Fed as a CB:

The Fed does system repos (which are Fed assets) as a form of collateralized lending.

Forget commercial banks - and substitute collateralized red money for those repos.

When the Fed does system repos, it creates bank reserves (Fed liabilities).

Substitute green money for those.

And your 5 for 5 works OK like that.

Collateralization seems like a useful normal constraint there.

Regarding net issuance if so desired for monetary policy - there just needs to be a non-money instrument of intervention (e.g. analogous to bonds in QE) to allow the CB to target a mismatch of red and green money on its balance sheet.

Not sure about your ECB question or how specific it might be to the ECB. Unwinding the abstraction feels a bit complicated. E.g. the Fed in fact also does reverse repos (on the liability side next to currency) which supply collateral, which isn't part of the analogy to green money above.

[Nick Rowe]

Thanks JKH. (I was remembering something you said in comments on MR a couple of weeks back, about the ECB being a red/green system. Target 2 I think. Some national banks have green money at the ECB, and others have red money, but the two cancel out?)

[JKH]

Right - I understand now - I was thinking consolidated Euro system

Target2 is essentially a clearing system for central banks operated by a super-central bank

So for example could be viewed as the ECB issuing green money (positive T2 balances) to the Bundesbank and issuing red money (negative T2 balances, sort of, or a loan of T2 balances) to the Bank of Greece for example

(T2 balances are not the same money thing as reserves held by Deutschebank with the Bundesbank for example)

It all nets out to nearly zero; I think there may be some minor technical mismatches due to small balances that might relate to some Euro CBs not are not (yet) part of the EZ

[Nick Rowe]

JKH: Aha! Thanks! That's what I had thought you had said on MR, but I wasn't sure I had understood you correctly. To me, that's a rather interesting fact about the ECB.

[Jamie]

Nick,

I seem to be retiring from this thread more times than Frank Sinatra but I had another brisk walk and had another thought. Here is another way at looking at this which might appeal to you more as it’s not about believing me but believing someone you trust - Paul Krugman.

Chris Dillow (UK econ blogger) wrote a post where he made a distinction between models and mechanisms.

http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2012/01/mechanisms-vs-models.html

Paul Krugman picked up on this.

http://krugman.blogs.nytimes.com/2013/08/02/models-and-mechanisms-wonkish/

Here are some extracts from Krugman’s post with comments from me in brackets.

“ a very useful point from Chris Dillow that I somehow missed about the importance of mechanisms as opposed to models in economic analysis”

“I would argue that the mechanisms we talk about in economics are themselves models — simplified representations of how people behave. But let’s not get hung up on semantics” (I agree with Krugman when he says that mechanisms are themselves models)

“a key part of economic wisdom is thinking about the mechanisms we suppose are acting in the REAL economy” (my emphasis on REAL)

“these mechanisms may not be specific to a particular model, and on the other hand any model had better have persuasive mechanisms in it, or it’s not helpful”

“so back to the original point: we can argue about whether the models versus mechanisms distinction is really a clear one. No matter: at all times, but especially in these times, it’s a very good idea to ask, when some economist offers a proposition about the economy, “Um, how exactly is that supposed to work?” You’d be amazed how often no answer is forthcoming” (this is what we have been arguing about).

It is posts like this which make people like me trust Paul Krugman MUCH more than other economists. The only disagreement I have with him is that, from my perspective, there is definitely a clear distinction between models and mechanisms. They are separate types of model which have different rules. Economic models can be as abstract as you want and economists set the rules. Mechanism models must obey the laws of physics and accounting, and must identify specific institutions in the real world through which the mechanisms achieve their effect. They must also have a trigger event. The trigger event helps you understand cause and effect i.e. the trigger event drives the mechanism. For example, if I sell you an apple then this transaction was probably triggered by you when you entered my shop. This is an important distinction in economics because many issues relate to disputes over whether problems are caused by demand or supply problems. For example, are commercial banks triggered to lend money by the action of the central bank in supplying them with more money or by a customer entering the bank and asking for a loan. If you don’t understand the trigger then you may develop a faulty policy to boost bank lending.

Note that, in Dillow/Krugman language, my models are what they are referring to as mechanisms while your NK model is what they are referring to as a model. From my perspective, I am agreeing with Krugman but taking it a step further by insisting that mechanism models obey certain rules to ensure their consistency. I guess that these rules are the equivalent of micro-foundations for mechanisms.

The only problem I ever have in understanding Krugman is when he talks about his models. I don’t know enough to think in terms of his models (and I am just a typical lay person in that respect). I understand the economic world via the mechanisms. You can see that by the fact that I draw analogies with the mechanisms of cars and oil refineries which might seem odd to you.

Lay people would find it much easier to understand economists if they explained mechanisms. I also think that economists would find it much easier to understand lay people (particularly politicians) if they discussed lay people’s perceptions of the mechanisms driving the economy (even if it was mostly to correct the lay people’s faulty understanding).

In Dillow/Krugman terms, you started this thread to try to translate from a model to a mechanism based on that model. I am just looking for descriptions of mechanisms I can believe. However if you have inconsistencies, such as defining red and green money as equal and opposite but then later adding them together as though they had the same sign, then I won’t believe you.

[Jamie]

JKH said: “Forget commercial banks”

Nick/JKH,

I have read posts by JKH elsewhere. I think he is very smart. In the terms we have been discussing he understands mechanisms, so I’m surprised by his comment on commercial banks. I have a challenge for both/either of you.

My understanding of QE is that it involves something like the following mechanism:

Central bank triggers the mechanism and creates green money
Central bank swaps green money for commercial bank assets
Something else happens which I don’t understand in order to get the green money from commercial banks to the wider economy.

I don’t see how you can describe this mechanism without mentioning commercial banks. If you can describe this mechanism without mentioning commercial banks then I will bow to JKH’s expertise. The only sort of mechanism I can think of that would omit commercial banks would be if the central bank hired a helicopter and dropped the new green money directly into the economy. I don’t see that happening anywhere near me.

[Nick Rowe]

Jamie: I'm fine on mechanisms and models. I talk about "stability" and "transmission mechanisms".

When we say "forget about commercial banks" we might mean: consolidate commercial and central banks together (the central bank takes over the commercial banks). We can imagine a world in which everyone has an account at the central bank. In part, that is the real world. I hold central bank money in my pocket. It's paper money, not electronic money, but it's the same thing. I have an account at the Bank of Canada, it's just they won't let me run an overdraft.

Open Market Operation (the proper name for QE) with no commercial banks: the Bank of Canada buys a bond from me, and gives me currency in exchange. That's the mechanism. Introducing commercial banks just complicates the story.

http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/10/immaculate-transfers-and-the-monetary-transmission-mechanism.html

[JKH]

Jamie,

I'm deferring to Nick's choice of a simplified model there to make the discussion consistent.

The QE analogy in that model by construction has to be a transaction between the CB and a non-bank agent.

So the CB buys something (maybe bonds) from somebody (maybe you or me) in exchange for new green money.

And its a non-conventional policy in the context of a "normal" red/green balance as described by Nick.