My Cunning Plan to reform New Keynesian Macro

Brad DeLong calls it my "self-imposed Sisyphean task". He's probably right. But it seems worth a try, as long as there's a small chance he's wrong. I have a Cunning Plan.

 

 

 

 

Like it or not (and there is much to like as well as dislike), New Keynesian macro has become the main accepted approach for teaching, research, and policy. It would be hard to persuade economists to ditch it. Rather than ditch it, I want to reinterpret the New Keynesian model as a model of a monetary exchange economy (and argue that it only makes sense as a model of a monetary exchange economy). Then I want to make small changes to the model so that the stock of money enters essentially (and argue that it only makes sense if the stock of money enters essentially). My Cunning Plan is a bait-and-switch.

Simplify massively, to clear the decks of anything that is not required for me to make my points. Large number of identical infinitely-lived self-employed agents who produce and consume haircuts (the only good). So wages and prices are the same thing, and output, consumption, and employment are the same thing. All agents set the same price (which may be sticky or flexible). The central banks sets a rate of interest (somehow, and this is a question that must and will be answered). To make it even simpler, we can assume the central bank indexes the nominal interest rate to the inflation rate, so it sets a real rate of interest. No shocks, nothing fundamental ever changes, and full employment equilibrium is 100 per period.

Suppose the central bank sets the rate of interest too high. Will this cause unemployment?

No. Any unemployed agent would simply cut his own hair.

Suppose we change the model so agents can't cut their own hair, to motivate trade. Can we get unemployment now?

No. Two unemployed agents would simply do a barter deal to cut each other's hair.

We need to change the model so that monetary exchange is essential -- they can't trade without using money as a medium of exchange. So let's do that.

You can't cut the hair of anyone who cuts your hair. So we get a Wicksellian triangle. And agents can only meet pairwise, and have bad memories for names and faces and can only remember the central bank. Or whatever. So they have to use central bank money to buy haircuts. Every agent has a chequing account at the central bank. The central bank pays a rate of interest r on positive balances, and charges the same rate of interest r on negative balances. And the sum of the positive balances equals the sum of the negative balances, so the central bank has no other assets or liabilities and zero net worth and zero income.

Now we can get unemployment if the central bank sets the real interest rate too high. Each individual wants to accumulate a positive balance in his chequing account by spending less money than he earns, which is impossible in aggregate.

Reinterpreting the New Keynesian model as a model of a monetary exchange economy, where every agent has an interest-earning chequing account at the central bank, kills two birds with one stone (it explains how the central bank can set the rate of interest, and explains how this can cause deficient-demand unemployment). Yet it leaves the equations of the model unchanged. No sensible New Keynesian macroeconomist should object to this reinterpretation. It's a friendly amendment -- and not even really an amendment.

That was the easy part -- the bait part of my Cunning Plan to bait and switch. And I'm just recapitulating my old post on solving the riddle of the New Keynesian Cheshire Cat.

Now for the harder part -- modifying the model to make the stock of money essential. That's the switch part.

There are two definitions of the stock of money that would be useful in a model like this:

1. The Net money stock = the sum of positive balances minus negative balances.
2. The Gross money stock = the (absolute) sum of positive balances plus negative balances.

In the model I have sketched above, Net money is zero by assumption. The central bank could make Net money positive by buying some asset, or negative by selling some asset (open market purchases or sales).

In the model I have sketched above, Gross money will be zero, because all agents are identical. Holding Net money constant, aggregate receipts of money must equal aggregate payments of money by accounting identity, but if agents are identical this also is true for each individual agent. Each agent's receipts and payments of money are perfectly synchronised, so his inventory of money will always be zero.

If we add individual-specific shocks to agents' receipts and/or expenditures of money, we can change the New Keynesian model so that agents' receipts and payments of money are not automatically perfectly synchronised, which means the Gross money stock is now strictly positive.

Assume that the central bank sets a spread between the interest rate it charges on negative balances and the interest rate it pays on positive balances. Assume it is costly for agents to synchronise their payments and receipts of money (for example by agents with a positive balance lending to agents with a negative balance). We now have a demand for gross money as a negative function of the spread set by the central bank.

We now have something that looks a bit more like a traditional macro model, because it does have a money demand function.

Hold that thought. Because I now want to take a detour, and talk about the New Keynesian IS equation.

There is a very big problem with the New Keynesian Macro model. It simply assumes, with zero justification for this additional (hidden) assumption, that agents in the model expect an automatic tendency towards full employment. As I explained in my old post, Old Keynesians would be screaming blue murder if they understood that New Keynesians were making this illicit assumption. Because it is precisely this question that Keynes wrote the General Theory to address.

To repeat the point I made in that old post, if the central bank always sets the real rate of interest equal to the natural rate of interest, that is a necessary but not a sufficient condition for output being at the natural ("full employment") level. There is a continuum of equilibria, with anything from 0% to 100% unemployment being an equilibrium. This result follows immediately from the Consumption-Euler equation. In the simple case of log preferences, where n is the rate of time preference proper, it is: C(t)/C(t+1) = (1+n)/(1+r(t)). The real interest rate only pins down the expected growth rate of consumption, not the level of consumption. And New Keynesians evade this problem by simply assuming that in the limit, as t approaches infinity, C(t) approaches the full employment level.

That's a problem with the New Keynesian model. A very big problem. How can we fix it?

This big problem with the New Keynesian model is the result of the New Keynesian Long Run IS curve being horizontal. It is horizontal at the natural rate of interest. So if the central bank sets the real rate of interest equal to that natural rate, the long run equilibrium level of output is indeterminate. As any second-year economics student knows, if you have a horizontal IS curve, you need an upward-sloping LM curve to determine the level of output.

Back to that thought you were holding, about how we can modify the New Keynesian macro model so there is a well-defined demand function for the gross stock of money. What else do we need to get something like a standard upward-sloping LM curve? You guessed it: we need a supply function for the gross stock of money. And if we want the LM curve to slope up, so that the level of output is determinate, that supply function cannot be perfectly elastic at any given rate of interest.

It is not sufficient for a central bank to set a rate of interest (or one rate of interest plus a spread) and let the stock of money be determined by demand at that rate of interest. Long run output (not to mention the price level) is indeterminate if it does that, even if it sets the correct rate of interest. It needs to control the nominal quantity of money too. The central bank needs to set some nominal anchor, not just to make the price level determinate, but to make the level of output determinate.

The only mechanism that can provide an automatic tendency towards full employment (if, and that's a big "if", the central bank does the right thing) is the hot potato mechanism. If we reinterpret and reform the New Keynesian model the way it needs to be reinterpreted and reformed, we end up with Keynso-monetarism.

I ought to talk about "haircuts" in the financial market sense, and how collateral constraints mean the central bank puts limits on individual agents' negative balances, and how this creates a link between the Gross and Net stocks of money, and how Open Market purchases increase both Net and Gross money. But this post is already too long, so I will stop there.

Update: In a comment on my previous Cheshire Cat post, Brad DeLong asks: "If it isn't an RBC model minimally-tweaked to deliver Old Keynesian conclusions, why is it what it is at all? What other telos could it possibly have?"

On Thursday I heard Michael Woodford give a talk at a Bank of Canada conference. He started his talk by saying he visited the Bank of Canada in the late 1990's, spent time talking with Chuck Freedman and Kevin Clinton about how the Bank of Canada conducted monetary policy, which had been very influential in his subsequent work. I understood him to be talking about his "Interest and Prices". Indeed, the only important difference is that it is commercial banks, and not regular people, who have chequing accounts at the Bank of Canada. Otherwise, the model fits pretty exactly. I think that is the telos. Blame Canada.

Comments

[Antti Jokinen]

JKH said: "But physical money is also reflected as a balance sheet account, so that distinction seems a little blurred as well."

This is what I meant with when I said that they are often intertwined (and when I said "Once one understands the accounting, one will understand what kind of role currency plays as part of the accounting."). I wouldn't say the distinction ends up being blurred, though. But I see what you mean.

If we think of the (old) Treasury notes, or, in general, notes issued by the government (not the central bank! MMT...), then physical money is more separated from "account money" -- it's not to be found in any bank ledger. I don't say fully separated, because even then it maintains its role as an item representing a credit balance in some ledger (even if we might need to use some more imagination to see it).

I'll comment on the rest of your comment when I have more time! I think we are very much in agreement. (I could perhaps start arguing that "deposits create loans", because the borrower really wants deposits from the bank, and the signing of a loan contract is just a nuisance to him... I get what you mean by sources and uses of funds -- that's conventional accounting terminology.)

[Jamie]

Roger Sparks: “I think I will focus only on the disagreement example”

If we were all working on a project in the real world, there would be a project sponsor and a project board, so there would be a decision-making chain to resolve this type of dispute. The project board would assess different options, or models, and we would all accept their decision. On a blog, we have a free-for-all. We each design our OWN models, even if they are just in our individual heads, and quality check them independently. If there is a consensus, that’s a bonus. As I have said to TMF, a lot of modelling is judgement. All we can do on these threads is to think about what others say, and decide for ourselves how to improve our OWN models.

I published my model as I think that the only way to debate these issues properly on the internet is for each person to produce their own model explicitly, in whatever format they think appropriate but including assumptions and definitions, and then look at the differences, but we must accept that this will be a very hit-and-miss process and if disagreements persist then that’s too bad.

What I have learned this time round is that there is no agreement on method for modelling and that I would need to explain my method more clearly to get others to accept my model, but that would need a whole new slide pack.

Roger Sparks: “One very good thing about Nick's green/red money concept--It certainly has provoked a lot of thoughtful discussion!”

I think that Nick is very brave to publish his models as the ensuing debates are always very messy, and it’s easy to throw bricks at any model that is made explicit. That’s why I think that each person in the debate should state their own model explicitly. It creates a more level playing field. However, you can’t mandate that on a blog.

I agree with you (on Antti’s blog) that the focus needs to return to the real world. I think that the only real issue is the loan issue but I think we have taken that as far as we can. I tried to embed loans into a green money world (for non-banks) where only banks have red money. Each person needs to make their own assessment on whether that is successful.

I have added your blog to my (already far too long) reading list, so I will try to keep up with your thoughts. I don’t post much though despite the evidence of the last few days. This is the first thread of Nick’s that I have commented on this year, although I have read a lot of his material. What is the specific focus of your own research?

[Jamie]

TMF: “I hope that is simple enough”

Maybe I’m not explaining myself well. My view is that, on the internet, we are all doing our own thing. My interest is in the total economy, not just finance. I know a lot about sectors which are never discussed here: from water & electricity, to pharma & law firms, to farming & state benefits. Finance is one of the areas where I know least! I am at an intelligent schoolchild level in this area, and happy to admit it. I use these threads to search out people who seem to be experts, like JKH, and then try to reflect what they say in my own simple models. I then check that what the experts say, subsequently, does not contradict my models and, if it does, I change my models.

What *I* would like would be for others to develop more sophisticated finance models, akin to my model in this thread, but with more finance content, so that I can learn more easily. However, there are no such models as far as I can see. I am not disagreeing with the content points you are making about capital. However, I don’t think I am the right person to produce the models you want to see. Why don’t you produce the type of model you envisage and publish it on a future version of this thread (of which there will, no doubt, be many)? Google has free to use word processing, spreadsheet and presentation tools. All you need is a Google email address and then register on Google Drive. The results can be published and shared easily. That is what I did on this thread.

I have other priorities in extending my own research. I want to consolidate the material I already have, rather than delving into new areas.

[Jamie]

JKH: “Keynes pointed out correctly that actual saving and investment are always equal in value”

I think that this is much easier to see from the bottom up i.e. every single transaction must comply with the identity. For example, Nick’s business sells JKH’s household a bicycle at cost for €100 requires quadruple entry as we have discussed earlier.

I + C = C + S is

I = Nick’s loss of 1 bicycle valued at €100 = - €100
C = Nick’s gain of €100 = + €100

C = JKH’s gain of 1 bicycle valued at €100 = + €100
S = JKH’s loss of €100 = - €100

Both sides total to zero and I = S. Two terms represent valuations of bicycles and two terms represent the medium of exchange. Each side of the identity has one term of each type.

If the business sells the bicycle at a profit, the S term must also include the profit (business saving) as well as household saving for the identity to hold. If business saving is included explicitly as a separate term and moved to the left-hand side, it becomes a negative term. At a macro level, this says that, if businesses hoard their profits rather than reinvesting them or distributing them as dividends to households, it holds the economy back.

[Jamie]

Nick quoting Brad DeLong: “why is it what it is at all”

I wish you luck with your task. Any disagreements on here are trivial compared with the need to bring money into macro, as non-economists just don’t believe macro based on no money and representative agents, so we inevitably question any advice based on these models.

I have one set of extremely basic questions.

One of the things that my old firm used to sell was mathematical models to solve problems at a micro level. It wasn’t my area at all but we were always encouraged to find out about other services the firm provided so that we could spot opportunities.

When our modellers talked about their work, they talked like anyone else in the private sector. They talked about their clients, the problems faced by their clients, and how they had helped their clients by building models. They would point out that the CEO of firm X had given them a publicity quote to the effect that he could not have solved his problem without our modellers’ help. They didn’t talk about their models.

The focus here is that client value from solving problems >>>>> modelling techniques.
or
WHY >>>>> WHAT >>>>> HOW.

I am always struck by the fact that economists talk about their modelling techniques a lot but rarely about what value their models create for others, or indeed whether they create any value at all. This is not just the New Keynesians. It is the Post-Keynesian / SFC people too.

Is that what Brad DeLong is saying here? Is it the case that these models do useful things (where useful is defined by a policy maker – not by the modeller) but economists don’t talk about it, or that the models just don’t work very well? I am reading Brad DeLong as saying the latter. Non-economists assume it is the latter unless told otherwise, so if it is the former then economists should learn to talk more like my firm’s modellers.

Do economists carry out blind trials of their models to compare the merits of different models, or any other formal quality tests that would give evidence of value to customers? If I were a customer of these models, I would ask this type of question. Demand pull is a much more effective mechanism for improving any product quality than supply push.

[Henry]

"if businesses hoard their profits rather than reinvesting them or distributing them as dividends to households, it holds the economy back. "

Not necessarily - business spends also.

[Too Much Fed]

Jamie said: "What *I* would like would be for others to develop more sophisticated finance models, akin to my model in this thread, but with more finance content, so that I can learn more easily. However, there are no such models as far as I can see. I am not disagreeing with the content points you are making about capital. However, I don’t think I am the right person to produce the models you want to see. Why don’t you produce the type of model you envisage and publish it on a future version of this thread (of which there will, no doubt, be many)? Google has free to use word processing, spreadsheet and presentation tools. All you need is a Google email address and then register on Google Drive. The results can be published and shared easily. That is what I did on this thread.

I have other priorities in extending my own research. I want to consolidate the material I already have, rather than delving into new areas.

I think you can produce those models. You are almost there.

Why Don't I? Word Pro, OK. Spreadsheet, OK. Presentation tools, needs a little work.

You don't really need a new area. Get the hedge fund/commercial bank/central bank model (capital multiplier) in there. You are pretty much good to go.

Rule C1 needs to be changed to existing or new for the start.

Anywhere to get the slide data that can be changed?

[Antti Jokinen]

Jamie: I don't want to waste time by continuing our earlier argument -- there's more important things to talk about. I think there were misunderstandings on both sides. No hard feelings on my side, and I hope not on yours either?

Like you, I would say I try to understand the economy as a whole. I'm building a macro model (not mathematical, though -- I don't currently see it even possible to tell the "story" in formal language). As you say, money, or at least the financial system, should be part of that kind of model. (I have abandoned the concept of money -- if you can't define it, get rid of it? --, but I don't ignore any of the phenomena related to our financial system. So I'm saying that money-as-we-knew-it doesn't really exist.)

In general, I agree with you that the focus should be on the usefulness of models. But at the moment, after the financial crisis reminded us that most of the macro models in use are not useful models if we want to understand crises, the focus is, understandably in my opinion, on including the financial system in the models. Or if it cannot be included, succesfully, in those models, then we have to come up with new models. So, in this context I understand that economists have turned very much inwards. (Of course the "money problem" -- not understanding money well enough -- has been there always, pushing people to try to find alternative models.)

You might agree with me on that, as you are, too, trying to build a model which includes the financial system.

You seem to be a very bright person with a lot of useful skills and experience, so it would be my pleasure if you still had time to comment on my blog. The comments are now open to anonymous commenters (I thought that was default when I started my blog not long time ago).

What still bothers me with your model is this:

You want to use quadruple-entry. That's fine -- I understand the SNA perspective. But does it really work when one of the counterparties is a bank? If you have Nick and JKH doing a bicycle trade, then quadruple-entry is clear, as you explained. The problem I see with banks is that money is not really their "bicycle". If I exaggerate a bit, I would say that banks do nothing but accounting. That accounting is double-entry. If JKH bought a bicycle from Nick by using an overdraft, then including the bank in your model would bring in the fifth entry (debit on JKH's checking account) and the sixth entry (credit on Nick's firm's checking account) (the credit entry might have been made first -- it doesn't matter).

You see that just the debit entry on JKH's account would cover what you describe as the bank creating a green and a red loan? And the credit entry on Nick's firm's account would cover what you describe as the bank creating green and red money. When I talk about bank accounting, I'm in no way choosing one perspective and ignoring the other if I say that JKH's checking account has a debit balance. It is clear to me and to anyone who is listening that we are talking about a liability of JKH recorded in a bank ledger, and that this liability will, or at least should, be reported on the LHS of the bank balance sheet -- and the items on that side we call the bank's assets.

But perhaps I've just misunderstood you. You said earlier that the bank makes all four entries, but perhaps you talked about the bank in your model, and not some real-world bank?

Like you, I'm not an economist. I majored in Accounting, and my last position before becoming full-time amateur economist in 2014 (I need an income soon...) was as business analyst in a pharma company. Like all "rogues" (Kerviel, Adeboli?), I have experience from the back office of a brokerage firm. I've also done fund bookkeeping for a private-equity firm.

[Antti Jokinen]

I said: "...you are, too, trying to build a model which includes the financial system."

Perhaps I misinterpreted whay you said. What kind of research are you doing?

[Too Much Fed]

"Rule C1 needs to be changed to existing or new for the start."

Make that C1 and C3.

[Jamie]

Jamie: "If businesses hoard their profits rather than reinvesting them or distributing them as dividends to households, it holds the economy back. "

Henry: “Not necessarily - business spends also”

Yes, but spending is not hoarding

If businesses spend their profit they are reinvesting it (Keynes’ I term) which stimulates the economy.

If businesses distribute their profit to households, it increases household saving (Keynes’ S term). This at least allows the households the opportunity to spend this money which would stimulate the economy.

The other choice for businesses is to do neither of the above, which is hoarding.

[Jamie]

TMF: “Get the hedge fund/commercial bank/central bank model (capital multiplier) in there. You are pretty much good to go”

I’m not sure what you mean. Can you be VERY specific about what you think I would need to add / change? I don't understand why you think that hedge funds are important here, and I know little about they do.

TMF: “Anywhere to get the slide data that can be changed?”

I agree that there are changes that are needed to the slides based on some of your challenges, but I will do this in my own time. I am not intending to republish the slides at the moment.

I will not republish the slides until I have a separate pack explaining my modelling method, so that people will have a better understanding of what I am doing. That's more important to me at the moment.

The Google presentation tool is pretty easy to use. It is no more difficult than a word processor.

[Jamie]

Anti: “No hard feelings on my side, and I hope not on yours either?”

I have no hard feelings. These things happen.

I started reading about economics when I gave up consulting in 2010. My professional background is in business and government, but little in finance. My initial objective was to find two books, read them and move on: one book on money, banking and insurance to fill in the gap in my sectoral knowledge at the micro level; the other book on macro. The books would be aimed at, in my terms, an intelligent schoolchild.

I couldn’t find the book on money and banking. I don’t think it exists. The books I found on macro appeared to be from an alternative universe and raised more questions in my head than they answered. For example, what is it about economics that makes it so difficult for non-experts to understand? Why do academic economists believe that widespread economic ignorance amongst the general population is sign of economists’ superiority to the rest of us rather than, as the rest of us see it, a sign of their abject failure to educate us?

I then started to read blogs (from a diverse range of economists and interested non-economists) and found that the whole area was completely disfunctional. For example, in some places it is regarded as heterodox to even ask a question about money and banking, and some economists boast about their lack of knowledge of banking as though it is a qualification for a higher level of thought. The policy prescriptions diverge widely, so how can policy-makers or non-economists decide which policy prescriptions to believe without first becoming experts themselves to adjudicate between the experts? Even the beginners’ courses in economics are controversial as students (in the UK at least) set up societies to complain that what they are taught is not useful – and the Bank of England is on the side of the students.

My objective, at the moment, is to design material which would encompass what I think should be in an introductory economics course covering macro and some aspects of micro which I think are essential to understanding macro. The quality criteria are that the 2010 version of me (or any other intelligent non-economist) would have found it credible, interesting, useful and easy to understand.

I don’t have a timetable for completion and I haven’t decided whether I would publish the completed material e.g. sets of slides or an e-book or blog posts, or just be content to view the material as the coursework from my own self-education course.

Regarding specific issues, unfortunately there are layers within layers of difficulties which need to be overcome.

I agree that there are different types of model. Most economists seem to use the term “model” to mean what I would call a behavioural model (mathematical simulation or similar). There are also descriptive models, logic models, process models, governance models and many others. Language and terminology is even a model as we can’t talk clearly about anything we can’t define clearly. All these models can be produced at different levels of granularity and accuracy; can emphasise different aspects of reality; and can be articulated in a variety of ways.

Imagine that the economy was car. Most people would start to understand the car by learning about the controls or the engine, but economists appear to start by modelling the behaviour of the car as it turns a corner or crashes into a wall. They then use this information to infer knowledge about the engine and the controls. This is very odd as it would be easier to open the car and look at it, or to ask a mechanic how it works. No other subject does this. If you asked the question “what does the economy look like”, I suspect that economists would not be able to answer or each economist would give an idiosyncratic answer.

Some specific points.

Antti: “The problem I see with banks is that money is not really their ‘bicycle’”

For commercial banks, I think that the loan is the equivalent of the bicycle, not the money. For central banks, the bicycle is whatever they buy with the money they create e.g. government bonds.

In my mind, the bicycle is always some sort of asset (or good or service) but NOT the medium of exchange. The quadruple entry always includes two entries for the asset and two for the medium of exchange. A transaction with only the medium of exchange is a gift rather than an exchange and banks don't make gifts.

Antti: “You said earlier that the bank makes all four entries, but perhaps you talked about the bank in your model, and not some real-world bank”

I would say that, in the scenario where Nick sells JKH a bicycle, the real world is Nick, JKH and the bicycle. I think that the accounting, the money and the bank all take place inside what you might call an “all-knowing computer system”. WHO does the accounting is not important. Maybe Nick’s business accounts for the transaction in its own accounting system. Maybe JKH keep a spreadsheet of his financial outgoings and doesn’t record his assets (including his new bicycle) at all. Maybe Nick uses accruals accounting and JKH cash accounting. Maybe the bank records some or all of the data for the transaction but maybe it doesn’t if JKH uses cash. Maybe Nick and JKH use different banks and their banks settle the payment for the bicycle via the central bank. None of that is in the “real world” and we can abstract it away by stating that it is all encompassed in the quadruple entry. It is only the basic accounting logic, i.e. the underlying logical rules of the system, that really matters, like in Nick’s train / tunnel / stick example.

We talk in these threads as though the banking system is more important than any other part of the economy. It’s not. We would all die in days without the water system. We would die in weeks without food, and, in some climates, we would die in weeks without shelter & heating / air condition. We would die of boredom without travel & entertainment and the various tools and technologies that facilitate that travel & entertainment.

Banking is just a very important utility. One day banks will be replaced by a computer system and no-one will notice. The local branch of my bank closed last year as no-one went there anymore. The underlying accounting logic is what will last. IMHO, we need to understand that logic to understand the behaviours of the economy.

The problem with this stuff is that even very long comments just scratch the surface, so more detail is best taken offline. Enough for today. I will come over to your blog tomorrow.

[Too Much Fed]

"Can you be VERY specific about what you think I would need to add / change?"

I'll try. I believe you are assuming a monetary exchange economy. Your commercial bank has no capital. You need that for any asset that has a positive capital requirement. A loan to Nick's dad would have a positive capital requirement. However, I believe your economy has zero "money" to start with. I don't see how the commercial bank can meet the capital requirement.

If you assume zero "money" to start, have a central bank start by buying new gov't debt of $1,000 (new currency for a new gov't bond). The capital requirement for the gov't debt is zero. Then, give a tax cut for the full loan amount (the borrowed currency) to say Andy. Andy buys goods from Betty. Betty buys goods from Carol. Carol buys goods from Andy.

Next, Andy saves $100 to start a hedge fund. This hedge fund will buy bonds. It has a 10% capital requirement for the bonds. Betty and Carol decide to go into debt at the hedge fund. They both sell $500 of bonds to the hedge fund and "buy" $500 of 1-day or less short-term debt from the hedge fund. Everyone uses the short-term debt as "money". There is savings of $100 and "dissavings" of $1,000, meaning spending goes up by $900 in the real economy.

There is the hedge fund acting "commercial bank like" ("money" creators!!!). Add deposit insurance, payment processing between banks, some kind of liquidity help, and maybe other things. Now you have a commercial bank.

Sound good for your model?

[Jamie]

TMF,

Thanks. That gives me a better idea of what you mean. I think that there are two separate issues here. First, how does the banking system intervene to support the rest of the economy on a transaction by transaction basis? Second, how did the banking system get started and what keeps it afloat?

I think that the current discussion is the first and that capital belongs in the second.

For the first discussion, I would like to park capital, so I need an assumption of an ongoing bank with sufficient capital. You are correct to say that my model doesn’t include the setting up of a bank or any capital considerations, so I need an assumption to close off that problem.

I think that the second discussion needs a whole separate set of slides which I don’t have time to produce (but I might sometime in the future as it is a very interesting area).

Let’s take a few of your points. First, I want to lose the term “hedge fund” and just call it “commercial bank”. More people will understand that term and, with a bit more time, we could challenge ourselves to tell a more complete story about where commercial banks came from, including things like deposit insurance in the overall story. We could extend that story further to talk about insurance more generally (management of risk) which I think is also central to a functioning economy.

TMF: “If you assume zero "money" to start, have a central bank start by buying new gov't debt of $1,000 (new currency for a new gov't bond)”

This sound like MMT to me. “In the beginning, there was the government. On the first day, the government created people so that it had something to govern. On the second day, it created banks and money”

That’s not what happened. I think that the story is something like:

People / families did everything for themselves

People agreed to co-operate locally and invented the division of labour

(Immediately after), people realised that to operate division of labour effectively, they needed to invent businesses (or types of specialist), counting (how many sets of clothes are required, how many animal skins are needed as raw materials), accounting (keeping track of things more generally), money (an accounting device which equates to something like purchasing power for the exchange of goods & services) and planning.

There is then a need to design a physical version of “money” (as this happened before computers). Money is only credible if it is backed by something that people can believe in e.g. gold, so the person who stores the gold (or equivalent) is also the best person to design and produce the thing (paper, coin, stick, whatever) that is used to designate purchasing power. That creates an early version of a commercial bank.

A little later, people would also have discovered a need for insurance e.g. when some farmers starved after their fields were flooded and their crops destroyed.

Later again, governments came along and took over some of the responsibilities of the commercial banks and the insurance companies, and standardised those activities over a wider area.

After that, government loans (bonds) began to take over from gold as the thing that people believe in that is used to back the commercial banks. That was because the supply of gold is limited and this puts strains on the economy, while government bonds can be created whenever the monetary system requires them (as long as the government is not run by crazy people).

In my story, commercial banks came before the government. In my story the people are God and the government wasn’t invented until the sixth or seventh day.

TMF: “Everyone uses the short-term debt as ‘money’”

This brings us back to the current discussion which, from my perspective, is that the terms “money” and “loan” (or debt or bond or overdraft) are closely related but not the same. We don’t use short term debt as money. We acquire debt in order to acquire money (purchasing power) at the same time. We then spend the money but are left with the debt. Money is the medium of exchange. A loan (or debt or bond) is not.

[Roger Sparks]

Jamie:

I easily follow your last two comments. Thanks for offering them.

My two-cents on TMF's comment "TMF: “Everyone uses the short-term debt as ‘money’”":

(carried over from Antti"s blog)

"A quick recap-- deposits and loans are both assets; the only difference is the time effect between the two.

In your comment, you write "If a loan fails, something is destroyed. What?". My answer to that question is somewhat philosophical. I think an asset-path-to-the-future is lost. The loan has no obvious present value except as to whatever predictability it might offer for the course of future events.

I think you are correct to observe that a bank deposit is identical to a loan in every respect except one: the bank deposit is a present-realizable asset-path-to-the-future while a loan is a future-realizable asset-path-to-the-future.

Does this make any sense to you?"

Just my two-cents contribution; another perspective.

[Antti Jokinen]

Jamie: Thanks for the long answer! I'll get back to it when I'm in another mood (requires deeper thoughts).

TMF said: "However, I believe your economy has zero 'money' to start with. I don't see how the commercial bank can meet the capital requirement."

Why would we need money to meet the capital requirement? Let the banker sell some diamonds or other real assets to the bank he is establishing. Against these he (acting as the bank) can issue shares to himself (acting as a non-bank). There's your capital?

[Too Much Fed]

"Why would we need money to meet the capital requirement?"

The assumption of a monetary exchange economy. The stock would be sold for "money".

[Antti Jokinen]

TMF: Too strict a definition of a monetary exchange economy, in my opinion.

If I remember correctly, even Facebook(?) gave shares, not cash, to the artist who painted the walls of its first office. That is, the artist sold art to the company in exchange for shares. In-kind contribution might not be the textbook case, but it is in no way inconsistent with a "monetary exchange economy". Especially when we are talking about the founder of the company, not an outside investor.

[Too Much Fed]

"If I remember correctly, even Facebook(?) gave shares, not cash, to the artist who painted the walls of its first office."

That is not going to help with capital for losses. Think of it like a company issuing stock for a factory. The company issues stock to get "money" and then uses to the "money" to buy equipment. If the stock is just given away, there is no "money" to buy equipment.

[Antti Jokinen]

TMF said: "That is not going to help with capital for losses."

Should I take this to mean that you don't appreciate that kind of art? :-) The artwork can be recorded as an asset, and it might very well increase the realizable value of the property.

Stock can be traded for the factory, or part of the equipment, directly. That is not unheard of in a monetary exchange economy, as you saw if you followed the link I provided.

[Too Much Fed]

"Stock can be traded for the factory, or part of the equipment, directly."

I would say money was traded for equipment and then money was traded for stock.

This is going to be last comment on it. I want to help Jamie with Jamie's model.

[Too Much Fed]

Jamie said: "Thanks. That gives me a better idea of what you mean. I think that there are two separate issues here. First, how does the banking system intervene to support the rest of the economy on a transaction by transaction basis? Second, how did the banking system get started and what keeps it afloat?"

Does the first one include whether commercial banks are creators of "money"?

"First, I want to lose the term “hedge fund” and just call it “commercial bank”."

OK. Just keep in mind these:

What happens when a central bank does QE?

What happens when a commercial bank does QE?

What happens when a hedge fund does QE?

"That’s not what happened. I think that the story is something like:"

I thought some entity wanted to start from scratch, not what happened in the past. Most economists would skip any type of gold standard if starting from scratch.

"This brings us back to the current discussion which, from my perspective, is that the terms “money” and “loan” (or debt or bond or overdraft) are closely related but not the same. We don’t use short term debt as money. We acquire debt in order to acquire money (purchasing power) at the same time. We then spend the money but are left with the debt. Money is the medium of exchange. A loan (or debt or bond) is not."

Here is the interesting one.

Would you consider demand deposits MOE?

And if so, why are demand deposits not a type of short-term debt (a day or less) with some different “rules” applied to them than other short-term debt?

When "getting a loan", is an entity borrowing demand deposits from the commercial bank?

[Antti Jokinen]

"I want to help Jamie with Jamie's model."

So did I. You suggested Jamie needs a central bank and government bonds to create money, so that money can be used to provide "capital" for the commercial bank. He said he didn't like that idea. I showed an easy way to get the capital, without any prior need for money, or central bank.