One Person's Debt Is Not Another Person's Asset

Let us get this clear: One person's debt is not another person's asset. Debt is one person's liability and another person's asset.

— Peter Golovatscheff (@golowitz) November 4, 2015

Can we all agree on this one?

Krugman?

Antonio Fatas?

More Explicit Claims On Underlying/Implicit Obligations

I will try to clarify a couple of points that seem to have caused much confusion. They are all connected to my Bookkeeping View (see my previous post for an overview of the concept).

1. When I talk about debt relations that are arranged through our banking/monetary system, I don't refer to any bounding, enforceable debt contracts between two pre-defined entities. Through the banking system, one debtor always faces millions of potential creditors, and one creditor always faces millions of potential debtors. A net debtor (i.e. someone with a net debit balance) doesn't need to find a net creditor in order to pay his debt; he only needs to find someone with the ability to credit the debtor's account (by debiting his own account). Likewise, a net creditor doesn't need to find a net debtor to get what is due to him personally; everyone accepts the credit balance (in bank ledger) which he has to offer in exchange for goods and services. I don't talk about a debt which would be always defined and enforced by law (as in a contract between two parties), but a debt that is slightly closer to reciprocity, "give and take", debt incurred and paid on the market. All this works, when it works, through transactions between free individuals, and the transactions are based on mutual consent. But the sums (prices) owed are clearly expressed in the abstract unit of account and law can be used to enforce these debts, so I'm not describing some abstract "debt" (eg, to one's country, forefathers or humanity in general). Schumpeter used the expression social bookkeeping system when he talked about something very similar to what I'm describing.

2. At macroeconomic/aggregate level, debt is paid only when a net debtor sells something to a net creditor. If he, instead, sells to someone who wasn't a net creditor before the transaction, then aggregate debt obviously stays the same (increase in buyer's debt matches decrease in seller's debt). Likewise, new debt is created when a buyer becomes a net debtor, or increases his net debit balance. If he bought from someone who was a net debtor himself, then aggregate debt obviously doesn't increase (as the seller's debt is reduced). But if the seller is not just paying his debt (i.e. he either is a net creditor or at least ends up with a net credit balance after the transaction), aggregate debt increases as a consequence of the transaction. Note: It is this macroeconomic viewpoint which is perhaps most important to me, because the pressing question (to me, the economic question of our generation) I've been trying to find an answer to is basically this: "What the hell is going on with the increasing private and public indebtness worldwide?"

3. I do not say that a commercial bank, or the central bank, or the government owes something. This is a point that seems to escape people, although I thought I had already clearly stated it. What I say --when I adopt the Bookkeeping View -- is that the "agents" with a net debit balance in a bank ledger owe something. I also say that if the government has a net debit balance (like it always seems to have, in form of cumulative deficits and current spending), then it is mostly the duty of taxpayers (there are other fees than taxes, though) to credit that balance (i.e. to pay the debt); in other words, government's debit balance is an indirect obligation of private agents. (This seems to clash with some people's view of the government; a view which suggests that the government is something separate from the people. I, instead, view the government as an entity formed by citizens, (trans)acting and signing contracts on behalf of citizens.)

4. Some have told me that a debit balance alone doesn't imply any real debt (obligation). They seem to back this statement by saying that the central bank/government doesn't owe anything (and I agree; see point 3 above). But by describing the Bookkeeping View, I try to substantiate my claim that a debit balance is always ultimately connected to a debt (perhaps not in a way explicit enough to some, but isn't it those previously hidden, underlying "rules" a scientist should try to discover?). I apply the Bookkeeping View to the real economy and study how these debit (and credit) balances behave. And by doing this I derive empirical evidence which suggest that all these debit balances actually behave as if they were part of a bookkeeping system, the purpose of which is to track real debt relations. It seems quite obvious to me that had  there been a clear, explicit accounting link -- even defined by law, as some seem to demand -- between government spending (credit) and tax obligations (debit), then there would be absolutely nothing for a scientist to try to discover here.

5. Finally, Naryana Kocherlakota in Money Is Memory (1996) -- my understanding is that he builds his ideas in the article mainly on J. Ostroy's The Informational Efficiency of Monetary Exchange, 1973 -- has suggested something that seems like a clear step towards the Bookkeeping View. He writes (somewhat "wonkish", as Krugman likes to warn; I underline and comment in brackets):

Within the class of environments under consideration, I show that adding money may expand the set of incentive-feasible allocations. However, I also show that the set of incentive-feasible allocations can be expanded by adding collective memory [a "social bookkeeping system"] to these environments. Here, memory is defined to be a historical record which reports to any agent at any date the full histories of all agents with whom he has had direct or indirect contact in the past. The main result of the paper is that in all of these environments, the set of incentive-feasible allocations generated by adding memory contains the set of incentive-feasible allocations generated by adding money. In this sense, in all of these environments, money is merely a primitive form of memory.

There is a simple reasoning behind the main proposition. John and Mary meet. John has apples and wants bananas. Mary wants apples but doesn't have bananas. In monetary economies, this problem is solved by Mary's giving John money in exchange for apples. John then uses the money to buy bananas from Paul; if John doesn't give the apples to Mary, John doesn't get the money and can't buy the bananas from Paul.

But of course the money itself is intrinsically useless. In terms of the reallocation of intrinsically valuable resources, we can think about the situation as being one in which John is considering making Mary a gift [see my point 1 above: this is reciprocity] of apples. If he makes the gift, Paul will give him bananas in the future; if he doesn't make the gift, Paul won't give him the bananas [point 1: "give and take"]. The money that John receives from Mary is merely a way of letting Paul know that John has fulfilled his societal obligations and given Mary her apples [Here the Bookkeeping View disagrees strongly: John possessing "money" obviously doesn't prove that he has fulfilled his "societal obligations"; he could be in debt. In other words, the possession of "money" doesn't reveal anything about the holder's trading history].

Thus, if we account for the fact that money itself is useless, monetary allocations are merely large interlocking networks of gifts [sounds like a "pure credit economy", or a "complicated and perfected system of barter"]. The point of this paper is to show that these same reallocations of resources are feasible if agents knew the past history of all actions: Paul could react to different histories of gifts on John's part in the same way that he reacts to John's having different amounts of money. It follows that any function performed by money can be provided by an ability to access the pasts of one's trading partners, their trading partners, and so on [our banking system makes, or at least should make, it unnecessary for individuals to access each others' trading histories; but the system itself tracks our historical, cumulative debits and credits, incurred and earned, respectively, by trading with others].

I have mentioned this before: I think that A. Mitchell-Innes's view on "money" was very much in line with mine, but he obviously didn't put it in explicit enough terms (see Innes here and here). The future will show if I manage to do better.

"Helicopter Money" As I See It

I have just finished reading Adair Turner's great new book: "Between Debt and the Devil: Money, Credit, and Fixing Global Finance". I intend to write a review on it later, but right now I want to give some food for thought for those who are interested in what is arguably the most controversial part of Mr Turner's overall message (a message I mostly agree with), namely, "Overt Monetary Finance" (OMF), or "Helicopter Money".

I'm still working on getting a firm grip of this concept, which in no way is as clear as it might sound to someone who hasn't really tried to study it (this, of course, applies to everything in science, or life in general). "Money printing" was in no way a clear concept even in Weimar Germany, and the real-time experience seems to have been in stark contrast to the simplified image of "pure monetary madness" created by writers afterwards.* To get an idea of the problems around the OMF concept, I suggest you read William White's take on it at Project Syndicate (don't miss Adair Turner's reply to Mr White which he has posted as a comment on that article).

Being aware of the danger of over-simplification, I nevertheless present, in simple terms, my take on OMF below. My aim is to provide a glimpse of the substance ("the wood") as I see it, without letting the form ("the trees") get into the way. There are many technical ways to achieve more or less the same outcome. My biased opinion is that behind the apparent simplicity of my description lies a fairly nuanced understanding of the subject, thanks to Messieurs Turner and White, and various other writers dead and living.

-------------------------------------------------------------------------------------------------------

"Just Like Money But Not Money"

a play by P. Golovatscheff

Act 1: Mrs Government meets Mr Supplier-Taxpayer

When Mrs Government decides to spend -- often to acquire goods or services to be used for the 'common good' of the nation -- she hands over IOUs (usually, but not necessarily, what we call "money") to the one who sells goods or services to her. This someone is often a government employee or, more generally, a government supplier. We can imagine how Mrs Government says to the supplier who has just provided her with goods or services:

"Mr Supplier, please take these IOUs and trust that they will be redeemed by taxpayers, sooner or later."

In other words, Mr Supplier should expect to be able to buy goods or services from other taxpayers using these IOUs, because a tax obligation makes it necessary for taxpayers to acquire -- really, redeem -- these IOUs. If others share his expectation, then the IOUs become generally accepted. As we see, the IOUs are not Mrs Government's own IOUs; she issues them on behalf of the taxpayers. This is comparable to a husband shopping with a credit card connected to his wife's account, when the wife is the sole income-earner in the family. It is she who will redeem (for instance, by selling labor) the IOUs her husband issues -- with the common good of the family in his mind, no doubt -- on her behalf.

This is the underlying logic I see behind government spending and taxation. This is, also, my reading of Alfred Mitchell-Innes and the kind of chartalism he seemed to endorse (here, and one year later here). In his words: "Whenever a tax is imposed, each taxpayer becomes responsible for the redemption of a small part of the debt which the government has contracted by its issues of money, whether coins, certificates, notes, drafts on the treasury, or by whatever name this money is called. He has to acquire his portion of the debt from some holder of a coin or certificate or other form of government money". I might be wrong, but I feel that Innes has not been fully understood even by people who often cite him (I'm thinking about some MMT writers, among others).

Act 2: Impeccably honest Mrs Government fails to fool Mr Supplier-Taxpayer

What the advocates of "helicopter money" are effectively suggesting is that Mrs Government should spend like she is used to spend, and actually spend a bit more, but this time she should sent a letter to Mr Supplier, saying:

Dear Mr Supplier / My Beloved Taxpayer:

Take these IOUs but understand that they are not really IOUs at all. My firm intention is not to bother taxpayers, You included, by placing any burden whatsoever related to this spending on Your shoulders. Not even by issuing bonds later to cover the deficit I am incurring through this spending, because the bonds would burden You with unnecessary interest charges. 

Having said this, I can assure You that personally You have nothing to worry about. These IOUs are fungible. By this I don't mean that they will be consumed by some eukaryotic organism, but that no one can tell them from the IOUs that are matched with a real tax burden. (On a more personal note: I cannot express in words how sorry I am for this real burden I impose on You, but that is unfortunately the only way my spending can be financed in any meaningful sense of the word -- rest assured that I will never forget Your sacrifice.) The fungibility of these IOUs will ensure that you are able to give them up in exchange for goods or services as before, just like they were real IOUs.

But please consider this friendly advice: If You take history as your guide, You might want to get rid of these IOUs rather quickly. This is because my honesty -- I scarcely need to remind You that I am a lady of high ethical standards, and, additionally, transparency seems to be in fashion -- around this matter should, if not in practice then at least in theory, cause any rational human being to expect higher inflation sooner or later. And any economist can tell you that if a sufficient amount of people expect higher inflation later, the inflation will actually arrive much sooner than expected.

Always at Your service, Truly Yours,

 Mrs Government

---------------------------- THE PLAY ENDS -------------------------------

I want to end this post my making two broad statements.

First, we cannot say that OMF can be used to "finance" certain productive investments by the government. Any attempt at "ear-marking" would be just an exercise in illusion. OMF will be an inseparable part of the overall government budget, and will thus "finance" in equal proportion all the consumption and investment that may arise from government spending -- also the wasteful activities. We are all imperfect, and the government doesn't make an exception here. Further, we should expect that any easily identifiable productive investments are already made by the government. In any case, our ability to undertake them should have nothing directly to do with OMF.

Secondly, and more importantly, it makes very little sense to say that OMF can finance anything at all. The whole point with OMF is that part of government spending will never be financed in any meaningful sense of the word. That a person of a very high intellectual capability can claim that OMF (yes, the F stands for 'Finance') can be used to finance government spending shows mainly how horrible is the state of our economic vocabulary. "Overt Monetary Fooling/Faking/Failure" would, to me, sound more descriptive. Unfortunately, sloppy language often corresponds with sloppy thinking, and even Mr Turner doesn't seem to be able to fully escape this trap.

Despite my harsh criticism above (which no doubt might lead to me being exposed as a fool later), I honestly believe that in Adair Turner we have one of the brightest minds when it comes to understanding debt. He has been clear about how OMF is potentially a very dangerous tool, and he has on many occasions stressed that his (immediate) goal is to create debate around it; to break the silence around this subject often considered a taboo.

I fully agree with Mr Turner. I would say that this kind of debate is not only welcome, but that it can lead to improved understanding of the problems caused by the global debt overhang.

It is my intention to engage in this debate with this piece.

* In order to understand how things appeared to various spectators, and actors, "in real time" during the Weimar experiment, one could do much worse than by reading historian Adam Fergusson's study, "When Money Dies" (1975), on the Weimar hyperinflation.

Pure Credit Economy, or "The Bookkeeping View"

I don't subscribe to any particular school of economic thought, because I haven't found any of the frameworks these offer compelling enough when it comes to explaining debt and "money". For instance, Post-Keynesians/Circuitists/MMT get many of the technicalities around "money" right, but to me, the really big picture is missing. Sometimes it seems that the more we focus on "money", the harder it is to establish the needed connections to the real economy.

Thus, I have been forced to build an understanding of my own around these matters. It was -- or rather, is -- quite a struggle, as anyone who has been into monetary economics must surely understand. How I ended up where I am in my thinking today is an interesting story in itself, but I'll leave that for later. What eventually emerged from this struggle is a view, or perspective, more or less consistent with Hyman Minsky's view which characterized the economy as a system of interlocking balance sheets (Thanks, Michael Pettis!), with the difference that what I suggest is both more concrete and, arguably, more radical.

We could call it the "Bookkeeping View". Simply put, I view our current economy as a "pure credit economy": something Wicksell, Hawtrey and Schumpeter, even Jevons and Hicks, imagined and perhaps thought possible, but nevertheless considered non-existent as long as "fiat money" existed. The Bookkeeping View defines even this "fiat money" in bookkeeping terms, and thus effectively gets rid of it. What we are used to call "money" (the non-abstract part of it) is just a credit balance in a ledger. For instance, physical cash refers directly to, or acts as, a credit balance in the central bank ledger. This view describes the entire monetary system simply in terms of credit and debit balances, and changes in these balances. These changes (as do these balances to start with) arise from credit and debit entries that are made on various accounts, and in various ledgers, in course of buying and selling. *

According to this view, banks (the central bank included) and other financial institutions can be considered "bookkeepers". They don't record their own claims and liabilities (Schumpeter, too, has suggested that deposit holders should not be viewed as creditors of the bank), but the claims and liabilities -- credit/debt relationships -- of the entities found on both sides of the bank balance sheet.

We are all used to think that what these credit balances refer to, i.e. what it is that is owed, is “money” (ultimately “cash”). But the Bookkeeping View challenges this. According to this view, these credit balances are just denominated in an abstract unit of account (numéraire; e.g, USD). In other words, they refer to a price. †

A price of what? A price of whatever is bought and sold. It might go like this: A creditor (owner of a credit balance, often in a bank ledger) goes out on the market, looking for goods or services, and chances upon a debtor (owner of a debit balance). The debtor is selling and the creditor is buying. (Of course, it is likely that they don’t know each other’s balance, nor should they know.) Assuming the creditor is interested in buying what the debtor is selling, they agree on a price. A transaction is made. And it is this transaction that is recorded in our monetary bookkeeping system. By selling, the debtor has redeemed (part of) his debt (to the amount of the agreed price), and that will be reflected in his reduced debit balance in the bank ledger (assuming we are dealing through a bank; it is easiest to think of this in terms of overdrafts instead of "traditional loans", because it gives a more accurate picture of the reality. What is essential is the net balance, which overdraft gives us automatically.). Similarly, the creditor’s credit balance is reduced. Now — only ex post — we know what was it that was owed. It was the object of the transaction, often a good or a service. And only ex post can we establish a direct link between a single creditor and a single debtor, brought together most likely by the “invisible hand” (or, market forces).

Think of this as an alternative way to view the world. One cannot prove this view wrong by just positing that "money as a means of payment" must exist because, well, we are used to agree that it exists. Naturally, adopting this view makes great demands on our cognitive flexibility -- it's been a tough journey for me: the view itself is simple, but getting rid of "money" is mentally hard --, but the rewards in the form of new insights on the most pressing problems in economics, and the economy, are, I believe, well worth the effort.



UPDATE, Oct 20, 2015:

Here is a quote from R.G. Hawtrey ("Currency and Credit", 1919) which sums up quite well how I view our contemporary economy (for Hawtrey, this was an imaginary economy):

Suppose then that society is civilised, and that money does not exist. Goods are brought to market and exchanged. But even though there is no medium of exchange, it does not follow that they must be bartered directly for one another. If a man sells a ton of coals to another, this will create a debt from the buyer to the seller. But the buyer will have been himself a seller to someone else, and the seller will have been himself also a buyer. The dealers in the market can meet together and set off their debts and credits. But for this purpose the debts and credits, which represent the purchase and sale of a variety of goods, must be reduced to some common measure. In fact a unit for the measurement of debts is indispensable. .... Where there is no money, the unit must be something wholly conventional and arbitrary. This is what is technically called a ''money of account". ... This is an approximation to the state of affairs which we are assuming. But however conventional and arbitrary the unit may be, once it is established as the basis of the debts and prices and values of a market, it is bound to assume a certain continuity. 

[…] 

Each dealer in the market calculates his own command of wealth in the same unit; it affords the basis for his valuation both of what he wants to buy and of what he wants to sell, and he looks for only such divergence from the previous prices as variations of supply and demand will justify. The total effective demand for commodities in the market is limited to the number of units of the money of account that dealers are prepared to offer, and the number that they are prepared to offer over any period of time is limited according to the number that they hope to receive. Therefore, arbitrary as the unit is, capricious variations in its purchasing power will not occur.

* I believe I'm very close to the (Steuart-)Mcleod-Innes "Credit Theory" line of thinking, and the way I interpret for instance Alfred Mitchell-Innes is such that he seems to be in agreement with me. Some contemporary writers, for instance Richard Werner, seem to follow this line of thinking, but the propositions they present differ from mine to such an extent that we seem to draw different conclusions.

† For an overview of the “abstract unit of account” concept, see, for instance, "Is Numérairology the Future of Monetary Economics?" (2007) by Willem Buiter. But note that what Buiter says doesn’t correspond with the “Bookkeeping View”. In his thinking, currencies like USD and GBP are “money” which serves as a “means of payment”, in addition to its function as numéraire (abstract unit of account). The "Bookkeeping View" position is that USD and GBP are only abstract units of account that are used to express the nominal value of a credit balance. These credit balances refer to prices denominated in USD or GBP.

Shrinking The Fed Balance Sheet

Gillian Tett of Financial Times has written an article on the eventual "normalization", or shrinking, of the Fed balance sheet: "A bloated US Federal Reserve prepares to shape up".

She correctly points out that "the realm of activist balance sheet management sits in something of an intellectual vacuum". In order to help fill this vacuum, I'd like to offer some thoughts on the subject. This is in no way an easy subject as it requires adopting a somewhat unconventional view on "money", so we all need to tread carefully.

Ms Tett writes:

"The second, related, issue is what happens to the funds that private banks have parked as spare reserves at the central bank in recent years. In the five years before the 2008 crisis, these “reserves” were tiny, just $11bn on average each day, partly because the Fed did not pay interest to banks. 

But by 2014 the reserve balance had risen to $2.6tn and the Fed pays 25 basis points of interest."

In reality, the private banks can't but hold these excess reserves, so it is actually the Fed who has parked these reserves... at the Fed. It explained this already in 2009 (NY Fed Staff Report 380):

"...the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react. In other words, the quantity of excess reserves... reflects the size of the Federal Reserve’s policy initiatives"

So it is best to call them "excess reserves", not (the tautological) "spare reserves". It follows that the interest paid on these reserves doesn't affect the total amount of these reserves. Here is what the Fed has to say on the interest on both required and excess reserve balances (federalreserve.gov):

"The interest rate paid on balances maintained to satisfy reserve balance requirements... is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions. The interest rate paid on excess balances... gives the Federal Reserve an additional tool for the conduct of monetary policy. ...during monetary policy normalization the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances."

By adjusting the interest rate it pays on excess reserve balances, the Fed can affect the interest rate banks (the ones with excess reserves) charge other banks (the ones with reserves below the required level) for these reserves on the interbank lending market. Back in time, when only a few of us had heard of QE, the Fed managed the interbank rate mainly by managing the total amount of reserves through open market operations, trying to ensure there weren't much excess reserves at all in the system. But now that the the amount of reserves is very, very excessive, the Fed has to manage the interbank rate through the price it pays on excess reserves.

A related thing I'd like to address here is the maturation of the Fed-held Treasury bonds. In the absence of a budget surplus, the Treasury will need to issue new bonds to the public when these bonds mature -- i.e. it will "roll over" the maturing debt. Technically speaking, when the new bonds are sold to the public, (excess) reserves will be moved ("drained") from the buyers of these bonds -- so called primary dealers -- to the Treasury's General Account (TGA) at the Fed. This "money" on the TGA will be "destroyed" as the Treasury settles its maturing Fed-held debt -- just like deposits are said to get destroyed when private bank loans are repaid. Both sides of the Fed balance sheet shrink by the same amount: on the asset side the bond disappears, and on the liability side the balance on the TGA is reduced. The Fed doesn't "receive money" from the Treasury, but neither do commercial banks receive money when a mortgage is repaid. There is no free lunch for the government connected to this. 

The outcome of all this is that the reserves which were created "from thin air" when the Fed bought the bonds are no more *, and the public, instead of the Fed, is holding the (new) Treasury bonds. It's almost like QE never took place -- although it must be the journey, and not the destination, which matters here. This outcome doesn't really differ from the outcome should the Fed sell the Treasury bonds to the public before they mature, so it's mainly a matter of timing -- avoiding market shocks, as Gillian Tett says.

Conclusion: The excess reserves will shrink either as the Fed-held bonds mature or as the Fed sells (or lends) them to the public. The private banks, in aggregate, cannot lend them out.

As is often the case, I believe we can learn something new about Quantitative Easing as we ponder its opposite: Quantitative Tightening.

* Had the maturing bonds been privately held, the total amount of reserves would have stayed intact. Reserves would have been recycled, via the TGA, from the buyer of the new bond to the holder of the maturing bond.

This is not much different, say, from a situation where a member of the public holds a corporate bond, as opposed to a situation where a commercial bank holds a corporate bond. In the former situation, bank deposits are transferred from the issuer of the maturing bond to the holder of this bond, whereas in the latter situation a bank deposit held by the issuer is "destroyed" when it makes a bond repayment to the bank. It is sometimes good to view the central bank as a bank like any other.

Where Does the Buck Stop?

The Example of Nations in relation to Money would be a very uncertain Rule... opposite measures have been us'd in some Countries to what have been used in others, and contrary measures have been used in the same Countries to what was used immediately before, not because of any difference in their Circumstances, but from the Opinion, that since the Method used had not the effect design'd, a contrary would; And there are good Reasons to think that the Nature of Money is not yet rightly understood.

- Money and Trade Considered, With a Proposal for Supplying the Nation with Money, John Law, 1705

310 years have passed since John Law wrote the text above. Judging from the current, often heated, discussions on Twitter and in the blogosphere, fueled by the Bank of England among others, I'm tempted to conclude that there are good reasons to think that the nature of money is not yet rightly understood.

Some time ago I read Walter Bagehot's Lombard Street, published in 1873. Afterwards it has crossed my mind that had Bagehot been brought to us, in person, with the help of a time-machine, he would have been able to teach us a lot about the current monetary system. I imagine him being able to focus on the most relevant parts of it and pose the most relevant questions.

As John Law describes above, the monetary system has evolved, and still evolves, through trial and error. Although -- or perhaps exactly because -- his own trial in France ended up in a very famous error, we should be thankful to Law for the work he did to increase our understanding of money.

To us mere mortals, the problem with trial and error is that at any given point in time, the more consecutive trials and errors -- and, necessarily, time -- have passed, the less understandable the system is to us. Think about the human brain and the universe. One thing is that the complexity of the system increases. Another one is that we get accustomed to things being as they are. We start taking things for granted. We might think that it can only be this way, missing the fact that we are in the midst of a trial. We adopt one viewpoint out of many possible ones. We stop asking questions, from ourselves and others.

Einstein has said: "It's not that I'm so smart, it's just that I stay with problems longer.". If you want to find a problem to stay with for the rest of your life, trying to understand the nature of money seems like a good bet.

Today, there are perhaps a million people, old and young, around the world, staying with the "Money Problem". Never has there been as many as there are now (thanks to increased leisure), and never have they had as good an access to information as they have today. Monetary economics, and macroeconomics in general, is on the rise. For this we can thank the Great Financial Crisis. The emergence of Quantitative Easing and negative interest rates, regardless of their effect on the real economy, has had an huge impact on people's understanding of money, or more precisely on the feeling of lack of understanding which has led to willingess to study the subject. This is in no way confined to amateurs: many of the academic economists often seem as puzzled as the laymen when thinking about QE, especially if they haven't been too familiar with monetary economics -- and most of them haven't. There is also a great sense of urgency, even unease, behind all this, much like there was in the 1930s. Something is wrong, and it seems it has a lot to do with money and debt.

To the point of this post. Where does the buck stop?

When discussing money (a term which I have mostly abandoned) with people familiar with monetary economics, sooner or later someone mentions "high-powered money" (HPM). I would be happy if we could shed more light onto this in the comments section later on, but let me try to make the first try here.

I see that most of the lines from (people who turned out to be) MMT advocates in a Twitter discussion I participated in yesterday are to be found in a single blog post by Bill Mitchell ("Money multiplier and other myths"), so I'll quote him below to represent what I assume to be the "MMT case". I want to stress the point that I'm not here to attack MMT. I'm someone who thinks for himself, and I have learned a lot by reading people who seem to consider themselves MMTers. I question many things they say, like I question nearly everything I happen to come by, be it written by New Keynesians, neoclassicals, Austrians or Post-Keynesians. Most importantly, I believe I question my own thinking all the time, too.

Mitchell critizes the "money multiplier" concept and says:

The monetary base does not drive the money supply. In fact, the reverse is true. So the reserves at any point in time will be determined by the loans that the banks make independent of their reserve positions.

I believe he is correct. Later on, discussing HPM, he writes:

Modern monetary theorists consider the credit creation process to be the “leveraging of high powered money”. The only way you can understand why all this non-government “leveraging activity” (borrowing, repaying etc) can take place is to consider the role of the Government initially – that is, as the centrepiece of the macroeconomic theory. Banks clearly do expand the money supply endogenously – that is, without the ability of the central bank to control it. But all this activity is leveraging the high powered money (HPM) created by the interaction between the government and non-government sectors.

Let's keep in mind that monetary base is another name for HPM. Money supply consists mostly of commercial bank deposits, which are held by non-bank businesses and households. Based on this, I don't fully understand how Mitchell can hold these two positions simultaneously:

1. Private credit creation by commercial banks (which affects the money supply) drives the amount of HPM. (first quote above)

2. Private credit creation process is leveraging of HPM. (second quote above)

Have I misunderstood something? To me, "leveraging of HPM" sounds a bit like "money multiplier". I find it hard to believe that Mitchell would hold such opposite positions, so I point this out in order to get this clarified.

Mitchell continues:

HPM or the monetary base is the sum of the currency issued by the State (notes and coins) and bank reserves (which are liabilities of the central bank). HPM is an IOU of the sovereign government – it promises to pay you $A10 for every $A10 you give them! All Government spending involves the same process – the reserve accounts that the commercial banks keep with the central bank are credited in HPM (an IOU is created). This is why the “printing money” claims are so ignorant. The reverse happens when taxes are paid – the reserves are debited in HPM and the assets are drained from the system (an IOU is destroyed). 

[...] 

So HPM enters the system through government spending and exits via taxation. When the government is running a budget deficit, net financial assets (HPM) are entering the banking system. Fiscal policy therefore directly influences the supply of HPM. The central bank also creates and drains HPM through its dealings with the commercial banks which are designed to ensure the reserve positions are commensurate with the interest rate target the central bank desires. They also create and destroy HPM in other ways including foreign exchange transactions and gold sales.

We can think of the accumulated sum of the vertical transactions as being reflected in an accounting sense in the store of wealth that the non-government sector has. When the government runs a deficit there is a build up of wealth (in $A) in the non-government sector and vice-versa.

He is obviously not saying that only the fiscal position affects the amount of HPM in the system. For instance, the amount of HPM in the US economy today has very little to do with the size of the fiscal deficit (say, five years prior and five years foward). So he must be saying that (a small) part of the HPM is "net financial assets" -- that is, until the deficit is covered by issuing government bonds which then take the role of "net financial assets" (until the central bank does QE...). Some MMT advocates seem to put a lot more importance on the fiscal deficit as a source of HPM, and this can be misleading.

My main problem with MMT described by Mitchell is this: Fiscal deficits do not create assets without corresponding liabilities. ("Only vertical transactions create/destroy assets that do not have corresponding liabilities.") The view is too narrow. Government acts on behalf of its citizens, and spends mainly on behalf of its taxpayers. Therefore the liabilities it acquires are acquired on behalf of the "non-government sector".

No IOU can ever present "net wealth" in the global economy.

Connected to this, we need to acquire a broader view where he writes that "HPM is an IOU of the sovereign government – it promises to pay you $A10 for every $A10 you give them!". It is an IOU which has a nominal value of $A10, denominated in an abstract unit of account (in this case, Australian Dollar; the IOU itself is not "a dollar"). What is owed is not defined -- only the nominal value of it is. It is left to the creditors (holders of this IOU) and the debtors (taxpayers and other debtors) to decide what is owed. It will be decided on the market. I will clarify this in my coming posts.

So where does the buck stop? It doesn't stop at HPM. It doesn't stop at "the money which is a promise to pay money". It stops at the transactions (often of goods and services) between creditors and debtors. Money is an IOU, and that is why money can never be what is ultimately owed.

Paying by Promising to Pay

John Hicks writes in "A Suggestion for Simplifying the Theory of Money" (1935) about banks:

... the security of their promises to pay is accepted generally enough for it to be possible to make payments in those promises.

I find it hard to accept that payments can be made in promises to pay. It is illogical. Yet, this is how we view and talk about the economy. We consider payments made mainly in banks' promises to pay, although we do accept another way to make payments which we call barter.

Merriam-Webster defines barter (verb) as follows:

to exchange things (such as products or services) for other things instead of for money

In a barter system, payments are made in goods or services. Some people contrast bartering with the use of money as a medium of exchange and claim that a system where sellers acquire credits -- but not money -- which they can later use to buy goods or services is essentially a barter system. To me, this is too big a stretch from the classical definition of barter. For instance, Adam Smith, writing in Wealth of Nations (1776) of a situation where paper money would lose its value after the loss of the gold stock of a nation, says:

The usual instrument of commerce having lost its value, no exchanges could be made but either by barter or upon credit. (Book II, Chapter II) 

It is good to see that Smith, though often blamed for having suggested that money emerged from the difficulties (see Jevons' famous "double coincidence of wants") related to a barter system, does recognize credit as something which enables exchange, and which he separates from barter.

Here comes my main point. What we all must agree upon is that a seller who, in a transaction, extends credit doesn't receive a payment. From this it must follow that the buyer involved in the transaction doesn't make a payment.

If accepting a bank's, or anyone else's, promise to pay is not extending credit, then what is?

I, too, have grown up thinking that payments are made in money, that bank deposit transfers are money transfers, and so they constitute payments. But I'm ready to question all this if it helps me understand better how the economy works. Having now, for some time, entertained the thought that one cannot make payments in money *, I have come to believe strongly that it must be so. And not only that, but actually everything seems to make more sense when viewed through this "new lense". Although I have always considered myself a contrarian, I must admit that here I have exceeded myself.





* What I in the current post say about commercial bank deposits, I extend to central bank notes and deposits as they, too, are "promises to pay". See my earlier post for more information on this wider perspective.

Growing Household Indebtness as a Cause For Inequality

There is a widely recognized correlation between, on the one hand, income and wealth inequality, and household indebtness on the other. IMF researchers Michael Kumhof and Romain Rancière, for instance, write in the Introduction of their IMF working paper "Inequality, Leverage and Crises" (2010):

The United States experienced two major economic crises over the past century—the Great Depression starting in 1929 and the Great Recession starting in 2007. Both were preceded by a sharp increase in income and wealth inequality, and by a similarly sharp increase in debt-to-income ratios among lower- and middle-income households.

The direction of causation between inequality and indebtness seems to be as widely recognized as the correlation itself. Raghuram Rajan, in his book Fault Lines (2010), writes:

Politicians, always sensitive to their constituents, have responded to these worrisome developments [growing inequality] with an attempt at a panacea: facilitating the flow of easy credit to those left behind by growth and technological progress. And so America's failings in education and, more generally, the growing anxiety of its citizenry about access to opportunity have led in indirect ways to usustainable household debt, which is at the center of this crisis. (p. 23-24)

The chapter of the book where Rajan establishes the link between inequality and easy credit is named "Let Them Eat Credit", a choice which in itself suggests a one-way causation running from increasing inequality to growing household debt. Also, in their IMF working paper, Kumhof and Rancière state -- referring to Rajan's book -- that

While not formally modeled there, the link between income inequality, household indebtedness and crises has been recently discussed in opinion editorials by Paul Krugman, and in books by Rajan (2010) and Reich (2010). Both authors suggest that increases in borrowing have been a way for the poor and the middle-class to maintain or increase their level of consumption at times when their real earnings were stalling. But these authors do not make a formally consistent case for that argument. Our model allows us to do so.

[...]

Rajan’s argument is that growing income inequality created political pressure, not to reverse that inequality, but instead to encourage easy credit to keep demand and job creation robust despite stagnating incomes.

They also present some interesting statistics:

Figure 1 plots the evolution of income inequality and household debt ratios in the two decades preceding the two major U.S. crises - 1929 and 2007. In both periods income inequality experienced a sharp increase of similar magnitude: the share of total income (excluding capital gains) commanded by the top 5% of the income distribution increased from 24% in 1920 to 34% in 1928, and from 22% in 1983 to 34% in 2007. During the same two periods, the ratio of household debt to GNP or to GDP increased dramatically. It almost doubled between 1920 and 1932, and also between 1983 and 2007, when it reached much higher levels than in 1932. In short the joint evolution of income inequality across high and low income groups on the one hand, and of household debt-to-income ratios on the other hand, displays a remarkably similar pattern in both pre-crisis eras.

Could it be that growing household indebtness is not just an effect of increasing inequality, but actually one of its main causes? I haven't seen anyone even posing this question, not to speak of trying to answer it. Yet, my analysis so far suggests that the answer to this question must be positive.

As the 1990s approached, there was not much talk about stagnating real wages, but households had already started to gorge themselves with credit. The intellectual backing for this was something that first emerged already in the middle of the 20th century. It goes by many names: "intertemporal choice", "intertemporal consumption", "life-cycle hypothesis", "permanent income hypothesis" or "consumption smoothing".

Guy Debelle writes in “Macroeconomic implications of rising household debt” (BIS Working Papers, No 153, June 2004):

"The rise in household debt that has occurred over the past two decades reflects the response of households to lower interest rates and an easing of liquidity constraints. This is likely to have allowed households to achieve a more desirable path for lifetime consumption."

My hypothesis -- the title of this blog post -- is mainly based on the following observation:

How can the value of sales increase if firms in aggregate don't pay their employees -- indirectly their customers -- more? Sales can increase if customers take on debt to finance purchases of firms' products and services. The deposits which are used in these purchases are created when households acquire more debt. An increasingly disproportionate share of these deposits ends up as profits for business owners and as higher salaries, and bonuses, for top earners. These people don't represent a large portion of the customers of our main businesses, our largest employers, and higher payments to the "top 10 %" (I, like Rajan, prefer the no doubt arbitrary 90%/10% division to 99%/1%)  accompanied by lower payments to low- and middle-income households would normally -- in the absence of growing household indebtness -- translate to lower sales of many items; for instance, big ticket items like cars. It was clear already to Keynes and his contemporaries that these households, the "masses", are the ones whose consumption ultimately drives the economy.

For the lower income group, the "bottom 90 %", I can't think of a surer way to lose bargaining power than by transferring their future earnings, by way of credit, to their employers when their current earnings fall short of their "desirable consumption". This flow of (indirect; see discussion in comments of my earlier post) IOUs from households to businesses might seem like "windfall income" for the businesses -- income which these businesses can freely distribute to their owners and top employees.

So, I depart from Kumhof and Rancière who write about "the recycling of part of the additional income gained by high income households back to the rest of the population by way of loans, thereby allowing the latter to sustain consumption levels, at least for a while" by arguing that this "additional income" is itself a result of the rest of the population sustaining, and often even increasing, its consumption levels by way of loans.




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I'm attending the Annual Conference of the Institute for New Economic Thinking next week, from April 8 to April 11, in Paris. I would be happy to get together and share thoughts with any colleagues, so feel free to contact me via Twitter or e-mail if you are attending too!

What's Wrong With "Helicopter Money"?

Quite a lot.

Adair Turner has written a somewhat provocative article for Project Syndicate: "Japan’s Accounting Problem". As a scientist I'm indebted to Turner in many ways. For instance, his "Stockholm Speech" provided me with a very clear overview of the "big picture" around our global debt overhang and helped me forward with my theoretical work.

When it comes to this new article, and "overt money financing" (OMF -- Turner's name for "helicopter money") in general, I strongly disagree with him. As "money" itself is just an IOU, government debt cannot be monetized in the way Turner seems to suggest.

Quantitative Easing replaces government bonds (IOUs) in the hands of the public with reserves/deposits (IOUs). The total nominal value of government IOUs in the hands of the public remains more or less intact. Whereas the repayment of bonds held by the public (Case 1) leads to deposit transfers from taxpayers to bondholders, the repayment of bonds held by central bank (Case 2) -- as those bonds fall due -- leads to deposit transfers from taxpayers to the government/central bank.

In Case 1 (see above), the consequence of this government debt repayment is reduced aggregate nominal value of all government bonds held by the public, while the aggregate nominal value, or amount, of deposits held by the public remains intact.

In Case 2, the consequence of repayment is reduced aggregate nominal value, or amount, of deposits in the hands of the public. This reduction is equal to the reduction of aggregate nominal value of all bonds held by the public in Case 1.

Thus, what is important is not the type of IOUs in the hands of public, but the overall budget deficits and their eventual effect on agents' inflation expectations -- which are affected by agents' trust in the government's "promises to pay" (IOUs) -- promises to pay via taxation. Whether these deficits lead to an increasing amount of bonds in the hands of the public, or to an increasing amount of deposits in the hands of the public, is close to irrelevant. This is especially true now that government bond yields are close to zero -- as has been the case in Japan more or less since 1998 when 10-year JGB yield fell below 2 %.

OMF offers, unfortunately, no easy solution to our global (government) debt problems.

I have criticized "helicopter money" advocates for their implicit assumption that inflation can be micromanaged (by "micro-" I mean something like "within 5 percentage points") in a previous post: 

Inflation Cannot Be Micromanaged, or "Greenback Whirlybird Down!"

For more information on deposits being IOUs, see, for instance, these two posts (I elaborate my "postulates" in the comment sections of the posts):

What Is Money?

Making Credit(s)

Making Credit(s)

Instead of money, it is credit, in the form of an IOU, which functions as a medium of exchange and a store of value. Only credit takes a concrete form through debt contracts, while money remains an abstract measure -- a unit of account -- of the assumed value of these contracts (for my definition of "money", see an earlier post).

As I have stated earlier (see this post), a seller does not receive a payment when he receives an IOU. To claim otherwise would be illogical. "IOU" is an abbrevation for "I owe you"; it is synonymous with a "promise to pay (back) (later)".

I understand very well how this might cause confusion. And, as my statement is strictly unconventional, and for many even counterintuitive, it would be only natural if the ones I manage to confuse assumed that I, the writer, must ultimately be the one who is confused. The source of the confusion must be me, because the "facts" seem to be clear: money must exist and it is silly to suggest that money cannot pay for anything.

Perhaps I could be dismissed as a confused philosopher -- a logician who doesn't understand economics and the real world. But that would be wrong. Everything I say here is either derived from real world observations, or, tested against real world evidence.

This is science. This is economics.

Once we accept that where we used to see money is only IOUs, then many things start to make more sense. There's no more mysterious money that can be created "out of nothing". Paul Krugman's "debt is money we owe ourselves" loses all the meaning it might have previously had. The money which sloshes around the world is drained -- for good. (Was money yet another "flood myth"?) No more headlines like "ECB unleashes a wall of money" in The Financial Times. Note that here I'm only referring to respected sources, not to any fringe theory advocates who think that real money must assume material form.

On Negative Bond & Bund Yields

Frances Coppola has written an insightful article titled "The ECB’s policy mix is poison for banks" (FT.com).

Here's one sentence which caught my attention:

If the expectation is first that inflation will continue to fall and second that central banks will continue to intervene in markets to try to prevent inflation falling, then yields will continue to fall without limit.

Well, "without limit" might be too bold a statement, but it is hard to tell where any limit eventually lies. For me, the important point to draw from this is that, as things stand, "short-selling" government bonds with a negative yield could be a "widowmaker" on a par with selling short Japanese government bonds (JGB) in the past two decades. But here I mainly talk about German bunds and some other AAA/AA bonds. Due to political instability and fragility in the construction of the euro system, we cannot extend this to any and all eurozone bonds. Prudence, not hope, should guide our decisions.

Here's Ms Coppola again:

Even in a deflationary environment, retail customers — who provide the majority of banks’ stable funding — are generally unwilling to accept negative rates on deposits, especially as physical cash is an alternative. This, of course, is the reason for the ECB’s minus 0.2 per cent limit. It cannot lower the interest rate on excess reserves much without hitting the “slightly negative lower bound” at which banks would exchange reserves for vaulted cash.

I must admit I had mostly overlooked the possibility that banks could exchange reserves for vault cash. Would be interesting to hear about any practical limits to this. For instance, would the authorities print 100-800 billion worth of new euro banknotes (large denominations) just like that? I doubt it.

Overall, Ms Coppola seems to possess an independent and searching mind. In my opinion, we need people like her if we are to make sense out of all what is going on in the world economy today. As is typical and even natural for this kind of mind, her article includes some "clumsy statements" and no doubt errors too, but those are more than balanced by the new insights she offers and thoughts she provokes. It seems to me that she is not too wedded to any economic theory, so she is more free to describe what she actually sees; what really is happening in the real world -- quite literally so, as her focus on real interest rates shows.

But here I think Ms Coppola goes wrong (assuming I don't misinterpret her):

First, the investment function of government bonds is changing. Traditionally, they have been used as hedges in a diversified portfolio. But once yields are deeply negative and falling, they can no longer be regarded as hedges: since holding them incurs an inevitable loss, they must be regarded as risky, not risk-free, and therefore actively traded for a capital return. Their replacement would, of course, be physical cash and other zero-yielding assets, possibly including zero-coupon issues from blue-chip companies.

 First, to equate "risk-free" with "hedge" is hasty, to say the least. I'm sure she knows how risk-free was never really free of all risk. It's more like a heuristic, or at worst, conventional wisdom. For instance, holding these "hedges" has given investors very good returns since the early 1980s as bonds have appreciated. These returns, depending on the timeframe we choose, are often competing head-to-head with stock returns. In a high inflation environment, we would have seen these "hedges" bring considerable losses to investors.

Second, holding these bonds doesn't incur an inevitable loss. Buying them at more than face value and holding them to maturity does incur a nominal loss. Well, this is probably what she actually meant.

Here is my third, and most important, objection to Ms Coppola's statement: Why would these bonds be less risk-free than they used to be if the investor who buys them today is guaranteed a nominal loss if he holds them to maturity? I don't see much risk in a guaranteed nominal loss, the size of which is known ex ante. This statement is also in contrast with her showing earlier in the article how she understands how it is real, not nominal, outcomes which ultimately matter. We need to assess real risk, not nominal risk. Government bonds have always carried real risks. And we cannot assume that blue-chip companies would be a safer bet, even if their bonds yield more. Neither is physical cash safer for anyone with hundreds of millions, if not billions, to look after.


Next I delve into something Ms Coppola seems to omit in her article -- as I believe most of the other commentators have done too.

CORRECTION (MAR-10-2015 -- 20:50 GMT): Frances Coppola kindly advised me that she has discussed the "hot potato" effect (which I discuss below) already in another article (see here) which her FT post linked to. It seems I have a lot of relevant stuff to read tonight. My apologies & thanks for the feedback, Frances!

Commercial Banks and Hot Potatoes

As a consequence of QE, the commercial banking system as a whole ends up holding excess reserves. (For how this works, see this paper from New York Fed -- a paper I referred to in my first post in which I present a sketch on bank reserves and other "monies".) These excess reserves, which usually yield less than any alternatives (I'll get to these soon), become a "hot potato" which any individual bank would like to get rid of, but which banks in aggregate cannot get rid of. One could think that this "hot-potatonizement" is especially strong when the deposit rate "paid" on these reserves is negative -- as it is now at ECB --, but does it need to be so? What probably matters more is the "spread" between the yield on reserves and the yields on any alternative assets banks might want to hold.

If we assume that European banks are operating in a "risk-off mode" (they build buffers while they adapt to a stricter regulatory environment), we can conclude that these banks would prefer to hold, instead of excess reserves, any "near reserves" as long as those yield more than reserves. These "near reserves" can be German Bunds and other AAA/AA bonds which banks can, any day, exchange for reserves should they need them. By buying these bonds from investors with accounts in other banks (so that the bank ends up transferring reserves to the other bank), a bank can switch excess reserves to bonds with (slightly) higher yields -- until the yields on these converge with the yield on reserves.

Even if it won't make much sense for the bank to buy more of these "near reserves" when the yields on them have already converged with yields on reserves, it might make sense for a bank to hold on to these bonds as they are an asset that keeps on appreciating -- regardless of the reason it does so.

There is, of course, the "hot potato" problem: these reserves might eventually return to the bank if other banks try to pass them on in a similar fashion, although it might be mainly a problem of the largest banks where most of the deposit accounts reside. In any case, the U.S. commercial banks have increased their holdings of "near reserves" (Treasuries, and Agency Securities like MBS) significantly during QE1, QE2 and QE3:

As Bloomberg reports:

Investing in government bonds is proving to be a profitable move for banks. They’re making over a full percentage point more by purchasing five-year Treasuries instead of leaving the idle cash parked at the Fed, where they earn only 0.25 percent.

Now, I don't claim that this is the only, or even the most important dynamic behind the very low and in some cases even negative bond yields we are witnessing. No doubt German Bund yields are driven down also because those are one of the few euro-denominated "safe haven" securities -- especially if one factors in the risk of certain countries leaving the euro in the foreseeable future. The current yield on a German 2-year Bund speaks for these other yield-compressing factors, as it stands already at minus 0.24 percent. And like always, there is a lot of "front-running" by other investors involved in this. All this makes it very hard if not impossible to rigorously test any "causal hypothesis" against the market data.

What Is Money?

Money is an abstract unit of account.

This is all there is to money. If something else is called "money", it is a matter of convention.

In economics, the term "unit of account" is synonymous with "(monetary) unit of measure". "Measure of value" carries very much the same meaning, too. There are various units of account in use around the world and worldwide, for instance "US Dollar", "Euro" and "Malaysian ringgit" (all abstract).

Here is a formal expression which might further illustrate my point:

P = r  x  [P]

where P is a monetary value ("price"), r is any real number and [P] is money (e.g, US Dollar).

The monetary value of various objects and contracts is expressed as P (price), which in turn is denominated in [P] (money). It logically follows that money can never be touched, nor can it be lent or owed. In other words, [P], money, cannot take the form of any object. In this sense it is no different from a "metre", a unit of length. Let's say we have an iron bar which is 1-metre long. The iron bar can have many functions, for instance "building material" or "a weapon". But no scientist would posit that the iron bar, in addition to its other uses, functions as a "unit of length".

Why should we define money in this narrow way?

First, I haven't seen any other definition of money that would be both logical and meaningful. Just like that, the enigma called "money" disappears; money is not what money does, but an abstract unit of account. Second, this definition allows us to build an economic theory which is both simpler (more elegant) and better in explaining various economic phenomena than any of our prevailing theories. Unlike the prevailing, often competing and contested, theories, this new theory helps us answer a wide range of pressing economic questions of our times -- questions related to the amount of global debt and its sustainability; and also to the widening income and wealth inequality in our societies.

Do you find any reasons why we shouldn't define money in this way?






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J.M. Keynes used the term "money-of-account" when talking about our narrowly-defined money in his A Treatise on Money (1930):

“Money-of-Account, namely that in which Debts and Prices and General Purchasing Power are expressed, is the primary concept of a Theory of Money.... Money itself, namely that by delivery of which debt-contracts and price-contracts are discharged, and in the shape of which a source of General Purchasing Power is held, derives its character from its relationship to the Money-of-Account, since the debts and prices must first have been expressed in terms of the latter”

It seems he wasn't able to let go of the conventional concept of "money", so he only separated it in two: "money-of-account" and "money itself". It was a good start, but it was clearly not enough to bring clarity into the matter.

The Global Savings Glut Explained

The savings we talk about when we talk about a "global savings glut"  (see, for instance, this article) are all in the form of IOUs, mainly as deposits and bonds. Any other type of savings could not be "searching for safe assets". And these safe assets, of which AAA/AA-rated bonds constitute the absolute majority, are just another type of IOU. There is, actually, one pure barter market in the world and that is the financial market where one type of IOU gets exchanged to another type of IOU only if there exists a "double coincidence of (credit, or IOU) wants". (Remember: deposits are IOUs.)

So, with our massive, global debt overhang, we must have a "savings glut". It is a matter of logic. These savings are just the flipside of the debt we have amassed. These savings are not a cause for lower interest rates and increased total debt -- they are the effect of lower interest rates and increased total debt. Naturally, we have reflexivity at play here, so that any "excess deposits" -- which came to being through increased bank lending -- are searching for willing borrowers. It's important to notice that these must be bond-issuing borrowers (government bonds, MBS, ABS, investment grade, high-yield, etc), as commercial banks do not lend existing deposits to their loan customers (as explained by Bank of England).

When the bond is issued by a commercial bank/financial institution (as in the case of MBSs/ABSs), then the transaction does not add to the total amount of IOUs in the economy: a deposit is just switched to a bond, i.e. the deposit disappears (see my second post for further details). But when the bond issuer is a non-financial business, the transaction adds to the total amount of IOUs in the economy. A new bond is created and the deposit changes its holder/owner, but does not disappear.

The important point to realize is that the excess deposits arise from increased commercial bank lending -- increasingly to households since the 1980s -- and this can be seen as the ultimate cause for our "savings glut".

If these excess deposits, created in the course of commercial bank lending, are taken as "money-as-a-commodity" -- and not correctly as "money-as-an-IOU" --, then we get fooled and start thinking that there is a lot of savings out there. And we view these IOUs as current ("real") wealth, incorrectly ("incorrectly" from a macroeconomic perspective, and this is the perspective we need to adopt here). As a consequence of this misunderstanding, everyone feels richer, for a while. This is what has happened during all credit bubbles we know of (see my sketch of credit boom dynamics).

Tell me where I go wrong? I really hope I do.

Inflation Cannot Be Micromanaged, or "Greenback Whirlybird Down!"

Contrary to conventional wisdom, central bankers don't have have the tools required to maintain price stability. Neither do governments. This is not to say that their actions don't affect inflation. When we combine the tools the central bank has (mainly the target rate) with the tools government has (mainly its control over the budget deficit/surplus), we are able to create inflation or deflation, depending on which one we want.

The ability to create inflation doesn't translate to ability to maintain price stability. The problem is that even though we can create inflation at will, we have no idea how much of it we will get -- and even more importantly, what will be the rate of change in inflation (for geeks: this is the second derivative of the hypothetical, general price level) at any point in time. Two years after the start of a government intervention, inflation could be three percent or it could be 10 percent, and it could be accelerating or decelerating. The most technically-minded among us might try to convince you otherwise, but they ignore the importance of inflation expectations and the role psychology plays in forming these.

The appearance -- or even a threat thereof -- of large fiscal deficits would affect inflation expectations among the public (investors included) in a very unpredictable way. As a consequence, inflation itself would be unpredictable (to be clear, time-lags, too, would make inflation management very difficult). This is because inflation expectations -- which depend heavily on human psychology and the relative attractiveness of competing stories -- are what really drives current and future inflation. All this is related to reflexivity.*

The "natural" (this is, absent a large-scale government intervention) outcome of our current debt overhang would be debt deflation. As far as I know, this is what William White is alluding to when he says "They have created so much debt that they may have turned a good deflation into a bad deflation after all.".

As I suggest above, and as Milton Friedman among others has suggested before me, a deflationary spiral could be countered through very large fiscal deficits (~10-20 %, without pretence to accuracy). This deficit could be "sterilized" (I stretch this concept) through a) new issuance of government bonds (by Treasury), or b) sale of existing ones (by central bank), or it could be un-sterilized as in "helicopter money" (see, for instance, Simon Wren-Lewis here) or overt money financing (OMF). (Related to this, I'd like to hear from Wren-Lewis, or any other expert, what is the difference between financing the deficit, on one hand, through bond issuance, and via OMF on the other, in a world where 2-5-year bond yields are negative while cash yields zero?)

So, my mental framework (or, theory) suggests that through large fiscal deficits an impending, severe debt deflation can be turned into volatile and unpredictable inflation. This inflation, or expectations thereof, would initially bring us increased spending, increased output and employment. It would increase the real GDP. This is exactly what the most short-sighted of us are after when they call for substantial government spending financed by a large fiscal deficit (this is why the "austerity vs. stimulus" debate doesn't make much sense to me). But this boost to the economy would be, to a large extent, due to increased speculation. At the extreme, we would see a Black Friday-esque spending frenzy as perfectly rational agents rush to buy real assets with existing and newly-created IOUs (formerly known as "money"), as they expect the value of currency to greatly diminish in the future. All this should be clear to any attentive student of inflation. Almost as clear to me is that we have already seen this kind of speculation in 2009-2014, albeit on a very small scale relative to potential.

Eventually, after a period of accelerating inflation, we would need to do what Paul Volcker and the Fed did -- thanks to sufficient public, and thus political, backing -- in the early 1980s. We would need to bring inflation down through an instant, deep recession and mass unemployment. Of course, there's always another option: to let the inflation run its course. I think we widely agree that it's better to take the recession than go down this path. Still, we cannot fully count on this to remain the case if push comes to shove.

There's always a possibility that the fiscal deficit would not be large enough -- let's say, due to political resistance -- to get the inflation even at the target level. In my world, this deflation or "low-flation" would ultimately have its cause in authorities' inability to convince agents that they should spend before inflation arrives and starts eroding the purchasing power of the currency. Something like this has been going on in Japan for something like two decades. But as my critique is aimed mostly at the same people who insist that Japan has not yet tried hard enough, and that all would be better there had they just tried harder, I won't analyze this possibility in detail here. All I want to say is that if we try hard enough, at one point we will get the volatile inflation and the (new) problems that come with it.

I state my critique once more: Inflation is not micromanageable in the way Modern Monetary Theorists (MMTers) or the living advocates of The Chicago Plan (CPs) seem to suggest. And I'm willing to bet that many of our best investors agree with me. We should never underestimate the effect of speculation on economic outcomes. Neither should we underestimate the difficulties we face if we try to differentiate between speculative and non-speculative transactions.

The biggest reason why we ended up with this massive, global debt problem is our inability to understand how all "money" is just a promise to pay (an IOU), and, as it logically follows, that it is not possible to pay for anything with this "money" (see my post from yesterday). Once we accept this, we must accept that the Quantity Theory of Money (QTM) should be dismissed in its entirety. But this we haven't done. Even people who understand quite well how "money" is just an IOU (for instance, MMTers and CPs) still view inflation more like a technical issue, something that is micromanageable -- wait for it -- through well-calibrated injections and withdrawals of "money" by the government. Are they all monetarists now?

I'm puzzled. Sometimes I wonder if nearly all our economists are suffering from doublethink.

* I'm greatly indebted to George Soros who, with his book "The Alchemy of Finance" (1987), has shed much light on reflexivity both in financial markets and the economy in general. Robert Shiller has helped me better understand the role stories have in affecting outcomes (see, for instance, his article at Project Syndicate). I present Soros as the prime evidence for my claim that to understand the economy one needs to be a philosopher, while Shiller's work speaks for the importance of understanding psychology. The society consists of individuals who contemplate and participate (i.e. act); they both compete and co-operate. That's probably all there is to an economy.

Mumblings post scriptum

There are many ways out of our current mess. Some are much better than others. None of them is an easy one. We have only bad options left. On the normative side, once we get there, I have a lot of suggestions on how to ease the pain, how to take care of the society and build a better future for all of us. (I'm dismal only as a scientist, not as a human being.) But first, we need to agree on what is ailing us -- only then we can try to apply the right treatment.

What got us here is our mistaken belief in the existence, both on a microeconomic and a macroeconomic level, of "money". The truth is that our financial system consists only of debts and credits -- all kinds of liabilities and a mountain of IOUs. The current amount of these liabilities and the corresponding IOUs is just too big. This is what is ailing us. We need to get it back to a substantially lower level, and it seems to me that it will take a global recession ("It" will happen again) to achieve this. This is my diagnosis (it's based on a considerable amount of work I've done since 2008). As we analyze the treatment options and weigh them against each other, we should keep in mind the following goal: to get the world through this turmoil with the least possible damage.

This is only my 11th blog post. It won't take long to read all of them, in case you would like to get a better understanding of where I come from. If someone is interested, I could add a short bibliography. I find myself unable to add any specific references in my text, as I usually have no clue about the person who planted a certain thought in my head. My list of suspects is very long. A random sample ("name-dropping"): Adam Smith, Léon Walras, Charles Mackay, Silvio Gesell, Walter Bagehot, Knut Wicksell, Alexander del Mar, Eugen Böhm-Bawerk, Ludwig Mises, Alfred Mitchell-Innes, Joseph Schumpeter, Friedrich Hayek, John Maynard Keynes, Irving Fisher, Henry Simons, Karl Polanyi, James Tobin, Adam Fergusson, Charles Kindleberger, Milton Friedman, John Kenneth Galbraith, Hyman Minsky, Paul Volcker, William White, Adair Turner, Claudio Borio, Philip Coggan, Nassim Taleb, George Soros, Robert Shiller, Daniel Kahneman, Amos Tversky, Bill Gross, Howard Marks, Stanley Druckenmiller, Warren Buffett, Charlie Munger, George Cooper, Michael Lewis, Matt Taibbi, David Graeber, Steve Keen, Izabella Kaminska, Steve Roth, Noah Smith, Martin Wolf, Matt Stone, Trey Parker, Paul Krugman and "Tyler Durden".