Keep banks out of macro

Saturos sent me a recent article in The Economist:

THE models that dismal scientists use to represent the way the economy works are sometimes found wanting. The Depression of the 1930s and the “stagflation” of the 1970s both forced rethinks. The financial crisis has sparked another.

The crisis showed that the standard macroeconomic models used by central bankers and other policymakers, which go by the catchy name of “dynamic stochastic general equilibrium” (DSGE) models, neither represent the financial system accurately nor allow for the booms and busts observed in the real world. A number of academics are trying to fix these failings.

Their first task is to put banks into the models. Today’s mainstream macro models contain a small number of “representative agents”, such as a household, a non-financial business and the government, but no banks. They were omitted because macroeconomists thought of them as a simple “veil” between savers and borrowers, rather than profit-seeking firms that make loans opportunistically and may themselves affect the economy.

This perspective has changed, to put it mildly. Hyun Song Shin of Princeton University has shown that banks’ internal risk models make them take more and more risk as asset prices rise, for instance.

.  .  .

In Australia Steve Keen, an economist, and Russell Standish, a computational scientist, are developing a software package that would allow anyone to create and play with models of the economy that incorporate some of these new ideas. Called “Minsky”—after Hyman Minsky, an American economist celebrated for his work on boom-and-bust financial cycles—it places the banking system at the centre of the economy.

A long road lies ahead, however. “Nobody has got something so convincing that the mainstream has to put up its hands and surrender,” says Paul Ormerod, a British economist. No model yet produces the frequent small recessions, punctuated by rare depressions, seen in reality. But “ultimately,” Mr Shin says, “macro is an empirical subject.” It cannot forever remain “impervious to the facts”.

In fact, macroeconomists grossly overrate the importance of banking.  Robert Hall started off a recent survey article with the conventional wisdom:

The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses.  Less conspicuous has been the macroeconomists’ concern about why output and employment collapse after a financial crisis and remain at low levels for several or many years after the crisis.

Talk about “impervious to facts”!!  The financial crisis of 1931 occurred nearly two years after the Depression began, and was caused by the Great Depression.  The fall of 2008 financial crisis was partly exogenous (the subprime fiasco), but greatly worsened by the severe fall in NGDP between June and December 2008.  Most economists put far too much weight on banking crises as a causal factor, and far too little weight on monetary shocks, i.e. large unexpected changes in expected future NGDP.

Bank lending is not a causal factor—it mostly reflects the growth rate of NGDP.


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93 Responses to “Keep banks out of macro”

  1. Gravatar of Gregor Bush Gregor Bush
    22. January 2013 at 11:58

    Scott,

    I agree that bank lending is simply a contemporaneous indicator of NGDP growth. But it’s worth noting that bank lending STANDARDS (the SLO data) were a pretty good leading indicator of the NGDP collapse. These data tend to be fairly good leading indicators of past recessions as well (the series on comsumer loans goes back to 1967). Maybe these data reflect expected future NGDP growth. Or maybe these data help forecast future Fed policy errors – ie. the Fed systematically understates thier importance. Perhaps the Fed underresponds to what Nick Rowe calls “type L” data:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/09/p-data-q-data-and-l-data.html

  2. Gravatar of Geoff Geoff
    22. January 2013 at 12:29

    “Bank lending is not a causal factor—it mostly reflects the growth rate of NGDP.”

    But NGDP depends primarily on bank lending, since such a huge portion of NGDP consists of spent money created by prior bank lending.

    The Fed doesn’t create new money and spend it directly on final output (NGDP). The Fed creates money and spends it on treasuries and other securities that are not a part of NGDP, from the banks, after which the Fed hopes that the banks lend enough going forward.

    To argue that it is future NGDP that banks take into account when lending now, is kind of like saying the banks take into account their own future lending before they lend in the present.

    Unless the Fed starts depending on other means besides bank lending in order to increase aggregate spending (which isn’t even the Fed’s mandate anyway), then NGDP will remain a function of bank lending. Bank lending will remain a causal factor of NGDP.

    Imagine the Fed relied solely on your lending to increase price inflation. The Fed would not directly affect price inflation, or total spending (NGDP). It would rely on you to lend more, which creates demand deposits once spent. The Fed will of course encourage you to lend more by way of increasing your money holdings through purchasing your assets, but it still depends on you.

    Even if the Fed said to everyone that it is going to make NGDP rise 100% next year, then everyone will still look to you to see if you are really intending to lend that much. If, however, you tell them “My lending is going to rise at a normal rate, like before”, then the Fed’s announcement would be an empty one. Nobody would take it seriously, because they take you more seriously as the sole conduit by which the Fed increases price inflation and NGDP.

    The only way the Fed can actually bring about 100% NGDP growth next year, given that you are going to increase your lending at only “normal” rates, would be if the Fed stepped around you altogether and increased people’s money accounts some other way besides your lending.

    Now, the likely response to this is that if the Fed really wanted to increase NGDP by 100%, then it has the ability to do so, by increasing your money balance by such a high degree that you really will be convinced to lend more than “normal.” OK, but that still depends on your positive choice to lend more. If however you are dead set against lending that much more, because the available investment opportunities, as you perceive them, are not attractive, then you will simply accumulate most of the cash the Fed sends you, until enough factor prices in the market come down, making investment opportunities profitable and thus encouraging you to lend more. THEN you can have your NGDP growth.

    So what can the Fed do that will increase money balances and spending other than relying on banks? Is the Fed willing? What would they buy? And from whom would they buy?

    I submit that the Fed is a banker’s bank, and so it won’t sidestep the banks the way that is necessary to increase NGDP given that banks are skiddish to lend more.

  3. Gravatar of Don Don
    22. January 2013 at 12:30

    Is it safe to assume that everyone has a google news filter for ‘Scott Sumner’?

    http://www.businessinsider.com/goldman-janet-yellen-has-endorsed-ngdplt-in-all-but-name-2013-1

    I like the idea of speculating on the next Fed Chair. Politically, Obama needs to find some visual diversity for his group photos.

  4. Gravatar of JCE JCE
    22. January 2013 at 13:05

    Banks (or, rather, the financial system) is important because they can accelerate the velocity of money to an infinite degree. that’s wicksell’s conclusion in his ‘interest and prices’.
    later keynes in the treatise took the analysis further and argued that banks can actually create money (not just accelerate a given quantity of it)

    how is the capacity to create (and allocate) money not important for macro? i don’t get it

  5. Gravatar of marcus nunes marcus nunes
    22. January 2013 at 13:12

    And “Bankers” also…
    http://thefaintofheart.wordpress.com/2013/01/22/the-big-guns-come-out-against-ngdp-targeting/

  6. Gravatar of RebelEconomist RebelEconomist
    22. January 2013 at 13:15

    “The fall of 2008 financial crisis was partly exogenous (the subprime fiasco)”

    No, the sub-prime fiasco was endogenous. The Fed repeatedly eased in response to incipient crises (as some commentators on this blog like Andy Harless actually think that they are supposed to do) so that on the one hand investors in risky assets became over-confident and on the other hand cautious investors got disappointed in their returns and went over to the dark side. The result was the monstrous moral hazard described by Michael Lewis in the Big Short.

    In what would be a final act of endogeneity, the introduction of NGDP targeting might provide some disappointed investors in risky assets with one more chance to escape.

  7. Gravatar of RebelEconomist RebelEconomist
    22. January 2013 at 13:29

    And by the way, this moral hazard view of mine is not some post-crisis rationalisation: http://reservedplace.blogspot.co.uk/2008/06/greenspan-put.html

  8. Gravatar of ssumner ssumner
    22. January 2013 at 13:45

    Gregor, I agree that in the real world banking problems can be a leading indicator of NGDP decline. But I’d like to change the world so that monetary policy was less inefficient, so that monetary policy prevented banking problems from impacting NGDP.

    JCE, You said;

    “Banks (or, rather, the financial system) is important because they can accelerate the velocity of money to an infinite degree. that’s wicksell’s conclusion in his ‘interest and prices’.”

    If he said this he’s wrong, as most base money is cash held by the public.

    Marcus, Yes, I suppose I’ll have to respond to that.

    Rebeleconomist, No, easy money did not cause the subprime bubble, as money was less easy than during the previous 4 decades, none of which had a subprime bubble.

  9. Gravatar of Shining Raven Shining Raven
    22. January 2013 at 13:46

    Geoff said already most of what I wanted to say, and probably much more succinctly. Banks isolate non-bank actors in the economy from Fed action, and if they do not transmit the actions of the Fed, there is no effect on the economy.

    Seriously: I get that it is a sensible idea to start from simple macroeconomic models to understand how things work. This can be really useful and clarify one’s thinking.

    However: I cannot see how a discussion of monetary policy can exclude banks. The money that I am using is for the most part not created by the central bank, but by a commercial bank. I hardly ever convert my bank money into central bank money (i.e. withdraw cash), and in fact do most of my transactions by some form of electronic payment. I usually don’t even use central bank money, and I don’t think I am so unusual in this regard. (Yes, I know, my bank needs reserves to settle those of my payments that are to somebody with an account at another bank.) The amounts paid electronically dwarf cash payments in currency.

    The “money” that is important for setting the price level must be the money used for transactions, i.e. commercial bank money, nothing else makes sense. If you compare e.g. the Canadian system with zero required reserves, where all payments between banks essentially are netted to zero at the end of the day as far as possible, and the US system before and after 2008 with vastly different amounts of reserves in the system, it is obvious that the amount of bank reserves (plus currency) is *not* what determines the price level. I really cannot see how one can still claim this after quantitative easing.

    I think the evidence from recent years is pretty clear in this regard. If banks were not important, quantitative easing simply *had* to lead to massive inflation, since the monetary base increased to an unprecedented degree. Well, that did not happen. The extra reserves are sitting safely in the banks’ accounts at the Fed. So *obviously* the Fed cannot increase the money supply by simply increasing the monetary base, but banks need to transmit this to the non-bank public.

    How are you going to model this without banks? And how do you want to say anything sensible at all about the current situation if you do not account for what the banks do or don’t do? So yeah – bank lending is essential, if you want to understand what’s going on.

  10. Gravatar of James in london James in london
    22. January 2013 at 13:47

    Bank loans can often fall with no fall in RGDP. Industrial and Commercial loans fell in the US in the 1970s, 1990s and 2000′s without any recession. Banks love to claim credit growth is “vital to the real economy” but it simply isn’t in accord with the facts. There is no rule that bank lending as a % of GDP has to inexorably rise. Many of the most successful, Asian, economies have quite low loans to NGDP.

  11. Gravatar of Shining Raven Shining Raven
    22. January 2013 at 13:53

    Scott, your reply to JCE is a classic: JCE talks about the velocity of “money”, and you immediately equate this with “base money” held by the public, i.e. currency.

    Really, this is not the “money” most people are talking about. Most of my “money” is sitting in a checking account, and I do payments electronically. So obviously here banks help to accelerate the velocity of this money actually used in payments. Cash payments really are a small portion of that.

  12. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    22. January 2013 at 14:03

    ‘Steve Keen, an economist,’

    There are four words alerting me to not take seriously the person who wrote them.

  13. Gravatar of RebelEconomist RebelEconomist
    22. January 2013 at 14:03

    “easy money did not cause the subprime bubble, as money was less easy than during the previous 4 decades, none of which had a subprime bubble”

    There is, I think, some truth in the long cycle theories. After a really gut-wrenching bust, like the South Sea Bubble or the 1929 crash, the folk memory (not to mention rules like Glass-Steagall) counsels caution. The likelihood of a similarly large bubble stays low until the folk memory fades with the people who experienced the bust, over perhaps two generations (although we had a go in the mid-eighties).

  14. Gravatar of Geoff Geoff
    22. January 2013 at 14:17

    RebelEconomist:

    “No, the sub-prime fiasco was endogenous.”

    No, the sub-prime fiasco was both endogenous and exogenous. The Fed’s easy money up to 2007 had SOMETHING to do with it.

  15. Gravatar of Bill Woolsey Bill Woolsey
    22. January 2013 at 14:26

    Bank lending has traditionally been important to central banks. Under a gold standard, the “nominal anchor” question is not really the responsibility of the central bank. What is left? Low interest loans for the government? “Stablizing” the banking system? Keep the banks from making too many speculative loans?

    Of course, today, the central banks are responsible for the nominal anchor. Too bad they haven’t entirely absorbed that this is their core function.

  16. Gravatar of flow5 flow5
    22. January 2013 at 14:38

    “re-thinks me-thinks are stink-thinks.

  17. Gravatar of Geoff Geoff
    22. January 2013 at 14:56

    Bill Woolsey:

    The Fed still relies on banks to lend more in order for the Fed to achieve its price inflation and employment targets.

    The Fed doesn’t purchase final output, it purchases securities from banks hoping that the banks would lend more and that lending then drives NDGP.

  18. Gravatar of Geoff Geoff
    22. January 2013 at 15:16

    Dr. Sumner:

    “Rebeleconomist, No, easy money did not cause the subprime bubble, as money was less easy than during the previous 4 decades, none of which had a subprime bubble.”

    Woah, I think this is definitely a problematic inference.

    As far as I know, nobody who argues that the Fed is largely responsible for the sub-prime bubble claims that easy money ALWAYS generates exactly one type of bubble, namely a sub-prime mortgage lending bubble!

    I think the argument is that easy money never has exactly the same exact effect, because the easy money at the time expands portions of the market that are themselves contingent upon technology, politics, preferences, and so on at the time.

    The main argument, as far as I know, is that easy money blows up something. What it exactly is depends on the non-monetary circumstances at the time.

    The easy money during the 1990s for example played a large role in blowing up the Nasdaq bubble, as tech and internet stocks were already attractive. Then, in response to that bursting, the Fed’s easy money then played a large role in blowing up the real estate bubble, as real estate was already attractive at the time, instead of another Nasdaq bubble, since tech and internet stocks were no longer as attractive (for obvious reasons!).

    In response to the real estate bubble bursting, I’ve heard around the grapevine, although I don’t know for sure, is that the Fed’s current easy money (as defined by the extent of its OMOs and the Fed funds rate) has played a large role in blowing up not a Nasdaq bubble, not a real estate bubble, but a sovereign debt bubble, as sovereign debt was already attractive at the time.

    The effects of easy money are not always precisely the same. Positive monetary shocks doesn’t mean people will always spend more money on burgers every time!

    I consider inflation as fuel, not the spark, in fire making. Once a fire starts somewhere, then easy money can turn that fire into a raging inferno.

  19. Gravatar of Geoff Geoff
    22. January 2013 at 15:23

    I think focusing on NGDP can lead to false impressions on the state of monetary policy, because it could very well be the case that stable 5% NGDP growth for 20 years means relatively little Fed direct activity, whereas the next 20 years of 5% NGDP growth means relatively great Fed direct activity.

    Imagine a country that suddenly experiences a large increase in its trade deficit, which would otherwise see large quantities of money leave the country, which reduces the quantity of money and volume of spending at home. For a central bank that is concerned about NGDP, if it increased its direct activity in order to counter-act that fall, then should we all observe the same 5% NGDP growth, we would be concluding that monetary policy is the same it’s always been, despite the fact that direct Fed activity is vastly different.

    Thus, past 5% NGDP growth wasn’t bubble making, but current 5% NGDP growth is bubble making.

    Bubbles aren’t fueled with high NGDP, they are fueled by relatively high direct Fed activity.

  20. Gravatar of Peter N Peter N
    22. January 2013 at 15:45

    ” Most economists put far too much weight on banking crises as a causal factor, and far too little weight on monetary shocks, i.e. large unexpected changes in expected future NGDP.”

    And what causes an unexpected change in future NGDP? The leading contender would seem to be uncertainty, since the multiplier for investment is rather high.

    A shock to the financial system such as the freezing of the commercial paper market makes businesses postpone investment until they are sure that an inability to get funding won’t make them wish they hadn’t committed the money.

    As for the effect of banks, it’s more the effect of the entire financial sector. Goldman wasn’t a bank in 2007. High leverage supported by short term borrowing becomes fragile when uncertainty raises the cost of funds.

    There were also some structural weaknesses involving bad risk estimates on certain types of instruments (CDO’s in particular). The better rated tranches of even subprime mortgages performed as expected. Of course, banks held onto the toxic waste tranches, since there was no market for them (other than bundling them in CDOs).

    This paper surveys the effect of credit on financial markets

    CREDIT BOOMS GONE BUST:
    MONETARY POLICY, LEVERAGE CYCLES AND FINANCIAL CRISES, 1870–2008
    Moritz Schularick
    Alan M. Taylor
    Working Paper 15512
    http://www.nber.org/papers/w15512

    This is a short talk by Keen on reconciling his methodology with traditional terminology. He got together with an economic mathematician from McMaster and worked out the details.

    http://www.youtube.com/watch?v=UzxQcTOs4JA&feature=player_embedded

    Oddly enough (or not) the Schularick paper supports Keen about the importance of the second derivative of debt as a predictor. I’m fairly sure they weren’t familiar with his work when they wrote their paper. He isn’t cited, but Kindleberger and Minsky are, along with 70 others.

    This talk by his partner Grasselli applies the theory to austerity, which proves to be a bad idea in a weak economy, but OK in a strong one. It involves the basins of attraction of 2 competing equilibria.

    The economic equations are related to the classic predator- prey equations.

  21. Gravatar of flow5 flow5
    22. January 2013 at 15:55

    Don’t fall back into the Keynesian trap – that interest is the price of money & not the price of loan-funds.

    Roc’s in MVt mirror roc’s in all transactions. Roc’s in MVt are a proxy for nominal-gDp. No r2 is higher.

    Dec. 2008 was the juncture recognition point.

    If there is a better reason to target nominal-gDp (rather than just prices), you would think it would be because of limited upward & downward price flexibility (the hallmark of a healthy competitive economy). But what seems more intractable is closing the “output gap”.

    The time it takes to catch up to the trend rate of real-gDp income streams seems much longer than “transitory” pricing. The downside to unemployment, federal, state, & local deficits, etc. all seem more important (harder to reverse).

    Real gDp:

    2008-04-01 13310.5 peaked
    2011-10-01 13441.0 caught back up

    Gross Domestic Product:

    2008-04-01 14415.5
    2010-07-01 14576.0

    Personal Consumption Expenditures: Chain-type Price Index (PCEPI)

    2008-07-01 110.235
    2009-12-01 110.290

    SEE

  22. Gravatar of Doug M Doug M
    22. January 2013 at 16:03

    Banks create money!

    Open market operations turn assets into reserves. And banks lend against those reserves injecting money into the economy! This is the pillar that holds up monetary theory. Heck, you don’t even need a central bank, but need the rest of the banking system.

    You say that Bank lending growth is a reflection of NGDP growth. But, you have also said that NGDP growth is entirely a function of money supply growth. And banks create the money!

  23. Gravatar of dtoh dtoh
    22. January 2013 at 16:04

    Scott,
    I can’t entirely agree.

    I have argued that the triggering mechanism by which OMP works is the exchange of financial assets for real goods and services caused by a rise in the real price of those financial assets, and I think you have explicitly endorsed this because you have conceded that Bill Gates doesn’t buy a new Ferrari because he has more cash.

    Fed action (OMP) causes this exchange in three ways: i)raising the nominal prices of financial assets through increased FED demand for these assets ii) raising the real prices of these assets through increased inflation expectations (lower expected real return = higher real price), and iii) raising the expected return on investment/purchase of real goods and services through higher NGDP expectations.

    To a certain extent, an exogenous increase in bank lending can have the same effect through i) and iii) but the impact would be offset or reduced unless there was a concomitant increase in the base. Why? Because the increased AD caused by an increase in bank lending would require additional money for transactional requirements and would be expected to be deflationary absent any Fed action to provide additional base.

    BTW – Any comments on the yesterday’s BOJ announcement. I was very disappointed.

  24. Gravatar of Rademaker Rademaker
    22. January 2013 at 16:08

    Would it be an outrageous suggestion to say that banks might play a part in the explanation as to why so much stronger monetary action was NEEDED than the Fed thought wise to engage in? It’s easy to judge their decisions with the benefit of hindsight. The situation the Fed was faced with was extraordinary. This is the pre-condition of their failure to react in the right measure.

    What caused the extraordinary conditions?

  25. Gravatar of Bill Woolsey Bill Woolsey
    22. January 2013 at 17:42

    When the Fed purchases bonds from anyone other than a bank, this increases the quantity of money directly. It also increases reserves, and if the banks don’t want to hold those reserves and also buy bonds from anyone other than a bank, this creates additional money. But even if the banks simply hold the added reserves, the quantity of money increases. Only if the Fed purcahses bonds from banks is there no direct increase in the quantity of money, but only an increase if the banks choose to buy bonds (or make loans.)

    Not all bank liabilities serve as medium of exchange. For example, there are a variety of certificates of deposits that banks use to fund loans. If banks issue more certificates of deposits and make more loans, there is more lending with no increase in the quantity of money.

    If banks fund the existing amount of loans with checkable deposits rather than C.D.’s then the quantity of money rises with no increase in lending by banks.

    If the Fed purchases bonds from someone who is not a bank, then that directly increases the quantity of money. If the person who sold the bonds uses the money to purchase capital goods, then there is an increase in spending on output and no increase in the supply of credit and lending.

    I think checkable deposits created by banks are the most important form of money. The banking system plays a key role in determining nominal GDP. However, because each bank’s deposits are redeemable in base money, the Fed can limit the quantity of bank deposits. And as long as the Fed has assets it can purchase, it can create enough base money to offset any decrease in the quantity of bank deposits.

  26. Gravatar of dtoh dtoh
    22. January 2013 at 18:22

    Bill Woolsey,
    You said,

    “If the Fed purchases bonds from someone who is not a bank, then that directly increases the quantity of money. If the person who sold the bonds uses the money to purchase capital goods, then there is an increase in spending on output and no increase in the supply of credit and lending.”

    I think this is exactly right. Except to the extent that OMP are sterilized by banks exchanging assets sold to the Fed with excess reserves, all OMP are essentially an exchange of money for financial assets, and the ultimate counter-parties (not the primary dealers or other intermediaries) are economic entities who are doing this exchange not because they want to hold more money but because they want to use the money to purchase real goods and services. This is the actual mechanism by which OMP increases AD….not some ethereal HPE. OMP causes higher real prices (1/the expected real annualized return) of financial assets relative to real goods and services which in turn causes this marginal increase in the exchange of financial assets for real goods and services.

  27. Gravatar of Suvy Suvy
    22. January 2013 at 19:00

    I disagree on this one. We live in a credit driven economy and banks are the ones that issue credit. The amount of credit doesn’t depend on the supply of credit as the money multiplier has no real effect in determining the amount of credit. Banks issue credit while creating deposits in the process and look for reserves later. Banks play a critical role in the way credit is issued and what it is used for. If credit is used for productive purposes, then debt/income ratios won’t increase; however, if credit is used for unproductive purposes, then debt/income ratios could very well increase creating problems later on. Large amounts of debt are destabilizing as they make a system more fragile and this can destabilize an economy very quickly and can make problems systemic. Looking at any economic data set larger than 60 years clearly shows this impact.

  28. Gravatar of Jon Jon
    22. January 2013 at 19:48

    How’s progress on the depression era book

  29. Gravatar of Suvy Suvy
    22. January 2013 at 20:19

    Doug M,

    “Banks create money!

    Open market operations turn assets into reserves. And banks lend against those reserves injecting money into the economy! This is the pillar that holds up monetary theory. Heck, you don’t even need a central bank, but need the rest of the banking system.

    You say that Bank lending growth is a reflection of NGDP growth. But, you have also said that NGDP growth is entirely a function of money supply growth. And banks create the money!”

    Absolutely. There are two forms of money: credit and base money. The total money supply is a sum of both.

  30. Gravatar of Mike Sax Mike Sax
    22. January 2013 at 20:35

    ‘Steve Keen, an economist,’

    “There are four words alerting me to not take seriously the person who wrote them”

    And yet you took it seriously when Sean Hannity predicted a Romney landslide.

  31. Gravatar of Mike Sax Mike Sax
    22. January 2013 at 20:37

    What all this means is that MMT is gaining a foothold or at least having influence as this is the idea they push more than any other.

    Apparently, Scott, your strategy of rejecting it out of hand isn’t being used elsewhere.

  32. Gravatar of ssumner ssumner
    22. January 2013 at 21:24

    Shining Raven, Under the gold standard people rarely used gold as money, but it played a crucial role in the economy. The base is key because the Fed has a monopoly on production of base money and it’s costly to produce and it’s the MOA. I’ve explained why QE didn’t “work” as well as I’d like a million times. The Fed basically said they didn’t want it to work—they said 3% inflation would be a horrible idea. So of course it didn’t produce 3% inflation. Why is anyone surprised?

    James, Good point.

    Rebeleconomist, You said;

    “There is, I think, some truth in the long cycle theories.”

    It’s always nice to have theories that can never be refuted—that fit any facts.

    PeterN, You said:

    “And what causes an unexpected change in future NGDP?”

    You misquoted me, read it again. I’m talking about NGDP expectations. Those are controlled by the Fed.

    dtoh, Yes disappointing, but I’ve always been a bit skeptical that this would go through.

    Rademaker, You said;

    “It’s easy to judge their decisions with the benefit of hindsight.”

    Any fool could see that NGDP was too tight in late 2008. It was criminal negligence if the Fed didn’t realize NGDP expectations were plunging. (They did realize it.) Where is the NGDP futures market? Why isn’t it up and being subsidized by the Fed?

    Suvy, Show me a recession where RGDP plunges despite stable, on-target growth in NGDP, all because credit dries up.

    Jon, It’s supposed to come out this year.

    Mike, Ask your hero Krugman what he thinks about MMT. He’s only being halfway polite because MMTers are fellow leftists. In private I’m sure he views it as snake oil.

  33. Gravatar of Saturos Saturos
    22. January 2013 at 21:27

    More people who don’t understand that NGDP instability is worse than inflation instability: http://www.voxeu.org/article/monetary-targetry-might-carney-make-difference

    (HT Tyler Cowen)

  34. Gravatar of Saturos Saturos
    22. January 2013 at 21:41

    Scott Sumner vindicated again: the BoJ just doesn’t want more inflation: http://www.slate.com/blogs/moneybox/2013/01/22/bank_of_japan_punts_on_higher_inflation_target.html

    But there is ambiguity, which still makes me think that fiscal stimulus might have some demand-boosting effect.

  35. Gravatar of Suvy Suvy
    22. January 2013 at 21:49

    “Suvy, Show me a recession where RGDP plunges despite stable, on-target growth in NGDP, all because credit dries up.”

    I never said it does. Government can create money too. When a central bank prints money, it increases demand by issuing credit(high powered cash). Milton Friedman always used to compare inflation to alcoholism–the good effects come first, the bad effects come later. Initially, printing money creates a boom, but later prices have to adjust.

  36. Gravatar of Suvy Suvy
    22. January 2013 at 21:53

    Printing money serves a very important purpose in preventing the economy from collapsing. As debt(money) gets destroyed by the private sector, the increased amount of government money neutralizes the effect on demand. Without the money printing by the Fed, we would’ve had a full scale debt deflation where debt/income ratios rise faster(like what happened in late 2007-mid/late 2008).

  37. Gravatar of dtoh dtoh
    22. January 2013 at 23:39

    Scott,
    I think Abe got totally hoodwinked. The conversation probably went like this.

    Shirakawa: “Ok we’ll raise the target to 2% if you agree not to change the BOJ law and allow us to pick an BOJ insider as my successor.”

    Abe: “What about asset purchases.”

    Shirakawa: “We agree to unlimited purchases.”

    Abe: “When?”

    Shirakawa: “Next year.”

    Abe: “Are you kidding?”

    Shirakawa: “No. Don’t worry. This all works primarily through expectations. Your own advisers have told you that, and you’ve seen it with your own eyes in the fx and stock markets over the last 3 months.”

    Abe: “Well OK”

    Shirakawa: “Well do we have a deal then?”

    Abe: “Ok.”

    The only problem is that expectations aren’t worth anything if you explicitly say your aren’t going to do anything different for at least another year.

    Abe was totally played and the conundrum he’s now in is that the markets are a lot smarter than he is and will be right back at the levels they were at in September.

    Abe is either going to need to renege on the deal or live with the economy in the toilet until he gets kicked out of office.

    The other possibilities are a) that the whole thing was entirely a campaign ploy, or b) there was no deal and Shirakawa was doing the minimum he thought he could get away with.

    I doubt the former, and while I hope the latter might be true, I’m doubtful as the BOJ announcement should have elicited immediate criticism from Abe absent any pre-agreement deal or understanding.

  38. Gravatar of flow5 flow5
    22. January 2013 at 23:55

    “there is more lending with no increase in the quantity of money”

    Transfer from DDs to CDs represent the indirect consequence of prior bank credit creation (as double-entry bookkeeping on a national scale shows).

  39. Gravatar of flow5 flow5
    23. January 2013 at 00:11

    “No, easy money did not cause the subprime bubble, as money was less easy than during the previous 4 decades, none of which had a subprime bubble”

    This must just be semantics. Geoff is right. It would be impossible for easy money not to have created the housing bubble. The purchase & turnover of new or existing property requires increasing roc’s in M x Vt. The Fed can control both variables.

    The Fed turned 38,000 intermediaries into 38,000 CBs via the DIDMCA. Then the Fed reduced reserve requirements to the point where they were no longer binding (early 90′s). Doesn’t take a rocket scientist to understand that those changes were the receipe for a diastrous inflation.

    The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves & reserve ratios.

  40. Gravatar of Shining Raven Shining Raven
    23. January 2013 at 01:39

    Scott, I do not think that it is helpful to compare the role of currency in the Fed system to the role of gold under a gold standard. Obviously, the central bank under a gold standard cannot at will increase the amount of gold it holds, but it can essentially without cost increase the amount of currency (I don’t understand why you say that base money is “costly to produce” – it quite obviously is cheap to produce).

    Bank deposits are of course *convertible* to base money/currency, but they are not “backed” by currency in the same way that “money” is “backed” by gold under a gold standard. The analogy simply does not apply.

    And yes, I know that you have explained 10^6 times how you think that QE does not work, but I think your explanation misses the point. Interest on reserves does nothing that a Fed funds rate target did not do as well to restrain the money supply. You should be calling for a lower Fed funds rate target if you think the money supply is not increasing quickly enough. Somehow you seem to think there is something magical about IOR that prevents an expansion of the money supply, but really, things are not that different from the way the Fed operated before. You are probably not interested, but Scott Fullwiler lays it out nicely here:

    http://neweconomicperspectives.org/2013/01/understanding-the-permanent-floor-an-important-inconsistency-in-neoclassical-monetary-economics.html

    Anyway, I agree with Doug M and Suvy that banks really create most of the money, and you cannot ignore that and hope to say something useful about monetary policy.

  41. Gravatar of Doly Garcia Doly Garcia
    23. January 2013 at 03:22

    Banks might not be a cause of crises, but that isn’t a good reason to keep them out of the model. It looks likely that, while banks by themselves can’t cause a crisis, they can and do have the capacity to make it a lot worse. Flu by itself is almost never a cause of death, but flu when it affects an already fragile patient can finish him off. It would be vastly useful to figure out ways of vaccinating the economy against bad practices by banks, that might not be harmful in a healthy economy, but can have disastrous consequences on an unhealthy one.

  42. Gravatar of RebelEconomist RebelEconomist
    23. January 2013 at 03:35

    dtoh, I would be surprised if Shirakawa managed to get Abe to agree to appoint someone of the BoJ’s choosing as governor, but given that the BoJ law remains intact, whoever Abe does choose and can get past the MoF and Diet may not be quite as aligned with his plan as he might hope.

    Note also that it is questionable how much the BoJ conceded by agreeing to a 2% target. The BoJ already had an inflation forecast well over 2% for Fiscal 2014 because of the planned consumption tax hike. If Abe reneges on that (despite having got the early election that brought him to power as a quid pro quo for passing that tax increase in the Diet), Abe would hardly be in a strong position to criticise the BoJ for failing to achieve the inflation target.

  43. Gravatar of Mike Sax Mike Sax
    23. January 2013 at 03:56

    I agree Krugman’s not a fan of MMT. He has though on his own been talking about getting banks into modeling. He hand Eggertsson had some paper back in 2009.

  44. Gravatar of Mike Sax Mike Sax
    23. January 2013 at 04:02

    Actually it wasn’t banks it was debt he was talking about getting into modelling.

  45. Gravatar of Mike Sax Mike Sax
    23. January 2013 at 04:03

    Actually it wasn’t banks it was debt he was talking about getting into modelling.

  46. Gravatar of JN JN
    23. January 2013 at 04:05

    Scott,

    “Rebeleconomist, No, easy money did not cause the subprime bubble, as money was less easy than during the previous 4 decades, none of which had a subprime bubble.”

    You misunderstand the importance of banking, capital and financial regulations.

    Nobody says that easy money WILL necessarily cause a subprime bubble.
    Easy money is likely to cause a bubble in a part of the economic system:
    1. where it is beneficial for economic actors to invest (and/or)
    2. towards which economic intermediaries are incentivised to maximise the flow of lending.

  47. Gravatar of ssumner ssumner
    23. January 2013 at 06:30

    Saturos, Fiscal stimulus might help (although it hasn’t worked in the past.) But it would be far easier for Abe to simple replace the leadership at the BOJ.

    dtoh, Thanks for that info.

    Shining raven, That was a typo, I meant costless to produce.

    You said;

    “Bank deposits are of course *convertible* to base money/currency, but they are not “backed” by currency in the same way that “money” is “backed” by gold under a gold standard. The analogy simply does not apply.”

    The analogy is exact. “Backed” means “is freely convertible into.”

  48. Gravatar of ssumner ssumner
    23. January 2013 at 06:34

    JN, You have a theory with no empirical support. Why should I be interested I such a theory? You have anecdotes, and even worse the anecdotes are not even correct. People assume that the 1% interest rate back in 2003 meant money was easy. But low interest rates tell us nothing about whether money is easy.

  49. Gravatar of Errorr Errorr
    23. January 2013 at 06:48

    I think this difference shows how fiscal policy could be effective in a way. Fiscal policy would shortcut the banks by directly transmitting monetary easing to firms. This is not ideal and in Scott’s ideal system would be unnecessary but it could avoid a collective action problem when the Central bank has failed already.

  50. Gravatar of JN JN
    23. January 2013 at 07:47

    Scott,

    I could elaborate a lot more on that and provide some “empirical” support, although, unlike some readers, I don’t think this is the right location to write a book!
    Maybe I should create my own blog? :)

    “Engineering the Financial Crisis” by Jeffrey Friedman and Wladimir Kraus provide a beginning of answer along the same line, in case you haven’t read it.

  51. Gravatar of Shining Raven Shining Raven
    23. January 2013 at 07:50

    Scott, how can the analogy be exact if in one situation, my bank deposit is “backed” by something that is costless to produce for the central bank and in fact given away right now at no cost to the banks, whereas in the other case it is “backed” by something that is in limited supply and can not in fact be produced by the central bank.

    I submit that also under a gold standard, there are demand deposits and there is currency, into which demand deposits are convertible. In a fiat system, there are still demand deposits and currency, but no gold.

    Hence, currency in a fiat system clearly does not take the same place as gold in a gold standard system, since there is also currency under a gold standard.

    The role of currency in a fiat system and of gold under a gold standard are clearly not analogous. The analogy is not exact.

    (Perhaps we should get Mike Sproul to explain what backs money in a fiat system in his opinion – I don’t agree with him, but he would certainly identify the analogous assets of the central bank…)

  52. Gravatar of JCE JCE
    23. January 2013 at 07:59

    about wicksell; you`re right. he said that in the case of a ‘pure credit economy’ i.e an economy with no cash. it’s one of the hypothetical cases he analyses

  53. Gravatar of Geoff Geoff
    23. January 2013 at 08:05

    Dr. Sumner:

    “But low interest rates tell us nothing about whether money is easy.”

    Nothing empirically tells us whether money is tight or loose, because we can’t observe any real competitive market in money production.

    Thus, when you make claims as to whether money is tight or loose during any period of time, you too are basing it on conjecture. Just because you define “tight” and “loose” money by the level of NGDP, it doesn’t mean you can say interest rates tell us nothing. Similarly, just because JN might define it in terms of interest rates, doesn’t mean he can say that NGDP tells us nothing. Both in fact tell us nothing.

    Friedman argued that lower interest rates usually signals money has been tight because he defined money tightness and looseness in terms of the money supply and rates of money supply growth. He didn’t define money tightness and looseness in terms of NGDP.

    You guys are all arguing over definitions. It’s nothing but semantic quibbling.

    Having said that, the question of what specific statistic the Fed should seek to control via its OMOs, that is where there can be some objective discussion, because then at least you’re no longer arguing over subjective definitions that go nowhere.

  54. Gravatar of Squarely Rooted Squarely Rooted
    23. January 2013 at 08:54

    Unrelated to the post at hand, but I thought the readers of this blog would be especially adept with this:

    Let’s model a kingdom. In this model, the kingdom is a closed economy, and (very importantly) it is “well-normed” – it has strong norms relating to governance and society that tend to be widely honored and respected.

    This kingdom is governed by two individuals: the king, and the wizard. Most formal power, as well as the titles of head of state and head of government, is vested with the king. The king has formally unlimited powers to tax and spend, raise armies, and adjudicate disputes, but in practice is limited by norms, sense of duty (symbolized in a sworn oath to serve in the interest of the whole kingdom and its subjects), and the patience of subjects; therefore, the king tends to maintain inherited intuitions to which their power has been delegated, like courts and military bureaucracy. The crown is hereditary – the first-born child of the king (this is a gender-progressive kingdom) inherits the crown, and in the past, though there have been occasional hiccups, most transfers of power have been peaceful and orderly.

    The king must retain a wizard, who is charged in vague terms with independently securing the safety, security, and prosperity of the kingdom. The wizard bears a hat that grants them vast yet mysterious magical powers. Unlike the crown, which is symbolic, the wizard’s hat is in fact where the magical powers are vested, and is not hereditary. When the existing wizard dies, the king selects the next wizard, who receives a lifetime appointment. Extremely strong norms dictate that the king select whomever is widely acclaimed the wisest scholar in the kingdom, regardless of their personal feelings towards that individual or inclination to select an ally as wizard. Often the wizard will survive the king.

    As stated above, the wizard has vast powers, but they are mysterious and to some extent ill-defined. There is no user manual for the wizard’s hat, and often throughout history wizards have surprised themselves with the consequences of exercising their powers. Therefore, norms have developed that the wizards exhibit strong restraint in exercising their powers, even in times of emergency. Extremely strong norms have also developed against the king making formal or open requests of the wizard, as well as against the wizard interfering in the quotidian or terrestrial business of the king. In the past, there have been some violations of this norm in both direction, but for the most part it tends to persist. Consequentially, the wizard tends to be reclusive, speak carefully and opaquely, and avoid commitments to use their powers. There is much dispute among the subjects of the kingdom to exactly what the wizard is doing or could be doing, and when the wizard ought to exercise their powers.

    Your assignment: model the governance and economy of this kingdom.

    http://squarelyrooted.wordpress.com/2013/01/23/the-king-and-the-wizard-a-modelparable/

  55. Gravatar of Paul Paul
    23. January 2013 at 09:47

    Curious. Milton Friedman put the start of the financial crisis at December 10 1930. When the Bank of the United States was allowed to fail. This was the trigger for an ordinary recession to become a crisis. The crisis was exacerbated by the Fed’s failure to prevent more bank failures and decrease in the money supply. The real issue is whether a simple bank run model is enough to get at the heart of the banking side of the problem, or is something more complex needed.

  56. Gravatar of Keep Banks Out Of Macro? Keep Banks Out Of Macro?
    23. January 2013 at 10:07

    [...] Scott Sumner says we should keep banks out of macro. I think that’s a very strange comment coming from a monetarist or even any economist. Whether he knows it or not, monetary policy works primarily through the banking system via the Fed’s ability to influence interest rates. When the economy is too hot, the Fed increases the cost of overnight borrowing, thereby reducing the spread at which banks make money in an attempt to tighten the supply of loans. [...]

  57. Gravatar of Tom Brown Tom Brown
    23. January 2013 at 11:12

    Scott, I see that you would “like to change the world so that monetary policy was less inefficient, so that monetary policy prevented banking problems from impacting NGDP.”

    But if you’re interested in modeling reality as it is now, and you believe your models are accurate without banks, then adding an accurate, high fidelity model of how banks and banking operates should only marginally improve the fidelity (and thus marginally change the results) from what your model produces now. This, in turn, would give you a powerful argument for ignoring the banks and put this issue to rest for good.

    I don’t know how things in the economic journals work, being an engineer, but that’s one approach I’m familiar with for putting fidelity issues like this to rest… or, alternatively, if they don’t put it to rest, learning something new about what’s important to model!

  58. Gravatar of Further reading | FT Alphaville | MG-PT Further reading | FT Alphaville | MG-PT
    23. January 2013 at 11:43

    [...] Keep banks out of macro, implores [...]

  59. Gravatar of Tom Tom
    23. January 2013 at 13:08

    Scott, I think on the one hand you are right to dismiss adding banks into macro models in relation to their direct impact on NGDP. Moreover, Minsky’s model is fundamentally flawed as it assumes like Fisher and Friedman that excess credit growth fuels inflation. This neither happened in the 1920′s nor in the 2000′s. However, credit growth impacts the value of financial assets, which can have an impact on NGDP when they are volatile and therefore do impact the behaviour of economic agents thus feeding back into NGDP due to demand shocks – both positive and negative. You might argue that EMH exists at the macro level therefore this is not an issue. Unfortunately the evidence supporting EMH at the macro level is not particularly compelling as highlighted by Shiller and Jung (2005). The transmission mechanism of the way falls in asset prices feedback into the real economy is purely a function of expectations of whether the level of leverage is sustainable in relation to future cash flows. If the expectations of future cash flows do not appear to be able to sustain the level of leverage, then economic agents will change their behaviour leading to shifts in NGDP.

  60. Gravatar of flow5 flow5
    23. January 2013 at 17:57

    “low interest rates tell us nothing about whether money is easy”

    Sumner’s right. Keynes’s liquidity preference curve (demand for money) is a false doctrine. Remember, that’s what the Treasury-Federal Reserve Accord of 1951 was all about.

  61. Gravatar of Suvy Suvy
    23. January 2013 at 18:46

    “Keynes’s liquidity preference curve (demand for money) is a false doctrine.”

    I think you mean Hicks’ liquidity preference curve. Keynes was “radically opposed” to the views of Hicks. Even says so in one of his papers after The General Theory. It’s called Alternative Theories of the Rates of Interest.

    Here’s a link to the paper:
    http://www.scribd.com/doc/11399026/Keynes-1937-Alternatives-Theories-of-Int

    Here’s a quote about Keynes referring to Hicks’ model:
    “The alternative theory held, I gather, by Prof. Ohlin and his group of Swedish economists, by Mr. Robertson and Mr.Hicks, and probably by many others, makes it to depend, put briefly,on the demand and supply of credit or, alternatively(meaning the same thing), of loans, at different rates of interest. Some of the writers(as will be seen from the quotations given below) believe that my theory is on the whole the same as theirs and mainly amounts to expressing it in a somewhat different way. ‘Nevertheless the theories are, I believe, radically opposed to one another.”

  62. Gravatar of RebelEconomist RebelEconomist
    24. January 2013 at 02:57

    @Scott / Shining Raven

    Excuse me for butting in to your debate, but as Mike Sproul has not commented, allow me to disagree with “The analogy is exact. “Backed” means “is freely convertible into.””

    “Freely convertible into” means that the holder of money has a right to sell their money back to the central bank AT THEIR INITIATIVE for whatever assets the central bank deals in in its OMOs.

    “Backed” is a weaker concept meaning that the central bank holds assets at least initially equal to the value of its issued base money, which allows the central bank to redeem money for backing assets AT ITS INITIATIVE.

    If I can try to speak for Mike, I think he would say that the difference is important, because the fact that the central bank might refuse to redeem money, for example because it has moved its inflation target higher, is why the backing theory of the value of money is not inconsistent with the quantity theory.

  63. Gravatar of ssumner ssumner
    24. January 2013 at 06:08

    Shining Raven, What is the ultimate form of liquidity in a gold standard? How about a fiat money regime?

    Paul, More recent research showed the 1930 crisis (which occurred 15 months into the Depression) was a very minor affair. The real crisis was in mid-1931.

    Tom Brown, I have no objection to explaining the monetary failures in terms of changes in the credit markets, my fear is that people will start arguing that banking instability causes macroeconomic instability.

  64. Gravatar of Shining Raven Shining Raven
    24. January 2013 at 06:36

    @Rebeleconomist: No worries, you are welcome to butt in, and actually, good point, although I guess it does not really help me.

    @Scott: This is a trick question, no? I guess you want to hear: “gold” under a gold standard, “currency” under a fiat regime? So that they are analogous in the sense that they provide the ultimate liquidity?

    Well, I disagree. I would say “currency” or “demand deposits” in both cases.

    Depends of course on what you mean by “liquidity”. Much easier to draw $100,000 on an account than to truck around several pounds of gold bullion that people actually might not wish to take (and which might not even be legal tender, even under a gold standard, but the mechanics are unclear to me).

    So really, no, I still do not think that currency constrains “money” in a fiat regime in the sense that “gold” constrains “money” in a gold standard world.

  65. Gravatar of flow5 flow5
    24. January 2013 at 12:17

    No mistake. I meant Keynes. Interest is the price of loan-funds, it is not the price of money. Gibson’s paradox is no paradox. Keynes’s liquidity preference curve is a false doctrine.

    Wikipedia: “The Quantity Theory of Money predicts that a slower money-growth creates slower price-rise. In addition, slower money-growth means slower growth of loanable funds and thus raises interest rates. If both these premises are true, slower money-growth should mean lower prices and higher interest rates”.

    It should be obvious. Two factors have had a large impact in recent years. One has increased the supply of loan-funds, the other has decreased the demand for loan-funds. Both have lowered real rates: (1) a “flight-to-safety” (increased supply in both a quantitative & schedule sense), & (2) & demand via gov’t debt monetization.

  66. Gravatar of flow5 flow5
    24. January 2013 at 12:21

    John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor & his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

    In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. This is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, the elimination of Reg Q ceilings, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, the Financial Services Regulatory Relief Act of 2006, the Emergency Economic Stabilization Act of 2008, sec. 128. “acceleration of the effective date for payment of interest on reserves”, etc.

  67. Gravatar of flow5 flow5
    24. January 2013 at 12:32

    I commented on 12-16-12, 01:50 PM #1 flow5
    Posts:203 Re: QE3 = nuttin’ honey

    “We’re close to seeing the real power of OMOs. R-gDp is likely to accelerate earlier & faster than anyone now expects. The roc in M*Vt before any new stimulus is already above average. With low inflation (given some deficit resolution), Jan-Apr could be a zinger”

    The Fed doesn’t know a bank (which creates new money whenever it makes loans or invests), from a non-bank (the turnover of existing money), i.e., doesn’t know money from liquid assets (Keynesian confusion).

    Expanded FDIC insurance coverage induced dis-intermediation within the non-banks (resulting in a de facto tightening of FOMC money policy). What caused M1 money growth to surge was that customers transferred their balances between deposit classifications – from savings/investment type accounts (interest-bearing without reserve requirements), to transactions based accounts (non-interest-bearing with reserve requirements).

    M1’s growth rate simply represented both an indifference on the part of depositors/savers given historically low yielding assets, & a preference for reduced risk (saver/holders received 100% unlimited FDIC insurance in the deposit classifications where they moved their money).

    Stocks current moves are PROOF:

    Scaling back coverage will partially reverse prior trends. Prior reductions in RETAIL sweeps to MMDAs, & reductions in COMMERCIAL sweeps to money market instruments (T-Bills, Euro-Dollars, & institutional MMMFs), will also contribute to a higher future velocity of money & collateral.

    The precise effect is hard to measure as contrary forces were at work. I.e., Operation Twist ended Dec 31st 2012 having re-infused short-dated “safe-assets” into the money market (facilitating shadow-bank lending or money velocity).

    But savings that were formally impounded within the CB system will again be released & flow back through the intermediaries (intermediaries between savers & borrowers), where they are “put to work” (matching savings with investment). I.e., savings held within the CB system are “lost to investment” resulting in a leakage in National Income Accounting. Contrary to all economists, CBs do not loan out existing deposits, saved or otherwise.

    As savings flow back thru the intermediaries it will boost the markets/increase real-gDp. It should also re-balance the EUR/USD exchange rate (as currencies will be converted), because it will stimulate growth in the unregulated, prudential reserve, money creating, Euro-dollar banking system.

  68. Gravatar of Becky Hargrove Becky Hargrove
    24. January 2013 at 13:04

    It will take time to convinced people that banks shouldn’t be a part of macro…the fact that they shouldn’t a situation they brought upon themselves. As far as putting banks back into models, they once had a very simple model which made them integral to income stability: creating housing loans that considered income in truly accurate context. Rather than stay true to that model, they went along with outdated housing manufacturing standards, which also created product that far surpassed actual income potential for large portions of the population. Worse, they looked the other way as further zoning and regulations proliferated, and when “preferred” unions related to construction prevented the adoption of more technology friendly possibilities. As a result, one gets the odd picture of austerity bankers who allowed too many outsized and bloated consumption packages in the first place.

    Which would be one thing if that rationale were being changed, but it is not. Rather than taking more incremental, practical and competitive approaches to growth in building technology for the future, they are quietly shifting the marketplace to make it appear as though housing is returning to normal, via demolitions and turning previously owned homes into rentals. One of the real dangers of an IOR floor is that the incentive for needed building reforms could easily be lost. That would mean no companies on the horizon with competitive alternative building components, such as high-tech pieces your grandmother could carry to site and snap together. Governments instead would continue allowing banks to offer up “more of the same” to a considerable portion of the public which needs something radically different: incremental and gradual approaches to wealth creation instead of the all or nothing scenarios that still exist.

  69. Gravatar of Geoff Geoff
    24. January 2013 at 14:24

    Becky Hargrove:

    “It will take time to convinced people that banks shouldn’t be a part of macro…the fact that they shouldn’t a situation they brought upon themselves.”

    Talk about blaming victims.

    Not every banker is monocled, wax mustached, and carrying money bags with dollar signs on them.

    Egads. The collapse of NGDP is what the Fed brought upon itself AND OTHERS.

  70. Gravatar of Becky Hargrove Becky Hargrove
    24. January 2013 at 14:48

    Geoff,
    That was actually an unusual post for me, in that I generally come to the defense of both banking and finance. What I wanted to point out here is that they have basically shot themselves in the foot in terms of where many of them are currently headed.

    In the present, the powers that be are basically trying to protect one another: the Fed protects the banks and the banks protect the more powerful of the locals. But that’s where the problems started, locally, in that over time people have built up massive walls that everyone needs to scale just to stay in the game. The person who made lots of money in finance just takes part in the transaction process, and the Fed has to print what seems to some like ungodly amounts of money to keep things from failing. But it all added up to a faulty Nash equilibrium, which NGDPLT could provide a counterbalance for now and correct further imbalances in the long run. Blaming the Fed is not any more meaningful than blaming the banks. However I wanted to point out what local banks could have done to keep housing from spiraling out of control, and what they could still accomplish far more effectively than any further pointless regulations that could be foisted on them in the present.

  71. Gravatar of Fed Up Fed Up
    24. January 2013 at 18:32

    So do you believe for every borrower there is a lender and that means debt is a zero sum change?

  72. Gravatar of ssumner ssumner
    25. January 2013 at 05:30

    Shining Raven I’d recommend Fama’s 1983 JME paper on currency.

  73. Gravatar of Suvy Suvy
    25. January 2013 at 06:50

    flow5,

    “John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an ‘optical illusion” to assume that “a depositor & his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.’”

    He wrote a paper about this to clarify what he said in The General Theory. It seems like he doesn’t see a bank as an intermediary at all. He sees a banking sector as something that plays an essential role in financing investment.
    http://esepuba.files.wordpress.com/2011/10/keynes-the-ex-ante-theory-of-the-rate-of-interest.pdf

    This paper is called The “Ex-Ante” Theory of Investment where in he says that investment cannot occur before the savings have taken place. He touches on this idea in The Alternative Theories of the Rate of Interest, but in this paper, he really shows how that’s impossible. He makes a point to separate himself from Ohlin and Hicks. This paper was written in 1937 after The General Theory.

    Keynes starts by saying that he overlooked the role of this in The General Theory.
    “I restrict myself in what follows to the discussion between
    Prof. Ohlin and myself, because this, I think, may prove to be a fruitful one. He has compelled me to attend to an important link in the causal chain which I had previously overlooked, and has enabled me to make an important improvement in my analysis; and as regards the difference which still remains between us, I do not yet abandon the prospect of convincing him. Whilst, however, the latter must probably await a future article which I intend to write dealing with the relation of the “ex-ante” and ” ex-post” analysis in its entirety to the analysis in my “General Theory,” I have, meanwhile, some comments on his latest contribution.”

    Later, he describes the process.
    “Now, ex-ante investment is an important, genuine phenomenon, inasmuch as decisions have to be taken and credit or “finance” provided well in advance of the actual process of investment”

    “Surely nothing is more certain than that the credit or “finance” required by ex-ante investment is not mainly supplied by ex-ante saving.”

  74. Gravatar of Suvy Suvy
    25. January 2013 at 06:53

    If Keynes’ paper The “Ex-Ante” Theory of the Rate of Interest doesn’t debunk IS/LM and how IS/LM is a bogus model, I don’t know what does.

  75. Gravatar of flow5 flow5
    25. January 2013 at 10:10

    “that investment cannot occur before the savings have taken place”

    Same thing. Keynes didn’t recant. Everyone’s a Keynesian:

    “Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements” [sic] – Testimony of Treasury

    “These measures should help the banking sector attract liquid funds in competition with non-bank institutions & direct market investments by businesses” [sic] Testimony of Treasury on the Financial Services Regulatory Relief Act of 2006

    CBs pay for what they already own. Reg Q ceilings induced dis-intermediations (an outflow of savings from the NBs which precipitated negative cash flows). The Fed’s solution, turn 38,000 NBs into 38,000 CBs. Then the Fed eliminated most reserve & reserve ratio restrictions. As RRs were no longer binding we got the housing bubble.

    The IOeR policy causes the same flow of savings problem. Economists dont’ understand. FDIC expanded insurance coverage just expired. This increases the supply of loan-funds, matches savings with investment, increases real-gDp. It was another “time-bomb”.

  76. Gravatar of flow5 flow5
    25. January 2013 at 10:19

    “Careful there, the rocks are slippery with moss; be warned of the fathomless logical cavities, the metaphysical cul-de-sacs, and all the methodological stalactites and stalagmites ready to snare the unwary intellect. Be not surprised if you see nothing you recognize. This world is not meant for ordinary mortals; it’s for the merest few—men of occult knowledge and ethereal genius, mathematical logicians with no little contempt for the crude statistics of that vulpine species, the businessman. Economic theory is as estranged from the real world as business enterprise as, say; quantum physics is estranged from the realities of the television repair shop. And yet, while the physicist’s theorizing may find rather immediate, most concrete expression in the repair man’s circuit boards, the economists’ theories have no clear nexus with the natural pulse of economic life. In economic theory, there is no necessary connection between generally accepted facts of experience and their theoretical interpretation…” – Edward Meadows

    “The Federal Reserve Plans To Identify “Key Bloggers” And Monitor Billions Of Conversations About The Fed On Facebook, Twitter, Forums And Blogs”

  77. Gravatar of Suvy Suvy
    25. January 2013 at 13:04

    Flow5,

    I mispoke. He says that investment must occur before the required savings takes place. That’s what that paper by Keynes is about. He does say that in the aggregate savings=investment through the circular flow through an economy. That’s the part I’m having difficulty with, I don’t understand why, even in the long run on the aggregate level, savings=investment.

  78. Gravatar of Doug M Doug M
    25. January 2013 at 14:22

    Suvy,

    Savings = investment…

    Lets ignore the foreign trade for a moment.

    Y = C + I + G

    Savings(private) = Income – Taxes – Consumption
    Government Surplus = Taxes – Government Spending

    Savings + Government Surplus = Y – T – C + T – G

    The T’s cancel. Substitute C+I+G for Y and you get…
    S(private) + S(public) = I

    S(private) can be broken into personal savings and retained earnings.

    When you bring in the foreign flow, the net foriegn investment flow – goods flow would also add to I.

  79. Gravatar of Geoff Geoff
    25. January 2013 at 15:07

    Doug M:

    “Suvy,

    Savings = investment…”

    Just FYI, the reason why there is so much dispute and controversy over that relation, is due to the fact that it is a relation that is abstracted away from time.

    Everyone has to integrate time into that relation in order to make it meaningful.

    When Keynesians see that statement, they integrate time into that relation by thinking that abstaining from consumption and holding cash is the first step in time, then a decision to invest or cash hoard is then made in a subsequent moment in time. So they say that savings can end up not equaling investment in the abstracted form of the relation as written.

    For myself, I always take into account time, so I say that given enough time, savings (typically misleadingly defined as cash holding) eventually equals consumption plus investment, because all dollars are held with the intention to eventually consume or invest.

    Strictly speaking, Keynesians have it wrong, because saving as cash holding and investment as productive expenditures are not only never equal, but are completely incommensurate concepts. One is an act of holding money, while the other is an act of productively spending it (on capital and/or labor).

    Anyone who says “Savings don’t necessarily equal investment, because cash can be held and not productively expended” are highly confused.

  80. Gravatar of Suvy Suvy
    25. January 2013 at 17:17

    Geoff,

    “Anyone who says “Savings don’t necessarily equal investment, because cash can be held and not productively expended” are highly confused.”

    That’s not what Keynes is saying; he’s saying the opposite. He’s saying that ex-ante, investment is greater than saving and that investment is financed by credit.
    “Surely nothing is more certain than that the credit or “finance” required by ex-ante investment is not mainly supplied by ex-ante saving.”–J.M. Keynes

    Also, as for those identities, they change once you add a financial sector. A financial sector can create investment without saving by issuing credit. That’s what The Ex-Ante Theory of the Rate of Interest is about.
    http://esepuba.files.wordpress.com/2011/10/keynes-the-ex-ante-theory-of-the-rate-of-interest.pdf

    In this paper, Keynes is fighting against the traditional Keynesian view that investment comes from savings. In fact, it seems like he’s saying, in a sense, that savings comes from investment.

  81. Gravatar of Suvy Suvy
    25. January 2013 at 17:29

    Keynes says ex-post, savings and investment are equal. However, ex-ante, investment must be greater than savings. That’s the difficulty I’m having. He also says that he “overlooked” this role of the financial sector and the banking system in The General Theory.

    Basically, Keynes is trying to convince someone else(Prof. Ohlin) that the traditional theory that investment=savings ex-ante is wrong.
    “He has compelled me to attend to an important link in the causal chain which I had previously overlooked, and has enabled me to make an important improvement in my analysis; and as regards the difference which still remains between us, I do not yet abandon the prospect of convincing him.”

  82. Gravatar of Suvy Suvy
    25. January 2013 at 17:34

    The reason I posted that article on this particular post is because it’s an interesting idea and is related to the idea of adding a financial sector/banks in macro.

  83. Gravatar of Fed Up Fed Up
    25. January 2013 at 18:15

    Good post:

    http://neweconomicperspectives.org/2013/01/understanding-the-permanent-floor-an-important-inconsistency-in-neoclassical-monetary-economics.html

    ssumner, could you check out my 23. January 2013 comments here?

    http://www.themoneyillusion.com/?p=18700

  84. Gravatar of Geoff Geoff
    25. January 2013 at 20:56

    Suvy:

    That’s still abstracted from time. The focus on “ex-ante” is an abstraction from time, and thus a separation of saving from investment. I think that is why Keynes concluded in the GT that saving can be greater than investment, and then a year later conclude that investment can be greater than saving.

    If on the other hand you take the whole time period that is constrained by the subjective intentions of the person in question, then it is nonsensical to say that one is greater than, equal to, or less than the other, for they would be incommensurate concepts. Holding cash can never be less than, equal to, nor greater than, productive expenditures. They are two separate choices that accomplish two separate outcomes.

    The confusion arises because of a sloppy way of dealing with what seems to be straightforward number crunching. Dollars are the unit used to understand both stock concepts and flow concepts, and so they are unfortunately compared with each other as if comparing two commensurate units.

    The center of attention however ought to be not the money, but the human behavior in using the money as a tool. A person who holds $100 and then invests $100 is not showing an example of saving equaling investment. It is an example of two consecutive choices over time, where the first decision is unique to that prior time, and the second decision is unique to that specific time. The latter decision is an act of investment, which is another way of saying an act of saving, if saving is defined as using money for something other than consuming.

    The only meaningful way of connecting these choices (holding cash, investment, etc) over time, is via the person’s choices, not the money abstracted from time as if variables in floating air have to be equal or not relative to each other.

    The fact that Keynes said opposite things about saving and investment not only when it comes to the GT relative to his paper a year later, but also within the GT itself, makes it clear that Keynes wasn’t “overlooking” Prof. Ohin’s point so much as changing his opinion on the matter because he didn’t center his attention on the person.

    One will always bounce back and forth regarding saving and investment in a context of time being used whimsically and sporadically because it’s not being made explicit.

  85. Gravatar of Suvy Suvy
    25. January 2013 at 22:00

    Geoff,

    I think I get what Keynes is saying and I think I understand what you’re saying–correct me if I’m wrong.

    I’m not sure, but I think he’s talking about how after investment, the money goes into incomes and profits. Those can either be used for consumption or saving. So in the aggregate after the fact, savings=investment, but investment is not financed from savings–it is financed from credit.

    Keynes, I think, is saying this. Investment is financed by credit, not by savings. However, the circular flow in an economy means that in the aggregate, savings=investment. Either way, he’s arguing that a banking sector should be in macro and he’s saying that the supply of savings don’t matter in the amount of investment taking place because investment is financed by credit before the corresponding savings takes place. Both points that I agree with (and have said earlier).

    “The fact that Keynes said opposite things about saving and investment not only when it comes to the GT relative to his paper a year later, but also within the GT itself, makes it clear that Keynes wasn’t “overlooking” Prof. Ohlin’s point so much as changing his opinion on the matter because he didn’t center his attention on the person.”

    Also, I went back to take a look at Chapter 4 of The General Theory. Keynes never says that investment comes from savings. He simply defines savings as any income not being consumed. He never says anything about investment coming from savings at all. He simply says that on the aggregate, savings=investment by definition. He talks about the exact same thing he was saying in the paper in Chapter 4 Part II of The General Theory.

    “Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income. Thus the act of investment in itself cannot help causing the residual or margin, which we call saving, to increase by a corresponding amount.”

    It seems like he’s being perfectly consistent with what he said in the paper. He’s saying that investment either has to slow down consumption or increase income–thus saving increases. This is perfectly consistent with what he says in The Ex-Ante Theory of the Rate of Interest. He’s saying that savings come out as a result of investment. Investment does not happen because of savings.

  86. Gravatar of Suvy Suvy
    25. January 2013 at 22:21

    Also, Keynes talks further about the thing you were describing about when savings is greater than investment in Chapter 7. He just uses that as a framework to talk about changes in profit. He specifically says so in Chapter 7.

    Keynes even criticizes Robertson for his primitive views on how investment comes from saving. Here’s the quote:
    “Mr. D. H. Robertson has defined to-day’s income as being equal to yesterday’s consumption plus investment, so that to-day’s saving, in his sense, is equal to yesterday’s investment plus the excess of yesterday’s consumption over to-day’s consumption. On this definition saving can exceed investment, namely, by the excess of yesterday’s income (in my sense) over to-day’s income. Thus when Mr. Robertson says that there is an excess of saving over investment, he means literally the same thing as I mean when I say that income is falling, and the excess of saving in his sense is exactly equal to the decline of income in my sense. If it were true that current expectations were always determined by yesterday’s realised results, to-day’s effective demand would be equal to yesterday’s income. Thus Mr. Robertson’s method might be regarded as an alternative attempt to mine (being, perhaps, a first approximation to it) to make the same distinction, so vital for causal analysis, that I have tried to make by the contrast between effective demand and income.”

    Keynes spends Part V of Chapter 7 even talking about how investment must occur before savings take place. He basically does a proof by contradiction to show that investment cannot come from previous savings.

  87. Gravatar of flow5 flow5
    26. January 2013 at 07:16

    Browsed the paper. Keynes didn’t understand the savings-investment process otherwise he would have made some important distinctions.

    Savings are impounded within the CB system. From a systems viewpoint, commercial banks (DFIs), as contrasted to financial intermediaries: never loan out, & can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time deposits, or the owner’s equity, or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money- (demand deposits) — somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

  88. Gravatar of flow5 flow5
    26. January 2013 at 07:31

    “investment cannot come from previous savings”

    Doesn’t ring true. Unspent or unused savings exert a depressing effect on the economy.

  89. Gravatar of Suvy Suvy
    26. January 2013 at 08:49

    Flow5,

    “Savings are impounded within the CB system. From a systems viewpoint, commercial banks (DFIs), as contrasted to financial intermediaries: never loan out, & can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time deposits, or the owner’s equity, or any liability item.”

    I think Keynes may have referred to this at the end of his paper(last page-last 2 pages area), but I’m not really sure though. His writing is very difficult to decipher.

    “When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money- (demand deposits) — somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.”

    Right. Banks issue credit creating deposits in the process and look for the reserves later. I don’t think Keynes mentions this particular process in the paper; although there may be times he may have referred to it(I’m not really sure).

    I think you’re right though. Keynes touches on some points of modern banking and finance, but he doesn’t quite grasp them fully.

  90. Gravatar of flow5 flow5
    27. January 2013 at 06:36

    “His writing is very difficult to decipher”

    Edward Meadows:

    “Through the years, Keynesian exegesis, debate, and reinterpretation have consumed many reams of book paper and many buckets of printer’s ink; hundreds of “major” articles, dozens of “important” books have been done, and more will roll off the presses this year and the next. The titles often bear unwitting traces of satire. One asks, “Was Keynes a ‘Keynesian’?” Another expounds on the economics of Keynes as opposed to Keynesian economics. Many a career based been built upon the clever elucidation or emendation of this Keynesian postulate or that one. Many a career has been dominated even obsessed, by the avuncular ghost of Lord Keynes It’s not unrespectable to be known as a prominent Keynesian theorist, if not proselytizer. It’s surely no worse than being, for example, the seventh biographer of Gerard Manley Hopkins, and what with the dank esoterica of Keynesian exegesis, the prestige is greater. But the Keynes Industry offers succulent ironies to contemplate”

    “First irony—that not one Keynesian economist in a hindered has ever read the General Theory. For though Keynes was capable of high elegance, his major tome has become famous for the elusiveness of its arguments. Professor John Kenneth Galbraith, himself an early Keynesian, has made much of the General Theory’s general inscrutability—a quality which has let Keynes’s disciples read what they wish into it. But this irony is greater yet. Surely every Marxist theorist has, at some moment, at least thumbed through Das Kapital. Can one conceive of a Doctor of Divinity who never once lifted a finger to open the Holy Bible? Still it’s acceptable not to have read the General Theory, which Galbraith dismissed as “an ACROSTIC of English prose.”
    ————-

    “and look for the reserves later”

    Very deceiving. That’s how monetary policy is conducted by design. It is not the proper policy. This began c. 1965 when the operations at the FRBNY’s “trading desk” began using the Federal Funds Rate “bracket racket”, i.e., using interest rates as their monetary transmission mechanism.

    SEE I think: Thornton

    The Relationship Between the Federal Funds Rate and the Fed’s
    Federal Funds Rate Target: Is It Open Market or Open
    Mouth Operations?
    ———-
    Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real-gDp.

    But given our incompetent monetary management, then they have to target nominal-gDp.

    By using the wrong criteria (interest rates, rather than member bank reserves) in formulating & executing monetary policy, the Federal Reserve has always been the engine of inflation.

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