Hydraulic Macro: A Fable

I came up with this while thinking of a way to explain the Keynesian model to my high school class. But scroll to the end to see comments related to the recalculation model.Once upon a time, Joe lived in Keynesiana, where he was a representative agent.

Joe worked in a GDP factory, making GDP. Every Monday morning, he went to work, and he worked five days a week. He was paid $1 for every 24-minute segment he worked, and he worked 100 segments (40 hours), so he earned $100 a week. Every Friday afternoon, Joe cashed his paycheck and went to the GDP factory outlet, where he spent it all on GDP.

One day, Joe decided that he needed to accumulate some savings. He made up a rule for himself. Knowing that he needed to consume at least $40 of GDP each week, he decided that his rule would be to save 20 percent of everything he earned over and above that $40. So the first week, that meant saving 20 percent of $60, or $12. So he cashed his $100 paycheck, but that Friday afternoon he only spent $88.

Next Monday, morning, Joe’s boss had some news. “A funny thing happened last week. We sold 12 percent less GDP than usual. So this week, we’re gonna put you on a short week. You work 88 segments, instead of 100.”

Joe was disappointed, because this meant he would only be paid $88 this week. Sticking to his new rule, he resolved to save 20 percent of $48, or $9.60. So that Friday afternoon, he cashed his $88 paycheck and spent $78.40.

Next Monday morning, Joe’s boss said. “Well, golly, it looks like we sold even less GDP last week. I’m afraid we’ll have to cut you back to 78.40 segments this week.” Still following his rule, Joe resolved to save 20 percent of $38.40, or $7.68. So he spent only $70.72 at the GDP factory outlet that Friday.

Seeing where this was going, the country asked Krug Paulman, the famous economist, what to do. He said, “The stupid people are saving too much. We need government to spend what the idiots are not spending.” So the government borrowed $29.28 from Joe and spent it at the GDP factory outlet.

Now, when Joe came to work on Monday morning, his boss said, “Good news, we sold 100 percent of what we used to sell, so you can work 100 segments this week.” Sticking to his rule, Joe saved $12 on Friday afternoon. But the government borrowed the $12 and spent it at the GDP factory outlet. They all lived happily ever after.

I see two problems leading to the need for government to spend Joe’s money for him.

1. There is no sign of the price mechanism at work here. The factory outlet sells less GDP than it wants to, but it does not cut price. Joe works less than he wants to, but he does not cut his wage.

2. The problem would go away completely if Joe would hold his savings in the form of GDP rather than in the form of cash.

Concerning (1): In terms of the recalculation model, we do not see instantaneous movement to a new full employment equilibrium. In a complex economy, where many people have to change jobs in order to adjust to new circumstances, it would be absurd to expect instantaneous adjustment. It also may be the case that sudden, sharp price changes would actually be destabilizing–causing too many people to make adjustments that later need to be reversed. So although prices and wages are not completely fixed, it is fair to say that the economy does not behave as if they were fully flexible.

Concerning (2): It is tempting to attribute macroeconomic significance to the role of money as a store of value. Keynes does so with the terms “liquidity preference” and “liquidity trap.” However, I think this is not a wise move. I think that it leads to more error than insight.

In a diverse economy with extensive division of labor, it is inefficient to pay people in the form of output. If I am the accountant for a bakery, it is not my comparative advantage to sell bread. Paying me in bread would lead to a waste of resources as I try to go out and exchange it for what I wish to consume. To take the point even further, picture me as an accountant in a hospital–am I to be paid in surgeries?

The problem is not that money is a store of value. The problem is that the plans of producers and the plans of consumers are not necessarily aligned. Edward Leamer, in Macroeconomic Patterns and Stories, puts it this way (p. 163):

The long supply chain characteristic of industrial economies necessitates the creation of capacity to produce consumer products many years before actual sales are made. With such long lead times, there is little possibility in a vibrant and growing economy that actual capacity will match actual sales month to month.

To the extent that consumer behavior changes slowly and/or predictably, plans are not too far off. The great calculation machine is able to keep most people employed. However, large unexpected changes in consumer behavior overwhelm the calculation machine. Until a new pattern of production and wants is established, there tends to be unemployment.

By the way, I will have more to say about Leamer’s book in a subsequent post.

By:

David Henderson

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By:

David Henderson

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By:

Arnold Kling

READER COMMENTS

READ COMMENT POLICY

Boonton

Aug 30 2009 at 10:38am

Not too long ago I remember seeing a report on pawn shops in Mexico. Families in the area didn’t have good banking options so they saved in the form of consumer goods. A family would have extra TV’s or appliances and if they needed money they would pawn them. Later on they would buy them back. Sometimes it seems the banking system creates its own problems…

Patrick

Aug 30 2009 at 11:43am

Don’t take this the wrong way Arnold, but there has to be an easier way to explain this to your high school class.

winterspeak

Aug 30 2009 at 12:20pm

ARNOLD: Your fable is actually pretty good. Key points you are missing:

(1) Price mechanism: Debts are nominally denominated, so lower prices trigger debt deflation. Fisher has an excellent piece on this which, in my mind, settles the price issue.

(2) You are absolutely correct, but the point is also moot as Joe wants to save in cash and there is a monopoly supplier of currency in town — the Government.

Savings (or “paid in equity”) can ONLY come from the Government. This transfer is recorded as a deficit. Government deficits FUND private savings.

For this reason, your causality is also backwards — Joe decides to save, but the Govt does not borrow from Joe to buy Joe’s output. The Government’s initial deficit outlay (of $100) was what gave Joe the money to save in the first place.

If the private sector wants to increase net savings, ONLY the Government can fund that desire through deficits. Can be through tax cuts — this is better the spending because it lets the “Great Recalculation” happen. But you cannot “recalculate” yourself to higher private sector savings.

Joe Marier

Aug 30 2009 at 2:18pm

I’d switch from calling it “GDP” to “Magic Potion.” “Magic Potion,” of course, being the stuff that fulfills all his human needs.

Don the libertarian Democrat

Aug 30 2009 at 2:46pm

“Now, we need a Great Recalculation to figure out a new allocation of skills and jobs that gets us back to full employment.”

Is this what you term “Normal Times”? What will this new “Normal Time” look like? How is it different from a baby recalculation? Is it inevitable? Is it a Steady State? If it is, why can’t you have a simple mechanistic method to keep it from falling out of this state? Is it a tautology: People need to hire the people that they need to hire?

Scott Grannis

Aug 30 2009 at 9:06pm

I think your analogy has a critical flaw. You imply that any desire to save means that money is withdrawn from circulation; that Joe simply puts the money under his mattress. In reality, though, while some people may decide to increase their savings by building up their cash balances, the vast majority of the money saved is effectively lent to other people, who then spend it. If I put a dollar in the bank, the bank can actually lend several dollars to someone else who will spend the money. So if consumers decide to save more that does not necessarily mean that GDP will contract.

Aug 30 2009 at 11:49pm

SCOTT: I used to think the same thing as you, but it turned out I was wrong.

Money saved in banks is *not* leant out. It is simply taken out of circulation as Arnold suggests.

Banks do not lend out deposits. It’s quite the opposite, banks simply expand both sides of their balance sheets, making loans which in turn create deposits. They are constrained only by capital requirements, and the will of regulators to enforce those requirements.

Jon Leonard

Aug 31 2009 at 12:56am

I find Keynes’s discussion of the assumption that the type of employment doesn’t matter interesting: It’s early in chapter 8 of his General Theory, and he explicitly assumes that the total income doesn’t change much with the details of employment. That’s more or less explictly the hydraulic assumption, and I think it’s even less true now than when he wrote it.

It is peculiar to assume that employment type doesn’t matter, and then use that model to recommend wasteful employment.

Christian

Aug 31 2009 at 8:30am

To use the terminology of “hydraulic” macro, your account discusses “C” and “G” but what what about “I” and “NX” which would seem to address the gap presented in your fable. It seems that Keynes — in his original presentation — seems to put the emphasis on the changing expectations of the future by “I” as the main cause of the shortfall of absorbing savings. This would seem to be the “recalculation” that you discuss, only that Keynes argued that it would over and undershoot while you seem to seem argue that recalculation produces a new steady-state equilibrium. Keynes seems to argue that recalculation would take too long and do too much damage while the market was making up its mind.

It seems that you are just relabeling an Austrian view of Hayek who sees the market as an information mechanism. Isn’t your recalculation the same as Schumpeter’s “creative-destructive” entrepreneur, etc.

Interested in your comments on Leamer’s book, having read the draft chapters I’m looking to buy it when the prices drops a little.

Aug 31 2009 at 9:35am

Scott,
In theory, savings ought to recirculate as investment. Keynes’ “revolution” was to deny that they do so. Lots of controversy over what he meant, whether he was right, etc. Telling that whole story would take much longer than a blog post, much less a comment on one.

Aug 31 2009 at 1:37pm

ARNOLD: In theory, savings does NOT recirculate as investment. Keynes was pretty clear about this. Investment comes first, and is accounted for by savings. So the causality runs investment -> savings, not the more commonly assumed investment -> savings.

Greg Hill

Aug 31 2009 at 1:40pm

The price reduction won’t produce the results you’re hoping for if markets are competitive and prices = MC. If you reduce the price, and Joe is the marginal worker, it’s no longer profitable keep him on the payroll.

The wage reduction won’t work because falling wages will lead to falling prices, and you’re back where you started.

The real problem, as Keynes noted, is that when Joe starts saving, he doesn’t place an order for goods to be delivered in the future, and all that businesses see, as a result of his reduction in spending, is a decline in revenue.

Money is a problem because it’s not produced by labor (in any significant sense), and, hence, increased demand for it doesn’t increase the demand for labor.

Aug 31 2009 at 1:48pm

ARNOLD: btw — it may be worth us taking this offline for an email or too. If you’re interested, you know how to get in touch with me. I’ve lost your email : (

GREG: You are right — money (esp. savings, the paid in capital that private credit rests on) is only produced by one source, the Government.

Increased demand for a monopoly product, with a monopolist who hoards it, as predictable outcomes.

Aug 31 2009 at 3:06pm

WINTERSPEAK: The government’s monopoly on the production of currency (as opposed to money) is not the problem. The problem is the public’s desire to hold wealth in forms that allow us to defer the purchase of goods until we’ve made up our minds about what we want, whether we’ll have a job next month, whether interest rates are about to rise, etc.

Aug 31 2009 at 4:44pm

GREG: I’m not sure it makes sense to look at either elements in isolation:
1. As I say, only the Govt can create net private savings (or “paid-in capital”) — a very precise definition of savings, and
2. As you say, the private sector’s desire to hold wealth and defer consumption

The two need to match. One is just the flip side of the other.

If the public wants to increase it’s net private savings, then the Government MUST fund that need or you will see aggregate demand fall and unemployment rise.

If the public does not demand an increase in net private savings, but the Government funds it anyway, you will see inflation.

Both situations are bad for savers: in one, a portion of them lose their jobs, and the rest are deprived real output to spend on (in the future); in the other, inflation is a pure tax on savings.

My view is that it is very easy and costless for the Govt to fund the private sector’s demand for net savings, so when that demand goes up, it should do so.

I view the private sector demand as natural, and endogenous, the realm of “animal spirits”. Is it really a “problem” that the public sector wants to defer some consumption, or is it just what it, usually, naturally what it wants to do?

Aug 31 2009 at 6:49pm

WINTERSPEAK:

1. You write that “only the Govt can create net private savings.” I’m not sure what you mean here. A firm that invests in a new plant certainly creates private saving (whether there are unemployed resources or not);

2. You write that “If the public wants to increase its net private savings, then the Government MUST fund that need or you will see aggregate demand fall and unemployment rise.” If the public wants to save more of its income, the consequent reduction in aggregate demand can be offset by increased private investment without the government funding anything. Keynes’s point was that the market mechanisms that connect saving and investment don’t function the way advocates of laissez faire think they do;

3. Finally, you ask whether it’s really a problem that the public “wants to defer some consumption, or is it just what it [the public], usually, naturally . . . wants to do?” In fact, the “problem” arises when the public increasingly wants to defer making commitments (particularly in long-lived goods) and wishes to hold a store of value – money – that makes this possible.

Graeme Bird

Aug 31 2009 at 7:00pm

A good effort but the problem with trying to get a grip on all of this is that with the exception of our greatest living economist, the economics profession, has failed to integrate economic science and double-entry accounting. You cannot defeat the Keynesian prize-winners if you go about things on the basis of GDP. It is matching ideologically based non-understanding with less rigid thinking but thinking that is not fully integrated and divorced from Keynesianism.

To analyse this fable in a way which integrates accounting and economics we must do the aggregations on the basis of the humble income statement of every separate business in the economy.

When we do this we see that wages-minus-savings does not begin to make up the business spending in the next time period. Nor does wages-minus-savings plus dividends-minus-bigshot-savings plus net exports do the job.

Wages and profits are not the totality of the income statement. Matter of fact wages and profits taken together are a small part of the totality of the income statement either individually or aggregated together.

Now supposing business revenues are unchanged one quarter to the next? Changes in consumer spending don’t affect business revenue in the next time period at all. Aggregated business revenue…. and the flipside spending….. being GROSS DOMESTIC REVENUE and not GROSS DOMESTIC PRODUCT.

Under 100% backing any extra savings do not affect spending at all. Since the savings are immediately lent out, and we can assume under reasonably tight money, always for business spending.

Fractional reserve doesn’t change this non-affect of an increase in frugality…… this non-affect over gross domestic revenue/

Rather fractional reserve makes the effect of changes in frugality on total business revenue SERENDIPITOUS. So not worth fretting over.

What does reduce spending is an increase in the demand for money for holding. Under 100% backing this reduces business revenues for a time in nominal terms for sure. Under fractional reserve it is indistinct the difference between the demand for cash money and the demand for demand deposits. And yet the former affects the banking system drastically. Whereas the latter affects business revenues a small amount.

In either case these are basically MONETARY effects. And if they are to be dealt with, they must be dealt with using MONETARY TOOLS.

If we posit either static business revenues or alternatively a fixed slow rate in business revenues of 1% per quarter… then we find that the wage-earner can save all he wants and this will not affect business spending in the next time period.

But it will affect profits two time periods hence. It will affect profits two time periods hence. Because business spending in this time period becomes cost of goods sold in the next time period.

But what is unique about extra government spending and extra consumer spending is……. well its not that they increase business revenues in the next time period. But business revenues in this time period become COST OF GOODS SOLD in the next time period.

What is different about increased consumption and government spending is that they become SOURCES OF REVENUE……… THAT DO NOT BECOME PART OF COST OF GOODS SOLD IN THE NEXT TIME PERIOD.

Hence two time periods later you will get this burst of profits even though alarmingly every bugger is still out of work.

Because you have revenues that will not become cost of goods sold in the next time period. Since only business-to-business spending (Gross Investment) becomes cost of goods sold in the next time period.

Hence in the time period after next a reduction in frugality and an increase in government splurging will create an increase in national average profits.

Since national average profits is business revenues minus cost of goods sold.

This will be hailed by Keynesians as proof that increased parasitism ended the recession. But in reality the whole experience has damaged the economy entire. Like slapping that child chimney-sweep around just to put a blush on his cheeks.

Keynesian fiscal policies increase profits by reducing the proportion of business to business spending to other sorts of spending.

But a true recovery ought to come from the exact opposite course of events. Since true and productive recovery can only come from what I’ve chosen to call “business renovation”. And the resources for business renovation come exlcusively from business-to-business spending and not from reduced frugality or increased government splurging.

phineas

Aug 31 2009 at 8:38pm

Winterspeak asserts: “If the private sector wants to increase net savings, ONLY the Government can fund that desire through deficits…. Government MUST fund that, or you will see aggregate demand fall and unemployment rise…. It is very easy and costless for the Govt to fund the private sector’s demand for net savings, so when that demand goes up, it should do so.”

Scott Grannis asserts, on the contrary, “If I put a dollar in the bank, the bank can actually lend several dollars [nearly 10 dollars] to someone else who will spend the money. So if consumers decide to save more that does not necessarily mean that GDP will contract.”

This is an exceedingly fundamental question about the economy. I confess that my understanding is insecure and foggy about it. And Arnold says there’s still “lots of controversy” about it. It’s horrible to think that economists still haven’t a clear answer to this question.

Aug 31 2009 at 8:55pm

“This is an exceedingly fundamental question about the economy. I confess that my understanding is insecure and foggy about it. And Arnold says there’s still “lots of controversy” about it. It’s horrible to think that economists still haven’t a clear answer to this question.”

Once you include all business spending rather than just C+ net I plus G….. the mystery ends. And we see that fiscal measures have absolutely no effect on the totality of business revenues and if they do have some effect an entirely serendipitous one.

But fiscal measures can affect profits. Wasteful fiscal deficits can be relied on to reduce employment and increase profits at the same time. Which may seem counter-intuitive.

What is particularly hard for people to believe is that a recovery of profits via fiscal means is in no way a recovery, nor is it a good thing, nor will it increase employment or set the economy up for a real recovery.

Aug 31 2009 at 9:58pm

GREG: I’m talking at a sector level. If the private sector, as a whole, wants to increase net savings (to be specific, the paid-in equity and retained earning line on the liability side of the balance sheet) they can ONLY do this if the Government funds that desire by running a deficit.

The private sector can shuffle assets between it, of course, and can expand credit within itself, but it cannot increase that line item, which is the true denominator for private sector savings.

Private investment is not savings. Savings is no-one elses income, and both investment and consumption, as defined in national income accounting identities, is someone else’s income.

Like I said, I used to believe what you do, but I was wrong.

GRAEME: I’m bringing double entry book keeping back into economics! It’s absence has been a HUGE issue. I cannot understand the rest of your post. I do know that you want to be looking at cash flow and balance sheets, not income statements though.

Maybe you can re-iterate your core point in just 2-3 lines?

PHINEAS: Scott Grannis is getting confused about fractional reserve accounting, which is where he gets the 10x from.

Totally understandable. It is very confusing.

Private sector credit (and balance sheets) can expand all by themselves, and do. This is why I was explicit about the paid-in equity line being “private sector savings”. This CANNOT expand by itself at a sector level, although balance sheets overall can.

Banks do not lend out deposits, as Scott thinks, and I used to think.

Banks are not reserve constrained in their lending, as Scott thinks, and I used to think. Reserve requirement are just there so the Fed can set interest rates because they create an overnight lending market. Canada has reserve requirements of zero, as an example alternate scheme.

Graeme is certainly wrong, as all the businesses depending on G for their income know full well.

Ozrisk

Aug 31 2009 at 11:48pm

winterspeak,
An individual bank is certainly constrained in its lending activity by the availability of funding for any loans. If funds are deposited in a bank that bank can then only lend out that amount minus any amount they decide to hold as a prudential amount for liquidity purposes.
Banks cannot simply inflate their balance sheet.
For there to be a multiplier effect any receiver of that money then needs to make a decision to re-deposit the funds in a bank – presumably after making some production or consumption use of those funds in the interim.
When you scale that up to a macro view of the entire banking system then it may appear as if the banks are inflating their (collective) balance sheets – but this is not actually happening at all. Macro appearances are simply the collecting together of a lot of micro events – and in banking those events are:
1. Some productive activity generates income
2. Receiver of income decides to deposit some or all of the income in a bank
3. Bank then lends some of the funds out
4. Funds are used to pay for some productive activity
5. Loop back to 1.
There is no money being generated in the system, merely a circular flow giving that impression if you total up all of the transactions at point 2.

Winterspeak

Sep 1 2009 at 12:48am

Ozrisk:

I thought exactly what you did, but I was wrong. Banks make loans they think will be paid back. They do this by making the loan, which then creates the deposit. If effect, the bank has made it’s balance sheet bigger

it is constrained by capital requirements, but not reserve requirements. If it is short reserves, it borrows what it needs overnight at the fed funds rate. If the system as a whole is short reserves, it borrows at the discount window

there is no money multiplier effect, which should be obvious from current reality as banks are swimming in reserves and yet deflation continues

the truth is wacky, no?

Read up on capital ratios and reserve requirements, as well as how the fed operationally sets rates and you will see what I’m getting at

Sep 1 2009 at 12:50am

There is no new money being generated in the system Osrisk? For one thing Andrew Reynolds you’ve got the Keynesian fiscal multiplier confused with the bank money multiplier. And secondly you are lying. Banks do indeed create new money via bank cash pyramiding. This has been explained to you many times and you ought to just learn the material rather than attempt to lie about the situation.

Mark Hill

Sep 1 2009 at 12:58am

“Banks do not lend out deposits, as Scott thinks, and I used to think.”

Yes they do. Why else could a bank run occur?

Sep 1 2009 at 1:12am

“There is no new money being generated in the system Osrisk? For one thing Andrew Reynolds you’ve got the Keynesian fiscal multiplier confused with the bank money multiplier.”

Graeme my dear boy you do have a fertile imagination.

Sep 1 2009 at 1:13am

Steady on Graem-no need for name calling

I would also suggest you use the term “private sector credit” extension instead of “cash pyramiding” as it is precise and broadly understood

Keynesian fiscal multiplier hides the change in private sector demand for savings, so I don’t like it. Money multiplier is simply wrong

Sep 1 2009 at 1:33am

Well the Keynesian fiscal multiplier and the Money multiplier are two different things. But there is nothing wrong with “money multiplier”. So you are wrong, not the term. “Private sector credit” is NOT the right phrase because credit can be generated without bank-cash-pyramiding. I can write you an IOU but it takes the banking system to generate new money through bank-cash-pyramiding. So while people talk about “private-sector-credit” in this regard its an ambiguous phrase and one doesn’t want to confuse people or oneself.

Mises called ponzi-money “fiduciary media”. I prefer using terms that rub peoples noses in it. So “ponzi-money” or “pyramided money” forces people who don’t understand the money-creation process to either learn it, or at least know what you are talking about. Whereas “private sector credit” may be preferable in order to not put the noses of monetary cranks out. But it can lead to confusion.

Cash in the hands of the public plus ponzi-money equals M1.

There is simply no way for people to confuse these crude and brazen formulations.

John Papola

Sep 1 2009 at 3:53am

Christian, Keynes was indeed focused on Investment with his notion of “animal spirits”, or as the shockingly keynesian Alan Greenspan put it “irrational exuberance”. You’re right that he saw that as the main driver of the boom/bust.

But what he got wrong was the means for entrepreneurs to invest comes from savings in a prior period or from someone else’s savings transmitted through the credit market (or loanable funds market) and it’s interest rates as a market price of savings. Keynes dispensed with the utility of savings through his “paradox of thrift” which in reality only seems possible if no one changes their behavior, production processes or prices in response to changes in demand other than to cut back on worker wages and thus cut off that “circular flow” of income in the closed hydraulic system described above.

The other element of Keynes bizarre misunderstands is the “liquidity trap”, though it seems to be the same thing as the “paradox of thrift”. People’s money demand becomes infinite he believed, and so money supply expansion offers no stimulative effect. But these two components are mistaking a broken banking system and people’s natural increase in money demand when facing higher uncertainty for some other bizarro mass psychology.

Savings are CLEARLY is the key to investment. The high-savings, high-growth nations of China and, at one time, Japan are living proof that the “paradox of thrift” is simply nonsense. Even now, the most orthodox Keynesians like Paul Krugman contradict (and thus invalidate) their master’s theory by blaming long term rates on a “global savings glut”. Such a cause is not possible according to Keynes, since interest is a function of “liquidity preference” alone, and savings are treated as some inefficient leftover.

So, indeed, keynesian theory is a hydraulic theory of closed circular flow where any leak reduces the pressure. It’s also nonsense. (or maybe I’m confused with my amateur interpretation).

Sep 1 2009 at 6:40am

Winterspeak,
Graeme’s objections aside, the usual process in loan disbursal is not to create a deposit but to disburse the funds (for example with a car loan or a mortgage) or to mark a new limit on an account (credit card or overdraft). In neither of these cases is a new deposit created – the funds are actually disbursed. Very rarely (these days at least) are the funds paid into a deposit account and then not spent very soon thereafter.
Creating a loan does not create a deposit – as you are claiming – creating a loan actually represents funds leaving the bank.
It may well be that the funds later come back to that (or another) bank, but there is no causal link.
Banks cannot inflate their balance sheets as you describe.

Sep 1 2009 at 7:06am

Don’t talk idiocy Andrew Reynolds. The usual practice is for banks to pyramid upon cash and create new money. That new money is balanced by a debt that banks owe to each-other. There will be interest charged on that extra credit limit. But since each banks owe eachother money that interest will cancel. The net effect to the banking system as a whole that they create money at no cost and out of thin air.

That new money immediately begins changing hands and therefore debases the currency. New money creation by banks means that for any amount of cash there are vastly more claims to that cash. Which means when we have a crisis the central bank has to bail these charlatans out with extra cash lest there be a recession.

“The problem is not that money is a store of value. The problem is that the plans of producers and the plans of consumers are not necessarily aligned. Edward Leamer, in Macroeconomic Patterns and Stories, puts it this way (p. 163):”

Under 100% backing plans of producers and consumers are aligned and they are harmonized through the interest rates. Fractional reserve changes all that. And these plans are never aligned again.

“Banks cannot inflate their balance sheets as you describe.”

No no. They do inflate their balance sheets exactly as Winterspeak describes. You are just lying Reynolds. I used to work in banking too Reynolds. So don’t try it on. How many years is it going to take for you to learn the basics? Three years now and counting.

Sep 1 2009 at 7:28am

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Sep 1 2009 at 10:05am

I will leave you with your thoughts, Graeme. Feel free to continue with them. Once you can show me how this is done – and in a way I recognise from a normal bank’s operation then you have a chance of me believing you.

Sep 1 2009 at 11:44am

JOHN: Savings and investment are clearly linked, but the causality runs from (real) investment-> (nominal) savings, not the other way around. Savings is the account of record for real investment. I used the think the opposite on this as well.

This is a step further than how Government deficits fund private savings, and how loans create deposits, and (to me) is more complicated than either of those two. Therefore, I’m not going to expand on this further in this thread.

OZRISK: I understand what you are saying, as I said I believed the same thing, and I was wrong. Even in your example, with the “fund being disbursed”, they’re disbursed to someone else’s deposit account!

When you and I make a loan, we debit one asset (cash) and credit another (receivable). Our balance sheet is the same size, but our assets have been reconfigured.

Our intuition, then, is that banks act the same way, and our intuition is wrong. At a system level, you can see why this is so just through logic and accounting.

Alternatively, you can look at how capital requirements work, or look at how the Fed themselves talks about deposit creation. The Chicago Fed has a paper on this (IIRC) that is clear about loans -> deposits, but then has a load of rubbish about reserve requirements in the next section. I cannot find that now, but here’s a good discussion:
http://neweconomicperspectives.blogspot.com/2009/07/another-embarrassing-blunder-by.html

MARK HILL: Banks experience runs because they need to rollover short term liabilities to match long term assets. (Maturity mismatching).

Sep 1 2009 at 5:07pm

Sep 1 2009 at 6:59pm

Here’s something from today’s U.K. newspapers that adds some topically to the above discussion:

***********{quote}
People paid off mortgage debt faster last month than they took on new debt for the first time since records began in 1993, Central Bank of England figures showed today. The Central Bank said mortgage repayments exceeded new borrowing by £418m in the month of July as people are using a period of ultra-low interest rates to pay off the capital on their mortgages. The wider measure of consumer credit also fell back slightly for the first time since 1993, implying that households are responding to the economic downturn by consolidating their finances, getting rid of debt and shunning new credit…. [One commentator prognosticates] “The fact that consumers are, in aggregate, opting to pay down their debts is reflective of a flight to savings that we expect will continue.” Worryingly, the Central Bank of England figures also showed that bank lending to non-financial companies in July fell by a hefty £8.4bn, or 1.7%, on the month, and the three-month annualised rate fell by 7.8%.

“The avowed aim of the [UK Central Bank’s] Quantitative Easing policy is to bolster the growth in money holdings of the non-financial sector,”….
*****************{endquote}

According to winterspeak, this “flight to savings” and de-leveraging necessarily causes a contraction of the economy, and must be offset by governmental “Quantitative Easing”.

Sep 1 2009 at 9:06pm

Arnold: Sorry to derail your thread, this will get back on topic by the end.

Winterspeak: maturity mismatch is what banks do for allocative efficiency, not the reason why they have bank runs.

Deposits are part of their short liability base. If they do experience a run through asset/liability mismanagement, it is at least partly due to lending out too much of their combined capital base of equity/liabilities such as deposits.

What you’re basically saying is that banks don’t operate on a spread. I strongly disagree. Banking relies on the existence of a spread.

As for Graeme’s comments about money:

Yes,they do create a class of money.

1. It isn’t fraud. (Foley v. Hill, (1848) 2 H.L.C. 28, 9 E.R. 1002)

2. It engenders positive outcomes (voluntary market action, also see 4.).

3. It doesn’t mean banks don’t lend out their reserves. It happens because they can. It also means they are liable to runs.

4. If we define money even under the broadest possible definition, then there is no fraud or deleterious impact on prices or output.

(This is based on basic maths using the quantity equation and the properties of the bank multiplier). I can show this but it is fairly boring.

The fact whether banks create or do not create “money” is immaterial. Since debt was around before money (see Sidney Homer), we can see how pointless missives about “debt as money” actually are.

5. Rothbard also includes insurance liabilities as money. The day I can buy a house with a few thousand car insurance contracts is the day you and Rothbard are right.

Some good analysis on Keynesian policy:

http://blog.libertarian.org.au/2009/08/31/growth-and-fiscal-policy/

Sep 1 2009 at 9:54pm

“What you’re basically saying is that banks don’t operate on a spread. I strongly disagree. Banking relies on the existence of a spread.”

No winterspeak didn’t say that Mark. You made that up.

“According to winterspeak, this “flight to savings” and de-leveraging necessarily causes a contraction of the economy, and must be offset by governmental “Quantitative Easing”.”

If Winterspeak said this phineas, then he is correct in this regard. Supposing that you don’t want an implosion of the money supply, and an even greater implosion of business spending, and a societal breakdown.

A monetary crunch is to be dealt with by quantitative easing, and a reserve asset ratio to stop the effects of that quantitative easing from overshooting.

The quantitative easing if strong enough will lead to the resumption of business spending. But if it is indeed that strong it will later lead the banks to pyramid on top of all the new monetary base and therefore cause inflation.

So the way to deal with this sort of problem is very strong quantitative easing to end the problem. But an RAR to stop the increase in spending from overshooting.

Sep 1 2009 at 10:04pm

The article linked to by winterspeak says: “guardian.co.uk. Here’s from

Sep 1 2009 at 11:14pm

Sep 2 2009 at 1:10am

winterspeak,
I do not want to labour this point and I would be the first to say that my opinion is not in full agreement with the mainstream of economics. It does, however, come out of a long history of working in bank treasury functions in several parts of the world.
The question of whether or not banks create money revolves around whether or not a bank deposit counts as “money”, properly so called. Personally, I doubt it is, as I cannot conduct payment transactions with my bank account – I need to be able to withdraw the funds first. This is a contractual question between me and the bank. Most of the time the bank will honour the demand to pay the funds, so under most circumstances the funds in my bank account are a close cash substitute and can therefore be regarded as money, and I agree with Mark above on that. In extremis, though, the bank may not deliver the funds – so bank accounts are clearly less liquid than cash. That situation is only likely to occur when the bank itself cannot deliver on the demand for cash – i.e. there are more demands for withdrawals than the individual bank has access to cash to meet those demands.
Really, then, the total pool of liquidity represented by any bank is not the total amount on deposit with the bank, but the (much smaller) amount they have in ready cash or other sources of funds to meet calls for withdrawals.
You are right that a loan disbursement (or deposit withdrawal) from one bank will often, even usually, result in a deposit with either that bank or another – but this is generally not immediate, so the withdrawal or disbursement is seperated by time from any re-deposit, nor certain. It may be that the funds withdrawn are not redeposited in any bank for some time – they could be kept under the bed, used multiple times for transactions or even go offshore.
The point here is that a particular bank cannot be sure where any disbursed loan funds may end up and can only count on a small proportion returning. This means that they cannot simply inflate their balance sheet by making loans and counting on the funds to come back as deposits. Additionally, if they did this their liquidity ratios (one of the key measures of any bank’s soundness) would steadily deteriorate, restricting their ability to make further loans. Their capital ratios would also steadily deteriorate, reducing their ability to raise funds.
.
To me, then, the question of whether you measure the total money supply to include or exclude deposits in the banking system is really irrelevant. That may well be a standard (and useful) measure for economic policy questions. However, to me, the total amount of funds actually available for transaction purposes in an economy does not include bank deposits (whether chequing or otherwise) but does include total liquid funds (cash, government bonds etc.) held by the banks – a much smaller figure. It is not increaed by the actions of banks in depositing and lending – in fact it is reduced by the amount of the solvency ratios.
I appreciate that this is not purely mainstream, but I know how these things operate in every bank I have ever worked in.
.
You may (OTOH) argue that, in the event of a likely bank failure to deliver due to insolvency, the government is likely to step in – the (either impicit or explict) “printing press” contingency. That may well be so – but if you are going to count the likelihood of the government stepping in and printing as part of the money supply then that should be explicity acknowledged, not implicitly included by counting all bank deposits. That then explicitly becomes further government created money, not bak created money.

Sep 2 2009 at 1:15am

“But a tendency for people to reduce debts rather than spending may not be helpful to an economy still in recession…. ”

Thats where the fallacy is. They only think that because they are basing things on GDP rather than GDR.

If you look at an old-time fractional-gold crunch at the end of the crunch the ratio of ponzi-money to gold will be less. The amount of debts will be less compared to income and wealth. And some of that debt will have been resolved via bankruptcy.

The important point is you want to make these changes as quickly as you can. In the context of getting business spending (NOTE: NOT BANK LENDING) up to its previous high and sticking it there.

So you want to pay down debt. Cut government spending. Cut Consumer spending. Stop paying dividends for awhile. Have a higher reserve asset ratio. But a lot more cash.

Sep 2 2009 at 1:21am

“To me, then, the question of whether you measure the total money supply to include or exclude deposits in the banking system is really irrelevant.”

But you are WRONG about that Andrew. And thats the end of the matter.

It completely relevant because the amount of money affects everything else in the economy. And that can’t change on the basis of your terminal unwillingness to learn the material.

See how can you say that? What do you mean by that? You are asking policy-makers to act like lunatics? And for what?

Supposing I go up to Ben Bernanke. And supposing I say. Ben. Act like lunatic?

Surely you must understand that its important that people don’t do stupid things that will hurt everyone? If he doesn’t include deposits as money, when they are money, and obviously so, he is going to hurt a lot of people.

This is a simple matter Andrew. Either you are going to learn the material or you are not.

Sep 2 2009 at 1:28am

“Relatedly, money is created by bank lending. That is exceedingly fundamental, in my view. I could not disagree more with Mark Hill when he says “whether banks create or do not create “money” is immaterial.”

Yeah bizarre isn’t it. How about this?

What do you reckon phineas? How do you deal with people like this?

Sep 2 2009 at 1:53am

“This means that they cannot simply inflate their balance sheet by making loans and counting on the funds to come back as deposits.”

Yes they can Andrew. Because they do it together Andrew. They do it as an industry. They all lend money to each-other. That interest is in effect cancelled. And since they can only expand and contract together That’s why we have the boom bust cycle.

And its not ok. Its not a good thing. So banks can expand their assets and the money supply, so long as they do it together. Thats just a fact. You gainsaying anyone on the matter doesn’t change this fact.

[Comment edited to remove over-use of upper case yelling.–Econlib Ed.]

Lauren (Econlib Editor)

Sep 2 2009 at 7:56am

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Sep 2 2009 at 10:29am

Phineas: I actually don’t think the “quantitative easing” that the BofE has engaged in has had any effect on their economy. Quantitative easing just changes term structures, it does not increase net private sector savings (or paid-in capital). UK officials are also struggling to see the impact of QE.

Gordon Brown has been very aggressive on the fiscal deficit side though — his VAT holiday in particular did a lot of good. I don’t think he will get credit for that, though.

MARK HILL: No idea why you think I don’t think banks operate on a spread. I’m convinced by Diamond-Dybvig on this issue, and this is explicitly a maturity mismatch issue. Most entries though incorrectly state that it is fractional reserve banking which sets up the problem and it is not, it is capital requirements.

OZRISK: Are you seriously suggesting that bank deposits — what you have in your checking account — is not money? Really?

Most transactions never pass through cash at all, at least not if they are large. They happen through check, or direct money transfer, where one deposit account is credited and another deposit account is debited. One important function of central banks is to make sure checks can clear across the system.

Management of physical cash is best seen as an inventory problem, like having enough cans of tuna at the supermarket. Fundamentally, deposits are absolutely money.

And remember, this is a macro thread, and I’m talking at a SYSTEM level. For the banking system as a whole, loans MUST create deposits. Even if they go “offshore”, this is true, as a dollar loan creates dollar deposits, and dollar deposits must remain on the Fed’s spreadsheet.

Capital ratios absolutely govern ability to lend. On this we are agreed.

I also view FDIC insured bank accounts as being accounts with the Fed, and therefore Government created money. So, banks create Government money (FDIC backed) whenever they make loans. BUT, this is private sector credit, at an economy wide level, cannot increase paid-in capital.

Andrew Reynolds

Sep 2 2009 at 12:54pm

winterspeak,
On the recent point – the contents of my chequeing account (not that I, in common with many Australians, have had a cheque account for many years) are plainly something less than physical cash as the bank can refuse to meet a cheque under certain contractual circumstances and / or if they have an inability to meet it due to their own liquidity issues. These problems do not present themselves with cash.
.
The part of your comment I took issue with earlier, though, was not a macro concept, but a micro one – “Banks … do this by making the loan, which then creates the deposit. If effect, the bank has made it’s balance sheet bigger” (my emphasis).
As I said earlier, banks (at least here, in the UK and other countries I have had experience with – though I have not worked in the US) usually disburse using the procedure I outlined – which does not make their balance sheet bigger. The reason for this is simple – to do it that way would worsen their liquidity ratios, as liquidity ratios are expressed as a percentage of the amount on deposit. Marking a limit on an account does not affect that. Creating a deposit does.

Sep 2 2009 at 1:16pm

ANDREW/OZRISK:

Thanks for your response. If you don’t keep your money in a checking account in Australia, what do you keep it in? A savings account?

How do you pay your mortgage? Do you take out cash and deposit that at a bank, or do you wire transfer the money from one account to another?

I understand that there may be operational delays in having a check clear, and also inventory issues (if you want to withdraw more cash than the bank branch happens to have on hand). I view these as being inconsequential to the matter at hand. I have never had any material issue in transferring money in my bank account — checking or savings — to another account, so long as the transaction is not flagged for fraud or has some other glitch.

Are you saying that, in Australia, if you have $100 in your account that you might have trouble transferring $10 of it to another account? Really?

You say that “the total amount of funds actually available for transaction purposes in an economy does not include bank deposits”. I am really surprised at this assertion.

Are you saying that I cannot transfer the totality of my bank balance to the local Porsche dealer in exchange for a 911? Or that I could not spend it all on a house? Are you really claiming that I cannot spend the money in my bank account? A lifetime of experience contradicts this assertion — help me out here. Under what circumstances is an individual not allowed to spend what is in their checking/savings bank account?

Sinclair Davidson

Sep 3 2009 at 5:41pm

Australians tend to not have cheque accounts because State governments had ‘Bank Account Debit’ taxes (known as the BAD tax) on cheque acounts but not savings accounts. These taxes were abolished in 2001, but nonetheless Australians have gotten out of the habit of having cheque books. People tend to pay bills on either debit cards or credit cards or with cash.

The mortgage market is very innovative. Few people have fixed rate mortgages. Many now have lines of credit where your entire salary offsets the mortgage and lowers the effective interest rate. A disciplined borrower can pay off a loan in under ten years.

Sep 3 2009 at 8:48pm

“These taxes were abolished in 2001, but nonetheless Australians have gotten out of the habit of having cheque books. People tend to pay bills on either debit cards or credit cards or with cash.”

Winterspeak don’t let these people pretend to you that there is any difference in how the money supply works here. We have on-call deposit accounts. And while we often pay with credit cards we can also pay straight from the savings account as well and never see any cash.

I can pay all my bills from my computer with my on-call savings account. This is a mutli-year battle where Reynolds refuses to acknowledge that banks create money.

Here he is back in 2007. He simply doesn’t want to admit it. There is no way to explain this. He just doesn’t want to do it.

http://www.catallaxyfiles.com/blog/?p=3205&cp=9

On this thread from 2007 he is making the claim that banks create money is a rumour made up by Rothbard and Major Douglas.

As to our Mortgage market being “innovative” as Sinclair oddly suggests…. Actually the situation is one in which banks have us so much over a barrel since they have managed to get everyone on variable rate loans. What this means is that when they get jittery and don’t really want to make too many more loans then effectively there is no competition. So they just jack the rates up on their existing loan holders to incredible highs.

I don’t know how innovative you would find this.

Sep 3 2009 at 10:19pm

Phineas,

It is odd that you think bank money creation is important but then talk about quantitative easing.

It is only important in so far as bank leverage increases the sensitivity of output and prices to the changes in monetary policy. But hey presto, the central banks know the aggregates and ratios very well (as would a private issuer of currency, and as banks know now and knew before the Federal Reserve was created). Bank leverage itself isn’t inflationary. They do create money*, but unless the bank multiplier figure isn’t known, central banks are ignorant or in free banking days, the market had restrictions on clearing, it is immaterial.

Again, please read Sidney Homer if you have fears about bank leverage or debt (i.e debt predates “money”). Please also view the Australian Libertarian Society blog post about Keynesian policy globally as well. It is worth the read.

Winterspeak:

If banks don’t lend out reserves, where do they earn their margin from?

*Clearly a different class of money. Cash doesn’t need a clearing house or 24 hour processing.

Sep 4 2009 at 6:37am

“If banks don’t lend out reserves, where do they earn their margin from?”

Mark what we are saying here is that the banks don’t merely act as a broker of savings. They don’t merely take in loans, recycle them, and take a cut of the interest.

The banks don’t just get their income from taking a margin on saved money. If that was their only income, in a country with a low savings rate, clearly they would all go under. Rather they get most of their profits by creating new money. And when they do not have the confidence to create new money their profitability takes a dive. Since they trade under technical insolvency, to be both insolvent and non-profitable would be fatal to them without the public bailing them out.

Now you notice that this thread is not about banking basics But it always gets back to that if people refuse to learn the material.

Sep 4 2009 at 6:42am

“It is odd that you think bank money creation is important but then talk about quantitative easing.”

What could you possibly mean by your notion that bank money creation was “unimportant’.

Define “unimportance.”

Its not the least bit odd that someone would understand enough economics to know that money creation was important and also know enough economics to bring up the subject of quantitative easing.

Sep 4 2009 at 9:10am

Graeme,

You are making a lot of assumptions that rely on misconceptions.

If a country has a low savings rate, it merely becomes a net importer of capital. This however can be deceptive as such a descriptor “low savings” can misrepresent actual needs for funds, as the capital and current account balances may be highly skewed by foreign direct investment – i.e direct foreign ownership in subsidiaries. Which of course has nothing to do with money creation.

“Rather they get most of their profits by creating new money.”

This seems rather impossible. Why can’t they just create unending amounts of money?* If a Government does this, the public reacts. You are inferring that banks with a maturity mismatch can be profitable by essentially devaluing their pre-existing assets. This seems highly unlikely.

“They don’t merely take in loans, recycle them, and take a cut of the interest.”

What do they do then, if they do not act as a financial intermediary with all of the well known economic benefits such as diversification, economies of scale etc?

*Actually they can’t, the growth of bank assets is Governed by a power rule that basically infers a strong diminution of marginal returns. Please refer to a banking handbook on asset/liability management for more.

Sep 4 2009 at 9:18am

I think you misunderstood me.

Bank money creation isn’t unimportant. It is odd if you note the importance of bank money but not the credit multiplier and the power of open market operations in expanding the base.

To that end, monetary policy still drives inflation. Bank leverage merely drives sensitivity.

James

Sep 4 2009 at 10:52am

It’s REALLY odd that several posters here seem to be under the illusion they can actually communicate highly complex and confusing economic points in short little blog comments.

Can’t you see you are just arguing past one another? It makes for very poor reading. Comments work better when you can clearly encapsulate your point in a few sentences, don’t assume too much, and don’t refer to other posts.

Comments are closed.