Tag Archives: basil moore

Reconciliation Of The Supply And Demand For Money

What brings the supply and demand for money into equivalence?

It is interesting that the recent Bank of England quarterly bulletin referred to an article of Peter Howells, a Post-Keynesian (also available here), although I don’t think the authors appreciate why the paper is interesting.

The title of my blog post is flicked from a paper by Basil Moore which is in reply to Howells.

Howells sets up the problem:

[B]anks set up their collateral standard and lending rates … and then meet all loan requests forthcoming. The demand for loans is determined by other variables in the economic system … making the loan volume exogenous from the banks’ point of view and the resulting quantity of deposits endogenous … Notice, crucially that in this view, increases in the money supply are demand-determined but the demand in question is the demand for loans … the question then is what reconciles the demand resulting from this lending with peoples’ willingness to hold money? … What is it that ensures that the supply of new deposits created by the flow of net new lending is just equal to the quantity demanded?

Let me present it in another way. To be clear let us assume the economy is closed. Output is determined by domestic demand or by private expenditure and government expenditure. Output is equal to the national income and is distributed to various economic units such as households who among other things allocate a part of their wealth into deposits. So there is a money demand. Of course expenditure is partly from income and sale of existing assets and by borrowing from other economic units and in particular from banks which lend by creating deposits in this process. So there is a change in the money supply. So there are two pictures with overlapping stories but not exactly so the question is – what processes ensure that

Ms = Md

is valid at every instant of time?

Does the rise in income and higher demand for money (because of a rise in wealth) alone ensure this? Is there a price clearance? Prices of what? Goods and services? Or prices in financial markets? (‘price’ includes interest rates such as deposit rates, loan rates, bond yields, equity prices and so on).

Also note this is in nominal variables. So is the rise in income purely due to a rise in prices or purely a rise in real output or a mix of the two? What causes inflation?

Where does QE fit into this? Does it raise output? Real/nominal? Raise prices – of goods and services or asset prices or both?

It is important to appreciate the formulation of the question. In case you don’t yet appreciate the question, more from Howells:

The starting point is that the demand for the loans that create the deposits originates in the desire of deficit units to spend in exceess of income. It is a question of financing an income-expenditure discrepancy. Furthermore, it is a decision made by a subset of the community since not everyone is involved in demanding an increase in their indebtedness to banks. (Indeed it is not even the case that everyone holds a stock of bank debt…). By contrast, the decision to hold (i.e., not spend) the newly created deposits is a portfolio decision. Furthermore, it is a decision made by different people (“the community as a whole”) from those concerned with borrowing it… the fact remains that so long as we are dealing with two groups of agents, with different motives, an ex ante coincidence of preferences is quite implausible. The question, then, is how are these ex ante preferences to be reconciled, ex post.

Back to Moore’s paper. Moore summarizes possible solutions suggested by Howells:

… Howells considers four responses that have been proposed to his conundrum:

  1. Kaldor and Trevithic[k] – any excess money is automatically extinguished as a result of the repayment of bank debt.
  2. Chick – the income multiplier process will automatically increase the demand for active balances.
  3. Laidler – the buffer stock demand for money is a demand “on average” over a period of time, rather than a demand for a fixed stock at a moment of time.
  4. Moore – “convenience lending,” the rejection of an independent money demand curve, rooted in a “full-blooded rejection of the idea of equilibrium”: In a non-ergodic world, no meaning can be attached to the notion of a unique general equilibrium stock of  money demanded.

Howells maintains that the above list offers “promising solutions” to the mechanism that reconciles net new lending to borrowers with the change in the demand for money for the wealth holders. But he concludes that “each … on its own is almost insufficient” for the “reconciliation. As a result, he proposes that variations in relative interest rates, “which can and do occur continuously, provide the key to the fine-tuning required by the balance-sheet identity” 

Frequently in such discussions the accommodative behaviour of the banking system is forgotten. So there is another mechanism as highlighted by Nicholas Kaldor in his book The Scourge Of Monetarism (Oxford University Press, 1982):

As it is, a highly developed banking system already provides such facilities on an ample scale, since it is prepared to accommodate the public’s changing demand between different types or financial assets by altering the composition of the banks’ assets or liabilities in a reverse direction. If the non-banking public wishes to switch its holding of gilts for interest-bearing bank deposits, the banks are ready to supply such deposits at the minimum of inconvenience, and at the same time to place their surplus funds into the gilts which were previously held by the public. Similarly the banks provide easy facilities to their customers for switching balances on current accounts into interest-bearing deposit accounts, or vice versa.

In general banks not only hold government bonds but also other kinds of securities such as mortgage-backed securities, agency debt and so on. In olden days, there was no securitization and banks would hold more government bonds which got substituted. (See the Fed’s H.8 weekly release for data on banks’ assets) [There’s a Geithner ppt which mentions this in one slide, anyone has a link?]

This point is an important one because here the reconciliation happens via changes in quantities. Remember it is not just loans which create deposits but also banks buying bonds from the non-banking system which create deposits.

The answers to these questions can be found systematically by using James Tobin’s asset allocation theory.

Let me mention some positions. At one end are Monetarists for whom the direction of causality is from money to other things. So there may be an excess of money and if so leads to higher expenditure and a hot potato process in which money supply and demand are brought into equivalence by rise in prices of goods and services. It can also lead to a rise in real output but the Monetarists emphasize the price aspect more. In addition they also distinguish between government expenditure and private expenditure and try to point out that the latter is more efficient and so on.

Looking at an economy as a moving picture, as expenditures increase, output rises and there is a rise in prices of goods and services and a rise in the stock of money. Monetarists look at coincident events and assign some strange causalities.

Moving beyond Monetarism, there’s also a view that the reconciliation of the supply and demand for money necessarily happens via a rise in interest rates on everything including bank loans leading to a crisis. Of course that it not true because beyond a point banks will reduce lending instead of offering loans at higher interest rates. Banks have their own animal spirits but this is via tightening credit standards, quality of collateral etc. Also this is not the only outcome because the process of lending and borrowing increases output and income and can stabilize debt ratios. Nonetheless, debts can move into unsustainable territories and financial crisis do happen, and when it happens, there’s a high demand for money and the reconciliation may happen via bankruptcies of firms and the central bank may need to accommodate the rise in demand for money by lending at a large scale since bankruptcies threaten a fall in output.

Of course there are many more mechanisms for the reconciliation which I have avoided. It may happen that due to changes in portfolio preferences, there is a stock market boom and firms will go IPO instead of borrowing from the banking system. So we have economic units who wish to hold less money and more equities and firms borrowing less from the banking system leading to a reconciliation. (A more careful analysis is needed because firms have deposits after having raised funds through an IPO).

Now consider convenience lending. There is of course some truth to it. If you receive you salary on a Friday evening, you are not rushing to allocate newly held deposits into the stock market because it is already closed (unless you have an international brokerage account). So you are holding the deposits non-volitionally. However, subscribing to convenience lending alone is a bit extreme. 

Now to QE/LSAP. When the central bank purchases financial assets such as government bonds from the markets, it creates bank settlement balances and deposits in the process. Wealth holders will then purchase other assets and the reconciliation happens via changes in prices of financial assets.

This post is far from any complete analysis of the interesting questions but hopefully I have got readers interested in something. The question on reconciliation asks what reconciliates the demand and supply of money – income, prices (of goods and services or prices in financial markets), quantities and so on.  Also, some seem to think that “price clearing” has to do with some notions about an equilibrium. I don’t think these two are the same things. One can have price changes and clearances without appealing to the notion of any “equilibrium”.

Bank Of England On Money Creation

In the natural sciences, controversies are settled in a few months, or at a time of crisis, in a year or two, but in the social so-called sciences, absurd misunderstandings can continue for sixty or a hundred years without being cleared up.

– Joan Robinson, 1981 (1979), What Are The Questions And Other Essays – Further Contributions To Modern Economics, M.E. Sharpe

The latest Bank of England Quarterly Bulletin (2014 Q1) will be released on the 14th. It has pre-released two articles which go into money creation and the myths associated with it. 

The page is here. The second article Money creation in the modern economy may interest you more but the first is also readable.

Interestingly, the second pape refers to Post-Keynesians : Tom Palley’s 1996 book , Basil Moore’s 1988 book, a JPKE paper by Peter Howells and a 1981 paper by Nicholas Kaldor and J. Trevithick which discusses the reflux mechanism (reprinted in Kaldor’s Collected Economic Essays, Vol. 9). It also refers to James Tobin’s 1963 paper Commercial Banks As Creators Of “Money”. 

One negative is the omission of fiscal policy from the discussion altogether and emphasising monetary policy. This underplay of fiscal policy and overemphasis of monetary policy is one deep bias of the profession. The paper also has a slightly different emphasis on what determines the quantity of lending than emphasized by Post-Keynesians but I won’t go into it now. Still the page is worth a look. 

The full bulletin will be available on this page in a couple of days.

Update: The webpage for the full quarterly report is now available and it is here: Quarterly Bulletin 2014 Q1

Endogeneity, Exogenous, Et Cetera

Louis-Philippe Rochon and Sergio Rossi have a very interesting article Endogenous Money: The Evolutionary Versus Revolutionary Views in the Review Of Keynesian Economics. I think it was written many years back and was in an unpublished form and has been published now. It is a nice critique of views of some Post-Keynesians such as Victoria Chick and also others such as Basil Moore. For instance, the paper quotes Moore’s view from 2001:

[w]hen money was a commodity, such as gold, with an inelastic supply, the total quantity of money in existence could realistically be viewed as exogenous.

Click the image to visit the ROKE website.


There are also some nice articles in a recent issue of JPKE on neoliberalism and the financial crisis.

Some gossip: The JPKE was initially supposed to have been called Journal of Keynesian Economics but it didn’t make it because the acronym would have been JOKE.

Also, Jayati Ghosh has written an excellent blog article on Thatcherism – the ‘triumph of private gain over social good’ (borrowing words from her).

Matias Vernengo has a recent blog post on the persistence of poverty in the United States. Which reminds me of an interview clip of Anwar Shaikh titled “The Sin Of Our Era”:

Back to formal matters.

What does it mean when an economist says words such as “endogenous”, “exogenous”? Most of the times, economists – mainstream economists – themselves confuse these terms and hence you see a lot of usage of these words in Post-Keynesian economics.

I was reading an article on econometrics by Fischer Black (of the Black-Scholes fame) titled The Trouble with Econometric Models

An exogenous variable is supposed to be a causal variable, if the structure of a model has economic meaning. In fact, it is usually just a variable that is put on the right-hand side of equations in a model, but not on the left-hand side.

Similarly, an endogenous variable is supposed to be a caused variable. In fact, it is usually just a variable that shows up at least once on the left-hand side of an equation

which is fair but there exists another language.

There is however another usage – that is in the control sense.

In an outstanding paper Federal Reserve “Defensive” Behavior And The Reverse Causation Argument, Raymond E. Lombra and Raymond G. Torto point out the following in the footnote:

Apparently no generally accepted concept of an endogenous money stock (or monetary base) has been defined. In statistical theory a variable is endogenous if it is jointly determined with other variables in the system. However, many monetary theorists have chosen to call a variable endogenous only if its magnitude is not under the control of policymakers. Such semantic problems have undoubtedly prolonged this debate.

For the money stock measure such as M1, M2 etc., there shouldn’t be any confusion. The trouble arises for things such as interest rates. For example, some economists may say that if inflation rises, the central bank may/will raise the short-term interest rate and it is endogenous while others will say it is up to the central bank to decide how much to change the interest rate, if at all. Such things lead to a lot of debate.

I like the latter usage (the control sense) but I think it is difficult to exclusively have the same usage.

The word “control” is also misunderstood. Here is a fine article on Wynne Godley in The Times from 16 June 1978 where he details on how misunderstood the word is:

Leading Economist Insists That You Cannot Control M3

(click to expand)

Some Aspects Of Central Bank Behaviour

There was a discussion last week on a social network site on Basil Moore’s book Horizontalists And Verticalists. Someone mentioned he never knew anyone who owned a copy of the book! Lucky me.

I was browsing through my copy and came across this – which I thought I should quote on central bank “defensive behaviour”.

Actually, among Post-Keynesians, Alfred Eichner was the first to understand and highlight the “defensive” nature of central bank open market operations.

Outside PKE, it was a paper of Raymond E. Lombra and Raymond G. Torto titled Federal Reserve Defensive Behaviour And The Reverse Causation Argument which started analyzing the details of the Federal Reserve defensive behaviour and supported the theory of endogenous money on which economists such as James Tobin and Nicholas Kaldor were writing at the time. The term “defensive” was coined by Robert Roosa of the Federal Reserve in the book Federal Reserve Operations In The Money And Government Securities Markets originally written in 1956.

Recently central banks around the world have been doing a lot of things (“unconventional measures”) in trying to “boost” their economies – such as “large scale asset purchases” (QE). For some, recent central bank action is the natural way to start to understand monetary economics. For me, it is first important to understand what they did before the crisis to correctly understand what they have been doing and judge if their actions have any usefulness at all – on a case by case basis.

Anyways, here is from Basil Moore’s book (pages 97-99):

Open-market operations: defensive rather than dynamic?

According to the conventional story taught in most textbooks and worked through by students in countless T-account exercises, central bank open-market security purchases have expansionary effects on the money stock by raising the high-powered base. Central bank security sales conversely lower the high-powered base, and so operate to reduce the stock of money outstanding.

Table 5.2 presents the relationship between changes in total bank reserves, the monetary base, and the Federal Reserve net open-market security purchases or sales. The data are monthly time intervals for the period October 1979 to December 1983. This is the period when quantitative targeting was purportedly at last rigorously instituted. Nonborrowed reserves were avowedly the Fed’s chief operating instrument for controlling the growth rate of the monetary aggregates.

To the student of introductory economics, and even to many economists, these results will surely be startling. On a monthly basis, Federal Reserve net open-market operations fail to explain any of the actual changes in unadjusted or adjusted total reserves! They explain only 5 percent of changes in the unadjusted and only 10 percent of the changes in the high-powered base. In all cases the coefficient on net open-market purchases and sales is extremely small. It has no statistical significance in explaining observed changes in bank reserves. Although the coefficient is statistically significant in explaining the monetary base, its magnitude implies that $1000 of open-market purchases or sales were necessary to change the value of the base by $1!

The explanation for these apparently puzzling results is not far to seek (Lombra and Torto, 1973). From the central bank’s point of view a large number of stochastic nonpolicy factors operate to add or withdraw reserves from the banking system. These factors can be analyzed by an examination of the central bank’s balance sheet identity. This documents the various financial flows that accompany any change in the base: changes in float, changes in the public’s currency holding, foreign capital inflows or outflows, changes in treasury balances held with the Fed, changes in bank borrowing from the discount window. All of these flows are completely outside the control of the monetary authorities. In order to achieve a desired level of the base, these flows must be completely offset by open-market operations.

If the Fed were to take no action in the face of these large stochastic inflows and outflows of funds, the banking system would experience sharp fluctuations in its excess reserve position. Such changes would be unrelated to the Federal Reserve’s policy intentions, and would provoke continued liquidity crises and great instability in interest rates. As a result most Federal Reserve open-market operations are “defensive” and designed to offset the effects of these nonpolicy forces. Central banks operate to make reserves available to the banking system on reasonably stable terms, from day to day and week to week.

Studies of Federal Reserve open-market operations have estimated that more than 85 per cent of Federal Reserve security purchases of [sic] sales are “defensive” (Lombra and Torto, 1973, Forman, Groves and Eichner, 1984). Such flexibility is needed to deal with the very large inherent volatility of money flows. On a week-to-week basis such “noise” in the behaviour of the narrow money supply accounts for dollar changes in reserves of plus or minus $3 billion more than two-thirds of the time. This represents nearly 10 percent of total reserves, which were concurrently in the order of $40 billion (J. Pierce, 1982). On a monthly bias, such “noise” accounts for changes in the money stock or plus or minus 5 percent about two-thirds of the time.

Income = Expenditure!

The accounting identities equating aggregate expenditures to production and of both to incomes at market prices are inescapable, no matter which variety of Keynesian or classical economics you espouse. I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second?… Identities say nothing about causation.

– James Tobin

In my previous post Income ≠ Expenditure?, I raised some accounting issues in a recent talk by Steve Keen. I found a paper European Disunion and Endogenous Money which has a background on this written with Matheus Grasselli of the Fields Institute, Toronto.

Let us look at their basic model which still has income not equal to expenditure. Now whichever way one presents it (with better defined terms using phrases “ex-ante”, “ex-post”, “planned”, “unplanned”, one cannot escape the conclusion income = expenditure).

The model is below – found on page 15.

Keen has a simple two-sector model of households and production firms and it can also be thought of as a three sector model where production firms borrow from banks to finance investments.

In the last equation, you see Keen and Grasselli’s claim that expenditure is income plus change in debt.

The trouble is with Keen’s behavioural assumption (1.4)

C = W + Π

Unfortunately the rules of accounting do not allow this!

If the assumption (1.4) is relaxed, firms’ increase in debt is mirrored by households’ saving.

In a three sector model with households, firms and banks, the increase in firms’ debt is mirrored as increase in households’ deposits.

It can be generalized with firms issuing some securities purchased by households.

So equation 1.8 should read:

YE = Y

with no need of Lebesgue Integrals to prove (1.8) is correct because it is not correct.

The Saving = Investment Identity

The Keen-Grasselli model doesn’t respect the identity

Saving = Investment

This can be easily seen. Households (in his language workers) having zero saving and zero investment. Firms have a saving of  ΠR  and investment of I.

So total saving = Πand total investment = I

But because these terms differ by ΔD (equation 1.5), they cannot be equal unless ΔD = 0.

So in the Keen-Grasselli model,

Saving ≠ Investment

The reason Keen and Grasselli get this inconsistency is because they assume that saving is volitional.

Basil Moore was aware of this and in his book Shaking The Invisible Hand, he wrote:

The belief that aggregate saving is the sum of volitional saving decisions by individual economic units is simply a spectacular macroeconomic illustration of the “fallacy of composition.” This fallacy has been reinforced by the unfortunate use of the colloquial verb “to save,” with its very powerful transitive volitional connotations, for an economic term which is merely an intransitive accounting definition: “income not consumed.” As economists know, it is a “fallacy of composition” that what is true for the part is necessarily also true for the whole. Total “saving” is the sum of total saving undertaken by individual “savers.” But since saving is the accounting record of investment it cannot be the sum of volitional individual saving decisions. Aggregate saving is not the sum of individual savers volitional decisions to save. It follows that in all monetary economies most “saving” is “non-volitional.”

[emphasis: mine]

Ideally (i.e., realistically) Keen’s model should sit inside a model with the government and the government would end up running surpluses. Non-volitonally :-) S = I would be maintained and so would Y= Y

Some Higher Mathematics: The Dirac Delta Function

Keen and Grasselli claim that confusions around economists being not able to see things in continuous time is the source of errors by them and that the reason is that debt injections are sudden.

Now, in calculus, there is a thing called the Dirac Delta Function.

[Paul Dirac didn’t get the media attention that Einstein got but he was surely his equivalent. The Delta function is just a small contribution when compared to what he did elsewhere. He was Feynman’s hero.]

The delta function δ(x) is zero at all points except 0 where it is infinite. But the integral of δ(x) from over the range of real numbers is 1. That is difficult to digest initially when first tries to learn it.

A debt injection is a step function jump in debt. The delta function has a curious property that it is the derivative of the step function.

So income flows can be represented as sum of delta functions which different coefficients at different points in time.

So Keen’s chart (Figure 13) in his paper should have income represented as delta function spikes.

To get the flow over a period, one has to integrate and this will result in the income over the period to be the sum of the coefficients of these delta functions.

So whether in discrete formulation or continuous time formulation, Y= Yfor the whole economy and the reason is not hard to guess because dD/dt cancels out with dA/dt since assets and liabilities are created equally.

For an individual sector it is true that Y= Y + dD/dt – nobody disagrees with that but to be more accurate the right hand side should include minus dA/dt.

Also, a continuous time formulation is just taking infinitesimal intervals and then treating infinite of them together.

It makes no sense to say income before debt injection was $100 for real world transactions in a continuous time formulation. It is actually zero just before a debt injection because all income/expenditure flows are “spikey”.

Just after the debt injection it is zero again because nobody spends the instant a loan is given. The debt injection increases assets and liabilities by the amount of the loan if the borrowing is from a bank.

So after the loan is given at the next infinitesimal, change in debt is zero and income/expenditure is also zero.

Then income/expenditure flow spikes at the moment the transaction happens – like a delta function.

But that is income for someone and for an economy as a whole Income = Expenditure.

Anyway, nothing of the analysis justifies the definition of “aggregate demand” (now renamed by Keen to “effective demand”).

Updated 14 Oct 2012 7:08pm. 

Is Paul Krugman A Verticalist?

24 years back, Basil Moore wrote a book Horizontalists And Verticalists: The Macroeconomics Of Credit Money (Cambridge University Press, 1988) which begins like this:

The central message of this book is that members of the economics profession, all the way from professors to students, are currently operating with a basically incorrect paradigm of the way modern banking systems operate and of the causal connection between wages, prices, on the one hand, and monetary developments, on the other. Currently, the standard paradigm, especially among economists in the United States, treats the central bank as determining the money base and thence the money stock. The growth of the money supply is held to be the main force determining the rate of growth of money income, wages, and prices.

… This book argues that the above order of causation should be reversed. Changes in wages and employment largely determine the demand for bank loans, which in turn determine the rate of growth of the money stock. Central banks have no alternative but to accept this course of events, their only option being to vary the short-term rate of interest at which they supply liquidity to the banking system on demand. Commercial banks are now in a position to supply whatever volume of credit to the economy their borrowers demand.

The book built on his own work and that of Nicholas Kaldor and Marc Lavoie among others goes on to describe the banking system, horizontalism and endogenous money. Money is credit-led and demand-determined was his message. Economists believing in the “incorrect paradigm” are Verticalists in Moore’s terminology.

Paul Krugman whom Post Keynesian have more respect than other mainstream economists probably disappointed them when he was arguing with Steve Keen in a 3-post blog series. Arguing like a Verticalist, Krugman claims (among other Verticalist claims) in his post Banking Mysticism, Continued:

… And currency is in limited supply — with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

The Defensive Nature Of Open Market Operations

The reason there is widespread misunderstanding of what the central bank does is because it carries out open market operations where it buys or sells government securities or does repurchase agreements. The orthodox view is that the central bank is acting the way it is to increase or decrease the amount of banks’ settlement balances and this affects the money supply – allowing banks to expand lending or leading them to contract – and thence the whole economy. The view is that the central bank has a direct control these operations and are purely volitional.

This is an incorrect view because no central bank claims to be “controlling” the money stock.

If money is truly endogenous, the question is why the central bank does these operations often. The reason is that operations of the central bank are defensive. 

In his article Endogenous Money: Accomodationist, Marc Lavoie argues:

Some post-Keynesians have pointed out long ago that open market operations had little or nothing to do with monetary policy.

For instance, It is usually assumed that a change in the Fed’s holdings of government securities will lead to a change, with the same sign attached, in the reserves of the commercial banking system. It was the failure to observe this relationship empirically which led us, in constructing the monetary financial block of our model, to try to find some other way of representing the effect of the Fed’s open market operations on the banking system. (Eichner, 1986, p. 100)

That other way is that ‘the Fed’s purchases or sales of government securities are intended primarily to offset the flows into or out of the domestic monetary-financial system’ (Eichner, 1987, p. 849).

So the central bank purchases government bonds and/or does repos to neutralize the effects of transactions which change the settlement balances. One example is the flow of funds into and out of the government’s account at the central bank. Another is the demand for currency notes by banks to satisfy their customers’ needs. The central bank has no choice but to provide these notes.

Here’s a preview via Google Books:

Also see this post Alfred Eichner And The Federal Reserve Operating Procedures.

Krugman is partly right when he says, “Banks are important, but they don’t take us into an alternative economic universe.” However he fails to see that money is endogenous and the way the banking system works show this endogeneity.

Of course, Steve Keen has issues with his models and accounting with which Krugman has troubles. Keen defines aggregate demand to be gdp plus “change in debt”. As much weird this definition is, it is double counting when investment expenditure is financed by borrowing rather than internal sources of funds. Also, if a person sells a home to another person who has financed this purchase by borrowing and the former does not make expenditure from this income, this does not increase aggregate demand – a point raised by Marc Lavoie here (h/t “Circuit” from Fictional Reserve Barking). But as per Keen’s definition it does. In his first post, Krugman seems to say the same thing as Lavoie – but in a roundabout way.

The resulting debate has however highlighted the Verticalist intuition of Krugman!

National Saving

Some of the previous posts went into the economic concept of Private Saving and Private Saving Net of Investment. For a closed economy these are:

Private Saving = Private Investment + Budget Deficit

Private Saving Net of Investment = Budget Deficit

For an open economy, we add the current balance of payments to the right of both these equations.

So we have the sectoral balances identity:


for Net Private Saving or Saving Net of Investment. Confusingly, Net Saving is used to mean Saving Net of Consumption of Fixed Capital. Consumption of fixed capital is the national accounting equivalent of depreciation but since there is a different accounting treatment, the former phrase is used.

In addition to Investment by the private sector, there’s also public investment and we need a bookkeeping concept of National Saving. 

Just like we consolidated the domestic private sector into one, we could also consolidate the whole nation for specific purposes.

First take a closed economy. Since Income = Expenditure and Saving is defined so that consumption and investment expenditures are treated differently, we have

Gross Saving = Gross Domestic Investment

To get Net Saving, one has to subtract consumption of fixed capital from both sides.

Economies however are open. Hence we need to modify the above equation. Simultaneously taking depreciation into account, we have:

Net Saving = Gross Domestic Investment – Consumption of Fixed Capital + Current Balance of Payments

Remember this Net Saving is different from the other usage which is Saving Net of Investment.

Before verifying that this is indeed the case for the United States, it is worth mentioning that the difference between saving and surplus (or financial balance) applies to the government sector as well. The following is from the Table F.8 of the Z.1 Flow of Funds Accounts of the United States.

(click to expand and click again to expand)

So in green – for the year 2001 for the United States – you see both the gross saving and saving net of consumption of fixed capital of the government sector is positive whereas the government’s budget balance is in deficit. 

This shouldn’t be surprising given we saw the same for the private sector.

Back to national saving, we can verify the identity. The current balance of payments is a nation’s income minus expenditure (only in a closed economy, these two are equal). If this is positive, the nation as a whole has a positive net lending. Else, it is a net borrower.

The identity can be seen using the numbers circled in red (and including the statistical discepancy).

The Paradox Of Thrift

The analysis above can mislead one into believing that since “saving” is a positive word, the nation as a whole should save by whatever means – such as by inducing the household sector to increase its propensity to save or aiming for a balanced budget (or worse, aiming to retire the public debt).

Both ideas are vacuous. A spontaneous increase in the propensity to save works by reducing the output and a tight fiscal stance achieves the same i.e., reducing the national saving or private saving as a whichever is the case – as a result of lower demand and output.

The Loanable Funds Fallacy

The simple accounting relations are also used in economics textbooks to promote saving in general because due to the above identity, one can be fooled into believing that a higher saving leads to higher investment. Again such ideas are promoted in public debates to argue against higher government expenditure and to even promote making balanced budget constitutional! The story goes that higher saving allows more investment because supposedly there are more funds to lend for investment.

This is based on the incorrect notion of the exogeneity of money. While this cannot be discussed in a single post, it’s where ideas of endogenous money and Horizontalism are illuminating.

Basil Moore had an article titled Saving Is The Accounting Record Of Investment, where he discusses some of the points here – never mind his claim that “total saving on an economy cannot reflect the volitional behavior of savers”. Here’s a Google Books preview:


The Mercantilists observe the accounting identity about national saving and the fact that it is related to the balance of payments and conclude that foreign trade is highly important in the growth of nations and hence well being and quality of life. The connection is that saving achieved via running a trade surplus with the rest of the world increases a nation’s net worth. To promote less consumption, the same mantra of national saving is used. So it is related to the paradox of thrift.

These ideas are used in public discussions on the problem of the external sector imbalance whether one believes in Mercantilism or not (their idea of rejection of the invisible hand). An increase in the household propensity to save (achieved by whatever means) or an attempt to reduce the budget balance by a tighter fiscal stance improves the current account balance, only because it results in a lower domestic demand and output and hence higher unemployment – all undesirable. That of course does not mean that one can unilaterally relax fiscal policy but just points to a more international effort needed badly right now to solve the problem of global imbalances.

While there is some truth to Mercantilists’ view, it’s for slightly different reasons – it is advantageous so some in one sense and injures others and hence inures everyone in the end.

Here’s Basil Moore on Keynes (from his 2006 book Shaking The Invisible Hand, pp 400-402):

In the General Theory Keynes introduced open economy considerations in his discussion of Mercantilism. He argued that the Mercantilists had been correct in their belief that a favorable balance of trade was desirable for a country, since increases in foreign investment increase domestic AD exactly like increases in domestic investment:

When a country is growing in wealth somewhat rapidly, the further progress of this happy state of affairs is liable to be interrupted, in conditions of laissez-faire, by the insufficiency of the inducements to new investment. … the well-being of a progressive state essentially depends … on the sufficiency of such inducements. They may be found either in home investment or foreign investment … which between them make up aggregate investment. … The opportunities for home investment will be governed in the long run by the domestic rate of interest; whilst the volume of foreign investment is necessarily determined by the size of the favourable balance of trade. …

Mercantilist thought never supposed that there was a self-adjusting tendency by which the rate of interest would be established at the appropriate level…

In a society where there is no question of direct investment under the aegis of public authority,… it is reasonable for the government to be preoccupied … [with] the domestic interest rate and the balance of foreign trade. … when nations permit free movement of funds across national boundaries the authorities have no direct control over the domestic rate of interest or the other inducements to home investment, measures to increase the favourable balance of trade [are] the only direct means at their disposal for increasing foreign investment; and, at the same time, the effect of a favourable balance of trade on the influx of precious metals was their only indirect means of reducing the domestic rate of interest, and so increasing the inducement to home investment.

Keynes emphasized that any domestic employment advantage gained by export-led growth was a zero-sum game and “was liable to involve an equal disadvantage to some other country.” He argued that export-led growth aggravates the unemployment problem for the surplus nation’s trading partners, who are forced to engage in “an immoderate policy that (may) lead to a senseless international competition for a favourable balance, which injures all alike.” The traditional approach to improve the trade balance has been to attempt to make the domestic export and import-competing industries more competitive, either by forcing down nominal wages to reduce domestic production costs, or by devaluing the exchange rate. Keynes argued that gaining competitive gains by reducing nominal price variables would tend indirectly to foster a state of global recession. One’s trading partners would be forced to attempt to regain their competitive edge by instituting their own restrictive policies. When nations fail jointly to undertake expansionary policies to raise domestic investment and generate domestic full employment, free international monetary flows create a global environment where each nation has national advantages in a policy of export-led growth. The pursuit of these policies will lead to a race to the bottom, that “injures all alike.

the weight of my criticism is directed against the inadequacy of the theoretical foundations of the laissez-faire foundations upon which I was brought up and which for many years I taught—against the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time.

These apposite warnings of Keynes have gone virtually unnoticed as mainstream economists have waxed enthusiastic about the benefits of liberalized financial markets and the export-led economic miracles of the Asian “Tigers,” and now the miracle of China. Modern economies have become more open than when Keynes was writing, so it is imperative that Keynes’ open economy analysis becomes better known.

The (Almost) Irrelevance Of Reserve Requirements

Earlier this week, the Reserve Bank of India reduced banks’ reserve requirements by 50bps. It’s called Cash Reserve Ratio and the RBI reduced it from 6.00% to 5.50% with effect from the following week.

The Reserve Bank of India is one of the most backward central bank in liquidity management and sometimes panics and changes the reserve requirements. Typically this happens when taxes flow into the government of India’s account at the RBI and since this is not smooth, the RBI simply doesn’t know what to do.

To me this confusion was good, because three years back when someone asked me to read about this in office, I came across this Reuters article and after reading it (and slightly before when I became interested in macroeconomics after the Federal Reserve announced a Large Scale Asset Purchase Program, popularly known as “QE”) I started having suspicions on the way economists seem to describe banking and economics. This ultimately led me to some Neochartalists’ blogs and finally to Post-Keynesian Economics.

In many countries central banks have a zero-reserve requirement, such as in the UK, Canada, Sweden, Australia and New Zealand. In the United States, the Federal Reserve imposes a requirement of 10% with additional complications.

Basil Moore in his 1988 book Horizontalists and Verticalists goes into the details of central banking operating procedures and provides a fantastic account of central banking. See pages 63-65 and 95-97 for reserve requirements.

From page 63-65:

… Fed non-interest earning reserve requirements put member banks at a disadvantage relative to non-members, who were generally allowed to hold interest-earning assets as reserves and who in addition typically had lower reserve requirements. Because membership in the Federal Reserve system is voluntary under the dual banking system tradition, as interest rates rose an increasing number of banks withdrew from the system. In desperation the Federal Reserve finally proposed to pay interest on required reserve balances. Congressional reaction to this potential erosion of seigniorage from reserve earnings was loud and swift and led rapidly to the Monetary Control Act of 1980. Its solution, to make reserve requirements universal and uniform for all depository institutions, whether members of the Federal Reserve or not, was, as revealed in the 1979 hearings before the Senate Banking Committee, a compromise clearly designed to safeguard the volume of Fed-Treasury transfers and at the same time reduce membership attrition for the Fed.

Contrary to conventional wisdom, changes in reserve requirements imposed by the central bank do not directly affect the volume of bank intermediation. A change of required reserve ratios influences the volume of bank intermediation only indirectly, by affecting the required reserve markup or spread. A rise (reduction) in reserve requirements raises (lowers) the cost of obtaining funds to place in loans financed via  additional reservable deposits, in the manner of an indirect tax. The banks will therefore raise (lower) the markup of their lending rates over their borrowing rates. As a result, depending on the interest elasticity of demand for bank credit, the volume of bank intermediation will be indirectly reduced (increased).

From pages 95-97:

… In practice the Federal Reserve fully compensates for any excess reserves created by a lowering of reserve requirements by open-market sales so as to maintain free reserves at some target level. This evidence is clearly consistent with the notion that nominal money stock is demand-determined …

There are other effects. The ECB governing council decided in December to reduce reserve requirements to 1% from 2%  January 18. This “freed up” a lot of collateral banks in the Euro Area needed to pledge to the Eurosystem, thereby providing some relief to the banking system in crisis.

Chart Source: ECB

On 18 January, reserve requirement was €103.33bn as compared to €207.03bn on the previous day.

Post Keynesian Markup Pricing

I was collecting some articles by Basil Moore and I found this table from an article In Praise Of Markets – Wage Imitation And Price Stability (unsure as to why the article is titled “praise of markets”). The article appeared in Challenge in 1982.

Post Keynesians adopt Kaleckian theory of pricing. There are two sectors – fix price and flex price.

(The following table is for the fix-price sector).

Of course, this is just a quick and dirty way of getting into Post Keynesian pricing theory which has a rich literature and has obsessed all the leading PKEists for years.

During the 1970s, wages in advanced economies rose due to the rise in the bargaining power of labour unions and this led to a wage-price spiral. As wages increased, firms increased prices in response. This led workers to demand higher wages so as to be compensated for inflation – leading to further price rises. The pricing was also complicated by increase in other costs such as energy prices which led to an increase in markup as well. When firms faced more wage costs, they borrowed more from banks and this led to a huge increase in the money stock. (I am resisting the usage of the  word “supply” for money, as it is misleading). Monetarism came to popularity as the Monetarists led by Milton Friedman were making a lot of noises and saw the relationship and used their political powers to ask central banks to “control” the money stock. When central banks responded saying they do not and cannot control the money stock, Milton Friedman declared them “incompetent”!

Some central banks were forced to bow into political pressures and had to raise short term interest rates (i.e, they still weren’t controlling the money stock, because it cannot be controlled). This had the additional complication that firms’ interest costs (on borrowings) increased and they were forced to increase prices more. In the end, interest rates was raised to such a high level that it led to a huge fall in demand and employment, even though Monetarists’ theories continued claiming that wages will fall and “free markets” will lead to full employment!

During the period (70s/80s), there were also debates about the “velocity of money” – the supposed stability of the relationship of money stock and money income. Some Keynesians try to argue that the relationship is not stable etc. However Marc Lavoie, in an article in response to a comment to his earlier article on endogenous money pointed out:

… The second point I want to raise is the question of the stability of the velocity of money. Gedeon says that an unstable velocity is the typical post Keynesian argument and she goes into a detailed  analysis of a demand for money function that would exhibit this characteristic … I do not think that the stability or instability of the velocity of money is a fundamental question since it ignores the more vital issue of causation. Provided it is recognized that money does not determine income, post Keynesians can feel comfortable  with either stable or unstable velocity.

Monetarism is no longer as popular now as it used to be, but traces can easily be found in most theories of economics such as the “New Consensus”.

Alfred Eichner And Federal Reserve Operating Procedures

Alfred Eichner was a Post-Keynesian economist known for his text Macrodynamics of Advanced Market Economies published 3 years after his death in 1988. He died at the age of 50 in an accident and at the time he was preparing to include an analysis of open economy macroeconomics in his story of how economies work.

This post is about an article/chapter he wrote (with Leonard Forman and Miles Groves)* in 1984 in a book titled Money And Macro Policy edited by Marc Jarsulic. It is a fantastic book with chapters written by Basil Moore and Marc Lavoie as well on the endogeneity of money. I discussed this previously in my post More On Horizontalism.

Google Books allows a preview of the chapter and embedding it on a webpage and I have done so at the end of this post. If it doesn’t appear properly in your browser, please let me know. Else, like me, you can buy the book :) Of course G-books won’t allow a preview of all pages due to copyright restrictions.

Eichner’s chapter (#2) is titled The Demand Curve For Money Further Considered. 

The authors start off the description with

First, the amount of bank reserves, and thus the monetary base, is not the exogenously determined variable assumed in both orthodox Keynesian and monetarist models but instead depends on the level of nominal income. This is because the central bank, in order to maintain the liquidity of the financial system, is forced to purchase government securities in the open market so as to accommodate, at least in part, the need for additional credit as the pace of economic activity quickens. With the amount of unborrowed bank reserves, and thus the monetary base, to a significant extent endogenously determined, it follows that the money supply is, to no less an extent endogenously determined as well. It is therefore a misspecification to assume that the money stock, or any of its components, is entirely exogenous, subject to the control of the monetary authorities, and then to derive a demand curve for money based on that assumption. In reality, the demand for and supply of “money” are interdependent, with no possibility in practice of being able to distinguish between the two.

Second, it is the demand for credit rather than the demand for money which is the necessary starting point for analyzing the role played by monetary factors in determining the level of real economic activity…

The authors then point out the neutralizing nature of open-market operations of the Fed. Usually this – open market operations – is presented in textbooks and in some old Federal Reserve publications as causing the amount of reserves to rise and allowing banks to increase the supply of reserves. Eichner had earlier worked with data and failed to see open market operations increasing the amount of reserves in practice. He realized that the open market operations neutralize flows:

… Thus, in the face of a fluctuating public demand for currency, flows of gold into and out of the country, variations in the amount of deposits held at the Fed by foreigners and others, changes in the amount of float and fluctuations in the Treasury’s cash holdings, the Fed must engage in open-market operations just to maintain bank reserves at a given level. This is the neutralizing component of a fully accommodating policy, and it is one reason why it is difficult in practice to relate change in bank reserves to open market operations …

What is so nice about the quote above is that Eichner knew exactly what factors affect reserve balances. At the time, “float” may have been more important than it is today. Eichner not only knew that the Treasury’s account at the Fed affects reserve balances but also holdings of other institutions such as foreign central banks – i.e., as a result of “flows of funds into or out of the Federal Reserve System” in his own words. (In the same paragraph from which the quote is taken).

Further the article goes:

An increase in the demand for credit will, to the extent it is satisfied, lead to an increase in bank deposits (especially demand deposits). This is because banks make loans by simply crediting the borrower’s account at the bank with the funds advanced. The increase in deposits will, however, require that banks maintain larger reserves at the Fed. Thus required reserves, ResR, will increase and, unless the Fed acts through the purchase of government securities in the open market to provide banks with the necessary additional reserves, banks will find themselves with insufficient reserves to meet their legal requirements… the Fed is forced to accommodate, at least in part,  whatever demand for credit may manifest itself.

The terminology “accommodating” was later made clear later by Eichner in his book Macrodynamics as operations aimed at pegging the short term interest rate whatever the economic or credit conditions. So when the Fed is not accommodating – in this terminology – it means it is pursuing a policy of raising rates at frequent intervals with an aim to impact credit and aggregate demand.

The Google Books link is embedded below.


*Chief Economist and Economic Analyst, respectively at The New York Times at the time of writing.