Tag Archives: james tobin

National Accounting As Atheism

The title of this post isn’t supposed to be taken seriously. It’s just a playful poke on Eric Lonergan’s post mentioned below.

On his blog, Sample Of One, Eric Lonergan has a post tiled Accounting as religion: Buffett, Derrida, and MMT. The post ends with the following line:

… but money is not a liability of the state.

Eric’s post is arguing with the Neochartalists but my post here has nothing to do with Neochartalism. I always find it amusing when people go “money is not the liability of the state, even though it’s technically a liability” and so on. I am going to take a different track here and make an argument like James Tobin’s brilliant 1963 paper Commerical Banks As Creators Of “Money” . I explained Tobin’s brilliant analysis in a post James Tobin, Banking And The Widow’s Cruse.

For this, I will go to a scenario in an open economy:

  • £ is the local currency and $ is the foreign currency.
  • Suppose foreigners hold £1bn in currency notes among other claims on residents. Of course in real life nobody holds £1bn in cash notes but I can always make my case more realistic.
  • Suppose the exchange rate £/$ is falling and the foreign exchange market is nervous and runaway expectations are building up on the exchange rate.
  • This forces the “£-central bank” to intervene.
  • The central bank has less foreign reserves, i.e., $s and hence asks the government treasury to issue $-denominated debt equivalent £1bn. This is done to obtain proceeds to make a sale of $s in the fx markets, with the hope that it reverses the direction of expectations.
  • The central bank sells $s worth £1bn in the foreign exchange market.
  • Foreigners who held £1bn in currency notes are the counterparties.

So liabilities have been dollarized.

Now in this story, the net asset position of the £-nation hasn’t changed. The net international investment position is the same. Only the composition of liabilities. However people who claim that “currency is not really a liability” will agree that the government has a liability in $s. In their way of counting, there is an additional liability (after netting). But that doesn’t make sense. I just walked you through transactions of equal monetary exchanges. If you think

money is not a liability of the state.

do you not see a self-inconsistency here?

In other words, the potential for liability dollarization makes accounting items such as currency notes, reserve balances at the central bank etc. as a liability in a true sense.

Moral of the post: Always start with the open economy.

Respect For Identities

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, 1997, p. 300, ‘Comment’, in B.D. Bernheim and J.B. Shoven (eds), National Saving and Economic Performance, Chicago: University of Chicago Press.

This is such a nice quote by James Tobin. Almost all economists, orthodox or heterodox would agree with it I believe.

In practice, however, economists confuse identities for behaviour and causation no end. They even confuse identities themselves. But it now seems that some think that usage of national accounting identities produces erroneous conclusions.

In a series of posts, (here and few posts before), David Glasner, the author of the blog Uneasy Money — Commentary on monetary policy in the spirit of R. G. Hawtrey, seems to be suggesting that letting identities go is the way forward for macroeconomic modeling.

Glasner says:

There are two reasons why defining savings and investment to be identically equal in all states of the world is not useful in a macroeconomic theory of income. First, if we define savings and investment (or income and expenditure) to be identically equal, we can’t solve, either algebraically or graphically, the system of equations describing the model for a unique equilibrium.

[boldening and emphasis added]

So it seems that using accounting identities in your model would lead to inconsistencies. I and a few other commenters have tried to convince Glasner of his errors in series of posts.

Some people seem to think that identities do not tell anything. The truth is not so straightforward. Identities constrain outcomes. Any macroeconomic model which does not use identities as constraints may produce non-possible states of the world.

Brad deLong confronted Glasner on Twitter with this point:

If you have time, interest and energy, please convince Glasner that accounting identities cause no issues in macroeconomic modeling.

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”.

Money Stock Determination

The recent Bank of England quarterly bulletin has interested blogosphere into what goes on to determine the stock of money.

Money can mean various things and here I restrict to the the monetary aggregates as defined by central banks – as in the referred publication. But whoever is interested in “money creation” also becomes interested in the creation of assets and liabilities, so the right question is more general.

As I had pointed out in my previous post, the Bank of England articles seriously ignore the role of fiscal policy. Winterspeak also mentions this.

So what is the answer? In my view the most systematic way of saying this via Tobin’s theory asset allocation, improved drastically by stock-flow consistent models of Godley and Lavoie.

Also there are two things – influence and determination. For example, something can have an influence on the stock of money but may not determine it.

Since economies are highly dynamic it is not easy to answer this in a single sentence but it can perhaps be said that fiscal policy, private expenditure and QE influence the stock of money but it is ultimately determined by the holders of wealth.

Of course since people generally have a Monetarist intuition, the right notion that fiscal policy, private expenditure and QE influencing the determination of the stock of money is incorrectly taken by people to mean that QE has the same effect as a fiscal expansion. Which of course QE does not.

First take private expenditure. Since we know that “loans create deposits” it can be suspected that bank credit has an influence on money. Of course this process is more dynamic as the expenditure has its own multiplier effect (not to be confused with the money mulplier!) on output and income. But bank credit determining the stock of money is stretching too much. For example, while a bank makes a house loan and creates deposits in the process, the process of securitization reduces the stock of money as ultimate buyers of the securized products exchange money with the mortgage-backed securities (MBS). And of course there’s the reflux mechanism via which economic units may reduce their debts toward the banking system.

Now take fiscal policy.  Like private expenditure, government expenditure and taxes also influence the level of aggregate demand. This has an influential effect on credit creation via effect of increased output and income on private expenditure and via the process highlighted in the previous paragraph this has an influence on the determination of the stock of money.

Also, while economic units are earning and making decisions on spending, they are also accumulating financial and non-financial assets. So they have a preference on how much of their wealth they allocate into each asset. A Monetarist would talk of an excess supply of money and this raising prices of goods and services and bringing the demand and supply of money into equivalence. But there is no need for this from an endogenous money perspective. One can have the equivalence brought about by adjustments of prices of financial assets and also adjustment of quantities of assets and liabilities held by various economic units such as banks. This is where the importance of the work of Tobin’s theory of asset allocation comes in.

Now let’s discuss QE. Large scale purchases of financial assets by the central bank – although influences the stock of money, doesn’t determine it. Also QE doesn’t have a direct influence on aggregate demand like private or public expenditure. It has indirect effects via raising prices of financial assets (which can be described by Tobin’s theory of asset allocation) and inducing capital gains and a wealth effect on consumption. The Monetarist intuition highly exaggerates the effect.

The point of my writing the post was to show that fiscal policy has a strong effect on influencing the stock of money. This happens via the strong effect of fiscal policy on output and income inducing private expenditure. Of course private expenditure needn’t be only induced and has an autonomous nature as well, so both fiscal policy and private expenditure have an effect. The effect is via a rise in output and income and this leading to a rise in wealth and economic units allocating a fraction of their increased wealth into ‘money’ (as in currency notes and deposits).

So Winterspeak is right in pointing out the incorrect statement of the Bank of England paper:

The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates.

The above quote is suggestive of a very strong influence of interest rates on private expenditure, ignores the autonomous nature of private expenditure and the role of fiscal policy.

Nick Rowe defends textbook economics over his blog and suggests some influence of QE on prices via the Monetarist hot potato process where there is an excess supply of money and via a non-equilibrium process leads to a rise in prices of good and services! But in this he mixes asset allocation decisions with expenditure decisions, as if the two can be treated as the same. In the market for goods and services, producers set the price based on costs and their markups. So it is hard to see the influence. The supplies and demands of assets are actually brought into equivalence in the financial markets rather than the market for goods and services. He may have a point but the degree to which this has an effect is low. So holders of wealth may allocate some of their portfolio into commodity funds (after having sold their bonds to the central bank) which may buy commodities in exchanges and expectations due to a price rise and speculation and myths may cause a price rise but this is quite different from his suggested dynamics. Or it may have an effect via a depreciation of the currency and change in the consumer price index due to a change in prices of foreign goods.  The question then is to what extent do what economists stress are important are actually important. 

Needless to say, the usual story from money to other things is misleading. The point however is that “how money is created” is a good starting point to understand macroeconomics.

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

Tobinesque Models

Paul Krugman writes today on his blog on James Tobin’s work:

Let me offer an example of how this ended up impoverishing macroeconomic analysis: the strange disappearance of James Tobin. In the 1960s Tobin developed and elaborated a sophisticated view(pdf) of financial markets that offered insights into things like the role of intermediaries, the effects of endogenous inside money, and more. I’ve found myself using Tobinesque analysis a lot since the financial crisis hit, because it offers a sophisticated way to think about the role of finance in economic fluctuations.

But Tobin, as far as I can tell, disappeared from graduate macro over the course of the 80s, because his models, while loosely grounded in some notion of rational behavior, weren’t explicitly and rigorously derived from microfoundations. And for good reason, by the way: it’s pretty hard to derive portfolio preferences rigorously in that sense. But even so, Tobin-type models conveyed important insights — which were effectively lost.

Compare that to his article in response to another article on Wynne Godley which appeared in the New York Times – completely dismissing Godley’s work.

Three things: first Krugman claimed earlier that we needn’t look at old ideas:

But it is kind of funny to see a revival of old-fashioned macro hailed, at least by some, as the key to a reconstruction of the field

directly contradicting what he says today.

Second – obviously not having read Wynne Godley, he missed the point that Wynne’s analysis has significant improvement of James Tobin’s work.

Third, of course, Krugman’s understanding of monetary economics in general is poor, as can be seen when he gets into debates with heteredox economists and makes the most elementary errors. So it is strange he is lecturing others on this and fails once again to acknowledge heteredox economists.

Here’s Marc Lavoie describing in his article From Macroeconomics to Monetary Economics: Some Persistent Themes in the Theory Work of Wynne Godley in the book Contributions to Stock-Flow Modeling: Essays in Honor of Wynne Godley:

As Godley points out on a number of occasions, he himself owed his formalization of portfolio choice and of the fully consistent transactions-flow matrices to James Tobin. Godley was most particularly influenced and stimulated by his reading of the paper by Backus et al. (1980), as he writes in Godley (1996, p. 5) and as he told me verbally several times. The discovery of the Backus et al. paper, with its large flow-of-funds matrix, was a revelation to Godley and allowed him to move forward. But as pointed out in Godley and Lavoie (2007, p. 493), despite their important similarities, there is a crucial difference in the works of Tobin and Godley devoted to the integration of the real and monetary sides. In Tobin, the focus is on one-period models, or on the adjustments from the initial towards the desired portfolio composition, for a given income level. As Randall Wray (1992, p. 84) points out, in Tobin’s approach ‘flow variables are exogenously determined, so that the models focus solely on portfolio decisions’. By contrast, in Godley and Cripps and in further works, Godley is preoccupied in describing a fully explicit traverse that has all the main stock and flow variables as endogenous variables. As he himself says, ‘the present paper claims to have made … a rigorous synthesis of the theory of credit and money creation with that of income determination in the (Cambridge) Keynesian tradition’ (Godley, 1997, p. 48). Tobin never quite succeeds in doing so, thus not truly introducing (historical) time in his analysis, in contrast to the objective of the Godley and Cripps book, as already mentioned earlier. Indeed, when he heard that Tobin had produced a new book (Tobin and Golub, 1998), Godley was quite anxious for a while as he feared that Tobin would have improved upon his approach, but these fears were alleviated when he read the book and realized that there was no traverse analysis there either.

Draft link here.

On Models

Ryan Decker has a blog post on DSGE models. Although I don’t like DSGE models, I think he has something nice to say about modeling:

We must get econ pundits to understand that we’re all using models, including non-economist bloggers, even if they’re not written down as mathematical expressions. Writing a model down in its entirety so that its assumptions are made explicit and its internal workings can be examined by anyone is an act of intellectual humility. It is baffling to me that people who write down their models formally so we can all argue about them are supposedly worse and more arrogant than those who think they can identify a narrative model’s assumptions and keep it internally consistent.

James Tobin had something similar to say in his 1982 Nobel lecture Money and Finance in the Macroeconomic Process (alternative link):

Theoretical macroeconomic models of one brand or another are very influential. They guide the architects of econometric forecasting models. They shape the thinking of policymakers and their advisers about “the way the world works.” They color the views of journalists, managers, teachers, housewives, politicians, and voters. Almost everyone thinks about the economy, tries to understand it, and has opinions on how to improve its performance. Anyone who does so uses a model, even if it is vague and informal.

[emphasis added]

In his 1999 paper Money And Credit In A Keynesian Model Of Income Determination, Wynne Godley says:

This paper takes a step in the right direction by incorporating EM [endogenous money] ideas into a complete, if very much simplified model of the whole economy. Writings on monetary theory commonly rely solely on a narrative method which puts a strain on the reader’s imagination and makes disagreements difficult to resolve. The narratives in this paper will all describe simulations which are grounded in a rigorous model, which will make it possible to pin down exactly why the results come out as they do.

Personally I find stock-flow consistent models extremely useful to think about the working of the world as a whole. It is when you sit down and work through the models, that you realize how complicated the whole thing is and how naive intuition isn’t good enough. Of course models aren’t the only way to study, so one needs a mix of models and a non-mathematical narrative and some empirical analysis to add colour to the story. It is true models have disadvantages but beware of people who just highlight the disadvantages and don’t know the advantages because their intuition is also a naive model of the world.

Happy Diwali

Happy Diwali

picture via bluemountain.com

James Tobin’s papers are very interesting. I have a special liking for him even though he sometimes said strange things and used a lot of neoclassical analysis. His asset allocation theory is one of the most interesting things in monetary economics.

I came across this paper from his book Essays In Economics – Vol 1: Macroeconomics titled Money And Income: Post Hoc Ergo Propter Hoc? (also available here if you neither have the book nor jstor access).

The paper is also noted and analysed in Louis-Philippe Rochon’s book Credit, Money, and Production: An Alternative Post-Keynesian Approach (p 124 – )

In this paper Tobin takes Milton Friedman to task by constructing what he calls an “ultra-Keynesian” model which he describes as

In the ultra-Keynesian model, changes in the money supply are a passive response to income changes generated, via the multiplier mechanism, by autonomous investment and government expenditure.

(note: multiplier as in expenditure multiplier and not “money multiplier”).

For some strange reason Tobin says he doesn’t believe in this model but shows how Friedman’s empirical findings (the latter’s assertion that “changes in the supply of money are the principal cause of changes in money income Y”) are all wrong especially his assertion about leads and lags. This was also noted by Nicholas Kaldor in his 1970 article The New Monetarism reprinted in his Collected Essays, Vol 6 as Chapter 1.

… Suppose the initiating change is a decision of some firms to increase their inventories, financed by borrowing. The first impact is to cause some other firms whose sales have increased unexpectedly to incur some involuntary disinvestment. It is only when that is made good by increased orders that productive activity is expanded; any such expansion will cause higher wage outlays which in turn may involve further borrowing. The ultimate effects on income involve further changes in productive activity arising from the expenditure generated by additional incomes. There is every reason to supposing, therefore, that the rise in the “money supply” should precede the rise in income – irrespective of whether the money-increase was a cause or an effect.

So much for the various tests using Econometrics by Friedman – these don’t prove anything.

Again in his 1980 paper Monetarism and UK Monetary Policy, Kaldor states:

… the change in the money supply may be the consequence, not the cause, of the change in the money incomes (and prices), and that the mere existence of time-lag – that changes in the money supply precede changes in money incomes, is not in itself sufficient to settle the question of causality – one cannot rule out the possibility of an event A which occurred subsequent to B being nevertheless the cause of B (the simplest analogy is the rumblings of a volcano which frequently precede an eruption).

Back to Tobin. He says the following from what his “ultra-Keynesian” model:

… The main point of the exercise can be made by assuming that the monetary authority provides the bank reserves as necessary to keep r constant… The monetary authority responds to the “needs of trade”. With the help of the monetary authority, banks are able and willing to meet the fluctuating need of their borrowing customers for credit and of their depositors of money.

… The financial operations of the government and the banks are as follows: The government and the monetary authority divided the increase in debt … between “high-powered money” and bonds in such a manner as to keep the interest rate on target… the monetary authority provides enough new high-powered money to meet increased reserve requirements and any new demand for excess reserves. The remainder of the increase in public debt … takes form of bonds and is just enough to satisfy the demands of the banks and the public.

An important observation made by Tobin is that because the stock of money rises following a fiscal expansion due to a rise in income, an ultra-Keynesian

… would not even be surprised if some observers of the accelerated pace of monetary expansion in the wake of a tax cut conclude that monetary rather than fiscal policy caused the boom.

Tobin shows how “every single piece of observed evidence that Friedman reports on timing is consistent with the timing implications of the ultra-Keynesian model”.

This is quite important. Somehow most observers cannot understand the role of fiscal policy and there is almost total attention given to “what the Federal Reserve is doing or going to do” by economic commentators and “experts” of Wall Street with most comments on fiscal policy being that fiscal deficit should be somehow reduced. “We are all Keynesians now” is quite misleading because most economic commentators are heavily distorted by the quantity theory of money even though sometimes they claim to not believe in Monetarism.

Anyway, have a look at Tobin’s paper Money And Income: Post Hoc Ergo Propter Hoc?

James Tobin Already Knew The Answer

Question: Are flexible exchange rates better than fixed exchange rates?

Answer: Silly oversimplified question.

In a blog post today, Paul Krugman asks Do Currency Regimes Matter? – in the context of the Euro Area. My answer to that would be James Tobin’s wisecrack:

I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem.

Of course that doesn’t mean one ties both shoes together and irrevocably fixes exchange rates (and give up the government powers to make drafts at the central bank) but the essential problem referred above – although gets diluted – doesn’t go away outside a monetary union. Also, a crucial element often missed in the discussion is the existence of the “common market” which acted as (and still acts as) a constraint on Euro Area economies to expand domestic demand.

Sadly by blurring issues such as this and oversimplifying the macroeconomics behind all this, the Euro Area was formed with the incredible lacuna.

One of economists’ fantasy is assuming the existence of a floating exchange rate regime without any need of official intervention. Although it is true for some nations, it doesn’t mean any nation can simply “truly float” and stop worrying.

In the same article A Proposal For International Monetary Reform, Tobin also points out:

Clearly flexible rates have not been the panacea which their more extravagant advocates had hoped …

although also pointing out that:

… I still think that floating rates are an improvement on the Bretton Woods system. I do contend that the major problems we are now experiencing will continue unless something else is done too.

Incidentally, I do not think Tobin tax in the foreign exchange markets is the way to go as has been pointed out by economists working in fx microstructure theory. Nonetheless Tobin’s highly important insights remain.

John Maynard Keynes’ biggest disservice to the economics profession is to not start with an open economy. In a world of free trade and free movement of capital, a nation’s biggest constraint on raising output is the “balance-of-payments constraint”. It is sad that in spite of the crisis the economic profession has not even started debating on the constraints imposed on nations due to free trade (and the whole world as a consequence).

On Effects Of QE

I am having a discussion on the effects of the Federal Reserve’s Large Scale Asset Purchases (“QE”) especially on the money stock with someone online. Here are some thoughts.

First we have to be crystal clear that there is no direct causality from money to prices of goods and services.

Now, as I highlighted in my post Some Simple LSAP/QE Accounting, QE does increase the money stock if the ultimate sellers of the Treasury securities and mortgage-backed securities are non-banks.

Let me repeat the argument here:

Let us assume the Federal Reserve buys $10bn of Treasuries. We can have two scenarios – Scenario 1: purchase from banks and Scenario 2: purchase from non-banks. (In general a mix).

Scenario 1

Federal Reserve:

Change in Assets = +$10bn
Change in Liabilities = +$10bn
Change in Net Worth = $0


Change in Assets = $0
(of which: change in reserves = +$10bn and change in Treasury securities = −$10bn).
Change in Liabilities = $0
Change in Net Worth = $0

Scenario 2

Federal Reserve:

Change in Assets = +$10bn
Change in Liabilities = +$10bn
Change in Net Worth = $0


Change in Assets = +$10bn.
Change in Liabilities = +$10bn
Change in Net Worth = $0


Change in Assets = $0
(of which change in deposits = +$10bn and change in Treasuries = −$10bn)
Change in Liabilities = $0
Change in Net Worth = $0


In Scenario 1, the Federal Reserve’s assets and liabilities increase by $10bn since it has $10bn more of Treasury securities as assets and $10bn more of reserves as liabilities. The values of banks’ assets and liabilities do not change as it exchanges one asset for another and its reserves increase.

In Scenario 2, Fed’s balance sheet changes are the same as Scenario 1. Banks see a rise in reserves (assets) and a rise in deposits (liabilities). Nonbanks’ assets and liabilities do not change – just the composition of assets (they have $10bn of more deposits and $10bn less Treasury securities than before).

So in scenario 2, there is a change in deposits and the money stock rises as a result of QE.

On the other hand, it is observed by commentators that the money stock has not increased beyond the trend rise. This however seems contradictory to the previous analysis where it was shown that the money stock rose but these observations are not inconsistent because one has to compare the factual in which there is QE with the counterfactual in which there is no QE.

Although we could not have observed the counterfactual because it is another world, the following FRED2 graph gives some hints:


A more detailed analysis would look at all the balance sheet items of banks but at this point since the divergences between loans and deposits which moved hand in hand till the crisis is significant during and post-crisis, we may ignore the rest.

So in the above graph, it can be seen that deposits have not shown any rise above trend in the factual. However since the net creation of loans goes sideways, we may think that the money stock may not have risen by the trend and followed a path similar to loans in the counterfactual.

Because QE creates deposits, it – money stock moving sideways – didn’t actually happen and the money stock rose as per trend.

Of course there is also a lot of talk on the effect of QE on asset prices. I discuss this in my post Central Bank Asset Purchases And Its Connection To Tobin’s Theory Of Asset Allocation.

I also recommend Nick Edmonds’s blog Reflections on Monetary Economics for analysis on this.