Tag Archives: neochartalism

Strong Assertions

In a recent article (from last month), Warren Mosler makes strong claims. He says:

I reject the belief that economy is strong and operating anywhere near full employment. I also reject the belief that a zero-rate policy is inflationary, supports aggregate demand, or weakens the currency, or that higher rates slow the economy and reduce inflation.

What I am asserting is that the Fed and the mainstream have it backwards with regard to how interest rates interact with the economy. They have it backwards with regard to both the current health of the economy and inflation, and, therefore, their discussion of appropriate monetary policy is entirely confused and inapplicable.

Furthermore, while I recognize that raising rates supports both aggregate demand and inflation, I am categorically against raising rates for that purpose.

The problem with the mainstream credit channel is that it relies on the assumption that lower rates encourage borrowing to spend. At a micro level this seems plausible- people will borrow more to buy houses and cars, and business will borrow more to invest. But it breaks down at the macro level. For every dollar borrowed there is a dollar saved, so any reduction in interest costs for borrowers corresponds to an identical reduction for savers. The only way a rate cut would result in increased borrowing to spend would be if the propensity to spend of borrowers exceeded that of savers. The economy, however, is a large net saver, as government is an equally large net payer of interest on its outstanding debt. Therefore, rate cuts directly reduce government spending and the economy’s private sector’s net interest income.

I don’t understand why as a heteredox author, Mosler simplifies his analysis so much.

This post is not about discussion about whether it is time to raise interest rates in the United States. It’s not the time. It is about Mosler’s claim that monetary policy works opposite to what is usually assumed.

This oversimplification can easily be debunked. If the central bank raises the short term interest rate to say 15% from 0.25%, it will obviously lead to a reduction in borrowing. Firms will reduce investment and stock building as higher rates will require them to pay higher interest and the expectation that the economy will slow down will dampen production. Households may postpone plans for purchases of new houses and take out lesser loans and those with existing loans on floating interest rates are likely to reduce consumption when faced with a higher debt burden because of higher interest payments. Further, raising rates from say 0.25% to 15% may bankrupt a lot of firms because interest payments on debt may become very high. There are also feedback effects: a slowdown of output will lead to higher unemployment and less consumption and so on. It can be argued that interest payment by one economic unit is income for another so one needs a model to see how all this works: complications such as consumption propensities of interest payers and receivers.

Of course this effect may not be so strong if the short term interest rate is raised from 0.25% to say 2% but asserting that there is no effect and that the effect is exactly the opposite is too simplified a claim.

Does that mean that rising short term interest rates is always accompanied by a lower output? No. Monetary policy is only one channel. It is possible that while the central bank is raising interest rates, other things that affect aggregate demand conditions are working to raise output. For example, the government may be raising pure government expenditure while the central bank is raising rates, or exports are rising.

Now reconsider Mosler’s point quoted above:

For every dollar borrowed there is a dollar saved, so any reduction in interest costs for borrowers corresponds to an identical reduction for savers. The only way a rate cut would result in increased borrowing to spend would be if the propensity to spend of borrowers exceeded that of savers.

Not sure what that means. Dollar is not fixed in quantity. Further an economic unit may be both a net borrower and a saver. To see this think of a simple example: Your disposable income is $1mn, your consumption is $200,000 and you borrow $4.2mn to buy a house for $5mn. Your saving is $800,000 and your net borrowing is $4.2mn. You are both a saver and a borrower. Also, I am not sure how “propensity to spend of borrowers” means, as long as one is talking of borrowing to not make purchases of financial assets: all that is borrowed is spent, so this propensity is always equal to 1.

Perhaps Mosler has in mind the debt/income ratio. In the above example, your debt/income has risen but it isn’t necessarily the case with firms as investment is self-financing. Firms may borrow more in response to a fall in interest rates. But this needn’t cause a rise in debt/income as investment is also a source of income for firms as a whole. So firms’ debt/income may actually improve.

Mosler discusses the net lending of the private sector when he is talking of “net saving” (saving less investment expenditure), which is identically the net lending. Even if the private sector as a whole sees a deterioration of their net lending position it isn’t necessarily problematic in the short run. There is no reason that this is a constant relative to output or income which Mosler implicitly is assuming.

Finally the point about interest income on government bonds: it is true that if interest rates are higher, the private sector is receiving more income from the government and this is one factor to consider among all factors which affect aggregate demand. But there is no reason to assume that this effect is always higher.

In stock-flow consistent models, one sees the long run output depend positively on interest rates. But short term, this effect isn’t always positive except in simple pedagogic models.

Mosler gives the example of Japan to show what he says vindicates him. Low rates in Japan hasn’t helped Japan. The analysis is oversimplified because output depends on so many other things than monetary policy. There is no need to make simplistic assertions. Heteredox economists will be be seen as simpletons because of analysis such as that of Mosler. Mosler’s idea of writing was perhaps to stress the importance of fiscal policy and that mainstream economists underplay the positive role of fiscal policy and exaggerate the role of monetary policy. It can be said directly instead of claiming “the mainstream have it backwards with regard to how interest rates interact with the economy.”

Massive Overstatement Of Profits?

In an article, The Profits’ Conundrum, Marshall Auerback uses Kalecki’s profit equation analysis (which is just a simple rearrangement of terms of the sectoral balances equation) to claim that corporate profits have been overstated in the United States.

Now consider the US deficit and explain how on earth we can still have profits as a record percentage of GDP.  There is no way that we can have had a fall in the fiscal deficit to GDP ratio from ten percent to three percent (we are in the middle of fiscal yr 2014 remember) without some kind of significant decline in the profit share of GDP.

But NIPA says there is no such fall.   All the people who use this sectoral balance analysis keep saying that the profit decline is coming which of course is nonsense.  If it is to be it is here and now; we are dealing with an identity.  This cannot be ignored, but it is by virtually every single Wall Street analyst.

This does pose the real possibility that we have a massive overstatement of profits.

While it is possible this is the case, I don’t see how this follows from the usage of Kalecki’s profit equation or the sectoral balances equation without any dynamical analysis thrown in.

While the government deficit has fallen, the household sector saving has fallen too and there has been a big rise in firms’ investment expenditure in recent times. So let us look at the data but before that derive the profit equation.

From sectoral balances we know that net lending (in the language of the U.S. Z.1 Flow of Funds report) of all sectors should add to zero.

Firms’ undistributed profits FU is the sector’s saving. So firms’ net lending is:

FU − If

where Iis firms’ investment expenditure.

This should be the sum of net borrowing of all the other sectors – households, government and the rest of the world: Household net borrowing + Government net borrowing + Rest of the World net borrowing

Or, in the more usual language,

FU = If  + Government deficit − Household Net Lending + CAB

where CAB is the current account balance of international payments.

Each term is a flow and has a time subscript such as −1 or 0 or 1 but I will avoid it. Now let’s compare 2013 and 2009.

We need the numbers highlighted in yellow to check what’s going on from the Fed’s Z.1 report:

Table F.8, Z.1 Q4 2013 Highlighting Corrected

(click to expand and see clearly)

Government deficit is the negative of net lending and between 2009 and 2013 this has reduced by $776.5bn. However, private investment has increased by $704.4bn and household net lending fell by $216.2bn. The change in current account balance over the period is small (line 42). So the rise in private investment and the fall in household net lending (and change in the current account balance) more than offsets the fall in the government deficit.

Also remember, reported profits is the sum of undistributed profits and distributed income of corporations. Table S.1.a has data only till 2012 but it shouldn’t be difficult to get a feel for the numbers.

Table S.1.a, Z.1 Q4 2013

(click to expand)

So the change in distributed income also has been high.

And add complications of taxes to the numbers (pre-tax vs. post-tax), the difference in profits in the last few years is even higher.

Why this exercise if you can get the profits numbers directly? To show that things do add up except for small discrepancies which are always present.

So pure rearrangements of terms of sectoral balance identity doesn’t prove the overstatement of profits as claimed by Auerback. Of course it still leaves the possibility of dynamics which lead to a contraction of aggregate demand and hence profits but Auerback’s claim is that this is purely due to accounting identities and this claim is erroneous.

Last Updated: 07 March 2014 11:27am UTC (minor errors corrected)

Neochartalism, Original Sin And The Backfire Effect

[This post is a sort of part 2 of the previous post Indebtedness And Liability Dollarization]

In the Neochartalist blogs, one frequently comes across the notion of monetary sovereignty, together with the notion of a “sovereign currency” – their notions of such things. One also sees an admission that countries whose governments have debt in foreign currency are constrained in boosting domestic demand to increase output and employment.

So this blog post by Bill Mitchell Defaulting on public debt as a way to progress has a few things to say about it.

Today I consider the idea that governments which have surrendered their sovereignty either by giving up their currency issuing monopoly, and/or fixing their exchange rate to the another currency, and/or incurring sovereign debt in a foreign currency might find defaulting on sovereign debt to be their best strategy in the current recession. I consider this in the context that any government that has surrendered their sovereignty is incapable of pursuing policies across the business cycle that serve the best interests of their population. While re-establishing their currency sovereignty may not require debt default, in many cases, default will necessarily be an integral part of the move back to full fiscal sovereignty. This is especially the case for nations that have borrowed in foreign currencies and/or surrendered their currency issuing capacities to a common monetary system. So here are some thoughts on when default is a way for a nation to progress.

[boldening: mine]

and then goes on the present the “balance-of-payments constraint” story as a mainstream economics story.

Now, it is clear from the above quote that Mitchell admits that nations with government have a constraint on fiscal policy. But the more troublesome fact is that he presents it as if the government doing this had some full volition to not have been indebted in foreign currency.

Incidentally Randy Wray writes a post – his latest and admits nations face a balance-of-payments problem and makes it look as if he has not shifted his extreme views:

I am not flippant about the many real constraints faced by a poor, developing nation. At an early stage of development, imports are very hard to get. The national currency faces little external demand. The world doesn’t want the nation’s produce, so it cannot export. Borrowing foreign currency can easily lead to excessive debt service and financial collapse.

Neither floating nor fixing is going to easily resolve these problems. That MMT does not have an easy solution to them does not, in my view, prove that MMT is flawed. My suspicion is that floating the currency and taking advantage of the sovereign’s ability to spend domestically is a step in the right direction. Capital controls are probably necessary—even more so if the country does not float. Foreign aid is probably necessary to finance needed imports.

[emphasis: mine]

Oh yeah doesn’t prove that the muddle which has come to be known as “modern monetary theory” is flawed? Wow!

But let’s get back to government borrowing in foreign currency. The original sin hypothesis is that many nations actually do not have a choice but to borrow in foreign currency. Now I won’t repeat the argument of the originators but present my own to argue that the hypothesis is roughly right. But the originators’ solution – creating policies to increase the size of financial system is far from a good solution.

Here’s how: What determines the trade balance? Imports depend on income and the income elasticity of demand for imports and exports the same but different elasticities. Now, there is also a price angle to this, but without much argument for now, Post-Keynesians argue that non-price factors are more important. Roughly this is because price is just one aspect of why the ultimate economic unit (consumers/households and producers purchasing machines for example) buys what it buys.

In neoclassical theory, absolute advantage any producer has doesn’t last long and is eliminated presumably because of the “price mechanism” and it is only comparative advantage which matters. And there is a market mechanism which resolves imbalances supposedly. But in a world full of giant corporations based in a few nations, this is hardly a good assumption. Worse, comparative advantage story is the reason used to push free trade agreements between nations. And since imbalances are rarely resolved by price adjustments, neoclassical economists start blaming the government – as if governments cannot solve the problem by coordination.

And the “income elasticity of demand for imports” is what non-price competitiveness is about. It is true price adjustments have a role to play but this has been massively exaggerated by economists.

That’s a model way of saying that competitiveness is important and that in a world of free trade, if domestic demand is boosted and if exports aren’t growing sufficiently fast, a fast rise in output will lead to an income-induced effect on imports and the balance of payments will deteriorate.

Ignoring revaluation gains/losses, a current account deficit implies a rise in net indebtedness to foreigners (or a fall in net international investment position in general). Non-residents are continuously making choices on their portfolio allocation and based on their preferences allocate their wealth into various assets including the liabilities of resident economic units of the nation we are discussing. In general they prefer a mix of assets in domestic and foreign currencies and such things depend on a lot of things such as expected returns on assets, expectations of the movement of the exchange rate and so on. At one extreme is the case where all liabilities of residents to non-resident are denominated in the domestic currency. If this increases, the exchange rate may move to clear the supplies of assets and liabilities. But it is possible that no movement of the exchange rate – while still maintaining external stability – may clear the market and only if the government adjusts its liabilities in various currencies so that the stocks of assets and liabilities are consistent with international investors’ portfolios will it lead to some stability in the foreign exchange markets. In practice the adjustment is also from the asset side: central banks sales of foreign currency in the foreign exchange market. So with the risk that the exchange rate may become unstable, central banks or the government Treasury – sometimes via their “exchange stabilization fund” issue debt in foreign currency. And unable to take protection for trade in goods and services, they suffer when balance of payments deteriorates.

So the Neochartalist story that somehow the government shouldn’t borrow in foreign currencies is vacuous. Only a few nations have the ability to attract investors to purchase their debt in domestic currency and typically these nations are successful in international trade. But this by no means guarantees continued success – if net indebtedness to foreigners keeps rising relative to output because trade in international markets for goods and services turns weak, then output gives in. And a shift in investors’ portfolio preferences also can lead to the original sin, even if one starts with zero government debt in foreign currency.

In general however, success in international trade leads to further success and failure leads to more failure. And the latter are unable to increase domestic demand by fiscal or monetary policy. Hence we see the massive differences in the national income of nations.

The culprit of all this is of course free trade. Economists now admit they had been incorrect on things such as capital controls (ie their pre-crisis notion that capital controls are bad) that but nobody wants to change the current rules of the game in international trade in goods and services. If anything more free trade is imposed.

Now the backfire effect: in the “modern monetary theory” blogs, examples such as those of Pakistan are presented as if it was Pakistan’s policy makers huge error to have borrowed in foreign currency and to their fans this appears to strengthen the view that in the supposed world which the Neochartalists fantasize, there is no balance-of-payments constraint. And the error is the failure to recognize that “money” has an international aspect in addition to what it has to do with the government and banks.

At present, the solution is for the world leaders to provide a coordinated fiscal expansion and induce the creditor nations to increase domestic demand and hence increase latter’s level of imports. But the long term solution is to move away from a system of free trade. And that is far from the “MMT” overkill description of the world and overly simplified solutions.

Updated: 25 Feb 2014, 3:12 AM UTC

Indebtedness And Liability Dollarization

In the previous post, I commented on Neochartalists’ questionable intuitions on the external sector of an economy – let me add more. There is a silly notion in there that somehow public debt held by foreigners (but in domestic currency) is not debt in ordinary sense at all and things such as that. I will try to show that this is highly misleading. So supposedly since (if) the government can make drafts at its central bank, it doesn’t owe anything in the ordinary sense. This is the worst economic intuition.

First, the Neochartalists start on the wrong foot by using phrases such as “non-convertible currencies” when starting discussions. This is dubious. All currencies are convertible. First official convertibility still exists and second market convertibility is the more important one. The official and legal language use the phrase convertible and convertibility and one frequently sees discussions of FCAC – achieving full capital account convertibility. So it is distortion of language to say some currencies are non-convertible and so on.

I will try to outline how this intuition arises. First, a closed economy doesn’t have a national debt. People mix the phrases public debt and national debt but as if that is not enough, they mix up the concepts as well. So let us be clear:

public debt = debt of the public sector, and,

national debt = net indebtedness of all resident sectors to non-residents (including equity securities held by foreigners).

And a closed economy has no national debt.

So the “national debt” is the negative of the net international investment position. Of course, the phrase “external debt” is used sometimes to count only debt which is not equity securities but this notion is slightly misleading. Also because financial assets are identically equal to liabilities, some nations are creditors and others debtors.

Of course, the world as a whole can be thought of as a closed economy but the difference is that is different from a textbook closed economy which has a single currency and a single central government.

So a closed economy doesn’t have a national debt to begin with because there are no foreigners to begin with. The public debt is a mirror of the private sector stock of financial assets (net). So the government can expand fiscal policy to increase demand and output and is only constrained by the nation’s capacity to produce and inflationary pressures. Any challenge to the public sector by the financial markets can be taken care of because the government will have the ability to make drafts at the central bank. It is true that a portion of the income generated by output goes to bond-holders, but it can easily be shown that this doesn’t rise in an unbounded way.

So far nothing “MMT” – a standard notion known from ages to Keynesians such as Nicholas Kaldor to James Tobin.

But the Neochartalists (“MMTers”) extrapolate this notion to mean any official debt held by non-residents is not an issue  – in select cases by bringing in the phrase “sovereign currency”. Monetary sovereignty is a concept existent before Neochartalists started writing but this phrase “sovereign currency” is slightly dubious. Mainstream economists on the other hand have confused the issue of talking of the public debt as if it is the national debt.

So suppose we start with a scenario in which the public debt is 100% of GDP, the private sector’s net stock of financial assets is 40% and the net indebtedness of all sectors to foreigners is 60% of GDP. One can think of more general situations but let us suppose for simplicity that the 60% held by foreigners is the debt of the central government in domestic currency. What would have led to this configuration of stocks? Current account deficits mainly. A current account deficit means a fall in assets held abroad or a rise in gross indebtedness to foreigners or a mix of the two – meaning a rise in net indebtedness to foreigners. Of course, this is not the only way – revaluations of assets and liabilities, both due to the movement of exchange rates and a change in the price of assets and liabilities can affect the international investment position, but a lot of it typically is due to current account balances.

So is this 60% not debt at all in the ordinary sense of the word? Well as long as foreigners have the ability to redenominate the debt, there is an issue. This process by which debt in domestic currency is converted to debt in foreign currency is called liability dollarization. Of course this involves the intervention of the central bank in foreign exchange markets but the alternative to let the currency find its course when there are destabilizing forces acting is silly.

How can this happen? One simplified example. Suppose the value of the domestic currency is given by FC 1 = DC 1,000. Around this point, foreigners sell public debt in domestic currency in large quantities, but let us say they sell DC 1tn worth of public debt in domestic currency to resident banks and exchange the currency for foreign currency with banks acting as dealers in the foreign exchange market. Assuming banks are at overdraft at their foreign correspondent, at this point, banks’ assets and liabilities have increased by DC 1tn and for foreigners, the composition of claims on residents has changed. Now suppose the central bank intervenes at this point and makes an exceptional financing transaction by borrowing FC 1bn of foreign currency from non-residents and selling it to resident banks and makes a compensating transaction (usually called ‘sterlization’ – a misnomer) with banks by buying the government bonds from them. The banks then use the foreign currency to close their open position. The result of these series of transactions is that the composition of the debt to foreigners has changed from domestic currency to foreign currency, with the public sector now left with debt in foreign currency equivalent of FC 1bn. So the debt in domestic currency has dollarized and surely the ones with the dubious intuition that debt in domestic currency “is not really debt” will agree that now the government appears indebted.

(Alternatively one can think of the central bank losing foreign reserves from its existing stock and later making exceptional financing transactions to borrow in foreign currency to replete the lost reserves).

So in the above, a debt of DC 1tn of the government (in domestic currency) was dollarized to FC 1bn (in foreign currency) during a process in which the the foreign exchange markets forced the hands of central bank to intervene. Under what conditions do these happen? According to an IMF paper Official Foreign Exchange Intervention:

Disorderly market conditions are characterized by illiquidity in the foreign exchange market, wide bid-offer spreads relative to tranquil periods, and sudden changes in foreign exchange market turnover and order flow.

Of course there are other characteristics such as widening of long-term bond yields, widening of interbank rates, increases in forward premia in the foreign exchange markets and so on.

So much for the intuition that debt in domestic currency to foreigners is something special. It is but in a different sense: as long as foreigners continue to hold debt in domestic currency, international investment position is protected from revaluation losses for the nation. That is completely different from the vacuous punchline found in Neochartalists’ blogs that the “government debits securities account and credits reserves account”, to mean indebtedness to foreigners is not an issue. As long as the risk of liability dollarization exists, the naive intuition mentioned earlier fails. A lot of things written float on the wings of the almighty dollar, because although the United States is a net debtor of the rest of the world, there are several complications in the analysis of its balance of payments – complications which allow an economist to interpret things any which way he prefers.

The problems of the world are not easy to solve because of imbalances. One needs efforts to reverse these imbalances with an expansionary bias rather than a deflationary bias as is the case now. And it is quite different from the Neochartalists’ Panglossian notion of simply deficit spending and ignoring the income-induced effect on imports of the rise in domestic output. But for them, continuous current account deficits are not imbalances: Imbalances? What Imbalances? as the title of a paper says, sugarcoating it as a “dissenting view”.

Thomas Palley Dismembers MMT

Thomas Palley has written another critique of Neochartalism aka “Modern Monetary Theory” in the blogosphere.

Title and abstract:

Modern money theory (MMT): the emperor still has no clothes 

Eric Tymoigne and Randall Wray’s (T&W, 2013) defense of MMT leaves the MMT emperor even more naked than before (excuse the Yogi Berra-ism). The criticism of MMT is not that it has produced nothing new. The criticism is that MMT is a mix of old and new, the old is correct and well understood, while the new is substantially wrong. Among many failings, T&W fail to provide an explanation of how MMT generates full employment with price stability; lack a credible theory of inflation; and fail to justify the claim that the natural rate of interest is zero. MMT currently has appeal because it is a policy polemic for depressed times. That makes for good politics but, unfortunately, MMT’s policy claims are based on unsubstantiated economics (The full paper is HERE).

To me, the most striking contradictions of what’s called Modern Monetary Theory is the notion that external constraints go away and a nation simply has to float its exchange rate in the markets.

Palley points out:

What is bizarre about this defensive invocation of flexible exchange rates is that it does not work and it also puts MMT in the company of Milton Friedman (1953), who was the ultimate booster of flexible exchange rates. Friedman argued that exchange rate speculation was stabilizing because profit-seeking speculators would close the gap between the exchange rate warranted by fundamentals and the actual exchange rate. They would sell when the exchange rate was over-valued relative to fundamentals, and buy when it was below. Such arguments run counter to the destabilizing speculation logic of Minsky’s (1992) financial instability hypothesis, with which MMT claims close affinity.

So in recent times, Turkey is good example because of its large current account deficits. It’s exchange rate keep plummeting and CBRT – the central bank had to massively raise interest rates to prevent a runaway exchange rate. And this came after a huge central bank intervention of selling foreign reserves which didn’t soothe nerves of creditors.

USDTRYchart credit: netdania.com

Paradoxically the government of Turkey issued a 31-year US dollar denominated bond to augment foreign reserves, yet again dispelling the Neochartalists’ notion that somehow governments can choose to be not indebted in foreign currencies.

I guess to the blog reader, Neochartalism comes out as something new because he/she is likely not aware of Post-Keynesian economics anyway but as Palley points out, ‘the criticism is that MMT is a mix of old and new, the old is correct and well understood, while the new is substantially wrong’.

Strange Claims About KfW

Earlier, I had two posts on this but now these have been merged into one. 

Chartalists again!

This blog post The fiscal role of the KfW – Part 1 by Bill Mitchell of Australia makes the most exorbitant claims about an institution called KfW and the government of Germany.

Bill Mitchell claims:

It is a major reason why the public debt ratio in Germany is 80 per cent rather than close to 100 per cent. It is a major reason why the federal deficit has been reduced without scorching the German economy. It is a story about smoke-and-mirrors accounting, German-style.

This is a bizarre claim. For Mitchell’s claim on the deficit to be valid, KfW should be a net borrower each year of a big size. For the claim on the public debt, KfW’s net indebtedness should be large. If Mitchell means anything other than this when saying “fiscal role”, what is it?

Unfortunately for Mitchell, KfW is a net lender to the private sector and the rest of the world sector in the flow sense and a net creditor in the stock sense.

First, Germany’s 2012 GDP was €2.666tn (source: OECD.StatExtracts) and 1% of that is about  €26.66bn and 20% of GDP is €533bn.

Here’s the 2012 financial report of KfW.

Let’s get an order of magnitude of the numbers. The net lending of KfW would identically be its undistributed profits minus capital expenditure. KfW doesn’t distribute profits (page 10 of the report) and so its undistributed profits is equal to its profits. Page 66 of the financial report says 2012 profits is €2.38bn and capital expenditure is negligible (page 72).

Hence KfW is a net lender and not a net borrower!

In other words, Prof. Mitchell seems to present a story in which the German government is using KfW as a tool to have a higher budget deficit than what it shows in its own books but it is in fact the opposite. This is because the combined entity KfW + Government of Germany has a lower deficit than the deficit of the government of Germany.

Moving to the balance sheet, its size is about €511bn – also quoted by Mitchell. But the size is not the main thing here. It is whether KfW is a net debtor or not. The balance sheet (page 68) says that equity is about €20.69bn. Of course, the item equity doesn’t by itself say anything about net indebtedness – an economic unit can possibly have a large net worth (in this case with no stock market shares issued, the same as equity) and yet be a net debtor if it holds a large proportion of its assets in non-financial form. The balance sheet however suggests that this is not the case – property, plant and equipment and intangible assets are small compared to other numbers.

Hence KfW is a net creditor and nothing like an institution with net indebtedness of about €533bn (100% minus 80% of GDP, see the quote at the start of this post.)

This was for 2012 but for other years just mirror the analysis – different numbers but of order of magnitude like these and nothing like what Prof. Mitchell interprets them to be. Supposedly, according to him, KfW

It spends, I mean lends millions each year at very low rates … pumps millions of Euros in the domestic economy and the export sector.

I suppose it subsidies lending and the fiscal part is how these subsidies are calculated and not the amount of lending which Mitchell seems to present by saying “pumps millions of Euros”. These lending flows are not like a government expenditure flow.

And spending is not lending!

In other words, the subsidy provided indirectly by the government via KfW. This can perhaps be estimated by the profits of a domestic bank of similar size or by some similar sort of comparison – and estimating what profits would have been otherwise. After this one would compare it to various numbers in the government budget. This however in my opinion will be nothing like what Mitchell makes it out to be.

Further Bill Mitchell makes another claim:

There are three reasons to look closely at the KfW:

1. It played a role in the Deutsche Telekom (so-called) privatisation, which helped the German government slip out of an embarassing excessive deficit procedure in 2004. Sleight-of-hand is the best description for what happened.

Except that there was no sleight-of-hand.

In national accounts such as in the 2008 SNA, items such as privatization appear in the financial account and perhaps sometimes in the “other changes in assets accounts”. This ECB Convergence Report June 2013, page 68, box 6 says:

a reduction in financial assets (as a result of privatisations for instance) tends to reduce the borrowing requirement as it generates cash, while leaving the deficit unchanged.

In other words, the privatization of Deutsche Telekom has no effect on the deficit. It reduces the public sector borrowing requirement and the public debt, but the private sector net worth doesn’t change at the time of the transaction. So it is not as if the private sector holds more of financial assets as a result of the privatization. It may see holding gains but that is a different matter.

At any rate, what would have been the alternative to bring the gross public debt down to meet the debt-deficit-criteria? Attempt to deflate German domestic demand and consequently demand and output in the rest of the Euro Area?

Also, even if one counts the effect of privatization in the deficit, it would have Germany’s deficit from 4.3% to 4.2%. As a commentator in Billy Blog writes:

Take for instance the purchase in November 2003, which according to you was done as a result of the pressure from the EU in reducing the deficit. The KfW purchased about 200 Million stocks, wow, sounds impressive… except the actual value of those stocks was only about 2.5 Billion €. The german deficit in 2003 was 89 Billion € or 4.2% of the GDP, so without the KwF buy it would have been… 4.3% (if you round up generously). The KfW buys and sells had no practical relevance for Germany either going below or above the deficit rule of the Growth and Stability Pact – the sums involved were simply not big enough for that.

Thus, the entire story about the supposed fiscal role of the KfW is incorrect.

More Strange Claims On KfW (10 Dec 2013)

Phil Pilkington writes in defense of Bill Mitchell in response to my previous post Strange Claims About KfW [Updated].

Pilkington’s errors are simple accounting errors and misunderstanding of flow-of-funds. Pilkington seems to assume the same logic of Mitchell. According to him:

The trick is that this borrowing doesn’t appear on the government balance sheet so, given a level of aggregate net expenditure equal to,

[Government Deficit + KfW Lending],

the Federal deficit is lower than it would otherwise be if the government had to foot the bill for all this expenditure.

First, the government would not have to “foot the bill for this expenditure” if it were to lend directly to the private sector on its books because the lending would not be “expenditure” but a loan by the government and it would be making a profit on it. The loan would not add to the budget balance even if the government were to directly lend. The expenditure would be for the firm using the proceeds of the loan and it is not public expenditure. Pilkington seems to confuse income/expenditure flows with financial flows. Or in the language of the 1993/2008 SNA confuses current accounts with the financial account.

In fact the profits if the government were to lend directly would reduce the federal deficit by a bit, not increase as claimed by Pilkington.

Further Pilkington seems to assume that another counter-factual in this case is less borrowing by the private sector and hence lesser private expenditure. No! this counter factual is the private sector borrowing from other banks – i.e, private banks. Why would German firms find difficulty in borrowing if they happened to show their creditworthiness to KfW?

Also, as I highlighted in the previous post, a proxy for the subsidy would be the profit of the bank of a similar size minus the actual profit of KfW. It is nothing like Mitchell’s rabble-rouse.

Updated 10 Dec 2013 930pm UTC.

Endogeneity Of Budget Deficits

In this New Economic Perspectives post Randy Wray and Eric Tymoigne confuse accounting identities with behaviour.

In a context, the bloggers claim:

… Only a government deficit induced by fiscal policy leads to net saving.

where “net saving” is saving net of investment.

This posits a one-way causality of the sectoral balances accounting identity S − I = G − T from the right to the left.

This is inaccurate because of the endogeneity of the budget deficit which Wray himself is aware of but nonetheless confuses. This is because private expenditure may lead to a change in output and tax flows which may change the sign of the private sector balance (S minus I)

Suppose the private sector is in deficit and the government budget in surplus and the household sector drastically reduces its propensity to consume. This will lead to a fall in output and income and hence reduce tax flows to the government even if fiscal policy hasn’t changed (government expenditure and tax rate decisions haven’t changed) and the private sector’s balance can turn into a surplus from a deficit position.

That’s what endogeneity of the budget balance is all about. [Some government expenditure may change because of social transfers but the magnitude of this may be much lower than other things involved such as the private sector balance or changes.]

Second, it ignores the external sector.

Moreover the authors make another claim:

Monetary policy can change the composition of net saving by buying financial assets in the domestic sector in exchange for government currency, but it cannot change the size of net saving, i.e. the net accumulation of financial assets.

Cannot change the size of private sector saving net of investment?

Suppose the private sector is in surplus and interest rates are high. The central bank reduces interest rates drastically to induce the private sector’s expenditure to rise. If there is a large rise in investment for example, the private sector can go into a position of a deficit. It is true that the private sector may want to target a small surplus but this isn’t the case always and the private sector can remain in a deficit for long – not necessarily due to fiscal policy.

In the opposite case/scenario, starting from a case of a private sector deficit, suppose the central bank drastically raises interest rates to the point of causing the economy to go into a recession. The private sector balance may rise as people save more and output will fall, leading to lower tax outflows to the government and hence changing the private sector balance.

Some humility is needed by a few people who incorrectly seem to think they know how the world works with confused language such as “taxes aren’t revenue”!

Last edited 3 Dec 2013 9:52pm UTC (Minor errors/typos and grammatical errors fixed)

Firestone Backfiring More

So I happened to get a reply from Joe Firestone on my reply to his blog post.

I don’t have too much patience for going back and forth but a few points stand out.

I created a situation in which the current account balance of payments is at 4% of GDP, private sector balance is at 2% of GDP and the government budget balance at 2% surplus.

Joe Firestone thinks it is necessarily a contraction. Here is quoting him:

Ram, in the situation you’ve described, the Government is running a surplus of 2%, so it’s destroying net financial assets that would otherwise be flowing to the private sector if it had a smaller surplus, a balanced budget or a deficit. The budget surplus isn’t high enough, given the size of the trade surplus, for the Government to be causing a negative accumulation of NFAs in the private sector; but that doesn’t mean that the Government’s fiscal policy can be called “expansionary.” In fact, it’s contractionary relative to even a balanced budget, much less a deficit.

[boldening: mine]

First Firestone confuses “private sector”. According to him the private sector has a negative net accumulation of financial assets! (when given it has +2%!).

Second he fails to understand that the budget deficit is an endogenous variable – he has been conditioned to think that a surplus budget is necessarily contractionary. He cannot see that in the given situation fiscal policy can be expansionary. Firestone seems to compare it with a situation in which the budget would have been in deficit or surplus. Actually he should be comparing it with the previous periods. Moreover, even if compared to a situation where the budget could have been in balance or in deficit (future scenario) it doesn’t mean 2% surplus is more contractionary. All that matters is how the private sector responds to the expansion. A fast expansion can improve private sector expectations about the future and they may respond by higher production than the case if the government indicated a weaker expansion. [update: a fast rise in production due to a faster expansion – meaning a combination of higher expenditure and/or tax rate cuts may bring the budget into surplus because of higher total taxes resulting from higher national income, as compared to a less expansionary policy]. Plus there are other things such as deregulation, monetary policy etc. You cannot conclude 2% surplus is more contractionary than a balanced budget.

But more generally to the basic point, he concedes that net HPM creation is not NAFA even though this was an important point in his post.

So he says;


Net HPM creation is not equal to private sector NAFA.

Again, I didn’t say or imply that it is. if you think I have, then please quote me.

Here is from his original post:

High-powered money includes cash money and reserves emanating from the Government, including the Federal Reserve. If there’s no deficit spending the Government is destroying as much money through taxation as it is spending/creating. And so, it is not doing any net high powered money creation.

He uses the example of a balanced budget to show that balanced budget does not do “net high power money creation” – as if a deficit does net high powered money creation.

Fact is even if the government is in deficit, the HPM created due to expenditure minus taxes is offset by bond issuance. So even a deficit doesn’t directly do any net high power money creation.

Now, imagine a closed economy situation with 10% reserve requirement instead of 0%. Also assume the private expenditure is rising relative to private income and the private sector is in near zero balance. This leads to higher domestic demand and higher bank borrowing. Banks will need more reserves due to higher borrowing to satisfy higher reserve requirements. In such a situation the central bank would provide HPM to banks but the government budget is balanced as a mirror image of the private sector balance.

So we have a situation in with a balanced budget and net HPM creation!!!

But some souls are forever confused!

Once again, fiscal policy is highly important and the most important thing driving real demand generally speaking but no overkills please.


There is the question – what is net high power money creation.

First, since the government’s expenditure, taxation and bond issuance and actions of the central bank lead to creation/destruction of HPM, net can simply mean the flow of high powered money or ΔHPM in any period of accounting. Here deficit is not needed for ΔHPM to be positive.

Second, Joe Firestone perhaps is thinking of non-borrowed reserves. Again, even in this situation, a deficit is not needed for non-borrowed reserves to be positive. Let us say in one period, the government’s budget balance is zero and banks require more reserves. In this case, the central bank can create HPM by outright purchases of government bonds, so again balanced budget doesn’t imply zero increase in nonborrowed reserves in any one period.

There is always a third possibility but then what is it?

Firestone Backfiring – An Unfriendly Critique ;-)

Firestone's Gun

Joe Firestone’s gun

Joe Firestone has a blog post critiquing Marc Lavoie’s critique of Neochartalism.

Among other things, he seems to have issues with Marc Lavoie’s critique of the Neochartalist claim [which he quotes] that

. . . the creation of high powered money requires government deficits in the long run; . . .

Firestone states:

High-powered money includes cash money and reserves emanating from the Government, including the Federal Reserve. If there’s no deficit spending the Government is destroying as much money through taxation as it is spending/creating.

The trouble with Neochartalism is that Neochartalists and “MMT” fans go to over-overkill levels to show the importance of fiscal policy. In general it is a mix of doublespeak and outright incorrect statements and it is highly unacademic and unscholarly.

Firestone is mixing various things. HPM or “high powered money” is different from the net financial assets created by deficit spending of the government.

To see this point, first imagine an open economy in which there is a current account balance of payments surplus of say around 4% of GDP for over 10 years or so (some proxy for “long run”) and the (domestic) private sector “NAFA” – net accumulation of financial assets is around 2% of GDP. The government budget will be in surplus – as a matter of accounting. This needn’t cause any trouble for the private sector.

Of course this doesn’t take away the role of fiscal policy and in no sense is the above statement meant to propose a policy for the government to be in surplus. In fact since the government’s budget balance is endogenous, it could well be the case in the above situation that the government’s fiscal policy is expansionary.

HPM is a different matter. The central bank can easily provide banks with reserves via open market operations or direct lending. Deficit spending is not really needed.

It may also be the case that while taxes flowing into the account of the government at the central bank is “destroying” more HPM than what expenditures is creating, net redemptions of government bonds (as the government is retiring debt) is creating HPM.

Now consider another case but a closed economy.  Assume that the private sector NAFA is negative for many quarters/years and the government’s budget is in surplus. This by itself is not a problem for HPM but may become unsustainable because the nonfinancial sector can start to have liquidity pressures – i.e., financial assets/income of the private nonfinancial sector may start to deteriorate even though net wealth/gdp is not falling (wealth includes nonfinancial assets such as firms’ fixed capital and households’ houses) and this may lead to more financial fragility.

Again, fiscal policy can be expansionary even with a surplus budget because the government budget balance is endogenous. Cannot be found from the above given data.

But Firestone blurs such matters giving the reader an impression that the private sector is losing assets and sees a reduction in output and income. And to the basic point, this has really little to do with HPM.

Firestone is highly confused and muddled when he says

Lavoie seems to think that net high powered money creation isn’t necessary for an economy, even if it is good to have.

Net HPM creation is not equal to private sector NAFA.

In fact typically the government’s cash flows do not affect the HPM when looked over larger time intervals. Expenditures add to HPM as the government moves its balances from its account at the central bank and taxes do the opposite. Bond issuances reduce HPM and redemptions increase it. Over short intervals, the flows are offset by central bank operations. Also for the wonkish, this needn’t always be the case: when there is a flow out of the government’s account at the central bank, it can simply lead to reduction of banks’ daylight overdrafts instead of increasing HPM. Firestone confuses cash flows with deficits.

Fake Trade-Offs

Elasticities for one last time for now.

Recently Tom Palley wrote a fine critique of the Neochartalist approach to solve the world problems with oversimplistic solutions. Among other things, Palley challenges the simplistic Chartalist solutions due to dilemmas posed by the external sector.

Bill Mitchell of Australia wrote a reply in which he states the following:

It is easy to see that a Job Guarantee model requires a flexible exchange rate to be effective. We can identify two external effects. First, given the higher disposable incomes that the Job Guarantee workers would have compared to if they were unemployed imports would likely rise.

With a flexible exchange rate, the increase in imports would promote depreciation in the exchange rate. We should expect the current account to improve and net exports increase their contribution to local employment. The result depends on the estimates of the export and import price elasticities. The body of evidence available suggests that import elasticities are small (around –0.5).

This is a typical oversimplistic and incorrect approach.

First, Mitchell incorrectly claims that import elasticities are low for Australia citing a “body of evidence”. The number he quotes is price elasticity. He hides away from income elasticity. I suppose he thinks that the numbers estimated are “low” enough not worthy of mention. Unfortunately it is not.

Second, he claims that as a result of running an employer of the last resort by the government, the Australian exchange rate would fall and this would actually lead to an improvement of the current account.

This is a primitive neoclassical argument. While it is true that a depreciation of the Australian dollar would act to reduce imports due to price effects, it is no guarantee to reduce the trade imbalance. This is because if incomes rise faster, the trade imbalance may be rising (i.e., imports are rising) even if the Australian dollar is depreciating. Note that is different from the J-curve effect. Exports on the other hand depend on the competitiveness of Australian producers and demand conditions in the rest of the world and hence improvement of exports is dependent on how the rest of the world grows which cannot be assumed arbitrarily.

[Incidentally, producers in other nations may be even less competitive than Australian producers – thereby implying a stronger constraint on those nations because exports may not be rising as fast]

Funnily, the blog posts claims in one place that imports reduce and later that it increases. In that discussion, Mitchell seems to be addressing imported inflation – a somewhat less important detail here in this post.

Third and the most important point is since the exchange rate is not under official control, there is no guarantee that the exchange rate will depreciate. It may appreciate and stay at appreciated levels for an uncertain period till the net indebtedness of Australia rises to alarming levels.

I suppose Mitchell believes there cannot be a crisis because according to a 2008 paper coauthored by him, There is no financial crisis so deep that cannot be dealt with by public spending. Ironically during the global financial crisis which started in 2007-8, Australian banks went into a heavy US dollar funding problem which had to be resolved by the Reserve Bank of Australia using its credit lines at the Federal Reserve (via swap lines). This puts his huge claim that crises can simply be solved by public spending into pieces.

Now, if incomes rise in Australia, this has the adverse effect of deteriorating the balance of payments which Mitchell denies reguarly. Of course in real life, Australian authorities won’t like a deterioration. Here is where the fake trade-off of the employer of the last resort proposal comes in.

If incomes are to not rise because imports have to be kept under check, then the ELR is simply a redistribution to the ELR employee out of taxes. This is because more people receive the disposable income due to production and if output is constrained from the external sector, so are incomes – thereby implying lower disposable incomes for others already employed and not in the ELR.

Incidentally I mention in the passing that Australian banks are subject to vulnerabilities due to funding from foreigners – something Chartalists (who are also Minskyians) would deny. The huge amount of external funding needs of Australian banks – both in domestic and foreign currencies is a direct result of the current account imbalances accumulated over the past.

Somehow a group of Keynesians think that simply deficit spending solves all our problems.

Updated 13 Feb 2013, 3:15 PM GMT