Monthly Archives: May 2013

Some Simple LSAP/QE Accounting

It isn’t really all that complicated.

There were some responses to my previous post on Steve Keen and his new model for QE. One commenter wrote that Keen’s “charter” entry is needed because of fundamental equations of accounting and secondly SNA – the System of National Accounts has “deep problems”. Strange claim.

Keen’s entry “charter” appears in his “Godley Table”. (taken from his Naked Capitalism post).


Of course this has nothing to do with Wynne Godley – as he never used “charter” in central bank balance sheets. And “charter” is really not needed.

So let us get straight to the point.

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).

Of course this is at the time of the transaction and little about what happens next. However, it is important to get the above right and then proceed rather than bringing in some “charter”.

My own views of the effect of LSAP is found in a previous post: Central Bank Asset Purchases And Its Connection To Tobin’s Theory Of Asset Allocation.

Dear Steve

Dear Steve,

I came across your Business Spectator article article Is QE quantitatively irrelevant? today*

You have to be more careful.

I generally agree with Philippe Hales who comments on your article at 

About the rich aunt example: In some system of accounting, the actual values of liabilities and net worth appear with a minus sign but the symbols themselves are presented with a negative sign! So the minus of equity decreases by $1mn. Some commenters have commented on this.

QE is for central bank purchasing government securities (and sometimes mortgage-backed securities) and these are bought directly from both banks and non-banks. In the United States, the ultimate seller is the non-banking sector and the outright purchase of these financial securities does increase the money supply. Only in the case where a bank is the seller, does it not increase monetary aggregates such as M1 etc.

Even if monetary aggregates increase – at least at the time of the purchase, it isn’t a cause for concern because the Monetarist causality from money to prices (of goods and services) doesn’t apply. Now once the security is sold to the central bank, the seller may “rebalance” his portfolio and this will again affect the money supply and even affect equity market prices.

QE is not a repurchase agreement. It is an outright transaction. It is true that the Federal Reserve will ultimately reverse the purchases but that will happen via direct sales and the buyer at that time may be different. The Federal Reserve typically rolls over government securities when they mature and in this case with a large stock of Treasuries and MBSs, it may simply let them mature without rolling them over (instead of selling it to the private sector) when it implements an “exit strategy”.

Also since QE creates reserves – whether the purchase of bonds is from banks or non-banks – banks earn interest on these reserves rather than paying the Federal Reserve some interest.

More importantly you don’t need the Minsky and Godley tables you have to show all these things. Also, people have less time and make fast impressions. Your errors may dissuade them from reading the works of Hyman Minsky and Wynne Godley. You are sort of a face for Post-Keynesianism in the media and the internet. Kindly be more responsible for this role. You are standing on the shoulders of giants and be careful about them. Neoclassical economists will pounce on such things and claim to have debunked the whole of Post-Keynesianism. I have already seen a neoclassical economist (from Cambridge of all places) hint such a thing in a subtle way.

*which also appears at the blog Naked Capitalism.

Kenneth Rogoff Is Back With Another Sneaky Article

Kenneth Rogoff is back with more unscholarly stuff.

In a new article for Project Syndicate Europe’s Lost Keynesians, Rogoff subtly tries to belittle Keynesians and Keynes himself.

According to him,

The eurozone’s difficulties, I have long argued, stem from European financial and monetary integration having gotten too far ahead of actual political, fiscal, and banking union. This is not a problem with which Keynes was familiar, much less one that he sought to address.

Now, Keynes himself was aware of problems that arise in an open economy, the above quote tries to mislead the readers into thinking that neither Keynes nor his followers were aware of the problem.

It was in fact Keynesians who warned about the troubles the Euro Area would face. Last year, I dug out an article by Nicholas Kaldor from 1971 which shows how highly prescient he was. The article The Dynamic Effects Of The Common Market first published in the New Statesman, 12 March 1971 and also reprinted (as Chapter 12, pp 187-220) in Further Essays On Applied Economics – volume 6 of the Collected Economic Essays series of Nicholas Kaldor is written as if it was written yesterday!

Here is from the article:

… Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

[italics in original]

To read more excerpts from the article please read the following two posts from this blog:

  1. Nicholas Kaldor On The Common Market
  2. Nicholas Kaldor On European Political Union

In fact Nicholas Kaldor had already figured that the kind of fiscal union Europeans were thinking was a kind of a pseudo fiscal union – as can be seen by reading the excerpts (see the second post above).

Also Wynne Godley – a close friend of Nicky Kaldor – also reminded the dangers of the Maastricht Treaty in his 1992 LRB article Maastricht And All That.

Kenneth Rogoff is being ignorant and unintellectual. First he writes as if Keynesians had no clue about the problem and secondly he is unaware of the fact that the kind of fiscal union in talks in Europe is a pseudo fiscal union which Keynesians such as Nicholas Kaldor have pointed out since 1971.

He ends the article by saying

… there still will be no simple Keynesian cure for the single currency’s debt and growth woes.

which is ignorant. The solution if it comes about is Keynesian and Keynesians had warned it will be difficult to resolve a future crisis because of political difficulties which arise.

Rogoff’s attitude is that of a person who ignores the doctor’s warning continuously and then ridicules the doctor when  medical problems finally appear. Just like the cure will come from the doctor, so will the resolution via Keynesianism.

Central Bank Asset Purchases And Its Connection To Tobin’s Theory Of Asset Allocation

Recently, Martin Feldstein wrote a WSJ article The Federal Reserve’s Policy Dead End with a subheading summary “Quantitative easing hasn’t led to faster growth. A better recovery depends on the White House and Congress”.

This has led to various dubious debunking such as “Feldstein doesn’t understand how QE works”.

In the following (although I am no fan of his) I will try to show that he is about right – at least with his WSJ article.

Feldstein neatly summarizes:

Quantitative easing, or what the Fed prefers to call long-term asset purchases, is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the “portfolio-balance” effect of the Fed’s purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here’s how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

This has also been the position of Ben Bernanke. Here is from his Jackson Hole speech in 2012:

Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well.

and both the views are as per Tobin’s theory of asset allocation.

Now before we proceed let us agree from the start that the naive Monetarist view that central banks creating reserves and this leading to more lending because of the money-multiplier effect is incorrect because – as has been stressed by Post-Keynesians since long, the causality is the opposite. Just because banks hold more reserves doesn’t mean banks’ customers become more creditworthy. Moreover, the naive Monetarist view suffers from confusing fiscal policy and monetary policy.

This however doesn’t mean that LSAPs (Large Scale Asset Purchases) or “QE” doesn’t have any effect. So the question is if it has any effect on asset prices such as equities. This can be seen easily. The non-bank private sector allocates its wealth into various assets and with central bank purchasing government bonds, the non-bank private sector has less stock of government bonds to allocate its wealth into. Of course in the first approximation the supply of equities is independent of central bank asset purchases, so the asset allocation equations lead to a higher clearing price of equities. And this is proportional to the amount of asset purchases by the central bank.

So rise in equity prices because of central bank asset purchases isn’t inconsistent with the theory of endogenous money.

Of course, firms may issue more equities or bonds seeing the rise in asset prices so there is a competition but the net effect will be a rise in prices because firms net issuing more securities depends on many things such as their management’s outlook about demand for their products and services in the medium term and it isn’t the case that they see any significant rise.

Assuming it leads to rise in prices of equity securities, this will lead to higher holding gains. Since this leads to higher household wealth, consumption will rise. However, the effect on output is too less and cannot be noticed in national accounts as pointed out by Feldstein and there is little sign that LSAP had produced this effect.

Tobin’s theory of asset allocation can’t be summarized so easily in a blog post but is roughly as follows: households receive income from various sources such as wages, dividends, interest payments etc. and consume a proportion of it. The remainder is allocated into various assets – financial and nonfinancial. They also have wealth accumulated over time and the theory of asset allocation (improved significantly by Wynne Godley) models this by writing equations for the allocation of wealth into assets. Each asset has a different return and different uncertainty attached to it and there is a different preference for each. So the allocation into one asset class depends both on the return and the portfolio preference. Of course there needs to be a system wide consistency and one has to worry about such technicalities. Some parameters are exogenous (such as the short term interest rate set by the central bank) and some are determined by the model – such as the price of equities, so that demand and supply are brought into equivalence. So the model also determines variables such as amount of money held by households and so on.

Tobin’s theory of asset allocation can also be used with little modifications to consider central bank LSAPs. So central bank purchases of financial assets won’t have direct effects on household consumption but will have an effect on asset allocation and an indirect effect on consumption and output because of capital gains.

Back to the real world from the model world.

To be clear, there are two effects here. The first is the rise in the price of equities and the second a rise in output because of higher consumption due to capital gains . The former may be high but not the latter. Or both may be high (unlikely in the current scenario). But plainly asserting there is no effect is incorrect.

Feldstein seems to understand this except emphasising the the rise in stock prices has been more due to rise in earnings than due to the asset allocation effect of LSAP. So while he seems to understand this, his emphasis is different.

In my opinion, the Federal Reserve LSAP has led to higher asset prices than otherwise but this hasn’t had any measurable effect on consumption.

Worth mentioning is the muddled Krugman IS/LM + liquidity trap view based on the loanable funds theory – although Krugman has been arguing rightly about fiscal policy in recent times. In my opinion, Krugman himself has managed to divert attention away from fiscal policy in all these years.

The unfortunate part of the debate is not the debate itself but the huge waste of time and the Federal Reserve has played a big role in this by implicitly downplaying the role of fiscal policy. Central bank asset purchases is promised land economics.

Gattopardo Economics

Here is a nice new working paper by Thomas Palley titled Gattopardo economics: The Crisis And The Mainstream Response Of Change That Keeps Things The Same.

From the introduction:

Il Gattopardo (The Leopard) is a sweeping movie, based on the novel by Giuseppe Tomasi di Lampedusa, about social tumult and class conflict in Sicily in the 1860s. Directed by Luchino Visconti and starring Burt Lancaster, the film follows the Prince of Salina who is intent on preserving the existing aristocratic class order in the face of a rising bourgeoisie. As the crisis grows, Tancredi, the prince’s wily nephew, speculates that things must change if they are to remain the same. And they do. After the revolution, the old aristocracy remains in charge, allied via marriage with the new urban elite.

The concept of gattopardo is directly relevant for understanding the response of the economics profession since the financial crash of 2008. The response has been gattopardo economics, which is change that keeps things the same.

Endogeneity, Exogenous, Et Cetera

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

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

Click the image to visit the ROKE website.


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

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

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

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

click to watch the video on YouTube

Back to formal matters.

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

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

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

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

which is fair but there exists another language.

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

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

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

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

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

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

Leading Economist Insists That You Cannot Control M3

(click to expand)

Erroneous Use Of The Sectoral Balances Identity

Andrew Lilico of The Telegraph takes issue with the arguments presented using the sectoral balances identity. The website describes him as:

Andrew Lilico is an Economist with Europe Economics, and a member of the Shadow Monetary Policy Committee. He was formerly the Chief Economist of Policy Exchange.

After interpreting the accounting identities in his own way, Lilico goes on to say:

Here’s where the argument goes wrong.  When we talk about “private sector deleveraging” what do we mean?  We mean things like households paying off loans to the bank, or corporates paying off bonds or other loans.  The vast, vast majority of such loans are loans private sector agents make to each other.  So for every pound reduction in borrowing made by one household or company, there is one pound fall in savings by other households and companies.  The net change in the indebtedness of the private sector as a whole, relative to other sectors (i.e. relative to the government or to foreigners) is zero.  Within the private sector, households could pay off all of their debts to each other, and that would (in an accounting sense) make no difference whatever to the net lending of the private sector as a whole to the government.

Unfortunately for him, his argument is erroneous at the most elementary level.

What did the financial crisis lead to? Before the crisis, in many advanced economies, private expenditure was rising relative to income and the difference was increasing. A sudden U-turn in this behaviour led to a fall in output and simultaneously increased the public sector deficit because of lower taxes caused by the fall in output.

Lilico’s argument seems to think of the budget deficit as exogenous – i.e., under the control of the government but a careful study reveals that this ain’t so. His argument is another example where accounting identities are misinterpreted as behaviour.

There are various other errors: Lilico confuses the terms borrowing and saving – as if they are exact opposites. Various intuitions go wrong when one applies it without a proper understanding of national accounts and I showed this in my post from last year for this particular case: Saving And Borrowing.

The most fundamental error of Lilico of course is that he holds output constant in his entire argument. When discussing a scenario with sectoral balances, it is also important to keep in mind the behaviour of output. Most economists who come across the sectoral balances approach err on this. Part of the reason why he errs on this – knowingly or unknowingly – is the chimerical neoclassical production function view of the world where output is determined by supply side factors.


Seems Lilico has been arguing with people in Twitter. Here is a Tweet from him:

This is confusing the two usages of the phrase investment in macroeconomics – investment as fixed capital formation and investment as allocation in financial assets! If you give your mother £1000, she can consume or have investment expenditures or allocate the remaining in financial assets.