Tag Archives: james tobin

On Effects Of QE

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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

Banks:

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

Banks:

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

Non-banks:

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

Summary:

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:

fredgraph

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.

Wynne Godley: The Keynes Of Flow Of Funds

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Monetary and financial data, so far as they are based on institutional balance sheets and prices in organized markets, are abundant. Modern machines have made it possible to improve, refine and expand the compilation of these data, and also to seek empirical regularities in financial behavior in the magnitude of individual observations. On the aggregate level, the Federal Reserve Board has developed a financial accounting framework, the “flow of funds,” for systematic and consistent organization of the data, classified both by sector of the economy (households, nonfinancial business, governments, financial institutions and so on) and by type of asset or debt (currency, deposits, bonds, mortgages, and so on). Although many people hope that this organization of data will prove to be as powerful an aid to economic understanding as the national income accounts, this hope has not yet been fulfilled. Perhaps the deficiency is conceptual and theoretical; as some have said, the Keynes of “flow of funds” has yet to appear.

– James Tobin in Introduction (pp xii-xiii) in Essays In Economics, Volume 1: Macroeconomics, 1987.

[bolding: mine]

Paul Krugman writes in his blog responding to a recent Times article on Wynne Godley with a dismissive tone with mischaracterisation on saving etc. He writes:

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.

Strange. First it is the story of a journalist from NYT who presented it the way it was. The NYT article was fine – what more can we ask from the journalists? But the funny thing is Krugman’s blog post itself which appeals to Friedmanism. Even funnier is the fact that Paul Krugman himself has turned to Keynesianism in recent times and talks about Michal Kalecki but when it suits his purpose, he dismisses Godley’s ideas as old fashioned!

Paul Krugman in his debates with heteredox economists has been exposed with his poor understanding of the nature of money. Wynne Godley’s approach on the other hand goes into a detailed look at the nature of money using the flow of funds among other things in a Keynesian way.

Now Krugman’s post is hardly a critique of any sort to deserve a response. But I thought quoting James Tobin is a good way to advertise Wynne Godley’s work because he has achieved what Tobin dreamed of and could not do it himself.

Also Wynne’s own idea about his work and aims can be seen from his writing in his article Keynes And The Management Of Real National Income And Expenditure, (in Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983):

… I have been forced to the conclusion that Keynes was a long way from achieving a coherent theoretical basis for maintaining them [correct ideas], and largely for this reason, his ideas have proved very vulnerable to the attacks from many different directions to which they have been subjected, particularly in the last fifteen years.

Wynne Godley’s work lays the foundation for Keynesian Economics. And Wynne Godley is the Keynes of flow of funds.

Correction: I am mistaken about Jonathan Schlefer’s background. He is in academics.

James Tobin Turns In His Grave

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When I was a boy of 14, my father was so ignorant I could hardly stand to have the old man around. But when I got to be 21, I was astonished at how much the old man had learned in seven years.

– attributed to Mark Twain, Reader’s Digest, September 1939.

Steve Keen has a blog post The Getting Of Wisdom in which he compares Tobin’s view in his 1963 paper Commerical Banks As Creators Of “Money” to his 1982 paper The Commercial Banking Firm: A Simple Model and finds Tobin has so many things (i.e., “loans create deposits” in 1963 to “loans create deposits” in 1982) in those years!

According to Keen:

The difference between the Old and New Tobin is as stark as that between the Old and New Testament. Not only is there an emphasis on the uniqueness of banks in that 1982 paper, Tobin also makes copious use of T-accounts and double-entry bookkeeping to explain why banks do matter. So just as the Testament message moved from “An eye for an eye” to “Turn the other cheek”, Tobin moved from “banks don’t matter and the belief that banks create money is a shibboleth”, to “banks are crucial to macroeconomics and they can and do create money”.

And whereas Tobin the Younger imagined that newly created bank money could be taken out of the system in a form other than bank deposits or cash, Tobin the Elder realizes that those are the only two options at the systemic level. Individuals might get out of bank deposits into (say) gold, but to do so they transfer money from their deposits in one bank into the deposits of the gold dealer in another bank. The only way for money not to be held in a bank is for it to be converted into some other kind of asset that is not a bank liability first. The only candidate here is cash—notes and coins—which you can insist on when you make a withdrawal (you might insist on gold instead, but a bank is under no obligation to deliver it in response to your withdrawal).

(italics in original, boldening mine)

Keen obviously is wrong when he says “the only way for money to be not held … ” because he first he misses the reflux mechanism where money can be extinguished by reducing indebtedness to the banking system. He obviously knows what “reflux” is but nonetheless misses it. Among other things he misses is that the bank can induce the non-banking public to shift in and out of money (or in the opposite case accommodate the non-banking public’s desire to change its portfolio) by changing bid/asks of markets they are dealers in such as government bond prices. So there is a price adjustment in the financial markets as well (leading to changes in deposits)

[Of course Keen attributes it to Tobin but looking at his agreeing tone, looks like it his own claim].

Others examples include but not limited to – a shift of deposits abroad with accommodative transactions which do not bring back the deposits to the original level, a “Treasury Supplementary Financing Operation” type of operation by the government Treasury which reduces the deposits in existence etc.

But more importantly he misses the mechanism which Tobin highlighted in his 1963 paper in which non-bank financials can compete with banks in the loan markets by taking away some borrowers and this leading to a fall in deposits. And this way, it is important not only for a single bank but for the banking system to induce depositors to bank with them.

Another thing which Post-Keynesians (some, not all of course) sometimes do is to think erroneously that bank borrowing (for purchases of goods and services at any rate) adds to demand and that non-bank borrowing/lending is demand-neutral and reading Keen’s post it seems he is close to saying something of the sort. And in his models, borrowing for purchases of financial assets also adds to “aggregate demand”.

I had written the following and am repeating it again about how a non-bank induces a borrower to borrow from it (who then extinguishes his loan from banks to become a borrower from the non-bank financial) and how this reduces the banking system’s balance sheet and hence deposits in the process – something Keen can’t see.

The following example is given in Tobin’s 1963 paper with my own numbers.

Start with a bank with initial balance sheet of 100 units. I will neglect capital and other liabilities to keep things clean so if you are not comfortable you can always change the liabilities side by reducing deposits by say 10 and replacing it with other liabilities. Also I call NBFIs’ liabilities “shares” and this is more like money-market mutual fund shares and shouldn’t be confused with stock-market shares.

t = 0

Banks

Assets: Loans = 100
Liabilities: Deposits = 100

Non-Financial Private Sector

Assets: Deposits = 100
Liabilities: Loans = 100

Non-bank Financial Institutions

Assets: Deposits = 0
Liabilities: Shares = 0

t = 1

At t = 1, let us say NBFIs attract 10 units of deposits from bank depositors. So the balance sheets will look like:

Banks

Assets: Loans = 100
Liabilities: Deposits = 100

Non-Financial Private Sector

Assets: Deposits = 90, Shares = 10
Liabilities: Loans = 100

Non-bank Financial Institutions

Assets: Deposits = 10
Liabilities: Shares = 10

t = 2

At t = 2, someone extinguishes his/her/its loan to the banking system by 10 unit. So,

Banks

Assets: Loans = 90
Liabilities: Deposits = 90

Non-Financial Private Sector

Assets: Deposits = 80, Shares = 10
Liabilities: Loans = 90

Non-bank Financial Institutions

Assets: Deposits = 10
Liabilities: Shares = 10

t = 3

At t = 3, someone borrows 10 units from NBFIs. So,

Banks

Assets: Loans = 90
Liabilities: Deposits = 90

Non-Financial Private Sector

Assets: Deposits = 90, Shares = 10
Liabilities: Loans = 100

Non-bank Financial Institutions

Assets: Loans = 10
Liabilities: Shares = 10

NBFIs who had 10 units of deposits no longer have it because they have lent 10 units which involves transfer of deposits. The net result at the end is that banks have lost a share lending of 10 units out of the initial 100 to non-banks and also deposits worth 10 units.

This of course can go on and it is in the interest of banks to prevent this from happening and induce the public to bank with them. In Tobin’s asset allocation theory, asset demands are dependent on the portfolio preference parameter and also the interest rate paid on the asset (or expected returns in general). So putting up interest rates on deposits would partly prevent this shift to non-bank financial intermediaries.

So in trying to show something, Keen’s effort turns counter-productive because his claim:

The only way for money not to be held in a bank is for it to be converted into some other kind of asset that is not a bank liability first.

turns out to be wrong and misleading.

He misses out Tobin’s insight that banks individually and collectively have to induce the non-banking public to hold deposits with them in his 1963 paper which the simple “loans create deposits” phrase does not highlight and how the banking system’s deposits can reduce due to competition from non-bank financials.

Plus there are more Tobinesque mechanisms (via his asset allocation theory) as I highlight in my previous posts James Tobin, Banking And The Widow’s Cruse and Holier Than Tobin? in which price changes of financial assets leads to a change in the stock of money which Keen is not aware of.

Instead his post has basic errors in monetary economics.

James Tobin, Banking And The Widow’s Cruse

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There is good discussion in the blogosphere on James Tobin’s 1963 paper Commerical Banks As Creators Of “Money” – also mentioned in my previous post Holier Than Tobin?

This blog post is an attempt to present Tobin’s ideas from the paper in a more simplistic way.

One of  Tobin’s points is a critique of the notion that since loans create deposits, it makes banks special as compared to non-bank financial institutions and the over-emphasis on this point by many.

Tobin goes on to show how this is misleading. The fact that a non-banking financial institutions don’t simply credit shares like banks is not too important.

From the viewpoint of a single bank, while loans make deposits, the deposits can “fly out” to another bank and hence the bank is limited by its deposit raising ability. In general, a bank can fund itself by using other things – not just  deposits – so a bank will need to fund itself. It is sometimes said that “banks lend first and look for deposits later” but this is a bit misleading because while it is true in general, it is in the confident knowledge that the funding will be available at a not so costly rate. If the bank fears or the whole banking system fears a funding crisis, then lending will be curtailed.

It is true that the bank can fund itself from the central bank but even this is not available for unlimited amount. It has to provide collateral to the central bank which is limited. Usually these are marketable securities and not loans provided to the private sector and the amount of marketable securities is a small fraction of banks’ balance sheet.

At a macro level however, deposits leaving a bank may move to another bank so one may conclude that the banking sector as a whole collectively possesses a Widow’s Cruse.

Tobin however goes on to show how the presence of non-banking financial institutions (NBFIs) presents problems for such a view – by hook or crook, the banking system has to induce the non-banking private sector to hold deposits with them than depositing it with NBFIs. In general flight of deposits abroad is also important. This comes at a cost – the easiest to think of is the interest rate paid on deposits but one can also think of other things such as advertising costs etc.

In the following I show how this happens and how the banking system’s balance sheet can shrink because of flight of deposits to NBFIs who can take away banks’ market share. The fact that loans create deposits is not so important as is emphasized many times. Even though non-banks cannot simply credit the “share” account  doesn’t mean much. They can keep attracting deposits from banks and lend.

So let us take a simple example: start with a bank with initial balance sheet of 100 units. I will neglect capital and other liabilities to keep things clean so if you are not comfortable you can always change the liabilities side by reducing deposits by say 10 and replacing it with other liabilities. Also I call NBFIs’ liabilities “shares” and this is more like money-market mutual fund shares and shouldn’t be confused with stock-market shares.

t = 0

Banks

Assets: Loans = 100
Liabilities: Deposits = 100

Non-Financial Private Sector

Assets: Deposits = 100
Liabilities: Loans = 100

Non-bank Financial Institutions

Assets: Deposits = 0
Liabilities: Shares = 0

t = 1

At t = 1, let us say NBFIs attract 10 units of deposits from bank depositors. So the balance sheets will look like:

Banks

Assets: Loans = 100
Liabilities: Deposits = 100

Non-Financial Private Sector

Assets: Deposits = 90, Shares = 10
Liabilities: Loans = 100

Non-bank Financial Institutions

Assets: Deposits = 10
Liabilities: Shares = 10

t = 2

At t = 2, someone extinguishes his/her/its loan to the banking system by 10 unit. So,

Banks

Assets: Loans = 90
Liabilities: Deposits = 90

Non-Financial Private Sector

Assets: Deposits = 80, Shares = 10
Liabilities: Loans = 90

Non-bank Financial Institutions

Assets: Deposits = 10
Liabilities: Shares = 10

t = 3

At t = 3, someone borrows 10 units from NBFIs. So,

Banks

Assets: Loans = 90
Liabilities: Deposits = 90

Non-Financial Private Sector

Assets: Deposits = 90, Shares = 10
Liabilities: Loans = 100

Non-bank Financial Institutions

Assets: Loans = 10
Liabilities: Shares = 10

NBFIs who had 10 units of deposits no longer have it because they have lent 10 units which involves transfer of deposits. The net result at the end is that banks have lost a share of 10 units out of the initial 100 to non-banks and also deposits worth 10 units.

This of course can go on and it is in the interest of banks to prevent this from happening and induce the public to bank with them. In Tobin’s asset allocation theory, asset demands are dependent on the portfolio preference parameter and also the interest rate paid on the asset (or expected returns in general). So putting up interest rates on deposits would prevent this shift to non-bank financial intermediaries.

Tobin would say that “at this point the widow’s cruse has run dry”. Perhaps there is an over-emphasis on this but I leave it to the reader to decide.

One thing Tobin didn’t emphasise is the role of effective demand. I would imagine he would explain why lending doesn’t explode by using some neoclassical marginal curves instead of the Post-Keynesian answer.

Holier Than Tobin?

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It sometimes happens that important insights of great contributors to an academic field are missed. One of the most important things in Monetary Economics is Tobin’s asset allocation theory which although is well known is sometimes poorly understood.

James TobinJames Tobin (Source: Econometric Theory)

But sometimes a holier-than-thou attitude can lead one to miss an important and insightful aspect of a work.

The blogger Winterspeak – well aware of some of Tobin’s work such as his paper Commercial Banks As Creators Of “Money” from  1963 has written as post A Bank is not a Financial Intermediary and concludes that

… This then is the conceptual fallacy at the heart of academic macro and what it thinks about banks, and it goes at least all the way back to 1963.

Winterspeak is stuck on a quote from Tobin-Brainard paper (1963) which says:

…the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expand their holdings of real assets… On the other side are lenders who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default.

This is also repeated in Tobin’s Commercial Banks As Creators Of “Money” which obviously states explicitly that loans create deposits and that the money mutliplier view is highly inaccurate:

According to the ‘new view’, the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expand their holdings of real assets – inventories, residential real estate, productive plant and equipment, etc. – beyond the limits of their own net worth. On the other side are lenders, who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default. The assets of financial intermediaries are obligations of the borrowers – promissory notes, bonds, mortgages. The liability of financial intermediaries are the assets of the lenders – bank deposits, insurance policies, pension rights.

Winterspeak is adamant about the usage of the phrase “intermediary” and that since banks create deposits out of thin air, they shouldn’t really be called intermediary and that Tobin’s views are equivalent to the loanable funds view. For the first part – maybe but Winterspeak seems to crucially miss out the mediating role played by banks in the portfolio allocation decisions of wealth owners such as households. See my comments in that blog.

First it is crystal clear that Tobin knows loans create deposits. Second, he presents a “new view” in which the distinction between “money” and “bonds” is blurred and this led him subsequently to his asset allocation theory. It is true that Tobin’s model was far from complete and this was improved substantially by Wynne Godley, but nevertheless Tobin’s insights were wonderful and the work of a genius.

Perhaps I would have worded what Tobin wrote differently if I were to teach this but this is just a matter of emphasis.

Perhaps “the essential function” is better worded with “an essential function” so that the reader doesn’t take it to mean that the concept I will come to,  isn’t taken to mean “the only function” or “the most essential function”.

The mediation role played by banks is related to the super-version of “loans create deposits” – asset purchases by banks also create deposits.

So when a bank purchases say a government bond from a household (or a mutual fund selling in response to redemptions by a household), banks create more deposits in the process. In the opposite case, there is a destruction of deposits.

Now suppose for some reason – such as improved animal spirits of entrepreneurs, firms borrow more from banks and the expenditures transfers funds to households. Coincidentally – for different reasons – households wish to hold less of their wealth in deposits and more in bonds or other securities. There is now a discrepancy and it is reconciliated by banks standing ready to sell bonds to households. This decreases the stock of money (monetary aggregate) in existence so that there is no discrepancy at all. There is of course another way in which this may happen – i.e., by price changes (of financial secruities and not that of goods and services) bringing supplies equal to demand but this needs a full course on asset allocation theory discovered by nobody else than James Tobin himself!!

Of course there are other ways. There is the reflux mechanism and more complicated mechanisms involving asset allocation theory such as higher issuance of equities by production firms. In the reverse case when households desire to hold more of their wealth in deposits, firms may need to borrow more from banks so that the “supply” of money is equal to the “demand”.

In contrast there is the Monetarist hot potato process which mainly relies on prices changes of goods and services. In ideas such as the asset allocation theory including the mechanism of the mediating role of banks is a blow to the Monetarist hot potato.

Of course there is the notion of convenience lending – one favoured by Basil Moore – in which household volitionally hold bank deposits non-volitionally but it is too artificial.

This mediating role of banks (and not the most important if you like) is also endorsed by some Post-Keynesian authors such as Wynne Godley and Nicholas Kaldor.

In an article In his essay Keynes And The Management Of Real Income And Expenditure, (in Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983), Wynne Godley says (p 151):

Even though I am not going in detail into monetary mechanisms it is worth drawing attention to the fact that the commercial banks’ role, apart from creating credit to finance certain kinds of expenditure, is to mediate the non-bank private sector’s portfolio choice, given the income flows and the central authorities’ funding policy.

Nicky Kaldor’s The Scourge Of Monetarism (Oxford University Press, 1982) is more clearer than simply stating:

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. Hence, while the annual increment in the total holding of financial assets of the private sector (considered as a whole) is nothing more than the mirror-image of the borrowing requirement of the public sector (in a closed economy at any rate), neither the Government nor the banks can determine how much of this increment will be held in the form of cash (meaning notes and current deposits) and how much in the near-equivalents to cash (such as interest-bearing demand deposits) or in various forms of public sector debt. Thus neither the Government nor the central bank can control how much or the total financial assets the public prefers to hold in the form of ‘money’ on one particular definition or another.

Again in 1997 in Money Finance And National Income Determination Wynne Godley repeats himself although criticising Tobin but nevertheless realising the importance of his work – this time writing an explicit model for the whole thing which incorporates Tobin’s ideas:

… I am saying that (within strict limits e.g. concerning credit-worthiness) banks respond passively to the needs of business for loans and to the asset allocation activities of households (as well as providing the means of payment).

Conclusion

It is true that PKE authors and bloggers do have a much better understanding of monetary matters than mainstream economists but in trying to emphasise this point, sometimes they miss out on important matters. There is no need to say (as Winterspeak says “Tobin … sees … [banks as] something which brings efficiency and eases friction between the actual lender and borrower.”) especially when Winterspeak doesn’t seem to understand the mediating role of banks in the portfolio allocation decisions of financial asset owners which really has less to do with any “friction”. Perhaps the word intermediary is not the best but it is a minor point. In fact the ideas of the 1960s and later are missed by younger ones.

Thomas Palley On International Coordination

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Thomas Palley has a new article Coordinate Currencies or Stagnate on international coordination of exchange rates. (h/t Matias Vernengo). He has a nice small critique of the Chicago school according to which “market forces” work toward resolving imbalances.

It is great such a thing has been raised because the importance of policy coordination (in general – monetary, fiscal and exchange rates) is often forgotten.

In an article Agenda For International Coordination Of Macroeconomic Policies, Tobin wrote [1]

Coordinate policies! So economists urge governments. Financiers, journalists, pundits, politicians take up the cry. Central bankers and finance ministers agree, as do presidents and prime ministers. They meet, they talk, they announce progress. It turns out to amount to very little…

But the global imbalance has worsened and it has now created a situation in which such coordination is more badly needed.

Wynne Godley had been warning of such things in the 2000s. In a 2005 article [2] with his collaborators, he wrote:

A resolution of the strategic problems now facing the U.S. and world economies can probably be achieved only via an international agreement that would change the international pattern of aggregate demand, combined with a change in relative prices. Together, these measures would ensure that trade is generally balanced at full employment…Those hoping for a market solution may be chasing a mirage.

I have also found the last words in academic literature very insightful [3]:

… It is inconceivable that such a large rebalancing could occur without a drastic change in the institutions responsible for running the world economy—a change that would involve placing far less than total reliance on market forces.

Time will tell how right he was 😉

References

  1. James Tobin, Agenda For International Coordination Of Macroeconomic Policies, Ch 24, p 633, Essays In Economics, Volume 4: National And International, The MIT Press, 1996.
  2. Wynne Godley, Dimitri Papadimitriou, Claudio Dos Santos and Gennaro Zezza – The United States And Her Creditors: Can The Symbiosis Last?, Levy Institute Strategic Analysis, September 2005. Link
  3. Wynne Godley, Dimitri Papadimitrou and Gennaro Zezza – Prospects For The United States And The World – A Crisis That Conventional Remedies Cannot Resolve, Levy Institute Strategic Analysis, December 2008. Link

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

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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.

Nicholas Kaldor On Floating Exchange Rates

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Martin Wolf has a nice new column on imbalances creating troubles for the UK economy in the Financial Times: What a floating currency gives and what it does not.

Why are current account deficits a haemorrhage in the flow of circular income? Weak external trade performance implies a drain in demand and hence pressure on the path to full employment and also that fiscal policy has to give in: else public debt and net indebtedness to foreigners keep rising relative to output which cannot be sustained for long. This means that if an individual nation or the world as a whole needs reflation, drastic changes need to made on how the world is run – especially using a system of regulated international trade rather than a system of free trade.

Nicholas Kaldor had a lot of change of mind about exchange rates during his lifetime. In the introduction to Volume 6 of his collected essays Further Essays On Applied Economics, he has a lot to say about his views.

Nicky Kaldor also had a paper The Relative Merits Of Fixed Exchange And Floating Rates – a memorandum as an economic adviser to the Chancellor in 1965 in which he was arguing for the merits of floating the exchange rates. In page xiii from introduction to Further Essays On Applied Economics he confesses:

The strategy advocated in my 1965 paper “The Relative Merits of Fixed and Floating Exchange Rates” thus proved in practice futile …

… So the policy which I advocated in the 1960s and developed at greater length in my 1970 Presidential Address to the British Association, of reconciling full employment growth with equilibrium in the balance of payments through adjusting the relationship between import and export propensities by a policy of continuous manipulation of the exchange rate, proved in the event a chimera. The main reason for this was that (along with most economists) I greatly overestimated the effectiveness of the price mechanism in changing the relationship of exports to imports at any given level of income. The doctrine that exports and imports are kept in balance through induced changes in their relative prices is as old and deeply ingrained as almost any proposition in economics.

So there you have it – realising his mistake earlier than anyone else.

He goes on further to drive this point:

… In other words, what the Harrod theory asserts is that trade is kept in balance by variations of production and incomes rather than by price variations: a proposition which implies that the income elasticity of demand of a country’s inhabitants for imports and those of foreigners for its exports are far more important explanatory variables than price elasticities.

which is essentially saying that it is non-price competitiveness which is far more important than price competiveness.

Further …

… If the Harrod theory provides the realistic explanation of the underlying forces which maintain the trade flows of an industrial exporter in balance (subject, of course, to the exceptions to this rule in the shape of long-term surplus and deficit countries, which must be capable of being explained in the same framework) this also carries the implication that the relationship of import propensities to exports will be relatively insensitive to such variations of relative prices as can be accomplished by monetary or exchange rate policies.

This latter implication (though discussed in the 1930s) seems to have got lost when the debate on fixed versus flexible exchange rates flared up again in the 1960s. This explains perhaps the exaggerated hopes placed on variations in exchange rates as an instrument of the “adjustment process” in international trade and payments and, for Britain in particular, on a system of “managed floating” as a means of securing higher and stable growth rates.

Again he later emphasises his learning:

… I was convinced that once exchange rates are freed from the rigidities imposed by Bretton-Woods, the forces of cumulative causation which made some countries grow fast and others slowly will no longer operate, or not in the same manner. That belief was so badly shaken by experience of subsequent years for for reasons explained in my most recent paper on the subject, which is discussed below.

James Tobin said it best once:

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.

Money And Shoes

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… Now let me give you a ridiculous example to make the point. Don’t take it too seriously. Suppose that some statistician observes that over a long period of time there is a high association, a very good fit, between gross national product and the sales of, let us say, shoes. And then suppose someone comes along and says, “That’s a very good relationship. Therefore, if we want to control GNP, we ought to control production of shoes. So, henceforth, we’ll make shoes grow in production precisely at 4 percent per year, and that will make GNP do the same.” I don’t think you would have much confidence in drawing this second conclusion and policy recommendations from the observed empirical association.

Over the years, according to the monetarists, the Federal Reserve has been acting like the producers and sellers of shoes. That is, the Fed has been supplying money on demand from the economy instead of using the money supply to control the economy. The Fed has looked at the wrong targets and the wrong indicators. As a result, the Fed has allowed the supply of money to creep up when the demand for money rose as a result of expansion in business activity, and to fall when business activity has slacked off. This criticism implies that the supply of money has, in fact, not been an exogenously controlled variable over the period of observation. It has been an endogenous variable, responding to changes in economic conditions and credit market indicators via whatever response mechanism was built into the men in this room and their predecessors.

… Perhaps the monetarists will be sufficiently persuasive of the Federal Reserve and of Congressional committees to bring about, in the future, a controlled experiment in which the stock of money is actually an exogenous variable.

– James Tobin, 1969

Ref:

  1. Tobin, James, “The Role of Money In National Economic Policy – A Panel Discussion,” in Controlling Monetary Aggregates. Boston: Federal Reserve Bank of Boston, 1969, pp. 21-24 (link)

Income = Expenditure!

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

– James Tobin

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

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

The model is below – found on page 15.

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

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

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

C = W + ΠD 

Unfortunately the rules of accounting do not allow this!

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

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

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

So equation 1.8 should read:

YE = YI 

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

The Saving = Investment Identity

The Keen-Grasselli model doesn’t respect the identity

Saving = Investment

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

So total saving = ΠR and total investment = I

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

So in the Keen-Grasselli model,

Saving ≠ Investment

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

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

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

[emphasis: mine]

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

Some Higher Mathematics: The Dirac Delta Function

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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