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Jayati Ghosh On G20

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Triple Crisis has a Spotlight-G20 series and Jayati Ghosh has an article aimed at leaders of G-20 who meet next week in Mexico: Spotlight G-20, If Not Now, Then When

She says:

… the G20 appears to have lost its way. Its original intention – to provide a relatively speedy and workable arrangement for global governance (especially economic governance) at a time when co-ordination of macroeconomic measures is seen as essential – has clearly fallen by the wayside in the past two years. Indeed, if it cannot deliver this time around, it risks sinking into irrelevance, at a time when the global economy badly needs some institutions to respond to what is more and more evident as a crisis of massive proportions

As global imbalances have reached unsustainable levels, the G-20’s role has become more and more important. It is now been forgotten by the economics profession that coordinated reflation of demand is important for growth and that the coordinated action after the crisis hit in 2008 had an important role to play in preventing a deep implosion.

James Tobin realized how shouts used to be ignored. In his article Agenda For International Coordination Of Macroeconomic Policies [1], he said:

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…

With its balance of payments at critical levels, the United States is no longer in a position to reflate demand and in the process continue to drive growth in the rest of the world by acting as the importer of the last resort. Hence it is no longer possible for the rest of the world to grow on the path it had taken before the crisis – i.e., depending on the United States. A recovery for the medium-term is only possible if there is a strong reflation of worldwide demand by governments.

More importantly even this will not be sufficient as it just postpones the reversal of global imbalances. However for now  immediate action is required and a strong forum is needed to work out a plan to address the bigger challenge.

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

Debt Monetization

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Let us take the public sector budget equation:

G – T = ΔH + ΔB

Inspired by Milton Friedman’s popularity in the 1970s and the 80s, most textbooks and journal articles incorrectly claim that the central bank “controls” the money stock (such as M0, M1, M2 etc). Simultaneously they also claim – rightly – that the central bank targets the short term interest rates.

Recently, Alan Blinder – formerly Vice Chairman of the Federal Reserve Board – said this in New York Times’ Room For Debate (h/t wh10):

Remember “conventional” monetary policy? The Federal Reserve shortens recessions by creating more bank reserves (“printing money”), which fuels a multiple expansion of the money supply and credit because banks don’t want to hold excess reserves. So they get rid of them making more loans and deposits, which also lowers short-term interest rates. Compare that to current reality: Banks are content to hold over $1.6 trillion in excess reserves, short-term interest rates are stuck near zero, and Fed policy often works on long-term interest rates instead. No, this is not your father’s monetary policy, and the old ways of teaching about it simply won’t do.

Einstein declared that everything should be made as simple as possible, but not more so. The crisis has made the “but not more so” part more important.

Alan Blinder is a good economist, but I guess the best way to put it is that the usual story is pure fantasy.

(To be a bit technical, let us assume – in what follows – till the next section that the central bank is targeting overnight interest rates using a corridor system)

Apart from the chimerical money multiplier story, neoclassical economists also bring in the government’s budget into the story. So the story goes that if the government wants to increase its expenditures, it will sooner or later ask the central bank to “monetize” its deficit. So the government’s Treasury and the central bank can decide the proportion of the deficit which is financed by issuing H (high-powered-money or currency notes and reserves/bank settlement balances) and B (government bills and bonds). This – higher issuance of H will cause a sequence of events involving higher private expenditure inevitably resulting in price rise and higher inflation in this story.

In my post Open Mouth Operations, I discussed two kinds of open market operations – temporary and permanent. As we saw, when the private sector needs more currency notes, the central bank must neutralize this outflow by engaging in permanent open market operations. The central bank just targets/sets the short term interest rates and simply cannot be anything but defensive.

Neoclassical economists however, think of this as purely being decided by the central bank (or the central bank acting under pressure by the government) and the process is called debt monetization. Since this involves purchases of government bonds, debt monetization is a process of purchases of government bonds by the central bank (directly from the government or in open markets) in order to increase the stock of money.

We however saw that this decision of the central bank is based purely on the private sector’s needs for currency or banks’  need for higher reserves/settlement balances and the central bank must act defensively.

This was understood well by members of the “New Cambridge” School and some of their critics. In an article attempting to show the full working of their model, New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, 1978, Martin Fetherston and Wynne Godley say:

… It will further be assumed that domestic monetary policy involves supplying cash and bonds in whatever amounts necessary to maintain private (and overseas) portfolio equilibrium at given (i.e., baseline) rates of interest…

This was from a conference Public Policy In Open Economies and Alan Blinder understood this – in a reply to the New Cambridge model, Whats New And Whats Keynesian In The New Cambridge Keynesianism (same link as above) he said:

Fiscal policy can, therefore, have no immediate effect on these asset demands. (It has a longer-run effect through raising net wealth.) The central bank monetizes just enough government debt to keep interest rates from rising, so there can be no “crowding out.”

on the New Cambridge model. i.e., as we move forward in time, because the private sector has higher wealth, the Bank of England will purchase government debt depending on how much of this wealth the private sector wants in the form of money.

Hence we can say that monetization is endogenous. So if the central bank purchases more government bonds than it is supposed to, banks will have more settlement balances and the central bank’s target will fall to the lower end of the corridor and will be forced to sell bonds in equal quantities. The description of the corridor and floor systems can be found in the post Open Mouth Operations.

The Floor System And Central Bank Large Scale Asset Purchases

In recent times (since the last three years), central banks especially the Federal Reserve – who have adopted a floor system – have been purchasing a lot of domestic government bonds in the open markets (and also other securities such as “agency debt” and “agency MBS”). This is also called “QE”, and it’s a bad phrase. However does this mean the private sector has “excess money”? The private sector’s wealth allocation decision depends on its portfolio preferences between various forms of wealth and since purchases also lead to a reduction of long term government bond yields (as compared to the case when the asset purchase program hadn’t been carried out) and hence the private sector wishes to hold less of its wealth in the form of government bonds and more in the form of money – hence sold the bonds the Federal Reserve intends to buy!

Of course the result is that banks have more central bank reserves than they wish to hold, but as a whole the banking system won’t convert these settlement balances into currency notes unless the non-bank private sector wishes to hold them. If the non-bank private sector needs more currency notes, banks will easily accommodate this need and so will the central bank and this need is not a function of how much settlement balances the banking system holds. And it won’t cause price rises either because “money” doesn’t lead to inflation. The strategy of the central banks in reducing long term bonds comes with asking the banks to hold the settlement balances for some time (and keeping them happy by paying interest on the reserves) and the Federal Reserve may sometime phase out the program by an “exit strategy”. However this has nothing to do with “inflation expecations” or some chimerical story about runaway inflation waiting to happen.

The Federal Reserve’s strategy has been to create more demand by reducing long term rates so that depending on the interest elasticity (as opposed to income elasticity) of investment by the private sector and/or its animal spirits, there may be higher activity. But since income elasticity effects are stronger, the LSAP hasn’t really worked as desired.

Private expenditure depends mainly on private income and LSAPs do not directly affect private expenditure. There can be indirect effects due to portfolio preferences – because LSAPs may induce the private sector to purchase other asset classes such as corporate equities leading to a rise in stock prices, leading to wealth effects via capital gains. Hence we see a lot of references to James Tobin’s work in central bank papers on this.

There were other effects which didn’t work as desired – such as refinancing of existing mortgages due to lower interest rates and this leading to extra demand because it was thought that households will be able to refinance in huge numbers and this will lead to higher consumption because they will spend the difference they gain due to lower monthly outflows to the banking system.

Of course, none of this has anything to do with the fantasy story that there is an excess of money appearing out of nowhere and which will be eliminated via higher expenditures resulting in a permanent price rise and fantasy stories such as that.

To summarize, stories around money leading to inflation, excess money due to central bank government debt purchases etc have all led to tragic debates around macroeconomic issues.

Here’s from Marc Lavoie’s Changes In Central Bank Procedures During The Subprime Crisis And Their Repercussions On Monetary Theory (working paper here):

The financial crisis has made these features of the real world even more obvious and it should make clear that nearly all of mainstream monetary theory as applied to central banking is nearly worthless, as is for instance the infamous money multiplier fable and the presumed causal relationship running from bank reserves at the central bank to price inflation.

Also, while central bankers simply did not know that a crisis was going to hit but did good work (in my opinion) in preventing an implosion of the financial system, there is simply no need to congratulate them for having purchased government debt such as as done by Paul McCulley here and as done by Adair Turner here at the recent INET conference. Their arguments sound something like: central banks prevented a deflation of prices by purchasing government debt!

SMP

A qualification needs to be made in the above analysis on the purchases of Euro Area governments’ debt by the Eurosystem under the ECB’s Securities Markets Progam (SMP). Here some government debt markets have/had the potential to become “dysfunctional” (ECB’s phrase) and NCBs purchase(d) government bonds in the secondary markets to prevent government bond yields from rising forever as a result of a self-fulfilling prophecy of financial markets and its inability to absorb government debt because of suspicions that some governments could become insolvent in the long run. This is useful because it just postpones the day of reckoning or buys some time to reach an economic state of lower activity to keep some Euro Area nations’ net foreign indebtedness in check.

The ECB website and communications stress that these operations are being “sterilized” and hence keeps price stability in check but the explanation is right if there is a Monetarist causality from money to prices!

Balance Of Payments: Part 1

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This is the first part of a series of posts I intend to write on the “rest of the world” accounts in National Accounts. This blog is about looking at economies from the point of view of National Accounts, Cambridge Keynesianism and Horizontalism. While various descriptions of balance of payments exist, most of them simply end up making money exogeneity assumption somewhere in the description!

In my view a careful description of balance of payments offers great insights on how economies work and what money really is. It is impossible to understand the success and failures of nations without understanding the external sector.

A description in terms of stocks and flows is the most appropriate for macroeconomics. Fortunately, national accountants have a good systematic approach to this.

Consider the following transaction: a government (or a corporation) raises funds in the international markets. The buyers can be residents as well as non-residents. The currency of the new issuance can be domestic as well as foreign. Does this by itself increase the net indebtedness of the nation as a whole?

The answer is No, and can be a bit surprising to the reader because the answer is the same whether the currency is domestic or foreign. The trick in the question is that an issuance of debt increases the assets and liabilities of the issuer!

(Note: the question was about the transaction, not on what happens after this)

Gross assets and liabilities vis-à-vis the rest of the world can be a bit more complicated and we need a more systematic analysis.

Consider another transaction. A government is redeeming a 7% bond with a notional of 1bn with semi-annual coupons. How much does the net indebtedness of the country change? Assuming that all the lenders are in the rest of the world sector, the net indebtedness changes by 35m. Does not matter if the currency is domestic or not. Why 35m? Because the semi-annual coupon has to be paid on redemption and the coupons are interest payments and this is recorded in the current account and this increases the net indebtedness. The principal payment cancels out the earlier liability – the bonds.

So between the start and the end of the period, foreigners earned 35m and this increased the net indebtedness of the nation who paid the interest. Of course there are other transactions which can cancel this out.

In another scenario, if all the bond holders were residents, the net indebtedness does not change – whether the bonds were in domestic currency or not.

The above was about financing. What about imports and exports? Exports provide income to a nation or a region as a whole and imports are opposite. If a nation is a net importer (more appropriately running a current account deficit), this means its expenditure is higher than income. When expenditure is higher than income, this has to be financed and this is via net borrowing. 

There is one important point worth stressing. Many people – including many economists (most?) – treat liabilities to foreigners in domestic currency as not really a liability at all – at least the government’s liabilities. The reason provided is that while usually the government is forbidden from making an overdraft at the central bank or have limited powers in using central bank credit, it can end up making a higher use of it than the limits allowed – in extreme conditions. This in my opinion, is a silly intuition.

While it is true that the governments of most nations (with exceptions such as the Euro Area governments) can make a draft at the central bank and this offers the government protection to tide over extreme emergencies, the government has to directly or indirectly finance the current account deficits and this can prove unsustainable. Despite this there is an advantage in having indebtedness to foreigners in the domestic currency because:

An indebtedness to foreigners in domestic currency prevents revaluation losses on the debt if foreigners continue holding the debt and if the currency depreciates against foreign currencies. If the debt is denominated in a foreign currency and if it depreciates, more income needs to be earned from abroad to service the principal and interest payments.

The discussion can be confusing because of the relative ease with which the United States has managed till now to finance its current account deficits because the US dollar is the reserve currency of the world and continues to do so and the holders are willing to accept liabilities of resident sectors of the United States, especially the government’s at low interest rates/yields.

James Tobin, who has provided the best description of the meaning of government deficits and debt said this in an article “Agenda For International Coordination Of Macroeconomic Policies” (Google Books link)

Nonzero current accounts must be financed by equivalent capital movements, in part induced by appropriate structure of interest rates.

We will discuss this further in many posts and for now here’s a good illustration of how the balance of payments accounts are kept. This is from the Australian Bureau of Statistics’ manual Balance of Payments and International Investment Position, Australia, Concepts, Sources and Methods, 1998

(click to enlarge)

So, one starts out with the international investment position and records the transactions in the current account and the financial account. The difference is that the former records income/expenditure flows while the latter records financing flows. The current account includes items such as imports, exports, dividends, interest payments paid to/received from non-residents etc., while the capital account records transactions such as residents’ purchases of assets abroad, increase in liabilities to non-residents and so on. Since debits and credits equal, the balances in the two accounts cancel out. To calculate the international investment position, we add the financial account flows and calculate revaluations to reach the end of period international investment position.

The international investment position records assets and liabilities vis-à-vis the rest of the world. If the difference – the NIIP – is negative, it means the nation is a debtor nation. In the construction above, all transactions between residents and non-residents are recorded – whether in domestic or foreign currency. The numbers are then converted to the domestic currency according to the best rules prescribed by national accountants.

We will look into these in more detail – including all causalities of course – in later posts in this series. Till then, the summary is: imports are purchased on credit. 

By The Theory’s Originators, At Any Rate

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While most people – including most economists – treat money as a commodity, there are some who understand the endogeneity of money. However, there is a degree of endogeneity assigned to the nature of money with some thinking money was a commodity in some periods in history. So one sees claims that what is written in economics textbooks works only in “gold standard” or worse – fixed exchange rate regimes. Fixed or floating is not the focus of this post, but I’d like to quote James Tobin who once said:

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.

… The man and his wisdom 🙂

Nicholas Kaldor wrote a major article in 1985 titled How Monetarism Failed (Challenge, Vol. 28, No. 2, link). The article goes into the heart of confusions in economists’ minds on the nature of money.

Kaldor talks about the Monetarists’ false intuition:

Given the fact that the demand for money represents a stable function of incomes (or expenditures), Friedman and his associates conclude that any increase in the supply of money, however brought about (for ex- ample, through open-market operations that lead to the substitution of cash for short-term government debt in the hands of discount houses or other financial institutions), will imply that the supply of money will exceed the demand at the prevailing level of incomes (people will “find themselves” with more money than they wish to hold). This defect, in their view, will be remedied, and can only be remedied, by an increase in expenditures that will raise incomes sufficiently to eliminate the excess of supply over the demand for money.

As a description of what happens in a modern economy, and as a piece of reasoning applied to situations where money consists of “credit money” brought about by the creation of public or private debt, this is a fallacious piece of reasoning. It is an illegitimate application of the original propositions of the quantity theory of money, which (by the theory’s originators at any rate) were applied to situations in which money consisted of commodities, such as gold or silver, where the total quantity in existence could be regarded as exogenously given at any one time as a heritage of the past; and where sudden and unexpected increases in supply could occur (such as those following the Spanish conquest of Mexico), the absorption of which necessitated a fall in the value of the money commodity relative to other commodities. Until that happened, someone was always holding more gold (or silver) than he desired, and since all the gold (and silver) that is anywhere must be somewhere, the total quantity of precious metals to be held by all money-users was independent of the demand for it. The only way supply could be brought into conformity, and kept in conformity, with demand was through changes in the value of the commodity used as money.

[boldening: mine]

Notice the wording “by the theory’s originators at any rate”.

And what about mining or the lack of mining?

… the value of the money commodity depended, in the longer run at least, on its costs of production, in the same way as the demand for other commodities. With the expansion of the general level of production, the value of monetary transactions through the purchases and sales of goods and services expanded pari passu, which made it profitable to expand the production of the money commodity in line with commodities in general. From the very beginning, therefore, the increase in the supply of money in circulation was a response to increased demand and not an autonomous event, though occasionally the supply of the money commodity ran ahead of the increase in the supply of other commodities, as with the gold and silver discovered in the new Spanish colonies of the sixteenth century; at such times, money could be said to have exerted an autonomous influence on the demand for goods and services. It did so because those who first came into the possession of the new gold or silver were thereby personally enriched, and thus became the source of additional demand for goods and services. But the converse of this proposition was equally true: where the increase in the supply of the money commodity lagged behind, this placed obstacles on economic expansion that historically were gradually overcome with the successive introduction of money substitutes.

Kaldor then goes into the development of the banking system:

This latter development was closely associated with the development of banking. Originally, goldsmiths (who possessed strong rooms for holding gold and other valuables) developed the facility of accepting gold for safekeeping, and issued deposit certificates to the owners. The latter found it convenient to make payments by means of these certificates, thereby saving the time and trouble of taking gold coins out of the strong room only to have them re-deposited by the recipient of the payment, who was likely to have much the same incentive of keeping valuables deposited for safekeeping. The next step in the evolution toward a credit-money system was when the goldsmiths found it convenient to lend money as well as to accept it on deposit for safekeeping. For the purpose of lending they had to issue their own promissory notes to pay cash to the bearer (as distinct from a named depositor) on demand; with this latter development the goldsmiths became bankers, i.e., financial intermediaries between lenders and borrowers. Since real money (gold) was only required on specific occasions (when payments had to be made abroad or when the contract specifically provided for payment in cash), the banks found that the amount of such notes issued to borrowers came to exceed by many times the amount of gold deposited in their vaults by the lenders- though the total amount they owed to the lenders was always larger than the total amount lent to the borrowers. The apparent contradiction between the formal solvency of the banks when the volume of credits granted to borrowers was compared with their total obligation to their depositors, and their palpable insolvency when the value of the promissory notes issued was compared with the amount of gold held for their encashment, was not properly understood for a surprisingly long period. It gave rise to prolonged controversies between those (like Edwin Cannan) who firmly believed in “cloakroom banking” and those who believed that, by issuing pieces of paper that came to serve as a circulating medium, the banks were “creating credit,” which meant an effective enlargement of the money supply.

Did central banks “control” the money stock during gold exchange standards? Kaldor says:

Traditionally, the core of central-banking policy consisted of protecting the reserves (in gold or reserve currencies) through the instrument of changes in the bank rate. Ostensibly, such changes served the purpose of keeping the balance of payments with foreign countries on an even keel – a loss of reserves was taken as evidence of an unfavorable balance, and vice versa. The policy worked in the sense that even moderate changes in short-term interest rates (relative to other financial centers) sufficed to reverse the trend in the movement in reserves. But until the new monetarism came into fashion, stabilizing the quantity of money in circulation, as distinct from stabilizing the volume of international reserves, was not regarded as a primary objective.

One more thing. There is a very interesting point that Kaldor makes at the beginning of the article – the ending of the following is the point of the greatest interest to me.

In the light of the above, the main contention – and indeed, the sine qua non – of monetarism, that the money supply of each “economy” is exogenously determined by the monetary authority of the “economy” concerned, may be questioned from the start. Monetarists, following Milton Friedman, assume that the monetary authority determines the so-called “monetary base” (or “high-powered money,” to use Friedman’s expression), which is nothing else but the amount of bank notes issued which at any one time are partly in the hands of the public and partly in the hands of the banks, whether in the form of vault-cash or of deposits with the central bank; either legally enforceable rules or conventions determine an established ratio between this “base money” and all other forms of money. Hence the “monetary authority” ultimately determines the supply of money in all forms. It does so partly by active measures such as “open-market operations,” by which the central bank buys or sells government securities in exchange for its own notes, and partly by passive measures, the re-discounting of short-term paper consisting of public or private debt, in which it seeks to achieve its objective as regards the money supply by varying its own rate of re-discount. The further assumption that the (inverted) pyramid of bank money bears a stable relationship to the monetary base is supposed to be ensured by the banks’ rationing credit so as to prevent their liabilities from becoming larger (or rising faster) than the legal or prudential reserve ratio permitted. It is admitted, however, that each “economy” characterized by the possession of a separate currency must be wholly autonomous, which means that the central bank is not under any obligation to maintain its exchange rate at a predetermined relationship with other currencies (as was the case under the pre-1914 gold standard or the Bretton Woods system); rather, it allows its exchange rate to fluctuate freely so as to achieve a balance in the foreign-exchange market without central-bank intervention. (The possibility that payments, whether among the same nationals or between different nationals, are effected in other currencies or through transfers between extraterritorial bank accounts has not, to my knowledge, been explicitly considered.)

[last emphasis: mine]

I will have a post in the future on international flow of money, correspondent banking, foreign exchange market microstructure, fx settlements and balance of payments to argue Tobin’s wisecrack that the fixed versus floating debate obscures the problems facing the world today.

Hopefully my post (which was mainly quotes from Kaldor) may force the reader to think about the Horizontalist claim that money is endogenous and it cannot be otherwise.

James Tobin On Public Debt

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James Tobin was one of the greatest economists. He had stock-flow consistency, understood how the monetary and financial system worked and had great ideas on open economy macroeconomics. However, he struggled to express his ideas at a more formal level, especially since he used some neoclassical formalism.

This post may be of interest to Neochartalists. It seems there was a Committee on Public Debt in 1949 and they released a report Our National Debt. James Tobin reviewed the report.

Tobin begins by saying:

The peace of mind of a conscientious American must be disturbed every time he is reminded that his government is 250 billion dollars in debt. He must be shocked by the frequent announcement that every newborn baby is burdened, not with a silver spoon, but with a debt of $1700. The citizen depressed by these somber calculations will find no solace in the book under review. The Committee on Public Debt Policy and its advisors are leaders in the worlds of banking, insurance, business, economics, and education. Experts in finance, they have undertaken to enlarge public understanding of the debt. The Committee believes that the challenge can be met, the difficulties overcome, the crisis surmounted. But these hopeful prophecies are voiced in the tone of a leader summoning his people to an uphill struggle which will demand all their courage, wisdom, and devotion. The world is too full of such struggles, and the Committee does the public it wishes to enlighten no service by elevating to epic status the management of the national debt.

The book permits lay readers to retain misconceptions of the nature of public debt and exaggerated impressions of its present size. The amateur is bound to project to a national scale his own experience of private debt. To him “debt” is a frightening word, and counting debt in billions staggers his imagination. But a national debt is a burden on the nation analogous to the burden of a private debt on an individual only if the nation is in debt abroad. If the United States owed 250 billion dollars to foreign creditors, our real national income would be reduced by the five billion dollars of our annual production exported to pay the interest. As the debt became due, we would face additional sacrifices to repay it, or we could extend it only on terms allowed by foreign lenders. Happily the 250 billion dollars are owed by the Government to its own citizens. Indeed, about one quarter of the present debt is not even an obligation of the Government to its citizens; it is essentially a debt of the federal government to itself or to state and local governments. Payments of interest are not an external drain on our production, and, thanks to the lending power of the Federal Reserve System, the Government need never encounter difficulty in refinancing existing debt or in borrowing more money.

The Committee’s report seemed to have been insistent on retiring the public debt on which Tobin says:

… Deficit spending in times of high demand and full employment is certainly inflationary. This does not prove that old public debt, merely by its continued existence, is inflationary and should be retired.

The present debt represents almost entirely the wartime savings of Americans, who earned record incomes in war production and could not find consumers’ goods to buy. Had the war been financed wholly by taxation, the public could not have acquired these savings …

And on interest payments:

The second possible danger in the public debt is the burden of interest charges. Transfer of interest from taxpayers to bondholders is a nuisance. Committing a large share of the national income in advance as interest on the debt weakens incentives for effort and risk-taking. Interest transfers may promote income inequality. These evils are scarcely serious enough to justify sacrificing other objectives of current public policy to a commitment for debt retirement. Interest payments now amount to only two per cent of the national income; the percentage should decrease with economic progress provided full employment and low interest rates are maintained.

And finally:

… Decisions concerning current taxes and appropriations should be geared to the current economic situation; they should not be influenced by irrational fear of the national debt. But the debt will undoubtedly continue to be an ideological symbol invoked in every public debate. The purpose of this book, the advancement of popular understanding of the debt, remains unfulfilled.

Financial Crisis And Flow Of Funds

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Marc Lavoie forwarded me the European Central Bank’s Monthly Bulletin, October 2011 which has a section on TARGET2 and the European monetary system. I have had good discussions with him on emails to nail the TARGET2 operations so it is good to see the conclusions being verified in publications. I am waiting to write a long blog post on TARGET2 and trying to collect sources I can quote/link and I came across a section on flow of funds in the same article. It appears on page 99 (page 100 of the pdf) and is titled The Financial Crisis In The Light Of Euro Area Accounts: A Flow-Of-Funds Perspective. 

The article has this chart which will be very familiar to readers because it has been in the Levy Institute’s Strategic Prospects since many years.

There are some differences in terminologies. Wynne Godley (and Francis Cripps) started using NAFA (Net Accumulation/Acquisition of Financial Assets) to denote a sector’s surplus in the 1970s and Levy Institute has continued using this. Modern national accountants use Net Lending (by a sector) and split this into Net Acquisition of Financial Assets and Net Incurrence/Acquisition/Increase of/of/in Liabilities and take the difference. Levy’s authors also use Net Lending but as Net Lending to a Sector – e.g., Net Lending to Households.

The article also presents this table (termed Transactions Flow Matrix by Wynne Godley – his greatest trick)

(click to enlarge)

and has this description:

The sectoral accounts present the accounts of institutional sectors in a coherent and integrated way, linking – similar to the way in which profit and loss, cash flows and balance sheet statements are linked in business accounting  – uses/expenditure, resources/revenue, financial flows and their accumulation into balance sheets from one period to the next.To this effect, all units in the economy are classified in one of the four institutional sectors (i.e. households, non-financial corporations, financial corporations and general government). Their accounts are presented using identical classifications and accounting rules (those of ESA 95), in a manner such that each transaction/asset reported by one unit will be symmetrically reported by the counterpart unit (at least in principle). Accordingly, the sectoral accounts present the data with three constraints: each sector must be in balance vertically (e.g. the excess of expenditure on revenue must be equal to financing); all sectors must add up horizontally (e.g. all wages paid by sectors must be earned by households); and transactions in assets/liabilities plus holding gains/losses and other changes in the volume of assets/liabilities must be consistent with changes in balance sheets (stock-flow consistency). The sectoral accounts are commonly presented in a matrix form, with sectors in columns and transactions/instruments in rows, with horizontal and vertical totals adding up (see the example in the table).

The first five rows of the table show the expenditure and revenues of each of the sectors (broken down into types of expenditure/revenue). In row 6, the difference between revenue and expenditure (the surplus/deficit) is shown.

The notions of revenue and expenditure are close to, but generally less encompassing than, the more traditional national account concepts of resources and uses. Income can then be defined as revenue (except capital transfers received) minus expenditure other than final consumption and capital expenditure (capital formation and capital transfers paid). For corporations, income corresponds to retained earnings. Savings is the excess of income over final consumption.

Surpluses/deficits are then associated with transactions in financial assets and liabilities in each sector. This is shown in rows 7 to 10. The bottom part of the table shows the stocks of assets and liabilities, which result from the accumulation of transactions and other flows. This table is extremely simplified (e.g. omitting an explicit presentation of the stock of non-financial assets).

The excess of revenue over expenditure is the net lending/net borrowing (i.e. financial surplus/ deficit), a key indicator of the sectoral accounts. Typically, a household’s revenue will exceed its expenditure. Households are thus providers of net lending to the rest of the economy. Non-financial corporations typically do not cover their expenditure by revenue, as they finance at least part of their non-financial investments by funds from other sectors in addition to internal funds. Non-financial corporations are thus typically net borrowers. Governments are also often net borrowers. If the net lending provided by households is not sufficient to cover the net borrowing of the other sectors, the economy as a whole has a net borrowing position vis-à-vis the rest of the world. Deviations from this typical constellation were apparent in several euro area countries before the crisis, in particular, with extremely elevated residential investment that resulted in households becoming net borrowers (as has been the case in the United States).

The adding-up constraints in the accounts require that any (ex ante) increase in the financial balance of one sector is matched by a reduction in the financial balances of other sectors. The accounting framework does not, however, indicate by which mechanism this reduction will be brought about, or which mechanisms are at play. The EAA makes it possible to track changes in net lending in the different sectors of the economy. It also specifies the financial instruments affected and shows how the transactions and valuation changes leave a lasting effect on the balance sheets of the sectors.

The article is worth a read.

The Bank of England also had a similar article recently but before: Growing Fragilities – Balance Sheets In The Great Moderation by Richard Barwell and Oliver Burrows and quotes the work of G&L (Godley and Lavoie). It also has a similar matrix as the ECB’s article.

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Godley and Lavoie build a series of closed accounting frameworks based on the system of National Accounts, which encompass: the standard national income flows, such as wages and consumption; the counterpart financing flows, such as bank loans and deposits; and stocks of physical and financial assets and liabilities. This framework lends itself to representation in a set of matrices. The first matrix captures flow variables (Table A.1). The columns represent the sectors of the economy and the rows represent the markets in which they interact. The matrix has two important properties. Each sector’s resources and uses columns provide their budget constraint — the sums must equal to ensure that all funds they receive are accounted for. And each row must also sum to zero, to ensure that each market clears — that is, the supply of a particular asset must be matched by purchases of that asset, to ensure that no funds go astray.

The table can usefully be split in two, with the top half covering the standard income and expenditure flows and the bottom half covering financing flows. The two halves of the table are linked together by each sector’s ‘net lending balance’, or ‘financial surplus’. The net lending balance can be used to summarise each sector’s income and expenditure flows as the difference between the amount the sector spends on consumption and physical investment and the amount that it receives in income. This difference must be met by financing flows — either borrowing or the sale of financial assets. In national accounts terminology, a sector’s net lending balance (NL) must equal its net acquisition of financial assets (NAFA) less its net acquisition of liabilities (NAFL). Across sectors, the net lending balances have to sum to zero, as all funds borrowed by one sector must ultimately come from another.

While it is useful to split the table for accounting purposes into income and expenditure flows and financing flows, it is important to note that the acquisition of financial assets and liabilities is not necessarily determined purely by imbalances between income and desired expenditure. Sectoral balance sheets can adjust for other reasons. Agents may want to borrow money to purchase assets, simultaneously acquiring financial assets and liabilities. And on occasion agents may want to shrink the size of their balance sheets, selling off financial assets to pay off financial liabilities. Finally, some agents may default on their debt obligations, which will involve a revision in the financial assets and liabilities of both debtor and creditor. At an aggregate level, simultaneous expansion of a sector’s assets and liabilities invariably represents one set of underlying agents taking on assets whilst the other takes on liabilities. The household sector provides an important example. If a young household takes a mortgage to buy a house from an old household, the sector in aggregate simultaneously acquires a liability (the young household’s mortgage) and an asset (the deposit created for the young household to pay to the old household).

All of these activities — leveraging up, deleveraging and default — involve NAFA and NAFL moving in lockstep. The net lending identity still holds: the gap between income and expenditure determines the difference between NAFA and NAFL. But the absolute size of the NAFA and NAFL flows is determined by agents’ actions in financial markets. The second table captures the balance sheet positions of each sector. The balance sheet matrix is updated over time using data on the acquisition of assets and liabilities from the transaction flows matrix, and revaluation effects to asset positions. Proceeding in this manner, balance sheets always balance across sectors, flows of funds are always accounted for over time and the impact of flows of funds on balance sheets is always recorded.

Again, good article!

The first time a proper transactions flow matrix appeared was in a 1996 Levy institute paper by Wynne Godley:  Money, Finance And National Income Determination – An Integrated Approach.

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James Tobin et al. had something similar – almost but not quite in A Model Of US Financial And Nonfinancial Economic Behavior :

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Nationalistic Solutions?

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A few posts back, I refered to an article by James Tobin [1]. It has a nice but pessimistic ending:

Coordination of macroeconomic policies is certainly not easy; maybe it is impossible. But in its absence, I suspect nationalistic solutions will be sought – trade barriers, capital controls, and dual-exchange rate systems. Wars among nations with these weapons are likely to be mutually destructive. Eventually, they, too, would evoke agitation for international coordination.

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

Coordinated Action? G7 Statement

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Via G8 Information Centre

Statement of G7 Finance Ministers and Central Bank Governors

August 8, 2011

In the face of renewed strains on financial markets, we, the Finance Ministers and Central Bank Governors of the G-7, affirm our commitment to take all necessary measures to support financial stability and growth in a spirit of close cooperation and confidence.

We are committed to addressing the tensions stemming from the current challenges on our fiscal deficits, debt and growth, and welcome the decisive actions taken in the US and Europe. The US has adopted reforms that will deliver substantial deficit reduction over the medium term. In Europe, the Euro area Summit decided on July 21 a comprehensive package to tackle the situation in Greece and other countries facing financial tensions, notably through the flexibilisation of the EFSF. We are now focused on the quick and full implementation of the agreements achieved. We welcome the statement of France and Germany to that effect. We also welcome the statement of the Governing Council of the ECB.

We are committed to taking coordinated action where needed, to ensuring liquidity, and to supporting financial market functioning, financial stability and economic growth.

These actions, together with continuing fiscal discipline efforts will enable long-term fiscal sustainability. No change in fundamentals warrants the recent financial tensions faced by Spain and Italy. We welcome the additional policy measures announced by Italy and Spain to strengthen fiscal discipline and underpin the recovery in economic activity and job creation. The Euro Area Leaders have stated clearly that the involvement of the private sector in Greece is an extraordinary measure due to unique circumstances that will not be applied to any other member states of the euro area.

We reaffirmed our shared interest in a strong and stable international financial system, and our support for market-determined exchange rates. Excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will consult closely in regard to actions in exchange markets and will cooperate as appropriate.

We will remain in close contact throughout the coming weeks and cooperate as appropriate, ready to take action to ensure stability and liquidity in financial markets.

So Finance Ministers and Central Bank Governors are indeed thinking about it, but with more emphasis on fiscal retrenchment (the muddle!) and more importantly …

Just today, I had two volumes of  Tobin’s Essays In Economics (Volumes 1 and 4) delivered to me by amazon.com and I straightaway headed to the chapter Agenda For International Coordination Of Macroeconomic Policies. Tobin writes [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…

History repeats itself!

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