## Tuesday, September 20, 2011

### National accounting equation by itself does not answer flow and causation among its components

The national accounting equation is an accounting of this year’s composition of national income as caused by the different actors of the economy. The GDP/Income equation by itself doesn’t tell us anything about what will cause income or savings or consumption to rise or fall, and it’s wrong to assume we can infer anything other than this year’s composition. The equation also does not tell us anything about what makes people desire more consumption or investment. All we know is what cleared, i.e., what goods were bought/sold.

These equations

1. Y = C + I + G + X - M

Income = Consumption + Investment +Government spending + exports - imports

2. S = Y - T - C

Savings = income -tax - consumption

do not answer the question 'What causes Y to rise or fall?' or 'What causes S to rise or fall?' We need completely new tools that better describe about flow and causation. We cannot infer flows from one factor going to other factors of the equation, and hence cannot infer from the equation which factor creates new money and hence increase general income level.

This is why many economists are in disagreement and each tends to use the equation to bolster his belief of what is needed to improve the current economic environment. Some believe that it is private sector C and I that increases Y, and that G, which drains money via T, lessens private sector S and therefore their C and I.

But it is equally believable, and in fact, a more compelling explanation, that it is G that increases Y and therefore helps induce more private sector C and I. If you have no government deficit spending, there is no new currency to go around, nothing to save, no money people can use to spend, no money to buy Government treasuries with.

Why is the concept that money should be existing first before government can borrow it more believable than the concept that government has to issue money first by spending before people can have money to lend back to government? Did some people create the first money before government decided it can take some away via T? How then did those people decide when to stop creating money? Why can't anyone just create money now as he likes? What mechanism made everyone at that time stop creating together? In other words, why is the framework that people created money easier to accept than the framework where government created it?

Equation 2 above for example leads some people to make this statement: “if you like, you could define S as “national saving” to include both private saving plus government saving.” Why claim that national saving is government plus private saving? Doesn’t a flow from one lead to an increase in stock of the other? I.e., ‘Private saving’ increases with more government spending, and ‘government saving’ increases with private dis-saving (greater taxation), and at an extreme (forgetting foreigners) adding both together results in zero.

Now let's think beyond the domestic system, to get to the X and M of national accounting equation. If there is more M than X, then money is getting out of the domestic economy. This by itself would mean that in the next period, there would be less domestic Y to fund that period's C and I. G will have to increase, such that it may need more funds than what it can get via T. If there is less money now in the economy, how does G fund itself? Where would the Government Treasury buyer's money come from?

Well, if money is getting out of the system, someone outside is getting more money than he wants to consume. That person now has excess reserves of money. In the extreme that everyone in the domestic system is short money, therefore cannot fund G, perhaps because in the last period they all spent their last cent buying the latest gadget from Mr foreigner, then those dollar reserves now owned by Mr. Foreigner is brought back into the domestic system via G, funded by treasury sales to Mr Foreigner.

Those excess reserves could not have gone to Mr Foreigner's bank account unless they were issued into existence first. That's why there's most often a buyer when the government issues a treasury, because the previously issued and spent dollar eventually gets to someone who just needs to save it for future consumption.

In short, G enables Y not to fall even when X-M is a negative number. G also creates the Y that enables both domestic and foreign investors to fund future G that is funded by borrowing.

Mario said...

totally econo rogue. stately soberly and clearly. hopefully it will make others consider the "paradigms" they are operating from.

G also creates the Y that enables both domestic and foreign investors to fund future G that is funded by borrowing.

I see what you're saying but remember that G is never "funded by borrowing"...at least not our G.

it is G that increases Y and therefore helps induce more private sector C and I.

I guess to put it more bluntly...the G in our economy stands for G-SPOT!!!! LOL

Rogue Economist said...

you're right, Mario. a better way to state it is probably: G also creates the Y that enables both domestic and foreign investors of Treasuries, for whatever reason they are issued and sold.

Ellen1910 said...

. . . the concept that money should be existing first before government can borrow it . . . .

It's not a concept; it's a commonplace, a tautology. Try borrowing a lawnmower from your neighbor who doesn't possess a lawnmower.

If you have no government deficit spending, there is no new currency to go around . . . .

Maybe on Mars but not in the United States of America. Here, banks create money by the act of lending; the government, on the other hand, spends preexisting money which it gets by taxing and borrowing.

When the balance in its accounts is inadequate to make its payments (deficit), the law requires the government to find preexisting money with which to make the payments. It does so by trading a promise (represented by a bill, note, bond) for a portion of the balance in someone's deposit account.

No money is created.

Rogue Economist said...

Ellen: "Try borrowing a lawnmower from your neighbor who doesn't possess a lawnmower."

You're right, that would be impossible if the lawn mower isn't there.

Ellen: "the law requires the government to find preexisting money with which to make the payments."

Yes, but that doesn't preclude the money the government borrows to have been spent by the government itself into existence first.

It would be like me renting you my lawnmower so that you can mow my lawn and every other house on the street for money. You never had money to pay the rent in the first place, so by yourself, you'll never ever find a way to make any money. But if someone lends you the mower in exchange for service, you get the money to pay for it as well as earn income for yourself.

Same principle happens with government spending. The act of using private capacity can create the income that the private sector can use to buy government's borrowing that fund the spending.

Ellen1910 said...

. . . that doesn't preclude the money the government borrows to have been spent by the government itself into existence first.

I'm trying to get you off Mars. Why is it so difficult?

Per MMT the money could have been spent into existence by the government (many MMTers would say that practice is preferable to borrowing it) -- but

IT WASN'T -- here, in the U.S. of A. the law forbids it.

Little story: I visit my banker and because I'm charming he (she never would) authorizes an unsecured loan of \$10,000. That's \$10,000 in my checking account (and \$10,000 in my banks reserve account with the Fed) -- money that heretofore didn't exist. Five pairs of Jimmy Choos later the retailer has my money AND instead of reordering inventory he buys a Tbond.

That transaction hasn't created any money.

Rogue Economist said...

Ellen: "I'm trying to get you off Mars. Why is it so difficult?"

And I'm trying to get you off your rickety little world where every money has to be borrowed into existence. Your world, if it were the real world, is a ticking time bomb one day bound to collapse, when the last person who borrows money decides not to pay the second last person to borrow, and so on. Everything in your world will come crashing down when that day comes, and all it takes is a few unscrupulous people to untangle that ponzi scheme.

How will it ever get back to work? No one can start the process again without having to borrow. As you say, the law forbids anyone or any entity from spending first. So if the people in your world are too afraid to borrow again, money in your world will cease to exist. Game over.

Tom Hickey said...

While it may seem like government either borrows from the private sector or taxes to get the reserves to cover its spending, it is government deficit spending that creates the reserves in the first place. In that sense, government borrows or taxes what it has already spent.

Deficit expenditure adds net financial assets to nongovernment exogenously, while all endogenous credit nets to zero. That is to say, deficit expenditure injects net financial assets because there is no corresponding liability created in nongovernment. All nongovernment credit transactions involve offsetting assets and liabilities within nongovernment.

When government taxes, it withdraws net financial assets from nongovernment. This operation changes both government and nongovernment fiscal balances, i.e, reserves shift from a nongovernment account at the Fed to a Treasury account at the Fed (likely through a TT&L account).

When government borrows, total net financial assets remain the same, only the composition and term changes. That is to say, when a tsy security is bought by a nongovernment entity, then reserves in a Fed account get switched into a securities account at the Fed. It is a monetary operation rather than a fiscal one.

What this implies is that government is not crowding out nongovernment through the competition for loanable funds. That is not applicable under the current monetary system.

Tom Hickey said...

The way MMT economist look at the way causality runs in the macro-equation is based on the assumption that nongovernment saving desire is the given. On the other hand, the government fiscal balace is discretionary and can accomodate changes in nongovernment saving desire, keeping the equation in balance at full employment with price stability at the desired level of saving.

The Arthurian said...

Wow! I really liked the post. Right up to the point where Mario said "G is never 'funded by borrowing.'" At that point, theory started to interfere with the existing understanding of things. That's what makes theory so reject-able. The government DOES borrow. All of the skirting-the-issue talk about "money ceases to exist" when the government taxes our tax dollars is outrageous invention.

I'm with Ellen on this: "Per MMT the money could have been spent into existence by the government ... but IT WASN'T" and trying to deny this, is what makes MMT a theory built on wishes rather than fact.

On the other hand, Ellen, borrowed money is spent into circulation by the government, and that is all that matters.

I'm not really sure, but I think Tom said the thing that I want to say, which is this:

When the government borrows a dollar and spends it, the dollar goes into circulation in the private-sector economy. And a measure of wealth (the TIZZY, as you dizzies like to call treasury securities) is added to the private-sector economy. But NO DEBT IS ADDED to the private-sector economy.

On the other hand, when "banks create money by the act of lending" (as Ellen puts it) debt IS added to the private economy. This is the key difference. It is the difference that creates Rogue's "ticking time bomb" scenario: "when the last person who borrows money decides not to pay the second last person to borrow, and so on. Everything in your world will come crashing down when that day comes..."

And that day has come.

Good post Rogue!

Ellen1910 said...

RE -- the fact is that in the U.S. of A. all money is created by the actions of banks extending loans. Government borrowing, on the other hand, merely takes money out of the hands of the lender which is then distributed to the government's obligees -- thus, a wash.

Your claim that such a practice is fraught with economic peril (your Ponzi scheme) doesn't make the fact untrue.

Ellen1910 said...

Now, to Martian Number Two --

Another little story: It seems my tax accountant was a little overzealous in filling out my Schedule B over the past three years and the IRS would like me to pay it \$10,000 -- soonest.

I go to my banker -- who just happens to be my accountant's loving brother -- and lo-and-behold the bank lends me \$10,000. I write a check to the United States Treasury all of which will, because the government's fisc is not in surplus, be returned to the economy.

Note: it was my bank, not the government, that increased the money supply.

So tell me how did deficit spending by the government put that \$10,000 in my checking account?

* To both of you Fourth Rock from the Sun inhabitants -- I don't say that the government can't create money, only that the law forbids it to do so -- see, debt ceiling crisis of recent date.

Ellen1910 said...

To the Arthurian --

"Circulation" -- good thing that "circulation" --

When the private sector is in extreme savings mode, the economy will collapse unless the government steps in and spends -- that is, maintains or increases demand which raises the spirits of actors, increases their confidence and gets them out of their funk and back to spending.

Where the government gets the money it "circulates" -- that is, by writing its own NSF checks (a flow change) or by borrowing it (a stock change) -- is the issue we're debating.

Ellen1910 said...

Further to The Arthurian:

MMT is not criticized because it is built on "wishes"; it isn't.

When it's criticized (usually by orthodox economists who haven't read MMT papers), it's criticized as being nothing more than a series of accountant's tautologies. Those critics are wrong. MMT is explanatory (in comparison the otherwise estimable Krugman has yet to show he understands modern banking).

Rogue Economist said...

Ellen: "To both of you Fourth Rock from the Sun inhabitants -- I don't say that the government can't create money, only that the law forbids it to do so -- see, debt ceiling crisis of recent date."

How would you explain government borrowing rising to the current level it has, \$15 Trillion and counting? Where did that money come from? All of it private bank created? So people are in the hook to pay it all back to some private banks? How did private banks ever get the balls to lend private people, who cannot manufacture money but have to earn it, those trillions of money that just ended up being used to finance government borrowing?

Please tell me the whole story behind this and I will gladly get behind your point. I had thought that the money used to finance those government borrowings came from income created by government spending. Perhaps you can explain to this Martian how government could somehow rachet up its debt level to that amount and still people could not have enough of it.

Ellen: "the fact is that in the U.S. of A. all money is created by the actions of banks extending loans…….Your claim that such a practice is fraught with economic peril (your Ponzi scheme) doesn't make the fact untrue."

On this, I'd much rather be from Mars than from the sand under which your head is buried. Must be exciting to just wait for the world to come to an end, knowing with ful confidence you can't do anything about it.

Ellen1910 said...

To RE:

You're confusing changing stocks with changing flows.

When the government borrows money, it simply exchanges newly created interest-bearing securities for money held in the M1 accounts of private sector savers and foreign central banks.

The only thing that changes is the duration of the parties' assets (lenders) and liabilities (government) -- both of which are increased.

No money is created.

Ellen1910 said...

Hey Rogue -- with your permission I think I'm going to hang around this site for a while -- a good place to get my thoughts in order.

I'm confident I'm right that government borrowing from the non-banking private sector and from foreign central banks does not increase the money supply. What I'm not clear on is the effect on the money supply when banks and especially, the FRB purchase government securities for their own accounts.

Is it the case that banks create money to buy treasuries? Just as money is created when my bank lends me money and debits my checking account, is the bank creating money when it buys a treasury from the government?

If so, which bank liability is credited (increased) to reflect the debit (increase) on the asset side (treasuries owned)?

Rogue Economist said...

Ellen, of course you’re welcome to hang around the site, as comments like yours help me in refining my thoughts as well. Also, my responses to comments have a way of developing into future posts, so it’s helpful for me that way as well.

I’m still waiting for a satisfactory reply to my challenge, which is how government borrowing managed to increase so much, when its growth is supposed (in your conception) to be caused by increasing private bank lending to private borrowers. How do private banks find a constant supply of creditworthy borrowers when all the money they lend ultimately (in your story) goes to fund government deficits and not future private sector income? I pertain nothing about changing stocks or flows of government borrowing, just asking how your conception works to explain its growth realistically.

Your question “Is it the case that banks create money to buy treasuries?” can probably be best answered by you, because this is probably an implication of your concept, not mine. Maybe your answer to this will bolster your own version of the story.

Ellen1910 said...

Getting my thoughts in order, I'm going to answer my question, posted just above:

The answer is as follows: when banks buy treasuries, they pay for them with reserves (thus, no increase in the money supply); if the Fed buys treasuries from a bank, it merely debits the bank's reserve account (thus, no increase in the money supply); but if the Fed buys treasuries from the non-banking private sector, that sector's current asset accounts (money) are debited, and the money supply is increased.

The reason why the money supply is increased in the last transaction mentioned seems to be that the Fed must "print" money in order to buy the treasuries, because non-banking economic actors don't have reserve accounts.

Rogue Economist said...

Ellen, is it common for the fed to buy treasuries from the non-bank sector? I don't know how common this is but ven if it is, how does this answer my question "how has government borrowing managed to increase so much, when its growth is supposed (in your conception) to be caused by increasing private bank lending to private borrowers."

Calgacus said...

Ellen, I answered your old (good) question on deficit spending and reserves in the prior thread, and hopefully clarified matters.

. . . the concept that money should be existing first before government can borrow it . . . .

This is not a tautology, but statement that can NEVER be true, if we are talking about a government's own money/debt.

Try borrowing a lawnmower from your neighbor who doesn't possess a lawnmower. The heart of the problem. Money is not a lawnmower, a rock, a thing. Money is a string, a relationship. Can you borrow a borrowing from someone who has (or hasn't) a borrowing? What on earth could that mean?

I agree that most expositions of MMT are confusing and do not sufficiently display the utter simplicity of the theory - which like all developed scientific theories consists of nothing but trivial definitions & obvious tautologies. And some recent supposed expository improvements are steps in the wrong direction.

The thing to do is read Mitchell-Innes' articles again & again & again. Geoffrey Ingham's The Nature of Money & articles are great too. The clearest & most theoretical of the big MMTers is Wray.

Arthur is wrong on MMT being built on wishes rather than fact - the government certainly does spend money into existence. The fact that it engages in stupid human tricks to hide this does not change things.

Rogue is wrong when he says And I'm trying to get you off your rickety little world where every money has to be borrowed into existence. Money has to be borrowed into existence, because money IS a borrowing. The government issuing a fiat dollar is thereby making a promise for the future to the recipient. If it buys a car from the recipient, it is getting something of real present value for a promise of the indefinite future. The value of money is entirely in futurity, entirely as a buffer stock against uncertainty.

The basic mistake is NOT conflating money (reserves, cash) and debt (bonds, bills). If you think of bonds as million dollar bills, everything will become clear. Or think of the government as always paying its bills in government securities/bonds. I found MMT unintelligible until I read Kalecki making this observation. The mistake is in thinking of bonds as promises for a dollar, and dollars/reserves as "the thing promised". No, bonds are money (nfa) ; money is a kind of bond. Both are of the same kind - a promise, a relationship, not a thing. As Minsky said, "anyone can create money" [make a promise] "the problem is getting it accepted" [having your promises mean anything].

Then the law about deficit financing is seen to be just a law about how the Treasury, which is only allowed to print bonds=millions, must have a positive balance of ones in its ones (reserves) drawer. The Treasury, which is allowed to create "millions" (bonds) out of thin air is where the real action is. Not, as conspiracy theorists tend to have it, the Fed, or banks, which are only allowed to create (or borrow) ones (reserves) in exchange for other things of value, T-bonds (or for banks, loan notes). The Fed & the banks are just money-changers. The Treasury, by its deficit spending, is the true money-creator. Even though, as I said in my last comment, that Ellen1910 is right when she notes that what she calls deficit spending does not change reserves.

Rogue Economist said...

Calgacus: "Money has to be borrowed into existence, because money IS a borrowing.The government issuing a fiat dollar is thereby making a promise for the future to the recipient."

I don't buy the argument that government spending is borrowing. I think your definition conflates the discussion further by defining fiat money as a promise. A promise of what? Money is a token that can equate to the value you provide the government for a service. This token is something you can then use to purchase something else of equal value.

If all government spending is just another borrowing, then deficit spending does not solve the problem of balance sheet recession, as you would be merely exchanging one indebtedness with another. Such is not what I am espousing here, otherwise I would be joining the chorus of people shouting that deficit spending is not sustainable.

"Ellen1910 is right when she notes that what she calls deficit spending does not change reserves."

Deficit spending doesn't change reserves only when it is funded by an equal amount of government borrowing. But if it is done by crediting new reserves to recipients in excess of borrowing, then it does increase reserves. And if a greater amount is taxed than the excess credited, then it decreases reserves.

Calgacus said...

Rogue, everything I said can be backed up by MMT scripture, and/or that of allied econosects. Much was such common knowledge that it once went without saying. So nobody (older) said it, nobody (younger) learned it, and a dark age of economics fell. :-)
As I said, I intended to conflate things. Thinking is impossible without conflation. The problem is that the mainstream conflates the wrong things at the very beginning: government & bank money/debt, and makes absurd, fundamental distinctions between things of essentially the same type: bonds & currency, debt with the same issuer & holder, which can and should be conflated at first without a problem.

All forms of money, all government debt, always and everywhere throughout history are forms of debt, promises. The barest essential of a fiat dollar is that it is a promise to cancel a debt going the other way - e.g. taxation. Money is not a token. Money-things are a token, of money of course. Money-things like dollar bills, like coins, like weights of silver in ancient Mesopotamia, are only representations of money, not money itself, which is not a thing but a relationship, a kind of credit/debt relationship.

If all government spending is just another borrowing, then deficit spending does not solve the problem of balance sheet recession, as you would be merely exchanging one indebtedness with another. The 1st & 3rd clauses are true, but do not imply in any way the middle one. Yes, indebtedness is being exchanged. That's what happened when the Great Depression was cured - government debt, money, payed off and then replaced previously unpayable private debt.

Such is not what I am espousing here, otherwise I would be joining the chorus of people shouting that deficit spending is not sustainable. Again, the second has nothing to do with the first; government debt is infinitely sustainable nominally, and the real constraint of inflation is very far off.

Rogue Economist said...

Calgacus, it’s this definition of money as government debt that confuses people like Ellen, and throws them off MMT and its recommendations. Debt is something that has to be paid back in real terms. If government-issued money were like real debt, people should be able to demand payment in whole whenever they wish. Devaluation via inflation would be considered debt revocation. People would not have the same contentions if it is seen as arising from payment or infusion, which it is. My two cents on this definition, if it is the MMT definition.