Monday, February 1, 2010

We are all Kosh

From Economics by Campbell R. McConnell:
When a bank makes loans, it creates money.
McConnell expects his reader to find this "a startling fact." (I remember being startled by it, back in 1977.) And this:
It is through the extension of credit by commercial banks that the bulk of the money used in our economy is created.
He calls it "bank money." And this:
It seems logical to inquire whether money is destroyed when the loans are repaid. The answer is "Yes."

I have three thoughts:

1. On the internet

Most of the time when I see the "banks create money" idea on the internet, it is associated with the phrase "fractional reserve banking" and seems to be considered some sort of criminal activity.

I won't argue the point, except to say I don't see how it could be criminal, since it is common and public and built into the institutions and the fabric of society. And it's not some great secret kept hidden from everybody; all you have to do is take an economics class to learn about it.

Anyway, the problem is not that banks create money and debt. The problem is the excessive accumulation of bank-money or credit-money or debt, relative to the quantity of M1 (money in circulation).

2. What happens to a dollar

What happens to a dollar of bank money during its lifetime? It works just like real money (because it is money). Maybe it was your boss who took out the bank loan, to meet payroll. So, you get paid this week with "bank money." Maybe cash, maybe payroll check, maybe direct deposit, it's still bank money, created when your boss borrowed it.

Do you feel cheated? I don't see why. Would it be better if the boss gave you a hand-written IOU or a verbal promise to pay you in a week or two? I don't think so.

It doesn't matter that the money you receive may have been created that very day by a bank lending it to somebody. In fact, it has probably happened to you without your even knowing about it.

3. Like the Fed

Across the top of a dollar bill it says "Federal Reserve Note." The dollar is issued by the Federal Reserve. The Federal Reserve is called "the Fed."

Picture the Federal Reserve buying assets from the public. The sellers receive "new" money for the assets they sell. That money stays in the economy until the Fed starts to worry about inflation, and decides to sell some assets and take money out of the economy again.

Picture me borrowing money from the bank. It's new money we create, the bank and I, and when I receive that money and buy something, I'm putting new money into the economy. Exactly like the Fed does.

When I make a payment on that debt, I capture circulating money and take it out of the economy again. Exactly like the Fed does. If I choose to make only the minimum payments, the money I put into the economy stays in circulation for a long time. Only when I take a dollar and use it for debt repayment -- only then -- does my money come out of the economy. Just like at the Fed.

We are, each of us, a little version of the Federal Reserve.

9 comments:

Tom Vest said...

"...when I see the 'banks create money' idea on the internet, it is associated with the phrase 'fractional reserve banking' and seems to be considered some sort of criminal activity."

Very ironic, since the Internet itself is at root an artifact of the exact same basic practice, the more scientific term for which is "statistical multiplexing." The Internet version of statmux, called "packet switching," makes it possible for the various physical, signal-bearing media used in telecom facilities to convey between 1-2 orders of magnitude more information per unit of time than they could have carried under the previous technology ("circuit switching").

Perhaps predictably, this capability has created the same kind of conflicts of interests and philosophies between the advocates of "the pipes" and their owners (i.e., typically incumbent telcos), and the advocates (typically ISPs) of that extended carrying capacity and the possibilities created by making it available it to a broader range of productive uses and users.

Steve Roth said...

Yeah I did a post a while back: "Don't like money printing? Pay off your loans!"

MMTers talk a lot about net financial assets (which equals government debt), but not much about gross financial assets -- which Keen seems to concentrate on. Is gross more interesting/useful you think?

The Arthurian said...

Hi Steve. Well yeah, assuming I have the terminology right. A wealth of gross financial assets would be the same thing as an excessive accumulation of debt.

Debt is a financial cost borne by the non-financial sector. Accumulating, it increases the cost of production and ultimately leads to cost-push inflation, falling profit, and a lethargic economy. For starters.

If you borrow a dollar and spend it, you put a dollar into circulation. It continues to circulate, at your expense, until you grab it from your paycheck and return it to the lender.

I'd prefer to rely on cost-free money (say, monetized Federal debt) for all spending associated with the existing level of output. And rely on bank money for the 5% or 10% of spending that is associated with growth. My goal is to minimize the factor-cost of money.

Then later, adjust the money supply for that growth by monetizing additional Federal debt, while policy induces the repayment of the credit that was used for growth. And as you know, paying down debt is a way to fight inflation.

jim said...

Hi Art

I would think debt causes inflation if the debt was predicted on the expectation of inflation. If the repayment is expected to be made with inflated dollars and the assets acquired with the loan are not expected to depreciate that becomes a self-fulfilling prophecy (until the music stops)

If the loan is based on expectation of acheiving more efficient production then that increased production would drive inflation down.

Paying down debt would counter inflation if repayment reduces disposable income. But if you print money to pay off debt, how does that fight inflation?

The Arthurian said...

I'm not big on expectations, jim. What I got from Milton Friedman is that the value-in-exchange of money varies inversely with its scarcity -- just as the value of gold or water or anything else does (in a normal economy).

So I probably miss what you are saying because it involves expectations. (If so, tell me again.)

"Paying down debt would counter inflation if repayment reduces disposable income. But if you print money to pay off debt, how does that fight inflation?"

Where we are today, deleverage is draining money from circulation and the Fed has been fighting DEflation. I want to redirect circulating money, people's income, back toward living expenses and away from debt repayment.

So then we are left with unpaid debts and the unsatisfied need to delever. So, we can print money and use it to pay off some debt. Pay off the part that destroys the money when the debt is repaid. Perhaps this is the debt of normal banks, as opposed to "shadow" banks. But you probably know more about that than I do.

In any event, the Fed is *already* printing all the money that needs to be printed. But they're not using it right.

It is true that expectations give rise to conditions. But it is *more* true that conditions give rise to expectations.

Art

jim said...

What I'm saying is most of the 10% per year growth in debt in the decade prior to the meltdown was based on the assumption that it would be paid back with dollars that would shrink in value balanced against personal assets that would grow in value.

It should now be obvious that there is nothing inherent in the monetary system to support those beliefs. They only appeared to hold true because decades of excessive borrowing made it true.

Today people see that loans may end up being paid in money that does not shrink in value and assets may never grow in value. That poerception of the future entirely changes the way people and businesses perceive the risks of borrowing (for the better IMO). Those expectations makes avoiding borrowing and saving money seem more prudent.

Right now we don't have deflation. The government is over-spending pretty close to what the private sector is under-spending. We have tiny growth in total debt and a small amount of growth in productivity. That is really an improvement over slightly higher GDP growth financed by unsustainable levels of private borrowing.

I don't see the fed having much beneficial affect by monetizing debt. That will increase inflation which will give people more reason to borrow and get back on an unsustainable path.

Lowering taxes would put more money in the hands of people. Creating more govt debt without the FED monetizing it has the same effect (to individuals) without being inflationary.

The Arthurian said...

"I don't see the fed having much beneficial affect by monetizing debt. That will increase inflation which will give people more reason to borrow and get back on an unsustainable path."

I think we already had inflation -- even if you only count the years since 1980 -- and not from printing money, but from the use of credit.

I think we could therefore change out dollars of credit, and put in their place dollars of money, without causing more inflation.

Now obviously if we use that new money as a base from which to generate a new mountain of credit-use, we *will* get more inflation. But that is not my goal.

jim said...

I think we could therefore change out dollars of credit, and put in their place dollars of money, without causing more inflation.
__________________________

Lets assume that somehow money gets into the hands of the public. This could be a govt check in the mail or just not so much taken out of the weekly paychecks or it could be scattered from black helicopters.

The question is what difference would it make if the federal govt printed that money or if it borrowed a matching amount from the public who are willing to buy securities?

Either way the recipients get the same amount. But if the govt does not borrow a matching amount, then the dollars you receive will be competing with the dollars that would have gone to buy TSY securities. That clearly would be inflationary. As in more money chasing the same amount of production.

If there is inflation and the realistic expectation of future inflation that will result in the reappearance of the mountain of credit-use that you say you want to avoid. Without inflation there is no motive to return to borrowing at that level.

The Arthurian said...

jim, sorry about the delayed response. you're making me thing, and I think slowly...

Wow. This is really well said: "Either way the recipients get the same amount. But if the govt does not borrow a matching amount, then the dollars you receive will be competing with the dollars that would have gone to buy TSY securities. That clearly would be inflationary."

Exceptionally clear.

Except, if I have a dollar and I want to buy a "tizzy" security with it but none is available, then I will probably want to find some other way to *SAVE* that dollar, as opposed to using it for consumption purposes. If I succeed in saving the dollar, it is not clear to me that the policy was inflationary. Yes, it increased the Q of M, but not the Q in the spending stream. (And actually, I'm not sure the policy increases the Q of M if new money pays off old debt.)

I have said we should print money and use it to pay off debt directly... You have said this is inflationary... But if the debt repayment destroys the new money, then it cannot be the new money that is inflationary. So then, what is inflationary? Is cancelling debt inflationary? No, it is only anti-deflationary. So I think it can only be the bank-money being promoted to base that is inflationary.

Or again: ...But if the debt repayment puts money back into savings and time deposits, then the new money is *removed* from the spending stream and does not cause inflation. It is not even "new" money. The policy simply fills holes in savings accounts where savers believe their money to be. You might think people would be happy about that.

This money, sitting the bank, now idle, is certainly not inflationary. But it is this money, old money freed up by the policy, that could be the cause of inflation via credit expansion.

//

You think that savings freed up by the repayment of debt will naturally emerge from savings and enter the spending stream. I do not think that is the case.

You think savers will *expect* inflation because debt has been repaid with printed money, and that their reaction will generate a self-fulfulling prophecy. I agree this is possible but I think they can perhaps be convinced otherwise about the effect of the policy. Savers don't like inflation. But they like to save. And if savers keep their savings in savings -- where they obviously wanted it -- it will not cause inflation.

But, yes, if the bank lends out that money again it could cause inflation. This is the part of policy that has to be carefully re-thought. Convincingly re-thought.

If lending and borrowing is not permitted to grow faster than everything else in the economy for decades at a time, the problem is essentially solved.


//

If the problem is inflation, jim, the cause is not my policy. The cause is policy since World War Two, which encouraged saving and encouraged the use of credit and encouraged the growth of finance and did not stop when we had more than enough of those things and they began to hurt us.

And if the problem is *not* inflation, then the problem is excessive reliance on credit, and the excessive debt and the excessive accumulation of savings and the excessive growth of finance that came with it. And the cause is policy since World War Two. And the solution is to re-think the simplest and most basic assumptions: that we must let the Federal Reserve fight inflation, and that we must expect Congress skew the playing field in favor of growth.