## Monday, January 21, 2013

### Kervick's Simplified

At Mike Norman's, Dan Kervick responds to Tom Hickey's Ellen Brown post.

Kervick simplifies an example, writing:

Suppose for the sake of argument that we had no commercial banks at all, just a single government-run central bank. There would still be two ways in which the government could inject money into the system: the Treasurer could spend it, or the central bank could loan it.

The Treasurer could still spend money into the economy, and the Fed could still lend it into the economy. To me, this is a useful simplification.

Even in Kervick's simplified system, there would still be "money" -- spent by the Treasurer -- and "creditmoney" which looks like money and acts like money but which eventually has to be paid back, and costs interest in the meantime.

Kervick writes:

Even if the loans were interest-free or subsidized so as to carry negative interest, the process would not be debt-free so long as the recipient was required to re-pay all or most of the principle.

I think that's right.

Consider two extreme cases. In the first case money comes into the economy in equal amounts from the Treasurer and the Central Bank. Assume a reasonable interest rate on bank loans -- say 6%.

Now the money circulating in the economy is half interest-free and half at 6% interest. So the average interest cost per dollar in the economy is 3%. That's not unbearable. To get the economy to grow at peak, we might need a little inflation just to offset the cost of interest. But I guess we're used to that!

In the second case, money comes into the economy in unequal amounts, with the Central Bank lending several times what the Treasurer spends each year. How much? Dunno, give me a minute.

 Graph #1: Additions to Circulating Money
The blue line is FRED's Federal Surplus or Deficit, divided by 1000 to convert "millions" to "billions", and multiplied by minus one to turn the negative numbers into positive additions to money that circulates.

The red line is the yearly addition to everybody else's debt except the Federal debt, in billions.

For Kervicks' simplified example, the blue line represents money that the Treasurer spends into circulation. The red line represents money loaned into circulation by the Central Bank.

This is a graph of the ratio of the two, the money lent into circulation relative to the money spent into circulation, and Graph #2 shows a useful chunk of it, useful because it is stable enough that we can zoom in and see something:

 Graph #2: Money Lent in to Circulation relative to Money Spent into Circulation, 1975-1995

Wow. That's the 20 years from 1975 to 1995, which looks low and stable in the linked graph, the one I didn't show. Oh, well.

Okay, consider it stable. Call it, what, an average value of 50? Let's go with 50.

That means, in real life, in those years, there was fifty times as much money lent into the economy as there was deficit spending. For our Kervick's Simplified example, it means for every dollar (beyond revenue) spent by the Treasurer, \$50 was borrowed and spent by the private sector and other non-Federal borrowers.

Fifty to one.

So now: In the second case, money comes into the economy in unequal amounts, with the Central Bank lending several times what the Treasurer spends each year. How much? Fifty dollars lent, for every dollar spent.

Let's get into the weeds.

In the first case, the amount spent by the Treasurer and the amount lent by the Central Bank are equal. Let's say, \$102 each.

There is a total of \$204 introduced into the economy.

The \$102 introduced by the Bank comes in at 6% interest, or \$6.12 total.

In the second case, the amount introduced by the Bank is fifty times the amount introduced by the Treasurer. Suppose the Treasurer introduces \$4, and the Bank introduces \$200 into the economy.

There is a total of \$204 introduced into the economy.

The \$200 introduced by the Bank comes in at 6% interest, or \$12.00 total.

There is approximately twice as much interest cost in the second case as in the first.

If in the first case, the drag created by financial cost can be offset by 3% inflation, then in the second case we will need 6% inflation to offset the drag and get decent economic growth.

In general, the greater the role of finance in the economy, the greater the financial cost. The greater the financial cost, the greater the inflation required to offset that cost. Or in the alternative: The greater the financial cost, the worse the economic performance will be.