Saturday, July 20, 2013

This Borg we call Finance


At Worthwhile Canadian, The trade cycle: debt is trade, by Nick Rowe.

Nick's first few paragraphs are very, very good. Classic. All they are, really, is the clear expression of a simple definition of GDP. Nick puts it in his own words in a way that leaves no doubt he understands this one all the way to the core. And then he uses that definition to come up with "something peculiar". Peculiar, and fascinating. And Nick is just coasting. Everything emerges from the one well-understood definition.

Here are the first 3½ paragraphs in all their pristine glory:

The trade cycle: debt is trade

GDP is high in booms and low in recessions (relative to trend). That is (roughly) how we currently define "booms" and "recessions".

GDP (roughly) measures the volume of trade in newly-produced final goods. But that is a narrow measure of trade. A lot of goods get traded that are not newly-produced. People buy and sell old houses, for example, where by "old" I mean "not produced this year". And those trades are not counted as part of GDP.

There is nothing wrong with excluding sales of old houses from GDP. Because GDP is supposed to measure the volume of production and not the volume of trade. But there is something peculiar in defining booms and recessions and the business cycle in terms of the volume of production, rather than the volume of trade. We produce goods and trade the goods we have produced, presumably because it makes buyer and seller better off, which is why production matters. But trade in old goods, like old houses, presumably makes buyer and seller better off too, so trade in old goods matters too.

In a monetary exchange economy, all goods, both newly-produced and old goods, get bought and sold for money. If something goes wrong with money, we should expect to see trade in all goods, both new and old, get disrupted. Some mutually advantageous trades in newly-produced goods don't get made; some mutually advantageous trades in old goods don't get made either. The decline in production we observe in a recession is just one symptom, albeit an important symptom, of a general decline in trade of both newly-produced and old goods.

Just to be clear, I'm not exaggerating my praise for those paragraphs. I really like the excerpt because Nick pulls so much from a simple definition.


Before long we get to the important part of Nick's post. Less simple, less classic, less definitional, but more to the point Nick wants to make. Thus it begins:

What do we trade? We trade newly-produced goods. We also trade old goods. We also trade IOUs. When I sell an IOU, we call it "borrowing". When I buy an IOU, we call it "lending". Borrowing and lending are trade, and those trades happen for the same reason all trades happen -- because the buyer and seller are presumably better off as a result of the trade. Of course there are exceptions, but then there are exceptions to all trades. Everyone has regretted buying or selling something, whether or not it was an IOU.

Notice how Nick slipped IOUs into the discussion? Before, it was new goods and old goods. Now, it is new goods and old goods and IOUs -- a list of interchangeable parts. But you can't eat old sushi, and IOUs are not goods.

He continues:
If you look at business cycles this way, as a trade cycle, in which the volume of trade rises in booms and falls in recessions, it is totally unsurprising that the volume of borrowing and lending should also rise in booms and fall in recessions. Because borrowing and lending is just another type of trade...

Wow. If I was writing this post, this is where I would want to start: "The volume of borrowing and lending rises in booms and fall in recessions." No explanation needed. But the next little bit -- "borrowing and lending is just another type of trade" -- I'm not comfortable with that. It's not "just" another type of trade. It is the monkey wrench.

The rest of that paragraph is good:
The same monetary problem that disrupts trade in newly-produced goods, and disrupts trade in old goods, also disrupts trade in IOUs. Because, in a monetary exchange economy, all those goods -- newly-produced goods, old goods, and IOUs -- are traded for money.

That's exactly right. But Nick leaves out the most important part: IOUs are used as money. Sure, he gets to it later, as an afterthought, after he gets to his conclusion. It's too late, then. You need to read the story this way:

The same monetary problem that disrupts trade in newly-produced goods, and disrupts trade in old goods, also disrupts trade in IOUs. Because, in a monetary exchange economy, all those goods -- newly-produced goods, old goods, and IOUs -- are traded for money. But IOUs are used as money.

IOUs are the monetary problem that disrupts trade. When "something goes wrong with money" the thing that's wrong is that there is an excess of IOUs relative to the quantity of money. It's not some unidentifiable "something". It's the excessive reliance on credit.

Nick doesn't say that. He relies instead on the sorry notion that "lending is just another type of trade". Nick touches on the truth when he identifies the problem that disrupts trade as a "monetary problem". But he seems unaware that this thought invalidates the other -- invalidates it because lending creates money. Lending is not "just another type of trade", because lending creates money.


I am happy to see Nick focus on the "monetary problem" as the problem that disrupts trade. But borrowing and lending are not "just another type of trade".

Labor is productive. Capital is productive. Finance is not productive. Finance only facilitates production. It's not the same thing. Production is power to the ground. Facilitation is a slipping clutch. Nick Rowe's "trade" treats them as equals.

Credit-use imposes a cost on production. Credit-use increases the cost of production. When there is little debt, the imposed cost is low. When there is a lot of debt, the imposed cost is high. The cost of excessive credit-use reduces profit and reduces disposable income and raises prices and makes our products less competitive internationally.

Labor is often blamed for the high cost of U.S. products. But all costs are costs. Even financial costs are costs. Why then do we always and everywhere blame labor for our cost problems?

Source: Mine of 23 June 2010

Debt is not just another type of trade. Interest income is not the same as wage income. Interest income tends to stay tucked away in the financial sector -- the non-productive sector -- where it can draw additional interest. Wage income is spent. Wage income is mostly recycled back to the productive sector where it can be used again as income.

Not every penny of wage income is recycled, of course. Some of it gets saved, finding its way to the financial sector where it, too, can draw in more of what remains of the money that has not yet been assimilated by this Borg we call Finance.


Let's wrap it up. I'm numbering the rest of Nick's paragraphs...
(1)What would be surprising and in need of explanation would be if trade in IOUs did not follow the same cyclical pattern as trade in other goods.
(2)Neil Irwin tells me that trade in IOUs is increasing in the US. (HT Mark Thoma). He's right that it's good news. I'm just re-framing what he is saying.
(3a)Yes, some IOUs are used as money. Which means that some trades in IOUs create money.
(3b)And this, depending on the monetary policy followed by the central bank, may create a positive feedback loop. But the job of a good central bank is to replace that positive feedback loop with a negative feedback loop, just like a good thermostat. (I'm talking about "banks", in case you missed it.)
(4)[After this afternoon, I will be taking a couple of weeks away from the blog.]

... and match-marking my responses:

(1)Nick is right. We should expect trade in IOUs to rise and fall with the economy. We should expect pattern similarity.

However, as time goes by, the rise and fall of trade leaves the total volume of IOUs at an increasingly higher level, relative to the total volume of goods. So after a time, the economy is not the same as it was at the start. The trade in IOUs has become a larger part of the total, the trade in goods a smaller part.

After a time, a larger part of the total income arises from and accrues to finance. A smaller part arises from and accrues to the productive sector. The effects of this imbalance are called, vaguely and carelessly, a "monetary problem".
(2)Nick is happy to hear that "trade in IOUs is increasing in the US". Happy, because to him it means that trade in goods is increasing also. He foresees recovery.

But Nick seems to overlook the fact that finance has grown large relative to the productive side. He overlooks the fact that a decent increase in the trade in IOUs may be accompanied by a pitiful increase in the trade that boosts income and employment and GDP.

If past performance is any indicator, if the marginal productivity of debt is any indicator, then we cannot possibly afford the increase in debt that would be required to get a halfway decent bit of GDP growth. Nick is overly optimistic.
(3a)Some trades in IOUs create money, Nick says. Okay. So the other trades in IOUs don't create money. They still create additional financial cost.
(3b)And when the positive feedback loop gets started, it builds on what has happened already. It is the increase in aggregate demand that has already happened that gives rise to the spreading view that demand is on the rise. And it is the increase in borrowing that has already happened, that pushes things to further motion. And it is the spending that has already happened that gives prices an upward spin.

And what does the central bank do in response? It jacks up interest rates. It increases the cost of future financial activity to curtail additional expansion. In other words the spending that has not yet happened, and cannot possibly have contributed to inflation, is suppressed.

Growth is suppressed. But no effort is made to accelerate the repayment of the recently created debt that stands as evidence of the "extra" spending which is what created the upward pressures on prices in the first place.

What is necessary is to keep interest rates low to encourage growth, always, and to set up tax incentives that accelerate the repayment of lingering debt.

We cannot leave it up to the central bank to replace the self-reinforcing, inflationary, positive feedback loop with a self-attenuating, price-stabilizing, negative feedback loop. We can't leave that up to the central bank and yet leave intact the massive and complex construction Congress has created to foster credit use and the accumulation of debt. No central bank could succeed in such an environment.
(4)Nick, have a good vacation. When you get back maybe we can talk.

16 comments:

Greg said...

Maybe Nicks best post ever. You are right that he is sharp about making his definitions clear and framing the problem mostly correctly (as I see it) but I have an issue with the way he views borrowing, as borrowers getting it form savers via banks. Its been his view from the beginning and is also the reason I am quick to caution those who heap praise on Nicks intellect. Banks are NOT just simply intermediaries between savers and borrowers they are creators of their own form of money exnihilo. In theory, everyone with an income could go and borrow at the same time and the level of "saving" in the banks does not provide a limit to the level. Its the incomes of the borrowers that provide the limit.

The fact that Nick insists on this flawed view of banks makes me question his intellect.

He's like a modern Dr that continues to think of flu as the result of a bacteria.

The Arthurian said...

I'm still not clear on that, Greg. Banks DO try to get deposits. I'm sure they don't pay interest to savers out of the kindness of their hearts. I think there has to be a connection between deposits and lending.

You are much more alert to this than I am, but I went back and checked Nick's 'debt is trade' post and didn't see anything about ... Oh, he does say some IOUs create money. So then he thinks that some don't create money. But that's correct, isn't it?

Greg said...

Sure banks try and get deposits (and they create new ones when they loan) but they do that, as I understand it, simply because if you are their customer they can make money off you. They dont NEED your deposits as a prerequisite to making a loan to someone else. If Im opening a checking account at BBT then BBT has things they can make money from like my debit card or credit card and then they can pay me a little for my efforts. Im also more likely to look there first for auto loans mortgages etc. My point is that Nick and others like Sumner think a bank is a simple mediary between savers and borrowers which I think you know is not true. Banks create their own money, they dont use mine to give someone else a loan.

This isnt to say that banks dont want deposits, of course they do, but they dont need them to make loans.

As Ive worded it before, when I go to a bank looking for a loan, they dont look in their own vault to see if they "have" the money, they simply look at MY finances and see if I have the income to pay them back. In essence I am borrowing my own future income..... for a fee.

He tries to model loans as a zero sum act. They are clearly not zero sum. Credit grows and grows.... til it stops.

I have no idea what he means about some IOUs not creating money. If its an IOU from or to a bank.....its money!

geerussell said...

(apologies in advance for long, rambling comment)

I'm surprised that Nick finds it so peculiar to define booms and recessions in terms of production. A new house implies a whole web of investment, incomes and jobs in the present to bring it to completion. A rise or fall in that activity directly suggests a boom or recession in the economy.

Trading and old house might optimize the allocation of money and housing between two participants but it's just rearranging the deck chairs. I'd go so far as to say you can't get a boom from that activity, only a price bubble which is why current efforts at monetary "stimulus" have failed to transmit to recovery.

On that side note of why banks want your deposits, there are three sources of reserves for banks. In order from cheapest to most expensive: your deposits, interbank lending, Fed lending. Minimizing the cost of liabilities maximizes profits for the bank so they want you because you're the least expensive and if you aren't savvy enough to avoid it, fleecing you for fee income makes for nice bonuses.

Note that the first two sources, customers and interbank lending, are zero-sum shuffling of existing reserves. For the system as a whole only the Fed can add or drain. Even in the case of circulating cash, it gets into circulation by drawing down on existing reserves. When you take your bag of cash to the bank to make a deposit, it's old reserves coming back home.

If its an IOU from or to a bank.....its money!

Not just a bank's IOU but all IOUs. There's a spectrum of acceptability with my signed cocktail napkin at one extreme and a bank's IOU co-signed by the central bank at the other end but they're all of a kind. Quoting Minsky, Wray summarized it well here:

Minsky took a broad approach to money creation, arguing that “everyone can create money; the problem is to get it accepted”. (2008b p. 255) Money is really just an IOU denominated in the money of account, but there is a hierarchy of monies—some are more widely accepted than others—with the monetary IOUs issued by the treasury and the central bank sitting at the top of the money pyramid. He saw banking as essentially the business of “accepting” IOUs, making payments on behalf of customers and holding their liabilities. Banks make payments in their own IOUs, which are then cleared using the central bank’s reserves. Further, “(b)ecause bankers live in the same expectational climate as businessmen, profit-seeking bankers will find ways of accommodating their customers; this behavior by bankers reinforces disequilibrating pressures. Symmetrically, the processes that decrease the prices of capital assets will also decrease the willingness of bankers to finance business.” (2008b p. 255) In other words, the “money supply” expands and contracts as bankers accommodate the demands of their customers in a pro-cyclical manner.

Greg said...

Agreed gee

I like your breakdown based on costs and the realization of the zerosumness of the first two operations.

My last statement was not well defined. An IOU between any two entities is money but IOUs with a bank or the govt are the most reliable forms of money.

Where Nick got his idea that some IOUs dont create money is probably talking about a hierarchy of money (not his term)



"I'm surprised that Nick finds it so peculiar to define booms and recessions in terms of production"

A lot of things he says surprise me. Many MMists have some blindspots that are quite surprising. I think they arise from this marriage to the money illusion idea.

The Arthurian said...

>> If its an IOU from or to a bank.....its money!

> Not just a bank's IOU but all IOUs.

I have this picture in my head. I would like either to confirm it or flush it out:

If I borrow from a "fractional reserve" lender, then the transaction creates money.

If I borrow from my mother-in-law, then she pulls money out of savings and I put it into circulation, but no money is created.

//

I bought an "old" ("not produced this year") house a few years back. My action helped the seller finance the construction of a "new" home.

Not sure how this fits with what's laid out above.

geerussell said...

I have this picture in my head

Me too. All my thought balloons are balance sheets.

If I borrow from a "fractional reserve" lender, then the transaction creates money

Yes. The bank's balance sheet grows by the amount of the loan on the asset side and the deposit on the liability side.

This gross expansion of balance sheets is money creation. The governor on this expansion that prevents a bank from just willy nilly writing an arbitrarily large loans is capital requirements.

"Fractional reserve" is a red herring in this concept because the bank isn't reserve constrained. Reserves are just an input cost. Even if the bank were required to hold 100% full reserves, the bank could still make the loan. The reserve requirement simply functions like a tax on lending, the bank's costs would rise and the bank would charge you more for the loan but the capacity to make the loan remains.

If I borrow from my mother-in-law, then she pulls money out of savings and I put it into circulation, but no money is created

The thing your mother-in-law gives you isn't her own IOU. What she pulls out of her savings and transfers to you are bank or govt IOUs. In contrast to the bank which begins the process by growing its balance sheet, she begins the process by shrinking hers.

I know it's not money creation because the accounting told me so.

However, I am arguing that anyone can create money by issuing IOUs so let's tell a creation story for your mother-in-law. You paint her house and she writes you a check for $100. The un-cashed check is her IOU, it is money and she created it. Does she actually have $100 in bank deposits to redeem the promise? We don't know but we trust her.

You want me to fix your lawnmower. My price is $100 and endorse the check over to me. You just spent the money she created.

I hire your MIL to cater a lunch for me, a service for which she charges $100. I hand her the check, once again spending the money she created. The IOU now having found its way back to the issuer is extinguished... she tears up the check.

Real productive activity occurred in house painting, lawnmower repair and catering. Money was created, spent, spent again and extinguished upon return to the issuer. Monetary circle of life.

Greg said...

If you borrow money from your mother in law and write an "I Art Shipman owe the holder of this note 100$ within 60 days" note to your mother in law she can then use it as money. If she deals with people who know Art Shipman or convince one who doesnt that he is good for it the same chain of transactions can take place as with a check. But it is not new money in that it doesnt add to circulating money, just like the check. Only the banks and Treasury can add to circulating money.

geerussell said...

If she deals with people who know Art Shipman or convince one who doesnt that he is good for it the same chain of transactions can take place as with a check.

The above sounds very much like a general description of circulating money.

But it is not new money in that it doesnt add to circulating money, just like the check. Only the banks and Treasury can add to circulating money.

Now I'm not so clear on what you mean by circulating money. I offer that circulating money encompasses everything in the hierarchy. There are many issuers of IOUs sitting at different levels (fed, treasury, banks, firms, Art, Art's MIL) all able to have IOUs circulating as money as long as there are users willing to accept them and the issuer is willing to redeem it.

Anonymous said...

My own interpretation of Nick's post is that he and other monetarists are coming to the realization that THE primary transmission mechanism for monetary policy is credit creation , and he's simply trying to preemt the warnings of debt doomsayers like ourselves by framing it as a perfectly natural consequence of "trade".

The Funding for Lending scheme in the U.K. , the recent efforts to encourage lending to SMEs in the EU , and the loosening of various types of credit standards here all represent explicit recognitions of our debt-dependent economies. Not to mention China , where they recently tightened severely , then got spooked and said " Sorry folks - our mistake - carry on !"

The fact remains that when debt/gdp grows continuously you're running a Ponzi scheme( at least in advanced economies where "capital deepening" is not a requirement for structural reasons ).

Monetarists have never and will never accept this fact.

Anonymous said...

Although it may be technically true that only commercial banks can "create money from thin air" , in practice "thin air" money can arise , in huge quantities , from elsewhere. Foreign suppliers of capital , often executing so-called carry trades , can provide the "real" money that will function in the same way as "thin air" money once it gets here. The fact that the consolidated books may balance over the very , very long time is of no value when unsustainable credit booms that have occurred over shorter time spans have blown up your economy.

Bank books are balanced across the developed world today by assuming that unpaid debt will in fact be paid. Nobody , not even monetarists , really believes that will happen in real terms. Monetarists simply think we should pay that old debt , as well as any new debt we care to generate as we please , with debased currencies.

The Arthurian said...

"If you borrow money from your mother in law and write an "I Art Shipman owe the holder of this note 100$ within 60 days" note to your mother in law she can then use it as money."

But in reality she probably can't.
Anyway, she doesn't. In fact, she had the money that I borrowed because she DIDN'T spend it. So she and I continue to expect her NOT to spend it, at least for the duration of the loan.

The money under consideration is the money that I borrowed from her. My IOU, promise-to-pay though it may be, is not money.

If the economy evolves to the point that my IOU is money, then money has become more expensive because of the attached interest obligation.

geerussell said...

But in reality she probably can't.
Anyway, she doesn't. In fact, she had the money that I borrowed because she DIDN'T spend it. So she and I continue to expect her NOT to spend it, at least for the duration of the loan.


If there's a liquid market for Art bonds, she can sell your IOU and spend the money. Or she can post your IOU as collateral to borrow and spend. The scope of her ability to use it as money is really limited only by the willingness of others to accept it. Maybe you're reliable and well-known enough for her to get a AAA rating on it. Or maybe it's junk rated and trades at a deep haircut. In any event, sitting on it to maturity is but one of an array of options.

If the economy evolves to the point that my IOU is money, then money has become more expensive because of the attached interest obligation.

Quite the opposite, really. From the point of view of the asset holder (your MIL or anyone she transfers your IOU to) that interest obligation isn't an expense, it's yield.

Greg said...

Thanks for keeping me honest gee!

Circulating money was a very imprecise term. The concept I was trying to get at is that in my scenario which produces an Art Bond the Art Bond does not add to the supply of money its just a substitution for the already exisitng money. A proxy of sorts. In the instance of a bank loan or a govt bond the loan or bond IS the money. The loan is also technically a proxy but its such a close proxy theres not really a difference in most instances

The Arthurian said...

Here's the thing. My "MIL" has the money and doesn't want to spend it. You guys are talking about 20 ways she can make it spendable.

It was already spendable.

geerussell said...

Here's the thing. My "MIL" has the money and doesn't want to spend it. You guys are talking about 20 ways she can make it spendable.

That the IOU is spendable is the overarching idea. She has exchanged the IOU she had (govt or bank IOU) for an Art IOU. The IOUs vary in liquidity and yield but they are all spendable. They are all money.

Specific to the contrast between your MIL and the bank: the thing you were demanding was an IOU of bank quality of higher. Your MIL doesn't have authority to issue such an IOU and is therefore constrained by the need to possess those IOUs prior to lending them. She is reserve constrained.

A bank can issue bank IOUs and has the backing of the central bank to redeem the bank IOUs the bank can create for govt IOUs it can't. This is why the bank can effectively create govt money from thin air. In backing commercial banks, the central bank delegates a degree of issuing authority to them.

This is all distinct from the question of your MIL's preference to spend or not spend. She could very well stuff her Art IOU in the same mattress she pulled the govt IOUs out of. Talking about her spending it though makes the story far more interesting. If she does spend, leverage, further securitize or otherwise apply various forms of financial wizardy and transformations she becomes part of the shadow banking system.