Issues with “Issues in the Design of Fiscal Policy Rules”

Bill Mitchell drew my attention to a paper that has purportedly influenced the economic policies of the UK Labour Party. This is Discussion Paper No. 429 from the National Institute of Economic and Social Research – Issues in the Design of Fiscal Policy Rules – written by the then Director of the NIESRJonathan Portes  and the well-known Oxford economist and blogger Simon Wren-Lewis.

Before I examine this paper, please permit me a prelude.

We are all very familiar with the common trope “glass half empty/glass half full”. If you think the glass of water is half empty, you are a pessimist; if you think it half full, you are an optimist. Which one are you?

I have long thought that there are two problems with this “insight”.

The first is that it excludes any alternatives, if you are not one, then you are necessarily the other. When viewed this way, one should look for other alternatives, in this case there is (at least) one. I say ‘at least’, because a single other alternative is all that is required to show this is not a real dichotomy. The realist view is that it is just half a glass of water, with reference to being half full or half empty adding nothing. Now it appears the dichotomy is false, so if you reject one view, it does not automatically follow that you endorse the opposite.

The second issue expands on the realist view in showing is that this is simply the wrong way to look at a glass of water. If I am thirsty the question is: is the half glass of water sufficient to satiate my thirst? Maybe it is, maybe not.  If I am in a country with near deficient water issues, they do not leave the tap running when washing their teeth but, often, use a partly filled glass of water. In that case, a mother might tell off her child for using a glass of water that is half full – now that means it is too much and more empty would be better. Nothing to do with being an optimist or pessimist. In other words, in order to establish the relevance of a half glass of water, context is required.

These two points of a false dichotomy and context are sufficient tools to examine this paper. You will be relieved to know that no great maths skills nor economic training required. Let us proceed.

The key question the paper seeks to address is

there was no equivalent for fiscal policy of the Taylor rule for monetary policy: no simple rule to guide fiscal policymakers…This paper is about the search for such a rule.

The Taylor rule is a simple algorithm to guide Central Banks in setting their interest rate to manage inflation, which is the primary tool for a nation’s Monetary Policy.  In reality Central Banks do not blindly implement this rule, although in the type of economic models that JP and SWL colleagues use, this is often used as a  ‘simplifying assumption’ when modelling Central Bank policy settings.  To the degree that Central Bankers do use the Taylor Rule as guidance that might be a reasonable simplification in modelling an economy, or maybe not.

Ok then, this paper is about fiscal rules. Now there are a few approaches to this, one I am very familiar with is Abba Lerner’s Functional Finance. Now, whilst I had zero expectation that SWL and JP would be advocating anything like this, what I did expect in something called a ‘paper’ on this very topic, was an examination of alternative rules and why they do not apply compared to the rule that the paper’s authors argue for. However there was no even a mention of this (or others), if only to be dismissed by, say, referencing another paper which did the presumed actual refutation. Nothing. In the whole paper. Nada.

Now I have read many papers in many fields in my time, including physics, biology, cognitive science, quantitative finance, philosophy, public health, paranormal studies and alternative medicine amongst others. Without any attempt at some coverage of views on this and arguments in favour of their approach, this paper is already beginning to look like the papers in the certain fields that are full of junk science and pseudo-scientific arguments.

This concern is further confirmed when I read in the second paragraph of the introduction that

basic theory suggests that fiscal policy actions should be very different when monetary policy is constrained in a fundamental way, while the reverse is not in general the case. There are two major examples of where this will be true. The first is when interest rates are at the zero lower bound”[My emphasis].

Basic theory”? “Basic Theory”!!

Now one cannot make all the arguments for a theory to apply to it a particular problem in every paper. That would be an absurd demand. However having studied various macro-economic models such as VARs, ISLM, AD/AS, DSGEs, CGEs and SFCs, to create a hidden or implicit presupposition that their approach is so far from being debatable that it is “basic” is very, very dubious. I knew in advance that  they were never going to argue for it, but to call it “basic” is quite underhand but would, of course, be accepted as standard gospel within the echo chamber of fellow orthodox economists and their acolytes or dupes (if Bill Mitchell’s concern re the Labour Party is correct) in political parties they are addressing. (I have concerns over the Zero Lower Bound argument but will not address that further in this post)

The second is where a country is part of a monetary union or a fixed exchange rate regime.

Here I can agree. The currency regime of a Eurozone economy is quite different to that if the UK’s. However my patience in examining their later policy analysis as a result of their core model will have run out long before I get to that and I will not discuss this any further here.

They complete their introduction, by noting the proposal of an optimum fiscal rule has to, most of the time, be ameliorated by managing “non-benevolent” government’s fiscal policies creating a “deficit-bias”. That is one might have to diverge from the rule to explicitly prevent profligacy and so on. However this is beginning to look like that false dichotomy is discussed in my prelude.

Everything they are doing is to preclude seeing what alternatives there are to their approach. The subtle (but not so subtle later) is that a government is either benevolent or not with respect to deficits and so, therefore “deficit-bias”. Is this the correct thing to be looking at in the first place? Where is the context, productivity (never mentioned), unemployment (mentioned once in passing), inflation – ok that is mentioned 18 times in this paper, you are beginning to see a bias – in the authors.

This post is beginning to turn into a fisk of their paper but I have neither the inclination nor the time to do that for the whole paper, nor  do I think would my readers have the patience! I am going to instead complete my analysis of section 2 on Optimum Fiscal Policy.

Suppose social welfare declines as taxes rise, because taxes are distortionary.

(They discuss a 1% from 20% and 50% base – the 50% base being worse in their view – but that is really irrelevant here). Well I would like to see their definition of social welfare, it is a key concept mentioned 6 times but with no explanation.

I can easily imagine two scenarios where a tax increase can increase social welfare.  The first is when the nation has demand  pull inflation – too much money chasing too few goods – in which case a tax increase reduces aggregate disposable income and reduces demand-driven inflation pressure. The second is with a nation around full employment and there are not sufficient real resources for the government to fulfill its elected social welfare agenda, a tax increase reduces demand – for real resources – and so frees up those resources – people, goods and services – that can be employed by the government to achieve those goals. In both cases, a tax increase serves to increase social welfare.

Now one can posit various objections to my points such as the lead/lag relationships with respect to inflation – but this same objection can also be made with respect to monetary policy with interest change lag effects on inflation. The point I am making is that they are again making assumptions, with many hidden presuppositions,  leaving no room for analysis or debate. A key ever-present, at least in my view, tacit dichotomy implying that if you reject these arguments you must be for non-benevolent government;s and their “deficit-bias”. In fact I am waiting for them to establish that their way of looking at this problem is the correct way to look at it. As I proceed, it appears I am waiting in vain.

They then derive or, rather mostly state but do not argue for, a  straightforward difference equation to minimise as their basic optimum fiscal rule. One that any  A-Level Maths student should be able to comprehend. I understand that many readers may have not studied A-Level Maths but do appreciate that this is not even of university level difficulty. (OK, we might not teach Lagrange multipliers – a technique to help solve minimisation problems – at A-Level but the maths itself, we do)

My unplanned fisking of this paper will be finished when I have completed analysis of this equation.

They assume in the multiplier that there is a government budget constraint not to default on its debt. Well that can come out of a simple balance sheet analysis, as a constraint they make it appear it is of a behavioural consequence but the whole point of their analysis is that it is not.

They examine the interest rate as a cost on the Government, but fail to consider that the interest rate channel is an income source to the private sector, in addition the primary budget balance (which excludes government debt interest payments), both increase private sector sterling reserves – which are not discussed. Of  course, they are fully aware of the difference between the primary budget balance and the fiscal balance (which includes transfer payments – payments not exchanged for goods and services – such as debt interest payments)

They do not explain how the  government can control their deficits, they assume that a benevolent Government can – although they do pay some lip service to automatic stabilizers but these are not in their model! They acknowledge that plans can be disrupted by shocks but that is a woefully deficient approach.

They note that the debt is a stock and the deficit is a flow. However they fail to develop a proper stock-flow view on the relation between Government and Non-Government – the Private and International sectors together.  Their model assumes away by not even considering the level of control that the Government can have on its deficit. There is no  discussion on the effect that the savings desires of the private sector can have on the deficit. No discussion on the Government – Non Government financial flows. No discussion on how trade and capital flows and real terms of trade can affect the Government deficit. No discussion on the goals of government policy that affects the deficit – reducing unemployment, increasing productivity, improving real terms of trade or any such like – only GDP and inflation are discussed – in other words the social welfare considerations that premised the motivation for this paper.

There is scant empirical evidence provided for supporting their view on managing Government Debt or even what it is. Should we just consider outstanding Treasury Issued Gilts or the net outstanding liabilities of the Whole Government – there is zero mention of Japan and its debt/gdp ratios.

However when they end up taking one version of their minimisation process to an, admittedly by them extreme, they say

If 𝛽(1 + 𝑟) > 1, then we get a very different and equally surprising result. Taxes gradually fall over time, until they eventually decline to zero. How can this happen, given that the government has spending to finance? The answer is that debt gradually declines to zero, and then the government starts to build up assets. Eventually it has enough assets that it can finance all its spending from the interest on those assets, and so taxes can be completely eliminated.

So what they are saying is that the private sector becomes in debt to the Government, after all if the Government can perform all its services through assets they own and the revenue they generate, then these assets can only come from the private sector, since, on the pain of double entry accounting, they are also liabilities of the private sector. The government does not tax us, partly since none of us have any ‘money’  issued by the government to pay its tax in! That is the previous now retired government debt (or its net financial liabilities)  were financial assets, issued by the Government to purchase goods and services from the private sector, that had not yet been reclaimed in tax – that is equivalent to all taxes not yet paid – these, on the pain of double entry accounting, were our assets and they have now all been paid. How does the Government build up assets? Somehow we have to pay the government taxes even though there are no longer any reserves from which to pay them and the Government continues (presumably it was already doing this before ‘s debt was retired) to buy our assets – presumably from bank issued credit? But there are no reserves so how do banks settle!  I could go but lets stop! (A proper analysis of is really needed but is outside the scope of my critique, I was only being very simplistic and brief in my comments just above).

Now it is one thing to develop a model and realise it has unusual and surprising consequences. These might very well be worthwhile pursuing and understanding. However in this case, even though it is an extreme outcome, it should tell the modeller there is something wrong with their model.

There may be some interesting things they say in the following sections but I cannot accept their model to use as a basis to consider any of that. Further they immediately provide add a  number  ad hoc assumptions – to the model  (not the policy arguments which follow) which makes this whole enterprise initially based on a clearly stated model, as far as I can see, completely pointless.

So are most everyone is a pessimist about government debt, and everyone should be concerned about a government’s deficit bias. Otherwise you are, or believe or want to be,  beneficiary of a non-benevolent government’s deficit bias.

And it is here I have to stop. There is much more I could say but I am out of time. For further critique of these please see Bill Mitchell’s posts, the one noted at the beginning of this post, one published today and one to come tomorrow.

The whole framing of this discussion is entirely misleading. Where is the context? What is the purpose of Government? What is social welfare? What are the macroeconomic implications, measures and tools? How do the price level (inflation), unemployment, productivity, poverty, terms of trade, taxes and other more specific concerns relate to social welfare. When looked this way the concerns of deficits and debts are secondary, not be ignored but not be the drivers either. Does it matter if a fiscal committee take over driving from politicians, if both are trying to drive by steering with the rear view mirror?!



Bretton Woods and the Golden Age Of Capitalism

Last night I went to a presentation for William Mitchell’s and Thomas Fazi’s new book “Reclaiming the State: A Progressive Vision of Sovereignty for a Post-Neoliberal World” . I am long familiar with Bill’s work, have read draft notes of his book published at his blog, Billy Blog. Thomas Fazi is new to me but I heard enough to buy his own book The Battle for Europe: How an Elite Hijacked a Continent – and How we Can Take it Back

The presentation was by Peter Ramsey, Professor of Law at the LSE and a blogger at the group blog The Current Moment:

This is neither a review of either book nor the presentation itself, which I did thoroughly enjoy. I think Peter did a stellar job summing the issues up. He was concerned that he was not an academic economist but I view that as a positive, since if this debate were to remain amongst only academic economists and interested laymen, who have put considerable work into to economics – such as myself – then the debate is lost. We need a far broader base rather than to be dismissed as dealing in complicated and obscure economic debates.

Anyway I really want to just make two comments here, one about Billy blog and the other about a question I asked in the Q&A.

I chatted with Bill in the pub afterwards and was asking about the effort into writing his blog.

Now, if you are not familiar with it, it is prodigious with high quality output, published 6 days a week, 4 of which are very well referenced arguments promoting and applying Bill’s take on the macroeconomics framework he co-founded, called Modern monetary Theory or MMT. Indeed I have not recently seen or followed any other blog in any area with the consistent quality of output from one person as his blog.

That does not mean I agree with everything he says, but I have certainly learnt far more from it, than I have found disagreement with. My learning method is to seek flaws and find challenges to whatever argument is presented, and see how the argument deals with them. I will get back to this just stated point in my following comment below, which was what I perceived as a challenge to his one of his arguments.

What really astounded me is that Bill claims that he tries to limit the time spent on each post to an hour, with a maximum of 90 minutes! If you start reading his blog you will realise why I am astounded. Many of his posts take around 15 or 20 minutes to read and digest! (Heck, maybe I am a bit slow, feel free to claim better). Clearly he does not included the actual research and he must have a very good index system, plus, I guess he knows how to touch type.

This, at least currently, is serving as an inspiration to me. I probably spend far more than 90 minutes a day on this field, including reading Bill’s blog, as well as many others, doing some other research, reading books and writing/building models (not ready to publish just yet), all slotted in amongst my many other commitments. I actually need to save some time on this and focus on other more pressing needs, as passionate as I am on this topic of evidence based macroeconomics. So I have resolved to when I have a clear idea write it up as soon as possible, limited to 90 minutes maximum and publish it, worts and all. I will note (for my own edification how long it took to write – 26 minutes so far, so the target is another 30 minutes, then the rest is references, proof reading etc.).

As a long-term programmer, I am a fast typist, but could far better, both for writing and programming, if I were a copy typist. In my typical maverick way, when I last learnt to type, I chose Dvorak rather than Qwerty. Have to think about that but need to properly learn one or the other soon. I will devote 30 minutes a day to that. I will report back as to whether that helps me writes these posts, if nothing else.

As for frequency of posts, I make no promises on that. I need to build up more content get some ideas in my head on paper to really see where they fit. I am thinking of getting together some like-minded economic thinkers into a group blog. But that is for the future.

Now onto the second comment.

An issue that has bothered me in the writings of MMT theorists is the relation of the “Golden Age of Capitalism” – the Post War to  the beginning of the 1970s period which operated under the Bretton Woods fixed exchange rate regime. Compare that to the post Bretton Woods floating exchange rate regime (from the 1970s till now) period, where MMT argues that states with sovereign non-convertible floating currencies have the largest available policy space. That has been the case in the post Bretton Woods era, (not immediately in some cases, and not at all, more or less with others, due to various attempts at currency boards, and in the Eurozone, the evolution to the Euro). So why was the Golden Age of Capitalism, with full employment, decent GDP growth, growth shared between wages and profits, the era that operated under a fixed exchange rate regime?

Now I was totally confident that Bill would come up with a decent reply, my point really being it should be more clearly stated and answered by Bill and others when writing books on the topics of Europe and states. I think sometimes these authors suffers from not seeing the wood for the trees and those new to these topics need to be shown the trees first.

I also added two elements. The first was that this growth was after the devastation and destruction of people and land. This, surely, made it easier to create full employment, given the tragic loss of other working age able-bodied people in the war, and, given, the need for huge infrastructure repairs, across Europe, for both the victors and losers, for significant growth. Given this, could we hope to go back to such days, since we far from having a deficit of workers and skills have the opposite (mostly) and we have a far better level of infrastructure (yes London roads are still terrible compared to most of Europe) than starting after the war.

Bill answered the first part of this question and Thomas answered the second.

Now I probably made my question clearer here than when I asked from the floor at the presentation, as both Bill and Thomas seemed to not fully address my question until I probed further. Was this due to my inadequacy in how I asked, or was this due to their frames missing the point, possibly thinking I was an anti-MMTer looking to find flaws in their views? I don’t know. I do often find people making interesting points but not answering my question even online and the question is there in black and white. I wont dwell on their initial responses, which whilst somewhat missing the point, I quite agree with anyway.

I will flesh out Bill’s reply with one addition of my own (clearly implied in Bill’s answer), that do not alter the substance of his reply. This addition is the Mundell-Flemming Trilemma which states “The policy trilemma, also known as the impossible or inconsistent trinity, says a country must choose between free capital mobility, exchange-rate management and monetary autonomy (the three corners of the triangle in the diagram). Only two of the three are possible. A country that wants to fix the value of its currency and have an interest-rate policy that is free from outside influence (side C of the triangle) cannot allow capital to flow freely across its borders. If the exchange rate is fixed but the country is open to cross-border capital flows, it cannot have an independent monetary policy (side A). And if a country chooses free capital mobility and wants monetary autonomy, it has to allow its currency to float (side B).” I chose this Economist quote, quite deliberately as it partly misrepresents the argument, which is not just about domestic monetary policy (interest rate management) but also domestic fiscal policy. That will be a topic for a future post.

Whilst states under a fixed exchange rate system need to earn the convertible base (in the case US dollars or the gold equivalent under Bretton Woods), they also had capital controls which prevented, mostly, capital flight and domestic currency destabilization and speculation. This did not prevent, in some cases, internal devaluation (austerity) or, failing that, currency revaluation (devaluation) but the rest of the time the social democratic policy of a mixed economy focused on full employment, with significant unemployment support (which was actually short-term in those days due to the full employment policies enable when possible), coupled with worker protection, and other welfare states provisions.

Now in the post Bretton Woods era there have been significant changes. Capital controls have been dismantled and the Monetarist/Supply-side Trickle-Down/Neoliberal ideology (there is no real empirical evidence for any of it), has also dismantled key worker and social protections and seek to demolish state regulation of the market and, with it, the whole mixed economy model that supported full employment.

We now live in a world of free capital and floating currencies and it looks like domestic monetary and fiscal policy suffers, with the increase of the capital share of growth and the decrease of worker share of growth. That is prior to the many new issues ensuing after the Great Recession of 2007/8.

Still it is not entirely clear to me how much of that Golden Age was specifically due to starting from both a lower infrastructure point and a surfeit of skills and workers, rather than this difference in the Policy Trilemma coupled with the Neoliberal versus “Keynesian” version of state governance. (I put Keynesian in scare quotes but this is also a topic for a future post).

So, with all this in mind, is it still feasible to get to the level and shares of worker in GDP and full employment?

Thomas answers yes but things will be different. The needs of today’s societies have changed to that period and require new and alternative skills and applications. The Job Guarantee and other state guided policies (such as Peoples QE – but drop the misleading label – Bill argues) can provide a range of jobs fit for social purpose that are invisible to the profit motivated private sector.

I want what Thomas (and Bill) says to be correct. One of the key thrusts of this blog is to investigate the Job Guarantee and other fiscal policy tools further.

A better review of Steve Keen’s “Can we avoid another financial crisis?”

Here is a better review than my own (that is one reason why I am blogging  – to get better at writing including reviews – practise makes perfect). This is by  Michael Hudson: Review of Steve Keen’s “Can we avoid another financial crisis?”

Steve Keen’s ” Can we avoid another finacial crisis?”: A review (Updated)

[UPDATE: This is a heavily revised and improved review]

Steve Keen is one of the few economists to have warned about the impending Global Financial Crash (GFC) of 2008.  Here he  shows the core reasoning that helped him make that call. Using the same approach, what can he say about the present in 2017 going forward?  Whether one ultimately agrees with his arguments or not, surely he has better earned a position at the high table than many others who failed to call the GFC, who  undeservedly remain at that table without merit? Would we not all benefit by having him and his arguments as part of the core debate of economic policy? This book is a bold, accessible and provocative attempt to remedy that sorry situation.

The Professor and Head of the School of Economics, History and Politics at Kingston University in London,  “Can we avoid another financial crisis” is his second book after “Debunking Economics” (He also has a collection of his papers in
“Developing an economics for the post-crisis world”). It is far more accessible than his first book and clearly his intended audience is different and broader. Indeed, even MPs and political journalists should be able to understand this except, maybe, it is still beyond George Osborne … since this is not a Ladybird book.

His concern is over the growth and change in growth of private debt as a threat to economic growth and financial stability. His main argument is that when the debt grows too large, its maintenance becomes unsustainable, and the process of us repairing our balance sheets leads to a reduction in the demand for credit, which, in turn, reduces total demand the economy and, especially if the debt is large enough, this can stall the economy and lead to a recession. This makes it even harder to repair our balance sheets and a vicious cycle can ensue.

He argues that a demonstrably erroneous and almost anti-empirical design and application  of mainstream neoclassical macroeconomics has rendered this perspective invisible, until recently mostly denying any importance or significance of private debt, as they must, given that their core models, as Steve says, excludes “banks, debt and money”! This  is why they all missed calling the GFC. This, in turn, misinformed and misinforms its ideological neoliberal sibling, so policies since the GFC have not enabled us to sufficiently repair our balance sheets and slow or negative credit growth has turned some economies into “zombies”.

Now  whether one agrees with him or not, can one reasonably deny that this should be part of the Overton window (the window of discourse)?  and, if nothing else, this book is a highly forceful and concisely readable argument to make this a central focus of future economic and populist debate.

Given modern attention spans this is a short book and certainly readable in a few hours but possibly quite dense in new ideas if one if unfamiliar with his work. This is probably easier to get with the background of  a decent scientific understanding but far less so if one is already immersed in (or corrupted by?) mainstream dogma or, even worse, educated in a  PPE course at university as far too many of our politicians and commentators have been.

There are many things he does not address (but maybe I read it too quickly) such as criticising the erroneous application of the household analogy to governments nor does he specifically mention the Loanable Funds doctrine although he does discuss this foundational mistake of mainstream economics at length and very clearly. Overall he amply argues for and demonstrates his theme that one of the main concerns of policy makers should the growth and change in growth of private debt – worryingly still not a concern of the UK Treasury and OBR. He shows, in very elegant fashion, without a single equation in sight (some are verbally stated to describe the most simple of his pure credit models) why this is likely the case. He also makes some very concise and clear arguments as to why the mainstream neoclassicals and New Keynesians – the backbone of neoliberal political ideology – repeatedly miss the point. I, in particular, liked his simple and profound verbalisation of the Sonnenschein–Mantel–Debreu theorem  which really demolishes the micro-foundation argument for macro economic DSGE models. However  he does not mention issues such as the Arrow Debreu model which was one response to this, although he does note Gorman‘s arguments. The point is this work will suffice to get you to understand the main issues involved, but would not be sufficient to argue with someone suitably informed but there are other sources, including his first book to take you further, if you are so inclined.

He is relatively pessimistic over the final outcomes that are possible or, certainly, politically feasible and, sadly, I have to agree. I wonder if he does not dwell enough on policy space and bank reform. He does discuss his debt forgiveness jubilee approach and how to circumvent the moral hazard issue of only rewarding debtors. Still he does not mention say, MMT’s Job Guarantee whilst possibly too fleetingly discusses MMT’s Godley inspired sectoral balances approach to clarify what Government or Public debt really is.  Futher, as two off the cuff examples, both Bill Mitchell‘s argument that banks should not on sell their originated loans and Richard Werner‘s argument over how to direct banking to more productive financing (he does discuss that though) could have augmented his arguments without much addition, focus or loss of clarity.

All in all this feels like a well-edited if not, possibly, an over edited book. By this I mean some other points including some as just noted could have been also simply argued but this might have detracted from the overall force of the book.

Still what results is a very important and accessible work. We need to insure that every MP, journalist and pundit is familiar with this.  I hope if you read this and you happen to know such a person you send them a copy in return for them giving you their informed opinion on it. If they are unable to do so then they really have no business being involved in politics.  What would result is that no-one could claim ignorance of the issue of private debt and that it becomes a key focus of the economic debate going to forward.


Cowdung and Credit Creation

Today is a momentous day for the United Kingdon, as Teresa May officially invokes article 50 to leave the European  Union.

Sadly, I am not yet ready to add commentary to current events, however important. My initial theme is to carry on explaining the operations of the UK banking system, presented in a way that should be available and understandable to anyone who is concerned about the economic reality we live in. No-one should be denied such access and needs to be equipped to detect and avoid the distortions presented by the COmmon Wisdom of the DominaNt Group a.k.a. “CowDung”. hopefully these posts can help in that regard.

In my last post on this topic, Can Banks Create Credit?, I noted that you should not take my word for this. This post is the first answer to that.

The Bank of England publishes an online  quarterly magazine called the Quarterly Bulletin. The Quarterly Bulletin 2014 Q4  contains two important articles with accompanying video overviews:-

This is essential reading for anyone interested money, pretty much everyone!

Money in the modern economy: an introduction

Money is essential to the workings of a modern economy, but its nature has varied substantially over time. This article provides an introduction to what money is today. Money today is a type of IOU, but one that is special because everyone in the economy trusts that it will be accepted by other people in exchange for goods and services. There are three main types of money: currency, bank deposits and central bank reserves. Each represents an IOU from one sector of the economy to another. Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves.

This article has introduced what money means and the different types of money that exist in a modern economy. Money today is a form of debt, but a special kind of debt that is accepted as the medium of exchange in the economy. And most of that money takes the form of bank deposits, which are created by commercial banks themselves. A companion piece to this article, ‘Money creation in the modern economy’. describes the process of money creation by commercial banks in more detail.


Money creation in the modern economy

This article explains how the majority of money in the modern economy is created by commercial banks making loans. Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.[My emphasis]

This article emphasizes some of the themes I have noted in previous posts regarding the myths of  Loanable Funds, Fractional Reserves and the Money Multiplier and the implications of these myths will be explored in following posts. Note that “some popular conceptions” (and other statements in the article) are a polite and diplomatic way of calling bullshit (or cowdung) on the banking sections of economics textbooks.

I need to finish with a  couple of caveats.

First is that just because this is published by the BoE does not mean it is immune from criticism. Far from it. Indeed a theme I will develop is how many central banks have misled themselves as well as others with distorting if not fatally flawed in-house models of their economies. Still I do regard the above two articles as very accurate given my background in actual banking.

Second, these articles were published in 2014, there are other and older references for these accurate descriptions of money in the Uk and elsewhere. I have not yet found a good summary post of all those central bank references and am slowly building up a file which I will post when I am satisfied with the content.