October 26, 2017

Basics of monetary theory: the two monies

Comment on Lars Syll on ‘INET conferencing beyond disappointment’

Blog-Reference and Blog-Reference on Oct 30

Frances Coppola twittered on Oct 25 “He [Pontus Rendahl] says (I quote) ‘Banks can’t create money or we wouldn’t have had to bail them out.’ What’s the fallacy in that statement, Twitter?”

And Ann Pettifor echoed: “Pontus Rendahl: ‘disagrees banks can create money. Only true if CB complicit with this’ Extraordinary! We do not live in CB dictatorship.”

Lars Syll assisted “And to even for a second think that a visionless neoclassical economist like Rendahl should have anything to do with new thinking in economics is of course totally gobsmacking!”

Time to finally settle the theory of money.

Because economics is a failed science it has to be reconstructed from scratch. Walrasian microfoundations and Keynesian macrofoundations have to be scrapped.

As the new analytical starting point, the pure production-consumption economy is defined with this set of macroeconomic axioms: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

Under the conditions of market clearing X=O and budget balancing C=Yw in each period the price is given by P=W/R, i.e. the market clearing price is equal to unit wage costs. This is the most elementary form of the macroeconomic Law of Supply and Demand. For the graphical representation see Figure 1.#1

The price is determined by the wage rate, which takes the role of the nominal numéraire, and the productivity. The quantity of money is NOT among the price determinants. This puts the commonplace Quantity Theory forever to rest.

Monetary profit for the economy as a whole is defined as Qm≡C−Yw and monetary saving as Sm≡Yw-C. It always holds Qm+Sm=0, or Qm=−Sm, in other words, the business sector’s surplus = profit (deficit = loss) equals the household sector’s deficit = dissaving (surplus = saving). This is the most elementary form of the Profit Law. Under the condition of budget balancing total monetary profit is zero.

What is needed for a start is two things (i) a central bank which creates money on its balance sheet in the form of deposits, and (ii), a legal system which declares the central bank’s deposits as legal tender.

Deposit money is needed by the business sector to pay the workers who receive the wage income Yw per period. The need is only temporary because the business sector gets the money back if the workers fully spend their income, i.e. if C=Yw.

Overdrafts are needed by the household sector for consumption expenditures if the households want to spend before they get their income. This time sequence is no problem for the central bank because the temporary overdrafts vanish with wage payments.

For the case of a balanced budget C=Yw, the idealized transaction sequence of deposits/overdrafts of the household sector at the central bank over the course of one period is shown in Figure 2.#2

The household sector’s deposits/overdrafts are zero at the beginning and end of the period. The business sector’s transaction pattern is the exact mirror image. Money, that is, deposits at the central bank, is continually created and destroyed during the period under consideration. There is NO such thing as a fixed quantity of money. The central bank plays an accommodative role and simply supports the autonomous market transactions between the household and the business sector.

From this follows the average stock of transaction money as M=kYw, with k determined by the transaction pattern. In other words, the average stock of money M is determined by the autonomous transactions of the household and business sector and created out of nothing by the central bank. The economy NEVER runs out of money.

The transaction equation reads M=kYw=kPX=kPRL in the case of budget balancing and market clearing and this yields the commonplace correlation between the average stock of money M and price P for a given employment and productivity level, except for the fact that M is the DEPENDENT variable.

Money comes into existence on the balance sheet of the central bank as soon as the central bank enters an overdraft for the business sector on the asset side and a deposit of equal amount on the liability side (step 1). This deposit is then transferred to the household sector as wage payment (step 2) and returns in the form of consumption expenditures (step 3). For the graphical representation of the complete cycle see Figure 3.#3

Now the commercial banks are introduced. They can create and destroy ‘money’ technically exactly in the same way as the central bank except for the fact that it is bank money and not central bank money. The crucial condition for the functioning of the two-monies system is that the business sector and household sector accepts bank money as practically identical to central bank money. For a graphical representation, it is only necessary to change the account titles in Figure 3 from Central bank to Commercial banks.

What happens if the households, which posses money in the form of bank deposits (step 1 in Figure 4,#4), demand real = central bank money?

The commercial banking sector has to turn to the central bank which creates overdrafts and deposits out of nothing (2). In the last step (3) the commercial banks then transfer their central bank deposits to the households. The banking money vanishes completely from the system. This does, in principle, not hinder the commercial banks to create new bank money by handing out loans in various forms from overdrafts to long-term mortgage loans. This quantitative expansion, though, can be limited in various ways.

Conclusion: Pontus Rendahl is right, banks cannot create money only bank money which is in normal times and for all practical purposes functionally identical to central bank money. However, if the household or business sector demand money the commercial banks have to turn to the central bank because, in the final analysis, the modern monetary system consists of two tightly coupled monies. As always, the “new” thinkers Frances Coppola, Ann Pettifor, and Lars Syll have made blogging fools of themselves.

Egmont Kakarot-Handtke

#1 Wikimedia, Pure production-consumption economy
#2 Wikimedia, Idealized transaction pattern, household sector, balanced budget
#3 Wikimedia, Creation and destruction of transaction money at the central bank
#4 Wikimedia, Switch from bank money to central bank money

Related 'Essentials of Constructive Heterodoxy: Money, Credit, Interest' and 'Reconstructing the Quantity Theory (I)' and 'Everything you know about MMT is wrong'. For details of the big picture see cross-references MMT.

Cross-posting on Oct 30

In her Guardian article ‘How the actual magic money tree works’ Zoe Williams repeats the argument that banks can create money. Fact is that bank cannot create money only bank money. This has been explained in detail already to other silly journalists and stupid economists in the following post.

COMMENT on Tom Hickey on Oct 31

You say: “What is at issue is the operation of a monetary production economy, that is, how finance, which is concerned with financial instruments, and economics. which is concerned with real resources, interact. Even most economists don’t understand this. How can the public?”

True. The task of economists is to explain how the actual monetary economy works ― not less, not more. But until this day, economists (Walrasians, Keynesians, Marxians, Austrians, and Pluralists) have no idea how the economy works, that is, they lack the true theory.

Why is economics a scientific failure/fraud? Because economists never had the intellectual capacity nor the time to do proper science. What they were busily occupied with instead was political agenda pushing. Agenda pushing is the natural choice for morons because one needs only an opinion, a big flap, and some acting talent.#1

Neil Wilson demonstrates here for everyone to see how easy it is to derail science by switching to politics: “And the hot button political issues have little or nothing to do with money.” André and Calgacus immediately jump on the bandwagon by telling their Bad Guy story. Thus, the whole discussion of what Keynes called the ‘monetary theory of production’ degenerates into a Pavlovian exchange of age-old political crap. It is the same pattern on all levels of economic discussion. There is no scientific substance in Krugman and Kelton and Hickey and all the rest.

What the representative economist has not realized in 200+ years is that politics is NOT his business: “A scientific observer or reasoner, merely as such, is not an adviser for practice. His part is only to show that certain consequences follow from certain causes, and that to obtain certain ends, certain means are the most effectual. Whether the ends themselves are such as ought to be pursued, and if so, in what cases and to how great a length, it is no part of his business as a cultivator of science to decide, and science alone will never qualify him for the decision.” (J. S. Mill)

From an economist, society expects scientific knowledge of how the actual economy works, just as it expects from engineers all the scientific knowledge that is necessary to get a huge metallic construct against gravity off the ground.

Economists have no such knowledge. They have wasted 200+ years since Adam Smith and Karl Marx with political blathering and agenda pushing. MMT is no exception.#3 Economics is a scientific failure/fraud, and MMT is part of it.

#1 For details see cross-references Political economics
#2 For details see cross-references Failed/Fake scientists
#3 For details see cross-references MMT

REPLY to Tom Hickey on Nov 1

You say: “MMT shows how finance and economics overlap and interact interdependently in a monetary production economy. It is a continuation of the analysis of a modern monetary production economic that Keynes initiated explicitly, although it was implicit in classical economics. Neoclassical economics ignored the monetary aspect in focusing on a barter economy and viewing the monetary aspect as a neutral veil that was useful in resolving the necessity for ‘double coincidence of wants’ in a pure barter system.”

It is true, of course, that orthodox economics in general and orthodox monetary theory, in particular, is provably false yet at the same time insufficient: “The moral of the story is simply this: it takes a new theory, and not just the destructive exposure of assumptions or the collection of new facts, to beat an old theory.” (Blaug)

In other words, orthodox economics has to be fully replaced, in methodological terms, economics needs a paradigm shift, in technical terms, the neoclassical axioms have to be fully replaced and ALL of economics has to be reconstructed based on consistent macrofoundations.

Keynes initiated the move from microfoundations to macrofoundations but failed. He failed because he did not understand macroeconomic profit: “His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al.)

This failure not only proves the utter scientific incompetence of Keynes but also of those who came before and after him. Economists do until this very day not understand the foundational concept of their subject matter. Which means that ALL economic policy guidance since Adam Smith and Karl Marx is misleading or disastrous or at best ineffective.

This is well-known among heads-of-state. Napoleon claimed “… that he had always believed that if an empire were made of granite the ideas of economists if listened to, would suffice to reduce it to dust.” (Viner) Because of this, politicians do not take economists seriously, they employ them as useful idiots.

MMT profit theory, as embodied in the balances equations, is false and by consequence, the whole theoretical superstructure is false and by consequence MMT economic policy has no sound scientific foundations, just like neoliberal policy and Keynesian policy and Marxian policy.

What the spokespersons of MMT, Mitchell, Tcherneva, Mosler, Wray, Kelton, Fullwiler, Forstater, Kaboub, Hickey etcetera, are in effect doing is political agenda pushing without one jot of scientific competence. And, clearly, it is NOT the agenda of We-the-people.