June 13, 2018

Nick Rowe’s soap bubbling about money

Comment on Nick Rowe on ‘The Parable of the Fruit Trees’


“The apple producer produces apples. The banana producer produces bananas. The cherry producer produces cherries.” The economist produces proto-scientific garbage.

What is wrong with Nick Rowe’s depiction of the economy? The subject matter of economics is, as Keynes said, the ‘monetary theory of production’. This sets the frame for the theory of money. The fact that Nick Rowe clings to a long-defunct barter parable proves that he has no idea how the economy works.

As the correct analytical starting point, the elementary 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 (1). This is the most elementary form of the macroeconomic Law of Supply and Demand.

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

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.

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 on Wikimedia.#1

The household sector’s deposits/overdrafts are ZERO at the beginning and end of the period. Money 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=κYw, with κ 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. There is NO such thing as “an excessive demand for one particular asset (the medium of exchange) relative to other assets.”

The transaction equation reads M=κPRL (2) in the case of budget balancing and market clearing. If employment L is doubled, the average stock of transaction money M doubles. If employment is halved, the average stock of transaction money M halves.

As long as the central bank finances the wage bill Yw=WL with money creation out of nothing, and with wage rate W and productivity R fixed, the price P does not move one iota according to (1). The average quantity of money M increases/decreases according to (2) but there is no inflation/deflation. Money is absolutely neutral. The creation of fiat money is the correct way of bringing money into the elementary production-consumption economy.

Egmont Kakarot-Handtke

#1 Wikimedia AXEC98 Idealized transaction pattern

Related 'The futile attempt to recycle Sraffa' and 'Money: from silly stories to the true theory' and 'Primary and Secondary Markets' and 'Exchange in the Monetary Economy' and 'Getting out of the economics swamp'.

REPLY to Nick Rowe on Jun 14

Nick Rowe clarifies his parable: “It is not an excessive desire to accumulate assets that causes recessions; it is an excessive demand for one particular asset (the medium of exchange) relative to other assets. It’s about the composition of their portfolios of assets, not about the total size of that portfolio.”

The two lethal blunders of Nick Rowe are:
• to frame elementary economic activity as barter of stocks of goods a.k.a. assets,
• to frame money as an asset.

The elementary economy is about production and consumption. Input is a real flow = labor time per period, output is a real flow = apples/bananas/cherries per period, income is a nominal flow, and so on. Money is neither a stock, nor a flow. Money is not a thing, not a real asset. Money is information. The information is stored on a medium, e.g. magnetic data carrier, clay tablet, paper, coin, etcetera. As a matter of principle, money cannot be scarce, only the physical data carrier can become scarce.

Money starts as a medium of transaction as shown in the previous post and it supports ANY level of economic activity. Problems arise if the households do not balance their budget, i.e. do not fully spend their period income, that is, if consumption expenditures C are less than wage income Yw. In this case, the household sector’s deposits at the central bank increase, and money morphs from a pure transaction medium to a store of value.#1

Precisely at this point, money becomes an asset, more precisely a financial asset. All real assets (apples, bananas, cherries) are zero at the beginning of the period and at the end of the period. The household sector’s portfolio consists solely of deposits at the central bank. This is how the monetary economy works. Nobody barters apples for bananas.

In the elementary production-consumption economy, the household sector can increase its stock of money if C is less than Yw. This has some obvious consequences for the business sector.

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, in other words, the business sector’s surplus = profit equals the household sector’s deficit = dissaving. Vice versa, the business sector’s deficit = loss equals the household sector’s surplus = saving. This is the most elementary form of the macroeconomic Profit Law.

The simple fact of the matter is: as the household sector’s deposits at the central bank rise, so do the business sector’s overdrafts. The central bank’s balance sheet is always balanced. The business sector’s debt increases, that is, its deposits at the central bank = money become very, very scarce, and THIS causes a recession. The composition of output and changes in the composition of output (apples, bananas, cherries) are absolutely irrelevant.

Now, give Nick Rowe a banana, and send him back into the barter woods.

#1 Money and time

REPLY to Nick Rowe and other commentators on Jun 15

In the two preceding posts, it has been argued that Nick Rowe’s barter parable lacks the elementary features of the monetary economy. Barter models have always been false and will always be false because the economy constitutes itself through the interaction of real and nominal variables.#1

It has been argued that the composition of output and changes in the composition of output (apples, bananas, cherries) are irrelevant for the money transactions between the household- and the business sector and that they do not cause a recession. Only a reduction of total nominal demand causes a recession.

To see this, let us make a simple example. Imagine two firms, 1 and 2 for short. The wage rates in both firms are equal, so the total wage income is Yw=WL1+WL2 and total employment is L=L1+L2.

In the initial period, the respective prices are equal to unit wage costs, i.e. P1=W/R1 and P2=W/R2. Therefore, the profit in both firms is initially zero. The household sector spends total wage income on the two products, i.e. C=Yw, so there is neither saving nor dissaving.

The distribution of total consumption expenditures C=C1+C2 between the two products determines the production of the respective quantities and the respective labor inputs L1 and L2. It holds C=C1+C2=W(L1+L2)=WL=Yw.

So, if the household sector wants more of product 1 it spends more on it and less on product 2, such that C1 goes up and C2 goes down and C remains unchanged. Accordingly, the business sector employs more workers in firm 1 and less in firm 2, such that L1 goes up and L2 goes down and total employment L and total income Yw remain unchanged.

The relative price, i.e. the exchange relation between the two products remains unchanged, i.e. P1/P2=R2/R1.

So, changes in the preferences between the two products are mirrored in changes in the distribution of labor input between the two firms. This configuration can go on forever. Problems arise only if the household sector reduces total consumption expenditures C, such that saving Sm≡C−Yw is now greater zero. In this case, the business sector makes a loss and the economy goes into recession.

#1 The irreparable unreality of all ‘real’ models

REPLY to Nick Rowe on Jun 16

The lethal flaw of The Parable of the Fruit Trees is the obsolete concept of direct barter. In the monetary economy, barter is indirect. In methodological terms, barter economists commit the Fallacy of Insufficient Abstraction.

In the monetary economy, agent 1 does not produce product 1 and barters directly with agent 2 who produces product 2.

In the monetary economy, agent 1 works in firm 1 which produces product 1 and gets the wage income Yw1 which is paid with a transfer of deposits at the central bank.

Analogous for agent 2.

Agent 1 then spends part of his income on product 2. Analogous for agent 2 who spends part of his income on product 1. This is how INDIRECT barter happens. By buying the other firm’s output, agent 1 barters “his” product with agent 2 and vice versa.

Indirect barter presupposes the existence of money which is used (i) to pay the wage bill, and (ii), to buy the products. Money is created and destroyed in the process. The cycle can be repeated ad infinitum. Transaction money is NOT a stock and NOT an asset. It is zero at the beginning and the end of the cycle.

Changes in preferences lead to changes in output and production and the allocation of labor between the two firms. Total spending and total employment and the relative prices do NOT change in the process. Production adapts quantitatively to preferences.

Put simply, if agents want more of product 1 and less of product 2 more labor input has to be allocated to firm 1 and less to firm 2. The change in the composition of output has NO effect on the monetary transactions. Total income and total consumption expenditures remain unaffected.

Only if the household sector saves, which gradually increases its “stock of money” = average amount of deposits at the central bank, problems arise in the elementary production-consumption economy. Changes in the composition of output do not, they only lead to a reallocation of labor input.

Needless to emphasize that normally the two processes, growth/shrinkage of total production/output/average stock of transaction money and change in the composition of output are mixed. Analytically, though, they have to be strictly kept apart.

REPLY to Henry Rech on Jun 16

You say: “There has to be money to start the transaction cycle. Money is needed for a purchase.”

Money is created in the act of transaction. Either the business sector creates an IOU and hands it over as wage payment to the household sector, or the central bank creates uno actu deposits for the wage receivers and corresponding overdrafts for the firms. The purchase of the output destroys money = deposits at the central bank. This is how fiat money works. The transactions themselves create/destroy money.

At the logical beginning of economic activity, there is neither a stock of goods nor of money. All physical stocks have to be produced and money is produced (or ‘created out of nothing’) by the central bank/banking system. The economic analysis starts at zero. And this holds also for the theory of money.

REPLY to Matthew Young on Jun 18

You say: “Simultaneous is a relative when money moves faster than fruit.”

The purpose of a parable is to make one point as clear as possible. For this purpose, the situation is radically simplified. Needless to emphasize that simplification and idealization are legitimate tools of analysis. However, as always, there is the possibility that the tool is misapplied and that the dilettantish scientific craftsman hits his thumb instead of the nail.

The problem with simplification/idealization is that it erroneously abstracts reality away instead of all the details that are indeed irrelevant for the question at issue. One of the most prominent examples of the Fallacy of Insufficient Abstraction is simultaneity. This is to eliminate time and this is sufficient to relegate any model/parable into the Dancing-Angels-On-A-Pinpoint category.

Nick Rowe’s Parable of the Fruit Trees, too, falls into this category. Its lethal defect is long known as the Hahn problem: “The Hahn problem reveals three things. First, a perfect barter GE solution always exists in any ‘monetary’ model erected on Walrasian GE microeconomic foundations. Second, inessential monetary features are easily attached to perfect barter microeconomic foundations but as easily removed, leaving the perfect barter solution intact. Third, attaching such inessential additions leads to logical error; the misuse of language that produces invalid conclusions.”*

Nick Rowe and Matthew Young have not gotten the point that in the monetary economy barter is indirect and that therefore the discussion of direct barter is pretty much a revival of the Dancing-Angels-On-A-Pinpoint disputations of the Middle Ages.

* Colin Rogers, Review of Political Economy

REPLY to Nick Edmonds on Jun 19

You say: “One problem we have translating your parable to the real world is that asset prices are generally highly flexible (and arguably asset markets can be much more easily cleared by price movements than goods and labour markets).”

Not at all! The real problem is that economists have after 200+ years still no clue how the price- and profit mechanism works.

To begin with, there are TWO fundamentally different types of markets.#1 In the elementary production-consumption economy one has the flows of labor input and product output (apples, bananas, cherries per period). The quantity produced is, for a start, equal to the quantity sold and consumed. So the stock of products is zero at the beginning and the end of the period. The primary markets (e.g. product, labor) deal with flows.

If part of the output is not consumed in the same period then there remains a stock of durable goods = real assets, e.g. houses. This is how the secondary markets come into existence.

The point is that the primary and secondary markets run on entirely different principles and that they can by no stretch of the scientific imagination be described with the barter parable nor with supply-demand-equilibrium. What Leijonhufvud has called the Totem-of-the-Micro has always been nincompoop-economics.

#1 Primary and Secondary Markets

REPLY to Nick Rowe on Jun 20

Nick Rowe concludes: “If we see recessions as a cluster of symptoms, that usually (but not always) go together, it’s not obvious how we define a ‘recession’, and whether we define it in terms of symptoms or of causes. And what’s true by definition and what’s true/false as a statement of fact. Bit like defining different illnesses.”

There is science, and it is binary true/false with NOTHING in between. Truth is well-defined for 2300+ years by formal and material consistency. And there is the large swamp of cargo cult science where, as Keynes said, “nothing is clear and everything is possible.”

In the swamp, vagueness, indeterminacy, inconclusiveness, confusion dressed up as complexity, unresolved contradictions, storytelling, filibuster, gossip, finicky scholasticism (Popper), known/unknown unknowns, and the Humpty Dumpty Fallacy are the prevailing components of communication.#1, #2, #3

This, of course, has not gone unnoticed: “The currently prevailing pattern of economic theorizing exhibits the following three characteristics: (1) a syncopated style of argument fluctuating back and forth between literary and symbolic modes of expression, (2) naive translation, or the loose paraphrasing of formulae into sentences, and (3) loose verbal reasoning for certain aspects of theoretical argumentation where explicit symbolic formulation is lacking.” (Dennis, 1982)

From Nick Rowe’s Parable of the Fruit Trees nothing can be learned about how the price- and profit mechanism works. This does not matter, though, because the purpose of economics has never been to clarify matters and to advance science but to keep everything and everybody in the swamp of inconclusiveness.

Vagueness and inconclusiveness protect the scientifically incompetent and secure the status quo because:
• “... you cannot prove a vague theory wrong.” (Feynman)
• “With enough fog emitted, almost anything becomes possible.” (Mirowski)

One will not find one single scientist in the swamp.#4 The swamp has always been the habitat of parable-tellers and cargo cult scientists.

Egmont Kakarot-Handtke

#1 It is better to be precisely right than roughly wrong
#2 “This is a tough question to adjudicate on scientific grounds since the issue is largely definitional and, as Lewis Carroll pointed out, everyone is entitled to his own definitions.” (Blinder)
#3 “’When I use a word,’ Humpty Dumpty said in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’ ‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’ ‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all’.”
#4 Getting out of the economics swamp