Kaldor on Money Supply Endogeneity

Some of my posts starting in October 2010 (the most recent one is here, with some conceptual graphics) have focused on the endogeneity of the money supply independent from the broad Post-Keynesian observation that loans create deposits. That is, the dynamism of the economy (largely courtesy of the financial sector) seemingly allows households and businesses on aggregate to self-determine their portfolio composition -- i.e., how much "money" they hold -- independent of both government policy and private debt levels.

Whether due to lack of familiarity or considered relative unimportance, there seems to be very little attention to this dynamic in the MMT-oriented econoblogosphere, even among the "primary" MMT bloggers when they discuss QE. If money supply endogeneity were only about loans creating deposits, then one should still expect to see QE changing broad money supply from whatever trend(s) it was already on, since QE isn't generally assumed to change people's propensity to borrow or their rate of deleveraging. Here are two updated charts of the MZM (Money Zero Maturity) measure of broad money supply:





Money supply did not grow as much as the QE operations alone would suggest. The actual trends are very volatile (probably having to do with uncertainty and liquidity preference during recession and expanding financial assets in line with a growing economy during economic growth) and so it's difficult to say anything conclusive other than that QE did not provide a 1-to-1 increase or obviously "shift" the trend lines while active.

Ramanan recently posted two great quotes from Nicholas Kaldor's The Scourge Of Monetarism (Oxford University Press, 1982). First, via Ramanan (emphasis mine):

"As it is, a highly developed banking system already provides such facilities on an ample scale, since it is prepared to accommodate the public’s changing demand between different types or financial assets by altering the composition of the banks’ assets or liabilities in a reverse direction. If the non-banking public wishes to switch its holding of gilts for interest-bearing bank deposits, the banks are ready to supply such deposits at the minimum of inconvenience, and at the same time to place their surplus funds into the gilts which were previously held by the public. Similarly the banks provide easy facilities to their customers for switching balances on current accounts into interest-bearing deposit accounts, or vice versa. Hence, while the annual increment in the total holding of financial assets of the private sector (considered as a whole) is nothing more than the mirror-image of the borrowing requirement of the public sector (in a closed economy at any rate), neither the Government nor the banks can determine how much of this increment will be held in the form of cash (meaning notes and current deposits) and how much in the near-equivalents to cash (such as interest-bearing demand deposits) or in various forms of public sector debt. Thus neither the Government nor the central bank can control how much or the total financial assets the public prefers to hold in the form of ‘money’ on one particular definition or another."

Kaldor certainly appears to have these concepts mastered (including financial sectoral balances) and this was 1982! It's amazing to me that virtually none of this could "rub off" onto the economics mainstream over a period of three decades! Ramanan quotes more interesting details from Kaldor in a second post (follow the link to read it).

This seems to me largely consistent with dynamics I've postulated. A copy and paste from my last post's summary of mechanisms:

Overview of Ways the Private Sector Can Reduce "Unwanted" Broad Money Supply:

1. Replace loans (which create money) with non-bank borrowing (which does not create money) independent of total debt levels. Examples of non-bank debt include corporate bonds, peer to peer loans, securitized loan pools, housing agency debt, etc. Most of this post focused on this mechanism.
   
2. Induce less bank lending by changing aggregated propensities to borrow. For example, many reports indicate a record number of cash buyers have been supporting the housing market. Logically, if there is an "excess" of deposits in the economy, then investors who would rather own other assets may outbid other potential buyers of those same assets who would have bought using debt. Thus, while QE's added money supply in this case doesn't eliminate existing bank loans, it serves to reduce the number of houses bought using bank loans, while at the same time other loans are continually being paid down. The net effect is that bank lending moves to a lower level than it would have been at had QE not occurred. Those who lost the bid for houses (who would otherwise have bought with a bank loan) might rent from the investors instead, so this point does not imply that QE will cause some to have no place to live.
   
3. Banks can sell assets (treasuries, loans, etc) to the rest of the private sector. A net decrease in assets in this way causes a net decrease in broad money supply. To see how this works, visit the Macroeconomic Balance Sheet Visualizer, and choose the operation "Bank Loan" followed by "Bank Loan is Securitized" (which is one way banks sell assets to the non-bank sector).
4. Banks can fund themselves with a higher portion of non-deposit liabilities (e.g., bonds) instead of deposit liabilities. This results in less broad money supply. As I understand it, this was part of the dynamic that RSJ described in this post.

I'm not sure whether I'm odd to find this stuff fascinating or whether my descriptions are not clear and/or don't seem credible (and I admit I still may have some things wrong!). It may just be that this is clearly less important than topics on "fixing" the economy's current primary problems. But I've considered putting together a mini step-by-step visualization on EconViz on this topic (when I can get to it) -- if anyone would find this beneficial in clarifying these interactions, please say so.

The US Becoming Japan... not in the way you may think!

It has become common in recent years to suggest that the US is headed the way of Japan, with the implication being that Japan has been an economic failure in recent decades. (I starting expecting in the early 2000s that the US would follow Japan, also, but for some right and some wrong reasons). Last year and again today I've highlighted the huge degree to which Japan's economic performance is a story about demographics and the confusion about nominal versus real in the context of periodic mild deflation.

However, by failing to adequately support US economic growth (that is, incomes and employment) in the wake of the "Great Recession", policy makers may yet find a way to send us down Japan's path:

"A sharp decline in fertility rates in the United States that started in 2008 is closely linked to the souring of the economy that began about the same time, according to a new analysis of multiple economic and demographic data sources by the Pew Research Center." -- In a Down Economy, Fewer Births

and

U.S. population grows at slowest rate since 1940s

So, poor economic growth could become a self-fulfilling prophecy via the demographic channel itself!

Of course I'm exaggerating for effect. The drop off in US fertility rate (about a 7% fall from 2007 to 2010) is not yet anywhere near large enough to give the US a demographic outlook like Japan's... plus there are long lags in demographic effects, and other factors such as immigration rate. And according to Eamonn Fingleton the reasons for Japan's demographics are quite different:

"The story begins in the terrible winter of 1945-6, when, newly bereft of their empire, the Japanese nearly starved to death. With overseas expansion no longer an option, Japanese leaders determined as a top priority to cut the birthrate. Thereafter a culture of small families set in that has continued to the present day."

"Japan’s motivation is clear: food security. With only about one-third as much arable land per capita as China, Japan has long been the world’s largest net food importer. While the birth control policy is the primary cause of Japan’s aging demographics, the phenomenon also reflects improved health care and an increase of more than 20 years in life expectancy since 1950."

Nevertheless, if US policy makers were to sabotage the US economy further by actively imposing austerity, we might yet follow in Japan's economic path (or worse) but in a different way than typically suggested!

I should also note that I'm not suggesting that higher population growth rates are inherently better, just that they contribute to economic growth (for better or worse). I recognize the planet's finite resources are being strained, but I am also a mild optimistic regarding our ability to accelerate "radical resource productivity" with the right fixes to the political system and the current massive problems of externalized costs.

Myths about Japan's Stagnation Revisited

Almost a year ago I posted two graphs and some comments on Real GDP Per Capita and Myths about Japan's Stagnation. I had realized that demographic factors and mild deflation played a different role than the conventional wisdom which held that they are each merely a factor in Japan's supposed "malaise". It turned out that demographics and the difference in real versus nominal growth entirely account for the illusion that Japan has suffered two lost decades. That is, real GDP per capita growth for the US and Japan since 1980 are remarkably similar, with one [longish] period of meaningful divergence. Here are the same graphs repeated from my post last year:

Annual Growth of Real GDP Per Capita in the US and Japan (1980-2009)



Annual Level (Indexed) of Real GDP Per Capita in the US and Japan (1980-2009)



Recently there has been some discussion among higher profile bloggers on this topic:

• The Myth of Japan’s Failure by Eamonn Fingleton
• Japan, Reconsidered by Paul Krugman
• Japan's Lost Decade: All Too Real by Matthew Yglesias
• Japan had one lost decade, but not two by Noahpinion
• More On Japan (Wonkish) by Paul Krugman
• The Japan Story by CEPR

Noahpinion may have read my previous post because he or she used my first graph above without changing the file name I had chosen.

I won't discuss all these posts in detail and there are points in each I disagree with.

However, Paul Krugman's second post contains a graph of Japan's Log Real GDP per working-age resident. I had myself been interested in the per-working-age-resident data as compared to the per-capita data, since changes in the participation rate (partly due to demographics) could cause the two to differ, but hadn't gone to the trouble of getting the data. Unfortunately Paul Krugman starts at 1990 rather than 1980 and so I'm not sure his conclusion tells the full story:

"This picture suggests that the Japanese economy was indeed depressed for about 16 years, and deeply so after the slump of the late 1990s. But it may have returned to more or less potential output on the eve of the current crisis."

Look at my second graph (above) and you can see the extraordinary growth in the late 1980s in Japan. Was this growth "above potential"? Was Japan somehow borrowing from the future in the 1980s, and are the Austrians correct that slower growth in the 1990s to undo the "excesses" and get back to the trend line must be an inevitable outcome? (I do think the answer is closer to "no" than "yes", but don't have all the answers for how/why).

Is the correct framing Krugman's, i.e., that Japan stagnated from 1990 onward and didn't return to the potential growth trend line for a decade and a half? Or is the more accurate framing that Japan's growth accelerated above trend line in the 1980s and took a decade to revert to the trend line? (In a mostly smooth fashion, excepting the unfortunate 1997-ish austerity, rather than a crash and depression!)

I believe MMT shows how the "hangover" theory of economic growth is wrong (as opposed to asset prices, which MMTers generally agree must be allowed to adjust after bubbles pop). This is because it is always possible for the flow of national income to be sustained by government deficits or net exports even if the leakage to private sector savings increases. Perhaps there was a massive inventory effect from overbuilding of real estate in the 1980s, requiring less building in the 1990s. Should that or other dynamics have pushed unemployment so low as to cause accelerating inflation? Glancing at some graphs it appears Japan's late 1980s unemployment got down to around 2%, with inflation rising to around 4%. What would have happened if the economy hadn't slowed after 1990? Would inflation have accelerated upwards uncontrollably? It doesn't seem obvious that it would, but I don't know the answers.

If not an "overbuilding" dynamic or a labor force participation dynamic (not yet investigated), then perhaps the majority of the late 1980s surge can be explained by a huge above-trend rise in productivity. If so, is there any implication that productivity will inevitably grow below trend after such a surge? It doesn't seem like such a reversion should be inevitable, but perhaps there are dynamics specific to the types of productivity improvements in Japan in that time frame that would provide more answers.

Comments and insight are welcome.

I'll split a few more observations on demographics into a separate post to keep this from getting too long.

New EconViz Blog & Survey Results

Thanks to those of you who have tried out the preview draft version of the How the Economy Works Visual Tutorial and submitted feedback! (And thanks Tom for the extra traffic from your post).

I have created a dedicated blog for EconViz.org on which I'll announce major content and functionality updates to that site. Feel free to subscribe to the RSS Feed if you are interested in seeing what unfolds there and perhaps giving further feedback. So far there are two posts -- an introduction, and the results of the mini-survey I included at the end of the tutorial.

My goal is to keep up occasional posts on this blog on macroeconomics topics outside of concept visualization -- hopefully more frequent than they have been recently! But neither will be a high volume blog any time soon.

Public Service Announcement for Google Reader users: If like me you were driven crazy by the huge amount of wasted screen space in the "refresh" to Google Reader a few weeks ago, I recommend the Google Reader Demarginfier script (works with the Greasemonkey browser add-on).

Concept Visualization and Macroeconomics

Across many theoretical subjects, it seems that much more effort has been spent on data visualization than on concept visualization. There are a number of good reasons for this, but I think concept visualization is still behind where it should be (at least in the educational material I've been exposed to).

Macroeconomics is a subject extremely well suited to conceptual visualization, yet the majority of the educational material on the web seems to be text-centered (other than supply-demand curves and the occasional simple diagram or balance sheet). While equations such as “GDP = C + I + G + ( X – M )” provide precision and rigor and aren't even mathematically complex, their inclusion in content (for example, blog posts) necessarily narrows the potential audience.

As most readers know, my first attempt at concept visualization for macroeconomics was the Macroeconomic Balance Sheet Visualizer. However, it did not appear to be as accessible to newcomers as I'd initially hoped. So I've been working on something intended for a broader audience.

Design goals include:

• Anchor as much of the verbal content to visual representations as possible, to reduce ambiguity and help illustrate concepts
• Be as concise as possible while covering the most important core concepts
• Have the core content be beginner friendly, but have additional details available just a click away at each step along the path for those who want more
• Use a web site rather than blog format, so the content can be evolved and improved in-place over time

While the content and illustrations are very far from complete (think of it as an evolving framework still in the rough draft stage), I think it's crossing a threshold where it could be worth having available to the public while work on it continues. (There's a chance I will take it offline again for a while if I get the impression it may do more harm than good in its current form).

My “to do” list is enormous for it... there is much much more that can be done graphically as well with better verbal coverage of concepts. It simply takes time... And you'll also have to excuse the amateurish graphics, for now.

That said, it's very useful to get feedback to help prioritize the “to do” list, plus you may have creative suggestions that aren't on my list! Also I hope you'll help keep me on track with direct and honest feedback (including negative reactions) if you think parts of it are heading in the wrong direction, or I've messed up or left out important things! If you do choose to try this new visualizer and respond, you can give anonymous feedback directly from a link at the bottom of each page in the tutorial, or you can post comments to this blog post, or email me.

And if you're just learning MMT and are short on time, you may want to just wait for a future improved version rather go through what's there now, since it's full of gaps and placeholders.

Here it is:

http://econviz.org/how-the-economy-works-visual-tutorial/

P.S. I do still have a good sized list of potential topics for this blog too, but have still been giving the EconViz stuff priority for the time being, so please excuse the silence.

Looking for a Volunteer

As previously mentioned, I've been gradually working on a new MMT-inspired visual tutorial on how the economy works. (It is completely separate from the macroeconomic balance sheet visualizer). My hope has been that integrating an animated flow diagram alongside the verbal explanations would make the concepts accessible to a broader audience than those willing to read and digest a typical MMT blog post.

I have a partial "proof of concept" working, though it's still too rough, ugly, and incomplete to release into the public wilds of the internet.

I would value high level directional feedback on what is working well and what isn't. Please email me privately if you'd be willing to take a look and give feedback. It could be especially helpful if you are either:

1. someone who has experience attempting to explain MMT to others, or
2. someone who is learning MMT and still trying to get up to speed on the core concepts.

Thanks!

A Visual Guide to Endogenous Money and the Failure of QE

I've wanted to do a more comprehensive post on the dynamics of endogenous money and the private sector's response to large exogenous events such as quantitative easing, but for now this post will be another incremental update to my previous posts on the topic from October and April. As stated previously, it's possible I've reached some incorrect conclusions, however my interpretation of a piece of Post-Keynesian Circuitist literature I was referred to suggests to me that these ideas are on the right track.

Basic QE Mechanics

Some people have read that the direct mechanics of Quantitative Easing only increase bank reserves but not deposits (broad money supply). That is true only in the narrow case where banks are net sellers of bonds from their own balance sheets to the Federal Reserve. But the evidence suggests banks have not drawn down their net bond assets in this way since QE began (the Fed has bought over $2 trillion in bonds!), and that the primary sellers are non-banks. To see why the immediate mechanical result of this is for QE to increase bank deposits (and thus broad money supply), please visit the Macroeconomic Balance Sheet Visualizer and run the operation "Quantitative Easing (Variation 1 - Households Sell)". Also, see this guide from the NY Fed:

"When the Fed buys an asset, the effect on the broad money supply depends on who sold the assets and what they do with the funds they receive. If the seller is a bank, reserves go up, but broad money only increases if the bank responds to the increase in its reserves by lending more to households and businesses. If the seller is an investor other than a bank, reserves go up, and broad money also goes up in the first instance as the seller's bank puts a sum equal to the amount it receives from the Fed into the seller's bank account. But if the seller uses the money to pay down debt, the broad money supply declines again by the amount of the debt repayment. As of early 2011, the behavior of the broad money supply, economic activity and inflation all suggested that recent money growth had not been excessive."

The guide mentions the well known idea that the broad money supply increase resulting from QE has been muted due to debt repayment, but as my past posts have indicated, I think that's only half the story.

Actual Broad Money Supply Changes During QE

The first graph shows broad money supply as measured by MZM (Money Zero Maturity), the second graph shows the year on year change.





It's not obvious that either QE program had a direct impact on the broad money supply trends, even though they should have if you consider only the direct mechanical results of the Fed buying bonds, and don't consider any private sector response! Of course it is difficult to tell for sure, as the money supply changes for lots of reasons besides just QE (e.g., it generally expands during economic growth, but perhaps also during times of uncertainty).

So where did part of the roughly $2 trillion in "money" that replaced bonds go? Did it only "disappear" to the extent that the private sector wanted to pay down debt? I've argued that it disappeared INDEPENDENTLY of whatever level of desire there was to pay down debt, and that the money supply growth that did occur would have occurred to almost the EXACT SAME DEGREE even if QE had not happened. In other words, money supply grew because the private sector "wanted" a larger money supply as part of its aggregated portfolio preferences.

A Visual Guide to Money Supply Endogeneity

First, consider the general situation in which bank loans expand the broad money supply. The "Bank Loans" and "Bank Credit" bars are the same size by identity because loans create deposits:


Next, consider what happens during Quantitative Easing in terms of the immediate mechanical result. Broad money supply expands, "backed" by an increase in excess reserves held by the banking system:


The private sector controls all quantities with white labels. Excess reserves, with a yellow label, is the only quantity here fully controlled by government! The light yellow label on Required Reserves indicates partial control. Banks lend first and look for needed reserves later, and the Federal Reserve's open market operations ensure that reserves sufficient to meet reserve requirements will automatically become available (either as a result of the Fed buying/selling treasuries as part of OMO, or via loans from the Fed). So the quantity of Required Reserves adjusts in response to changes in the quantity of Bank Loans, and the government only controls the size of Required Reserves if it changes the rules.

Lastly, consider how the private sector can work to "undo" the change in money supply imposed by QE, without having to alter its borrowing desires!


One of the reasons bank loans can be replaced by other forms of borrowing (perhaps with a lag?) is that when you look inside the aggregates, the economy is very dynamic under the surface. There are always some households and companies borrowing new money, others making debt repayments and others completely paying off debt.

Some bank loans may be repaid early and replaced by non-bank borrowing, but in general there is always new borrowing being done, even when the big picture is one of deleveraging.

When there is "excess" money and investors would rather hold bond assets, those investors will likely outbid banks in the contest to fund new borrowing needs. That is how the mix of bank debt versus non-bank debt can be affected. Even unconventional borrowing markets may play a part in this, such as "peer-to-peer" lending (going to family and friends for a loan instead of to the local bank). Another example of non-bank borrowing is new corporate equity issuance — perhaps angel investors and the like are outbidding banks on meeting funding needs, too.

Overview of Ways the Private Sector Can Reduce "Unwanted" Broad Money Supply:

1. Replace loans (which create money) with non-bank borrowing (which does not create money) independent of total debt levels. Examples of non-bank debt include corporate bonds, peer to peer loans, securitized loan pools, housing agency debt, etc. Most of this post focused on this mechanism.
   
2. Induce less bank lending by changing aggregated propensities to borrow. For example, many reports indicate a record number of cash buyers have been supporting the housing market. Logically, if there is an "excess" of deposits in the economy, then investors who would rather own other assets may outbid other potential buyers of those same assets who would have bought using debt. Thus, while QE's added money supply in this case doesn't eliminate existing bank loans, it serves to reduce the number of houses bought using bank loans, while at the same time other loans are continually being paid down. The net effect is that bank lending moves to a lower level than it would have been at had QE not occurred. Those who lost the bid for houses (who would otherwise have bought with a bank loan) might rent from the investors instead, so this point does not imply that QE will cause some to have no place to live.
   
3. Banks can sell assets (treasuries, loans, etc) to the rest of the private sector. A net decrease in assets in this way causes a net decrease in broad money supply. To see how this works, visit the Macroeconomic Balance Sheet Visualizer, and choose the operation "Bank Loan" followed by "Bank Loan is Securitized" (which is one way banks sell assets to the non-bank sector).
4. Banks can fund themselves with a higher portion of non-deposit liabilities (e.g., bonds) instead of deposit liabilities. This results in less broad money supply. As I understand it, this was part of the dynamic that RSJ described in this post.
   

Implications

Why does this matter? To the extent that these dynamics really occur as described in my three posts so far:

1. This shows in even stronger terms why Quantitative Easing as practiced so far (targeting quantities rather than prices) has had no meaningful effect other than on sentiment. QE truly was a placebo.
2. It lends even more power to the concept that money is always debt and can NOT be modeled like a commodity. Its quantity is extremely dynamic and subject to the portfolio desires of the private sector. IS/LM curves and the like are not relevant. One of the arguments by the Fed was that QE would increase deposits in portfolios relative to the supply of available bonds and provide a bid under other assets due to "formulaic" institutional portfolio investing, but the premise of persistently expanded money supply and reduced longer duration assets appears to be false.
   
3. It lends even more weight to the idea (frequently argued by MMTers) that interest rates are determined independently of borrowing demand, and thus that there can be no financial crowding out of the private sector when the government issues debt! Economy-wide interest rates truly are anchored to the short term Fed Funds rate plus expectations of future rate settings. (Not that the market can always consistently estimate future rate settings!)
4. Conventional wisdom is that one goal of QE was to help the banking system. Ironically, QE may have hurt banks more than it helped them! The banking system seems to operate as a private sector lender of last resort, and by triggering a shift to additional direct (non-bank) lending, QE seems to have reduced the role of banks in the economy, and thus reduced their potential to accrue earnings from loans!

UPDATE 6/23/2011: Made a few minor edits for clarity, and added Implication #4. Also, here are the two previous related posts:

• How the Loan/Bond Choice Helps the Private Sector Self-Determine the Money Supply — AND Yet Another Reason QE is a Non-Event for the Economy
• Further Evidence that the Private Sector Fully Controls the Money Supply and QE Doesn't "Work" as Advertised