I'm a bit surprised at the general b-sphere response to Hempton's article, but probably shouldn't be. It's brilliant, but I wish it were slightly clearer. I wonder how many understand what he is saying (including me).

E.g. it seems to me the critical characteristic of his test 3 is the inclusion of an assumption for future accrual book earnings over some specified time horizon for the measurement of solvency. Tests 1 and 2 are based on existing book capital measures, representing various hurdle points for the definition of solvency on that basis (e.g. full regulatory requirement; > 0 capital; 1/3 regulatory requirement).

But unlike test 3, in no way do his test 1 and 2 capital measures include an assumption for future accrual book earnings, or equivalently, the present value of future accrual book earnings as an incremental valuation component. This is the biggest conceptual difference in his various interpretations of solvency.

The incorporation of FE or PVFE allows for the bank to recapitalize itself over time, which is fundamentally why it is a more generous measure. The easiest example is that of a bank whose current equity, if properly measured, is wiped out by a properly measured trading book mark-down, but which can be recapitalized on the basis of a currently properly measured accrual book generating earnings over the next 5 years. That recovery would not be captured by test 1 or test 2 but would be by test 3.

In that sense, because test 3 includes the contribution of FE or PVFE, it is a dynamic scenario capital model, whereas tests 1 and 2 are static capital models. Being dynamic, it must assume ongoing viability, which is where the assumption of reasonable funding costs comes in, but only indirectly as the required assumption (for consistency) underlying an income statement approach (including periodic accrual FE) rather than a balance sheet approach (instantaneous book and market value view).

Hempton doesn't seem to fully emphasize or highlight this FE or PVFE component as such, when it is the most fundamental distinction in the comparative discussion across all of his models. (The other dimensions are loss expectation and discount rates for loss expectation, which can affect the value attributed to both accrual and trading books). But his post is generally brilliant.

The following was my admittedly weaker and less robust effort at tackling what is essentially the same subject matter, but from the vantage point of the effect of mark to market on crisis response engineering, as opposed to the interpretation of solvency per se:

http://worthwhile.typepad.com/worthwhile_canadian_initi/
.... (join)...
2009/02/guest-post-mark-to-market.html

It's not a free put - there are haircuts required which vary for each asset class and the term of the facility. The issue is whether or not the haircuts are large enough ( for example, I have no idea if a 10% haircut on the AAA tranche of a 5 year prime auto loan facility is big enough).

Unfortunately all of this is now just rearranging deck chairs on the sinking Titanic. It's all useless discussions. The old order's expiry date has arrived and no amount of machinations - no matter how brilliant or well intentioned - can save it. It's just nature at work.

In think the TALF program horse has already left the barn. So that socialism for the wealthy program is up and running. Read the FAQs on this program. It specifically allows for the formation of investment spinoffs, as long as the parent company is US based.

Once the public finally starts to understand the underlying principal at work here, socialism providing a moat for wealth, all heck is going to break lose. The shame is that when this happens, and it will happen believe me, Obama's terrific programs for tax reform, energy reform, universal health care, and education will be flushed.

Same as the comment above but with a link that works -

Please please please know the difference between a put and a call. I realize by put/call parity that the true option value, ie time value, is the same but you are looking at this wrong. The FED is selling a free call, not a put. Here is a simple example.

Neglect transaction costs, interest rates, and 'haircuts' or margin capital for the sake of simplicity. Assume BofA owns an asset that happens to be Citi stock (could be any asset, but this clearly shows my point) currently priced at $2.00 per share. If I understand non-recource correctly, BofA delivers the Citi stock to the FED in exchange for $2.00 per share. Then over the next three years, BofA has the RIGHT but NOT THE OBLIGATION to repay the $2.00 and receive the shares for repayment of the loan. This is a call, BofA has the right to purchase the Citi stock for $2.00. This P/L profile is EXACTLY the same as selling the shares to the FED for $2.00 and receiving a free three year CALL with strike of 2.

FYI: Citi Jan 2011 2.5 calls are 1.01 bid

JD — This is an old discussion, and the crucial point is what you allude to, put-call parity. The implicit option in a non-recourse or limited liability leverage arrangement can be viewed as both a put or a call, specifically you can view the levered equity holder as long assets and a put option or as long money and a call option. Write that as an equality...

long assets + long put = long cash + long call

and rearrange by subtracting the long options (equivalently adding short options) to both sides of the equation and you get

long assets + short call = long cash + short put

which is the canonical form of put/call parity:

covered call = fiduciary put

(I'm neglecting the exponential factor next to the cash indicating the time value of money. That's quantitatively crucial, but qualitatively unimportant here.)

I find the "put or call" question to be very much like looking at one of those optical illusions: is it two faces, or a vase? an old lady or a young maiden? Sometimes I find it more intuitive to think of the limited liability levered equity-holder / non-recourse-financed asset holder as a dude with cash and a call option, at other times more intuitive of her as a broad with assets and a put option. I wrote it as a put option, because I think that's more intuitive for most readers, since in terms of the superficialities of ownership, the borrower "owns" the assets but can "put" them back. But in economic substance, it is equally accurate to view the situation the way that you have described, and since the assets are pledged as collateral, you might find that more intuitive. Again, is it a vase, or two faces?

All — Sorry, I don't have time right now to participate extensively in the comments thread. I felt I had to respond to an accusation of not knowing the difference between a put and a call option, lest my finance testicles shrivel away to nothing. But I won't be able to give much in the give and take.

As far as the test 3 is concerned, it is dynamic in one sense, can be thought of as valuing the assets and liabilities at market, assuming that you cover the entire balance sheet.

That is, deposits are cheap funding and are worth more then face value. You could, in theory, sell deposits for more then their book value with the excess considered either an asset or contra liability. In addition, the debt is worth less then par, which would also increase capital.

The idea of a real m2m accounting world with all parts of the balance sheet marked consistently is unworkable. A perfectly healthy business *could* melt down (or get a windfall) if the market perception of risk changes significantly, even in the absence of any other factor. If your only business is derivatives and you mess up on volatility, then ok -- that makes sense. Real businesses need stability and most balance sheet items don't have anything approximating efficient markets.

Fortunately, banks don't mark whole loans to market. They book them at amortized cost less a provision for loan losses. These (loan losses) are under stated, since they don't fully reflect the known lags in a business cycle. However, they also don't pretend to know the inflection point. Further, the direction of the error is pretty well known and thats one reason they hold capital -- to use it as a buffer. If economic capital can't drop under stress, then why even hold it?

Regular banks don't hold the alphabet soup of assets, outside of investment banks or those with capital markets operations.

The plan "could" work but only if the assets are already booked way below par. And if the current booked values seem attractive if they can be bought with leverage. As long as private money takes the first x% of the losses, they might be able to use enough leverage to make the entire idea work. I'm not holding my breath.

Looks like a "gift" from the taxpayers to the investors to me.

If the PPI is not the same as TALF, but instead a structured deal, couldn't it result in fair prices even with non-recourse financing? I'm thinking specifically of the following case: The private investor puts up at least 25% of the price (determined by the private investor) and takes the first loss position. The government provides 75% non-recourse financing and only incurs losses after the private investor's stake is wiped out. This would, of course, mean that the private investor could receive no income or principle from the investment until the government was fully compensated.

While I don't know that such a plan would do much to establish bank-friendly prices, it might serve to silence the people who claim that the only problem is lack of liquidity for private investors.

No one would sell to the Fed unless the Fed were overpaying. This is just an explicit subsidy to those that have brought us to this point. And the accounting gimmicks are part of the problem, not the solution. Things should be booked at lower of cost or market at all times ... and this would have been avoided because the "capital" wouldn't have (fictitiously) appeared for the additional lending. I must also say that the market fired a lot of these "managers" (public and private) in 1987, 1992, 1998, 2001, and now in 2007. It's the Congress and the Fed providing bailouts and keeping this game going against all of us, not the Congress trying to "save" the system that was co-opted by evil aliens. Congress does this because they want a market to fund their overspending. The Fed does it for the connected financial insiders. The Solution? Deposits are only 60% of obligations for Citi and JPM (70% for WFC). Convert the non-deposit bondholders to equity and go from there. Just to give the reader an idea of what has transpired so far: roughly 10 trillion of private debt was converted to public debt ... there is only 12 trillion in total residential mortgages!

Rereading Steve's post, I think he is actually saying the same thing I'm saying about maturity matching.

In which case, we agree that matched maturities do not prevent you from getting a margin call if you're levered and your assets go south! Maturity matching may make prudent lending stable and profitable, but there is no formula for prudence. (Despite many rumors to the contrary.)

mencius> One of the main obstacles is that there is no way to get from standard "T" accounting to liquidity solvency. You cannot calculate liquidity solvency by summing on a bottom line. It is useless to talk of the "value" of an asset. A liquidity-solvent financial intermediary must match every pledged outgoing payment with an expected incoming payment, on or before its date. Is this difficult? In the 21st century? No, it's just different. Change is good.

Looking at Hempton's post, what he is saying is that banks the way they are set up now can't survive a bank run because their reserve capital comes from deposits and deposits are not locked in -- i think you are saying that it should be possible for a bank to remain solvent even if there _is_ a bank run and deposits go to $0.

I don't want to hijack the thread and make it about this idea, but I don't think this is simple. On one hand, a lot of products don't fit into this -- you could have no products with contingent payments or draws -- no callable bonds and no guaranteed lines of credit for example. You couldn't make any assumptions at all about currency movements -- you would have to run completely separate accounts in each currency. On the other hand, you would still have to set aside a separate reserve for credit losses, which are indeterminate, and so you couldn't make any strict guarantees about indefinite future solvency. So it is difficult for me to see what you gain by this.

At this point in time a lot of what banking does is provide semi-fungibility (through the medium of future money) between varying assets. I think what you are saying is "don't do that -- if they are not fungible you have to keep them in separate accounts." in that case it's difficult to see what the function of the banking system is.

re above:

"sufficiently close" is probably a sloppy way to put it, but you get my point, I think

JKH,

Precisely. The conventional view is that maturity transformation is like the temperature of Goldilocks' soup - you can have too little liquidity risk, too much liquidity risk, or just the right amount of liquidity risk. Which is true, of course, for default risk. So it's easy to see how the idea persists.

Whereas from the Austrian perspective, liquidity risk is more like the level of fecal coliform in Goldilocks' soup. There may be some acceptable level, but it is not a high level. And less, surely, is always better.

As you note, however, it is impossible to construct a quantitative (or even qualitative) metric for what "the right amount" of liquidity risk might be, whether for an institution or for an entire financial system (it's perfectly safe to transform maturities if you're the only one doing it). To me this seems like a good tip that something is not quite right with the whole design. Note that there is no difficulty in crunching the numbers for default risk.

SRW:

Non-recourse financing

= Asset + put + liability

= (Cash + call – put) + put + liability

= Cash + call + liability

= Call

= Synthetic Call

WS,

I'm glad someone is convinced!

I would rather see the fiat system flattened, stabilized, and de-MTized, because I think fiat currency is perfectly fine and in fact slightly more optimal than gold (the money supply can be fixed). However, I do not expect this to happen. It would require a government several orders of magnitude more thoughtful and effective than the one we have.

What I expect is one of three outcomes - curiously, all desirable. In the long run. I list them in order of descending desirability.

(a): Present conditions continue indefinitely, until the world's savings flee, slowly at first and rapidly in the end, to gold. Eventually, not even governments can resist the trend, and all fiat assets have to be revalued (at a much lower price than could be attained at by exchanging them now) in gold. New mechanisms and institutions for gold finance are created. Civilization resumes its forward progress with a sound monetary system.

If (a) happens, it happens because the fiat system can no longer create fiat investments that generate a positive gold-on-gold return. Thus there is no force to suck money out of gold and into paper, as there was in the '80s with Volckerific 20% rates. There is certainly a force for capital flight from gold to paper - although the result remains minor, at present.

(b): (a) starts to happen, and capital controls on PMs are imposed. Honestly, I don't think a government that doesn't have the stones to nationalize a bankrupt bank has the stones to do this. But I could be wrong.

The result: a terrifying descent into panic, chaos and mayhem, as people realize their monetary system is sustained not by faith, but by force. The military steps in, suspends the Constitution and restores order.

The outcome: order, which is good. Another desirable outcome.

(c): by some miracle, Geithner and company get the debt engine started again. Possibly by filling the entire chassis of the vehicle with monetary gasoline, and lighting it with a giant rock of pure fiscal crack. Burning with a horrible green flame, the FIRE economy begins to roll again, lending, spending and building with new, demonic speed. The debt-to-GDP ratio, which had become dangerously stagnant and even threatened to decline, resumes its healthy and vigorous quest for infinity.

In other words: recovery. So this is a good outcome, as well.

The only trouble, however, is that there is no investment which does well in all three good outcomes...

babar,

Why? If you have a higher level of credit loss than you have provisioned for, you can still be undercapitalized.

Yes, of course. The confusion is my fault. I meant "bank run" in the sense of a systemic, self-reinforcing collapse, caused by the redemption of contingent instruments.

A bank run in the sense you mean is just a decline in the value of the instruments issued by an institution whose financial condition is not as expected. This is no different from a decline in the stocks and bonds of IBM, if IBM reports bad results. If these instruments are negotiable securities - all instruments should be negotiable securities - their market price will decline. Possibly to zero, if IBM has screwed up badly enough.

But this is an endogenous problem, ie, one coming out of planning mistakes in the real productive economy. This form of pain will always exist, and someone will always have to eat it. What we don't need is pain caused by the financial structures themselves.

Compensation incentives caused the crisis IMHO.

Many things caused the crisis IMHO, including this thing.

However, I would say the main cause was the collapse of a time pyramid in which $100 trillion of present-value financial assets were built on less than $1 trillion of actual present dollars. What should be surprising is not that it collapsed, but that it stayed up so long, and that such large components of it remain standing albeit as ruins.

Logically, this structure could only stand with government support, ie, the presumed existence of trillions of dollars of Federal loan guarantees, which were presumed to be standing even behind the "shadow banking system" due to the "too-big-to-fail" delusion.

USG probably should have bit the bullet, printed all those dollars and saved the shadow banking system. But in retrospect, I see little chance that it could have. USG is much bigger than anyone thinks, but much weaker, too. Wall Street was leaning on an extremely broken reed.

It is easy to think that continuous debt expansion is normal, healthy and sane, because it has been going on for our entire lives. Both logic and history, however, tell us that this is an incorrect assumption.

I get your idea of a bank as a big "matching engine" and it makes some sense. (Lots of NP-complete problems!)

Very funny, babar. And true. We obviously have had some of the same training.

It would certainly take quite a bit of coding to adapt high-powered, high-geared computational finance to a liquidity-solvent financial system. But our present system of computational finance, or perhaps I should say our legacy system, needs to be rewritten, because it was constructed on the basis of assumptions that turned out not to be true.

What we are witnessing is not the death of free-market finance, because free-market finance is the truth and the truth cannot be killed. You can throw out Nature with a pitchfork, but she always crawls back in.

What we are witnessing is the death of "free-market finance," ie, the cargo-cult zombie version of the real thing. Free-market finance: Mises. "Free-market finance": Friedman.

Perhaps an appropriate comparison is to Lenin's NEP. It was simply delusional to think that this activity could continue indefinitely under a system of government now rooted firmly in the principle of state socialism, in which the American people have finally come to believe.

Most importantly, turning "free-market finance" into free-market finance is not at all a straightforward operation. Old software does not become young again. I fear that real free-market finance will have to grow out of some tiny, hidden sprout, rather than a patch to today's broken OS.

Which means that NP-complete problems aren't really the issue. Before financial engineering comes basic finance: lending and borrowing, stocks and bonds. 1.0 before 4.0. At present, we don't even have an 0.1.

Menicius,

I'm reading part 1 of your intro to UR. Nice overlap of subject matter with www.landofopportunitv.com...

Best,

mencius said:

"What we are witnessing is not the death of free-market finance, because free-market finance is the truth and the truth cannot be killed. You can throw out Nature with a pitchfork, but she always crawls back in.

What we are witnessing is the death of "free-market finance," ie, the cargo-cult zombie version of the real thing. Free-market finance: Mises. "Free-market finance": Friedman. "

What in the hell is free-market finance, minus the scare quotes? We have always had boom/busts and financial panics as long as we've had a financial system, for the reasons Minsky noted - debt financing of production + uncertain future = endogenous instability. This occurs under a gold standard or fiat money, central bank or no central bank, government intervention or no government intervention. It is historical fact.

And why did you bring "Nature" into this? As Bentham noted over 200 years ago, all talk of natural laws and natural rights amounts to "nonsense upon stilts". There are no universal laws governing human behavior in all contexts, and natural rights are a social contruct created by people (even Mises admitted this much).

A balance sheet! JKH, we can only dream.

RTD,

You are believing the libertarian version of history and assuming that something like free-market finance existed in the past. It did not. It sort of did, but only by default. The free market isn't something that just happens. It needs to be designed and invented. The past is at best an inspiration.

In particular, not even the classical gold standard of the 19th century was a true hard-money standard. Again, the Bank of England has been watering the gold supply with paper, using FRB/MT, since 1694. Not to mention the various American follies. Even in the English-speaking world, America has been notorious for paper money since the 17th century.

The last hard-money bank (metals warehouse, basically) was the Bank of Amsterdam in the Dutch golden age. I think there was also a hard silver bank in Hamburg. Only small, isolated cases exist in the English-speaking world.

But two of these are described by Condy Raguet, here: Gibraltar and Havana, in the early 19th century. Raguet's description of Gibraltar is especially provocative:

Such being the theory of this branch of my subject, I have the satisfaction to state in regard to the practice under it, upon the testimony of a respectable American merchant, who resided and carried on extensive operations for near twenty years at Gibraltar, where there has never been any but a metallic currency, that he never knew during that whole period, such a thing as a general pressure for money. He has known individuals fail from incautious speculations, or indiscreet advances, or expensive living; but he never saw a time that money was not readily obtainable, at the ordinary rate of interest, by any merchant in good credit. He assured me, that no such thing as a general rise or fall in the prices of commodities, or property was known there; and that so satisfied were the inhabitants of the advantages they enjoyed from a metallic currency, although attended by the inconvenience of keeping in iron chests, and of counting large sums in Spanish dollars and doubloons, that several attempts to establish a bank there were put down by almost common consent...

JKH: "Felix Rohatyn was interviewed this morning on CNBC. One of his central points was that it's a fundamental mistake to classify government outlays on infrastructure as expenditure rather than investment. Maybe you're related?"

What does it matter? Government spending is Government spending, and is fundamentally different from private sector (or microeconomic) spending.

The Government must run persistent deficits in order for the private sector to net save. This is true as a matter of accounting.

That spending might be good or bad, but you certainly will not get the answer to that question by classifying it under one entry on a balance sheet vs another.

If the Government outlays were reclassified as "investment" or as "blueberry pancakes" it would make no difference as to whether they were wise. The first question is: is the Government funding the private sector's demand to save as quickly as that demand is increasing, or is the private sector having to save out of aggregate demand?

The second question is: are the Government expenditures which exist, wise? (Either for reasons of economics, or charity).

A balance sheet treatment does not answer either of these. Even worse, a standard, private sector balance sheet treatment would be aghast at the huge, negative entry that is "equity and retained earnings" and trigger actively harmful activity, like cutting the deficit.

A standard balance sheet treatment also generates unhelpful ideas like "intergenerational transfer of wealth" or "the public debt will need to be paid down someday" or "who will finance the deficit". etc. etc.

Accounting, for a currency issuer, whose purpose is "public good" (not profit maximization) is profoundly different from accounting as we know it. I am a friend to accounting, but a Government balance sheet would, and should, look profoundly different from a private balance sheet, and honestly, is less important that the cash flow statement.

Winterspeak,

Why is it important that the private sector "net save"?

The private sector saves, even when "net saving" = zero.

What is so special about the condition of "net saving" being greater than zero?

Winterspeak,

I disagree.

In a closed (e.g. global) economy, saving equals investment.

The level of both global saving and global investment is roughly 23 per cent of global GDP.

Public deficits constitute negative saving by the public sector, by definition.

Thus, the global private sector saves 23 per cent of global GDP, PLUS its financing of the global government budget deficit.

The PLUS factor is your definition of net private sector saving.

In fact, this PLUS factor has nothing to do with global investment or global saving, since government dissaving offsets net private sector saving according to your definition.

So the question remains, what is so special about the PLUS factor, which is a net wash against government dissaving?

Winterspeak,

That was quite a good exposition. I agree with much of it, but it still doesn't answer my question.

I have no problem with the idea that the private sector has a greater demand for net private savings in an environment of rapidly imploding aggregate demand and deflation such as the one we're in. That to me is another way of saying that there is good reason for Keynesian type fiscal stimulus and running larger government deficits in such an environment. It's easy to connect those two ideas as two sides of the same coin.

But that's not my question. My impression from what you've written on a number of occasions is that you believe the private sector has a demand for net private savings in a structural sense. You've described here the rationale for changes in net private savings at the second derivative level, which I agree with. But my question is why do you think (G – t) must be greater than 0 as an ongoing structural phenomenon – not why you think (G – t) must grow in size in an environment like this.

Second, you've noted the fact that compositional issues are important in the context of both I = S and (G – t) = NPS. Of course, compositional issues are important. They're important whether (G – t) is greater than zero, zero, or less than zero. But the fact that compositional issues are important in any context doesn't address the question of why it is important that (G – t) be greater than 0 in the sense that the private sector has a demand for net private savings as I'm assuming you claim it does at a structural level.

And, by the way, I'm sympathetic to the view that (G – t) should structurally be greater than zero. I just haven't heard a convincing explanation of why this should be the case.

mencius,

Yes, I've been assuming the definition of saving as per Keynes.

Also, I believe Keynes defines saving as a “flow” (i.e. saving from income) and savings as a “stock” (cumulative saving). The former is action; the latter state.

Discussions about particular points do become more challenging when the definition of things is allowed to change. Nothing wrong with changing the definition of things, but zeroing in on what a person means exactly by something can become more difficult, I think. So my question here depends more on the maintenance of definitions than definitions being Keynesian.

In this case, I might acknowledge that net private saving should normally be positive to allow for the fact that monetary base growth is normally positive and the monetary base normally funds government expenditure. But this falls apart if the rest of the budget is in surplus to the same degree.

What I'm really getting at is that there is a slightly obscured implication in the assumption that “net private saving” must be structurally positive, which is that government under this set of definitions can't or shouldn't run a surplus from time to time. That's certainly wrong as a fact. But still my question is should governments aim toward structural deficit as the norm,and I probably mean structural deficit beyond the funding of the monetary base, although I'm not sure. Depending on this, the premise of the question may conflict with a view that the monetary base should not be expanding in the first place.

WS,

Au contraire - equity has no intrinsic value. If I sell 100,000 shares in my daughter's nonexistent lemonade stand, what I have is 100,000 pieces of paper. Nonetheless, all these pieces of paper obey the rules of equity: each share has the same value (zero),

FRNs are special in a couple of ways. While FRNs have never paid a dividend and never will, USG creates a vast amount of demand for FRNs in three ways which are very foreign to conventional accounting.

One, it standardizes them as a medium of exchange. Two, it demands them in exchange for taxes. Three, one and two combine to make the FRN the winner of the Nash equilibrium game for the standardization of savings.

And, of course, USG is sovereign. Otherwise, its scrip is just scrip. There is no magic about it. If a government is a sovereign corporation, sovereign accounting is corporate accounting. Of course, most corporations do not denominate their own accounts in their own shares! But one could imagine a world in which they did, terrifying and awful though it would be.

As far as prices are concerned, I would argue, stored dollars most certainly exist: they set the demand schedule for all the markets in which one can exchange dollars for something else. (More precisely, this demand curve is a function of stored dollars plus dollar substitutes, ie, savings in the normal, English-language sense of the word.)

Eg: if no one has any stored dollars, the dollar price of everything is zero. If anyone can print dollars, the dollar price of anything is infinity. A currency lives on the curve between these endpoints, and price schedules in that currency are entirely a function of its stock and distribution.

As for lending: when I buy a promise of future money, or goods, or sexual favors, or anything else, issued by X, I feel it is appropriate to state that I am lending to X. This is true whether the purchase is directly from X, or there is some middleman involved, or I buy the bond on the open market.

Thus, when I buy a USG-issued T-bill, I am lending to USG. In my vocabulary. You see how tricky these words can be.

USG can create its own money, but it does not want to create its own money - or rather, it prefers to create future rather than present money. Among other things, this teleports the "inflationary" consequences of its fiscal indiscretion from the present to the future. Although maturity transformation can teleport them right back.

I agree that USG, unlike any normal corporation, is not terribly motivated to maintain the purchasing power of its own "shares." This is one of the many unsolvable financial and management problems with USG - an entity I feel is in need of comprehensive restructuring.

Above, read "each share has the same value, zero, and the value of all the shares together is the value of the nonexistent lemonade stand - zero."

mencius,

Thanks. I've bookmarked Hazlitt.

Mencius - Again, what in your view constitutes true free market finance? A hard currency standard where all transactions are literally conducted with the physical transfer of gold and silver bullion?

WS,

I don't have a problem with fiat currency at all, actually. And I am happy to call FRNs "scrip" rather than "shares" if you want. The basic principle still applies: every dollar entitles the holder to the exact same benefits, whatever these may be.

In the case of FRNs, the benefits USG provides to the holder are not dividends, but the right to defray taxes with FRNs. Different - but still quite valuable, if you consider the consequence of nonpayment.

Imagine if Starbucks ran its entire accounting system in Starbucks stock. To buy an espresso, you would need to hand over a share (or whatever) of stock. This would go into the treasury and be destroyed. Starbucks could pay its contractors and employees in shares, of course - I've seen it done. And shareholders would not receive dividends, but they could exchange their shares for lattes (or sell them to people who had dollars and wanted lattes).

This would be retarded, of course. From an accounting perspective, however, it could be made to function. And it is not at all dissimilar to what USG does with its "dollars."

No - a holder of an FRN is not lending to USG. He is holding USG's scrip. However, if he exchanges present FRN for USG's future FRN, ie buys a T-bond, he is most certainly lending to USG.

Similarly, you could imagine Starbucks issuing "Starbucks bonds," priced in present Starbucks shares, payable in future Starbucks shares. So you could exchange ten present Starbucks shares for eleven 2010 Starbucks shares. Same difference.

I think the main difference between our perspectives is that I think even with a fiat currency, there is no legitimate business reason for the state to debase the currency - ie, issue more of it. A fiat currency should actually be harder than a gold standard, because the quantity of it can be permanently fixed.

Why is there no rational reason for dilution? Because dilution amounts to nothing but redistribution. Anything you can do by diluting a fiat currency, you can do by redistributing it (and rewriting contracts in it). Neither of these are normal activities under a healthy, stable government.

There are exceptions to this rule. USG at present is running a financial system with artificially high level of debt relative to the number of actual dollars. In order to wind down this system without massive liquidation, it is necessary to print dollars to buy the debt (or accomplish the equivalent through redistribution).

But, like JKH, I fail to see the reason why G should chronically exceed t. For me, the difference between targeted, controlled dilution and chronic dilution is the difference between surgical anesthesia and morphine addiction. Surely you can't deny that USG displays many symptoms of the latter.

As to why there might be a "ratchet" effect to government spending, private firms are actually loathe to commit to high-cost, long-run, uncertain fixed capital investment. If they enjoy a legacy of such investments, they tend to sit on them and manage the rents that accrue to them. If such rents deteriorate, such firms have severe difficulties with reducing their "operational leverage", (as currently with GM), though other investments must take the place of such declining firms. But oligopoly, due to economies of/increasing returns to scale, and the high levels of productivity they induce in the economy, (such that oligopoly rents are not simply dysfunctional, but partly earned and serve to help manage long-run investments through a variety of business cycle conditions), is the predominant reality of developed industrial capitalist economies. Which fact gives the lie to pure "free market" competitive accounts of such economies, as well as to marginalist accounts of price-formation, (since decreasing, not increasing, "marginal" costs tend to dominate most of the oligopoly cost-curve and the management of rents entails that many prices are manipulated or administered, such that their "markets" don't constantly or readily clear). Further, profits from successful productive investments need to be recycled into further investment opportunities, else an over-accumulation of profits will lead to a contraction of investment-spending levels and a corresponding contraction of aggregate demand, and a decline and disaggregation of the current networked or interlinked valuation of extant capital stocks. Hence government spending will serve, if of the right composition and policy mix, not just as a management of aggregate demand levels, but as a supplement and encouragement to real long-run productive capital investments, as well as, a facilitator of transitions and restructurings/inter-sectoral shifts from declining to emergent industries.

The upshot then is not only that government fiscal deficits will and should vary counter-cyclically with the level of demand and productive activity in the overall economy, but that surpluses accumulated during boom times need not entirely counter-balance deficits during busts, provided, given the uncertainties involved in any future prospects, the rate of growth in public debt remains prudently less than the reasonably expectable prospective growth in future output/GDP of the economy as a whole.

john c. halasz: Federal surpluses will certainly bring boom times to an end! Although I cannot get my head around why the Fed can, or would "accumulate" surpluses. It's like an airline "accumulating" it's own frequent flier miles. Curious.

Mencius said: "Simple: a free-market financial system is one with "separation of bank and state." Ie, the state does not lend money or guarantee private loans. Its interaction with the financial system is limited to contract enforcement."

It's difficult to address this sort of statement without lanching into a "what is the proper role of the state?" digression, but I will try. One commonly agreed upon function of the state is to regulate activities that lead to or may lead to significant negative externalities. We do not have an unregulated, free-market system of nuclear power generation where anyone can build a nuclear reactor in their backyard and sell electricity to other parties because such a system would inevitably lead to radiation leaks and possible meltdowns that would negatively affect many people apart from the plant operator and his customers. The history of financial markets demonstrates them to have similar characteristics - when there is a financial crisis, it quickly spreads to other parties both within and outside of the financial sector; there are broad systemic impacts. In my experience, those who advocate for unregulated financial markets have placed the historical cart before the horse - we do not have financial crises because the government regulates the markets, we have regulated financial markets because past experience has shown them to have more severe and frequent crises in the absence of regulation.

Mensius said: "(Obviously, this precludes the "lender of last resort" function, which precludes FRB/MT. For a free-market interest rate, private lending must equal private borrowing at every maturity. The market itself will enforce this regulation, although at least at first it can't hurt to have a watchdog as well.)"

This seems to smack of the libertarian view that we don't need to have food safety regulations because the market will regulate itself - when restaurants serve tainted food and people die from it, no one will visit those restaurants anymore and thus they will go out of business leaving only restaurants that serve safe food. This view ignores the problem of asymmetric information (it also ignores the fact that such an approach is cold comfort for those that ate the food and died).

Mencius said: "Note that this definition is orthogonal to the choice of currency. This could be gold, USG shares or other scrip, IBM shares, etc, etc. From the economic perspective, a fiat currency is exactly the same as a gold currency, if the latter is issued by a government who owns an infinite gold mine."

And what prevents it from being deposit account balances at fractional reserve banks? I can certainly understand a posteriori criticisms of the RESULTS of FRB, I cannot understand what, a priori, prevents such a system from arising under a free market.

RTD: You really should ignore FRB. FRB has no impact on banks ability to lend. Banks make the loans they want, and then borrow the reserves they need to hit their requirements, either from other banks, or directly from the Fed. It's just this weird old mechanism left over from gold standard days that is now used to set the Federal Funds rate.

Capital requirements, and quality of borrowers are the real constraint on lending, not reserve requirements. FRB is a red herring.

Sure, you can rephrase it "does the private sector need to chronically increase the number of dollars it stores", but I don't think it's obvious that the answer is "no".

Sure it is. Let me expand on why. The proof does not require any empirical observation about mortgages, etc. It is a matter of deductive logic.

Let's simplify the dollar system and get rid of these pieces of green paper. Let's also get rid of the banks. Flatten the system. Everyone has an account at the Fed. The number of dollars in that account is the number of dollars you have. You pay your bills with your cell phone, etc.

Let's also forget that there are any other financial assets in the world - instead, we will just have dollars. Perhaps USG nationalizes all traded assets at their current market price, replacing them with dollars. And we could have both present and future dollars (ie, current money and bonds), but let's not - only present dollars for the moment.

And let's, in the same big Fed server, have a single database in which all contracts that involve payment in dollars are registered.

Now: it is obvious that if we add a zero to both everyone's dollar account, and everyone's dollar obligations - a dime becomes a dollar, a ten becomes a hundred - we have changed nothing at all in the real state of the world. That is: aside from a little confusion, peoples' behavior the day after the change will be the same as before - as it would not be if you performed some other change, eg, randomizing everyone's balance.

And the same is true (except for remainder pennies) if we divide by 10. Or by 7, or by 0.7, or by any other factor. We can express this clearly by performing our dollar accounting not in dollars, but in fractions of all dollars outstanding. What matters is the pattern in which the dollars are distributed across accounts - not the denominator.

What does this tell us? It tells us that for any state of the world in which the Fed's computer contains X dollars, there is an economically equivalent state in which it contains Y dollars. Thus, for any quantity of dollars Q in the Fed's computer, any real-world state outside the Fed's computer is possible.

And thus, for the state of the world to change, there is no need for the quantity of dollars to change, which directly contradicts your argument.

Now: how does this play out in the intuitive sense in which you are using the word "saving?" Simple - as I increase my hoard of stored dollars, those dollars are not coming fresh and hot off the Fed's printing press. I receive them in exchange for goods and services, from someone else who had them before, but doesn't now. In your terms, my "saving" is precisely balanced by his "dissaving." Net "saving," across the economy: zero.

Suppose everyone wants to increase their hoard of stored dollars, as you postulate? But remember the fractional accounting. It is not mathematically possible for everyone's balance to increase relative to everyone else's balance. If everyone wants more money, some must gain and some must lose. Everyone does indeed want more money, and this is indeed how it works. Once again, logic matches reality.

Basically, varying the quantity of money adds a free variable to a system that doesn't need the free variable. All it contributes is instability. A fixed pool of money is like a string pulled tight; a variable poll is like one that is loose. There is only one way to be tight, but many ways to be loose.

You can also see a monetary authority as a counterfeiter, of course. The intuitive feeling that counterfeiting is in some sense parasitic and criminal is one of great antiquity, and not to be cast aside lightly. A benevolent monetary authority is a benevolent counterfeiter. A contradiction in terms? I think so.

Even if the counterfeiter does not merely spend his fresh bills, but instead lends them out. Nay - even if the counterfeiter does not even lend, but just uses his printing press to back free options that he gives away to his friends. Presumably in exchange for delicious, back-scratching favors.

You remain wedded to your conception of money as a store of value. You say you don't, but I cannot interpret your battery analogy any other way. As a fact, you are wrong -- fiat money is no such thing.

The battery analogy is an illustration, not an exact description. I actually detest the word "value" whenever I see it - it is usually hiding some kind of confusion. I don't know exactly what you mean by "store of value," and nor do I know exactly what I would mean if I said "store of value." So I try not to. But I may slip up. If so, you are right to call me out.

I will maintain, however, that there is one and only one motivation for holding money, whether fiat or metallic: the intent to make further purchases with it. (Okay, in a gold standard, it is possible that you want to melt down your Krugerrands and make a necklace. But this is an unusual case, even in a gold standard.)

If you feel there is some other motivation, please say so! Otherwise, I will assume we agree, "store of value" or not.

Mencius - Of the three options you laid out, number 2 would be closest to reality, except the ultimate outcome would be very different. In fact, we already have a perfect example of "private inspection services" today, they're called Ratings Agencies, and judging by how all of those AAA rated securities are doing right now, it's safe to say that the concept is an abject failure.

Winterspeak:

I was responding to your basic question as to why the government might tend to "chronically" run deficits, that is why government spending minus taxes might tend to be a recurrently positive number.

Two preliminaries: 1) my answer is a a general, "in principle" one, and doesn't directly address the current debacle, which may be beyond remedy, or, at least, we don't know fully how severe the damage will be, except that the responses with far have been variously lagging, inadequate and inappropriate. 2) One can gain any clear view on the matter by focusing solely on the financial "economy" and the issues of money and credit to e exclusion of all else, since the financial "economy" is largely a superstructure that functions to intermediate the real productive economy, and the "values" of financial assets will tend endemically to deviate from and lag the value that is being generated in the real productive economy or not, such that the former is anything but a transparent reflection of the latter, at most a fun-house mirror, though, to be sure, the dysfunctions of the former can disrupt the operations of the former.

That the sovereign government issues currency so that taxes might be paid is thus far nothing but a tautology, as if the government would be paying its own taxes. Obviously, the currency must circulate in mediating the activities and exchanges of he real productive economy, which the profits and wages realized thereby then partly serve to pay the taxes. The provision of a uniform and stable currency is one of the basic "services" the sovereign government is there to provide. (And, though this is a trivial point, the Fed does, in fact, "normally" run a surplus, due to interest from the bonds on its balance sheet, which it periodically remits to the Treasury, though nowadays it's implicitly running a loss of tens, if not hundreds, of billions of $. And the Fed normally "prints" money simply by buying bonds from the public stock of debt to put on its balance sheet, thereby adding to base-money, though under deflation it might as well monetize the gov. debt by directly buying bonds newly issued by the Treasury. There is some limit, however, as to how far a central bank could go in monetizing debt before it bankrupts itself, both through running against the counter-productive effects of the inflation it would produce and through exceeding the ability of the Treasury to recapitalize it through any further issuance of debt, which Willem Buiter, if I understand him correctly, estimates at 40% of GDP).

So my suggestion was, if you want to find a realistic reason why government spending "chronically" exceeds taxation, and thus government debt grows, in absolute, if not relative, terms, you won't find it by focusing on a sheerly monetary definition of "savings", but you need to look to the production/business cycle in the real economy, both medium-term and long-wave, (i.e. the cycle of such cycles). And, in my view, the production/business cycle is rooted in two basic asymmetries and lags: 1) productivity-enhancing. cost-reducing real capital investments that result in increases in the real distributable surplus-product, i.e. increased real output and increased real wealth, in any meaningful sense of "real wealth", which spark a boom and yield high profits, result in a need to re-invest such profits, while opportunities for profitable reinvestments gradually start to yield diminishing returns and dry up. (Note that the need to reinvest high profits will spark an inflation in the "value" of financial "assets", both based on rising expectations from prior realized profits and because realized profits will tend to get diverted into bidding up such "assets", which will have the effect of raising costs for real capital investment, while lowering returns, which would occur regardless of any CB manipulation of interest rates, whether accurately judged and timed or not,- though I tend to take technocratic fantasies of perfect control with considerable grains of salt). 2) Profits from successful productivity-enhancing real capital investment will only partly and with a considerable lag be re-distributed to wage-based demand, whether through lower real prices or higher real employment and wages, such that eventually high real output will run up against deficient real effective demand, even as returns on investments have been diminishing. The result is a bust, in which both investment spending by firms and consumption spending by households will diminish and dry up, and both will attempt to increase "savings" by paying down debt, even as prior asset prices decline, further diminishing savings: the paradox of thrift. Government deficit spending will then automatically increase, both due to lowered tax receipts and due to increased spending on automatic stabilizers and relief measures, and, if the government attempts to decrease the deficit by raising taxes or cutting spending, the result would only be to exacerbate the downturn and increase the rate of contraction in a downwardly spiraling cycle. Hence public deficit spending/debt accumulation tends to rise automatically in downturns, in response to increased private "savings",- (and the drop in financial assets prices and increases in private default rates tends to make gov. bonds relatively attractive vehicles for "risk-free" savings/investment, especially as the risks of private investments rise and opportunities diminish), just as public deficits and debt tends to diminish as private spending increases during booms. Further, additional increases in public spending and debt can serve to palliate the blows and lessen the extent of the downturn , while facilitating recovery, through recycling idled private resources, providing further new opportunities for private investment, and through redistributing income to prop up wage-based demand.

The foregoing might serve to explain why government spending tends to "chronically" outrun taxes and hence public debt tends to grow over time, but you won't get to such a realistic account by focusing solely on a monetary definition of "savings", as if it were a matter of hoarding $ now to spend them later. Money standardly functions as a medium of exchange, unit of account, and store of "value", but there is nothing to say that the temporary purchasing-power of money must endure sempiternally as a hoard withdraw from circulation: there is a reason why it is called "currency". In fact, the "genius" of industrial capitalism largely consists in the way it constantly recycles surpluses to regenerate and increase surpluses, which contrasts with the hoarding of surpluses under feudalism. (I'm amused that enthusiasts for "free markets" often don't seem to appreciate the key role of bankruptcy in promoting market "efficiency", as it facilitates the recovery and recirculation of the remaining "value" of resources). And such a dynamic system is constantly redistributive, but there is nothing to guarantee that any temporary distribution is "natural", optimal, or "right". (Indeed, insofar as prior market outcomes, as a result of some distribution of probabilities, are always more a result of "luck" than inequal skill or effort, locking in such prior results into permanent market advantage is more likely to produce less effective investment and especially "investment" geared toward maintaining advantage rather than increasing aggregate real output, than periodically reshuffling the distributive deck to allow for new initiative by different agents, insofar as as new investment opportunities involve a "discovery" process, and require inter-sectoral shifts in labor and skills). Theoretically, the function of financial capital markets is to optimally allocate investment spending such that the rate-of-profit is equalized across all businesses and sectors as at optimal "equilibrium", and, though there may be operative tendencies in that direction, due to changing productive ratios underlying the real productive economy, even leaving aside error rates and information asymmetries, such an "equilibrium" is never actually attained, while, equally, the effects of an investment boom will tend over time to shift financial "asset" prices away from any optimal "equilibrium". The results of such cyclical readjustment processes are likely to show up as being counter-balanced by increases in public debt. But the overall upshot here is that there is no form of monetary "savings" that is not obversely a form of spending, by some agent or agency or another, whether "I" or "C" or "G". One might save through buying a long-run durable good, such as a house, the equity in which might be recovered by later re-sale, or by buying a share in the legal claims to a set of capital goods, from which future revenues accrue, or by buying a debt-obligation such as a bond, or simply by putting one's money in a bank. But there is nothing to guarantee that the future monetary "value" of one's savings will equal or exceed its current "value", though the least likely case is simply withdrawing a hoard of currency from circulation.

There is nothing necessarily wrong with mild price deflation, as opposed to debt deflation, which increases the real burden of debts. But arguably, a regime of mild price inflation is preferable, as it encourages investment through the "scent" of perceived demand, through attenuating the risks of assuming debt, and through discouraging any hoarding of money. (One could simply "invest" in collectibles, such as stamps, which will increase in price a) with the general price level and b) with the general real expansion of the economy, and hence the available demand for such collectibles, an excellent "tax-free" way for small fry to save for retirement). Severe inflation would, of course, result in forms of hoarding and distortions in investment allocations. But the main point is that money, at bottom, is just a symbolic cypher, such that its "value" is not "absolutely" determined by some quantity, nor by any cost-of-production. There is nothing wrong with increasing the stock of base money to accommodate increases in real output, and arguably to fail to do so would have deflationary and contractionary effects. However, one should take account of Post-Keynesian accounts of the credit/finance system, such as Steve Keen's, that expanding the monetary base does not cause and precede the expansion of credit, but rather the expansion of credit, endogenous to the production cycle, precedes and expands the monetary base. The equality of savings with investment is a short-run NIPA accounting identity, but the question as to whether savings produce investment or vice versa is chicken-and-egg. Insofar as productivity-enhancing, cost-reducing real capital investments increase the real distributable surplus-product, then they not only produce savings, qua cost reductions, but they increase the supply of loanable funds through the recycling of profits, even if some prior supply of savings is required to supply the basis of the credit system. But any system of lending and therefore of credit would involve the very same embedded leverage, as is involved in FRB, in whatever different guise, and would be "justified" by the realization of successful investment in the same way and to the same degree, even as it would absorb the losses of failed investments, just the same. Which is to say, that given the dangers and excesses involved, FRB or any other operative system of credit and finance requires careful and strong regulation. Which is why claims that our current woes are due to government regulation and intervention in the financial system, rather than the failure, evasion, and captive complicity of government regulation, are thoroughly bogus. (The proposed, or rather fantasied, alternatives to a regulated system are even more defective, if not entirely inoperable). But, even granted that the government, in issuing currency, doesn't directly have to concern itself with its "value", I disagree with you that it has no cause to do so. For one thing there is a dilemma between the desire to inflate away the accumulation of public debt and the increased interest and social costs of doing so. Insofar as the "private" sector has recourse to public debt to increase its "savings", inflating away those "savings" and raising borrowing costs, nominally and possibly really, might be counter-productive, since it is the lowered prices of financial "assets" that reduce investment costs and encourage recovery. But, more importantly, the for-ex value of the currency is of importance to the sovereign government, or, at least, to those dominant "interests" that have captured and control the sovereign power. A high US$ might be favored by Wall St. and the MNCs, insofar as it advantages their terms-of-trade, and allows for cheaper FDI and for the buying up of foreign banks, companies and resources, to increase the scope of the rents that they draw off of the RoW. That it also increases the trade deficit, lowers domestic wages and increases household debt might be just added fringe benefits for such wealthy elites. Conversely, a lower for-ex value might be desirable to encourage export-led growth. (Though Sweden's bank nationalization is often touted as a precedent, it's little mentioned that the key to both economic and financial recovery was a 30% devaluation of the Krona, which kicked off exports. But, of course, nowadays, no country can count on devaluing for export growth, given the global collapse in trade). But it's simply not the case, that, just because currency doesn't have any "absolute" value, there are no policy interests conditioning its relative "value".

Austrian "economics" would apply, if at all, only to a steady-state, constant-reproduction economy. What is truly odd about it's insistence on a "hard money" absolute standard of "value", which supposedly could only be assured by a completely "free" market system, is not just how it misses the effects of technical improvements in real capital stocks and the radical alteration in (re-)production ratios that involves, which is the main source of the success and growth that capitalist "markets" provide, but rather in how it relies on an essentially feudal notion of hoarding, preventing the recirculation of surpluses, which is the very "secret" of capitalist markets. But what could one expect from a bunch of Austrian aristocrats and wannabes, nostalgic for the lost glories of their dying empire and the hierarchical "liberty" it allowed, and imagining it would all return to them in the utopian future, if only markets would just be "free" enough. Dear Mencius has just provided us with a restatement of "Say's Law", together with an exposition of the "neutrality of money" thesis, which even "New Keynesians" still adhere to in that ever elusive long-run. As if a monetized industrial production economy, in which increases in productivity and output underwrite increases in profits, could be reduced, if not to a primitive barter economy, then to commodity exchange in a petty producers' economy, the artisan economy that accompanied the feudal agrarian economy, in which there is only a C-M-C circuit and no M-C-M' circuit, i.e. in which increases in profits generate no asymmetries in exchange, by virtue of the fact that they do not, because can not, occur. Wonderful! Wunderbar!

It looks to me like the core issue is the intended full bailout of bank creditors, more so than the facilitating partial bailout by a thousand dilutions of bank equity holders. The repeated government capitalization of Citi seems designed to avoid the first outcome at all costs, including whatever residual value remains to the original equity holders as an unfortunate by-product.

The nationalization debate is poisoned by at least implicit disagreement on the definition of nationalization. Nationalization is as much a virus of a given intensity and depth, starting with FDIC maturity transformation insurance, as an ultimate event per se.

I'm still not sure I see a robust argument why (G – t) should be secularly positive, except for central bank monetization of natural currency demand. I can see the argument for a countercyclical tendency during times of bust. But I don't see an argument against the opposite countercyclical tendency during boom times. Clinton did manage a surplus for several years, and Canada did it for a decade. I think the proof of (G – t) being optimally secularly positive, apart from demand determined CB currency monetization, could be linked to some sort of asymmetric Kondratieff correlation, but I don't think I've seen such.

Mencius:

“Basically, varying the quantity of money adds a free variable to a system that doesn't need the free variable.”

That strikes me as being at the heart of the truth, if it is true.

RTD - If use of sound money is tantamount to barter, then maybe your aunt does have, uh, well, you know. Actually, even if she does, it isn't. That is true practically by definition (look up "money" in a dictionary if you're wondering what I mean.)

The "modern economy" you apparently refer to is clearly intertwined with arbitrary manipulation of currency (whether fiat or faux gold standard) and that is its primary weakness, as said manipulation distorts price signals and inevitably leads to imbalances and overindebtedness that, as I said, cause the sort of bust our modern economy is currently in.

You also state the obvious when you suggest that in an economy in which any quantity of the medium of exchange can be - and is - created out of thin air at will, the "quantity of money is largely endogenous." That's the problem!

Obviously, every one will make up his/her own mind, especially here. I am offering a clearly unorthodox alternative analysis along with the suggestion that there has been much propaganda embedded in the conventional wisdom.

We each have a filter through which we view the world. The more aware we are of that filter and the manner in which it distorts reality, the better able we will be to improve our lives (see, e.g., flat earth.)

MENCIUS: Thank you for your model. I think it's excellent, and reduces the issue to its core. Let's run with it.

Say, in your system, we have four accounts. Let's call them Sovereign, Investor, Entrepreneur, and Bystander. All begin at zero.

-- Scenario 1

To fix money supply, let's say that only one account, Sovereign, is allowed to carry an overdraft. It injects an initial amount of money into some combination of Investor, Entrepreneur, and Bystander, crediting their accounts and debiting its own. Let's call this amount G-T, and let's not care about how it's distributed across the other three account. Our Sovereign, watchmaker like, now sits back and participates no further. Its account carries an overdraft of G-T.

Sovereign, Entrepreneur, and Bystander carry, between then, a combined G-T on their asset side, and G-T on the liability side (as equity). Any of these three can shrink their balance sheets, so another can grow its balance sheets, but the balance sheet of the system as a whole cannot change. There would essentially be no debt financing, because even though one entity might choose to finance another via debt, since accounts cannot go into overdraft they would have to maintain at least a zero balance, so in essence it would be an equity investment or straight cash transfer.

I find it difficult to imagine how this money system would support economic growth. It could bear deflation, as there would be no nominal debt contracts. Entrepreneur makes an equity investment in Investor, which is successful. This requires Bystanders balance sheet to shrink, and successful investments usually require buyers. Clearly this system is dramatically different from what we have now, and maybe it does not work because I lack imagination. Won't be the first time.

-- Scenario 2

Let's keep the watchmaker Sovereign, as before, so Investor, Entrepreneur, and Bystander begin with balance sheets of G-T across them (cash of G-T on the asset side balanced by equity of G-T on the liability side), and the Sovereign carries an overdraft of G-T but acts no further.

Let's let *everyone* be allowed to carry an overdraft now too.

Investor no longer needs to write down cash to make an investment in Entrepreneur. Investor can issue Entrepreneur a loan by crediting Entrepreneurs with the cash, and balancing that with a receivable. Entrepreneur accepts the loan as a credit, and balances that with an amount due as a liability. Entrepreneur and Investor now both have larger balance sheets, which they can use to buy things with. Bystander feels he is being diluted, just as he would if Sovereign gave another G-T slug to Entrepreneur and Investor. The point is that if you allow non-Sovereign accounts to run overdrafts, then you get dilution just as you would if the Sovereign prints money and issues it to a favored entity. Allowing debt enables dilution, no matter what the Sovereign does. If you're measuring "CPI" you'll even see an uptick.

Of course, in this system, if any entity takes on more debt they can service, balance sheets will shrink, potentially in a bank-run, domino type effect until everyone who carried an overdraft repudiates their debts back to zero (and have no balance sheet, as their equity has gone to zero) and those who carried positive balances see those positive balances reduced down to whatever initial cash balance they had. The non-Sovereign sector is always in danger of collapsing back to a balance sheet size of G-T. This is true whether there is MT or no, but MT makes things much worse.

It's easy to see how this system support growth. Entrepreneur comes up with some new idea, which increases their income. This income enables them to service larger debt, so they can maintain a larger balance sheet. Entrepreneur wins, investor wins, and although Bystander is being "diluted" they're probably better of as well because of whatever Entrepreneur came up with. You can think of "ideas" as reasons for the non-Sovereign entities to trade with each other. More ideas enable more trading, and thus higher measured GDP. But in order for this additional trading to enable higher consumption, you have to let the non-Sovereign sector, as a whole, increase its balance sheet, which means some non-Sovereign entities need to carry a negative balance (overdraft).

A final observation: In the above, we now have a reason for the Sovereign to continue injecting money into the non-Sovereign sector -- it enables the non-Sovereign sector to increase the size of its balance sheet while not taking on additional leverage. The higher the amount of leverage, the greater risk there is of the non-Sovereign sector to collapse its combined balance sheet down to the initial G-T. By leveraging up, the Sovereign enables the non-Sovereign to delever. If a larger balance sheet is necessary for economic growth (which it might be), then a chronic increase in G-T is valuable in making that growth less prone to collapse.

JKH: Time to define "chronic". There are certainly times when a Sovereign would want to run a surplus and destroy money in the private sector. During inflationary periods, for example. But if larger balance sheets are requirements for economic growth (big if) then, as an economy grows (with stable CPI) you would want to see larger deficits overall to limit the potentially destabalizing leverage underneath the whole system.

MENCIUS: You are correct -- it is strange to think about a sovereign "overdraft" which is why I don't like the phrase "Government debt". The Government can always pay any debt it carries. "Deficit" is the most neutral way I can think of the simple G-T entity, and I took pains to stress that it would be carried in perpetuity.

Your analogy of an infinite goldmine is correct, but even being the monopoly holder of such a wonderous contraption does not vitiate the need for accounting. How much gold have I extracted from this mine? How much have I returned to it? What is the amount of gold I have extant at this moment? You know that by counting G, and T, with the difference (G-T) being gold still out in circulation. The Government must take more gold out of the mine than it puts into the mine in order for there to be any gold above ground at all. Whether you calculate this as G-T (a positive amount) or T-G (a negative amount) doesn't matter -- you either count a surplus or a deficit. But *something* must be in deficit for something else to be in surplus.

A goldbug views gold as an asset to someone, and a liability to no one. In a proper accounting system though, every asset must be balanced with a liability. Depending on what you choose to label things, this can create some negatives in your spreadsheet cells. Deficit does not mean loan.

--- Let's take Scenario 2 first

I ask you to desist from the term "counterfeiter", "thief' etc. etc. Let us discuss before we judge.

I hope you agree that Government action, further slugs of G-T, are not the sole cause of dilution in an economy, *any* type of debt financing is as it grows balance sheets. In fact, anything that increases balance sheets causes dilution. So your target is not Government deficits, but any kind of debt at all. Maybe the Christians and Muslims were right?

So, we can dismiss *increasing* Govt deficit financing as the villain in this piece and shift our cross hairs to debt, or if you prefer, net expansion of private sector balance sheets.

--- Scenario 1

I struggled to make sense of what economic growth would mean in a world of truly fixed money supply (so, no debt financing at all, every balance sheet remains fixed in size, etc.) I find it challenging to keep distinct real goods and services from the money used to count and trade them.

I don't think the standard GDP number is useful, as it's nominal and we really want to talk about whether a real economy can grow and have balance sheets -- which are always to be in nominal terms -- stay the same.

But while all balance sheets will sum to the same (which is what I said), GDP need not. If I choose to spend, that transaction gets recorded in GDP. If I choose not to spend, then it will not. Balance sheets can stay exactly the same, but everyone's income can fall to zero. Velocity matters to GDP calculations, and cash flow and income statements for the non-Sovereign sector as a whole. It does *not* matter to the consolidate balance sheet of the non-Sovereign sector. We have banished debt deflation, but animal spirits are still very much with us.

Still, no credit means no credit collapse. The fortunes of Investor, Bystander, and Entrepreneur may change, but one's gain will always be another's loss. The system as a whole is stable, but it may also be stagnant.

I'm finding it hard to imagine an economy with no loans at all that can still grow. Ironically, maturity matching, which you have convinced me on, has become a moot point! D'oh!

BSG: "If every unit of currency represents, for example, a fixed amount of goods at a given moment in time, lending that unit does not cause dilution of anything."

Nope. Every unit of currency is simply a number in a spreadsheet.

During lending, the lenders balance sheet and the recipients' balance sheet gets larger. If that loan is repaid, both balance sheets stay at this new, inflated size. If the investment fails and the loan is not repaid, both balance sheets shrink back to the original size (or smaller). If the borrower takes the money, then his balance sheet remains as big (and his liabilities get restructured) while the lenders balance sheet shrinks. It's the same as if the lender simply gifted money to the borrower. Certainly in the gift scenario, there is no dilution.

Are loans essential for growth? Do balance sheets have to grow as an economy grows? Can a corporate entity grow, and have its balance sheet stay the same size. What does "grow" even mean if your assets, and liabilities, are remaining constant in size?

It really is important to think of this from a balance sheet perspective, as "loans" gets our intuitions wrong. Can a real economy grow and have a constant number of assets and liabilities on its consolidated balance sheet?

You have balance sheets in a barter economy too -- they would just be different from what we think of as a balance sheet. I don't think that not having money gets you away from accounting.

I'm finding it hard to imagine an economy with no loans at all that can still grow.

An economy with a closed money supply most certainly contains loans. It's just that each borrower who gains the use of money for the term of the loan, there must be a lender who loses it. The system is, again, watertight.

But I suggest you reread my answer to scenario 1. The word "grow," which is of course an analogy, conceals quite a few assumptions.

Here is another way to think of it. Again, consider "the economy" as the consolidated balance sheet of all businesses. This balance sheet can be seen as a business in itself, Allcorp. Then "growth" consists of an increase in the sales of Allcorp.

An interesting question is: what is the market capitalization of Allcorp? In other words: what is the net market price of all the debt and equity that Allcorp can issue?

Clearly the market capitalization corresponds to the total returns (sales minus costs) that Allcorp can receive over time. There is an obvious bound on this value: the total amount of currency that Allcorp's customers have. If it extracts all of it from them, leaving them with none, it will have done its job to perfection. If can perform this feat instantaneously, its value will be equal to the value of said currency. But this is truly unimaginable, so it must be less.

Suppose, for example, that all of Allcorp's shareholders and debtholders are aliens. They have an insatiable desire for pictures of dead presidents. When they receive these lithographs, they pack them off to Alpha Centauri and save them forever. None of the returns of Allcorp are "recycled."

But the value of securities cannot depend on who holds them. And Allcorp, in particular, cannot possibly increase its market capitalization by printing Allcorp shares and issuing them to its customers. If aliens hold 100% of Allcorp, they cannot increase their returns by doubling the shares outstanding and giving each share to a randomly selected Earthling. The same is true if they start by holding 1%. At best, all the returns will be recycled and the value of the aliens' holding will not change. In reality, it will probably decrease, because the loss from dilution will not be made up fully by the customers' increased purchasing power.

(It is interesting to observe, therefore, that the market capitalization of all industries today exceeds the quantity of currency in circulation by almost two orders of magnitude. I feel this is a good indication of how dependent our financial system is on the printing press. Ie, it indicates how far securities prices would fall if the Fed suddenly and permanently recused itself from the sovereign privilege of minting new currency. True hyperdeflation.)

But the most important observation is that with a fixed (or normalized) money supply, Allcorp's sales will be stable (but not static). So should its profit margins. Therefore, its capitalization should be stable (but not static). And therefore, so should its balance sheet.

And finally, I need to note the extremely dangerous and subversive suggestion that everyone in the economy should be able to act as a self-minting lender, not just the Fed.

In other words, everyone can borrow an infinite quantity of dollars from Pluto, at an infinite term, in exchange for noting on their balance sheets that they owe a debt to Pluto.

What happens? Everyone does exactly this. They borrow an infinite amount of money with a thousand-year maturity, and spend it. They need have no concern for the amount of debt they are incurring, because it matures only long after their deaths. And in any case, the currency will become worthless, thus making the debt easy to repay. Even if Pluto limited his loans to 10 years, the result would be the same: instant hyperinflation. Despite the fact that all balance sheets are balanced.

mencius:

You really should improve your manner of addressing arguments, if you actually want to address any real issues rather than just adventitiously skew matters to accord with your own peculiar obsessions, as if to "prove", to yourself, if no one else, your own "cleverness". (And Humpty-Dumpty games of perpetual nominal redefinitions do your case no credit).

"This claim is unequivocally false. Production of goods and services does not require production of currency."

No, it requires the production of profits, which is the actual "hoarding" taking place, i.e. what can't be reduced to prior accounts. And the point is those profits need to be recirculated through reinvestment and/or increased consumption, in order to absorb increased real output and to maintain the "value" of the extant network of real capital stocks, which have no other "value" than that which is realized through revenues from the sale of output. (This is part of why the predominance of oligopolies is such a problem for "free markets", because, though their rents are partly "justified" by high technical levels of productivity and the need to manage long-term fixed capital stocks, they tend to stove-pipe and seal-in profits, skewing income distributions and domestic "terms of trade" and forestalling further productive and innovative investment that don't accord with their market-dominance, not to mention their ability to convert their market dominance into capture of government policy and regulation. "New Keynesians" note that "imperfect competition" results in "sticky prices", but that does not go anywhere far enough).

"
Sez the man who believes that counterfeiting isn't counterfeiting, if the government does it."

Sure, ask any lawyer or Secret Service agent. Though, again, adventitiously redefining terms out of their stable natural language meanings won't do. Even qualified lawyers aren't really capable of doing that.

"John, are you curious at all about the history of the ideas that you yourself hold? You might enjoy looking into the biographies of Richard T. Ely, Irving Fisher and John Maynard Keynes."

What exactly would those 3 economists have to do with one another, a German historicist Progressive reformer, a neo-classical disciple of Wicksell, and a critic of neo-classical optimum equilibrium assumptions? And why would you assume a) that I am not aware of the history of economic ideas, and b) that any of those three would be prime sources of my thinking or understanding. But more to the point, you're just gratuitously engaging in ad hominem argument, without making any "substantive" point. I myself don't mind if someone entertains religious beliefs, so long as s/he is otherwise rational and responsive, and I wouldn't evaluate such beliefs or their import outside their historical context, wherein they might be quite commonplace and not especially "maniac". ("Religion is what a man does with his privacy", said Whitehead. And I find the matter about as interesting as someone's boasts about his/her sex life, which is generally in inverse proportion to its passion or meaning). And if that buggerer Keynes was an "aristocrat" more dissolute than Nero, someone should have informed the hierarchs of Cambridge U. But then a person's motives do not necessarily vitiate the quality or validity of his/her ideas, eh? What point could you be making, other than to manipulatively defend your own sacred idols, by slandering all other economists? On the other hand, my placing the Austrian school in its historical/ideological context serves solely to bring out the oddly archaic quality of its thinking, at once highly concretistic and fixedly static. Further, it oddly abstracts from some key features, which make capitalism, er, well, capitalistic, which abstraction is not at odds with its concretism, but its counterpart. And the version of "liberty" it extols is fairly transparently a defense of hierarchical privilege, which it oddly imagines a completely "free" market would uphold and reproduce,- again abstracting from some obvious features and consequences,- if it were only "free" enough. None of that is a matter of any ad hominem or genetic fallacy. Rather it's a matter of educing some peculiar lacunae of that school of economic thinking. And pointing to their reactionary origins.

And if you want to appeal to the history of economic ideas, might I recommend Karl Polanyi's "The Great Transformation"? He was a senior editor of the Viennese equivalent of the WSJ, until he was fired for suspect political sympathies, after street fighting in Austria had resulted in the ascendancy of the hard right, several years before Anshluss. So he was thoroughly versed in the ideas of Austrian laissez-faire "liberalism" and part of the point of the book, though it's not often noted, is an extended polemic against the effect of those ideas, especially in giving the lie to its typical plea that it is the antipode of German fascism and had nothing to do with its rise.

It's amusing to me how you utterly fail to see how unrealistic and unworkable your ideas are, though you're obviously caught up in some gratuitous moralizing. But economics concerns functional matters, and has only a glancing relation to morality or ethics. Then again you're apparently lacking in any "serious", plausible account/analysis of human agency, "freedom", imagining that it resides in some factitious "quantity", volition, which is the property of atomic individuals, and any "violation" of which is an obvious outrage to morality. I like to ask libertarians, though I don't know if you'd so label yourself: how is freedom possible in a causally determined world? It's not like no answer can be given; several plausible accounts might be offered, provided suitable conjunctions of causality of suitable sorts, at least partially indeterministic in "nature", which would approach our feelings or intuitions that human agency is a real phenomenon. But the question forces one to realize that it is a limited, finite "quantity", and never entirely unconditioned and self-determined. Further, any such account would involve language/symbolic thinking, which means that agency is always social and bound up in relations and interactions with others. Hence not only is society not a matter of additive relations between atomic individuals, (and hence neither are markets, which can only occur within an institutional frame, which supports and "authorizes" them), but such atomic individuals themselves do not, because can not, exist. Hence no arrangement of social relations is or can be entirely voluntary, nor could that be a self-sufficient criterion for evaluating the former. Further, there is no system of contracts that could resolve such relations without large and consequential externalities, (which, e contrario, would amount to assuming the omniscience of lawyers, which even their grandiose self-conceit wouldn't allow for), nor could any system of social exchanges, of which markets are a dominant case, remain static and recur to a prior equilibrium based on prior intentions, since any such system is one of cross-secting mutual constraints, which "constitute" both the system and its agents in the first place, such that the "system" is formed and re-produced through its functional capacity to handle the consequential transformation of its conditions, which has to do with agents being agents and, er, acting, in the first place. Which is to say, that such atomic individualism is of no "moral" worth, and fails to "ground" any sort of ethics. Its claim to speak on behalf of "liberty" or "freedom", above all else, anything short of which is violent coercion, are not just incoherent, but actually involves a displacement of such violent coercion. But still more fundamentally, it appeals to a system of exchange that would vouch-safe it, that is, er, without consequential exchange, mirabile dictu, which is, indeed, an archaic "aristocratic" fantasy. Passingly strange as an account of a "free" market economy, still stranger as an account of its functional "virtues", as producing real economic growth on behalf of the hoi polloi. I don't want to get into some elaborate dispute over "methodological individualism", though I obviously think it's an inadequate approach to developing a realistic account of an economy, (since institutions and organizations are more relevant "agents"), but I'll just note it does not "translate" into any account of "substantive" individualism, and the mistaking of the former for the latter, of functional criteria for "moral" right is the very height of folly, indeed, "divine comedy".

You apparently fail to grasp that money is simply a "universal equivalent", rather than any actual "object" of exchange, a reduced symbolic medium, a semiotic instance, representing "value" without having any of its own, which only acquires "value" through circulation and exchange. And that is the case whether its "medium" is gold, sea-shells, "real bills", $, or secured electronic transmissions. You further fail to grasp that any lending involves "credit", (Latin for belief), the obverse side of which is debt, (which probably goes back etymologically to blood-money in tribal systems of exchange, Geld = guilt). I don't lend my ox to let you plow your field and forgo plowing my own field, but rather I lend my surplus corn to allow you to buy an ox. Money, derived from the circulation of exchanges, is different from debt, but also allows such debt transactions.There is no way to reduce such debt to "prior" monetary exchange, anymore than one can convert corn to oxen, other than through a sequential production process. I'll go further. The notion that lending is time-preference might seem intuitive: I forgo current consumption in order to allow you to engage in consumption, while increasing my resources for future consumption. Except that a) there is a more-or-less large population of potential lenders with differing time-preferences, which evens-out such an issue, and b) productive consumption increases the very surpluses, derived from prior exchange, which "pays" for such lending and more. Further, the extension of such time-preference into such productive consumption and into an account of the "round-aboutness" of production misses that production is a constantly ongoing process. Yes, there are vertically integrated stages of production, but they are constantly re-adjusting to one another, under ongoing, changing conditions, and there is nothing to say that such production processes are market mediated, "outsourced", rather than contained in vertically integrated oligopolies or Japanese-style "keiretsu" arrangements. Which is to say, that there is nothing to say that the current rate-of-interest is determined by time-preference, rather than the current state of the productive economy, (and, er, the need to recycle such corporate profits and the lack of available opportunities for such). The "marginalist" account of production,- (and, yes, the Austrian school is a fully paid-up member, since it was only after they realized that their account couldn't "work", that they turned to eschewing the "scientism" of mere mathematics),- fails precisely on the score that production systems can not be reduced to market exchanges. There are re-production requirements that introduce constraints that are far different from market-exchange constraints.The sphere of production is cross-dependent or cross-implicated with the sphere of circulation and exchange. But neither is reducible to the other

Mencius: (You're also too quick to dismiss Irving Fisher. Yes, he was crazy, but his craziness also caused him to lose all his money on the stock market crash, and *change his mind* about his economic ideas afterwards. Anyway changing their mind as a consequence of reality is so rare, that I think it's worth comparing before and after. This account of debt deflation is excellent, and I think you would agree with much of it.)

WS: "Your target as chief dilutionist has been the Fed. I'm trying to point out that Banks dilute as much. If you want to target dilution, you need to target debt financing (as it exists today in reality)."

As I recall, several here, including Mencius, JIMB, IA, myself and perhaps even Steve have repeatedly said that fractional reserve banking (your "as it exists today in reality") is a major culprit and explained why. Have you been agreeing all along?

>"Banks mint money, and they are meant to only be able to mint money in >proportion to increased economic growth (does not show up in CPI, does >dilute currency). "

Since the Fed was created, has there been a single year outside the Great Depression in which the CPI did not rise? How about asset prices, most of which are excluded from the CPI?

WS,

Before going any further, can we agree that, at least initially, the Sovereign needs to run a deficit in order for the private sector to have some currency at all, and that this is true whether you're talking about a monopoly infinite gold mine, or numbers on a spreadsheet? I think that if I cannot get you to agree to that, then I cannot get you to embrace a balance sheet perspective on money and we can go no further.

How on earth could I accept this? Before the 20th century and excluding the brief innovation of Kubla Khan, all currency was metallic and was produced by finite, non-monopoly gold and silver mines. Not government deficits.

You: "During lending, the lenders balance sheet and the recipients' balance sheet gets larger."

Me: "Depending on the definition of "gets larger," this could be interpreted in a number of ways. But using the simplest definition - the sum of both columns increases - I disagree."

You: "Hah! How about we use the normal definition? The asset column always equals the liability column."

Yes, of course. By "both columns" I meant "each column." This was not some new accounting innovation, just clumsy English.

But go back and read my point again. The lender's balance sheet does not increase, because he is exchanging one asset (cash) for another of equal price at the time of the transaction (the loan).

You: "In a debt world, the lender creates a credit entry on their own balance sheet (receivable) and a debit entry (loan). The borrower creates a credit (cash) and a debit (payment due)."

No. This is the heart of your error, I think. This is just wrong.

Your lender is always a minting lender, and you are combining two transactions into one. One: the lender creates money. Two: the lender exchanges money (present cash) for a loan (a promise of future cash).

Operation one creates money and expands the lender's balance sheet. But it has nothing to do with lending. Operation two is the essence of lending - but it does not create money or expand the lender's balance sheet.

The essence of a loan is that present cash is exchanged for a promise of future cash. This transaction does not involve monetary creation.

It is dangerous and subversive! In practice, we have one "private" entity with the charter to do this, known as a "bank".

No, not even. We have one entity with the charter to do this, the Fed. (Whether the Fed is legally "private" or not is to some extent a matter of opinion, but it is obviously official in reality.)

The Fed can create dollars and lend them. In the US today, a commercial or investment bank cannot lend dollars it doesn't have. It has to borrow them, ie, from depositors. Or sell shares. Or whatever. But it most certainly does not have the right to create dollars out of thin air.

The banking system in effect, through the magic of guaranteed maturity transformation, can create money. Or rather, it can teleport it from the future. But this mechanism, she is not working well at the moment.

Banks mint money, and they are meant to only be able to mint money in proportion to increased economic growth...

Aha! This doctrine is a key part of 20th-century loose-money doxology. About a century ago, the term was "elastic currency" - the idea was that a fixed supply of money (or even a gold supply that expands through mining only) does not allow for, well, "economic growth."

(Since, as I explained earlier, "economic growth" is a statistical artifact of inflation itself, this is in a sense true. But not in a meaningful sense.)

But the point is that said elastic currency was supposed to, in some mysterious automatic sense, expand "to meet the needs of trade." Since there is no ordinary commercial transaction that involves, much less requires, the creation of currency, this makes about as much sense as most early 20th-century pseudointellectual propaganda.

In my money system, also known as fiat money, also known as current reality, money and accounting is zero sum.

All I mean by "zero-sum" is that every transfer of money is zero-sum in the game-theory sense - ie, the transaction does not increase or decrease the amount of money in the system. This total is most certainly positive.

As for fiat money, again: fiat currency is not in any way qualitatively different from a gold standard, as my infinite-gold-mine standard generates. It is a difference of degree. You can go from an infinite gold mine to a finite but very large one, to Fort Knox, etc, etc.

You can also see the continuum in terms of equity: from USG dollars, to IBM shares, to GLD shares, to actual pieces of gold. The question for both IBM and GLD is: what gives the shares value? What does their owner own? A piece of property. This is not a liability, except in the sense that it is the property's liability to be owned by its owner.

Perhaps this is the sense you mean? In your abstract world, does each Krugerrand have a balance sheet? Nonetheless, it is a physical object and cannot be created by Excel.

[Fisher's] account of debt deflation is excellent, and I think you would agree with much of it.

I think I've seen an excerpt, and from what I recall I think you're right. Although I'm not sure Fisher's analysis was all that original. Mises had certainly provided quite a compelling explanation of the structure of a credit contraction, back in 1912, and I don't think he was the first either.

I am not quite sure as to what the post-1929 Fisher's views were. The Fisher I know is the "commodity dollar" man, ie, the champion of price indexes. I don't know that he repented of this. But who has?

Perhaps it's worth pondering the reason we have balance sheets at all. What is a balance sheet, anyway? Why do we have balance sheets, rather than nothing?

Imagine you are building a virtual world, like a MUD or MMORPG. The first feature you need is an inventory - a list of the goods carried by a player. These are assets. There are no liabilities. Before debt, there is property. An inventory is not a balance sheet.

A balance sheet is needed when players start making promises to each other. What is a promise worth? It depends what a player has to fulfill it with. Therefore, any purchaser of a promise will demand to see the balance sheet of the promiser, which describes (a) what assets he has, and (b) what promises he has made. The essential question is: can he be expected to fulfill all his promises?

On the left, the balance sheet contains a copy of the player's inventory. On the right, the balance sheet lists all promises to deliver that the player has made. The left side is not to be confused with the inventory or with the assets itself; the right side is a list of the promises, not the promises themselves.

(Note how this can be extended from the usual, simplistic scalar definition of balance-sheet solvency (total realizable price of assets, sum of promises) to prohibit maturity transformation. We construct a time schedule of incoming and outgoing cash flows, requiring that outgoing cash come from incoming cash which is scheduled to come in before it goes out.)

But a balance sheet is just a tool. It is not reality itself. In reality itself, people own assets and they make promises. They cannot make promises without owning assets, but they can own assets without making promises.

MENCIUS: I don't want to mess with the great Khan! And yes, there have been various forms of currency throughout the ages. That said, if the great Khan established a longer period of Sovereignty, he would establish a fiat monetary system. And when he did, he would have had to run a deficit to give the private sector their seed money.

I'll rephrase my question as "in a fiat money system, the Sovereign needs to run a deficit in order for the private sector to have some currency at all".

I think the question of non-fiat money is very interesting, actually, as all third world countries live on a mix of local currency, gold, foreign currencies, etc. Very few countries have the luxury of the Sovereign being a pure currency issuer, and subjects being pure currency users. There is room for a global switch to gold yet.

--- Interbank lending

Excellent question. The Fed wants an interbank lending market because that is the mechanism by which they set the Federal funds rate. They issue Treasuries to drain excess reserves for the Fed, and thereby create this interbank lending market. It's this bizarre gold standard remnant, and they should do away with it.

The constraint in bank lending is capital requirements (how big can their balance sheets get on the equity sliver they have?). The purpose of SIVs was to circumvent there requirements. The purpose of CDS, CDOs, etc. etc. was to circumvent them further. The purpose of the Fed's recent alphabet soup is to maintain those circumventions.

We live in a world where the currency is fiat, but those in charge of it think we are on some flavor of the gold standard. That's what gives us ideas like "reserve requirements", "US needs to fund its deficit", "the Govt should balance its budget" etc. etc. etc. It's why they think you need to save banks to save the economy. If you're going to insist on driving a tractor, sit in a tractor. If you're going to sail a boat, sit in a boat. But sitting in a tractor and trying to find the center board is just a recipe for disaster. Sadly, that is the situation we are in.

Mencius:

Sorry. The latter-day remnants of the Austrian school are a cargo cult, with the likes of Murray Rothbard witch-doctor-in-chief. This is distinct from the classic thinkers of the school, especially Boehm-Bawerk and von Hayek, who did make genuine, if failed, attempts at economic understanding. The school effectively ended as a going concern when Sraffa and Kaldor, (who, aside from being an Hungarian, came from LSE, von Hayek's stomping ground, and was originally a disciple), decisively refuted its account of business cycles.

It's not me who's lacking in any serious conceptual understanding of economic thinking. Your obsession with "currency dilution" is trivial, though all-determining, preventing any actual causal analysis. I eye-balled a chart once, obviously a reconstruction, since NIPA didn't exist for most of the covered history, of per capita British output. If one drew a straight line through the variations of the 1800-1900 period, it looks like maybe a 1% per annum rise in productivity. Then starting around 1900, the slope of that line sharply increases to maybe 2.5% productivity growth per annum. That should offer a strong hint why the alleged golden age of "orthodox finance" saw and lost its hay-day, since, er, economies evolve historically and not utterly without "reason". Though you're actually just referring to an historically circumscribed period of the gold standard under the hegemony of the British Empire, the passing of which nostalgists the world over mourn with plagent tears, as the passing of the very ideal of civilization itself. Oh, and you seem unaware that during that glorious 19th century, financial/economic crises in the U.S. were common, recurrent, and the economy spent nearly half the time at stagnation "equilibrium", as opposed to 20% of the time since WW2, before now. So much for the utter failure of the "New Economics", which Hazlitt so sagely declared in the 1950's.

I'm not aware of having "redefined" production. The word seems plain enough. It's you who are constantly redefining terms, with an extreme nominalism worthy of Mauthner, (to make an obscure reference to an obscurantist). Nor do I recall using "real value" as a fundamental reference, though it is a question that all sorts of participants are constantly asking themselves and trying to ascertain. You obliterate the question, in accordance with your supreme sovereign whim, while constantly hankering after it through undiluted currency. But, in fact, all real productive investment contains a speculative element and "maturity transformation" is an aspect of all such investment, given the uncertainty that ineliminably belongs to future prospects, whether there is FRB or not. As for the "origins" of money, who cares? That's an archaic metaphysical way of framing the matter: what counts is its current function as, er, currency. One theory is that the traditional ratio between gold and silver was established by the cycles of the sun and the moon. What's fallacious is the notion that such currency would operate "freely" in the absence of its issuance by a sovereign. But the question I posed in response concerned the source of profits, since, in my account, it's the recycling of corporate profits that effects the level both of loanable funds and aggregate demand, a connection that you would appear utterly clueless about. And that issue would occur, FRB or not. In fact, you have no actual analysis of the current situation, in terms of the connections between huge trade/CA deficits, housing bubbles, upward mal-distribution of wealth/income, excessive credit expansion, and low levels of real cap-ex. (But, of course, to know of any such matters, you'd have to consult NIPA figures, mere data, which according to you is at the root of all "fraud"). No, it's a much better, sounder intellectual procedure to pursue your archaic obsessions, with a solipsistic arrogance that simply obliterates, with a variety of sophistical techniques, all other points-of-view.

And you seems blissfully ignorant of the fact that conventional commercial banking has been in decline for decades, since the 1970's, and the current credit-bubble debacle, (which, yes, I've been watching for years), is largely "rooted" in credit expansion through the "shadow banking system", relying on "capital markets". I'd be the last one to defend the Fed or the cult of central bankers and conventional monetary policy, but it's not government intervention and regulation that's at fault, but the very lack of it, since the rise of the right-wing corporate hegemony under the banner of "neo-liberalism" 3 decades ago, in which the promotion of "market" economics under the slogans of "liberty", opportunity, and competitive vigor served as a smoke screen for oligopolistic rent-seeking, and especially Wall St./MNC sponsored globalization under the banner of "free trade", which served to weaken governmental policy-making and regulatory capacity. But no, it's all due to that evil gummint that seeks to oppress us free spirits, and the local yokels, who should bow to our superior insight. The whole world would be fine and just hunky-dory, if Mencius were king, and could sweep away all extant arrangements and impose his dictat, restoring the "true" currency, which is also lacking in anything so gratuitous as "real value". But not even King Alfred could so command the tides.

Wrestling with a pig, indeed. Coming from you, that's probably a compliment. More like trying to argue with a snake, one not nearly half as intelligent, knowledgeable or cogent as his pedantic reptilian brain tells him.

Mencius: Banks absolutely do lend by borrowing money from themselves. In your zero overdraft world (scenario one) you need to have a deposit in order to offer it out as a loan. For the period of that loan, you, the lender, do not have that money since it is loaned out. A "loan" is a transfer of money, with the promise to return it in the future. Straightforward!

In scenario 2, which is closer to the real world, banks have the ability to borrow from themselves and, as institutions, go into overdraft. How deeply they can go into overdraft is governed by capital requirements, which have proven disastrously ineffectual in the recent past. Here, instead of a deposit enabling a loan, the loan itself creates the deposit. The bank makes the loan with money it does not have, and credits the borrowers account with it (creating the deposit as a liability on its own books). It balances this liability with an asset, a receivable. The borrower balances his new asset (cash deposit) with a payable liability. Since the bank balance sheet has gone up, it is now more levered as its equity sliver has not changed.

Two things to note: 1) the bank has diluted the currency. This is why you, targeting the Fed as the chief diluter, is wrong. In the real world, most dilution is this scenario 2 kind of loan. Banks carry overdrafts so non-bank, non-govt entities can be in surplus.

2) Banning maturity transformation helps, a maturity matched balance sheet is much more stable than one which is not, but it does not fundamentally alter the dilution. If the bank had a time series balance sheet, and had the liability time matched with the asset, it would still have borrowed from itself and diluted the currency.

WS:

Here, instead of a deposit enabling a loan, the loan itself creates the deposit. The bank makes the loan with money it does not have, and credits the borrowers account with it (creating the deposit as a liability on its own books). It balances this liability with an asset, a receivable.

I now understand the transaction you're talking about. But I still think you're wrong. The way in which you're wrong is quite interesting, however.

Again, we are looking at two transactions which are bundled into one. These are perfectly separable, and neither creates dollars ex nihilo. Nor does either require the bank to use dollars it doesn't have.

In the first subtransaction, bank B pays X dollars to citizen C, in exchange for C's promise of X+y dollars at time T. This is the loan. Note that it does not expand B's balance sheet. Nor does it create dollars.

In the second subtransaction, citizen C deposits X dollars in bank B. Ie, he loans X dollars to B with a continuously-rolling zero term. This produces exactly the cumulative effect on the bank's balance sheet that you describe. But it, too, does not involve the creation of dollars "ex nihilo."

Note that these subtransactions are perfectly separate. They are bundled only for the (dubious) convenience of B and C. Nothing prevents C from reversing the second transaction instantly, and storing his cash as cash, depositing it in bank K, etc, etc.

And of course many loans - mortgages, for example - do not show the second transaction at all. If I buy a house with a mortgage from bank B, the cash goes to the seller. I do not get an account, even a temporary account, at bank B which contains the money I have borrowed.

Note also that this double transaction is pointless - as you note - except for maturity transformation. MT is creating the illusion that banks can create money, by teleporting it from the future. If the illusion is backed by loan guarantees - formal or informal - the result is as you describe. If it is not so backed, we see what happened to the "shadow banking system."

But this is not a natural consequence of balance-sheet arithmetic. It is a Rube Goldberg machine which is fundamentally dependent on "the camouflaged hand." The hand was well enough camouflaged that the shadow bankers forgot that it existed, and thought that MT was a safe operation in a free-market financial system.

I agree that reserve requirements are an extremely gamable, and basically failed, way of controlling this mechanism. Note also that according to inflationist doxology, it is not supposed to need control. The money supply is supposed to expand automatically to meet the "needs of trade," as the inflationists of a century used to argue.

(The inflationists of today seldom argue - they can just assume. Or even just bloviate. Power hath its privileges.)

Wow, Mencius! You really out-do yourself. You prove yourself an even bigger jerk, in your self-conceited hysterical paranoia, and adventitious, ad hominem piss-poor style of argument, which only indicates the severe limitations of your intellect in grasping any conceptual point, let alone any concatenated set of such concepts, i.e. any genuine theory. What would you ever do, if you were deprived of your fetish-object, "hard money", and had to deal with the world on realistic terms, by acknowledging its fundamental non-existence/impossibility? Would your whole entirely virtual world collapse, and, with it, your grandiose self-conception?

By what arrogance or divine right do you assume that I'm unfamiliar with "Moore's law", or that I am unaware of the effects of innovations in new processes and products. That the neo-classical price-index concept is flawed because there is nothing to say that a set of nominal prices will be the "same" in composition and "value" 30 years hence, as 30 years ago is a point I've made numerous times. (Though I utterly fail to see why that would support your unhealthy obsession with "currency dilution", as if it were the root of all evil in this world, and as if the historical defects of intergenerational "justice" would be remedied by its reversal, and as if it would assure you of gaining your rightful place on the throne, or at least close enough as your worship of hierarchy would allow). But you're really proposing to proceed utterly without data and uterly without quantification? A brilliant approach! Why didn't anyone think of that before? Let alone without any mode of explanation of how we get from here to there, since obviously history is a narrative of sheer decline from the golden age, literally, and any illusion of "progress" involve theft from the present by the ever so decadent future!

Now while I do tend to take statistical data with a grain of salt, as a rough approximation, let me offer an ad hoc interpretation of that chart I eye-balled. The changed rate of productivity had to do with a) the shift from a still primarily agrarian economy,- (in the case of the U.K. perhaps through imports),- to a more fully industrial one, and b) the "second industrial revolution" involving oil, electricity, chemicals, etc. Apparently you've never heard of or considered the problems of joint production, jointed techniques of production, differing capital ratios between sectors, or differing rates of change in productivity between sectors, nor, mirabile dictu, that technical conversions of capital stocks must occur at economic rates, which will be determined by a) their profitability to capitalists, and b) the sequential states and developmental dynamics of the overall economy.

But probably your deeper defect is that you simply lack the capacity to grasp the principle of real effective aggregate demand, which you think, in your superstitious mind, must be a witch's brew, concocted by that devil-worshipper Keynes, since you remain wedded to the notion that markets must be perfectly self-regulating due to nominal price-adjustments of supply-and-demand. But actually, there's a fair argument that Michael Kalecki scooped Keynes, except that he wrote in Polish and a bit in French, so no one noticed, and I'm offering a more Kaleckian version. To be brief, there are lots of reasons why ready price adjustments don't occur, not least is the monetary illusions that wage adjustments would be under, which Keynes' emphasized, since efforts to lower wages to keep up with falling prices would further lower the price level, while still further reducing demand levels, etc. But still more fundamentally is the factor I focused on, which is that long-lived investments in capital stock would be gratuitously destroyed by such price declines and lack of aggregate demand. Though the Austrian school, with their Viennese indulgence in more-than-Spenglerian pessimism, since Vienna was the "laboratory of world destruction", as Karl Kraus put it, were more than pleased to recommend such catastrophic liquidationism. And this based on their time-preference theory of interest, since economic "value", or prices, if you repudiate the term, though "time-preference" was actually supposed to be an account and measurement of such, would supposedly be determined sheerly through subjective perceptions and their aggregation, without any objective factors or constraints. You sneered at "deconstruction", though I'd guess your too dim-witted to have any understanding of what the term might mean, but "dismantling conceptual criticism" might be a fair paraphrase, and, if you had bothered to actually read what I posted, in however an infelicitous style, I offered precisely such a criticism of the Austrian "time theory of production".

You prattle on about "maturity transformation", as if you'd discovered the Holy Grail, but the world is condemned through failure to heed your brilliant discovery. But, aside from the fact that you fail to adequately distinguish between the issues of illiquidity and insolvency, though, to be sure, the hinkiness of financial accounting can readily obfuscate that issue, it's true that investments can always fail and result in net losses, and the further out into the future you project, the more likely outcomes will deviate from current expectations. However, any long-lived real productive capital investment is financed out of current production,- you can call that "savings" if you like, though it's likely basically the "savings" from the profits of current owners of capital stocks, or you could call it "production switching". But it means that "maturity transformation" is always an issue, regardless of the exact arrangements involved in a financial system, which, whatever its pretentions, is always just a superstructure inter-mediating real production and the revenue/income flows therefrom, whatever tendency it might have to out-run those flows. The core issue is the recycling of profits from real productive investment, which will effect both the supply of loanable funds and the level of real effective demand, and, if an adequate set of opportunities for further productive investments and/or an adequate redistribution of incomes to reflect productivity gains does not occur, then profits will tend to bleed into the inflation of financial "asset" prices, until a bust results. But none of that has to do with the "evils" of currency dilution, as if wealth were really a store of "hard money" to be distributed through noblesse oblige, (a notion that befits the illusions of a landed aristocracy), rather than deriving from claims on the ownership/output of real illiquid capital stocks. And you utterly failed to answer my question: why on earth would capitalists invest in increases in productivity and output, if it would only serve to dissipate their profits into deflated output prices in a "hard money" regime? (And as a further aside, rapid increases in productivity and quality in the IT sector,- and much recorded productivity growth during the tech bubble was self-referentially confined to the tech sector,- do not result in general productivity growth unless they bleed out into applications in other sectors, whereas, in a stagnant economy, they might just result in "Baumol's cost desease", whereby the gains accrue to other sectors through increases in their relative prices, a version of the worry that Ricardo classically expressed in his theory of rents).

So nothing really has to do with any "hard money" standard. In fact, you're seriously confused about the difference between base money and credit, and you think the two should somehow be the same, else there must be fraud involved and aborginal wealth is being confiscated. In fact, AFAICT, Winterspeak has been correct and clear in his colloquy, and I don't see why he's interested in attending to your picayune insistencies, as you just seem to be making concretistic errors. (If C takes out a mortgage to buy a house, then seller S, unless buying another house, deposits his money in a bank, which creates further reserves for lending: that's the "fractional" part of FRB). Now it's not as if FRB is unproblematic. For one thing, it involves tight inter-linkages between banks, which can spread financial contagion. But the same sorts of inter-linkages occur between businesses in the real economy, except that they tend to be intermediated by banks, hence the problems in the real economy tend to first show up there. And for another, there is embedded leverage involved in the FRB system, except that such leverage would be involved in any system of credit, insofar as it involved credit and not just the transfer of hoards of "hard money", converting increased investment into decreased consumption. Which is why the dangers of FRB require backstopping and tight regulation by governments. Austrian "banking" proposals would involve both such a low level of loans as the production cycle would be slow to develop and perhaps never get started, (which is what is meant by the endogeneity of credit), and be so capital inefficient as to be entirely unprofitable. If you're recommending a public system of credit, I'd be willing to consider it. But if you want a market-based profit driven system of credit, then such proposals wouldn't do. But they also would not bring about the illusion of static equilibrium accounts, whereby all market prices would adjust instantaneously and fluidly to clear all markets in a perfectly self-regulating process. Indeed, a perfectly unregulated, "free market" banking system would inevitably end up extending credit anyway, but would do so in ways that a) resulted in frequent bank bust and bank runs and b) would result in "market discipline" restricting credit to minimal levels, stifling the real economy, which is to say, not an optimal "free market", but a permanent stagnation "equilibrium", which seems pleasing to the Austrian mind-set, since the rich would remain rich and the poor would remain poor, except that they fail to grasp that, though the poor would suffer most in such a condition, the relative wealth of the rich would actually be lowered more. But Austrians, of whatever degree of "sophistication", are always a broken record, repeating monomaniacally that its all do to an evil conspiracy of the government interfering in the perfect workings of the market, which bears a metaphysical identity with "freedom" itself, via the Fed and the debasement of the currency due to its back-stopping FRB. Blah, blah, blah. Analysis never proceeds any further or more deeply, because it's the perfect righteousness of an invariant ideological answer for "everything" that's at stake, not any genuine effort at understanding. Your adventitious, impressionistic, and evidence-free style of argument strikes me as an indication that you simply lack the capacity for clear consecutive conceptual thinking by which to connect any dots.

As for the Lower East Side back then being free of street gangs and full of wholesome happy families, based on undoubted contemporary testimony, and all subsequent social decay being due to people having stopped snorting gold dust and thus started snorting crack, is something only one addicted to Austrian fairy dust could "believe". And Graziani is a contemporary economist, not a crank. His first name is Augusto, if you want to google him, just so you don't mix him up with some soccer player. And Post-Keynesian accounts of endogenous credit are not the same as nineteenth century accounts of endogenous money, though their certainly different from Monetarist or New Keynesian doctrines, which rely on macro-economic models that strangely lack any specification of money and credit. But it's not a matter for "monetary cranks". In fact, you're the one who's a monetary crank, though the mystifications surrounding money as a symbolic "universal equivalent" have thrown up a wide variety of such cranks. The way that you just randomly through up names of such,- (really, Ezra Pound!), is just a further indication of the quality of your style of and capacity for argument.

I also don't mind that I'm thoroughly unoriginal. If I weren't, then that would indicate that I hadn't learned anything, since, while truth is not identical to consensus, truths of any sufficient generality will tend toward consensus, at least locally and historically. But then you're utterly unoriginal yourself, endlessly mouthing stale discredited dogma. And the idea that money is a "stationary bubble" has long been standard in academic economics, though it comes literally from the physical of fluid thermodynamics, with a well-defined mathematics. It's more turbulent fluid dynamics that raises the mathematical difficulties. I also don't mind being compared to a pig. They are quite intelligent animals actually, and not at all uncleanly, except that their human owners keep them so. And I certainly don't mind rooting about in the mud for some earthly understanding. Pigs also have an excellent sense of smell, by which they can discriminate between a fine truffle and a steaming pile of sh*t.

i'm delighted, and very flattered, to host very smart, eloquent, and high-spirited commenters.

and in the end you can speak as you please, i don't "moderate" anything.

but i do have preferences, and i would prefer that some of the high-spiritedness be expressed a bit more civilly. if one must be insulting, tone can be more effective than direct name-calling, and I find it more satisfying from an aesthetic standpoint.

JKH: I'm sorry, I did not understand your post.

Were you agreeing with Mencius, or not?

I take my statement to be both an accounting identity and also true. If we had a sovereign monopolist gold miner, the sovereign would have to take some gold out of his mine, and exchange it with non-sovereign sector for something. Let's call this G. There sovereign also has the option to demand some of his gold back, let's call that T. For the non-sovereign sector to have any gold to trade back and forth, the sovereign would have to spend more gold than he took back, let's call that G-T>0, and yes, it is a deficit.

But in no way is the sovereign "borrowing" money from the non-sovereign sector -- quite the opposite, he is funding it. In a fiat system, it simply makes no sense to say that the monopoly currency issuer is "borrowing" from currency users.

"The liability of X is an asset of (not X)."

Did I ever say (or imply) anything different?

I understood Mencius as claiming that there are assets out there that are liabilities to no one. This is certainly the standard concept of money in a gold standard world.

So you and I are square (at least on this point)?

WS:

Yes, we are looking at the same transaction. I feel we are quite close.

My main point about this transaction is that it's actually a sequence of two simpler subtransactions, neither of which violates the conservation of money. If money is not created or destroyed in either subtransaction, it cannot be created or destroyed in the sequence.

And note the extremely suspicious nature of the sequence. A loans money to B - and B loans it right back to A! Does this smell like good accounting to you? Is there actually a legitimate economic purpose here?

MT is indeed crucial to the existence of the structure. Think about it: if the term of A's loan to B is the same as the term of B's loan to A, the two cancel perfectly and there is no point at all in the transaction.

But if A can back present-money obligations with future money, it can effectively engage in Mosler-style monetary creation. As long as it has the FDIC to supply the informal guarantees that make B willing to loan the money back to A, making A's deposit obligation to B (which is not money, but a private promise of money) pegged to the dollar.

Through "borrowing from themselves" with this transaction, banks can increase their capitalization, without actually having to raise capital from actual lenders. Thanks to the FDIC's free option, they are in a sense borrowing from the Fed - but the transaction is invisible and informal. This, again, is the precise opposite of good accounting.

Let's supposed that there is a fixed supply of money-stock, whether gold or any other medium, corresponding somehow to a fixed or constant supply of resources produced and exchanged, such that any exchange of transfer of a fixed amount of resources would exactly correspond to the exchange of a fixed amount of money. This would be a world in which Say's Law would be immutably true, in which a system of monetary circulation and exchange would be a transparent reflection of an industrial barter system. Savings would be defined as deferred consumption, whether such savings were hoarded through being withdrawn from circulation, or lent, and lending would involve ego forswearing current consumption for claims on future consumption, in exchange for alter currently spending the money, whether on current consumption or investment in production, in exchange for alter supplying ego's claim on future consumption. Now let's suppose that productive investment is made by alter, to build productive capacity for future output and consumption, that would increase technical rates of productivity and thus increase output and lower prices, i.e. would produce more unit output per the same unit input of resources. However, given fixed resources and fixed corresponding money-stock, this would involve production-switching, as productive goods were withdrawn from meeting current consumption demand to build future production capacity. Hence, there would be a lower supply of production to meet current consumption demand, but, note, the work force building the future production capacity would still be paid out of current output. Hence a gap between current production supply and current consumption demand opens up, which can be meet either through inflating prices or deflating wages, but, either way, involves lowered current aggregate demand.

Hence there's a dilemma here, maybe even something approaching a paradox: the re-entry in the future of increased productive capacity would occur in a lowered aggregate demand condition, which it's own production would have occasioned. It's true,- even ignoring that the new capital stocks competitively would drive out older stocks and the costs incurred thereby of recycling the remaining value of bankrupt businesses and re-employing unemployed laborers-, that lowered output costs would nonetheless imply higher real wages and thus some increase in overall consumption demand and productive output. But the gains to output would be limited by the constraint of such lowered demand and thus the incentive to productivity-improving investment would be diminished. The "solution" that bridges this dilemma is credit, which is not primarily a matter of "teleporting" future money into the present, thereby creating "artificial" demand, but rather of "teleporting" current productive capacity into increased productive output in the future. It's true that not all extensions of credit will work out and be repaid, not least because older capital stocks will be competitively driven out and result in bankruptcies, and also because the sharing of risks and uncertainties, as well as gains, through credit arrangements will not map, perfectly somehow, onto future prospects and outcomes. That's what interest rates and term curves are all about, and it's a matter not of avoiding any losses, but whether the gains out-weigh the losses.

It's also true that the extension of credit can outrun the availability of real productive possibilities, and, given the unavoidability of production/business cycles, rooted in the limits of available, unexploited technical possibilities and the need to convert capital stocks at economic rates that allow for their realization before depreciation, credit crises will periodically occur. But that's why any system of credit,- (and any system of lending that gets beyond the concretistic account and its dilemma, with which I began, will be a credit system with embedded leverage, in which risks and rewards are shared between the operating leverage of productive enterprises and the financial leverage employed by aggregators of savings/underwriters of credit),- needs to be tightly regulated and supervised, to prevent their real dangers from getting out of hand. A completely "free market" system of credit would tend all the more to run out-of-hand, and be all the more disaster prone, or else, would be so limited and constrained as to utterly fail to get production cycles started. (It's also ironic, given the Austrian's emphasis on the embeddedness and dispersion of information, at the root of markets, that they fail to notice that their banking proposals would drastically increase the cost and lower the efficiency of information-gathering, so that such banking would both be too unprofitable to survive in a "free" market, and too unreliable for ordinary savers and tradesmen). Again, our current debacle is not due per se to government "intervention" and regulation in the banking/finance system, but rather to the failure of such under the auspices of "free market" ideology. (And, though an analytic distinction can be made between policy and market failures, there is not always a clear line to be drawn between the two, especially if there is a failure to recognize that market failures are potentially and pervasively endemic, not just the result of intervening policy failures, and policy failures are frequently the result of their entanglement with market failures, through regulatory capture and rent-seeking by "private" interests).

It's also not true that credit extension amounts to an increase in the money supply, or, at least, that's an inverted understanding. It is true that credit-implements can be more-or-less readily exchanged for currency, (as with, e.g., secondary markets for bonds), but credit actually always out-runs and exceeds the circulating money supply. Indeed, it would be hard to see how there could be readily available opportunities for ordinary savings, if it didn't, as then savings would have to seek out specific opportunities for investment,- (and as for the costs involved in that, just think of the whole largely useless “financial adviser” industry today)-, or would amount to a hoarding of $, withdrawing currency from circulation and decreasing its needed supply. What's important here is that savings be recirculated into productive investment without impairing adequate demand. But, just as well, credit supply can not be controlled by controlling currency supply, since currency supply tends to follow after credit supply, (as the failure of Monetarist policies testify). Which, again, is why credit “creation” and finance need to be subject to tight regulation, to prevent the build-up of excess leverage that out-runs actual and potential real output, the revenues and incomes produced by sustainable realizations in the real economy, through corporate profits and wage incomes, which excess credit results in financial “asset” inflation and compounded interest, beyond any reasonable future prospect that such financial claims could be fulfilled, which inevitably results in bust and general default. (Though one should not ignore the income distribution variable, which if skewed upward, results in an excess of “savings” over real investment at the top, lagging effective demand in the middle and increasing debt at the bottom, which also results in financial “asset” inflation and bust). However, even with a well-regulated financial system, periodic downturns will occur, adjusting to failed realizations and mistaken expectations, and the public debt will increase, both automatically and at discretion, to compensate for the liquidation of “private” debt, providing the “liquidity” that is missing to over-extended private credit. (The point I tried to make earlier is that the tendency in developed industrial economies to incur increasing public debt is due to the the need to compensate for production/business cycles being accumulated across series of such cycles, since government will always need to correct for market failures, without there being a need for government budgets to be balanced across a given cycle, rather than debt maintained below the level of real growth. There are other factors involved, such as demographics, though government-mediated transfers at low transaction costs are not necessarily public debt, unless growth fails to be sustained at rates projected in budgets).

But none of the above would be apparent from a neo-classical marginalist perspective, which reduces production dynamics to market-exchanges. If there is a highly inefficient distribution of resources, then a set of “Pareto-improving” exchanges could readily occur that would move toward a “Pareto-optimal” distribution, increasing overall economic efficiency. But once such a set of markets is in place, such improvements become increasingly “scarce” and markets would tend toward constant re-production/stasis. (Which is what Robert Solow “discovered” by running then reigning GE models and finding they could scarcely account for recorded economic growth). And analysis of the sources of productive surpluses and their distribution, as in classical and Post-Keynesian economics, is far more to the point, not least because by not reducing economic “value” to an account of nominal price-formation, it does not conflate money and financial markets with goods markets, and thereby fail to recognize the endemic tendency for the two levels to diverge. But I also think it doesn't “pay” to focus sheerly on the monetary and financial level of Post-Keynesian accounts and fail to understand the linkages to Post-Keynesian accounts of production in the real economy. It's correct, as far as it goes, to say that sovereign governments at once provide the currency that pays the taxes it collects and provides a compensating stock of public debt to facilitate private savings. (In fact, Australia provides an interesting empirical case in point, as it,- though this is about to change obviously, by one account has no public debt, the 20% of GDP debt after the last recessionary crisis having been entirely paid down by Howard and Costello, that notable comedy team, but, by another account, it provides a stock of debt at 15% of GDP precisely to provide “risk-free” implements to the private sector. On the other hand, Australia's external debt is +100% of GDP). The government system is entangled with the economic system, to be sure, if only through the entwined issues of the fiscal budget and taxation. But it's bootless to deny that the government depends on resources produced elsewhere in the real productive economy and draws those resources off of it, whereby, if it “produces” the means of circulation, money, and commands resources thereby, through taxation, there is a significant difference between those two “moments”. That would be especially obvious in the case where the government consists largely just of the sovereign and his hangers-on, with taxes derived from expropriated agricultural surpluses, and “public” debt accrued for purposes of sovereign warfare, and raised from merchant-bankers, who derived their fortunes from trade-credit, as in the good old days at Versailles, which case is the actual origins of the modern state, from early modern absolutism, (“lo stato” originally referring to the prince's estate, which property he nonetheless had ostensible feudal obligations to protect and provide for).At least, in such cases, the pretension that the sovereign provides public debt in the public interest are, er, severely limited. Hence the government and its finances are at least as dependent on the “commonwealth” and the circulation and output that occurs therein, as the latter is dependent on the sovereign provision currency and fiscal/financial regulation.

When NIPA accounts were devised, the accountants decided that there was no way to account for government expenditures in terms of output, as to whether any of it counted as investment or production, (though obviously some of it does, whether directly by government agencies or through government contractors), and whether government workers achieved any specifiable level of productivity, so government expenditure G was counted as sheer consumption and revenue T as undifferentiated taxation, (i.e. regardless of its sources or incidences or whether they involved any implicit subsidies, etc.) And, indeed, since governments don't run a “profit” and their budgeting processes don't distinguish between specific expenditures and outputs, such a convention seems well-nigh inevitable. But it is just a convention and all modern governments, regardless of how “democratic” they are, are deeply involved in variously regulating, supporting, subsidizing, and otherwise sustaining the real productive economy, for reasons of their own fiscal and financial sustenance, which have some unspecified limit, beyond which they can not compensate for the failings of the real economy, (which limits, of course, will vary, depending on the position of the country and its currency in the international pecking-order). Hence an account of macro-economic aggregates and gross fiscal dynamics will not suffice. A decomposition of government budgets and the policies and activities they sustain is as essential as an analysis dependencies of the “private” economy on government supports and expenditures, whether as sustaining a general “public interest” or as private capturing of rents, just as the “private” economy is susceptible to inter-sectoral analysis of the composition of outputs and activities. In short, a simple “macro” level of analysis, assuming a clear-cut distinction between public and private won't do, not because “micro foundations” are missing from the macro-economic analysis, but because a more “meso” level of institutional analysis is required to understand the actual workings and dynamics of modern “market” economies. That might then permit a more general discussion of what ends are in the "public interest", and what should be allowed to it.

JKH: Something just struck me. Could bank created M1 be used for anything other than consumption and investment?

Winterspeak,

Completely off-topic, but here is what looks to be an interesting paper on the credit crisis by John Taylor.

http://www.stanford.edu/
~johntayl/FCPR.pdf

I haven't actually read it in full yet, but it caught my eye because I have an extraordinarily deep and visceral hatred for the "global savings glut" theory, which he destroys in several sentences.

I think I know, and suspect I would agree, but what would the "paradigm" have to say about the GSG theory?

Winterspeak,

“Re: M1 -- I was wondering if it could be *created* for the purposes of saving (not spending).”

I can give you an example of where this happens, sort of.

The Chinese Central Bank buys dollars from exporters and “prints” RMB M1 in doing so.

To the degree that dollars earned by exporters associated with China's current account surplus, and to the degree that the CA surplus is a component of Chinese savings, M1 has been created for the purpose of saving.

This association isn't perfect. The fact is that saving as defined according to national accounts is a flow and M1 is a stock. The M1 in this example is simply an intermediation channel for saving. Also, the mapping is not precise from export dollars to PBOC dollar purchases to PBOC RMB monetization to current account surplus to domestic saving.

Mencius: I see what you mean (I think) but I still don't think we're there.

"The bank dips into its vault and lends the borrower money - actual cash - with a term of 30 years. The borrower puts this bundle of Benjamins in a suitcase, walks across the bank lobby from the loan office to the teller window, and deposits it with a rolling term of 0."

Nope. A bank can start with zero money in the vault and still do the transaction. The borrower can begin with zero money, and still do the transaction. Balance sheets really do get larger. And it can all happen with maturities being matched.

As before, you have a seller, buyer, and bank (for a house). The seller transforms his house into a 30 year CD deposit -- balance sheet stays the same. The buyer gets a loan (30 year, installment) as a liability, and the payable as a liability. The bank gets the deposit as a liability (30 year, matched) and the $100 receivable as the asset. Both the buyer and the bank have larger balance sheets. The deposit is matched to the loan. The payable and the liabilities are matched too.

Mencius: Good god--let me try again without the typos!

"As before, you have a seller, buyer, and bank (say for a house). The seller transforms his house (asset) into a 30 year CD deposit (asset) -- his balance sheet stays the same. The buyer gets a payable (loan, 30 year, installment) as a liability, and the house as an asset. The bank gets the seller's deposit as a liability (30 year, matched) and the buyer's loan as a receivable (asset). Both the buyer and the bank have larger balance sheets. The deposit is maturity matched to the loan. The payable and the receivable are matched too. Have I missed something?

One could visualize a system where banks keep exactly the same type of currency “on deposit” at the Fed that they do in their own vaults. Each day's clearing would consist of deliveries of currency in the amounts of the bulk bilateral settlements between banks for their share of the net clearing. The result would be the same as if there were a 100 per cent (currency) reserve system, except in those cases where short banks needed to borrow currency from the Fed. Given that the Fed “prints” reserves in the same way it “prints” currency, there really is no effective distinction between this pretend system and the system as it is, at least in terms of the net result of the clearing of reserves between banks.

JKH: I missed that Krugman article. And yes, disappointing. But Krugman's disappointed for a while now.

I did not pick up that Brad was a global savings glut adherent too (in general, I like his site a great deal). It boggles my mind that, in the face of massive global deleveraging, where even at ZIRP incomes cannot service debt loads, anyone could claim that the private sector *leveraged too little* 2000-2007 with a straight face.

As for your proposed system, another benefit is that it removes interbank lending risk. As you know, I support such a system. Big change from today though, no?

Re above, from Bernanke's speech this morning:

"The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy. Its fundamental causes remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.

The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances. However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States. The details of the story are complex, but, broadly speaking, the risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets. In certain respects, our experience parallels that of some emerging-market countries in the 1990s, whose financial sectors and regulatory regimes likewise proved inadequate for efficiently investing large inflows of saving from abroad. When those failures became evident, investors lost confidence and crises ensued. A clear and highly consequential difference, however, is that the crises of the 1990s were regional, whereas the current crisis has become global."

This is actually a tweaking of Bernanke's original explanation of the glut, where he contended that the glut was truly "global" in the sense of excess global saving driving down real rates of interest. He backs off that somewhat here, noting "joint responsibility" instead of implying a "global" problem that was implicitly everybody else's making. This is a much improved explanation from his original. Still, a Mosler consistent paradigm would view the US current account deficit as financing capital inflows, which I have believe for a long time. It's the US originated financial engineering that generated the financing of the housing bubble that generated mortgage equity withdrawal that generated the CA deficit that generated the US capital inflow, in my view. This is also consistent with Taylor's fed funds explanation. Of course, the fact that China didn't want to buy any stuff from the US didn't help.

http://www.federalreserve.gov/newsevents/
speech/bernanke20090310a.htm

john C. halasz,

Bruce Wilder wrote:

“As far as I know, Lehman's failure had some, but limited effects on other institutions holding Lehman paper. I think one money market fund busted a buck. But, even that was more a demonstration of what could happen more broadly -- it was not, in itself, a broad, substantive effect on many money market funds.”

This was not the case. Bernanke in this morning's speech:

“Another issue that warrants attention is the potential fragility of the money market mutual fund sector. Last fall, as a result of losses on Lehman Brothers commercial paper, a prominent money market mutual fund "broke the buck"--that is, was unable to maintain a net asset value of $1 per share. Over subsequent days, fearful investors withdrew more than $250 billion from prime money market mutual funds. The magnitude of these withdrawals decreased only after the Treasury announced a guarantee program for money market mutual fund investors and the Federal Reserve established a new lending program to support liquidity in the asset-backed commercial paper market.”

Systemic money market fund outflows following the Lehman event caused the Fed to fear the entire system was at the brink. This was the pivotal event. Bernanke referred to it again in Q&A; Buffet also noted it in this weekend's interview.

JKH: Hah! I think you are right. How else to explain the fact that we're still arguing over this two years into the greatest financial crises since the Great Depression?

I think you are quite right that we'll see MTM being suspended. But will financials rise or fall on that change? Eventually all the transfer has to matter, yes?

Finally, could you drop me a note at winterspeak AT winterspeak DOT com? Just wanted to thank you for the good discussions.

Winterspeak,

I don't know precisely what the MTM adjustment will be if they do it.

But the effect will be positive.

Bank stocks will rally big time.

The reason is that it effectively extends the time horizon for capital adjustment. This allows for the Hemptonesque solvency model that includes internal capital generation.

It's a smart thing to do.

MTM is not a necessary condition for transparency.

BTW, did you see my Worthwhile Canadian Initiative guest post on MTM?

http://worthwhile.typepad.com/
worthwhile_canadian_initi/2009/02/
guest-post-mark-to-market.html#more

(I really didn't want to do it. They asked me. It's a headache of a subject.)

Winterspeak,

The mark-to-market issue has been gathering quite a head of steam in just the last few days, with a congressional hearing on it today.

Holman Jenkins, Wall Street Journal, yesterday:

http://online.wsj.com/article/
SB123672700679188601.html

“Now comes Warren Buffett, a big investor in Wells Fargo, M&T Bank and several other banks, who, during his marathon appearance on CNBC Monday, clearly called for suspension of mark-to-market accounting for regulatory capital purposes ... Mark-to-market accounting is fine for disclosure purposes, because investors are not required to take actions based on it. It's not so fine for regulatory purposes. It doesn't just inform but can dictate actions that make no sense in the circumstances. Banks can be forced to raise capital when capital is unavailable or unduly expensive; regulators can be forced to treat banks as insolvent though their assets continue to perform. CNBC, sadly, has been playing a loop of Mr. Buffett's remarks that does a consummate job of leaving out his most important point. Nobody cares about the merits of mark-to-market in the abstract, but how it impacts our current banking crisis. And his exact words were that it is "gasoline on the fire in terms of financial institutions." Depressing bank stocks today, he said, is precisely the question of whether banks will be "forced to sell stock at ridiculously low prices" to meet the capital adequacy rules. "If they don't have to sell stock at distressed prices, I think a number of them will do very, very well." He also proposed a fix, which CNBC duly omitted from its loop, namely to "not have the regulators say, 'We're going to force you to put a lot more capital in based on these mark-to-market figures.””

So what Jenkins/Buffett are saying here effectively is that MTM should be disclosed, but not necessarily systemically forced through profit and capital accounts, the same as I've said elsewhere.

Bernanke and Buffett have both said over the past week that MTM should not be suspended. But they've also said that meaningful adjustments should be considered in translating MTM information to regulatory capital requirements.

I'll predict that there will be some sort of adjustment coming out in the coming weeks, and that it will have a positive effect on the banking crisis, the interpretation of the Geithner policy response (details still forthcoming), and bank stock valuations.

Winterspeak,

MTM implementation increases measured market risk, and therefore capital requirements, and so is one aspect of capital pro-cyclicality. Bank capital attribution models are based to a great degree on corresponding value-at-risk models; the “great moderation” reduced real and financial volatility and so reduced Var and capital attribution calculations. Nassim Taleb was all over this.

Capital is crucial to regulation. One of the ironies of the common “reserve multiplier” mistake is that it distracts from the true dynamic of bank balance sheet credit and deposit expansion, which is capital based. The purpose of capital is to absorb losses and insure against risk. A bank's allocation of capital involves choices for balance sheet expansion based on risk. The “reserve multiplier” has nothing to do with risk.

It's interesting that the Mosler paradigm is not a model of risk per se. That's unusual for a financial or economic model of any type these days.

Not sure about Summers - unconventional usually means quantitative (monetary base) and or/qualitative (asset credit risk) easing. The Fed has done both already except they haven't yet starting buying treasuries under quantitative easing. The purpose of buying treasuries in this environment as I understand it would be to help get mortgage rates down.

oops!

Thought you meant Larry Summers. But now I recall reading the Scott Sumner blog also. Didn't really connect with it in any event.

JKH: I read the Hempton thread, and am not sure I understand it either. I think by "non recourse" he simply means that the private capital is in a first loss position, but the bulk of the losses may be borne by taxpayers (in this instance). So, with a regular bank, equity holders (private capital) gets wiped our first, but the tax payer picks up the rest (via FDIC). I have no idea where private debt holders stand as they seem to enjoy a truly exalted place in the cosmos. Hempton is saying that, if we are OK with having taxpayer money at stake, so long as private money is in a first loss position, then the only question is: do we have a large enough private stake in that first loss position?

Just my guess though. I don't like putting words in other people's mouths.

My personal view is that all of this talk about "taxpayer losses and gains" is meaningless. All money comes from the Government -- it has no need to "make" money on a deal as it can simply create its own, if it so chooses. The image is like "if the Government drives a bargain like Warren Buffet we'll get a tax break because the Govt will have made so much money". Nonsense -- Govt can make as much money as it wants, whenever it wants.

The real key is transfer here and now. The Govt could have guaranteed all liabilities in the case of Lehman (so counter-parties were made whole) and let debt and equity holders go to zero. They could so the same thing with Citi and BofA. Or they could just declare a 5% haircut -- not big enough to kill anything that wasn't already essentially dead, but enough to say that bondholders need to, ahem, think about what they invest in. When we think about what risks to take out of the system, and what to put in, counterparty risk seems unhelpful at this point. The cheap leverage the Fed is offering to private equity is a total transfer to a group of insanely rich people. I see no reason why this should be non- recourse (or why the PE firms should not be at risk for more than 100% of their "investment").

JKH, I'm on the road tomorrow and will be traveling for quite some time, so this will have to end the thread. Was serious about the offer though: winterspeak AT winterspeak DOT com. I'll buy you a beer if we turn out to be nearby.