March 21, 2010

Oh no … Bernanke is loose and those greenbacks are everywhere

Filed under: Uncategorized — ktetaichinh @ 6:57 pm
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My RSS feed and E-mails have brought some shockers in the last few days from the financial markets – official bulletins from banks that don’t make any sense at all (US about to default-type arguments); hysterical Austrian school logic (from a large player in the Asian markets) and news commentary from a so-called business insider magazine. The latter should immediately close its doors and declare they are not competent to comment on matters relating to banking. Coincidentally, I also received several E-mails in the last few days asking me to comment on the particular Austrian document noted above that has been circulating within financial markets recently. I deal with that later in the post. Anyway, apart from my main research and other writing activities this blog stuff is “all in a day’s work” – Friday March 19, 2010.

Bernanke about to kill the World

Yesterday (March 18, 2010) one Michael Snyder wrote in horror that – Bernanke Wants to Eliminate Reserve Requirements Completely.

He correctly notes that the US has maintained a “fractional reserve” banking system up until now although he doesn’t realise that this is just one of the many relics that remain from the gold standard/convertible currency era that ended in 1971. Everyone will catch up eventually.

You can read about the fractional reserve system from the Federal Point page maintained by the FRNY. For example, they say:

As of December 2006, the reserve requirement was 10% on transaction deposits, and there were zero reserves required for time deposits … The transactions-account reserve requirement is applied to deposits over a two-week period: a bank’s average reserves over the period ending every other Wednesday must equal the required percentage of its average deposits in the two-week period ending the Monday sixteen days earlier. Banks receive credit in one two-week period for small amounts of excess reserves they held in the previous period; similarly, a small deficiency in one period may be made up with excess reserves in the following period. Banks that fail to meet their reserve requirements can be subject to financial penalties.

So straight-forward but totally unnecessary.

Mainstream economics textbooks think that the fractional reserve requirements provide the capacity through which the private banks can create money. The whole myth about the money multiplier is embedded in this erroneous conceptualisation of banking operations. The FRNY educational material even perpetuates this myth. They say:

If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+…=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+…=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

This is clearer than Mankiw writes but just as wrong if it is trying to represent the way the banking system actually operates. And the FRNY knows it. If you read on they qualify to the point of rendering the last paragraph irrelevant.

After some minor technical points about which deposits count to the requirements, they say this:

Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.

Read: no role.

As we have discussed many times banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).

These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds as noted in the qualification above by the FRNY.

At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.

For further discussion on this, please read – Money multiplier and other myths .

Further, please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion on bank reserves.

That is all essential background for understanding the rest of the story.

So back to Snyder and his so-called expert banking commentary who is getting all hot under the collar about some testimony that the Federal Reserve Chairman Ben Bernanke gave to the US House of Representatives Committee on Financial Services on February 10, 2010. You can read the full text HERE.

Now if I wanted to be really mean I would conjecture that Snyder’s late reaction to this statement – more than a month has now passed and finally he is trying to beat up some story out of it as headline news – is because it challenges his capacity to understand even the most basic elements of the banking system. He might have been shifting restlessly wondering what it meant for the last 5 or so weeks and then read some Austrian school stuff or other equally vapid rhetoric and suddenly yesterday came to the conclusion that Bernanke wants to create “money out of thin air” and that “(i)t’s going to be a rough ride”.


Here is what Bernanke said about eliminating the minimum reserve requirements currently in place in the US system.

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

End of civilisation is approaching.

Snyder, as if in a bad dream, posed what he must have construed to be a very deep question and the gave his response:

So is Bernanke actually proposing that banks should be allowed to have no reserves at all?

That simply does not make any sense. But it is right there in black and white on the Federal Reserve’s own website….

If there were no minimum reserve requirements, what kind of chaos would that lead to in our financial system? Not that we are operating with sound money now, but is the solution to have no restrictions at all? Of course not.

What in the world is Bernanke thinking?

Well Michael, Bernanke is finally showing that he might be starting to understand the monetary system that he has been in charge of (for too long). I might remind Michael that many countries no longer hang on to this gold standard relic. Australia, for example, abandoned reserve requirements years ago as it realised that in a non-convertible currency system they are totally unnecessary. Reserve accounts (called exchange settlement accounts over here) just cannot be in the red.

As an aside, the terminology used by the Australian system is much more meaningful in relation to the purpose of bank reserves – Exchange Settlement Accounts – that is, to faciliate smooth functioning of the payments system between banks. Bank reserves exist for no other reason.

Further, in the most recent crisis, Australian banks remained sound with zero bailouts (although helped by an Australian Government wholesale loan guarantee). There has been no chaos in the Canadian banking system which also has no requirements – indeed, the Canadian banking system is essentially sound unlike its counterparts across the border to the south.

What kind of chaos are you expecting Michael?

His article is a bit light on in that regard. He chooses to rehearse arguments made by Texas Republican Congressman Ron Paul who apparently “understands that creating money out of thin air is only going to create massive problems”. Paul tackled Bernanke at at the February 24, 2010 hearing of the House Financial Services Committee on “Monetary Policy and the State of the Economy” – the entire video is HERE.

The exchange was quite humorous in fact.

Anyway Snyder quotes the following Paul statement:

The Federal Reserve in collaboration with the giant banks has created the greatest financial crisis the world has ever seen. The foolish notion that unlimited amounts of money and credit created out of thin air can provide sustainable economic growth has delivered this crisis to us. Instead of economic growth and stable prices, (The Fed) has given us a system of government and finance that now threatens the world financial and political institutions. Pursuing the same policy of excessive spending, debt expansion and monetary inflation can only compound the problems that prevent the required corrections. Doubling the money supply didn’t work, quadrupling it won’t work either. Buying up the bad debt of privileged institutions and dumping worthless assets on the American people is morally wrong and economically futile.

What this statement has to do with eliminating the 10 per cent reserve requirements is beyond me and Snyder does not choose to explain. I guess he is still trying to catch up with the fact that this all went down 5 weeks ago.

Reflecting on Paul’s comments – I have some sympathy with them. The lax regulation of the monetary authorities in the US under Greenspan and then Bernanke was a major cause of the current crisis. This had nothing to do with having reserve requirements or not though.

It is also clear from the blogs I referred to above that expanding bank reserves does not expand the capacity of the banks to lend (create credit). It was always a foolish policy venture to think that quantitative easing would do anything other than stabilise the financial system. Japan proved that a decade ago.

But then I note that the US inflation rate yesterday moderated (that is, fell). So if Paul was correct we should be seeing rapid inflation by now. You will not in the foreseeable future see any inflation problems arising from the demand-side of the economy. Perhaps, those pesky OPEC oil barons will drive some supply-side price shocks into our economies but that will have nothing to do with budget deficits or the build-up of bank reserves.

At any rate, none of this has anything to do with the idea that minimum bank reserves (above zero) will cause chaos.

Snyder though finally says that the policy change would “give bankers power to make money up out of thin air” and be inflationary. Well commercial banks can already make create deposits by writing out loans – and they do this whether there is humidity in their office blocks or not (thin or thick air).

Japanese bankers can do it. They have had deflation for two decades.

Australian bankers can do it. No inflation problems here arising from this source of demand. And I could go on.

Snyder concludes that:

And things are only going to get worse. Especially if Bernanke gets his way and reserve requirements are eliminated entirely. The U.S. economy is a giant mess already, and we have got a guy at the controls who simply does not have a clue. It’s going to be a rough ride.

The only person who hasn’t got a clue is obvious here. The US economy is in a giant mess but the change in reserve requirements will have a zero impact on whether it gets worse or better.

The idea that you maintain financial stability by regulating the liabilities side of the banking system is erroneous. That is how monetary policy operated during the convertible currency days when central banks had to maintain a tight grip on monetary growth to ensure it was compatible with the need to defend the parity in the foreign exchange markets.

In a non-convertible currency system, there is no applicability at all to liability side management. All the regulation has to be put on the asset and capital side of the bank balance sheets, which is the current international approach – albeit poorly formulated.

Further, there is a case for general rules-based regulations – along the lines I noted yesterday. Reduce the capacity of the unproductive financial sector to grab real income by ensuring real wages grow in line with productivity (that is, increase the wage share) and then ban any speculative behaviour that is not connected with ensuring that the real economy is more stable (for example, forward markets that help manufacturers offload foreign currency exposure).

George Washington is dead and powerless

Another report I received yesterday was from the Hong Kong-based Jim Walker who calls himself Dr Jim presumably because he thinks that people will conclude – has Phd must know something. I have been in the academic game a fair while and I can assure you there is not even a strict correlation between those two things (all of my past students are completely excluded from that assessment (-:).

At any rate he is big in South East Asia.

His company puts out “member only” reports and the one I refer to now – sorry I cannot give you a link so you will have to trust me – was Issue 10/2010 published on March 2010 called ExposAsia – Tu ne cede malis sed contra audentior ito.

Which is a quote from the classic Roman poet Virgil and means from the Latin – Do not give in to evil but proceed ever more boldly against it. Profound!

Walker attended a conference last month in the US at the “birthplace of the Fed” at Jekyll Island in Georgia. The conference was organised by the Ludwig von Mises Institute (the foremost Austrian school institution) and consisted of 10 papers with around “2-300 like-minded individuals who value freedom, liberty and sound money” in attendance. Upstanding citizens all of them!

Walker devotes his financial briefing to his clients as a rapporteur of the conference. It is gruelling I can tell you – 11 pages of total tripe – and I suppose the only saving grace is that very few trees were sacrificed in its production given it is an electronic delivery.

I won’t go through it in detail but several people in the last few days who get the publication but are now reading my blog and getting more suspicious of the dogma coming from the Austrians wanted me to clarify a few things.

The paper has a section on “What do Austrians discuss when they get behind closed doors?” and while what they do is open to conjecture the section contained a rather parlous (amateurish) rehearsal of Kuhnian philosophy of science.

Here we learn that the pure Austrians who have never been listened to but are always right are about to tell us all “we told you so” as the dominant paradigm – wait for it – that evil “Keynesian-monetarist nexus on economics” finally collapses under the weight of the poverty of its ideas.

So this alleged degenerating paradigm the “Keynesian-monetarist nexus on economics” dominates at present and is characterised by the “insufficient aggregate demand approach”.

This was an eye-opener to me – I also have a Phd in economics and studied the evolution of Keynesian and Monetarist thinking in some detail. So the concept that a Keynesian-monetarist nexus on economics exists really had me thinking (-:.

This financial markets briefing from Dr Jim appears to be providing a major revision of the history of economic thought that has evaded scholars for all these years.

Say it out aloud – the “Keynesian-monetarist nexus on economics”. You soon learn reading this stuff on a daily basis (year-in and year-out) that misrepresentation is the key to the literary style practised by these commentators.

Any basic understanding of the macroeconomics literature would not define any nexus between the Keynesians and the Monetarists.

In my recent book with Joan Muysken – Full Employment abandoned we cover this paradigm shift in some detail. Specifically we show that Friedman’s work unambiguously aimed to build on the early research of Irving Fisher and was up against a new macroeconomic orthodoxy in the 1950 – Keynesian thinking.

By the 1920s, Irving Fisher was setting the groundwork for what became Monetarism some 42 years later. The work of Fisher was obscured by the rise of Keynesian macroeconomic orthodoxy. The Phillips curve, reflecting the adjustment of nominal magnitudes to real disequilibrium in the labour market, was a central expression of the confidence acquired by policy makers through eliminating the business cycle during the 1960s.

However, Friedman and others were working on the foundations of a resurgence of Neoclassical macroeconomics based on the Quantity Theory of Money during the 1950s and 1960s. The Monetarist reinterpretation of the trade-off between unemployment and inflation, which emphasised the role of expectations, revived the Classical (pre-Keynesian) notion of a natural unemployment rate (defined as equivalent to full employment). The devastating consequence was the rejection of a role for demand management policies to limit unemployment to its frictional component.

They recast the Phillips curve to be a relationship where mistakes in price expectations drove real shocks (via supply shifts) rather than the way the Keynesians constructed the relationship – real imbalances driving the inflation process (via demand shocks). The two approaches are not the slightest bit similar and constitute two separate paradigms (or philosophical enquiries) although one cannot cast it as a Kuhnian shift (see below).

The importance of this shift in macroeconomic thinking after the OPEC oil shocks to Monetarism was that it scorned aggregate demand intervention to maintain low unemployment. Any unemployment rate was optimal and the a reflection of voluntary, utility-maximising choices. The policy emphasis shift from full employment to full employability and the period of active labour market programs began in earnest.

The rise in acceptance of Monetarism and its New Classical counterpart was not based on an empirical rejection of the Keynesian orthodoxy, but in Alan Blinder’s words:

… was instead a triumph of a priori theorising over empiricism, of intellectual aesthetics over observation and, in some measure, of conservative ideology over liberalism. It was not, in a word, a Kuhnian scientific revolution.

However, the shift in the Phillips curve in the 1970s as the OECD economies began to fail was a strong empirical endorsement for the Natural Rate Hypothesis, despite the fact that the instability came from the supply side. Any Keynesian remedies proposed to reduce unemployment were met with derision from the bulk of the profession who had embraced the new theory and its policy implications. The natural rate hypothesis now became the basis for defining full employment, which then evolved to the concept of the NAIRU.

So how Dr Jim can create a nexus out of these developments is a mystery to me and would qualify him for the Nobel Prize in Economics.

But not to let some real analysis get in the way, Dr Jim chooses to quote from one of the papers at the Conference in Georgia he attended. Some character “summed up the insufficient aggregate demand approach and the Austrian objection to it as follows”:

Taking resources from one part of the economy and giving them to another part, doesn’t make us richer. Printing green pieces of paper with pictures of past Presidents on them, doesn’t make us richer either.

So you get the gist. This is the Austrian macroeconomics course 101. Apparently macroeconomics is about redistribution of resources and printing green pieces of paper (except over here in Australia we are more colourful with our currency designs – but we get the idea eh!).

Now I cannot comment on the “Keynesian-monetarist nexus” because I have never understood there to be one. But in a fiat currency system the principles are clear although governments do not always understand them or implement them to best advantage.

Several commentators (regularly) suggest I have a naive faith in governments. Please be informed that I think governments are highly flawed institutions that are prone to corruption and mistakes. But if you understand the way the monetary system operates then you also realise that they are the only show in town with the currency-sovereignty which they have to use to transact with the non-government sector.

Once you realise that then the progressive agenda has to be to spread that news as widely as possible to influence public debate and hopefully force a citizens’ take-over of the democratic process – “to keep the bastards honest” as a former Australian politician once said when he broke away from one of the major parties and launched his own party (read about him HERE).

Anyway, the logic of Modern Monetary Theory (MMT) is clear and it is a body of thought that implicates insufficient aggregate demand (spending) as the primary reason why national output and income falls and unemployment arises.

The other reference to “(t)aking resources from one part of the economy and giving them to another part” presumably is about taxation. Taxation is not designed to make anyone rich. Taxation is a flow that aims in the main to balance the public and private purchasing power. It has nothing to do with “funding” government spending but has everything to with limiting the purchasing power of the non-government sector to ensure aggregate demand growth is consistent with the real capacity of the economy to absorb it.

So to think that anyone thinks it is designed to make us richer misunderstands its purpose.

Other taxes deliberately aim to influence resource allocation by discouraging what society considers to be damaging behaviour (for example, smoking).

Redistributive policies within the non-government sector certainly improve the resource access of the recipients while reducing the resource access of those who pay the taxes. There is no robust empirical research literature to support the claim that taxation reduces work incentives. That is another myth that cannot be empirically supported. At the macroeconomic level there has been no discernible negative effect detected by countless studies. At the margin of the welfare system there is an issue of overlap when you have benefit-retrenchment at marginal tax rates of 100 per cent as you earn extra income. But that is a different matter altogether.

Having understood that, the second part of the claim can be put in a better context. From the MMT perspective the statement that “(p)rinting green pieces of paper with pictures of past Presidents on them, doesn’t make us richer either”, however folksy, has no relevance to the monetary system we live in. Governments do not spend by “printing money” – they credit bank accounts in the main.

Quantitative easing did not even involve any money being “printed”. It was just a swap of a bank reserve for some other asset. Net change in financial assets denominated in the currency of issue – zero! This is all covered in the blogs I referred to earlier.

But we know that they are referring to government spending so lets just take it at that level. There is another issue about whether we should be talking about economic growth (that is, growth in national income – a flow) or growth in wealth (a stock of financial and real assets). I will come back to that.

It is unambiguous that government spending directly boosts aggregate demand and as long as there is spare capacity in the system to produce extra goods and services – this spending should stimulate income growth. We can construct all sorts of examples where the government is so incompetent that it cannot actually go into a shop and order 10,000 shirts for the army or 1 million reams of paper for the education system or whatever.

But the reality is that government spending is going on every day and adding demand and boosting national income. You cannot deny that.

Clearly, if government spending drives nominal demand faster than the economy can produce then once inventories run out inflation emerges and no further real national income can be gained.

All this only tells us that the risk of too little government net spending (relative to the other sectoral balances) is rising unemployment and lost income opportunities and the risk of too much government net spending is inflation. MMT is clear on that.

Now, to understand how this might influence wealth creation we need to delve into those sectoral balances again. Dr Jim goes straight there.

Here is his version of what he calls “Keynesian/monetarist logic”:

The mainstream breaks down the economy into three macroeconomic ‘balances’: the private sector balance, the public sector balance and the external balance. It contends that, at any given point in time, the private sector in any economy will either be in surplus (saving more than it spends) or in deficit (spending more than it saves), so too will the public sector and so too will the external balance with the one condition being that the three balances MUST add up to zero.

Apart from the “Keynesian/monetarist logic” tag, the representation of the sectoral balances is fine although you will rarely find them in a modern mainstream macroeconomics textbook these days. You will also rarely find a mainstream macroeconomist even referring to them and often they will make statements which violate the accounting consistency that is required by the balances.

So statements like the government has to run a surplus so the private sector can save when a nation is running an external deficit is often heard but is just fundamentally impossible.

Dr Jim applies this framework to his (invented) “Keynesian/monetarist logic”:

… in a recession, the private sector will be moving from deficit to surplus (or from surplus to even greater surplus) ie, it is ‘hoarding’ or saving more. Therefore, there will occur a deficiency in aggregate demand to meet current supply. In order to stop the downturn, it is argued, the public sector must save less or spend more (and, in the best of all possible worlds, the external sector will contribute by moving, say, from deficit to surplus thus easing the burden on the public sector). But it is this fundamental distinction between the private and public purses that is at the heart of stimulus programmes around the world. It forms the rationale for all current government policy. In other words, Private sector balance + public sector balance + external balance = 0.

The last equation is true by definition as he points out. And by and large his representation would be consistent with a Keynesian position (and a MMT position) but not a monetarist position – but lets not get tied up by that. Governments at present have behaved in a fiscal sense according to this logic and in doing so they have saved the world from a depression.

The fact they have also been pursuing useless monetary policy interventions (quantitative easing) just tells you how fractured the policy making understanding is at present. Policy makers have been listening to the mainstream macroeconomists telling them that Keynesian use of fiscal policy was dangerous and ineffective anyway and the only aggregate policy tool to use was monetary policy and then only to target inflation rates. The alleged market processes would ensure “optimal growth” if inflation was stable.

That orthodoxy collapsed in this crisis and after toying with their monetary policy tools for too long early in the crisis – as it got worse they were forced to take a reality check and implement fiscal interventions.

So policy is a shambles at present – caught between paradigms. But having said that – the crisis has shown that fiscal policy rules. Get used to it!

Dr Jim though is not happy with this because he thinks it stops natural processes of capital destruction from occurring which are necessary to cleanse the system and realign the capital structure.

This is a popular argument that the Austrians use – that it is better to let a total meltdown occur – which destroys bad capital sure enough but also takes down good capital; impoverishes millions; interrupts the generational process of human capital augmentation and entrenches permanent disadvantage as a consequence; and reduces the future growth path because of well-documented asymmetries in physical capital formation.

Their religious belief that these processes are rapid so the costs are minimal is without empirical application. Even with significant government intervention a major cyclical event such as a recession takes years to work through. The Austrians, however, never commit to a time profile for this adjustment.

At least the Monetarist, Milton Friedman did finally disclose some temporal forecasts. He was famously asked to actually put a time frame on his recommended disinflation processes to expunge inflationary expectations. He said that unemployment would have be very well above the alleged “natural rate” for around 15 years – and he didn’t even blink an eyelid when he delivered this wisdom.

The other point is that government intervention does not have to “save” high cost capital. That should be allowed to die and the growth cycle should start with a younger vintage of capital and renewed productivity growth. I agree with the Austrians on that need. But attenuating demand shocks will not save the marginal capitalists anyway.

Anyway, Dr Jim thinks that the idea of supporting aggregate demand when there is a major collapse in private spending is “rubbish”.

The whole point is that, while definitionally neat, there is no difference between the private and the public sectors. For the public sector to increase its spending it must take the money from the private sector (it could borrow from abroad but that just acts to reduce spending there). This is because, when all is said and done, governments have no money of their own. They do not create wealth in the way that the private sector does but merely live off the fruits of private sector labour.

So you can imagine that I just sank back in my chair at this stage, eyes glazing over … I was still trying to get to grips with Dr Jim’s Nobel Prize winning “Keynesian/monetarist nexus” and then I get confronted with the notion that a fiat currency-issuing government is just like the private sector and has “no money of their own”.

Will someone write to the University that awarded him his Phd in economics and raise questions about their academic standards please?

First of all Dr Jim has clearly not learned anything in his macroeconomics courses at university and better start at the beginning – Deficit spending 101 – Part 1Deficit spending 101 – Part 2Deficit spending 101 – Part 3.

First, the private sector has no currency until the government issues it. The private sector cannot pay its tax obligations until the government spends the currency. The government doesn’t spend by taking anything off the non-government sector.

Second, the government only borrows the funds that it has previously spent – irrespective of whether domestic institutions/residents or foreigners purchase the debt. In a fully stock-flow consistent macroeconomics that has to be the case.

Third, it is true that a “government” has no intrinsic labour power. Taxation, in part, functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

The orthodox conception is that taxation provides revenue to the government which it requires in order to spend. In fact, the reverse is the truth. Government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. It follows that the imposition of the taxation liability creates a demand for the government currency in the non-government sector which allows the government to pursue its economic and social policy program.

This insight allows us to see another dimension of taxation which is lost in orthodox analysis. Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the non-government sector. The unemployed or idle non-government resources can then be utilised through demand injections via government spending which amounts to a transfer of real goods and services from the non-government to the government sector.

In turn, this transfer facilitates the government’s socio-economics program. While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities. Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue. Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes.

So it is now possible to see why mass unemployment arises. It is the introduction of State Money (which we define as government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment.

Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages). Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account through the offer of labour but doesn’t desire to spend all it earns, other things equal.

As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

Now we can extend that to wealth creation which takes us back to the sectoral balances. If the non-government desires to spend less than it earns and there is an external deficit (common in most countries), then unless the government balance is in deficit, national income will fall and the saving desires of the private domestic sector will be thwarted.

So the stock implications of the net public spending flow is that it provides support for the income flow such that the non-government sector can net save in the currency of issue and accumulate wealth in the form of financial assets. The private sector can convert their financial wealth into real wealth in addition to this.

With a consolidated private sector including the foreign sector, total private savings has to equal private investment plus the government budget deficit. In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. In a closed economy, NX = 0 and government deficits translate dollar-for-dollar into private domestic surpluses (savings).

In an open economy, if we disaggregate the non-government sector into the private and foreign sectors, then total private savings is equal to private investment, the government budget deficit, and net exports, as net exports represent the net financial asset savings of non-residents.

Please read my blog – Stock-flow consistent macro models – for more discussion on this point.

But by this stage Dr Jim is on a high and just cannot restrain himself:

In short, the private-public-external balance argument is a fraud. There are only two relevant balances, domestic and external. In a gold standard system a persistent deficit in the latter brings about fast adjustment in the former through reduced money supply (gold has to be exported to the surplus country) and deflation of domestic demand. Unfortunately, in our fiat money system imbalances can be sustained for much longer – meaning that capital structures can become misallocated for much longer too – because of the inflation process that masks the deficiencies in real funding for capital projects or real demand for consumers goods. Once these deficiencies become apparent though, the process of correction (the bust) begins. Throwing more good money after bad in an effort to artificially raise demand regardless of consumer preferences merely prolongs the process of adjustment and probably makes it worse.

So there you have it – he wants to return to the gold standard and have America ship all its gold to China and impoverish Americans with continual unemployment and wage deflation.

You also realise this stuff just comes from the heart when you read that “the inflation process that masks the deficiencies” in real spending. Which inflation process pray tell? Japan has had significant public deficit support for aggregate demand for two decades (bar a short period where they went crazily neo-liberal) and they have had no inflation – the opposite in fact.

At present the World is experiencing significant swings towards public deficits and no inflation.

What the fiscal interventions are helping to do is maintain enough demand so that “good” capital doesn’t go down the drain with the “bad”. A global depression that would have lasted at least a decade without the policy interventions would have destroyed massive volumes of private wealth (both real and nominal) and many people would never have recovered – not just the wealth but the lost skills and educations etc.

The evidence is very strongly in favour of the view that interventions reduce these costs and get economies moving again so that new investment in best practice technologies can occur and drive out the old unproductive capital. The damage to the skill composition of the labour force is also less the shorter and more moderate the downturn is.

Further, while Dr Jim claims it slows down the private deleveraging process the contrary is true. As long as the distortions in the credit markets (lax credit policies etc) are regulated away, the income growth from the fiscal support allows heavily-indebted households etc the room to increase saving and reduce their debt exposure while retaining employment.

The Austrian solution would replace this process with mass bankruptcy and life-long suffering (damaged credit ratings, forced foreclosures, loss of life savings etc).

Dr Jim closes by telling all his supporters to Buy Gold. So you gold bugs out there get all the cash you can assemble and buy some of the sweet ore and put it under your bed or hire a private militia to guard it for you – although you will have to persuade them to take gold coins because you won’t have any cash left – it will be worthless anyway before long. And for god sakes … feel good about yourselves – after all you are all for “freedom, liberty and sound money” … except you haven’t got any money left because you bought the gold.

Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for more discussion on this point.


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