Nick Rowe has an interesting thread with a number of good contributions about Steve Keen’s Theory of Effective demand.
Here’s what I think Steve Keen is maybe trying to say:
Aggregate planned nominal expenditure equals aggregate expected nominal income plus amount of new money created by the banking system minus increase in the stock of money demanded. (All four terms in that equation have the units dollars per month, and all are referring to the same month, or whatever.)
And let’s assume that people actually realise their planned expenditures, which is a reasonable assumption for an economy where goods and productive resources are in excess supply, so that aggregate planned nominal expenditure equals aggregate actual nominal expenditure. And let’s recognise that aggregate actual nominal expenditure is the same as actual nominal income, by accounting identity. So the original equation now becomes:
Aggregate actual nominal income equals aggregate expected nominal income plus amount of new money created by the banking system minus increase in the stock of money demanded.
Nothing in the above violates any national income accounting identity.
Only last year he said he didn’t get it, but clearly has had second thoughts.
Much of this lack of understanding comes from confusion about the tools used. Those used to thinking in terms of ex-post accounting identities have struggled with whether there is an exposte- ex ante discrepancy. Those used to fixed periods and thinking of money as a stock struggle with how to conceptualise income and spending as instantaneous time flows. Those used to the GDP definition of income as deriving from value added struggle with how net purchases and sales of assets affect income. Those used to the loanable funds approach struggle with how demand can be affected by debt which they simply see as a transfer of existing income. Thankfully most but not all) of these issues have been tackled through Keens adoption of a double entry approach and its mathematisation with the aid of the Fields Institute. Most of the comments dealt with such issues of clarification and misunderstanding and I wont repeat them here, you can read the original thread and comments. Its us small usual bunch of monetary theory suspects im afraid, we could all fit in a telephone box.
Keen responded on Nick’s Blog
you’ve done a very good job of providing a Rosetta Stone between standard Neoclassical macroeconomics, and the perspective on endogenous money macroeconomics that I put forward
and then more fully on his own that
This is the first concerted (and very accurate) attempt to put my endogenous money approach in a form that Neoclassically trained economists can understand. This could be the start of a real dialogue in economics.
A quick note on Nick’s approach then ill look at an unresolved issue or two from the blog debate.
Keen has traditionally tackled the issue from actual realised income then placed back in the monetary circuit i.e. not saved (hoarded). Nick reformulates this in terms of the language of intertemporal optimisation beloved of neoclassical economics.
To give a very simple example lets say someone earned a disposable income of 10,000 dollars a month and they save 5,000 a month totalling 100,000 over time towards deposit on a house requiring a 500,000 loan. In previous months there actual nominal income 5,000 dollars equals expected nominal income (10,000 dollars) minus ‘increase in the stock of money demanded’ – savings in plain English – (5,000 dollars). In the month they get a loan there realized expenditure is 10,000 dollars minus, plus the 100,000 loan plus 10,000 disavings.
Keen has never explicitly covered the treatment of savings in this manner but I have long felt, and said a number of times on this blog, that his logic implies such a treatment. Indeed a number of historical predecessors of Keens approach to the circuit such as Norton and Johannssen.
Outstanding issues though concern what happens when a bank credits money without an accompanying financial asset and the difference between banks and nonfinancial institutions.
Rowe on this
Steve…If I sell my computer to my bank, the money supply expands. If I then buy that computer back from my bank, the money supply contracts.
Similarly: If I sell my IOU to the bank (if i take out a loan), the money supply expands. If I then buy that IOU back from the bank (if I repay the loan), the money supply contracts…
What’s special about banks is not what they buy with the money they create, but that they create money. And thinking about banks as buying and selling computers or land can help us make that distinction more clearly.
No, in the first case the bank is making a purchase of a commodity from you that it has to source from the liabilities and equity side of its ledger–not the asset side. To do otherwise is to commit seignorage–to use its capability to produce the IOUs we all use for transactions for its own use. So when a bank buys goods from non-banks, it uses the funds it has legitimately earned from its business of lending, not by using its capacity to create money. So there is no change in the money supply in either case.
He expands on this in his own blog
ending by an S&L … transfers money from its bank account to the borrower’s account, and therefore does not alter the total amount of money in existence. Lending by a bank … increases both the bank’s assets and its liabilities and thus increases the amount of money in existence. If workers try to get out of money and into gold .., they reduce their bank accounts but increase those of the dealers from whom they buy the gold….The only action that can take money out of the banking system is a withdrawal of money as cash
Nick Edmonds on the other hand, expanding his point on his own blog, disagrees. He argues from T accounts and accounting identities that non-bank financial institutions lending does increase the amount of money in circulation but not the overall stock of money and so this can have similar affects, though ultimately the ability to do so will be limited by the amount of savings they can attract.
Rowe in summing up his approach
Steve: I think (maybe) the biggest difference between us (in this context!) is that you focus more on the asset side and I focus more on the liabilities side of banks’ balance sheets. Let me state my view, to see if this clarifies things.
What’s on the asset side matters for a bank’s solvency and liquidity if people want to redeem their money. This matters a lot for commercial banks, which promise to redeem their money at a fixed exchange rate for central bank money. It matters also for central banks that promise to redeem their monetary liabilities at a fixed exchange rate for gold or USD or some other good. … If there’s a risk of insolvency or a bank run, the size and composition of the asset side matters. But provided the assets are good enough so we can ignore those risks, it is only the liabilities side that matters in the money-creation process.
So in my view:
A bank buying an IOU
A bank buying a computer
A bank buying a meal at a restaurant for its staff to celebrate Christmas
A bank giving money to charity
are all the same, in terms of creating money, and their effects on the liabilities side, though they will have very different effects on the asset side.
Ok the way I think about it is to distinguish between clearing banks and bank like institutions, shadows banks (including mutual funds utilising fractional reserve lending), and none bank financial intuitions (S&Ls, full reserve savings banks and the like) as each has very different mechanisms to back the credits they issue.
Whats special about banks?
Lets say a bank buys a computer, to use Nick’s example, if the computer company has an account at the same bank they can simply credit money in their account. If they don’t they can simply issue a cheque and create the money to redeem it, the end result is the same. The bank has increased its liabilities without creating an accompanying asset, the same as giving the money to charity. The key restraint on them doing so however is their balance sheet. A bank cannot issue money to buy the whole world’s supply of computers, they are restrained in doing so by the right hand side of their balance sheet, their capital, their equity, retained earnings and assets. Keen has tried to develop a theoretical approach whereby bank’s ability to lend is constrained by their charter value, the intangible asset that banks trade on from being a bank able to credit money and engage in fractional reserve lending/maturity transformation. I have tried to expand this into a mathematical model that takes account of banks capital and reserve ratios. I term this the lending power approach reviving a term from early endogenous banking theory.
Banks cannot expand their lending books without cost, and neither can they expend their asset of lending power on none loans (as in Nicks example) without opportunity cost. A bank forgoes potential profit on a loan in favour of a diversified portfolio which includes assets with a rate of return which may be higher than loans. This is the approach to bank portfolios which the later Toblin explored in several papers.
If a bank credits an account or redeems a cheque the Central Bank will accommodate that monetary demand. If they do so in terms of a loan then the creation of money will be cancelled out over the term of the loan by debt repayments and the bank as interest as profit. This interest payment is simply a transfer payment from the non-bank sector to the bank sector. If it credits a liability without creating an asset then it must run down an existing asset to stay solvent, which must come from pre-existing savings and profits. So the effect on the liabilities side is the same (Nick is right about this) but Nick neglects the constraints on banks ability to do so and that they can only do so through dissaving, which is already included in this framework.
Similarly Nick Edmonds argument is another case of a credit without an asset creation – as only banks and shadow banks can do so (the only difference between banks and shadow banks is that the central bank acts as lender of last resort for the former only, and clearance of final payments occurs through banks only), which also involves dissaving. Lets give an example. Lets say savings and loans typically create x billion of loans over a period and this is cancelled out by x billion of savings. Lets say interest rates change and there is a net increase of lending and net dissaving. Then from the formula above we have a net change in debt and a net dissaving, which cancel each other out.
Therefore only bank and shadow bank lending has a net macroeconomic effect.