‘Thin Air’ and Economic Causality

Micheal Pettis has a a long and interesting post which is effectively a critique of Steve Keen.

the tremendous confusion about what it means to create demand out of nothing is dangerous. When banks or governments create demand “out of this air”, either by creating bank loans, or by deficit spending, they are always doing one or some combination of two things, as I will show. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other equally easily specified cases they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand “out of thin air”, as many analysts seem to think, and doing so would violate the basic accounting identity that equates total savings in a closed system with total investment…. he questions arise in the context of a discussion of some of Steve Keen’s work among several regular commenters on my blog…. I think what Keen might actually be saying is that if investment in the next period is greater than savings in the current period – if it is boosted, so the argument goes, by the ability of the banking system to fund investment by creating debt “out of thin air” – this does not violate the identity, and it is not only possible, but even likely. (If by any chance Steve keen should read this, perhaps he might respond.)

The reference being to Steves formula Investment = Savings + change debt which appears to violate the S=I Keynes identity to which Pettis holds to. Certainly Pettis is on the right track in criticising the ‘thin air’language (from Schumpeter) which implies a spooky costless and causeless economy which could grow by itself forever. A constant theme on this blog has been that whilst money creation is ex nihilio money is not created out of thin air.  Like everything else it is limited by economic laws, in this case the general equation of accounting- which means that liabilities must in all cases be backed.

However in the entire post Pettis does not refer to temporal changes, economic growth, and how this governs the accounting relationships between the real and monetary economies.  Hence in a model based on such assumptions nothing can ever change if all accounting identities are at unity. In creating the S=I identity Keynes was seeking a way of avoiding the complications of capital and monetary theory.  In effect the general theory was an ít doesnt matter’theory in that what ever went on under the hood the Kaldor multiplier would ensure that incomes (& savings) were driven by investment.  All well and good but it obscures us to important issues, such as the credit cycle, that drive changes in investment.  This is the trap I think Pettis has fallen into.

I’ll present below a structure I think helps in explaining what happens between money creation and investment, correctly mathematically formulated it allows us to construct a model with intersecting balance sheet identities, that is stock and flow consistent, and has dynamic change. Imagine we are modelling the shortest possible duration of economic time between a decision to invest and its spending.  That money can come from one of three sources, either from idle balances, from state money creation or from bank credit creation.  If we go to the limit of continuous time there will always be a period of idle balances between one of the two originary points of money creation – state or bank, and all idle balances can be tracked back to the point of origination. This point between creation and spending – to a balance – to respending – can be traced through a Taylor series into a geometrical contraction so that the additional effective demand from the money creation declines over time so there are no idle balances left either in the original account or in all subsequent accounts into which the balances are transferred.  This is precisely the multiplier mechanism sketched out by Keynes and Kahn. It is this process that generates the Samuelson-Hansen (1949) Multiplier- Accelerator model.  The re-spending of the generated money creates a multiplier effect and the additional incomes generates an investment accelerator effect.  In the Samuelson-Hansen model though their is no inventories and no stocks, the sequence analysis approach is lacking.  We can correct this.

Consider bank credit creation.  The creation of a liability must be backed by equity (or debt) to avoid a cash flow issue.  The banks first call will be to balances on hand (included invested equity and retained profits) before using the clearing process and seeking debt – a consequence of the general equation of accounting.  You can refer to some of my other posts for this set out in detail in T accounts, however if the bank has to obtain funding this always has a cost, it either has to transfer existing balances (including where additional cap[ital is sought) or resort to debt.  Again the money must trace back to a source, other banks or state money creation.  There is a problem with relaying wholly on other banks, whilst an individual bank can expand its balance sheet as much as it can be funded the banking system as a whole is constrained unless there is a central bank.  This is the Davidson/Phillips formula – which is another example of this geometrical contraction- the expansion of lending must be funded from real balances or lending and the balance sheets it toto cannot expand from banks lending to each other.  Ultimately the capacity for credit to expand across the economy as a whole is dependent of state money creation. No-one rationally invests unless there is an increase in surplus which the render takes a share of profits from to fund interest. The ability of the economy as a whole to invest is constrained, either by the ability to postpone current consumption (Crusoe like saving) for future consumption – or – and this is the omission made by Adam Smith and the Austrians, to take the risk of losing future consumption without investment for the potentially higher returns of future consumption with it.  However the limit of potential investment is the Net Present Value of future investment.  If this is higher then what can be funded by present account balances then the gap MUST be made up through state money creation.  Austerity therefore reduces future potential incomes. Pettis is in effect relying on the Says Identity – S=I where S is unspent balances, without allowing for the fallacy in Says Law, that planned savings and planned investments adjust with a variable time lag and may not be realised. One could extend this further by looking at this from a capital theory perspective and the natural rate of interest, and bring in factor returns – but I hope you get the idea.


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