Current Economic Conditions - SFC Perspective

Real output flows of the US are below potential as evidenced in the low labor participation rate, high unemployment rate and low factory utilization rate (i.e. we’re not using or maintaining a portion of our real asset stocks, Chart 1a, 1b & 1c). This “output gap” is the most urgent economic issue facing the country because this “gap” lowers the country’s standard of living irreversibly (smaller “pie” to go around either now or in the future) and because it has large impacts on the distribution of real/money flows (e.g. newly unemployed get smaller real flows, etc.). The main macro driver of the output gap can be identified by looking at aggregate money flows since these money flows drive real flows. As discussed previously nominal economic growth only occurs via spending of prior period savings or via increases in debt (which creates money stocks that increase money flow/real flow transactions unless used exclusively for existing asset purchases). This is the case because either action by an actor in the economic flow (see previous blog post) increases the money flow rate around the cycle. One way to evaluate these actions is to examine the sectoral balances, which combine these two actions into an overall net saving or net borrowing position by sector (with the net position being zero overall, because again - the US$ economy is "closed" in that there are two sides to every transaction, so every debtor has a creditor). Looking at the sectoral balance graphic (Chart 2) we can see that the foreign sector has not changed much – it is still in surplus (spending less than it earned during the period – subtracting from the economic flow), that the government sector has increased its deficit (but is otherwise similar in sign to prior years) and that the household/business sector has had a drastic swing from deficit (spending more than they are earning) to surplus (spending less than they are earning). Clearly the sector which has had the biggest change is the private domestic sector (households & businesses) and which therefore should be the chief suspect as the main driver for the current malaise.

GDP = Income = C + I + G + (X - M) = Spending = C + S + T

Rearranged:

(I - S) + (G - T) + (X - M) = 0

Chart 1a

Chart 1b

Chart 1c

 

Chart 2

The unusually large surplus in the private domestic sector (households and businesses) is why this recession has been called “a balance sheet recession” since the surplus has been thought to reflect individuals and businesses spending less than their incomes in an effort to “fix” their balance sheets. Savings are being used to either 1) pay off debt (e.g. underwater mortgages, excessive leverage relative to newly adjusted risk assessments (credit market freeze impact, etc.) or 2) increase stocks of money (e.g. increased savings for retirement since housing wealth decreased, increased rainy day fund due to increased perception of financial liquidity risks, etc.). The degree to which each of these factors are driving saving desires is observable in economic data – for example the drop in mortgage debt since the financial crisis (Chart 3) shows that some savings are being used to pay down debt (I’m assuming bank loan write-downs cannot explain the entire decrease since I don’t believe they have the capital to absorb this). More broadly, Chart 4 shows that private debt levels overall have decreased over the last few years, and therefore that increases in saving desires are not all due to increases in money stock hoarding.

Chart 3 

Chart 4

The fact that the private domestic sector is spending less than its income (net) is also of course a function of investment decisions (new debt acquisition) by households and firms, a function which is driven in large part by current capacity utilization (do I currently need the investment?), expectations of future sales/income (will I be able to pay the debt back?) and debt capacity (can I convince banks I’ll pay it back). The previous charts show that saving desires currently exceed desires to borrow by this sector (since the net is a decrease in debt) and that this net balance is unusual, as this sector is usually increasing its stock of real assets via net debt acquisition, which as I have described previously is a good, sustainable process as long as the real assets produced provide the flows that allow the debt to be repaid. Chart 5 and Chart 6 below clearly illustrate that investments by firms (non-residential investment) and investment by households (residential investment) both decreased drastically during the great recession, but that they have both since rebounded. However, while businesses are approaching the level of fixed investment attained during the prior period boom, households are still investing at a much slower pace than before. This data suggests that the continued decrease in money flows (which is producing the output gap) is primarily the result of increased saving desires of businesses and individuals (to pay off debt or to increase money stocks) and decreased housing investment desires of households.

Chart 5

Chart 6

This reality of private sector deleveraging does not necessarily mean that an output gap must occur. The other players in the economic cycle can more than offset this reduction in money flows and in fact lower the output gap relative to pre-crisis levels. The foreign sector can provide money flow increases by spending more USD$ than they earn, yet unfortunately we see, via the sectoral balance diagram, that this is not the case. The foreign sector continues to spend less than they earn (i.e. they have a trade surplus with the US – instead of goods they get USD$ money stocks), which has been a drag on money flows for a few decades now. The drivers for this accumulation of USD$ money stocks are many but include 1) foreign currency reserve needs (to “guarantee” access to foreign goods and to provide foreign currency which can be used to manipulate exchange rates in the future), 2) the result of prior foreign currency interventions made to support export led economic growth strategies and 3) the desirability of USD$ savings vs. foreign currency savings. The foreign sector money flow “leakage” is clearly something the US needs to address as it exacerbates, not helps, the money flow problems coming from private sector saving desires.

With the foreign sector unable to offset the money flow decrease caused by private sector deleveraging the government has been forced to try and fill the gap. Specifically, with the “river” of money around the economic cycle being diverted to the private domestic sector and foreign sector money stocks (lakes) the government has been forced to inject money flows into the economic cycle to maintain real flow production. Since state and local governments are unable to run large, sustained budget deficits (by law) it is the federal government that has been forced to inject money flows. The federal government has been “forced” to act in such a way due to public opinion (e.g. the stimulus act) and, more importantly, due to existing legislation. Such legislation falls under the label of “automatic stabilizers” since they remove money flows when the economic cycle flows are “too large” and add money flows when cycle flows are "too small". We all know of the money injections that increase when the economic cycle slows – unemployment compensation, welfare, food stamps, etc., yet often forget that money flow removal (i.e. taxes) is designed to slow during downturns as well due to the income based source of most federal government imposed taxes. The end result of both the discretionary and “automatic” federal government money flow changes can be seen in Chart 7 – very large money injections which, by accounting identity, produce corresponding debt stocks.

Chart 7

In addition to fiscal policy the government has also responded to the great recession using monetary policy, which is executed thru the Federal Reserve. Most of the Federal Reserve’s post-financial crisis activities (e.g. lowering the Fed Fund’s rate, buying Treasury bonds and private mortgage backed securities) have focused on lowering interest rates in order to 1) make debt levels more manageable (decreasing debt repayment and freeing up money flows for non-interest related purposes), 2) to increase asset prices due to lower discount rates/opportunity costs of capital (which affect money flows via the “wealth effect” ( increased balance sheet net worth)), 3) to encourage new debt accumulation (which may increase money flows) and 4) to decrease saving desires directly thru consumer intertemporal optimization effects. The impact of this monetary policy endeavor is hard to quantify since it works thru multiple pathways and empirical studies have many confounding factors to deal with, but in my opinion the positive effects of these monetary policy actions are vastly over-rated. It is true that lower interest rates have lowered debt service costs (see Chart 8) and increased asset values (see Chart 9), yet I do not believe that lower interest rates appreciably impact intertemporal optimization (see Chart 9a - people do not consume more simply because the real rate of interest has decreased) or business investment (since there are much bigger drivers, like sales, plus the fact that business investment spending is no longer usually funded by new debt (retained earnings provides most funding)). Further, as I repeat often, interest payment transactions impact at least two parties – if debtors pay less interest then creditors receive less interest. The net impact on money flows going to real flow production depends on which party is more likely to spend the resulting money stock on real flows. You might believe that debtors, by their very nature, would be more likely to spend the "saved" interest money flows, except when you realize that the largest debtor is the US government which is not constrained in its spending like non-currency issuing entities are (ignoring the extremely misguided debt limit). The Federal Reserve returned nearly $89 billion to the Treasury in 2012 (see Chart 10) a large part of which is due to interest paid on government bonds that are now owned by the Fed (reserves at the Fed yield much less than the bonds they replace). These interest expense savings reduced the federal budget deficit and the money flow injections they represent. Overall I believe the Fed’s actions since the financial crisis has helped to increase money flow/real flow transactions, but to a small degree and in a way that may not be beneficial in the long term (more on this later).

Chart 8

Chart 9

Chart 9a

Chart 10

The final actor in the economic cycle – the banks, were initially the main cause of the money flow decreases that created the US economic output gap (i.e. when solvency issues became apparent trust between transacting parties disappeared which resulted in a credit freeze - another paper in itself). Due to rule changes and central bank interventions this source of money flow reduction was quickly addressed, and to a large degree the banking system is now operating in a similar manner as before the crisis (sadly). An example of this is shown in Chart 11 – consumer credit (loans to households excluding housing-backed loans) continues to increase (hopefully creating/sustaining human, physical or technological real assets which will allow for debt repayment). [Note that this does not contradict earlier charts – the increase in this type of debt is simply smaller than the decrease in housing debt]. The banking sector is an integral part of the economic cycle but one which is supposed to facilitate, not drive, money flows around the economic cycle. This is of course only partly true, and there are many very important (and troubling) issues surrounding banks, but for the sake of brevity I will not discuss banking in detail at this point but instead focus on bank controlled factors that are contributing to or ameliorating the current output gap.

If you have made it through my last few blog posts you understand that bank lending is constrained by bank capital (shareholder equity) – so the first question must be – is this constraint currently binding? [Note – if you still don’t believe this read the following: http://rwer.wordpress.com/2012/01/26/central-bankers-were-all-post-keynesians-now/ ] Based on government stress tests almost all banks are adequately capitalized and able to issue new loans. This is partly due to continued bank profitability and optimistically valued (or hidden) assets (i.e. asset held off balance sheet or valued based on book value, not market values, due to the partial removal of mark-to-market rules). Lower interest rates (which are set by the Federal Reserve exogenously) impacts the demand for loans but generally does not impact the profitability of loans since this is just a function of the spread between lending rates and funding rates (i.e. yield on asset side of the balance sheet vs. the cost of the liability side of the balance sheet), assuming of course that banks have properly hedged/matched the duration of their assets vs. liabilities. Treasury bond purchases by the Federal Reserve do not increase lending directly (the “money multiplier” is a myth) but they do increase bank profits since the resulting expansion of bank balance sheets (bonds are transformed to bank deposits and reserves at the Fed) creates another spread (with virtually no risk weighted capital requirements) which banks can collect (i.e. rate paid to depositors is less than the rate received from reserves). Mortgage backed security purchases by the Fed is potentially even more profitable for the banks as unlike Treasury purchases MBS securities contain credit risk – did the Fed pay too much for the MBS’s (money flow spent > money flow ultimately received)? Did the Fed buy the junk that the banks do not want to hold? Regardless of the effect on profitability the off-loading of MBS’s to the Fed does increase bank’s lending capacity as it reduced their capital requirements (which are based on risk weighted assets). This effect somewhat offsets new rules which are increasing bank capital requirements (to help prevent future bailouts). From a flow of funds perspective this is a good thing as increasing bank capital requires money which could otherwise flow through the economic cycle (bank capital is essentially bank savings (a stock), and like all savings represents a leakage to the economic cycle flow). The total collapse of the securitization market does negatively impact bank capital as it would require banks to own more risky assets, such as home mortgages. However, the GSE’s (e.g. Freddie and Fannie) continue to lessen this impact by insuring, or outright owning, most mortgages issued today. Lastly, we should remember that bank profits are like business profits in that they do not necessarily slow the economic cycle flow as long as they are returned to their owners (although they can still impact flows through their distributional ramifications – more on this later). Retained earnings on the other hand does slow money flows as they represent savings which add to money stocks (note that bank balance sheets are like business balance sheets in that they are linked with their owners, so bank dividends do not change net worth). So to conclude I believe that banks themselves are not a major, direct driver of the current output gap.

 Chart 11

Now that we have detailed how the actors in the economic cycle have contributed to the current output gap we can begin to identify ways in which the output gap can be eliminated. This process will be the focus of my next blog post and will involve less aggregated data which will provide a better understanding of why each sector is acting in the way which we have identified above. To preview an issue which will feature prominently in this discussion, I quote a former Federal Reserve Chairman (from 1934-1948) Marriner Eccles:

“We could do business on the basis of any dollar value as long as we have a reasonable balance between the value of all goods and services if it were not for the debt structure. The debt structure has obtained its present astronomical proportions due to an unbalanced distribution of wealth production as measured in buying power during our years of prosperity. Too much of the product of labor was diverted into capital goods, and as a result what seemed to be our prosperity was maintained on a basis of abnormal credit both at home and abroad. The time came when we seemed to reach a point of saturation in the credit structure where, generally speaking, additional credit was no longer available, with the result that debtors were forced to curtail their consumption in an effort to create a margin to apply on the reduction of debts. This naturally reduced the demand for goods of all kinds, bringing about what appeared to be overproduction, but what in reality was underconsumption measured in terms of the real world and not the money world. This naturally brought about a falling in prices and unemployment. Unemployment further decreased the consumption of goods, which further increased unemployment, thus bringing about a continuing decline in prices. Earnings began to disappear, requiring economies of all kinds – decreases in wages, salaries, and time of those employed.

…..

It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they can not save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying. It is for the interests of the well to do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.”

http://londonbanker.blogspot.com/2011/09/testimony-of-marriner-eccles-to.html

However, my recommendations will not simply entail money flow redistribution. As I have discussed previously, the level and efficiency of real stock utilization (current standard of living) and the rate and wisdom of real stock production (future standard of living) is a function of current money flows, expectations of future money flows and the institutional structure and functioning of markets (which equate money flows with real flows via value judgments). My policy recommendations will therefore address all of these factors – simple recommendations such as more progressive taxes (which shift money flows to the less wealthy) or a workfare program (like the MMT job guarantee proposal) can potentially address the output gap issue, but by treating the symptom instead of the underlying cause.

Stock – Flow Consistent Economics (Post Keynesian Economics)

 

Every transaction has both a seller and a buyer, or more generally, there are at least two sides to every market transaction. This indisputable fact, although extremely general and abstract, is one of the only true economic laws but one which is often forgotten. One reason why this fact is often overlooked is that its ramifications are most easily seen in the world of accounting – transactions are measured via income statements which lead to changes in balance sheets. Every transaction creates at least 4 accounting entries (two for each party). Accounting relations, in themselves, say little about what caused things to happen or reveal much about key economic variables like relative scarcity or utility, but they quantify a true constraint that exists in our market economy and provide a pseudo scientific framework with which to study economies. This methodology, stock-flow consistent macroeconomic modeling, has been developed by multiple Post-Keynesian economists such as Wynne Godley and Mark Lavoie¹.

To help visualize the accounting quantified economic system I will use the flow of a river to represent the flow of purchasing power (money) between buyer and seller. These flows of dollars occur at a certain rate (i.e. $/year) corresponding to the market determined exchange for “real” goods, services and assets. As time passes these transactional flows (recorded on income statements) lead to stocks (recorded on balance sheets) just like how a river fills or drains a lake. Below is a diagram that details all of the major flows in the US economy. Stocks of money and stocks of real assets are not shown but should be thought of as being “lakes” of potential flows attached to each actor in the cycle. The blue lines represent money flows between transacting parties while the green lines represent real good/service/asset flows. The diagram is circular because the US$ system is “closed” (no external in/out flow of US$) and since every buyer has a seller.

A few things to note about the Economic cycle diagram:

-        The income of households equals the total amount of money that flowed to them during the period and this amount equals the amount they spent plus/minus net money flow additions or subtractions completed by others in the cycle.

-        The flow of income during the year is decreased when an individual in the cycle decides not to transact but to accumulate the money flow in their stocks (increase their balance sheet assets (e.g. bank deposits) or “lake” of money). The flow of income increases when an individual chooses to spend (transact) a portion of their stored money flows (e.g. decrease their bank deposits). The only way the economy grows (nominally) is via increases in debt (money creation) or the spending of savings.

-        Money is created by the government and banks. After being created (via 2 accounting entries – loan & bank deposit) every dollar flows from one money stock to another until it moves back to a bank or the government which chooses to destroy the money by cancelling it against an equally valued monetary liability (like outstanding debt or a bank deposit) on its balance sheet. For every dollar that exists there is a liability (debt) of the same amount.

-        The speed at which money flows around the economic cycle is called the “velocity of money”. The number of times an average dollar flows around the cycle in a given period equals the Keynesian “money multiplier”.

-        Inflation (price increases) is when the flow of real goods/services/assets transacted slows relative to the money flows given in exchange. Deflation occurs from the opposite real flow/money flow rate change.

-        Investment spending creates savings (not the other way around) since the process of investment entails money flows from businesses to households (to obtain/construct the “real” assets) but does not involve any money flows from households to businesses (meaning households now have savings). In an ideal world the real asset created will provide real flows that will be valued in money flows that equal the stock of money saved (hence helping to maintain money/real flow balance in aggregate over time)

-        Most real output flows, like haircuts and healthcare, cannot be saved for future use because they are time specific flows. This fact is the major impediment to maintaining real flow / money flow balance. “Too many dollars chasing too few goods & services” is easier to avoid when you can fully adjust both sides of the equation using “buffer” pools of stored flows.

-        Stocks of real assets, with their ability to produce goods and service flows, is what ultimately defines the country’s potential standard of living now and in the future. The other key to living standards is the distribution of these real flows.

-        Distribution of real stocks and money stocks between households is of critical importance but which is not readily observable using high-level stock-flow consistent economic flow charts or sectoral balance equations. Distribution issues can be elucidated using more micro focused stock-flow consistent analyses and assumptions.

Diagram 1 – Circular Economic Flow

 

The relations illustrated in the economic flow chart above can also be expressed using the following tautology (equation that is true by definition):

Spending ($ Uses) = Income ($ Sources)

C + S + T = C + I + G + (X – M)

The spending variables (C, S and T) are shown in three arrows flowing out of the Households box – C – representing consumption (expenditures to businesses), S – representing savings (money flows with banks) and T – representing taxes (money flows to government).

The income variables (C, I, G and (X-M) are combined together in the money flow from businesses and the government to households but which flowed initially from the expenditures from households plus money created/destroyed by banks plus the net inflow or outflow of money associated with foreign trade (X – M, exports – imports) plus money flows created/destroyed by the government.

The above relation can be rearranged into “sectoral balances” as follows:

(S – I) = (G – T) + (X – M)              

The three groupings are called the private sector (businesses and households, in blue), the government sector (in red) and the foreign sector (capital account, in green). Below are the sectoral balances since 1952:

The sector balances and national accounting relations discussed above come from the transactions that define our market economy. To get a better understanding of these transactions we will now discuss each stock, flow and sector in the economic cycle. Note that I will also include other insights from Post Keynesian economic theory².

Money

Money is usually defined as having three characteristics – 1) a medium of exchange (the flow ability of money – the ability to exchange for real flows), 2) a unit of account (a stock and flow characteristic of money – the unit by which money stocks and flows are measured) and 3) a store of value (a stock characteristic of money – the ability of money stocks to retain value over time). This definition of money is appropriate for the accounting based economic framework that we are using. However, it is important to understand that all of these elements are required for something to be considered money. For example, accounts receivable is a financial asset that was created as a result of a real flow, yet this financial asset is not readily exchanged for additional real flows and thus cannot be considered money. Throughout this paper I use the term money to refer to items such as physical currency, bank deposits (including savings/checking/CD’s etc.), reserves and Treasury bills/bonds. The last item is included due to the ease by which Treasuries can be exchanged for cash and the debtor’s ability to pay (i.e. risk free). I will assume that all financial assets not backed by a bank or the government cannot function as a money flow. I will ignore such items.

Debt

As mentioned previously fiat money (as opposed to gold backed money) is always accounted for as an asset to the holder and a liability to the issuer. This fact is true for both bank issued and government issued money (in the case of physical cash the liability of the government is to provide a new bill in exchange for the old bill). The mirror image of the money stock is the debt stock – for every dollar in existence there is an equal amount of nominal debt (private + public) – this is the essence of a credit based economic system. The accounting reality of money adds another element to the money “river” that flows around the economic cycle. Specifically, debt can be thought of as a stock of soil which can consume “lakes” of money (think of filling a lake with dirt – the water is absorbed by the dirt and in the end the lake no longer exists). Similarly, the act of digging up a pile of dirt (debt) provides an equal volume (amount) of water (money) [again, money = debt, so the size of the money “lake” = size of the debt dirt pile].

Debt is critically important to businesses and households because it provides them money to spend which otherwise they would not have. Debt growth adds to money stocks and in doing so usually increases money flows (economic activity increased) while debt contraction usually subtracts from money flows (economic activity decreased). Of course the cost of debt is that it needs to be paid back, with interest, to the issuer. It is therefore critical that money flows facilitated by debt provide the user an opportunity to pay it back, by say providing a real asset which can generate money flows in excess of the debt or by providing the individual a means to survive while money stocks are accumulated (saved) to repay the debt (destroying the money in the process). This fundamental requirement of debt is a key weakness of our market economy since the misguided use of debt can result in financial ruin of both the non-government creditor and debtor (e.g. the housing bubble). Furthermore, the fact that debt is fixed (nominal amount unchanged by inflation/deflation) economic recommendations that require deflation in wages is problematic as this would make debt repayment or servicing harder. Inflation on the other hand lowers the burden of debt stocks and lowers the value of saved money stocks – inflation is not bad for everyone. Money stocks are a form of insurance since they can provide real flows when needed – the price of this insurance is inflation.

US Federal Government

The US federal government (Fed + Treasury) has unlimited money creation abilities (via “keystrokes”) and unlimited money destruction abilities using taxes. Government spending occurs to provide real flows to the household sector (e.g. roads to drive on) or money flows to the household sector (e.g. Social Security). Government taxes to remove money stocks from the players in the economic cycle, primarily because if they did not inflation would occur as government created money moves from stock to stock via spending transactions. The specific spending /taxing balance chosen is politics but always quantified in terms of a net spending flow with the private sector overall – either creating or destroying money stocks. Government deficits (public net financial liabilities) lead to an equal amount of private sector saving (private net financial assets) because again there are two sides to every transaction. Government surpluses reduce private sector savings (way to go Bill Clinton!).

I have discussed the operational role of the Federal Reserve and Treasury in an earlier paper (titled “US Monetary System & Deficits”), so I will not go through it again beyond a few simple statements of fact. All transactions between banks occur on the books of the Federal Reserve which maintains the inter-bank clearing/settlement system. This system processes more than a trillion dollars’ worth of transactions EVERY DAY and as such the overall objective of the system is to ensure all transactions settle and that the system does not come to a crashing halt. The Federal Reserve’s unlimited money creation ability ensures that this system will never fail and that interest rates (both short and long) are always under its control (although the Fed usually focuses on just short term rates). In fact, contrary to common knowledge, deficit spending (money creation) by the government actually decreases interest rates due to the nature of the corridor system usually employed by the Fed (excess reserves results in overnight interest rates falling to whatever interest rate the Fed provides on reserves, while insufficient reserves results in overnight rates rising to whatever interest rate the Fed charges on overnight loans). The current policy of paying interest on reserves makes the “corridor” much smaller (approaching a single point), assuming reserves continue to be well above the level required by law. Payment of government debt simply involves the transfer of money from savings accounts at the Fed (government bonds) to checking accounts at the Fed (reserves). Since the Federal Reserve is prohibited from buying debt directly from Treasury a system of primary dealers (usually large banks) have been established that buy Treasury securities. Since the Federal Reserve targets interest rates and can buy unlimited amounts of government bonds in the secondary market (unlike in the Eurozone) the risk to Primary Dealers is basically zero. This arrangement is great for the primary dealers since the process provides them with a spread (difference between buy & sell prices) basically risk free, but this obfuscation makes it appear that the government depends on private sector money creation. While it might appear that primary dealers do in fact buy the debt it is critical to note that the moment Treasury moves the resulting bank deposit back to its main account at the Federal Reserve the Primary Dealer would be short of reserves (assuming they had none previously) and so would have to sell the previously purchased bond to the Federal Reserve – taking the Primary Dealer out of the picture. Of course when Treasury spends the funds “procured” from the bond sale the banking system would have the reserves to buy back the bond from the Federal Reserve. Again, two points are key to understanding the process – only the Federal Reserve creates the balances on its books, and balances on the Fed’s books can only be destroyed by transforming them into physical currency or into Treasury securities – they can’t be “lent” to businesses or individuals (who do not have accounts with the Fed).

Banks

Banks, in our fiat currency system, are licensed by the government to create money by making loans. However, money creation by banks is limited in numerous ways, most importantly via the fact that banks must remain solvent (positive shareholder equity on their balance sheets). Solvency requirements do not limit bank’s money creation per se, but the more money that banks issue via loans the greater the chances that some of these loans will go bad which could consume existing  shareholder equity and force the bank into bankruptcy. A bank levered up 30 to 1 (loans to shareholder equity) only needs a 3.4% loss on their loans to become insolvent. This reality has led to regulation of banks (Basel rules, leverage limits, etc.), which unfortunately have been slowly relaxed over the last few decades. Government provided deposit insurance (on most deposits) ensures that the risk of default does not discourage depositors from trusting the bank with their money. Banks make money via the spread between the cost of funding their liabilities (e.g. interest on deposits, interest on loans from investors and the Federal Reserve, etc.) versus the yield from their assets (e.g. interest from loans, interest from deposits at the Fed, capital gains from trading, etc.).

Foreign Sector

The foreign sector’s spending flows are similar to the domestic private sector’s flows - money flows can grow or shrink based on saving/borrowing desires and real goods flow in the opposite direction. One potential difference is that foreigners often need to exchange foreign currency for US$ (because of course they cannot create US$). This process of exchanging foreign money flows into US$ flows used to involve governments when the conversion rate was fixed (e.g. gold standard) but nowadays, in our fiat, non-convertible currency system, the process of exchange represents a key step in equalizing the real flow/foreign money ratio with the real flow/US$ ratio. [Note: A floating currency value has other benefits including interest rate flexibility (don’t need to be as concerned about how interest rate changes will affect currency exchange values)]. Another obvious difference with the foreign sector is that real flows to it are a loss to the country as any derived benefit/utility goes to the foreign country buyers. Imports divided by exports (both in real terms) equals the countries terms of trade and the short term welfare of the country is best when this ratio is the highest. Over the long term this ratio is also a key indicator of US welfare, but an indicator which is not clearly apparent at any point in time as stocks of money and exchange rate movements can change the ratio over time (e.g. the US has given Japan “less” real flows than they have given us, although Japan’s stocks of $USD relative to US holdings of Japanese currency (Yen), suggest that this ratio will change in the future). I believe Japan/China etc. will spend their $USD money stocks one day and thus I consider foreign holdings of $USD as a debt of the US which will be paid using real flows at some point (net of US holdings of foreign currencies, which equals approximately $5 trillion at the moment).

Business Sector

The business sector represents firms of all types (e.g. Incorporated firms, LLC, employee owned, etc) and their function is straightforward – they purchase labor and materials from households using money (from saved money stocks or borrowed from banks) which they use to produce real flows which they sell back to the household sector, the government sector or the foreign sector. For simplicity purchases to/from other firms are netted out (ignored). Owners of the business have a claim on all net assets of the firm – household’s balance sheets are therefore linked with business balance sheets (shareholder equity is a “liability” of the firm and an asset of households). Further, asset value above the amount reflected in shareholder equity can be reflected in multiple ways (e.g. implied or actual market value of equity), but in all cases the accounting representation shows that the net worth of all businesses are owed to their owners (so for listed firms p_stock*shares of stock = the liability of the firm and assets of the households). Dividends for example produce two sets of accounting entries with households – one representing the money flow and another reflecting the decrease in the firm’s net asset value (which together net to zero on both balance sheets). Just like the household sector, the balance sheets of businesses reflect both real assets and financial/money assets.

Households (and non-currency issuing governments)

The money flows to business in exchange for real flows (goods and services) is, as stated before, the key to our current material standard of living. The specific goods and services flowing, and the corresponding money flows depend on numerous factors including individual preferences, consumer budgets (money flow and money stock based constraints) and real resource constraints (due to current and past real flows to businesses, the current level of technology, etc.). Trade between households is assumed to equal zero since all good and service production is assigned to firms (so one can think of a sole proprietor as being both a business and a household).

Real Asset Stocks

Real assets are anything you can touch (the physical world) and some things that you can’t touch (e.g. technology patents, human ability, etc.). The defining feature of real assets is that they can produce real flows which someone values (and hence can be exchanged for money flows). The creation and use of real assets is what a market economy is all about – and a function which it does better than any other economic structure. This is not to say that markets are perfect (they’re not) or that governments can’t improve market outcomes (they can) but that the default structure of an economic system should involve markets for their ability to communicate value judgments. With that said I believe that humans are not always rational and are susceptible to logical issues such as herd mentality (doing something because everyone else is doing it) and loss aversion (people's tendency to strongly prefer avoiding losses to acquiring gains). These quirks in the human psyche, in addition to genuine uncertainty, can lead to the production of real assets that cost more than the real flows that they can produce (e.g. the housing bubble). However, for the purposes of stock-flow consistent modeling we assume that market prices do reflect intrinsic value and therefore use these prices to value real assets on balance sheets. If real asset market prices change during the accounting period then there will be an adjusting accounting entry that changes the asset value on one side of the balance sheet and equity (net worth) on the other. Since this valuation change did not involve a monetary transaction such entries do not appear in the economic circular flow described herein.

Asset Swaps versus Asset Production

When someone buys an existing asset such as a house, or buys claims on existing assets such as stock in a company this purchase is just an asset (stock) swap – money in exchange for a real/financial asset. Such transactions do not represent income (top arrow “salaries & profit” on flow chart) since there was no real flow produced which necessitates salary/profit payments to households. The money flow occurs on the left hand side of the cycle (or between individuals in the household sector) exclusively, (net worth implications depend on the paid price relative to the valuation currently used on the balance sheet). Lastly, since the transaction changes who owns which asset there are potential secondary flow impacts (e.g. the person now with the money stock is more/less likely to spend it).

Interest Money Flows

A fundamental stress within a credit based economic system is that of interest expense – interest is due to banks based on loans provided, yet no money is created to pay this interest (unlike the loan principal itself which creates an equal amount of money stocks in the “loan creates deposits” process). This is a stress for the system as a whole since interest payments are a money flow (time specific) that need to come from existing money stocks (unless banks loan (create) money to pay the interest). This is not necessarily a constraint since money stocks are much larger than flows, making such repayments feasible – although actual payment of the interest requires the right people obtaining the money stocks (else we have loan defaults). The ramifications of interest expense on aggregate demand (money flows) is uncertain as it depends on the marginal propensity to spend out of current income of creditors relative to debtors (i.e. will the bank or individual receiving the interest payment spend it or save it).

Stock Flow Consistent Economic Cycle Conclusions 

The accounting derived relations detailed above always hold in properly functioning market based economic systems (e.g. we’re assuming barter transactions and unpaid production is insignificant and that a legal system is in place to ensure no money counterfeiting, etc.). It is a shame that the economic profession does not often recognize this reality and as a result posits macroeconomic theories that are mathematically impossible. Further, by not recognizing the stock-flow dynamics of our economy they miss many important insights (like how stocks influence flows) and again posit forecasts that have unrealistic or impossible results. We would be much better off if every macroeconomic policy forecast was verified to satisfy the accounting constraints detailed thus far – if we’re going to use math to represent economies we better make sure that everything adds up!!

Below is a simple example of a transactions flow matrix, which is the format by which stock flow models are represented. Note that all rows sum to zero (buyer/seller - closed system requirement) and that +ve values are the use of funds and –ve values are the source of funds. Everything comes from somewhere and every transaction has two sides – there is no black holes. The top half of the transaction flow matrix is basically a summation of all income statements, while the bottom half shows the balance sheet implications. There is another matrix that shows how income statement changes flow into ending period balance sheets (this matrix shows that every row totals zero except for real assets).

 

Utilizing the Stock-Flow Consistent Framework

The stock-flow consistent, accounting based framework discussed thus far provides many insights into our economic system. However, in order to develop more detailed economic forecasts and policy we need to leverage this framework by the use of additional economic data, theories and assumptions. For the sake of brevity I will not go through all of these details except for a few key points regarding micro-macro relations, market structure and behavioral assumptions. If you want to obtain further details about stock-flow models I urge you to read the book by Godley and Lavoie¹ or search for similar writings by other Post Keynesian economists (as referenced²).

Macroeconomics was separated into a distinct discipline from microeconomics in part because of the articulation of two fallacies – the fallacy of Composition and the fallacy of Division. The fallacies of Composition & Division simply point out that: 1) inferences regarding macroeconomic topics using microeconomic data can be problematic (fallacy of composition) and 2) inferences regarding microeconomic topics using macroeconomic data can be problematic (fallacy of division). It is important to remember these warnings when thinking about the issues discussed above – for example - even though the Household sector might be saving overall there is in fact a very diverse distribution of savings levels amongst households (some are spending way more than they are earning, etc.). This does not diminish the validity of the stock-flow consistent framework discussed, but it does limit the insights that can be obtained from the framework itself without additional data or assumptions. To minimize the degree to which assumptions are necessary stock flow consistent modelers often go into more detail than I have discussed in this paper (e.g. by splitting households into groups based on income, etc.). Lastly, it is important to note that neoclassical (mainstream) economists have somewhat blurred the distinction between macro and micro by use of their “micro-founded” dynamic stochastic general equilibrium (DSGE) models which contain elegant math but at the cost of a huge number of highly questionable assumptions and utter disregard of money and debt (yes, the most “advanced” DSGE macroeconomic models do not contain money or debt!!).

The main assumptions underlying the almost religious belief of some that “free markets” yield pareto optimal outcomes (no one can do better without harming someone else) are as follows: rationality, no market power (firms are price takers), symmetric/”near perfect” information and no positive/negative externalities (all costs/benefits internalized - all costs/benefits accounted for in the market price). I contend that very few markets actually satisfy these assumptions and that some, such as health care, deviate greatly from each of these assumptions – producing the potential for asset misallocation and suboptimal outcomes in the short and long term. For example, my education and experience in business has shown me that businesses try to avoid markets that function like a “free market” and instead differentiate their offerings (or utilize existing laws and regulations) to obtain some degree of market power which allows them to be a price setter and not a price taker. However, even if the optimal free market assumptions do hold the outcome obtained is dependent upon the initial allocation of resources – if the allocation of resources is skewed, due to fraud or inheritance for example, then the free market will not correct this but simply optimize outcomes from this starting point. So in conclusion, understanding the true nature of markets leads me to conclude that models which depend on Pareto optimal “free markets” are wrong and that government involvement in private markets can improve the utility (general well-being / happiness) of the population.

Economics biggest weakness, in my opinion, is its simplified behavioral assumptions. This fault is being addressed by the growing field of behavioral economics, but in the meantime this Achilles heel is something every economist must be concerned about. I mention this here because in order to predict future economic outcomes or fully explain current transactions we need behavioral assumptions. Thankfully, this behavioral assumption need is somewhat diminished in stock-flow consistent models relative to “micro-founded” neoclassical models since the former utilizes more facts (e.g. balance sheet composition of the players and closed system dynamics) that help explain and constrain behaviors. One of the most important behavioral assumptions needed in all macroeconomic models involves the formation and utilization of expectations due to their undeniable impact on investment and other decisions that influence real or nominal stocks (which span periods by definition). However, most post Keynesians, including myself, believe that assumptions regarding expectations are often misguided. Specifically, I believe that:

1)                      Folks do not analyze decisions like economists do (i.e. over analyze) and thus that much economic decision making is done without much analysis or quantification of outcome probabilities. This was clearly articulately by Keynes in 1936 – “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities”.

2)                      Even if individuals attempted to develop “rational” expectations based on all available information (a huge “if”) their ability to complete this endeavor is highly unlikely given the number of factors that would need to be accounted for. Further, post-Keynesians contend that the future cannot even be characterized using probability distributions since future outcomes are truly uncertain which by definition cannot be represented by probability distributions. Given these difficulties many individuals simply look to the immediate past or to other’s behavior to inform them regarding the uncertain future – and this can lead to problems (e.g. dot com boom and housing bubble).

3)                      Individuals often do not have the ability to act upon their expectations due to financial constraints and/or market power constraints (e.g. inability to secure salary increases).

 

It is for all of these reasons that I discount any argument that relies heavily on expectations. Again, I am not saying that individuals are not usually rational (or “bounded rational”) but that the assumption that they are always rational is clearly wrong and to such a degree that macroeconomic models assuming such behavior at its core (neoclassical economics) produce unrealistic economic forecasts and policy guidance (post Keynesians were the only economic school of thought that predicted the financial crisis (Austrian economists were a close second, but their forecasted mechanism was wrong). The following are two specific examples where I believe rational expectations is incorrect.

Ricardian equivalence is an expectations based behavioral assumption. This theory boils down to the following: deficit spending cannot increase aggregate demand since individuals will expect the deficits to create higher taxes in the future and thus will immediately increase savings (AD down) to pay for these future taxes. I have never met anyone who behaves in this manner and there is amply empirical evidence dispelling it, yet it remains a stick that some fiscal conservatives use to attack Keynesian policy recommendations (that involve deficit spending).

Assumptions regarding inflation expectations are particularly problematic since they are thought to be often self-fulfilling. However, the current situation in the US and the last 20 years in Japan have clearly shown that inflation cannot simply be wished (or “printed”) into existence but instead require action (i.e. money flow / spending increases) or market changes which create real flow changes (e.g. oil supply changes, market power changes, labor market changes, etc.) to come about. Heck, people don’t know who Ben Bernanke is let alone what his committee is forecasting regarding inflation. Most businesses cannot raise prices because they expect future inflation increases (many cannot raise prices even if costs actually increase!). Inflation in financial markets or asset markets are much more likely, yet such effects are also less enduring since ultimately they need to be validated by the real flows such assets produce (e.g. housing and dot com bubbles produced temporary inflation in these areas).

 

US Current Economic Conditions

My next paper will discuss current economic realities and potential economic policies to improve them.

 

 
 

 

¹ Godley, W. and Lavoie, M. 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production, and Wealth. Basingstoke: Palgrave Macmillan.

² Insights have been provided by numerous Post Keynesian  economists or Post Keynesian friends including: Warren Mosler, Cullen Roche (Monetary Realism), Scott Fullwiler (New Economic Perspectives), Bill Mitchell, Dean Baker, Steve Keen, Steve Randy Waldman, Ramanan, Mike Norman (MNE), Marriner Eccles (best Fed chairman ever), Real World Economics blog and many others both past and present – I’m standing on many shoulders.