Reasonable Explanations to Some of Those Difficult Questions Concerning National Economy

To improve our understanding of money creation and state borrowing let’s tell a little story about a  small island society.

Originally there was a small number of people, 20 in total, men and women. They were castaways who landed up on an island in the south sea. For tens of years they had no contacts with outside world. The island had ample resources: There were coconut palms and plenty of fish. The original  population multiplied so that after a couple of generations they were more than hundred.

One problem they faced was lack of money. The original people had around 100 coins with them and that was all the money in circulation. The value of that money had grown much. In some years just a couple of transactions involving money were done. People hated to part with their money as they knew in the future it is valued more.

The islanders had created a council to govern them. It had ten members who were elected for a term of two years. Sometimes the council organized efforts based on voluntary participation to do public work, say to erect a public meeting hall. Anyway there was need for more work, like building schools or bridges. On the other hand people had lot of spare time but were unwilling to use much of it for public work if it would not encompass whole population.

In this case the council came up with a highly innovative solution. One of the members had become a master in carving shells. They proposed to introduce new money made out of a specific type of shell with clever and elaborate carvings. The value of such shell would be 1/100 of the value of coin. They would initially be used to pay for public works but were intended to go for any payments. In the future they would stop issuing that money and instead collect some back as taxes. At that time everybody should have found a way to earn his or her own shell money. The old coin money was going, too, but due to its scarcity and high value would seldom be used.

The new plan was accepted. It permitted the construction of a quay and bulwark to help the safety of fishing rafts. A new town hall was build and used for public occasions like dancing parties.

The public works were not the only ones to benefit. When money become freely available it permitted establishing trade and commerce. Now it was more sensible for specific persons to specialize in certain handicrafts. Coupled with the availability of ample amounts of only partially employed people this permitted a significant improvement of the material conditions of inhabitants.

End of story, Now with this excellent economic model in place let’s tackle some of the more difficult macroeconomic questions:

From where did the new wealth come: Was it from the money, from the guy carving the shells? No, obviously not. No doubt he was due to have a reasonable compensation for his labors but the actual increase in general livelihood came from the additional useful work performed by all inhabitants. New wealth was possible because of better management of macroeconomic arrangements: Proper amount of liquidity and broader distribution of work and incomes.

Is the whole scheme some kind of cheating? To use inherently worthless items to pay for real services? No, it’s fair. The whole point in having the concept of money is to have a broadly usable measure for the value of goods and services. It provides a technical means of payment. As long as counterfeiting can be avoided those shells are proper representatives of actual value. They act as tokens of value the same way as play marks in a casino act as tokens for normal money. No part in the process of introducing or using that money is unfair in any way but reasonable and fair. The money people receive for their labor has adequate value for making purchases. The additional utility from more public works goes to benefit the majority of population as intended.

Is it fair to initially use the money to pay for state expenses? Yes. The state has a basic requirement to provide services and facilities that are useful to the members of society. Another thing is that the amount of money in circulation most of time has to increase. To combine those two is fair as it’s useful and does no harm to anybody. The alternative way to do it via separate money creation, tax collection and balanced state budgets will not provide any advantages in this situation.

Likely there is some optimum amount of money in circulation. How to define that? It seems to be mostly empirical and depends on various patterns of money usage. The start of significant inflation is a limiting sign. General situation in the society must be taken into consideration if it’s very special, say major catastrophes.

Another approach to the story is to observe that the society has suffered from some kind of hidden lack of demand. A normal money based society may experience stress during a crises, either external or one created from the internal imbalances in the economic structures. This causes nearly all companies to start saving. As part of that they stop recruiting and initiate layoffs. That causes many private citizens to concentrate on loan repayments instead of taking new loans. Both reduced economic activity and increased unemployment cause state finances to land in deficits. This may bring about misguided requests for the state to save ‘as everybody else must look for savings’. The request may be accompanied with a claim that striving for balanced budgets will improve confidence and bring about positive outcomes. A situation where everybody concentrates on loan repayments and piling up cash implies reduced demand for goods and services. Lack of demand will intensify the negative spiral and call for more savings in the whole economic spectrum. This leads to recession or depression. Actually it seems that this is not only a causal consequence but they are just other names for a situation where everybody is saving at the same time.

The previous is not in any way a new invention but has log roots. In 1830’s the French businessman Jean Babtiste Say was wondering how can it be that there are depressions when all people attempt to provide such services and merchandise which has real demand. Brad de Long quotes John Stuart Mill from 1844 as the first solution to Say’s problem as follows: “Money, consequently, was in request, and all other commodities were in comparative disrepute. .. money must itself be considered as a commodity”. That’s a clever way of describing the situation. To make the argument easier to understand it may, however, be generally better to present the solution without such extended meanings of words. For more discussion see Famas Fallacy and Says Law Yet Once Again

The solution presented by J.M.Keynes in 1936 was more elaborate. To describe various aspects of the situation he used such terms as missing propensity to consume, liquidity preference or hoarding of money. Unfortunately none of those are part of everyday vocabulary. No person, company or state treasury while paying debts and cutting expenses admits they are hoarding money. The actual problem is lack of demand and an alternative is to talk of too much savings.

To describe the stand of Keynes, not in his own words, but Steve Kangas’

“..times become tougher when everyone starts hoarding money: Depression, Keynes believed, is an especially severe recession in which people hoard money no matter how much the central bank tries to expand the money supply. People hoard money in difficult times, but times become more difficult when people hoard money. Depressions were recessions that had fallen into a “liquidity trap”. A liquidity trap is when people hoard money and refuse to spend no matter how much the government tries to expand the money supply. In these dire circumstances, Keynes believed that the government should do what individuals were not, namely, spend.”

The above note is important as many economists in the real business cycle school, among current German economists and elsewhere have actively defended misleading opposite claims under term of Say’s Law. It comes up in two forms: That there can’t exist such things as economic depressions and if those still were then it would be impossible to reduce unemployment with state spending. To be more precise the monetarist theory first claimed that depressions can be cured with central bank policy alone without expanding state deficits. The Real Business Cycle school has sharpened the claim by maintaining that depressions may not occur. None of those claims has been able to stand the test of practical experience. As an excuse for the non-functioning of theory the RBC schoolers have offered the theory of excessive rigidity of labor markets. Attempts to achieve correction that way have produced totally inadequate improvements. The anti-Keynesian claims from Germany are surprising as most people there are well aware that Adolf Hitler was very successful in eliminating unemployment by means that did not include balanced budgets.

The terminological mess is actually quite bad. Keynes and his followers were well aware of the imprecise meaning of the word “savings” when used in connection of Gross Domestic Product. They didn’t care as it was an established tradition. It is not at all the same as retained earnings. Steve Roth elaborated on this confusion. From Wikipedia we get following formula:

National Savings = Y – C – G = I

Savings S is defined to be equal to money used for investments and claimed to be total earnings minus consumption minus government purchases. That implies that when you bring money to the bank then it is not “savings” outright. If the bank uses the money to provide a loan to somebody for car purchase then it’s consumption. If the loan goes to build a house only then it’s both investment and “savings”. For the islanders in our initial story the newly carved shells will be counted as “savings” and investment. Similarly for new exogenous money generated by the central bank. The same for the endogenous money generated by the financial system. It may become consumption, investment, “savings” or none of them depending on how the money is used. Both “hoarding” and “savings” are inappropriate and misleading words to describe the source of funds for investments in GDP. Our islanders above might be able to reach a Chinese situation where half of national economy is investment. They would do it without any actual savings in the usual meaning of the word. The formula above has two equals signs and neither of them actually holds when words have normal meanings. When talking about excessive amounts of saving activity as the reason for economic depression one should be aware of the mixed background. Both investment and consumption will improve actual demand whereas more actual savings or retained profits is not needed.

Much misunderstanding of national economy starts from the assumption that it is nearly the same as private economy. Accordingly successful businessmen and bankers are assumed to be experts on state finances, too. Likely they are competent in many ways but the crucial difference is that a large national economy is a nearly closed system whereas firms operate in open markets. A company where customers and employees are exactly same persons would be similar to state. Firing of an employee implies firing a customer and there are no other customers.

Would it be better to organize it all the way it’s done in civilized world: One person is nominated to be the central banker. Another is a commercial banker.

The money maker, or the mint, provides the money to the central bank. Then the commercial bank borrows it from there. The commercial bank provides loans to citizens so they can buy various items and make investments. They must earn money with their work or investments so that they can pay the loans back. The central bank may lend money to government, too. That is used for government expenses. Eventually taxes will be collected and the loan will be repaid. Alternatively he loan can be replaced with a new loan.

The above is the method that with some small modifications is followed in all countries of the world. In addition those commercial banks receive deposits and use them as another source for loans. Further on they are able to generate endogenous money by themselves but let’s not talk about that right now.

Doing it in such indirect way is intended to protect the society from the profligacy of irresponsible politicians. They are assumed to be inclined to offer too great benefits to too many groups in the society using too much debt financing to the detriment of productive branches in the real economy Unfortunately the actual result now has been the irresponsible central bankers to bring about too many depressed economic periods. Those assumed professional experts have concentrated in their own expertise and have been much too eager to fight any small or imagined dangers of inflation by raising interest rates to cool down the economy. The worst examples include the European Central Bank raising interest rates in 2010. Millions of persons have been thrown to unemployment without any actual reason. That has ruined their lives.

Such system implies that an increase of national wealth must normally be accompanied by an increase in overall debts, private, public or both. It is structured so that the actual source of money issuance is difficult to see and everywhere assets and liabilities appear to match. In most countries the central bank creates its liabilities against imaginary entities while assets are real. In US this has been brought one step further. The 12 regional banks of the Federal Reserve System borrow the money from the state treasury. Those balance sheets are real. The Treasury has no balance sheet and so there is not a problem.

Oversupply of money will eventually cause inflation. Some amount of that will do little harm. Too much is, however quite bad. A situation where potatoes keep their value better than money distorts greatly any economic planning. Such inflation is grossly unfair for older people who have used tens of years to save enough money for retirement.

How big is the danger of inflation? Well, when capacity limits, either available idle manpower or other limits, approach then increase of money and demand will not increase production but instead will increase prices. For the state to issue new money in such a situation implies that the value of existing money is going to diminish. For most of the time it’s not possible to create wealth by just printing money. That can be seen as hidden tax imposed on holders of money, be it cash or accounts or bonds. It is not inherently bad if there is grave need for those state expenses but it’s a sneaky way of doing the financing. Either skipping such new consumption or collecting the costs directly with taxes would be more honest methods.

Is it possible to achieve full employment at any time? To some extent yes. New sensible jobs can be created using new financing but there are dangers:

  • Issuing too much money will eventually create inflation. At the end of path is a hyperinflation in Weimar or Zimbabwe style. It is not, however, a very near situation. We don’t actually know where the limits are but they are surprisingly far. See Hyperinflation Skeptics
  • Very long lasting easy money in specific parts of the society will cause them to add unnecessary fat and stiffen useless structures. The great turmoil of privatization and deregulation of state institutions and the waves of company takeovers were both reasonable responses to too long lasting sclerosis. Sure they released lots of resources. Unfortunately it was not accompanied with efforts to re-employ those resources in more productive and useful jobs. Having much unused resources partially nullified the potential gains that might have been available to the society as a whole. As we have big lack of resources in health care, education, care of old people end elsewhere we should take measures to fill the voids.

Is there some ‘natural’ distribution between material production and production of services? Is there a ‘natural’ distribution between private enterprise and state? Some thoughts on such questions might be presented based on our simple society. In a bigger, more affluent and more complex society the answers would be different and so possibly it’s not worth the trouble to speculate those questions right now.

I started this writing to understand the moral implications of the approach called Modern Monetary Theory, or MMT. Then there were adjacent concepts that had to be clarified and it carried on a bit further. Important background is in my eralier writing EndogenousMoney.

Many thanks for inspiration, direct or indirect, from numerous persons including Warren Mosler, Steve Roth and others.

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