Basics of Money and Employment


This document attempts to shed light on three basic questions:

  • What is money and what part it plays in the economy (The fun part)
  • Short rehearsal of gross domestic product
  • Causes of unemployment (the pain)


In recent years several former money market dealers in making critical remarks bout the financial sector have claimed that banks are able to create money out of thin air and extend that as credits. Those claims have been largely omitted but not claimed to be wrong. A central part in this document presents detailed trading arrangements to create such endogenous money. We find that if we have a reliable promise of loan repayment and there is one another bank willing to trade with us then we can create the requested money and extend that as loan. This finding has several consequences which are described shortly:

  1. The ability of our bank to increase revenues from loans depends almost exclusively on the ability to find new loan customers and not on available savings.
  2. There seems to be no way to totally circumvent eventual loan repayment. If the lender can’t do that then our bank must shoulder the loss. If we can’t and we go bankrupt then our trading partners must take the hit. Chances of loan renewal depend on the credibility of new repayment promises. Outsiders, like taxpayers and foreign governments may be asked to help. Inflation may be of some use.
  3. Greatly increased loan base is one of the factors enabling large increase of revenues and increased power of the financial sector.
  4. Availability of ample financing for various business takeovers and reorganizations has affected companies in the production side of economy. The reorganizations have likely increased profits and possibly reduced employment.
  5. Pumping extra liquidity to the economy produces increased activity similar to Keynesian stimulus. It is, however, not of cycle attenuating but cycle amplifying type.

These processes have been extensive during boom periods after around 1980 and more occasional in earlier times. The recent phases coincide with the introduction of certificates of deposit CD and many other modern instruments. Some previous periods were based on bonds.

Concerning unemployment we find that the problem is not how to stop the expansion of state part in national economy but how to make the expansion of services, both private and state, to occur in most sensible ways avoiding various pitfalls. The leak of financial resources out from production related economy appears to be a significant problem.

Neo Liberalistic Economics is Dead

After something near 1980 it has been impossible to get approved a masters or doctoral thesis in the economics department of any respectable university in case the text would have been somehow critical to the monetarist and neo-liberalistic thinking.  After 2008 the situation changed. Consider following:

  1. The mainline economists were utterly incapable to see the coming of a major recession. The recognized forecast for the period 2000-2012 was that the great superiority of modern economic knowledge will permit US to extend national wealth by a significant amount. The realized result in many areas was no growth. For some less orthodox observers (Doug Noland of Prudent Bear, Steve Keen) this was obvious long before.
  2. In 1991 the general forecast for old Soviet Union and Eastern Europe was to unleash the production forces held back by communist bureaucracy and over-administrative command economy.  The expectation was to have fast economic and social development. In reality the gross national product of Russia in 1996 was some 60% down from 1990 figures for Soviet Union. Nearly half of that was the result of Ukraine, Baltic countries and others going their way. Anyhow it implied that great poverty not seen for a long time encompassed most of Russian countryside. There are several reasons for this process to happen. Anyhow the theories actually presented and utilized were utterly incapable to predict anything sensible.
  3. The International Monetary Fund (IMF), World Bank and others used to make great pains to guide the economies of developing countries. For some time Argentine was the darling of neo-liberalistic economists. Then after 2002 it became the scapegoat. South-East Asia was considered largely orthodox before the crisis of 1998, then not any more. China has been the great success story for a longer time than anybody remembers. They have done some policies exactly as told by neo-liberalistic thinking but some others totally the other way.
  4. The ‘modern financing theory’ with Modigliani-Miller theorem as its foundation has proved out to be a major catastrophe. It claims that borrowing will not increase financing risk when compared to equity.  That was the thing that Icelandic young managers, like many others, learned in US business schools. The result of that learned experiment was a collapse of the national economy in Iceland. (Yes, that Modigliani is the same person as was one of the founding fathers of European Union)

However, even in 2012 the proponents of neo liberalistic economics still hold the power in universities and in ministries of finance. The theory is clearly invalid but it just lives on as a living dead. The problem is we don’t seem to have or at least not to recognize a better theory that would actually succeed in describing economics of dissimilar countries and predicting their near or middle term development.

The people for whom the neo-liberalistic theory is the only one they know and believe in are very much controlling most important institutions. The worse for those institutions, but life itself has proved the theory to be incorrect anyway. Yes, we truly need a better theory.

To recollect, some of the existing macroeconomic frameworks are:

  1. Keynesian theory was prevalent from 1930’s to 1970’s. It’s now considered obsolete.
  2. Monetarist theory as started by Milton Friedman was prevalent after that. It still rules most of academia and many national departments of finance.
  3. Neo classical, empirical and new consensus theory: While US based organizations like World Bank and International Monetary Fund IMF have forced monetarist thinking on developing countries the US itself has not followed that since 1990’s. Federal Reserve seems to be following empirical economics based on actual financial history. In many cases that is close to Keynesian stimulus ideas but empirical theory is incapable to predict the course of events in situations like present for which there are no clear predecessors. The ‘new consensus’ of 1970’s and neo-Keynesians of 1990’s are pretty close. High level professionals like Paul Krugman or Joseph Stiglitz are capable to deliver serious analysis. In some way it however, seems still to lag in explanatory power.
  4. Several US republican presidents have created their budgets on approaches originated by Ronald Reagan. George Bush the older amply coined the name ‘voodoo economics’ for this ‘deficits won’t matter’ type of economic thinking. Some form of this ‘supply side economics’ is popular among business-minded politicians and economists in many countries, including Finland. There seems to be quite little practical or theoretical evidence of its correctness.  On the surface it’s often presented as monetarism while actually it seems to be lacking a real theory except that it provides legality to limitless greed. A claim has been made it to origin as some kind of mockery of Keynesian ideas.
  5. The classical economic thinking went to grave in early 1930’s. It has re-emerged in US as a loud voiced group calling itself the Austrian Economists or libertarians. Representatives of this group generally refuse to use any formulas or to make any numerical predictions of future developments.

It’s quite obvious that none of the popular theories has been actually successful in predicting future events or recommending efficient policies. In a way this was to be expected. The ruling macro­economics since 1980’s has quite much went back to the laissez faire of 1900. The policy has attempted to minimize any state intervention and any regulation in the belief that to be best for economic growth. In industrialized western countries there actually hasn’t been any policy, so it won’t matter what the theories predict. Actual financial landscape has not been dominated by state policies but by other phenomena. The emergence of modern treasury business after 1970 enabled huge generation of liquidity that is independent of central banks. The extensive development of various derivative types somewhat after that made it possible for the liquidity to totally disappear in a day. On one hand it’s possible for any theory to claim to be the only correct one as the actual use of theories has been very limited. There’s little experience and evidence of active use.

Issuing Money

The word “money” means two separate concepts. One is money as a measure of wealth. It’s customary to measure wealth of people, worth of production equipment or value of intellectual assets in money terms. That’s a very important idea but we are not going to say much on that. Another concept is money as means of payment. That denotes the banknotes, account balances or financial instruments that can be used to make actual payments. It’s a very peculiar concept as on one side it has surprisingly little meaning and on the other side it has consequences far bigger than itself. Keynes called it the “veil of money”. For central banks around the world the amount of money has been important forever. It seems that during last 30 years the only important things for central banks have been inflation rate and amount of money. Let’s provide some details.

A very special factor affecting national economy is the increase or decrease of the amount of money. Creation of new cash money occurs when the central bank grants a loan and the borrowing institution decides to withdraw that in cash. Decrease of money amount occurs when the borrower pays the loan in cash. This is primary money or M0. However the thing is very similar if the borrower won’t withdraw the cash but just uses the credit in the central bank to transfer a payment to another institution. This is current account money or M1. A third case happens when the state, some town, some bank or company decides to issue freely negotiable financial instruments (bond, bill, CD, CP, …) Such an instrument which can be sold to anyone and comes with a promise that the issuer will pay a fixed amount to the current holder on a certain day is a form of secondary money. It’s holder can use it to pay things or change it to the primary money with some current rate. This money in the money markets appears in statistics as M2. For the M0 and M1 money the central bank charges an interest called the seignorage income. That makes the central banking a very profitable business as actually they print the money themselves.  (Note: From Wikipedia on seigniorage: “Seigniorage on bank notes is simply defined as the interest payments received by central banks on the total amount of currency issued”)

Money as means of payment is not the same as wealth or property or capital: Those are the real substance while money is the veil on top of them.  Yes, those more essential things can be measured in money but they are still not the same.  Money is the technical means of exchange in all non-barter trade. It can be one of several things:

  • An intermediary: Somebody has sold an asset or some service and accepts money as a payment to be used for some future purchases. It’s not necessary to buy and sell some tangible things in one operation as in barter trading.
  • A promise: The issuer of some kind of money promises redemption in terms of some other, more generally approved type of money.
  • A temporary store for wealth
  • Money is the lubricating crease of economy, it’s not the wheels.

The amounts of secondary money can increase very much during a bull market. See writings by Steve Keen. Some features of ‘secondary money’:

  • It’s able to increase liquidity: Say, our bank A issues CD’s worth of 100 m$ and bank B buys them. Then bank B issues 100 m$ of CD’s and we buy them.  After that our bank has all the same money we had in the beginning and additionally the securities of 100 m$ value. They can be sold freely to buy something or to get some other kind of money. Let’s call this the method of mutual placements
  • Similarly when our bank receives a deposit of 1 m$ in cash and then uses that to grant a loan to another customer then both the total means-of-payment and liquidity increase.  The same cash is circulating in the economy and additionally the depositor has a bank account available for payments.
  • Yes, the amount of equity in our bank limits how much we can extend our balance sheet. Government requirement may be for 8% of balance sheet to be own capital. The previous items can’t be repeated too much. Let’s do it better: We buy some new shares issued by the other bank and they buy some shares issued by us. Now both of us have increased the equity and are able to increase the balance sheet by 12 times that or something. All the cash we needed we got back.
  • Generally any secondary money represents a promise to get money in the future. That promise has full value during a bull market.
  • The credibility of institutions and their economic operations sets one upper limit for the processes described above, often referred as endogenous money creation. That name is actually misleading as the real act is to create liquidity with money as a desired byproduct. It’s that even in a case where the central bank issues banknotes.
  • When a depression hits then that liquidity disappears as nobody really can trusts the banks and companies credibility any more. Anybody can go bankrupt overnight because of some exotic liabilities or off-balance derivatives not known to outsiders. This contraction in liquidity is very painful as it makes it more difficult to find financing even for sound investments, manufacturing and trade. The ‘disappearing of money’ will hit badly the ‘real economy’, responsible for producing tangible goods, as both consuming and investment falter.

A bank has many ways to earn income. Various fees and commissions have become very important. Let’s however still concentrate on interest.

There are some limits on the increase of liquidity as set by requirements for bank’s own assets. During bull market periods some special tricks will be invented to move part of activity to outside institutions having regulations of different types so that the limits can be circumvented.

As to promises, all money is some kind of that. For the ‘secondary money’ it’s quite obvious. But even gold bullion is a promise that somebody will sell bread or something for it. All creation of money except gold is in itself not creation of wealth but creation of promises.  Any issuance of money will not directly create wealth to the issuer but an asset and liability of equal value. For a bank it’s vital to appear as a credible entity for all depositors and buyers of issued instruments: The bank lives on the interest rate difference of liabilities and assets. That difference is directly related to the difference in credibility between the bank itself and its lending customers. If all banks are made to live by same rules then bigger ones will be more credible and will earn better profits. By time they will buy the smaller banks and become too big to fail.

Issuing financial instruments implies the creation of an asset and a liability of similar size.  The asset permits immediate business extension while the liability must be properly satisfied in the future. This is the same as borrowing has always been: Having money now for immediate needs and an obligation to pay it back in the future. One can even think of similar relations in a society not using money: If a farmer needs a new barn then he may ask his neighbors to help in getting the timber and actual building. They may help under an understanding that in the future the roles in helping may reverse. Even there we have an asset now and a liability in the future. In financial markets these things occur in a huge scale. In all cases there are limits on reasonable quantities.  The full credibility of promises is critical.

We can even do more complex barn building as that. Let’s say farmer Smith needs a new barn. He asks his wealthy neighbor Forsythe to help. This tells he can’t personally help right now but he may be able to find somebody else. He contacts farmer Jones and tells that if he can help Smith this year then he can promise similar help to him in coming years, either from Smith or from himself. As Jones has time and resources he agrees to help subject to that promise. Then Smith and Jones build the barn. Here we have a case of lending based on confidence in a no-money society. Mr. Forsythe is the financial system. Even without any prior savings it’s possible to arrange resources resembling loans based on trust and confidence where future repayment is likely.

As savings is concerned it is the opposite in several ways: Money moves in the other direction, the individual or corporation doing some saving moves his own consumption or investment to the future. When the savings is deposited in a bank or invested in company shares it will expand the funds there. Requirement for trust and credibility is reversed: The owner of funds has to trust the bank or company. In the national economy this permits concentration of resources and transferring funds to active businesses from owners with less urgent or less profitable investment needs. The depositor still must trust a promise of future repayment but if the bank is very strictly regulated like savings banks were in the past then he may be quite confident.

There’s some irony in that as at the same time in 1970’s when monetarist theory was conquering academic and business world the huge development of modern treasury practices in banks and elsewhere together with related deregulation of banking made it a nonsense for central bank to have powers to actually control the amount of M2 circulating. Still in 2012 the European Central Bank believes that to be possible, still most economic writers in newspapers believe firmly on that. The emperor clearly has no clothes. This will be a great time for the little boy.

In normal times it’s always possible to arrange funding for a loan. The question is only whether the margins in interest rates provide sensible income for us. Let’s look how to create some money. Say we establish our bank A so it initially has an equity of 10 million in cash:


Another bank named B initially owns nothing. Anyway they issue a 12 month CD of 10 million and we buy it with cash. The non-zero balances in our books after that:


Then we issue a 12 month CD of 10 million, bank B buys that and places payment on our current account with them:


After that we provide a commercial loan of 10 m to an industrial customer X. When they withdraw the loan we provide the payment from our account at B via some intermediary, say an account in the central bank acting as a clearinghouse. Even a bank has account money only as money that other banks owe to us. It’s not possible to owe that to ourselves. Customer X initially keeps the money on a checking account in our bank. The accounts look like this:


Note to non-accountants: On the left (debit) side we have our assets consisting of cash amounts and debt that outsiders owe to us. On the right (credit) side we have money that outsiders have placed at us and owners equity. Those are our liabilities. Most transactions either affect both assets and liabilities to outsiders or the type of assets. The size of the balance may increase or decrease or the type of asset may change. For simplicity we show above only non-zero balances, no bookings or interest amounts.

When company X uses their money that will affect their checking account and our account in the central bank. If you want to think that we haven’t kept the cash we had in the beginning then of course we can issue another loan to bank B to get them to pay it again. When we issue CD2 then our creditworthiness makes it reasonable for B to purchase it confident that we will pay them back on time. This trust is the source of the value of the instrument.

We create here a chain of asset – liability pairs. Each step creates one more. In creation order it’s a chain of placements. In reverse order it’s chain of issuances. Each asset can be transformed to another type, say loan or cash. Such type change may disconnect from previous chain and switch to a new one. An asset in our bank is a liability for the counter-party.

At maturity day the original issuer of loan has the liability to pay the related principal and interest to the present holder of issued instrument. This completes the lifetime of that instrument. The asset and liability cancel each other and disappear. At money originator the type of assets changes back to original. Only interest amounts remain.

There’s nothing illegal or improper in the scenario above. Banks have been doing this forever. The nineteenth century merchant banks did it quite much when re-discounting bills of exchange to each other. Anyway as those are issued by manufacturers and traders, not banks, there is some limit to the madness. The discovery of double entry accounting in fourteenth century Lombardy is the main basis of money generation. Another is introduction of re-marketable financial instruments. Bonds were the first to permit bank created booms and by now the selection of instruments is quite extensive. The standard theory claims that large demand of loans will cause scarcity of money and interest rates will go up. That never happens. It was likely from experience when such economists as Keynes, Kalecki, Schumpeter and Minsky always knew that in a society with advanced banking any scarcity of money or lack of savings is not a real problem. Accordingly interest rates are not dependent on money availability but on other factors. The traded amounts that central bank dealers use to regulate rates are a minuscule part of existing money stock.

From where does the money for a loan come? Well, it may come from retained earnings but it may come from the future, too. If your wealth, income and honesty make it sure that you will repay a loan then the financial system is able to make a discounted value of that payment available to you today. If our bank can trust that future repayment then we can arrange the funding. As a trustworthy liability that future repayment of yours can be monetized now.

One of the most important features in this scenario is that the financial system earns interest on money created internally. This is similar to the seigniorage income coming to central banks. The huge ballooning of loans provided to the ‘real economy’ facilitates the huge growth of income in the financial world. Simultaneously such success creates the aggressive greed that makes the banks the primary proponents of all kinds of financial bubbles. It’s not possible for a single bank to create money from thin air but together they can master the trick of creating asset-liability pairs out of trust and confidence. When company X has withdrawn the loan in the previous example then the balances are as follows:


Here bank B may use the cash to provide a loan and earn more interest or we may generate more money first to provide more loans. More interest income can be earned as our initial cash would have permitted.

If company X uses the money to pay an investment and the payment goes to some contractor having account in bank Z then it is as presented. If, however, they want the money as physical cash then some more moves are necessary.

Hyman Minsky has described extensively the phenomenon where investments depend on predicted future income and not on past savings making loans available. This coincides with the old Keynesian claim that as money circulates back to banks the investments will eventually finance themselves. The time factors in that theory seem suspicious. We are better on a reliable ground by observing that money and liquidity can be generated as needed.

What actually happened in that merry go-around? How was it possible? We all know that when somebody places money in a bank then there are three aspects: The bank can use the money as an asset to grant loans, bank gets a liability to return the money to originator as agreed and the originator still owns that money but the type of asset has changed. A placement of money creates both an asset and a liability at the target institution. This event can be forwarded further on to new parties. With simple placements, however, only the last in chain can use the money for actual purchases. In a medieval cash based society only the last asset was available for payments. The others may be characterized as sleeping assets.

When the receiver of money declares the related financial instrument to be re-marketable or negotiable then the situation changes. The issuer gets the money; the originator of money gets that instrument and can sell it. This implies that the money can actually be used at both ends of the transfer chain. Turning sleeping assets to active ones permits multiplying the means of payment and increased liquidity. The form of the asset along the chain can be changed to anything: Cash, loan given, placement or others. The chain of liabilities remains as is.

The value of the asset-liability pair originates in confidence. When a listed company issues new shares and people believe the money to provide big earnings when invested in it’s operations then they are ready to pay handsomely for them in expectation of good dividends. For financial instrument the future income is not subject to such speculation. There will be a predefined interest income and principal repayment from a reliable issuer. That prospect creates the present value of the instrument issued.

We were talking here of banks but in reality all that holds for large corporations, too. They are equally able to create means of payment if confidence is big enough. If this happens in a closed group of dependent entities then it may still be legal but it will generally be considered as some type of cheating. Such operations will not create wealth but they may create a sense of wealth that is used to mislead others.

Again: Creating money as means-of-payment is not creating wealth. The money may well come from retained savings but equally can it be created where trust and confidence are abundant enough. When all those loans are paid and the money disappears again it will not make anybody poor. When a liability gets obeyed and an asset is paid back they disappear at our institution. In the originating institution the assets returns to some other form, say from loan given to account balance or cash.  The only income and only source of wealth here is the interest rate margin between the different loans. If there’s trouble with repayment but still confidence enough then it may be possible to throw good money after bad money and prolong the process with a new loan. But finally if some parties involved are not worth the trust but will default then some others will suffer and will lose actual wealth. The requirement is that a party who has received money must duly return them. A chain of defaults will destroy existing real property of participants. This may reach up to the asset at the beginning and beyond.

As the banks actively attempt to extend their businesses the responsibility to behave rationally to a significant part falls on the borrowers. Memories of past financial catastrophes will teach them. Where new financial arrangements cause those memories to fade away there new catastrophes are waiting to occur. The big economic crises in recent years provide examples on what happens when trouble develops at the poor end of lending chain.

On Fractional-Reserve Banking

This term is often used to describe a similar arrangement. The idea is that if our bank receives money as deposit then there may be an official requirement to place some part, say 2%, of that as required reserve in the central bank. The rest may be placed in another bank which must deposit the same percentage in the central bank. As this geometrical series continues from bank to bank there is an upper bound on the ‘new money’ made available in the system. For practical purposes this mechanism can actually be used for tightening or loosening money supply. Many countries, like US and Finland, typically employ a low and constant required reserve rate like 1%. The Chinese use a high rate between 6% and 20% and adjust that actively. Some countries have zero rates. This is a theory favored by American libertarians but it totally omits such money generation as can be done with mutual placements described here above. See article  Here we attempt more to look what that kind of money means for the national economy.

Bank Supervision

Flooding a country with liquidity has occurred repeatedly in recent times. For a single borrower and loan provider it seems sensible to take a loan to construct a house. That makes national economy to prosper because of all that building. All parties are happy with this “ultimate discovery of sensible economic policy”. For the national economy this may, however, be fully unsustainable if there has not been comparable extension in production facilities. When the boom ends and payment day comes it’s all misery. The overconfidence in bank’s willingness to do things in sensible ways is to blame. The state must have means to contain unsound developments and to put forward more sensible investments.

Too much borrowing and indebtedness may become a real problem for private persons, companies and states as has been so often seen recently. The first danger is to use the abundant money for consumption and not for profitable investments. The second danger is accumulation of so much debt that interest and principal repayments become overly difficult. Such chain of events leads to easy living initially and much suffering later on. People are living on the expense of future generations or their own future self. To default on debt practically may come close to steal from someone else in the chain of liabilities. They originally provided those funds either by borrowing or having them. Surprisingly this is true even in the case of mutual placements. Non-payment of debt will always destroy some assets related to that liability. When Argentine defaulted on state debt in 2002 the losses in Spain, Italy, Argentine and elsewhere were real. When Britain and France decided not to pay the debts from first world war in 1934 then this helped much to stabilize their own economic situation but it made things worse in USA and prolonged the depression. Banks there booked losses and had to cut staff to improve profitability.

What remains of bank supervision in the present world is basically intended to guarantee that small depositors will get their money back in the event of bankruptcy. There used to be strict controls on larger treasury operations from 1930’s to 1980’s. That was abandoned as unnecessary in the belief that bankers know best what they are doing. This likely also was based on a naive belief there to be some ‘natural limits’ on what banks can do. Those assumptions are highly questionable as financial community as a whole is not legally permitted to create such structures as would be capable to analyze and control the operations as a whole. Actually each bank alone attempts to extend its lending and other operations as fast as possible. The operation of the financial system as a whole may become the opposite of sensible behavior. The idea of some internal intelligence and responsibility seems utmost naive and incorrect.

While it’s true that the greed of bank managers makes them to do stupid things it’s useless to say that. They must show capability to extend their business. The system requires that. On the other hand the authorities are incapable to know and understand what’s going on and they have political pressure not to cut off the present good economic growth. The tools the authorities have are inappropriate to regulate lending volumes as a whole. No bank supervision authority in any industrialized country is actually capable to restrict lending from foreign banks.

Some derivatives come with unlimited maximum loss. In a cyclical economy bad things are not statistically independent from each other, as assumed by mathematical risk models, but may come all at the same time. This makes those risk models not only unusable but dangerously misleading except during economic booms. By now we have a very wide set of derivative instruments. By itself this is desirable. With relatively modest fixed payment it’s possible to protect against large losses. The mirror of that is that a small speculative bet may cause tremendous losses. Further on we have different types of institutions and even that may be desirable. For those who prefer gambling there may be quite speculative institutions who anyway call themselves as hedge funds. Financial field is accustomed to misnomers. The idea to require all institutions to be similar is not very good. It might be just fine to have strictly regulated low-risk, low-equity institutions as the savings banks were in the past. The loan and savings crisis in US in 80’s showed their vulnerability to interest rate changes but that can be dealt with if we want. The other way is extending the Basel agreements. That likely will make large institutions ever more too big to fail.

The track record of states and rating agencies in dealing with systematic risks appearing as financial bubbles is poor. When the housing bubble was expanding in US there were public requests for the Fed to do something about it. Mr. Greenspan famously replied it not to be a responsibility of central banks to prick bubbles. The idea behind was trust on deregulation, markets and bank’s own capability to control risks. In Europe it was maybe worse. When the houses in Ireland and Spain were being built and Greece expanded state expenses then it was based on the idea that all parts of the Euro zone are basically as creditworthy as any other. To question that belief was against the European ideology. This is similar to religious beliefs. To speak against such claims shows the person as a non-believer. Such folks will not be listened to and will not be permitted to participate in decision making. To replace those semi-religious pro-EU approaches with something sensible is challenging.

In real life the availability of funds will not set any limits on bank activities. The only practical limit is the start of a full blown financial catastrophe. There will be huge losses and we head the question as who should pay it all. Present US bankruptcy legislation provides a good example. The first losers are the unfortunate borrowers: companies in construction and elsewhere and families. The second line is banks: In a normal restructuring the owners lose all and bondholders become new owners. The old owners may try to recover something from the bonuses paid to management in past years but changes of success are small. If the bank is too big to fail then outsiders in the form of national government in it’s home country and taxpayers may have to step in. A bank may have huge connections via various types of derivative contracts to the rest of the world and it may be wise to keep it alive to avoid more chaos. In that case ownership must, of course, be transferred to the state. It’s a very basic capitalist principle that the payer has the power and any possible future profits.

There are huge unconventional risks presently. The twelve banks making up the US federal reserve system own very large amounts of public and corporate debt. European Central Bank owns much debt issued by south European states. As a result of payment processing in the Target 2 system some national central banks in Euro area own very large amounts of assets that is debt from South European central banks and then further on from commercial banks in those countries. Those assets are loans to rundown local companies and families. The central bank in Germany, Finland and elsewhere is utterly incapable to protect any related risk unless ECB is permitted to have equity largely in the negative. The Peoples Bank of China has tremendous amounts of foreign currencies. Every time they increase the value of Chinese renminbi by 0,1% that means a loss of 3300 m$ for the central bank as diminishing value in foreign holdings. We are about to see times where the equity of some central banks goes widely in the negative. In some cases this will not mean much but there may be legal hurdles and exotic situations. In 1930’s legal restrictions were the main reason causing the Fed to follow a policy that made the depression worse.

On Lending

The motivation to issue financial instruments is hope to earn bigger interest on the asset than what has to be paid for the liability. Most often this is financial investment to other instruments. It may be loans to commercial or industrial companies. Very often this is related to physical construction and physical manufacturing. That ensures employment and well-being of population. Actual wealth in concrete form will be created. If investments are sound they will create profits and the loans can be paid and the borrower is left with some profit after that.

The traditional view is that loans are based on savings: Some refuse to consume or postpone that consumption by many years and that makes it possible to use existing money to finance investments. For circulation of existing money this holds. The cash issued by the central banks normally represents money in a stable and creditworthy form. In modern world it is, however, quite easy and extremely common to create new means of payment. That new money is available for the creator to use for any purpose. In best position are such institutions which are very creditworthy and which find the best investment targets. They attempt to issue the instruments at low rates and use the proceeds to earn large rates with low realized risks.

The creation of new money by the financial system should not be a big surprise for persons who have read newspapers in recent years. When the US banking system flooded the country with construction loans there was no discussion of insufficient availability of savings. The same when German, French and American banks flooded Spanish housing markets and Greek’s government finances with abundant liquidity. Further on the national statistics have told for long times that there’s more account money M1 than cash money M0. That account money M1 and liquid financial instruments M2 have to come from somewhere else but saved cash. For some professional researches in macro economy this may, however, be mostly new material. For people in banking all this should be somehow familiar. However, in banking creditworthiness is a core business value and publicly presenting these ideas will not improve that. Better pretend it all to be extremely complicated in mysterious ways. It’s a taboo to say that as much liquidity can be generated as is needed.

When a state or other public entity itself runs a deficit then they do similar things. One major difference is that for the most part a state consumes that new money instead of investing it in profitable ways. The objective is not to earn profits but to make living easier in times that else would be too difficult. Those loans can’t be paid with future profits but with taxes collected in better times.

For simplicity the previous discussion bypassed questions of interest and inflation.

Large fluctuations in the amount of promises outstanding are understandable. The US Federal Reserve system assumed responsibility for a huge amount of financial assets in 2008 and 2009. That meant that promises turned weak have been replaced by stronger, tax-buyer backed promises. Let’s consider how far those means of payment are still ‘real money’:

  • Taxation implies that government by taking some money away prevents some people from using it and uses it instead, often to distribute it to other groups of population. That’s very real.
  • Stealing from a bank causes that the bank has to distribute less money as dividends to owners or as interest to depositors. It will be more constrained in creating new secondary money to finance investments. It’s all very real.
  • If government takes loan from central bank to finance budget deficits, also called printing of money (in more abstract financial sense) then typically that is kind of cheating: There is no real and reliable promise to deliver anything of real value to back that money. Inflating the amount of money may dilute the value of all existing money. Yes, Milton Friedman and the monetarists in some cases have a point.
  • If government takes loan from domestic or foreign sources to finance budget deficits then that sometimes implies moving resources to current government expenditures instead of something else. That may be a good or a bad thing. Let’s list some extreme cases:

–                 If a famine is looming then generally it is a good thing to borrow money to keep the taxpayers alive

–                 If people are affluent but lazy then generally it’s a bad idea to borrow money to transform large amounts of bread to manure and assume future generations to pay that all. This borrowing from the future may imply that ownership of existing assets has to be moved to outsiders in the future.

–                 If the people is progressing fast in technical and economic skills but infrastructure is lagging behind then it makes sense to borrow money to construct roads and sewerages to permit transfer of goods and creation of cities. Increased economic activity will provide more taxable income to pay those investments. Some government investments in infrastructure and general education proves out to be very profitable over time whereas some other similar investments may prove out to be totally useless. This is one possible place for Keynesian stimulus.

When a depression hits the secondary money creation process works in reverse at stunning speed. The trust in promises disappears and many issued instruments can’t be sold any more, except at extremely low prices. If banks or other institutions are forced to value the items at those market prices in their books they must be declared bankrupt because of these valuation losses. The resulting escape to liquidity causes banks to stop normal short and long term financing for industrial and trading customers. That will push the real economy in recession. At the same time the stopping of money creation will cause consumption to contract. The disappearing of money is, of course, disappearing of confidence. This will continue as long as its unclear how large the defaults will be and who’s going to pay the loans: debtors, lenders or outsiders like taxpayers.

Any source of money to fund investments is as plausible. Large numbers of businesses are totally dependent on rolling credit. Companies small and large, successful and faltering ones alike have short term borrowing or loans with short term termination options. If banks are unable to find liquid funds for their regular outflows then they must stop all lending and reclaim all maturing loans. That forces the companies to take drastic measures like mass firing of employees and emergency sales of assets. Many will go bankrupt anyway. The remaining value of assets in a bankrupt company is roughly half of what it was before bankruptcy. This causes huge losses to owners, banks, customers and employees. The economic misery will spread out. This happened in the depression of 1930’s and again in Finland in early 1990’s. The positive process in an upturn is, however, not a direct mirror of the previous but much more tedious. Availability of liquid funds is necessary for actual growth but it is not in any way the decisive factor. If good investment opportunities are few then it only helps to create financial bubbles that will eventually burst.

Finance and Real Economy

Large scale creation of endogenous money has had deep going consequences. One very common trait for practitioners of many professions is, that they assume their own knowledge to provide superior capabilities to use power in the society. Think of lawyers, businessmen and professional politicians.  The masters of modern alchemy are no exceptions but additionally the control of huge amounts of money provides the tools to actually take that power. These people are able to create various kinds of investment vehicles and actually purchase many large corporations. The trouble is that they are utterly incapable to provide new business innovations to make those companies more successful. Instead they know how to make profit margins larger: First sell off anything that can be sold to finance the purchase, anything except the key business that is the one they can understand. Use mostly borrowed money so that high leverage permits large return on own capital. That’s what ‘modern financing theory’ teaches. All this works towards higher risk of bankruptcy, less employment, less commercial competition and bigger profits. It corresponds to the negative part of Schumpeters ‘creative destruction’.

As the amount of loans for corporations, families and states has ballooned the income to the financial sector has grown tremendously. Some of the money goes to bank clerks, branch office maintenance and similar activities. An increasing part, however, goes to speculative investment and luxury items. That money will be drawn outside of the normal services economy. This will manifest itself as lack of funds for services and deteriorating employment. We return to this in the last chapters.

Bank Balances and Inflation

How does endogenous money creation relate to inflation? Diminishing value of money causes that owners of saved assets lose wealth. For assets created in a loop this is of smaller importance. As long as the participants receive their income in the form of loan margins nobody cares much. The actual value of later interest payments will be somewhat less but maybe not that much. When principal is repaid and the asset-liability pairs disappear then most parties are not concerned much. In our example the final loan takers in the real economy will benefit as the loans are easier to pay. The originating bank will have the value of its equity diminish. For other financial parties the inflation is of no concern. Similarly when the well being of Finland was built in 50’s to 80’s there was often considerable inflation. Lending between banks was very small as compared to present practices. One key source of funds for the banks was borrowing at discount rate from Bank of Finland, the central bank. For those loans the same applies. When inflation caused the value of those loans to diminish this didn’t really affect commercial banks. The hit for the central bank was quite small, too. The liabilities were against an imaginary counter-party that central banks have. Those ones won’t complain. In summary: There is some amount of real suffering among depositors. If inflation is quite high then businessmen know that getting a large loan is a lottery prize. Anyhow all that will have negative impact on general confidence.

On Recent Inflation

In the small article ‘The Great Inflation Mystery, Still Unsolved’ in New York Times on September 23, 2007 Ben Stein nicely reminds us that none of the theories used to explain inflation seems actually to work. Yes, I know that any professional economist can tell you the theories are perfect.  Anyway neither the teachings of Milton Friedman nor of J. M. Keynes nor of many others have actually been able to predict the inflationary movements or lack of them for any reasonable time span, except during some very calm periods. Please try to apply any of them to US 1990-2011, Japan 1984 onwards, China 1990 onwards. Yes, you can fiddle by omitting or including M2 and doing other arbitrary tricks. Nothing works. How can it be like that? Some background:

  • For inflation to occur there has to develop a mismatch of solid demand and insufficient supply or an increase of money available and lacking availability of merchandise.
  • Inflation may be quite local or global depending on case as populations and types of merchandise are concerned.  Increased wealth of very rich increases only quite little the demand for most items. There will be demand for exotic luxury items and passive savings, not much demand for items important for the majority of people. The essential factor is available money of normal persons and companies. This is income plus increased borrowing. Increases in M2 money will quite much go to purchase of other M2 instruments. The actual money flow as loans to the real economy is a fraction of that.


  • Expansion of cheap production in China has been a huge inflation stopper worldwide: An ever expanding selection of goods has been available at decreasing prices. Large parts of western economies have shrunk together and large numbers of both salaried and wage employees have had to find some other living.
  • The US housing bubble initially implied easy money first in the financial community, then among house buyers, then among consumers in general. Anyway that was not enough to create a scarcity of consumer goods as the global production in China was able to tap the demand. Very little inflation came up and in many cases the prices were declining.
  • During the housing crash in US much ownership of private M2 money has been transformed to more trusted government created M2 money. Total money amount is not growing. Anyway the credit risk has been moved from private finance corporations to be taxpayers’ risk. There has not been much inflation in spite of large expansion of Fed operations.
  • The lack of actual expansion of production has kept Japanese consumers careful, prone to save and reluctant to consume.
  • Chinese economy has been well managed to create huge growth with fast moving key growth areas.

In modern world money moves very fast but it definitely won’t move to anybody. There are separate domains or layers for that. In 1990’s and early 2000 huge amounts of liquidity got created in the form of financial instruments. In US much of that initially went to housing market. That made house prices to rise. People started to think, that if they can buy a large house with no money down then by time they will become rich as the price of the house climbs up. Part of the money continued to flow to consumables market. That did not inflate those prices much. The liberalization of world trade removed huge amount of customs barriers. Merchants readily grasped the opportunity to move production to China so that production became much cheaper than before at home. Those products could be sold at somewhat reduced prices as compared to the past. First it was toys, then clothes, then all other consumables but food. There was nearly no inflation anywhere but in the housing market. This was a surprise to the followers of Friedman.

In Spain the extra liquidity went to housing similarly to US. The high optimism behind the boom came partly from the belief, that the Euro currency will open the doors to lasting prosperity in the country that was lagging behind the development of Central and Northern European countries. Not that much investment went to manufacturing.

In Greece the liquidity came in as loans to the government. It was used to increase wages and to expand construction.  Again there was some idea that this might be continued forever.

All those processes show how it’s possible that huge increases in money supply are able to create big bubbles that later on will split. In the modern world it was not at all necessary for any significant inflation to be triggered. Likely at some time in the future the rules will change again.

On Gross Domestic Product

Let’s consider the circulation of money in one country. The worldwide equations would be another exercise. In this case we will consider the creation of value in the form of goods and services. That leaves out all loan withdrawals, loan repayments and buying of fixed property as we want to concentrate on production.

The GDP or gross domestic product can be calculated in several ways, here the income and expense approaches. Both should represent the market value of all products and services produced in the country for a period of one year. For more explanation on GDP see

For our analysis we must also consider any increase or decrease of money that makes its way to ‘real economy’ as increase of loans. Such money is not different from government deficit in the way it stimulates economic activity. It appears on the expenses side as part of gross investments.

The analysis approach pioneered by M. Kalecki starts by equaling the income and expense calculations. The idea is to consider the flow of money. The expenses side is all payments from various parties in this and other countries needed to fund the final products (not counting raw materials or intermediary products many times). The income side is all income from production. Then we want to emphasize the different parts that capital resources and employees play in the economy. This implies that the analysis is somewhat more problematic and less accurate as a description of economy as some income may be interpreted either as capital income or wages. On the other hand this Marxian approach makes it possible to see how the roles of capital income and wage income are different in the economy. What we lose in statistical accuracy we gain in analytical insight.

Another special feature in GDP is the concept ‘gross profits’ or gross operating surplus. It’s clearly much bigger than the profit in commercial accounting as it includes depreciation, interest payments, rent and withdrawals from unincorporated business. Only wages and expenses have been subtracted from sales income. Loan service like interest and repayments should be included but it’s more practical to use asset depreciation instead of repayments. We might use some other name like company income but to maintain better conformance with existing literature let’s keep it like this.


Gross investments above may become pretty large in such a world where banks are able to produce credit as needed when outlook for future profits is bright.

If we subtract taxes less transfer payments (state finances) from both sides then that leaves us with:


By subtracting from both sides wages, salaries and transfers nett of taxes (the private economy), we obtain:


Isn’t it amazing what kind of power simple arithmetic’s and equation manipulation wield? Or do you possibly claim it can’t be so and we made something wrong? But how can that be like this? Well, much of the money for investment goes to wages and salaries either directly or indirectly via purchase of products and services. Then much of that money goes to consumption and again to wages and salaries. While this multiplier effect is spinning some money goes to profits and we get the result indicated. That is largely responsible for the related increase in employment rate. This result says that when investments initially go to wages and expenses then that money further on is used to buy other products and finally it has to end up somewhere. The result highlights the role of investments in driving the economy. In a few months investments made by some companies will turn to profits at other companies.

Capitalist’s consumption appears on the right side mostly as it’s part of the left side, too. Worker’s savings refers to all retained earnings that go out of daily circulation right now.

We all know that total profits on national level can be calculates by totaling the company level profits. Anyway as there are dependencies between various quantities on national level it turns out that the total profits can be calculated from those other quantities, too. The whole point in investing is, of course, to earn that back with profits after some years. This result here tells that additionally the money will appear as profit to other entrepreneurs much before that. There’s empirical evidence of the correctness of this formula. At least López, Laski and Reyes have found it to hold on US economy. In the later chapters on employment we will attempt to consider how to ensure proper profits in various situations.

Next step in Kalecki’s original analysis is to subtract capitalist’s consumption and add workers’ savings. Then we would get:


There we might call the left side as gross savings. This, however seems questionable as the new expression ‘Capitalists’ gross saving’ stated as Profits –  Capitalists’ consumption is misleading.  Gross investments may include large amounts of new endogenous money. It is true that it shall flow back to amortizations or repayments but it seems misleading to call it savings of any type. Here ‘workers savings’ refers to retained earnings. That goes to the financial sector where it is needed. It will participate in economic activity in an indirect way. The above equation will, however explain why we may often read that Chinese savings rate is some 40% or  50% of GDP. Even where people have high propensity towards saving it seems totally impossible to have that much retained earnings. Anyhow state owned banks may assume that when they give a 10 year loan then it will be paid back at a time when GDP is twice the present figure. Huge money creation by the central bank may be reasonable if many investment targets are profitable and state has full control over banks so bubbles too dangerous may be avoided.

On Employment

It is a natural wish of all men to do useful things to create wealth and earn respect within their families and broader social environment. People want to work to earn money and improve their living. Anyhow in most societies a significant part of population is unable to perform such work as they would like. Either they are unemployed or are forced to do work far below their skill level or far below a full-time employment they wish. Let’s look at some extreme cases:

  • In a primitive hunter – gather society anybody can attempt as miraculous achievements as one wishes. To get some extraordinary catch will increase a person’s social standing.  Periodically some bad times may occur causing starvation. The society seems to have basically full employment. Anyway one family controls some fixed set of hunting and fishing areas. Family members can exploit those areas freely but may get into trouble if try to extend them and may get involved in fights while defending them. During favorable periods many persons can proceed with relatively light work.
  • In many developing countries large amounts of semi-employed population have moved from countryside to slums surrounding major cities. They do not receive any social benefits but make a living with various kinds of odd jobs, temporary and permanent, legal and illegal, locally and elsewhere. The poverty will largely be inherited from generation to next. The level of school education is very low.  The network of social contacts and practices is well suited to the current situation but provides little help in improving the matters.

Isn’t it surprising that many societies fail so badly in fulfilling the most basic wishes of its members? Just think how much more efficient and prosperous the society would be if all its members would work at full capacity instead of just hanging around? How much fame and glory would it earn a society to provide all-time a reasonable near-full employment!

In the old Soviet Union to the best of my understanding they routinely over-budgeted all industrial efforts. The management hired as many people as they could find but always there were some unfilled vacancies. They reported to higher authorities the actual number of people and as much money was printed as was necessary to pay their wages. Initially this caused inflation as there were not enough items to buy with that money. Then the increased prices of the products of light industry  brought back a significant part of the money.  Those light industry products were basically bad quality output from state owned monopoly industries. Effectively the price inflation implied reducing wages for everybody. Wages to employees were controlled through rating hierarchies for all professions. The system had many deficiencies not discussed here that ultimately made it to fall. Anyhow it certainly was possible to have a full employment society.

One of the major faults in the Soviet system was that it encouraged people to try out how badly they can behave without losing their job. The waitresses routinely provided very slow and bad service to most customers. This permitted them to feel some satisfaction and maybe feel themselves to be better people than their customers.  Actually I have heard similar stories from Finland when some forest and park cleaning job was assigned for unemployed men. They preferred to sit by the fire most of the day and not to concentrate in doing their job properly. Frustrated people take pride in cheating their bosses and treating their customers badly.

A common claim is that specific measures should be taken to reserve available jobs for some preferred group, say for young people instead of old, for domestic people instead of foreigners, for men instead of women etc. These requests are clearly nonsense. It’s certainly not so, that there is unemployment in Finland because we have bigger population than Estonia or that Sweden has unemployment because they have more people than Finland. For some months such recipes might work but for any longer period it should be possible to find work for a very large part of available workforce, whatever the size and consistency of that workforce be.

The world of employment is quite different from the world of money as the phenomenon can far less be described with mathematical formulas. It’s a huge forest of various kinds of developments.

In a quite primitive society it’s up to anybody how much work she or he wants to do and how much results such as food, clothes, houses or anything one reaches by that work. In a modern society it’s totally different:

  • There’s a large spectrum of possible qualities a prospective employee needs for each specific job. People with job experience mostly have those qualities. Newcomers must get them by schooling, training or higher education
  • There is some spectrum of existing vacant jobs with different requirements
  • It’s possible to create new jobs in various parts of the society, in production, in services including administration

Basically it should be so that there always exist possibilities to provide new products and services that people actually want to get and buy. There should be willingness to expand all kinds of economic activity so that lack of personnel becomes the limiting factor for business expansion.

In practice it’s nothing like that. Every entrepreneur knows that establishing or expanding his business involves risks. Even if outlook for future profits is good there is a possibility of negative surprises coming up in many forms. This includes trouble with markets, technical systems, suppliers, customers, economic situation, authorities, employees and others. An expansion provides the possibility of more wealth and power but also possibilities of serious trouble. In most businesses profit margins are slim. There’s a fine line between profitability and loss making. A large number of factors must be right for the enterprise to succeed. In light of that many firms and individuals will refuse to grasp some available possibilities for expansion.

There’s no limit on peoples willingness to buy products and services but the amount of their means. There are, however, limits on what can be offered. Each product or service has some current production cost. For people to buy the sales price must be less than the perceived utility of that product.

Technological and organizational progress is constantly reducing production costs. New products or services can be introduced as technology advances and people are wealthier.

All Those Markets

The employment rate varies wildly in different types of societies and in different times. There exist a large number of more or less dependent separate work markets.  All those are not controlled by any single mechanism. Let’s list some of them:

  • All the food producers in all countries practicing free trade make up one market where wages and food prices depend on each other
  • All workers in consumable goods production form a similar market
  • To some extent workers on construction branch are part of a large, if not global market
  • There are many markets for local services: barber shops, taxi drivers, hospitals, social services, primary and secondary education etc.
  • Some service providers work on a global market: factory designers, oil drillers etc.

Each of those local or global markets gets its financing from many sources.

If we look employment from control engineering perspective then it’s quite odd. Employment rate may take wildly different values in various societies at various times. This seems like an a-stable, non-controlled system while actually the rate stays nearly the same for very long periods. This means it’s some kind of semi-stable system.

The technological innovations cause less work to be needed for production of old products. The same is true for market developments like increase in the monopoly rate. All that will decrease job opportunities by some 1-2% yearly.  On the other hand new innovation is one of the factors calling for expansion of economy.

In 1994 Paul Krugman wrote an study titled “Does Third World Growth Hurt First World Prosperity”. He used simple models for a situation where a wealthy country and a poor country have free trade arrangements and currency exchange rates are allowed to change. Conclusively a significant part of simple jobs moves to the poor country and improves living conditions there. Highly skilled persons in the wealthy country will find much new opportunities and their ranks will expand. For middle level jobs both possibilities are open. Currency levels will adjust so that payments will roughly match. The process tends to expand income differences in both countries. All this poses challenges for those societies to maintain reasonable equality and social rightfulness. It also opens the road for relatively fast development in the poor country.

How Extensive the Services Industries Can Be

In a very poor society only the rich people use any services. The others must use all they means to just survive. In developed societies it’s different. People earn more than required for basic living. They use the extra money to buy services.

We can describe the situation with multiplier effects: Increasing automation and mechanization permit an always smaller part of population to produce all the required food and more basic commodities. If one third of population can do that, then it might mean that there exists some distribution of income that permits the other two thirds to earn a living in service industries.

It seems, however, very unclear how to arrive at such a distribution of income to promote full demand of services. If a large part of total income goes to the very rich then they likely will not need that many services. Existence of a large unemployed population will intensify competition for the remaining jobs. Wage levels will go down to very basic minimums. Poverty is going to spread out. There may be deteriorating levels in public security, education, health care and others. This makes living harder for a large majority of population.

A quite common idea is that we should concentrate on the services industries and gradually run down the dirty production side. People do, however, still need food to eat, clothes to wear and houses to live in. To get products from outside we must sell something to outsiders. Selling goods is in many times an easier and a more stable business than selling always new types of services.

Modeling Service Economy

In previous chapters we used the Kalecki type GDP as some kind of binary model of the economy to gain insight between key factors related to production. Let’s introduce another binary model to describe the position of service industries. This hopefully helps in highlighting some key dependencies.


In the production part of society productivity increases constantly. Typically work efficiency increases while cost of raw materials may increase or decrease. In an industrialized society normally personnel numbers decrease.

In the services society productivity often increases but in many cases there are inherent limits on that. You can’t improve productivity in child care or police activities indefinitely. Requirements for investment are more modest than on production side.

The services side sells services to its own members and to the production side. It buys food, merchandise and other products from there. Sales and purchases should be the same plus any change in the loan bulk to the production side. Demand for services on the production side may be growing but not as fast as we would like. On the services side there’s more internal circulation as people are able to buy new services once their basic needs have been fulfilled. As economy gets more mature we are heading employment problems. The services side has the far bigger part of national population but there won’t be so much demand of services to production side as to create an over-demand of labor to eliminate unemployment. With time this situation will likely become outspoken. The recent attempts to make the public sector more competitive, while sensible in themselves, have intensified the problem. The services society comes pretty close to a zero sum game: Likely there are huge differences of earnings between its members. The total size, however, is delimited by factors that are changing only slowly and are not easy to control. Money that goes to non-productive purposes like financial speculation leaves less money to circulate.

The production society on its part is searching its own targets: Efficiency, expansion via innovation and scale advantages etc. We better support it in those endeavors.

The historical trend is that the services part will expand in number of people and the production part will have less. This makes it challenging for the services part to earn such funds as would permit it to purchase products enough. Further on this will restrain the utilization of capacity on the production side. It becomes a victim of it’s own success.

What should happen is that the improved supply of manufactured goods and food causes prices to decline so that a new equilibrium will be achieved. In practice this happens only slowly. Various friction mechanisms are part of the explanation. Oligopolies and monopolistic competition is another. Additionally some part of available purchasing power will leak out of consumption economy as people with large income use the money for speculative investment instead.

If the production side won’t require so much new services as to provide full employment to services side then we should do something else. With taxation we can make it more egalitarian. This provides funding for more communal and state run services. That permits better education, better health care, better security and others. There shall be some transfer payments from the wealthier to the poor people but the bigger benefit should be in improving employment. In that way poor people will also participate in paying it all. For some part we shall be able to emulate the deeds of the good baron  Munchausen in taking a firm grip in our own neck and lifting ourselves out from the swamp. More on that later.

The good news is that the Finnish economist Jouko Martikainen has developed a detailed model for this purpose. In his model the marginal reduction in support provided is only 50% of wage increase. It provides some increase of earnings and decrease of government expenses as compared to present unemployment benefits.

More on Profits

Companies in general should be profitable most of the time. If they are not then owners are losing wealth. For a state owned company that is taxpayers. For any company it may make sense to make a loss for some limited time, say during early years or during economically bad times.

For a state owned company it may make sense to have a limited loss for some time if tax revenue from worker income and sales taxes is bigger than that. It is, however, unfair towards private competitors to keep that kind of situation. Such a situation may also be financially bad for the state if private companies would be able to create taxable profits when allowed to expand.

Let’s consider again those GDP related formulas. A very much simplified consequence was that

Company profits                  =                    Investments

Here the company profits on the left consists from loan service costs (interest and principal repayments) and owner’s profits. The latter comprises dividends and retained earnings kept in the company. The money for investments on the right comes from such sources as prior profits, savings elsewhere to the banking system, state deficit and newly generated money. In a modern society we have several important processes that depend on this balance.

Availability of unlimited funds in the financial sector tends to increase it’s share in the equation.  Banking industry has a high propensity to create boom periods. Competition for market shares causes extensive liquidity to be made available. That causes increased optimism and more economic activity. That makes business life easier and loan repayment more sure for medium term loans. The self intensifying spiral continues until we reach economic madness of great magnitude. When the last fools have come to participate it’s time for bust and depression. Economic depressions are very harmful for employment. Much actual wealth will be lost. Young people have great trouble to enter active workforce. Lack of work experience makes later it difficult to proceed in work careers. Many employed persons lose they jobs and after years of unemployment find great troubles in finding reasonably good positions.

Turns for the worse in the employment situation may be quite fast. The processes improving the situation are slower by a large factor. This means that consequent boom – bust periods as a nett effect cause significant unemployment lasting much longer than the depression itself.

Not all companies are able to accumulate profits to finance new investments and loans must be available. We have various types of pressure to  organize funding via financial markets. This implies that much of the proceeds will go there, too.

The amount of investment depends on the predicted future profits for such present investments. The gross profits in GDP include loan interest and repayment costs. Those batches are a legacy from the past investments. In GDP calculations depreciation is normally used to arrive at smoother figures. Repayment is, of course, the figure affecting businesses more directly.

How much the increasing importance of financial world is a bad thing? Well, of course it’s gravely unfair that the capability to print money yields major power first in the productive economy and then in the politics. But how much it’s bad for the economy and the people? Are the occupy Wall Streeters forerunners of a more progressive society or are they a new crop of Luddites? Let’s return to that in a while.

The increasing share of financial profits has consequences. Those profits that go to original entrepreneurs may more likely be invested in some new activities. Such operations often have a positive impact on employment. The profits going to financial community as loan service cost or to entrepreneurs operating there will likely increase financial assets that may be used in some future company takeover.  The impact on employment is often negative when non-essential operations get eliminated and measures are taken to improve short term profitability. According to the equation above if profits for some significant group are very large then it implies profits for others to be smaller. The process described tends to tilt the balance from industrialists to financial players.

When companies get squeezed out of profits like a citron then sometimes that’s successful optimization. That releases people for more productive work elsewhere. Quite often it’s pointless short term trickery when actual key values in companies get ruined to reap short term profits. That will ultimately result in companies and industries being unnecessarily ruined. Other countries with better long term planning will grasp the occasion.

Special Cases

The previous may possibly provide insight into some difficult questions:

How much hope there is for the old industrialized countries? Well, there are always some means. A quite extreme method is called internal devaluation. That is intentional reduction of wages and prices. It was done in Finland in the early 1990’s. In the present world with huge management compensation people would likely prefer any economic catastrophe to that. Other means include innovation, automation, niche products and service industries. No great news here.

How bad the situation is for the slum dwellers in the ‘developing countries’ that actually have developed quite slowly during the last 60 years? Well, to make competitive products requires some amount of raw material everywhere. In more advanced societies highly mechanized production and competent employees permit high quality and low production cost.  To compete with that the poor countries need to improve education, have honest practices in legal and administrative systems, better infrastructure etc. That makes it possible to gradually attract investment and create new business areas besides the intrinsically local ones like oil drilling. That’s a long road and we’ve actually always been aware of that. What may be surprising is that in some sense it’s the advanced level of our manufacturing processes that’s making progress more difficult for them as much complicated processing is impractical there.

In a modern society there’s increasing demand for highly skilled people and less demand for people with less skill. In the old agricultural society even persons not that clever were able to find useful jobs. Not so any more. Sometimes there actually exist simple jobs they could do but legislation and union agreements prevent such special cases to be utilized. This includes rules on minimum wages and maximum earnings to keep certain social benefits. This causes that some useful work will not be done. On the other side when the unions make a key job in defending a more egalitarian society they also keep up the larger volume of national economy.

How Profits and Taxation Affect Employment

When discussing GDP we had essentially three income-expense layers:

  1. Profits <-> investments layer
  2. Wages <–> consumption layer
  3. Taxes <–> state expenses layer

The topmost is about money. The two others define present employment.

Any additional money works its way from the investments section to the profits section via the two other layers. On its way it expands them up improving employment.

Profits here consist of two major parts: Loan service and entrepreneurs profits. The latter one is the primary motivation for business extension. During depression the future outlook is dim and investments will dry down. Loan service has to be taken care anyway and so entrepreneur’s profits will be heavily hit. This fosters pessimism and hurts investments. Large amount of existing debt makes it worse. Then we have profit hogs who take the money out of the immediate GDP sphere: Banks and other financiers plus overpaid managers.

Oversized monopoly profits must generally be considered harmful. Companies that have controlling market positions are often able to extract quite fabulous profits. They typically have no incentive to extend their operations in any comparable scale. Part of those profits goes to such owners as pension funds that understandably need that money. Much, however, goes to financial circles that have purchased the shares with endogenous money. For the productive economy those profits will be lost.

Taxation is often presented as a huge burden on the national economy whereas actually it’s much more neutral. A business owner feels bitterly the taxes he has to pay but don’t observe how the same money creates demand elsewhere. The money taken away from some participants will be distributed to other participants in the form of state expenses and transfer payments. If this reduces the unnecessary leak of means to the financial sphere then it will increase production of both concrete items and services and improve employment. Some part of state expenses goes to infrastructure and education. If well managed then those investments will provide reasonable returns. Producing state services in health care and security is typically more efficient and better justified than leaving this to private actors.

The common request to have smaller taxes for wealthy people seems to be a bad idea. The intention is to provide them mental stimulus to expand companies and have some money to do such expansion. The suggestion actually always implies that the resulting gap in state finances shall be covered with more borrowing. In that sense this is a pervert modification of old Keynesian stimulus. In this ‘supply side’ case the stimulating effect is, however, actually smaller than the classical one. The tax reduction and the deficit will harm each other. Part of the positive effect of deficits will be eliminated by the negative consequences of the tax breaks for the rich whereas in classical Keynesian stimulus all is used for economy expansion.

Many people maintain that the current direction towards less taxes is the correct one and the past periods with higher taxation were a result of stupidity and some other qualities worse than that. How could it then be that in the past we had reasonably fast progress whereas presently a large part of population is experiencing worsening of living conditions? Including young people, old people, many ordinary people. A tree is known by its own fruit. Present economic thinking produces results opposite to those promised.

There’s quite long practical experience of Keynesian stimulus. Generally it has kept it’s promises. In Finland and Sweden quite typical cases went so that during a recession there’s request for financial stimulus, most notably from social democrats and unions. Some amount of it has been provided and part of the targets has been achieved. When times have improved we get requests to pay down the accumulated state debt. Conservatives are more active on that. Typically much has been repaid but not all as others claim that the economy can’t bear any more burden. Generally this has functioned as advertised: There’s been partial moderation of recessions and booms. During the economic crisis in 1990’s we had more austerity in Finland and they had more stimulus in Sweden. The claim was that our virtue will be rewarded and they will remorse in Sweden. It went the other way, we had to regret. Over time some other countries have tested the assumption that it is not necessary to pay down state debt ever. Results have been dismal.

The Keynesian theory, like other theories, failed to foresee the stagflation period in 1970’s. A situation where inflation expectations got built in all over in wage negotiations, pricing plans, loan rates etc. came as a surprise. The requirement to keep inflation between 0 and 2% was created as a remedy to that. In the present depressed economy that medicine, however, seems to be worse than the sickness to be cured. In economics there are rules of thumb that seem to fit in some situations and not in others. Presently the Keynesian rules seem to be fine while the 2% inflation rule is irrelevant.

In countries with serious corruption problems it’s customary for high ranking persons to hide great sums of money in secret accounts in various tax haven locations. This causes losses to the national economy first directly and then indirectly as circulation of transactions and multiplier effects will not materialize. Instead they would materialize if the money were distributed as wages and expenses in the social structure. Another thing is that leak of funds to speculative finance has similar effects. This occurs because of large monopolistic profits and overly excessive compensation to management members in large corporations. We should correct our taxation in similar ways as they should in those corrupt countries. The study by López, Laski and Reyes confirms that taxation of normal people is basically neutral as GDP is concerned. Taxation of the rich, instead, will expand GDP. This empirical finding is, of course, totally contrary to that what we have been told for the last 30 years. It is high time to respect such theories that work in practice too and not only sound plausible in the ears of rich people and the scholars hoping to eventually join their ranks.

As the production side gradually becomes more efficient then the services side, including state services, has to expand in both absolute and relative terms. A hundred years ago utopians thinkers assumed that only the number of working hours will be radically reduced. That is happening in a smaller scale. More important, however, is a natural process of resources in education and health care to expand. It’s pointless to put some artificial limits on how large share the state economy may be of national economy. It’s a stupid idea that we shall cut down useful services because production has become so efficient that the share of services in GDP is raising too much. As well we might require that the factories are not permitted to improve efficiency. Here in Finland we are reducing the numbers of policemen not because they aren’t needed but because costs “must” be reduced. In California they have been cutting down costs of education for a long time because of artificial limits on tax rates. The proponents of a small state shall be seen as the real Luddites of our times.

Taxation should be relatively neutral so that it will not promote artificial trickery. It shall be extended to eliminate all common tax avoidance schemes. This may require partial retreat in globalization process and free markets. Likely there’s a plethora of international agreements that must be partially scrapped. In former times we had some draconian decrees in our country. One was a general regulation that a business agreement that may be deemed to have tax avoidance as it’s primary purpose shall be considered void as taxation is concerned. Another stated that if the taxation related documents are found to be unreliable then taxation may be performed based on estimated income. The estimates used for say, taxi drivers and performing artists, were quite large until they started to use more transparent payment procedures. Methods this heavy are likely not possible any more but some new ones should be invented.

Note 1. Federal Reserve System as Money Creator

Let’s explain one special case: In US basic money creation is actually different. The treasury department (the ministry) issues the money. There is no single central bank but 12 local substitutes owned by local commercial banks. They have the right to mint coins. They pay a statutory dividend of 5% on the equity. These are under supervision of the ‘board of governors of the federal reserve system’. The chairman of that board is in public called ‘the manager of the central bank’. However, as there is no such bank his salary is more like that of a university headmaster than a real bank manager. A committee called the federal open market operations committee or FOMC makes decisions on the targets for short term interest rates. The dealers of NY Fed execute deals to affect those decisions in the markets. Normally this happens in so called Federal Funds market that deals with loans to cover the statutory requirement of commercial banks to place 1% of deposits in the banks of the Fed system as required reserves. For details see or or others.

Anyhow, the ways to issue money are similar to the normal ones. U.S. Department of the Treasury prints physical banknotes and lends them with interest. The banks making up the system issue loans to other banks.  Further on they can either issue or purchase various financial instruments, or secondary money in our terminology, in great amounts.


The book “Theory of Economic Dynamics” by Michal Kalecki, printed by Allen and Unvin in 1954, reprinted by Routledge in 2010

The book “Can It Happen Again” by Hyman Minsky, printed by M.E. Sharpe in 1984

Jouko Martikainen has developed a detailed plan for a sensible system of state payments to create big supply of worse paid jobs. The wage cost for the employer would range from near zero level to low middle pays. That would guarantee full employment together with a reduction of state expenses.  For  ‘Martikainen Model / Martikaisen malli’ see

Steve Keen is a pioneer in the study of endogenous money. He’s actively developing a set of economic models. Some links: Steve Keen on those, who were able to predict the Global Financial Crises: On Minskian instability in Berlin conference:

“Recollecting  Kalecki’s Studies of the US Economy” by Julio López G., Kazimierz Laski and Luis Reyes O. in state “..In our study we have been able to verify Kalecki’s hypotheses. .. .. However, in most general terms, the idea that the government can stimulate a business upswing by raising its expenditure, and that this stimulus takes place even when it finances its expenditure with higher taxes on profits, appear to us to be empirically valid for the US economy.”

Joseph Stiglitz on recommended ways to deal with bankruptcy (from book Freefall: America, Free Markets, and the Sinking of the World Economy)

Non-references / background reading:

Paul Krugman’s blog often contains excellent fact finding to dispel some recent neo-liberalistic claims:

Kevin Young:  The Propaganda of False Trade-Offs: Pitting the Public against Social Spending, Good Wages, and Environmental Protection

Marc Faber’s classical 2006 paper: Will the US Become a Banana Republic?

Ellen Brown: It’s the Interest, Stupid! Why Bankers Rule the World

“The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth” (The Global Financial Crises’ Placebo Effects by Satyajit Das, September 14, 2009 in

The author Olli Ranta is a computer programmer with experience in banking, treasury operations and customs procedures. He has a degree in control engineering.

This December 2012 version is similar to July version but Summary was added as proposed by J. Martikainen and much on employment was rewritten. Copyright @ 2012 by Olli Ranta

This work is licensed under the Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License. To view a copy of this license, visit or send a letter to Creative Commons, 444 Castro Street, Suite 900, Mountain View, California, 94041, USA.


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