The term (I-S) represents productive investments (I is total investment, S is total savings).  In monetary terms it may be identified with transaction money M1, which is the money used within the productive economy. 

All newly created bank money appears firstly as an increase in M1 (i.e., it is created within transaction deposits).  However a large part of that money migrates into savings deposits (on an ongoing basis).  Available statistics reveal that in times of economic growth (characterised by a modest level of inflation) an influx of new money increases I and S at about the same rate. 

However in times of economic contraction, production will be diminished and savings will increase, and there will be less demand for credit by the productive sector.  In these circumstances (I-S) will decrease.  Assuming for the sake of argument that the level of imports and exports does not change significantly (i.e., assuming that an export-led recovery is unlikely), we find that in order to avoid a period of deep and protracted recession the ONLY solution is for the government to spend more newly created money into the economy. 

Attempting to run a budget surplus in these circumstances is grossly irresponsible — perhaps insane would be a better description.

John Hermann

References:

http://krugman.blogs.nytimes.com/2012/03/27/minksy-and-methodology-wonkish/

http://krugman.blogs.nytimes.com/2012/03/27/banking-mysticism/

For example Paul writes:  ” If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand. “

The simple fact is than none of a bank’s retail deposits are ever loaned out, nor are the associated reserves ever loaned out to retail customers. Banks create new credit money when they advance retail loans. It amazes me that Paul does not understand this.

John Hermann

The money multiplier model of credit money expansion asserts that, in a fractional-reserve banking system, the total quantity of loans that commercial banks can extend (the bank credit money they are allowed to create) is a multiple of the quantity of reserves they hold in advance of the loans they extend. This multiple is a money multiplier and is the reciprocal if the reserve ratio.

However this money multiplier explanation, which is found in mainstream economics textbooks, is a completely wrong description of how fractional reserve banking actually works in the real world.  According to Prof Steve Keen, two hypotheses about the nature of money follow from the money multiplier model. These are:

1. The creation of credit money should happen after the creation of government money. In the model, the banking system can’t create credit until it receives new deposits from the public (that in turn originate from the government) and therefore finds itself with excess reserves that it can lend out. Since the lending, depositing and relending process takes time, there should be a substantial time lag between an injection of new government-created money and the growth of credit money.
2. The amount of money in the economy should exceed the amount of debt to the banking system, with the difference attributable to the government’s initial creation of base money.

Both of these hypotheses are strongly contradicted by available economic data. Testing the first hypothesis requires some data analysis, which was done by two leading neoclassical economists (Kydland & Prescott, Business Cycles: Real Facts and a Monetary Myth, Federal Reserve Bank of Minneapolis Quarterly Review, Spring 1990). Their empirical conclusion was:

There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series aregenerally procyclical and, if anything, the monetary base lags the cycle slightly. (p. 11)

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates(M2 minus M1) should be considered.  The difference of M2 - M1 leads the cycle by evenmore than M2, with the lead being about three quarters. (p. 12)

 

      Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than base money being needed to “seed” the credit creation process, credit is created first and then, after that, base money changes.

And it doesn’t take sophisticated statistics to show that the second prediction is wrong – all one needs to do is look at the ratio of private debt to money.

The actual mechanics of bank credit expansion are as follows. Suppose that the reserve ratio is designated by r (<1). This ratio might be a statutory requirement or it might be a voluntary liquidity requirement, depending on the country we are talking about. Suppose also that a commercial bank has deposits of magnitude Y and reserves of magnitude rY. In this situation there are no reserves excess to the bank’s liquidity requirement. Let us also assume that the bank’s assets and capital satisfy the capital adequacy requirement for solvency.

If the bank now decides to make a retail loan of magnitude X, then it will create a new deposit of that magnitude in the borrower’s demand account with that bank. The bank must now look for excess reserves of magnitude rX in order to satisfy the liquidity requirement. One way of doing so is to borrow reserves from the wholesale markets. If the central bank’s monetary policy is being adequately implemented, then there should not be a shortage of reserves across the entire banking system for the purpose of accommodating this requirement (and in the last resort, reserve funds may be borrowed from the central bank itself).

Another way of gaining the required excess reserves is to persuade one of the bank’s depositors to move a deposit of magnitude rX from a demand account into a term account (interest-bearing account). This action will free up reserves of magnitude rX, because there is a zero (or close to zero) reserve requirement for term accounts. Whether this method of gaining excess reserves is preferable to wholesale borrowing depends on the respective interest rates charged by the markets and the interest returns offered to the depositors, as well as the demand for interest-bearing deposits by the bank’s customers.

In conclusion, commercial bank lending is not reserve constrained. Banks lend to their customers first and, if necessary, look for the reserves they need later.

John Hermann

There is no universally accepted version of monetary reform. The basic proposal to abolish fractional reserve banking is often described as ‘Full Reserve’ banking.  However this description can refer to a system in which every loan advanced is matched by reserves on a one for one basis, or alternatively to a system in which there are no reserves at all and money is exclusively created by a central monetary authority – with financial institutions disempowered from creating bank credit money (and thus only capable of acting in a truly intermediary capacity). A variant of the latter system has been proposed by Ellen Brown — namely, that only publicly-owned banks should be allowed to practice fractional reserve deposit expansion, but operating in parallel with private sector financial institutions who are disempowered from doing so.  Her basis for trusting public banks to behave with due prudence, and for believing them incapable of falling into the mode of reckless lending behaviour displayed by many private banks in recent times, is that they are controlled by civil servants who presumably have no incentives for supporting Ponzi schemes or the casino.  However in my opinion such a split system would open up a hornet’s nest of tricky operational (not to mention political) problems.

One of the primary criticisms of ‘full reserve’ banking is that it is more difficult for capital accumulation to occur, making it difficult for entrepreneurs to raise start-up capital for large projects. However there are ways of addressing the issue of capital accumulation in the context of a “full reserve” financial system, such as appropriately structured investment trusts, without the sort of leverage that characterises fractional reserve banking.  The leverage currently placed in the hands of the large banks is often misused.  Far too much lending goes to support purely speculative activity in the financial markets, which distorts the markets, inflates asset prices, encourages financial fraud, increases the fragility of the banking system, and serves no useful purpose in the real economy.

I intend to restrict this discussion to an alternative ‘full reserve’ monetary system in which all money is created by the central bank (or a central monetary authority) and there are no reserves. Indeed, under such a system the concept and use of the word “reserves” would disappear from the economic lexicon.

The AMI model

The first type is the exogenous route, in which new money created by a central monetary authority is spent into the economy.  This is the basis for the monetary reform proposals put forward by the American Monetary Institute (AMI), and also form the basis of the recent bill introduced  into the US House of Representatives by Congressman Dennis Kucinich.

In expositions of the exogenous model there is usually a recognition that taxation will be necessary as a tool for exerting some control over aggregate demand and inflation (and secondarily as a tool for manipulating the distribution of wealth and income). However there seems to be less tolerance of the idea that central governments can issue public debt instruments, and that running a budget deficit via the issue of public debt would serve the purpose of authorising the government to spend newly created money into the private sector.

The Hummel model

The second type of monetary reform model embraces the endogenous route.

Australian economists Steve Keen and Bill Mitchell have both expressed a lack of enthusiasm for ‘full reserve’ banking, not because it is not technically possible, but because they are sceptical about the capacity of government agencies to get the creation of money right at all times. However this belief seems to imply that the expansion of the money supply, under such a scheme, would change from being endogenously driven to exogenously driven. Clearly in an endogenously driven system the government is not in the driving seat when it comes to the creation of new money, even if technically the mechanics of money creation involves the government spending newly created money into the economy. Thus it is the demand for new loans (in a debt-driven economic system) in line with the perceived needs of the overall economy, that drives monetary expansion. The central bank merely creates new reserves and introduces them into the banking system in response to those pressures, via the mechanism of achieving the interest rate targets which it perceives to be necessary for attaining an acceptable rate of inflation.

For a monetary system in which all money is fiat money created by a central monetary authority, I see no reason for assuming that monetary expansion would no longer be endogenously controlled. The mechanics of how such a system can be made to work in an endogenous manner has been worked out by William Hummel (see his website:  http://wfhummel.net/nationaldepository.html).  The Hummel model would work in much the same way that the current banking system operates, involving the implementation of monetary policy via the manipulation of interest rates,  with the important difference that there would be no reserves and no bank credit money.

Since all financial institutions in a ‘full reserve’ system would be obliged to behave as true intermediaries, Hummel has proposed – as a central feature of his approach – the creation of a single national depository.  Such a depository institution would neither borrow nor lend, but would simply exist to facilitate monetary transactions. Commercial financial institutions and post offices could act as agencies of this single national depository. It seems obvious to me that such an arrangement would be the most efficient way of ensuring the absolutely necessary demarcation between intermediary and depository functions.

Demarcation of the intermediary and depository functions

In both the endogenous and exogenous models, since banking institutions would be transformed into acting as true intermediaries, a mechanism would need to be found for demarcating the intermediary function from the retail depository function. This is because any workable payments system requires that a true intermediary (an institution which borrows and re-lends, making a profit from the interest margin) cannot simultaneously operate as a retail depository. And that is the basis for the introduction of a single national depository in Hummel’s scheme.

In order to better understand the nature of this imperative, we need to have a clear grasp of what a banking deposit consists of. The first thing I would mention about retail banking deposits is that they are a very special form of bank liability, and different from a borrowing.  The jurisprudential term is ‘bailment’, meaning that they are a form of money (albeit bank credit money, under a fractional reserve system) which must be held by the bank in trust and safekeeping.  And this is what gives the payments system its stability. The public needs to have confidence that their cheques will be cleared efficiently and without undue delay.

I am aware of various isolated legal rulings to the contrary, which have determined that bank deposits do not have special status and are mere borrowings.  However IMHO these instances merely reflect the economic ignorance of the judges concerned.  Moreover it is interesting that in practice no retail deposits are ever loaned out.  If they were merely borrowings then this would not be the case at all.

The second relevant thing about retail banking deposits is that they are always accounted – by central banks – as being part of the ‘money supply’.  The money supply is simply money which is accessible to, recognized by, and used by — the general public.  That is why reserves have never been seen as part of the money supply (nor are inter-bank deposits, nor are bank operating accounts, nor are central government deposits in holding accounts with commercial banks, nor is Treasury’s deposit account with the central bank).  Thus it is important to differentiate between the public’s banking deposits (which I designate ‘retail deposits’) from all other types of deposit.

The third thing I would say about retail deposits is that commercial banks have no need for retail deposits as useful assets.  Fundamentally this is because the commercial banking system both creates and destroys bank credit money as it deems appropriate.  Banks are only interested in acquiring the reserves which tag along in principle after all retail deposits, and have no interest in acquiring bank credit money itself.  This explains why any payments to a commercial bank – for any purpose whatsoever – entail the destruction of bank credit money and a temporary reduction in the money supply.  Only the associated reserves are retained intact.

All of this background will help to place into a proper perspective the Hummel proposal to create a single national depository – which is basically incompatible with a fractional reserve system.  Such a national depository would contain deposits of government-created money only, and would be unable to operate in parallel with existing banks issuing credit money deposits.  If banks were to become transformed into true intermediaries (like finance companies) then they would lose the power to create credit money, and the basic reason for their acting as depositories for the nation’s money would also cease to exist.  In these circumstances, a single national depository, which neither borrows nor lends, begins to make sense — as the most efficient way of carrying out the necessary depository function.

John Hermann

GDP = C + I + G + (X – M)

C = consumption

I = investment

G = government spending

X = exports

M = imports

Or stated differently;

GDP = C + S + T

C = consumption

S = savings

T = taxes

From there we can conclude:

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

Cullen has indicated that the key to understanding modern monetary theory is to recognise the significance of the zero net sum of (a) the private sector balance, (b) the public sector balance and (c) the foreign sector balance. Thus, rearranging the above we have:

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

(I – S) = private sector balance

(G – T) = public sector balance

(X – M) = foreign sector balance

One can see this in a fascinating visual form by viewing the sectoral balances in the USA going back to 1952:

John Hermann

A large part of the problem is that the most coherent explanations of modern monetary operations are counter-intuitive.  Such a state of affairs would not be a problem if we were talking about one of the physical sciences, where counter-intuitive explanations are commonplace.  However unfortunately economics is not yet a science, notwithstanding that mainstream economists love to play mathematical games based on flawed economic models.  These are models that simply ignore the mass of embarrassing empirical evidence which happens to demonstrate their falsity.  Such omissions and inconsistencies would never be tolerated in a genuinely scientific discipline. 

John Hermann

The reason why this explanation of debt growth is wrong is that the deposits destroyed when interest is paid on bank loans almost entirely reappear in the economy as deposits somewhere else. They return directly or indirectly as a result of bank spending. That includes spending on assets for the bank itself.

There is a small element of truth in the hypothesis by virtue of the option open to any bank to sit on some of the excess reserves acquired from the interest payments on its loans, rather than spending them. However it seems likely that the amount of excess reserves from interest earnings on bank loans would be self-limiting rather than cumulative. In that case, there would be some fixed loss in aggregate deposits, but not an ever-increasing loss as in the debt virus hypothesis.

There is a related issue in regard to the interest paid on bank deposits, which is sometimes conflated with the debt-virus hypothesis. Money invested in interest-bearing bank deposits (e.g., term deposits) is commonly rolled over – when each deposit reaches its date of maturity. This process includes the interest component, and therefore such investments compound exponentially. The interest-bearing deposits make up a large fraction of all bank deposits, and it may be concluded that the interest component which is tied up in these deposits is an ongoing drain on transaction money, M1. This is not necessarily a problem if goods and services are growing at the same rate as (or greater than) the average interest paid on bank deposits. The real issue here is the impact of saving on spending.

John Hermann

She makes the point that in the U.S. around 70% of spending is by households, and that whenever there is a significant fall in aggregate demand we should look towards implementing mechanisms designed to boost household spending as the highest priority. Examples of effective measures would include targeted tax reductions and government guaranteed employment creation and assistance programs.

Kelton also sees current beliefs and attitudes of politicians within the U.S. and in the Eurozone as major stumbling blocks which will need to be overcome before any real progress is possible.  The most firmly entrenched of those false beliefs include a widespread perception that there is no alternative to the current economic paradigm (summed up in the mantra “surplus good, deficit bad”), along with the belief spelled out in a recent statement by President Obama that “we are broke”.

Contrary to such a viewpoint is the recognition that no sovereign country ever needs to go broke or to worry about going broke.  Fears that the U.S. and other sovereign countries like the U.K. and Australia are in danger of falling into the debt traps exhibited by Ireland, Greece, Portugal and Spain are unfounded, because the latter group of countries abandoned their monetary sovereignty when they joined the Eurozone, obliging them to turn to the capital markets (mainly large European banks) in order to fund their deficits.

    It was the explosion of private debt on the back of asset inflation during the past decade – as a deliberate economic policy engineered by Fed Chairman Alan Greenspan – followed by the inevitable contractionary phase (the great recession), which subsequently persuaded the U.S. administration and other governments around the world to engage in stimulus spending (much of which was wasted because it was used for bailing out commercial banks and investment banks, but that’s another story) in an attempt to avoid massive deflation on the scale of the 1930s depression.

    The current “problem” of large public deficits is in reality not a problem at all in circumstances where there are idle workers looking for employment and idle productive capacity. However its existence may be regarded as an inevitable response to (and symptomatic of) the real problem.  Within the context of a debt-driven economic system, whenever budget deficits begin to rise significantly this is because private spending is weak and output growth is weak or contracting.  Such rising budget deficits are inevitable in these circumstances.  They are systemic within any debt-driven system, meaning that they are not engineered (contrary to what Tea Party members believe) as a direct result of government policies or government spendthrift tendencies.  The Tea Party interpretation of how public debt operates is a myth, believed only by those who have very little understanding of macroeconomics