Mitchellnomics

Newcastle economist Bill Mitchell criticises Greens economic policy from the left, which is welcome and quite apt on some points. It’s great to see this kind of discussion and it helps the left within the Greens.

He is right on about the wobbliness and incoherence of the commitment to full employment. But Mitchell’s views on money and government financing are problematic. Though he presents it as a case of “progressives who understand how the modern money system operates” versus “neo-liberal economics”, his ideas on money are a little eccentric even within the post-Keynesian or ‘heterodox’ community, hardly the obvious consensus he portrays with such confidence.

He says the federal government is a ‘monopolist’ in the issue of currency. This is not true, because the national currency is one among many. Everyone has the option of converting their money into a foreign currency. Most of us don’t do it unless we’re going on holiday or buying something on the internet, but of course managers of financial wealth are always comparing currencies, and if one national currency is expected to lose its  value, it will be sold for another. Even if Mitchell were right, and the federal government could expand its expenditure as much as needed for full employment by printing money without sparking inflation, the fact that financial managers would expect it to be inflationary would be enough for the dollar to dive.

And anyway, I don’t think Mitchell is right that it would not be inflationary, even if speculators happened to agree with him. When government expands spending with new currency, most of that currency will end up in bank reserves. This allows the banks to expand their lending and the money supply to a significantly higher degree, since they can carry deposits to a multiple of reserves. Mitchell would probably respond that if inflation developed, government could beat it by cutting back its spending again, or soak up the currency with open market operations. But this relies on some pretty heroic assumptions about the government having fine, well-timed control over its expenditure and ability to predict bank behaviour and its ultimate impact on demand.

Finally, Mitchell’s claim about the public sector deficit being the mirror-image of private sector saving (the balance of payments deficit/surplus aside): This is true by definition, but means very little. Perhaps he expects people to confuse ‘private sector saving’ with ‘household saving’. You can see why households as a group would want to have net savings over a period. But if their financial assets are to represent net claims over future real goods and services, they need to be claims on firms – shares and bonds, either directly or through banks, pension funds and other intermediaries. In other words, household savings are ultimately claims on firms, i.e. business debt.

But both firms and households combine to form Mitchell’s ‘private sector’. Why would firms and households collectively want to save over the long term in claims on the government? Except to the extent that governments are producing goods and services for sale, their income comes ultimately from taxation (or, if Mitchell ran the government, perhaps inflation) – which is a claim on the private sector! (It’s true, though, that the private sector is always going to want to hold currency and certain government securities, and to that extent the government does not need to worry about getting the deficit to zero – and in fact even when government debt was entirely paid off it still issued securities to fill certain asset needs of banks etc.)

I actually agree with Mitchell that much agonising over government deficits is bogus, and comes from the false idea that government finances work like household or firm finances. Government finance is always and everywhere a macroeconomic issue, as opposed to an accounting issue. But Mitchell’s proposals fall down on the macroeconomics.

The Greens should take full employment seriously. But they also need to realise the extent to which full employment requires a radical reorganisation of how wealth and investment is controlled. It would mean a full-on fight with wealth-owners. The fundamental problem with Mitchell’s analysis is that he makes it sound all too easy, just a technical problem that could be easily solved if only governments weren’t blinded by ideology.

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23 CommentsLeave a comment

  1. Dear Mike

    My response to your article appears in this blog.

    best wishes
    bill

  2. […] strikes back Bill Mitchell has responded to my criticism at great length. I’ll try and boil down the points of disagreement, but this is still going to be […]

  3. Mike: a quick technical point (which I also made on one of Bill’s posts). When you say banks “can carry deposits to a multiple of reserves”, you are getting caught up in the usual discussion of money multipliers that focuses on minimum reserve ratios. This does not apply as you describe it in Australia, as our regulatory framework does not impose a minimum reserve ratio on banks (unlike the US which has a 10% minimum reserve ratio).

  4. Cheers, Mr Mule, you’re right about the lack of a legal reserve requirement (though there are still regulatory capital requirements). The liquidity of reserves still matters in the prudential sense that banks need to be able to meet their net outflows. But that need not mean actual currency holdings, if the bank is confident of being able to liquidate another asset or borrow in a hurry. The financial system as a whole however is still constrained ultimately by currency, though in practice this does not manifest so long as the central bank is prepared to provide it in the money market at the target interest rate. Would you agree with that?

    • Regulatory capital requirements serve a different purpose. They address solvency rather than liquidity. What this means is that they aim to ensure that banks have enough equity to absorb losses from lending losses. This equity in no way deals with liquidity risk, namely the risk that when depositors want to withdraw funds or wholesale debt mature the bank has insufficent cash or liquid assets to make the payments. Liquidity problems can arise even if all the bank’s loans are performing perfectly well.

      Minimum reserve ratios (as in the US) are one regulatory approach to liquidity risk. In Australia, APRA takes a different approach to liquidity risk which requires that banks hold a portfolio of liquid assets, such as Government bonds, State Government bonds (“Semis”), more recently, Government-guaranteed bank bonds. There is not a simple relationship between total deposits and the size of this liquid assets portfolio. Rather it is based on modelling of potential liquidity requirements. The details are in Australian Prudential Standard 210.

      What this means is that the popular conception that money supply (as measured by, say, aggregate bank deposits) is not a simple multiple of the liabilities of the Reserve Bank (i.e. reserve accounts and currency). So, if that is what you mean when you say “The financial system as a whole however is still constrained ultimately by currency”, then I don’t agree. Of course, this may not be what you mean.

      • Yeah I’m familiar with the distinction between liquidity and solvency! But the question is about constraints on bank lending and money creation, which both are.

        I completely agree with your statement that “There is not a simple relationship between total deposits and the size of this liquid assets portfolio.” But there’s a big difference between the phrases “being a simple multiple of” and “constrained ultimately by”, which seems obvious to me.

        For every bank, and for the system as a whole, there’s a safe zone of lending in which they are very unlikely to get into liquidity trouble, and there’s a red zone in which they are pretty much definitely going to get into such trouble. In between these zones there’s a zone of increasing risk.

        For any given appetite for liquidity risk, an extension in the supply of liquidity increases the lending banks are comfortable with. Because risk appetites and the strength of demand for credit changes, deposits are not a simple multiple of liquid assets. But the former is still constrained by the latter.

      • “For any given appetite for liquidity risk, an extension in the supply of liquidity increases the lending banks are comfortable with. Because risk appetites and the strength of demand for credit changes, deposits are not a simple multiple of liquid assets. But the former is still constrained by the latter.” Not necessarily! Liquidity risk arises from short-term liabilities (at call deposits, term deposits, certificates of deposit, etc). However, banks can raise term funding. Consider a scenario in which a bank issues $10m in 3 year bonds and simultaneously lends money to a corporate for 3 years and, if necessary, issues some equity to meet the capital adequacy requirements for the loan. This introduces no liquidity risk. Furthermore, these transactions require no additional money. So, lending need not be constrained by liquidity.

      • “Consider a scenario in which a bank issues $10m in 3 year bonds and simultaneously lends money to a corporate for 3 years and, if necessary, issues some equity to meet the capital adequacy requirements for the loan. This introduces no liquidity risk. Furthermore, these transactions require no additional money. So, lending need not be constrained by liquidity.”

        You’re still thinking in terms of individual banks, whereas I am talking about a _systemic_ supply of liquidity. In your example, the long-term borrowing is coming from other units which must spend money on the bonds and equity. Even if the constraints appear to individual units as increasing interest rates rather than absolute unavailability, this is still a symptom of demand from many quarters chasing a finite supply.

      • The long term lending doesn’t have to come from other banks. Imagine that the corporate and the purchaser of the bank’s bond all banked at the bank and that the latter previously had $10m in a deposit account with the bank. After the loan and the bond purchase, the bank simply reduces the balance of bond purchaser’s bank account by $10m and increases the corporate’s bank account by $10m. No money from any other bank is required!

      • And, of course, if one bank can do this without requiring external funds, so can every bank. This means that what applies to a single bank applies to the system as a whole.

        Of course, you could then say that if liquidity was constrained (as in an earlier phase of the current financial crisis) then it would be difficult for banks to source long-term borrowing. I would agree with that, but by this point the concept of “liquidity” is being use in a much broader sense than where you started, which was that bank loans are constrained by the the amount of money created by the central bank.

      • Yeah, I think you realised in the second comment how I would have responded to the first! The bank’s still got to compete for credit and if a lot of banks are doing it at once, rates are going to rise and potentially – as you note has happened – credit will be unavailable.

        Credit and money markets are interrelated, Banks raising credit in the way you describe depend on the liquidity preference of the non-banks, on their collective willingness to hold less liquid assets, which means either a declining liquidity preference or higher interest rate. It’s a complex system, but it is still ultimately constrained by currency.

        A good paper on this interrelation is Chick and Dow [2002]: “Monetary policy with endogenous money and liquidity preference” in the Journal of Post-Keynesian Economics. It addresses exactly the points you are making. If you don’t have library access I can send it to you.

        I actually don’t think we are too far apart in our conceptions – if there was a monetarist in the room we’d be on the same side. I also don’t think banks come anywhere near the point of effective currency constraint in normal times in current institutional arrangements, not least because of central bank intervention in the money market.

        As for where we are compared to where we started, we’re also a long way from “simple multiple”. All I am arguing is that, other things being equal, more currency in the system allows a quantitatively greater expansion of bank liabilities. Also remember that in my debate with Mitchell I was arguing about the _difficulties_ in central bank restraint if the public sector is continually creating currency! So I agree with the spirit of your comments, that there are an awful lot of places to find liquidity, and we haven’t even got started on international borrowing!

      • I suppose the essence of the point I am making amounts to the following:

        * Bank loans can be used to create money (if the offsetting liability is a deposit or similar)
        * Creation of money is constrained by bank liquidity regulations (simple constraint with reserve ratios, more complex in the case of Australia)

        BUT

        * Bank loans do not *have* to create money.

        Think of it like this. If banks had no liquidity regulation then (in principle at least) there would be no limit to bank expansion of money supply. In exactly the same way, there is no limit (in principle) to the expansion of supply of bank term debt. Of course, in practice this expansion will be constrained by the demand for money or debt respectively, but this is not a central bank or regulatory constraint.

      • Well, even if there were no liquidity regulations, liquidity would still constrain banks because of their need to meet net outflows. Banks have their own liquidity preference which cannot be satisfied with their own liabilities, even though the latter pretty much _are_ liquidity to the non-banks.

        In this day and age, anyway, I think liquidity regulations are in practice there more for prudential reasons than for monetary policy, which they were important to in the past. This is due to the success of bank asset and liability management in getting around the restrictions. Capital requirements tend to ‘bite’ first in restraining lending, right? This is just a preconception, which I haven’t really investigated.

  5. A few more comments:

    1. You suggest that expecting the Reserve Bank to manage inflation through open market operations requires heroic assumptions. Isn’t that exactly what we have tasked the Reserve Bank to do? Are you suggesting we are already already being heroic in our hopes giving them this job?

    3. You ask the question “Why would firms and households collectively want to save over the long term in claims on the government?”. In Bill’s framework, there’s no need for savings to be in bonds. I’m not sure what gave you that idea.

    3. In discussing Bill’s point about the balance of payments between the Government and private sector you seem to be implying that the private sector can sustain a deficit (or a zero balance) while the household sector saves as the business sector would run a deficit because households buy bonds or shares. This confuses the capital account with the current account. Buying bonds or shares constitute movements in the capital account and are not part of the balance of current accounts across the Government, household and business sectors. For the Government to run a fiscal surplus (or balanced budget) while the household sector saves, it would be necessary for the private sector (on average) to be making operating losses!

    • Whoops! “2″ should be “3″ (feel free to edit!)

  6. Whoops! “2” should be “3” (feel free to edit!)

  7. Hey again Mule,

    1. I think it’s heroic to expect open market operations to be able to prevent inflation in circumstances where the government is continually injecting currency into the private sector with ‘unfunded’ deficits.

    2. Saving always involves an accumulation of some kind of asset, usually a financial instrument which is another unit’s liability. Right? I never said bonds alone, but “if their financial assets are to represent net claims over future real goods and services, they need to be claims on firms – shares and bonds, either directly or through banks, pension funds and other intermediaries”.

    3. Current and capital accounts don’t exist in separate universes but are interrelated. For every unit, some current income is spent and some is saved (or dissaved). What is saved by definition involves the accumulation of assets or the repayment of liabilities, and therefore enters the capital account. Same in the aggregate. It’s perfectly possible for households as an aggregate to save while the government budget and national current account are balanced, without firms making losses, so long as firms are borrowing or selling equities.

    • Mike,

      1. I’m a bit more optimistic about the task before the Reserve Bank. When you say that “the government is continually injecting currency into the private sector” you make it sound as though the quantum of Government spending occurring at the moment is disastrously huge. As I argued in recent blog post the projected size of the Australian Government (combined at both the Commonwealth and State Government levels), although certainly increasing is not unprecedented historically and is positively benign by global standards.

      2. Does that mean I should interpret your original statement “Why would firms and households collectively want to save over the long term in claims on the government?” as “Why would firms and households collectively want to save over the long term in any form of financial asset?”. If so, are you really arguing that is a good idea for the private sector to consistently run a negative savings rate?

      3. This one’s a biggie. You seem to have missed the point of the distinction between current accounts and capital accounts. I think I’ll have to come back to this one for a longer reply when I have some more time!

      • Hey Mule,

        1. I haven’t been arguing at all that the present deficit is inflationary. My point of debate with Mitchell is whether or not the state is able to run permanent deficits by issuing currency (i.e. without simultaneously borrowing) without eroding its value. This should be clear from the posts.

        2. No, obviously the point of saving by holding a financial asset is that it is a claim on future money flows. This is true whether it is a public or private liability. The unit whose liability the instrument is funds those flows through other economic activity. In the case of the state, except to the extent that it’s engaging in production, it funds the money-flows of interest payments and bond redemption through either tax, more borrowing or creating new currency. Both tax and borrowing are monetary flows from the private sector. Only a very small proportion of private sector wealth will be held in the form of currency. So ultimately, in holding claims on the public sector, the private sector is holding claims on itself.

        Of course, to individual private sector units, holding a government liability as an asset is as good as holding a private liability of the same value. Government debt and currency play important roles in private sector portfolios, and there will always be some demand for them. But, no, there is no reason why the private sector as a whole would want to accumulate more and more government liabilities as assets. The private sector as a whole ‘saves’ through the accumulation of capital used in production.

        3. Great, looking forward to it!

  8. In my theoretical world where loans are match funded by bank bond issuance, there is no liquidity problem because there are never net outflows. When the bond comes up for maturity, so does the loan. Either both are refinanced or both are repaid, no net outflow!

    Of course this doesn’t happen in practice because there is more profit to be made in banking by raising shorter-term funding than the term of loans.

    I agree with you that liquidity regulations are designed to preserve the stability of the system.

  9. But as I noted in the last comment, it draws liquidity away from the non-banks. Think about the buyer of the bank bond in your example: they swap cash for a bond, which, other things being equal, means a declining non-bank liquidity preference schedule or a higher interest rate. There is no movement of currency (i.e., high-powered money) out of bank reserves, but it is still a practice with limits.

    I’m starting to see how you got your name! 🙂

    • I’d agree with that, but would also go back to an earlier comment: “I would agree with that, but by this point the concept of “liquidity” is being use in a much broader sense than where you started, which was that bank loans are constrained by the the amount of money created by the central bank.”

      One of the problems in these sorts of discussions is that terms like “liquidity” and “money” get used to mean different things, so it’s very easy to end up speaking at cross-purposes.

      Finally, even Bill regularly acknowledges that lending, fiscal deficits etc. are ultimately constrained by supply and demand. This is, however, a constraint that can move around and is very different to hard constraints like the amount of money that can be printed in gold-backed currency systems.

      • Cool, let’s agree to agree then! I agree about the slipperiness of ‘liquidity’ – clearly to advance further in building a picture of the financial system you need to be more precise.

        As I’ve said elsewhere, my conception comes from the post-Keynesian structuralist position. Liquidity is related to the means-of-payment, and is defined as the ease with which an asset can be converted into an expected quantity of the means-of-payment. ‘Ease’ is not something that’s easy to quantify, but in practice it is valued on markets, though perceptions of ‘ease’ and risk may change the demand schedule even while the value placed on liquidity (liquidity preference) stays the same.

        Also, the means-of-payment is different for banks and non-banks: banks settle payments between each other and the central bank with currency (or ‘high-powered money’), while non-banks usually settle with bank money. This means different sense of liquidity for the different tiers of the system, although they interact in complex ways since banks and non-banks interact not only as despositor and deposit-holder, but also as buyers and sellers of financial instruments in the same markets.


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