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From Austrian Economics to MMT – a short guide in 7 steps

12 May 2011 19:35

Step 1).One of the classic examples about savings: – Robinson Crusoe collects 10 Coconuts a day, but only consumes 8 every day. So, he is actually saving 2 nuts / day. After a few days, he will have enough coconuts saved so that he can take a day off (only do things entirely unrelated to coconut collection), but will still be able to consume his habitual 8 nuts a day. Ergo: Savings enables future consumption.
This, of course, holds in a micro-economy – only one agent, producing for his own consumption.
From standard modern situations, we just assumed away: Trade, Market, Money, Bank(s), Credit, Central-Bank, and Government. (And of course, no civilization exist were any of the above is absent).
So, we will now, step by step, add the above features, and look if the assumption about savings still holds.

Step 2)
Assume there are two agents, both farmers, mostly self reliant. But farmer Apple has a big apple tree, while farmer Smith has the ability to forge knives. So there might be a mutual desire to exchange some apples against knives. Now, the rate for the first trade would be 10 apples against 1 knife. Will there be further trades? May be – maybe not. If A. would like a second knife, but S. has no use for further apples, there might be no price relation were apples are cheap enough that S. will produce and give up a second knife, because apples are not durable, and therefore, they are not a good store of value, thus S. will only accept some for consumption, but will not invest in apples.
Ergo: both agents have surplus capacity, but part of existing (apples) or potential (knives) supplies will not be exchanged (or produced), because the respective desires of the agent s don’t match.
So there are not much savings, but there already is unused capacity.

Step 3)
Of course, if more agents take part in the game, there would be a chance that someone else would offer things that S. might trade for knives, and there might be people with a desire for apples, and willingness to give some of their products to A. But in an unorganized, chaotic society, it would still be difficult (and time consuming) to find matching trading partners, as long as there is no market, and no generally accepted means of exchange. Now, some people argue, that such a universally accepted means of exchange could be found, that one particular commodity, gold, fulfilled all the qualities needed so serve as means of exchange. There is the little caveat, however, that gold nuggets are much less uniform (in purity, weight and size) than for example, apples and knives, and that exchanging irregular lumps of gold might prove difficult. So, besides the miner who digs the gold out of the ground, there has to be one more agent, the minter, who melts it down and forms it into uniform coins. [Of course, in reality, mints are usually government agencies – but for the sake of argument, let’s assume of perfectly working private mint, producing recognized standard coins.]
In such an economy, goods are usually exchanged against (gold) money – but still step by step. A producer has first to make products for sale, than exchange them for money (in itself a product, initially produced by the gold mine/mint), before he can exchange the money for other products.
With this modus operandi, savings still needs to precede investment, because there is no credit, and therefore, all payments are immediately due. What are now – after step 3 – savings?. Well, all goods that are not consumed – the good which cannot be consumed is money – as money is usually more durable than other commodities, surplus products will usually be sold, and money (gold) will be saved. Ergo – net savings equal the stock of (gold) money.
Of course, there is some uncertainty here – if saving takes the form of money, we can’t know what that money will eventually (in the future) buy. Using the example of the apples again – if in year 1, there is late frost after blooming, the appletree might bear almost now fruit, and therefore, apples might be extremely expensive in year 1 – my saved money buy’s few apples. In year 2, however, the harvest might be super-abundant, (and there might be several suppliers of apples), and therefore, the apple producer will barely be able to get the expected amount of money, because apples are now so cheap. So, whatever amount of money you saved, your ability to consume real goods and services will depend on the availability of those goods and services (and the price level) in the future.

Step 4) the big one – lets introduce a bank.
While gold coins have their advantages, they also have their disadvantages. As they are uniform and relatively small, I might lose some, or they might get stolen, and I will never be able to identify them as mine, so the finder / thieve might use them without problems. So, may be, I’ll find it more convenient to deposit them in a Bank. The Bank will give me a receipt / an account statement, that says that now, the bank owes me (say 100) coins, and that it will repay them on demand. May be the bank will also allow me to draw checks on my account, and will therefore transfer payments to other agent’s, that have sold me goods or services. As long as the bank does nothing else (that is – only serves as a safe deposit, and intermediary of deposits), nothing much changes. (Of course, the bank can’t make a profit, unless it charges me something for its services, which I might accept if I feel saver so).

But in practice, not only I have become a creditor of the bank (by depositing my money in it), but the bank will grant loans and therefore create credit. If the bank only loans out the funds that are deposited in it (as is often assumed), and hands the coins to the borrowers, it will not immediately be able to return me the coins I’ve deposited (it doesn’t have them anymore, because it handed them over to the borrower. It would have to get them back from the borrower to repay me, or it would have to seize an eventual security (say – a piece of land) that the borrower offered, but may be they will not get enough to repay all deposits, and so the bank will break. (Become illiquid, insolvent, and yes – that’s the source of the word – bankrupt (a broken bank)).

Of course, more often than not, the bank doesn’t hand over the coins to the borrower. In exchange for the loan (say a mortgage) it creates another deposit. So the bank now has two sorts of assets – loans and actual money (gold coins), but only one form of liabilities (deposits). And the sum of deposits exceeds the sum of base money. So, if depositors lose confidence in the bank, they might still all try to withdraw their deposits (bank run), and therefore, the bank fails.
There is no change in net financial assets yet – while money in circulation exceeds money in existence, the additional bank liabilities (private bank deposits) are balanced by additional private debt.

But there is one huge change – the ex ante savings constraint has fallen. With credit, it’s now possible that money in circulation exceeds savings. So, to spend, it’s not necessary to earn first, spending can also be enabled by borrowing. If there is excess capacity – and as we have seen in step two – there almost always is some – idle resources can now be mobilized by spending funds that have not yet been earned. This is an inversion of the savings constraint that held until step 3.
Until step 3, you had to put something (goods or money) aside (not consuming it / not spending it on consumption) to be able to spend more in the future – so savings enable investment, and put a constraint on it. But with credit, the inverse is true. As you can spend before you earn, savings are no pre-requisite for investment. Quite the opposite – investment creates savings. Aggregate income is generated by spending, spending on consumption, and spending on investment. Income from consumption and expenditure for consumption cancel each other out, and therefore, the income from spending will remain as residual, as savings. Therefore: Investment = Savings – or rather: Investment creates savings.

Step 5 let’s issue fiat money.
As we have seen, a bank failure is a distinct risk, as long as the bank has to make it’s bank (credit) money convertible in to gold. (Not enough gold in its vaults). OTOH, most people don’t care about gold coins – they are content to hold bank liabilities – either in the form of deposits, or in the form of banknotes, the most common form of cash in modern times. If we assume a single monopolistic bank, the risk of default / bankruptcy could easily be averted by ending the convertibility of bank money in to cold coins. Most people won’t feel a big difference – the always can withdraw banknotes up to the amount on their deposit, and for failed loans, the bank can just create more credit, additional loans. Of course, if she does so excessively, demand backed by money might actually exceed the capacity of the economy to increase supply of goods and services, and thus, inflation could result. But the bank would never default – bank losses would actually increase the net financial assets of the non-banking sector. (Private debt has gone under – but total deposits and cash remain unchanged).

Step 6 – what if there are many banks?
The example above dealt with a single, monopolistic bank. That’s of course, rarely the case. So, if different banks issue credit without co-ordination, what will happen? If both banks issue non-convertible credit money, there might be an imbalance, as Bank A might issue credit more easy than Bank B. In that case, we should expect a flow of money from A to B, because people that borrowed from A. have more money relative to their non monetary assets than people that do business with Bank B. As a result, we should expect the value of A-money to decline relative to B-money – so there will eventually be a floating exchange rate.
If, OTOH, banks want avoid that their money has a volatile value relative to the money issued by other banks, they have to assure convertibility – either in to gold or another stable commodity – or in to currency issued by a hierarchically superior currency issuer. So, Citibank $ are always convertible in to Federal Reserve $.
This currency issuer is usually called a Central Bank. (CB)
The convertibility in to Central Bank money limits the ability of the bank A. to issue credit, because it has to get the bank notes from the CB, and it has to clear payments to bank B via the CB, (via reserve accounts), because only then will B be sure that they can get the necessary funds if they accept payments from clients of A to clients of B’s deposits. Of course, the Banks can lend extra reserves from the CB, but only against collateral, and at a price.
The ability of the CB to grant further reserves to commercial Banks is limited, if the CB promises convertibility of its currency – either in to gold (as used to be under the gold standard) or in to currency issued by a foreign CB, as is sometimes the case with CB’s of smaller countries, that peg their currency to a larger currency, and have a fixed rate (say to US$). CB’s that don’t guarantee convertibility (and that’s all major Central Banks today) will have to accept a floating exchange rate, but OTOH they face no limits on how much of their own currency they may issue – so they can bail out as many private banks as they choose, and finance as much government deficit spending as desired.

Step 7 last but not least – let’s introduce government.
Many people might argue that government is just one economic agent among many – and that it has to be run by the same methods as a private business. There is, of course, something flawed with that argument.
First, government usually – unlike private firms – doesn’t sell its services on a service by service fee on the marketplace. It pretends to raise the revenue needed to finance its services by a system to collect money, called taxes, that are charged on income, property or transactions of the private sector. But taxes usually do not have a direct relation to government services.
So, even if government would tax to finance its services – in a system with gold money, the total amount of net financial assets would be limited to the total of gold money in existence. (Step 3) So, if the government would run a surplus (tax more than spend), it would reduce net private savings, as now the government would hold part of the total available savings, and thus private sector savings would have to decline. And a government deficit / government debt would shift more of the total savings to the private sector. Here, under the Gold Standard, total debt (public and private) might indeed hit a limit, and public debt might crowd out private investment.
But, as we have seen above, all major countries now have fiat currencies, so there is no upper (or lower) constraint on total net financial assets. Therefore, government deficits are the only way to increase aggregate private savings – if the government spends – with the cooperation of the central bank – it creates additional net financial assets – if it taxes, it destroys net financial assets. So, absent a gold standard – total private savings equal accumulated government deficits. If the government would pay back its debt by taxing enough to generate a stable surplus, this would remove purchasing power from the private sector, and would thus bankrupt the economy. And if the government would tax enough to generate a surplus big enough to eliminate debt, all high-powered money would have vanished from the system, no private savings could exist anymore, and therefore, the country would have fallen back in to the stone-age. [Of course, the government could eliminate nominal debt by paying back treasury bonds by just overdrawing it s account at the central bank – here, no adverse effects are to expect]. And, don’t forget it – if the government spends without limits, and taxes very little, nominal private financial assets will increase spectacularly, but such a increase in spending might actually be faster than the ability of the economy to increase supply, and hence result in inflation.


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