op - modern monetary theory - day 1

8/3/2019 OP - Modern Monetary Theory - Day 1

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OPINIONPIECE

Frank Ashe8 October 2009

A Kindergarten guide to modernmonetary theory Day 1

When reading about modern monetary theory I suggestthe following procedure:

Forget who you are.

Forget what you think of government good or bad unless you are going to be able to get rid of government(that is, establish pure communism) you are stuck with it.

Forget what you think of social policy you may hate theunemployed or you may feel compassion forget allemotions.

Forget what nation you live in it doesnt matter.

Forget all prior economic concepts and training (if any).

Then just try to understand what you read.

Bill Mitchell1

With a number of commentators coming up with contradictory viewson how the world will come out of the GFC I was forced to wade intothe morass of economic thought myself and see if there wasanything that could be sensibly said.

The risk of the world ending up in unpalatable economiccircumstances needs to be understood by any company in thefinance industry, so what should a risk manager know? In terms of a

standard risk management framework I was at stage one identifythe risks. Could I listen to the experts? No, they disagreed witheach other. Could I get them to sit down and debate the matterssensibly? No, they talk past each other and dont listen. That initself raises big risk management issues at a strategic level wemay or may not have a huge risk with no simple way of finding out.You have to assume its there and plan accordingly. Separately, Ichose to see if I could make sense of the arguments.

The following highly simplified account of fiat money and creditcreation is my attempt to put the economic theory into plain talk. I

1 Mitchell (2009) In the spirit of debate my reply Part 2


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have deliberately tried to dumb down the language as much aspossible to ensure that anything that may be wrong will be glaringlyobvious it is far too easy to hide critical issues behind obfuscatoryacademic jargon2.

For those people who start to read this and feel their hackles rising,

please read Bill Mitchells quote above. If you dont like theconclusions then please point out the error in my assumptions or mylogic. It is not sufficient to point to a conclusion and say that itsobviously wrong from personal observation, the obviousness of thewrongness is driven by cognitive dissonance. As Keynes said3

Practical men, who believe themselves to be quite exempt fromany intellectual influence, are usually the slaves of some defuncteconomist.

No kangaroos are allowed no jumping to conclusions that are notcompletely supported by the assumptions that have been made so

far.

Everything I know about economics should have been taughtat kindergarten!

Miss Moneypenny is a kindergarten teacher with a very bright set ofpupils:

Neo, a bright boy who loves playing with models and watcheslots of science fiction and fantasy movies peopled withsupercomputers capable of fantastic computations, beings who

can see all possible outcomes of theirs and others actions, andhumans without emotions clouding their thinking;

May, a clever girl who prides herself on changing her opinionwhen the facts change;

Karl, always thinking about the underdog;

Frank is a risk manager at a bank who has crept into the classbecause he cant understand whats happening in the GFC. Hehas a PhD in thinkology but still gets confused when academiceconomists throw big words at him.

Class Miss, where does money comefrom?

Moneypenny

Thats a long story. Well have totalk about people and groups ofpeople and trusting each other.

2 A more formal argument is given in the book Wray (1998) UnderstandingModern Money: The Key to Full Employment and Price Stability. Less formal is

the blog by Bill Mitchell http://bilbo.economicoutlook.net/blog/.3 Keynes (1936) The General Theory of Employment, Interest and Money,Ch24.

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The major players

Here are the Australian people

Here is their Government.

The people tell the government

what to do. This is democracy.Well ignore this for the momentand pretend the Government is notlistening to the people.

Here is the rest of the world wellignore them for the moment.

The government can do things thatordinary people arent allowed to,like make laws. This is one reasonthe people invented government.

But for understanding money weneed to just remember that wecant assume that the governmenthas to follow the same rules as

people its a different sort ofentity4.

The Real Economy Part 1Moneypenny

People have a habit of acquiringand disposing of things. This iscalled the economy.

4 Remember the Fallacy of Composition. The properties of an aggregate

entity may not be deducible from the properties of its constituents. The mostwell known examples in economics are most probably the Paradox of Thriftandthe Tragedy of the Commons.

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Neo What about making things? Isntthat important?

Moneypenny

Well only look at what peopleswap between themselves. If youmake something for yourself thenits your own business. Theeconomyis what everybody doesfor other people.

Class What is the size of the economy?

Moneypenny

The economy is big. If we add upall the cash and credit that peopleuse to buy things in a year thenthat is one way to guess the size ofthe economy in that year. But first

I need to tell you what cash andcredit are.

Cash

This is physical money. Somepeople call it cash.

Often people put a price on thethings they want to get, or get ridof.5

People can swap physical moneyfor things the price is how muchphysical money to swap. This iscalled buying and selling.

If people dont have physicalmoney then they can trust eachother to pay later.

Karl What if you have nothing to get ridof? How do you get cash or credit?

5 Things include services and intangibles.

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Moneypenny

Oh Karl! You always have yourfree time, or time that yourespending doing something youdont like.You might get someone to buy

your time to pick up some rubbish.Then you can use the cash to buythe time of someone to tidy yourroom. If you like tidying your roomless than picking up rubbish thenyoure ahead!

Credit

If I promise to pay you cash then Ihave a financial liabilityand you

have a financial asset.

No net financial assets or liabilitieshave been created6.

My liability of $100= Your asset of$100

This is called credit creation and itcreates credit.

Gross credit isincreased by $100

May What happens if you lose an IOU?

MP You lose a financial asset and theperson who owed you the money

no longer has the liability.Everything still balances.

Sometimes people trust each othera lot.The amount of credit goes upbecause were quite happy doingthings for people and trust well bepaid later.

Sometimes people dont trust eachother much.The amount of credit goes down.We give people back their IOUs andask for the money.

People lose trust if they think theother persons promises to paywont be kept.

Neo What will stop the amount of creditjust going up and up and up?

6 Notice that there is no net saving being done. Every asset has acorresponding liability.

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Moneypenny

Thats a difficult question that wellcome to later. But simply, if we alltrust each other enough then thereis nothing to stop the amount ofcredit growing bigger and bigger

and bigger, just like blowing abubble.

Neo Thats silly, Miss. People could seewhats happening and theyd stoptrusting each other.

Moneypenny

It would be nice to think so, but itdoesnt happen.

Financial Instruments

One person can promise anotherone to pay them $(1+i) in thefuture. This is a financialinstrument. The price of thisinstrument now is $1. A simplename for this is a bill.

The number i is a rate of interest.

If I sell you a bill then I have afinancial liabilityand you have afinancialasset.

May So if I wanted to spend cash so Icould run a shop, then I could sellyou a bill and get the cash?

Moneypenny

Thats right, May. I wouldnt evenneed to have the cash. If otherpeople trusted my credit then Icould just give my bills to you andyou use them to buy what youneeded.

Neo Wow! Weve talked about creditcreation and we haventmentioned banks!

Moneypenny

Banks are special, but not asspecial as some people think theyare.

May Is this credit really what we callmoney?

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Moneypenny

Some people would say so7, but itsconfusing if we do while we havethis conversation. Its not money,its credit.If we call this idea money creation

then some people get even moreconfused, so we wont!

The Payment System

Here is an ordinary bank.To keep things simple we willsometimes treat banks like people,but its silly to think like that all thetime.

People trust banks a lot8

If lots of credit has been createdpeople can lose track of who oweswhom how much.

Banks have created a paymentsystem to help solve this problem.This is a service that banks sell topeople.

Banks set up accounts for peoplewhere the people can keep track of

all the credit theyve created orbeen given.

Most people have bank accounts.

The account is a number in aledger.

If I give the bank $10 of physicalmoney they increase my accountby $10.

Bank liability = $10

owed to meBank asset = $10cash

If I take $10 of physical moneythen they decrease my account by$10.

7 See Committee on Payment and Settlement Systems (2003) The role of

central bank money in payment systems as an example of a document thatcalls this commercial bank moneyas distinct from central bank money.8 Usually!

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The banks balance sheet is alwaysbalanced

A positive amount in my account isa financial asset for me and a

financial liability for the bank.

If Adam and Betty have accountswith the same bank and Adamowes Betty $10 then Adam can tellthe bank to decrease his numberby 10 and to increase Bettys by10.After this Adam doesnt owe Bettyanything.

If Adam and Betty have accountswith different banks then Adamsbank will decrease Adams accountby $10 and pay $10 to Bettysbank, which will increase Bettysaccount by $10. This is aninterbank transfer.

To make sure that the transferscan occur the banks may keepsome physical money on hand.This is called liquidity.

The Banking System

Banks trust some people

Banks like buying bills from peoplethey trust. This is called banklending. Banks like big numbersfor i.

Banks dont have enough physicalmoney for all their lending and sothey create credit. The number inthe borrowers account goes upwhen the bank buys a bill (makes aloan)..

Liability = $100 inborrowers accountAsset = $100 PV ofbill

Everybody likes balance sheets tobalance, so we are happy.

May Lets pretend BankA is creatinglots of credit. What will happen?

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Adam has borrowed from A so hecan spend and now he owes moneyto Betty who banks with B.Through the payment system, Anow has to pay B some physical

money but cant do it, so mustborrow credit from B or fromsomeone who can transfer credit toB. This is the interbank moneymarket.

Liabilities:$50 in Adamaccount

$50 IB borrowingAsset:$100 PV of bill

IfA does this borrowing too oftenthen other banks will start todemand a large rate of interestbecause they wont trust A.

A simple way for A to manage this

risk is to have half of its liabilitiescreated by people who will bebuying things (borrowers) and halffrom people who will be sellingthings.9

The people who sell things willeither put physical money into theiraccount with A or will havetransfers into their account throughthe payment system.

To make sure people will lendmoney to A it must pay a good rateof interest.

Frank has to unlearn.He was taught that banks recyclesavings.Now he sees that bank lendingoccurs first and then the banklooks for savings to finance itslending.

9 Asset-liability management is actually only liability management!

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Neo How do we know the savings willoccur?

The interbank transfer earlier onlyoccurred when Betty had anincrease in her account as Adamspent his credit. If Adam hadntspent his credit there would havebeen no problem.If Adam spent his credit with Cathywho banked with A then therewouldnt have been any problemeither.

Lending creates the savings tosupport it.Frank has to unlearn more10.

If Betty demands that Adam payher with cash then Adam has toask bank A for the cash first. Thiswill come out of bank As liquidity.

Betty doesnt have to put her cashinto a bank account, she can justkeep it.Bank A has used its liquidity tofinance the loan to Adam.

Karl Where did this liquidity come from?

Other people must have given cashto A before Adam asked for it.

Karl What ifA doesnt have enoughcash?

Bank A will have to use credit tobuy cash from some other bank.

Karl What if no other bank has enoughcash?

Bank A will have to tell Adam thatit cant give him cash. Adam willhave to tell Betty that he cant giveher cash and must use credit.

10 Frank is grateful he only did one economics course. That limits the amounthe has to unlearn!

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If everybody wants to use cash andthere isnt enough cash thenpeople wont be able to do as muchbuying and selling. This means theeconomy wont grow and may even

become smaller.If I didnt trust the bank and myaccount was positive then I woulddemand physical money.

If everybody did this then thebanks would be in big troublebecause the amount of credit isusually much bigger than theamount of physical money11.

Fiat money

Only the Government can makemoney.

There are two ways theGovernment can make money.

Firstly, the Government can makephysical money

If any of the people try to makecash then the Government locksthem in jail. Jailing is another thingthe government can do thatindividual people cant do.

The government puts cash into theeconomy by giving it to people orbuying things from them.

Here is the Central Bank12.

11 This is not strictly fractional reserve banking, even though many peoplethink it is. For an account of fractional reserve banking see Wikipedia or anybasic economics textbook. At the level of discussion weve reached at thispoint there is no concept of a bank receiving deposits and then lending out afraction of those banks lend first and then get deposits. Fractional reservebanking looks at things in reverse and is more suitable for a gold-standard

economy.12 Im conflating the role of Treasury and central bank here, but as both arearms of government Im not losing anything. Im assuming that the

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The Central Bank is owned by theGovernment.

The CB thinks it is independent, butit will always do what thegovernment says to, if thegovernment really wants it.

Ordinary banks are owned by thepeople

Ordinary banks have an accountwith the Central Bank

This is called an ExchangeSettlement account.

All these accounts are just anumber in a ledger

The number for a bank has to bebigger than 0.

If a bank gives the CB cash thenthe ES account goes up, if the banktakes cash from the CB theiraccount goes down.

If bank A wants to transfer credit tobank B then it can ask the CB totransfer credit from As account toBs.This means A and B dont need tokeep as much cash as liquidity.

If a bank receives net credittransfers from other banks then itsES account goes up; if it pays netcredit transfers then its ES accountgoes down.

The government account

The government has an account atthe Central Bank.

The government can make moneyby telling the CB to transfer moneyout of its account to a banks ESA.

government knows what its doing and is coordinated. Please feel free to makeyour usual jokes at this point. At a practical level the Treasury and CentralBanks do coordinate the nitty gritty details of money extremely well.

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There is no limit to how much thegovernment can transfer from itsaccount.

$1,000,000,000,000= One trillion dollarsis only 13keystrokes.

The government account has nolimits it can be as big or small asit likes..

Only the government is allowed todo this.

When the government accountgoes down, some people call thisprinting money.

Physical money and ES balancesare called high powered money

(HPM) or central bank money. Wewill just call this money.

This transfer from the governmentaccount is the second way inwhich the government makesmoney.

This ends this lesson.

Class But this sounds like cheating.There must be lots of things that

can go wrong if the governmentcan just make more and moremoney.

MP May be, but that is a separatequestion and well have to considerit at another time. The questionyou asked was where did moneycome from thats what Ianswered.

Now lets do astronomy. I want

you to draw a black hole

Author

Dr Frank Ashe has a consulting practice specialising in riskmanagement and investments. Risk management covers the gamutfrom technical matters in option risk, to strategy, to comparativecorporate governance. He maintains a part-time Associate

Professorship at the Macquarie University Applied Finance Centrewhere he was previously responsible for the Financial Risk

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Management course when he spent 2002 to 2006 as a full-timeAssociate Professor.

Prior to 2002, Dr Ashe worked in Australia and Canada withconsultancies, insurance companies, investment management firms,bond dealers, and financial software houses. His 30+ years of

practical experience have been predominantly in the measurementand management of financial risk and return, with an emphasis onasset-liability management, and developing risk measurement andmanagement tools for novel situations. His passion is for the clearexpression of risk concepts to the non-specialist at all levels in theorganisation

He is a regular presenter at industry seminars and colloquia, and iscurrently President of the Australian Q-Group. He regularly travelsthrough East Asia, teaching financial risk management in Beijingand Singapore, and is a member of the Australian Institute of

Company Directors.

Dr Ashe obtained his PhD in Operations Research from theUniversity of New South Wales. He majored in Pure and AppliedMathematics, Statistics, and Actuarial Science, with First ClassHonours in Mathematics, from Macquarie University.

Contact

[email protected]

www.quantstrat.com.au

0425 291 833

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