MMT & Private Debt Dialogue PART II

[Part I here]

A. So, last time you discussed how understanding how money really works leads to insights that can help make the real economy perform better, and increase the real material well-being of a country. And all this talk about problems with a “national debt” is just non-sense. It seems only to serve the rich who would like to impose “austerity” on the rest of us. You focused on the national debt and how the household analogy is false, but still haven’t explained the crash of 2008. You said it was and still is about private debt.

B. Yes.

A. How?

B. Well, we talked about how all the so called “national debt” is mirrored exactly by the net financial assets of the private sector. So what is usually called the national debt should really be thought of as a good number that reflects the amount of assets the private sector holds. Government spending is what allows that accumulation in the private sector.

A.  Yes

B.  However, not all money is created through government bonds.

A. What do you mean?

B. The vast majority of money is created by banks out of thin air. When banks make loans, someone walks away with money, an asset, a plus in their account. Yet the bank also records that loan as an asset, a plus in their account. This increases the effective money supply (more or less what is known as M2 in the US), which in turn increases effective demand in the economy. This effect is large, with the vast majority of money actually being private bank-credit money, not money based on US bonds. [Note this has nothing to do with reserve requirements, which under the modern banking system are an anachronism, but with the ability of banks to make loans and get reserves later, which the central bank has to accommodate (bc it targets interest rates) and record the loans as pluses.]

This seems fine when the economy is doing well. But it means the effective money supply is largely based on private debt. The debt ratchets up until a point where the non-financial private sector is deeply indebted to the finance private sector and cannot easily take on new debt. Eventually, with some slight downturn in the economy, there is a loss of creditworthy borrowers, so the system collapses and with it a great portion of the effective money supply.  Thus exactly when the economy needs a boost in demand, it instead suffers a sharp contraction. And the banks are the ones holding either the money or the ownership of assets that are defaulted on. The non-finance private sector loses greatly to the benefit of the finance private sector.

A. So what can be done about this?

B. Well, mainstream economists do not even recognize the factors that matter in this scenario. So they literally have nothing useful to say about fixing the economy in this situation. With their bad theory they are like monkeys with razor blades in an operating room – worse than useless.  Just one example:  they don’t understand the process where private bank-credit money is created only due to the demand for loans by the private sector. So they thought that essentially giving money to the banks, “quantitative easing”, would stimulate the economy. But with no creditworthy borrowers, that money just sits there. To really understand what is at the heart of this finance-based depression, you have to look to economists who understand the interactions of finance factors & the economy in the first place.

Among them there is one view that if both 1) the MMT policies we discussed in Part 1 were followed and 2) better banking practices followed, the economy would not fall into the trap just mentioned. Aggregate demand would be provided through intelligent fiscal policy, not widespread private debt. And the banking sector would be regulated in a way so as not to allow bad assets to back loans and to limit the many financial shenanigans the wealthy created to game the system. So the system would be more stable. Warren Mosler presents perhaps the best clear statement of the needed bank reforms, and regardless of any other changes discussed here, they should be implemented ASAP to stop much of the current harmful or downright corrupt practices in the current system.

A. Would this work?

B. Maybe. The worry is that the effective money supply is still created largely through private bank lending. This provides a huge incentive for the banks, which under this system are likely to be rich and influential, to always, little by little, manipulate regulations in their favor. This is known as “regulatory capture” and in turn leads to an unstable buildup of private debt and the finance sector gaining at the expense of everyone else. Remember, the banks gain no matter what under the current system – either they earn directly from their loans and dubious investment vehicles in the good times, or in a downturn, they earn from claiming the assets that the private sector used as collateral and by being propped up by the government because they are “too big to fail”. Privatized (finance sector) gains and socialized losses. The headlines in recent years that the 1% has done well by the crash of 2008 are sadly true.

A. Is there an alternative?

B. Possibly. It is possible to simply not allow banks to create private bank-credit money. Rather than banks being able to credit borrowers’ accounts with money out of thin air, they would have to lend already existing money, either that they already own, or that they have pooled from investors seeking interest on money they actually hold. A loan would not show as a plus on their balance sheets, but as a minus on someone’s balance sheet – real money that they or their investors have transferred to a borrower. And they would not be allowed to sell their loans, but would have to keep them on their own books. This incidentally would give them a large incentive to raise their scrutiny of borrowers, and thus increase the quality of loans in the first place.

A. Why is this important?

B. This would mean that banks would no longer in effect create new money. They would only be intermediaries, uniting willing investors actually transferring their existing money to borrowers, nothing more. Crucially, this means that the money supply would not collapse in an economic downturn, what is known as a “cascading liquidity crisis”. Lenders might lose money if borrowers did not pay them back, but the total amount of money in existence would remain the same, and so would effective demand. Also, banks would not be earning money through creating money out of thin air. The system would thus both be much simpler and tremendously more transparent, and additionally the banks would be less powerful to change rules in their favor. A crash like 2008 would simply not be possible under this system.

A. So are there any drawbacks to this system?

B. Well, some think that under this system the less wealthy would actually suffer.

A. Why?

B. Because under the current system, even the less wealthy, at least when the economy is good, are sometimes able to get loans and financing for projects. Under the new system, the less wealthy would depend on existing holders of money to finance them, argued by some to mean putting economic power even further into the hands of “the haves”.  And some seem to think that having a private system that can create money in response to private demand is good, a dynamic system that responds to the needs of the economy naturally.

A. What do you think?

B. We must balance the true, full cost of the proven inbuilt instability of the current system with the possible good and bad of an alternative system. The true costs of instability in the current bank-credit money system are seldom weighed as a whole, nor presented in a way the general public can understand. What is the true and total cost to the public of the crises of 1907, 1929, 2008, the many smaller crises such as S & L, the Japanese asset price bubble, LCTM, banking crises in Finland, Sweden, Asia, Russia, Mexico, Argentina, Ecuador, Uruguay, and throughout Europe, the dot.com and housing bubbles, the bailouts of AIG, Northern Rock etc.? The true cost of the current system to the non-finance private sector are probably much much greater than is commonly thought, if proper accounting standards were used to measure it.

Also, there are other very real costs from the inherent instability and uncertainty of the current system. These costs arise from the uncountable suboptimal (due to high uncertainty regarding inflation, interest rates, and possible recessions and depressions) decisions on investment, insurance, and allocation of resources made by big business, government, and private households alike. The alternative system would be much more stable on every front, and there would be real gains in efficiency from this increased stability.

A. So that is the main downside some see to an alternative system where banks cannot create private credit money?

B. Yes, it seems the main concern by some seems to be that the little guys won’t easily be able to get loans and the system will not provide enough financing in general for the private sector.

But there seem to be good ways to finance worthy needs without banks creating money. There are lots of investors willing to risk their existing money to earn interest on loans. Additionally, there are many tried-and-true alternative finance options, such as tontine-type mutual funds, pari-mutuel mutual funds, and other banking arrangements that would provide plenty of access to funding for the private sector without allowing banks to create private bank-credit money.

Overall, the huge gain in stability would help everyone, from big business down to individual households.

A. So why isn’t the change tried?

B. The banks would fight it tooth and nail for a start.

Also, although directly using government bonds has worked well in the past, there has never been a pure system of this type – the banks always managed to force governments to allow them to create private bank-credit money.
Notable successful examples include US greenbacks, and the 700 years that the English/UK government used tally sticks. As we know, this period of British economic history was overall highly successful. But tally sticks and greenbacks were only part of their respective systems. The modern proposal for systemic change would essentially make the entire system run purely on what are in effect tally sticks or greenbacks.

A. So people would be afraid to try a system that has never been tried in full it seems.

B. Yes.

But there has never been a system like the current mostly bank credit-money one that has NOT suffered crashes like 2008. It may make sense to finally try something new.

At any rate, the take-home message is that the crash of 2008 was about private bank-credit money and private debt. Any full understanding of the real economy must take into account the long history of bank-credit money recessions and depressions and of ratcheting private debt causing real trouble in the real economy, and the close empirical correlations between changes in private debt, private credit money, effective demand, financial regulatory capture, and recessions/occasional massive depressions.

In Part 1 we discussed how MMT insights show ways to raise the productivity of the real economy to its natural limit, and thus the material well-being of a country. The theoretical debates concerning MMT have largely been worked out, and it is just a matter of time before the logic of it is accepted by the mainstream.

However, the debate on the full scope of the impact of the private credit-money system on the real economy has only begun to be worked on again in earnest.

Maybe implementing better fiscal policy and more logical banking regulations, as many MMTers propose, is enough to stop crashes like 2008 from occurring, and the ongoing regulatory capture of the finance system by the very rich.

But it may make sense to also change the finance system to a system where circulating Treasury notes alone forms the money supply, and banks can only serve as intermediaries of this money, and not create private bank-credit money through escalating private sector debt that alters effective demand, causes socialized losses and privatized gains (only for the finance sector), and ultimately leads to massive busts for the non-finance private sector.

A. Yes, that may make sense.

[PART I of this dialogue]

Question on Steve Keen/MMT Discussion, Total Size of Private Debt|FIRE Sector Bubble

[No claim to originality in this post – just want some opinions on some common views on private debt, MMT, Keen’s work, and the FIRE sector]

Steve Keen argues that private debt was/is an important factor in the “Great Recession” and that aggregate demand equals income plus the change (or rate of change) in debt. (Keen presents a number of interesting GDP to debt, change in debt, employment and other comparisons, here is one example:)


(debtdeflation.com)

This has sometimes led to debates with MMTers (much of which is being resolved already) regarding private credit-money creation netting to zero and related accounting aspects. A crude example:

“This is justified with vague references to “endogenous money”, another Keen shibboleth, with reasoning roughly as follows: Since money is endogenous, the banking system can add to demand by creating money “out of thin air”, without reference to anyone’s income or savings.” (This is here, there is some useful debate however. Also see comments on  Steve’s page)

The debates seem to go a bit like this:

Keen’s statements on private debt.

Someone, usually an MMTer,  pointing out it nets to zero, so doesn’t matter.

Then two counterpoints made- that either 1. the disconnect between Keen and MMT is possibly due to different aspects of dynamic modelling v. accounting, and/or 2. that the fact that private debt nets to zero on the books is hiding inflated asset values (I am not saying these are or are not right here, just running through the points. I will get back to this important conciliation of Keen and MMT in a later post).

Here my question is different.

Regardless of the fact it nets to zero, to what extent is the total size of private debt, and especially its associated asset price increase and FIRE sector size – relative to the economy a problem? This seems to have very negative redistributive effects.

(source)

I know people like Hudson, Bill Black, Mosler, and many others from just about every “school” of thought have done work on this (sometimes with technical terms that can hide its relatedness to this discussion) and criticized the growth or dominance of the FIRE sector (as unproductive, unfair etc).

But somehow I do not see the point being associated to recent online debates concerning Keen’s emphasis on private debt and the MMT emphasis that it nets to zero (but that its total size is much larger than before).

The argument goes something like this:

It is common to see arguments that the larger economy suffers while the wealthy involved in the FIRE sector gain. Saying it nets to zero suggests that it is not so bad for the average Joe either – some win and some lose on mortgages, small business loans, and the many aspects of the financial sector that touch their lives, but it nets to zero.

Some asset price inflation effects are bad – instability is bad for almost everyone. But the point seems not to be made enough that the private debt|FIRE sector bubble is  especially bad for the truly disenfranchised – the lower quintile who, unlike the middle class, have almost no direct exposure at all to the financial sector – they aren’t in the game at all,  just left behind in a world of ever more Starbucks and middle and upper class goods that they have almost no connection to. No mortgages for them, even to lose out on, no business loans, etc. (They would probably love to be in bankruptcy court debating ownership of cars, houses, and credit card debt). Because private debt nets to zero, much of the middle class both loses and gains (at least sometimes) from financialization in complex ways. But at least they are in the game.

It seems those not even in the game of rising (but net zero) private debt just lose.

Again, no claim to originality in any of this. Just wanted to hear more about it in the context of debates on Keen/MMT and private debt netting to zero.

Clint

Private Debt to GDP ratios since 2006

(http://www.incrediblecharts.com/economy/keen_debt_gdp.php)

FIRE SECTOR

(To see clear & interactive graph, go here:  On FIRE: How the Finance, Insurance and Real Estate Sector Drove the Growth of the Political One Percent of the One Percent )

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