In my previous post “It’s not a Deficit, it’s a Fiat” (which, like this post, is open access on Patreon and Substack), I showed that the so-called “Deficit” is actually government creation of “Fiat” money. If you haven’t read that post yet, read it now and come back to this one later.

In that post, I rejected the use of the word “Deficit” to describe government spending in excess of taxation, because mainstream economists have made it a pejorative word. Rather like the Pigs in Animal Farm, they declare that “Deficit BAD! Surplus GOOD”, when a deficit for one party in a financial system necessarily requires an identical surplus for another. What a government “deficit” actually does is create “Fiat” money for the non-government sectors of the economy, and from now on I’m going to use that word—Fiat—to describe the gap between government spending and taxation.

This post starts where that one ended, with the full 4-sector accounting of how the government, when it spends more than it collects in taxes, creates money for the private sector—as shown in Figure 1 here. The key point is that negative entry for Fiat in the Treasury’s Assets causes an identical positive entry in the private sector’s Assets: this is how a government creates Fiat money.

Figure 1: The basics of how a government creates Fiat money

What Figure 1 lacks is an explanation of government “debt”—which is another misnomer, since it doesn’t involve borrowing from banks at all, but rather banks swapping one Asset (Reserves) for another (Treasury Bonds, or TBonds for short).

I’m going to show why by starting with an operation which, in most countries in the world, is illegal: the Central Bank buying bonds directly from the Treasury. This operation is illegal for the same reason that smoking marijuana is illegal in most countries in the world, while drinking alcohol is not. It’s not because the former is more dangerous than the latter, but because legislators followed conventional wisdom rather than scientific research, and banned the safer drug while making the more dangerous one legal.

If the government doesn’t sell bonds, then what will happen is obvious from Figure 1: a sustained Fiat (“Deficit” for those who still haven’t got the memo) will drive the CRF (the “Consolidated Revenue Fund”, the Treasury’s account at the Central Bank) into overdraft. Without bond sales, there’s only one entry in the CRF account, and it’s negative.

On the other hand, if the Treasury sells bonds to the Central Bank, as shown in Figure 2, then there is a positive entry in the CRF—the proceeds of bond sales—as well as a negative. The CRF can then remain positive. In fact, if bond sales precisely equal Fiat, then the CRF will remain constant.

Figure 2: Treasury Bond sales to the Central Bank

Which situation is better: no bond sales and the CRF going into overdraft, as in Figure 1, or bond sales and the CRF remaining positive, as in Figure 2? Personally, I prefer Figure 2, since then the CRF, which is the Treasury’s deposit account at the Central Bank, remains positive, like deposit accounts in private banks. It would feel strange that a crucial deposit account in the overall financial system is negative while all others are positive, which is the case for Figure 1.

But that’s all that is involved here: it’s just a feeling. Practically, there is no significant difference between Figure 1 and Figure 2: in both cases, the government creates money for the private sector by going into negative equity itself, to a level that is precisely equal to the positive equity it creates for the private sector. This is simply how a fiat currency works.

Unfortunately, stupid laws mean that neither Figure 1 nor Figure 2 is legal. Instead, just like a stoner is forced by stupid laws to buy his dope from a dealer, the Central Bank is forced by stupid laws to buy Treasury Bonds from Private Banks. What actually happens in practice is shown in Figure 3: the Treasury sells to Primary Dealers, and the Central Bank buys off the Dealers.

Figure 3: Treasury sells to (Primary) Dealers, the Central Bank buys off Dealers

“Primary Dealers” is a very apt label for private banks, given that they function like drug dealers selling to drug consumers today. They only have a market because stupid laws enable their trade.

The end result of this process is, potentially, equivalent to the direct sale of Bonds by the Treasury to the Central Bank—if the Central Bank bought all the Bonds sold to the private banks. It certainly has no impact on the core fact that the government creates Fiat money by spending more than it gets back in taxation, which in turn increases private sector bank deposit accounts by precisely the same amount.

I haven’t shown interest payments yet for two reasons. Firstly, I’m making the false assumption that the Central Bank buys all the bonds. This is something it’s entirely capable of doing, but normally it doesn’t. Secondly, in most countries, the Treasury is not required to pay interest on bonds held by the Central Bank—and in countries where it is so required, the Treasury receives most of that back, because technically the Treasury owns the Central Bank.

Removing this assumption means that the Treasury has to pay interest on the bonds owned by the private banks—and that gets us to Figure 4, which is the real-world situation (minus one detail of the real world, that private banks sell a lot of the bonds they buy to NBFIs: non-bank financial institutions).

Figure 4: Interest payments on bonds create net worth for the banks

This changes the situation shown in Figure 1 in one important respect: as well as the Fiat creating money for the private non-bank sector, interest payments on bonds create money for the banking sector.

The reason that I describe the sale of bonds to banks as a gift is that, because of this sale, the Government pays the banks an income stream which it could easily avoid by having the Central Bank buy all the bonds issued by the Treasury.

Why should the government bestow this gift on the banks? One good reason is that the interest payments compensate the private banks for the costs they incur by running the economy’s payments system. Without interest on government-created money, the banks would have to profit solely from their dealings with the non-bank public: from charging interest on private debt, fees on depositors, etc. They do that anyway of course, but the higher the income banks make directly from the government, the less is the pressure on them to entice the non-bank public into debt.

The UK provides a striking example of how the erroneous obsession with reducing government debt—which, to labour the point, reduces the amount of Fiat-based money in the economy—encouraged banks to create private debt to compensate for the fall in their income from the government. Prior to 1980, private debt in the UK was normally below 70% of GDP, and stable. After then, it more than trebled—and this started at a time of high and rising official and private interest rates.

Figure 5: UK Private debt took off when government debt fell & banks were allowed to lend for house purchases

Two causal factors can be identified: the decline in private sector holdings of government bonds relative to GDP, and Thatcher’s decision to allow banks to lend for house purchases (before Thatcher, building societies had an effective monopoly on mortgage issuance in the UK). The former reduced the income of banks substantially, the latter opened up a market for private debt that banks took full advantage of—setting off a house price bubble in the process.

If we had people in charge of the monetary system who actually understood how money works, then private debt, not government debt, would be kept low, the Deficit Fiat would be kept at a level commensurate with the needs of the private sector for money for commerce and savings, and the finance sector would be kept in check.

Instead, with the anti-government debt obsession, we have inadequate government spending on vital services, inadequate amounts of Fiat money in circulation, and the Dealers rather than the authorities, are in charge of the joint. The “War on Deficits Fiat” has been about as successful as the “War on Drugs”.

The prominent Australian mainstream economist Chris Richardson recently celebrated the fact that the Australian government is now in surplus:

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His “temporary” and “permanent” comment was in relation to this earlier tweet: tax revenues are up but that’s temporary; there’s too much spending, and that’s permanent.

Yes, this is “stunningly strong” news for the government’s finances, seen in isolation. Figure 1 shows this situation. If the government spends more than it gets back in taxation, then it runs a deficit. The deficit reduces the amount of money in the Treasury’s deposit account at the Central Bank—the “Consolidated Revenue Fund”. This means that the government, which already has more liabilities than assets—and is therefore in negative equity—is pushed even further into negative equity. That has to be bad, right?

Figure 1: A deficit pushes the government further into negative equity! BAD BAD BAD!!!

Sure, if you take a partial view of the financial system, and look just at the government’s accounts in isolation. But that sort of thinking is something that economists, in other circumstances, deride as “partial” analysis. What you really need to do, to truly understand a system, is do a general analysis—and that means looking at the entire system. In the case of government deficits, that means looking at the accounts for the Central Bank, the private banks, and the non-bank private sector, as well as for the Treasury.

The “Consolidated Revenue Fund” (CRF), which is the Treasury’s asset, is the Treasury’s deposit account at the Central Bank: it is a liability of the Central Bank, just as your deposit account at a private bank is your asset and the private bank’s liability.

The private banks also have accounts at the Central Bank, which economists call Reserve accounts. When the government runs a deficit, the CRF falls and the Reserve accounts of the private banks rise. This is a necessary step in how the government’s spending and taxation affect the private sector’s bank accounts. This transfer of funds from the Treasury’s Consolidated Revenue Fund to the Reserve accounts of the private banks is shown in Figure 2—where I’ve replaced the wordy “Consolidated Revenue Fund” with its abbreviation CRF.

Figure 2: The Deficit transfers funds from Treasury’s CRF to the Reserve accounts of private banks

The increase in Reserves caused by the Deficit enables the private banks to increase the non-bank private sector’s deposit accounts—which is what a deficit does. A deficit occurs when the government spends more on the private sector than it takes back from the private sector in taxes. A deficit therefore increases the money supply, by increasing the private sector’s bank accounts. This is shown in Figure 3.

Figure 3: The Deficit increases bank Reserves and the private sector’s Deposit accounts

Finally, the Deficit increases the private non-bank sector’s net worth: the increase in the value of the private sector’s Deposit accounts doesn’t come with any offsetting increase in the private sector’s liabilities, so the net worth of the private sector rises. This is shown in Figure 4.

Figure 4:The Deficit increases the private sector’s Assets without changing its Liabilities, so the net worth of the private sector rises

So, what is a negative for net worth of the government—when it runs a deficit—is a positive for the private sector. When the government decreases its net worth by running a deficit, it increases the net worth of the private sector by precisely as much. A deficit for the government is a surplus for the private sector.

What is Richardson really celebrating, because the government is now running a surplus? He’s celebrating the government reducing the financial resources of the private sector. He’s celebrating the government reducing the money supply. Somehow, this is supposed to make the economy work better.

I deliberately haven’t considered the government debt issues in this post, because I want to focus on the core point that a government Surplus, while it increases the net worth of the government, necessarily reduces the net worth of the private sector. I’ll cover the government debt issue in my next post, but I hope this one points out something ridiculous in celebrating the government running a Surplus: you are also celebrating the private sector being forced to run a matching Deficit.

Finally, though Richardson’s celebration of a government surplus is typical of the flawed, partial analysis that mainstream economists do when they attempt to analyse the monetary system, it’s also, I think, a product of the pejorative nature of the words “Deficit” and “Surplus”.

A Deficit is BAD! A Surplus is GOOD!

Really? Not when you take a systemic, rather than a partial, look at the financial system. Then a Deficit for one sector is a necessary consequence of a Surplus for another sector: you can’t have one without the other.

Frankly, I’m so sick of this flawed partial thinking that I refuse to use the words “Deficit” and “Surplus”. I will instead use the word “Fiat” to describe a government “Deficit”, because what this so-called Deficit does is actually create “Fiat” money, while a government Surplus destroys Fiat money.

In my next post, I’ll complete the “debt” side of this model. In the meantime, I’ll await an explanation from Richardson of why it’s a good idea for the government to destroy Fiat money.

Figure 5: It’s not a Deficit, it’s a Fiat

Only the good ideas die young

The Post-Keynesian Economist Victoria Chick—Vicki to her friends—died earlier this year, and was celebrated today by the interment of her ashes in her beloved home of Hamstead, and a tribute to her at University College London, her academic home for over half a century.

With Vicki’s death, most of her generation—who were prominent critics of conventional economics in the 1960s and 1970s—is no more. I’ve attended several funerals now for scholars like Vicki, who opposed the Neoclassical mainstream in economics, only to see that mainstream outlive them.

Though it’s both hard and weird to acknowledge it, I’m now one of today’s elders of non-mainstream economics. I cracked 70 last month, friends like Marc Lavoie are close behind, and we’re watching a new generation of rebels take our place. The thought that made Vicki’s farewell both poignant and chilling for me was, will the Neoclassical mainstream of economics still be dominant when my day of internment arrives?

Unfortunately, I believe so. The fact that Neoclassical economics is still dominant today, when it has been empirically and logically contradicted for over a century, proves that Max Planck’s adage that “Science advances one funeral at a time” does not apply to economics.

If funerals alone could have killed it, it would have died in the decades after the Great Depression—the economic event which, more than any other, showed that there was something seriously wrong with the mainstream vision of capitalism as a self-adjusting system that, left to its own devices, will achieve a state of welfare-maximizing equilibrium.

Instead, Neoclassicals developed a twisted tale in which the Great Depression was caused, not by capitalism itself, but by the government. Specifically, they blamed the Federal Reserve for tightening monetary policy. Milton Friedman was the first to make this case, arguing, as Ben Bernanke put it, that:

Federal Reserve policy turned contractionary in 1928, in an attempt to curb stock market speculation… the main lines of causation [of the Great Depression] ran from monetary contraction—the result of poor policy-making and continuing crisis in the banking system—to declining prices and output. (Bernanke 2000)

Bernanke echoed this explanation in an obsequious speech he made at Milton Friedman’s 90^th birthday function in 2002:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Bollocks. The real cause of the Great Depression was the collapse of a private debt bubble that the economics mainstream completely ignored. The Roaring Twenties roared because of a private-debt-fuelled Ponzi scheme that began in real estate and ended up in the Stock Market. The party came to an end when credit flipped from almost 10% of GDP in 1928 to almost minus 10% in 1933—see Figure 1.

Figure 1: Credit collapsing from almost 10% of GDP to almost minus 10% is what caused The Great Depression

With their fallacious argument that bad monetary policy caused the Great Depression, this particular anomaly—from the point of view of mainstream economics—was dealt with. To this day, even after the “Great Recession” gave us a repeat performance (see Figure 2) the mainstream still hasn’t considered the argument that the private banking system, and not the Federal Reserve, caused the Great Depression.

Figure 2: Credit collapsing from over 15% of GDP to almost minus 5% is what caused The Great Recession

All other anomalies have been treated the same way: either ignored, or explained away by an alternative scapegoat that doesn’t challenge the mainstream view of capitalism as a self-regulating system.

This isn’t done because Neoclassical economists are paid shrills or apologists for capitalism, but because the Neoclassical model describes a utopia and, for whatever reason, humans seem to yearn for utopias. The Neoclassical model is a utopia because it asserts that people earn what they deserve—their “marginal product”—while also getting what they want from the system—they “maximize their utility” subject to their budget constraints. Even when the real world departs wildly from this textbook vision, the desire to believe overwhelms the desire to understand.

Funnily enough, this isn’t all that far removed from how actual scientists behave, as Max Planck—the discoverer of quantum mechanics—himself lamented. He remarked in his autobiography that:

It is one of the most painful experiences of my entire scientific life that I have but seldom—in fact, I might say, never—succeeded in gaining universal recognition for a new result, the truth of which I could demonstrate by a conclusive, albeit only theoretical proof. (Planck 1949, p. 22)

The difference between science and economics comes down, not to the behaviour of people, but to the nature of the anomalies that disturb the existing paradigm. Planck overturned 19^th century physics with the discovery that the only way to explain the radiation emitted by a “black body” was to accept that energy was not continuous, as in Maxwell’s theory, but that it came in discrete packets he called “quanta”.

Though Planck was correct, science made the move from Maxwellian physics to quantum mechanics, not because physicists were better people than economists (though in the main, they are), but because scientific anomalies don’t go away, whereas economic ones do.

Planck’s contemporaries continued to teach Maxwell’s theories and resist Planck’s paradigm. As time went on, these Maxwellian professors ultimately retired or died, and had to be replaced—and their replacements were students who were wedded, not to the old failed Maxwellian paradigm, but to the new paradigm of quantum mechanics. As Planck put it:

A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it. (Planck 1949, pp. 23-4)

Scientific revolutions occur in sciences because the anomaly that undermines the dominant theory doesn’t go away. But in economics, the anomaly passes with time: no student can reproduce the Great Depression and then check whether the mainstream rationalization or a radical new explanation makes more sense of the event.

A minority of students can’t accept the old way of thinking—which is where rebels like Vicki, and myself, and today’s members of Rethinking Economics come from. But another minority also exists that finds the libertarian message of the Neoclassical mainstream seductive, and it is they—rather than the rebels—who form the next generation of Professors.

So Neoclassical economics has outlived Veblen, and Sraffa, and Keynes, and now Chick and Harcourt. Someday in the future, it will outlive me, and Kelton, and Lavoie.

The only alternative I can see is far less pleasant: that rather than Neoclassical economics outliving its critics, it may in fact kill capitalism first.

Farewell then Vicky. I’m no believer in the afterlife, but if there is one, I’m sure you’re discussing your works and downing a pint now with your fellow departed economic rebels (Chick 1991, 1997; Chick 1998; Krugman et al. 1998; Chick 2001; Chick and Dow 2001; Chick and Dow 2002, 2005; Chick 2008; Chick and Dow 2012; Chick and Tily 2014).

References

Bernanke, Ben S. 2000. Essays on the Great Depression (Princeton University Press: Princeton).

Chick, V. 1991. ‘Hicks and Keynes on liquidity preference: a methodological approach’, Review of Political Economy, 3: 309-19.

———. 1997. ‘Some reflections on financial fragility in banking and finance’, Journal of Economic Issues , 31 (2) pp. 535-541. (1997).

Chick, Victoria. 1998. ‘On Knowing One’s Place: the Role of Formalism in Economics’, The Economic journal (London), 108: 1859-69.

———. 2001. ‘Cassandra as optimist.’ in Riccardo Bellofiore and Piero Ferri (eds.), Financial Keynesianism And Market Instability: The Economic Legacy of Hyman Minsky (Edward Elgar Publishing: Cheltenham).

———. 2008. ‘Could the crisis at Northern Rock have been predicted?: An evolutionary approach’, Contributions to political economy, 27: 115-24.

Chick, Victoria, and Sheila Dow. 2002. ‘Monetary Policy with Endogenous Money and Liquidity Preference: A Nondualistic Treatment’, Journal of Post Keynesian Economics, 24: 587-607.

———. 2005. ‘The Meaning of Open Systems’, Journal of Economic Methodology, 12: 363-81.

Chick, Victoria, and Sheila C. Dow. 2001. ‘Formalism, logic and reality: a Keynesian analysis’, Cambridge Journal of Economics, 25: 705-21.

———. 2012. ‘On causes and outcomes of the European crisis: Ideas, institutions, and reality’, Contributions to political economy, 31: 51-66.

Chick, Victoria, and Geoff Tily. 2014. ‘Whatever happened to Keynes’s monetary theory?’, Cambridge Journal of Economics, 38: 681-99.

Krugman, P., E. R. Weintraub, R. E. Backhouse, and V. Chick. 1998. ‘Formalism in economics’, The Economic journal (London), 108: 1829-69.

Planck, Max. 1949. Scientific Autobiography and Other Papers (Philosophical Library; Williams & Norgate: London).

 

For those that are too young to remember, the legendary English comedy show Monty Python had a famous sketch about a disgruntled customer of a pet shop, who realised he had been sold a dead Parrot. The shopkeeper steadfastly refused to admit that the Parrot was dead:

CUSTOMER: I wish to complain about this parrot what I purchased not half an hour ago from this very boutique.
SHOPKEEPER: Oh yes, the, uh, the Norwegian Blue … What’s, uh … What’s wrong with it?
CUSTOMER: I’ll tell you what’s wrong with it, my lad. ‘E’s dead, that’s what’s wrong with it!
SHOPKEEPER: No, no, ‘e’s uh, … he’s resting.
CUSTOMER: Look, my lad, I know a dead parrot when I see one, and I’m looking at one right now.
SHOPKEEPER: No no, he’s not dead, he’s, he’s restin’! …

Why has this sketch come to mind for me? Because Gregory Mankiw, the author of one of the world’s most popular economics textbooks, has just shown that this fictional shopkeeper has nothing on Mankiw and his mainstream economics colleagues, when it comes to pretending that something which is dead is actually alive and well.

The Dead Parrot in question is the “Money Multiplier”: the theory that banks create money by lending out reserves. It’s also called “Fractional Reserve Banking”.

The 6^th edition of Mankiw’s Macroeconomics textbook (there’s now a 9^th edition, but I’m not about to waste money buying a dead parrot) explains the Money Multiplier by starting with “an imaginary economy” in which the money supply is initially $100 in cash. Then the population deposits all that cash in “First National Bank”. The money supply now consists of $100 in bank deposits, while all the cash is in the vault of First National Bank. Next First National Bank decides to make loans, so it lends out $90 in cash. The money supply now consists of $100 in demand deposits and $90 in cash. Mankiw declares that:

The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money. (Mankiw 2012, p. 333)

The process then repeats, with the loan recipients depositing their $90 in cash in another bank, which also hangs on to 10% of the cash ($9) and lends out the rest ($81), also in cash. Mankiw explains that:

The process goes on and on. Each time that money is deposited and a bank loan is made, more money is created… The amount of money the banking system generates with each dollar of reserves is called the money multiplier…

The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/R dollars of money. In our example, R = 1/10, so the money multiplier is 10. (Mankiw 2012, p. 334)

There are numerous problems with this as a model of bank money creation, not the least of which is that it only works if all loans are in cash (a point that Mankiw at least notes). Though that may have happened in the 19^th century Wild West, today, banks make loans by increasing a customer’s deposit account, and recording precisely the same sum as a debt of the customer to the bank. No cash is involved, nor are bank reserves “lent out”.

Non-mainstream economists like me and my contemporaries and predecessors have been trying to kill this false theory for decades—see these references for a sample of the anti-Money-Multiplier literature (Moore 1979, 1983; Dymski 1988; Graziani 1989; Minsky, Nell, and Semmler 1991; Minsky 1993; Keen 1995; Dow 1997; Werner 1997; Rochon 1999; Palley 2002; Fontana and Realfonzo 2005; Carney 2012; Fullwiler 2013; Werner 2014; Schumpeter 1934; Holmes 1969).

But we’re used to being ignored. Mainstream economists reject our papers when we submit them to their journals, and they never read our journals or books. We were resigned to being right, but not taken seriously at the same time.

Then in 2014, a miracle occurred: the Bank of England published a paper that supported our realistic analysis, and rubbished the mainstream myths. Entitled “Money creation in the modern economy“, it began with the declaration that:

Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. (McLeay, Radia, and Thomas 2014, p. 14. Emphasis added)

It took direct aim at textbook writers like Mankiw with the statement that:

The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.” (McLeay, Radia, and Thomas 2014, p. 14. Emphasis added)

I remember how much this paper excited me when it first came out: surely the textbook writers couldn’t ignore the Bank of England? I felt the same thrill in 2017 when the Bundesbank came out with a very compatible paper, in which it declared that:

It suffices to look at the creation of (book) money as a set of straightforward accounting entries to grasp that money and credit are created as the result of complex interactions between banks, non-banks and the central bank. And a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves or deposits at its disposal. (Deutsche Bundesbank 2017, p. 13. Emphasis added)

We monetary rebels now had two central banks on our side, opposing the textbook writers, and over time many other Central Banks also joined the fray. Surely now, textbook writers would be forced to change their tune?

Well bollocks to that, as Mankiw’s post on April 5^th of this year showed. Entitled “The Importance of Teaching Fractional Reserve Banking“, it was written as if these Central Bank refutations of the Money Multiplier model hadn’t been written. I certainly doubt that Mankiw has read them.

In his post, Mankiw recounted a conversation with a fellow mainstream economist who “does not teach the students about money creation under fractional reserve banking”—and not because it’s a fallacy, but because he believes it’s “an unnecessary technicality”. Mankiw then defended the false theory on the basis that it explains how “a lower interest rate on reserves increases bank lending and expands the money supply by increasing the money multiplier”, and that it’s necessary to teach “the traditional pedagogy about how banks influence the money supply … if students are to understand the economics of inflation”.

“The traditional pedagogy”, as Mankiw puts it, is no more necessary for students of economics to learn than it is necessary for students of astronomy to learn Ptolemy’s Earth-centric view of the cosmos before they can understand the Copernican system. It’s a fallacy, it belongs in the garbage bin of science, and its continued presence in mainstream economics textbooks is a major reason why mainstream economists don’t understand money, or inflation, or the causes of financial crises.

I’d long ago given up on persuading the mainstream to see reason on this any many other issues, but this ludicrous blog post by Mankiw, and the Twitter conversation initiation by Jason Furman that alerted me to it, was a real “aha moment” for me: why bother trying to reason with these people? They get hit in the face by a wet fish dose of reality, the wet fish is wielded by someone they normally listen to, and yet they continue on regardless with their fantasies.

Figure 1: The tweet that alerted me to Mankiw’s blog post, and my acerbic reply

There’s just no point talking with them: they won’t listen to anything that disturbs their paradigm in any way. But they obviously dominate the training of economists: it’s as if the academic astronomy departments were still teaching students to believe in crystalline spheres, equants and epicycles, while Elon Musk and friends were using Newton’s and Einstein’s math to shoot for the stars.

So, what to do? By sheer happenstance, I have started teaching my alternative approach to economics in an online course for which I’m charging US$500. The main reason to charge for it is that most of the money goes to a marketing firm that is motivated by the money to reach a far larger audience than I could ever hope to reach by teaching my ideas for free here on Substack and Patreon. Their early marketing methods were annoying—and I apologise for that—but they’re learning about my audience, and improving their messaging over time.

I give ten lectures over ten weeks, which at $50 a lecture is pretty good value. It’s certainly better for your brain (and your pocket!) than paying for a degree in economics that teaches you the fantasies that Mankiw and other mainstreamers peddle. If you’d like to experience these lectures (with a money-back guarantee if you ask for a refund within the first 30 days), click on this link:

https://start.profstevekeen.me/products/email-am-rebel-economist

Tell them Greg sent you.

Carney, John. 2012. “What Really Constrains Bank Lending.” In NetNet, edited by John Carney. New York: CNBC.

Deutsche Bundesbank. 2017. ‘The role of banks, non- banks and the central bank in the money creation process’, Deutsche Bundesbank Monthly Report, April 2017: 13-33.

Dow, Sheila C. 1997. ‘Endogenous Money.’ in G. C. Harcourt and P.A. Riach (eds.), A “second edition” of The general theory (Routledge: London).

Dymski, Gary A. 1988. ‘A Keynesian Theory of Bank Behavior’, Journal of Post Keynesian Economics, 10: 499-526.

Fontana, Giuseppe, and Riccardo Realfonzo (ed.)^(eds.). 2005. The Monetary Theory of Production: Tradition and Perspectives (Palgrave Macmillan: Basingstoke).

Fullwiler, Scott T. 2013. ‘An endogenous money perspective on the post-crisis monetary policy debate’, Review of Keynesian Economics, 1: 171–94.

Graziani, Augusto. 1989. ‘The Theory of the Monetary Circuit’, Thames Papers in Political Economy, Spring: 1-26.

Holmes, Alan R. 1969. “Operational Constraints on the Stabilization of Money Supply Growth.” In Controlling Monetary Aggregates, edited by Frank E. Morris, 65-77. Nantucket Island: The Federal Reserve Bank of Boston.

Keen, Steve. 1995. ‘Finance and Economic Breakdown: Modeling Minsky’s ‘Financial Instability Hypothesis.”, Journal of Post Keynesian Economics, 17: 607-35.

Mankiw, N. Gregory. 2012. Principles of Macroeconomics, 6th edition (South-Western, Cengage Learning: Mason).

McLeay, Michael, Amar Radia, and Ryland Thomas. 2014. ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin, 2014 Q1: 14-27.

Minsky, Hyman P. 1993. ‘On the Non-neutrality of Money’, Federal Reserve Bank of New York Quarterly Review, 18: 77-82.

Minsky, Hyman P., Edward J. Nell, and Willi Semmler. 1991. ‘The Endogeneity of Money.’ in, Nicholas Kaldor and mainstream economics: Confrontation or convergence? (St. Martin’s Press: New York).

Moore, Basil J. 1979. ‘The Endogenous Money Supply’, Journal of Post Keynesian Economics, 2: 49-70.

———. 1983. ‘Unpacking the Post Keynesian Black Box: Bank Lending and the Money Supply’, Journal of Post Keynesian Economics, 5: 537-56.

Palley, Thomas I. 2002. ‘Endogenous Money: What It Is and Why It Matters’, Metroeconomica, 53: 152-80.

Rochon, Louis-Philippe. 1999. ‘The Creation and Circulation of Endogenous Money: A Circuit Dynamique Approach’, Journal of Economic Issues, 33: 1-21.

Schumpeter, Joseph Alois. 1934. The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle (Harvard University Press: Cambridge, Massachusetts).

Werner, R. 1997. ‘Towards a new monetary paradigm: a quantity theorem of disaggregated credit, with evidence from Japan’, Kredit und Kapital, 30: 276-309.

Werner, Richard A. 2014. ‘Can banks individually create money out of nothing? — The theories and the empirical evidence’, International Review of Financial Analysis, 36: 1-19.

 

Professor Steve Keen, Distinguished Research Fellow, Institute for Strategy, Resilience and Security, University College London.

One of the great ironies of economics is that, while the public regards economists as experts on money, the issue of how money is created is still not settled within economics.

In 2014, the Bank of England published a landmark paper explicitly rejecting the textbook model of money creation, stating that:

Money creation in practice differs from some popular misconceptions—banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits…

The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank ‘multiplied up’ into more loans and deposits. (McLeay, Radia, and Thomas 2014, p. 14)

Several other Central Banks published related papers, notably the Bundesbank in 2017, which stated that:

It suffices to look at the creation of (book) money as a set of straightforward accounting entries to grasp that money and credit are created as the result of complex interactions between banks, non- banks and the central bank. And a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves or deposits at its disposal (Deutsche Bundesbank 2017, p. 17)

And yet, just five years later, the Nobel Prize in Economics was awarded to Bernanke, Diamond and Dybvig for work which, as the “Scientific Background” to the Prize noted, claimed that banks function as “financial intermediaries” which “channel funds from savers to investors, receiving funds from some customers and using the funds to finance others” (Committee for the Prize in Economic Sciences in Memory of Alfred Nobel 2022, p. 4). The document did not cite these Central Bank papers, let alone note the contrary arguments in them.

In this paper, I use double-entry bookkeeping to prove that mainstream economists are wrong about banks and their importance in macroeconomics. Banks are money creators, not “financial intermediaries”, and financial flow analysis shows that bank credit creation has significant macroeconomic effects, contrary to assertions by Bernanke (Bernanke 2000, p. 24) and the Committee for the Nobel Prize in Economics.

Double-Entry Bookkeeping and the invalidity of mainstream economics

Banks are creatures of accounting: they create not goods and services, but financial assets and liabilities. Double-entry bookkeeping is central to both accounting and the operation of actual banks. Yet one striking feature of mainstream economics is the near complete absence of double-entry bookkeeping in its models of banking and money creation. This leads to mainstream economics being replete with concepts and models that contradict double-entry bookkeeping—and which are therefore false as models of the real-world.

The two essentials of double-entry bookkeeping are the classification of all accounts as either Assets or Liabilities—with the gap between the two being the Equity of the entity in question—and the recording of all transactions twice, so that the rule that is maintained for every transaction.

I have developed an Open-Source (i.e., free) software program called Minsky to enable monetary dynamics to be modelled easily (Minsky can be downloaded from the software repository SourceForge at https://sourceforge.net/projects/minsky/). Its key feature is called a Godley Table (named in honour of the non-mainstream economist Wynne Godley). A Godley Table classifies all financial accounts as either Assets or Liabilities, checks that every transaction obeys the rule that , and allows the user to build dynamic, monetary models of the economy that way.

When Neoclassical ideas about money are put into Minsky, they are shown to either contradict the rules of double entry bookkeeping, or to not have the outcome that Neoclassical economists expect. Take, for example, Bernanke and Blinder’s IS/LM-style model of banking (Bernanke and Blinder 1988). in which:

“the supply of deposits (we ignore cash) is equal to bank reserves, R, times the money multiplier” (Bernanke and Blinder 1988, p. 436).

This is standard fare in mainstream economics, and it presumes a simple mechanism between Reserves and the creation of Deposits. But it is easily shown that this mechanism either (1) violates the principles of double-entry bookkeeping, or (2) depends upon the existence of cash, which they ignore.

Before I illustrate this, I will show why the Bundesbank’s comments that “the creation of (book) money” is “as a set of straightforward accounting entries”, and that “a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves” are accurate—unlike mainstream economics. To create a loan, a bank simply adds the same number to its outstanding loans as it does to its Deposits: “Loans create Deposits”. The bank customer gets more money in their account, matched by an identical debt to the bank. Bank Assets—in the form of loans—rise as much as Liabilities—in the form of Deposits—and the key accounting equation is satisfied.

Reserves play no role whatsoever in this process—see Figure 1, which shows Credit dollars being added to the Banks’ Liabilities of Deposits, and Credit dollars also added to Banks’ Assets of Loans. It is, as the Bundesbank says, an extremely straightforward and easy to understand process.

Figure 1: The absolute basics of real-world lending: Loans create Deposits

Mainstream economists—including members of the Federal Reserve’s “Federal Open Market Committee” (FOMC) who determine monetary policy, and set interest rates—also believe that their model of banks lending from Reserves is quite simple and straightforward, as these quotes from Ben Bernanke and Charles Plosser (then President of the Federal Reserve Bank of Philadelphia) in 2009—during the depths of the 2008 financial crisis—illustrate:

Large increases in bank reserves brought about through central bank loans or purchases of securities are a characteristic feature of the unconventional policy approach known as quantitative easing. The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets. (Bernanke 2009, p. 5)

As real rates rise, the opportunity cost of banks holding on to vast excess reserves may lead to a rapid increase in the money multiplier and a conversion of excess reserves into loans or borrowed money. (FOMC 2009, p. 55)

In fact, the “conversion of excess reserves into loans” is virtually impossible: certainly, the simple, direct relationship between Loans and Deposits is does not exist. “Lending from Reserves” means that Reserves go down. Adding money to Deposits means that Deposits go up. Not only does this combination violate the rule that (as Figure 2 shows), it also doesn’t convert Reserves into Loans. Therefore, an attempt to fit the mainstream economic idea that banks lend out Reserves leads to the absurdity that lending reduces bank assets, rather than increasing them, breaks the laws of accounting, and shows Banks giving away Credit for free.

Figure 2: “Lend from Reserves” violates the rules of accounting

To conform to the laws of accounting, “Lending from Reserves” would have to reduce Reserves and increase Loans, as shown in Figure 3. The accounting is now valid, but there is still one weakness: how do borrowers get the money they have borrowed?

Figure 3: “Lend from Reserves” now obeys the rules of accounting–but how do borrowers get the money?

The only way this can make sense is if the loan is in the form of cash, as shown in Figure 4—but recall that, in their model of lending, Bernanke and Blinder ignored cash.

Figure 4: “Lend from Reserves” requires that loans are in the form of cash

Of course, banks generally do not make loans in cash today—instead, they directly add Credit to Deposit accounts, as shown in Figure 1. Reserves play no role in lending, as the Bundesbank stated, and the mainstream attempt to argue that they do generates a caricature of actual bank practice.

The same applies to another aspect of mainstream thinking about banks, that they are “mere intermediaries” that enable savers to lend to borrowers.

Loanable Funds versus Bank Originated Money and Debt

Though Paul Krugman is the main proponent of the “Loanable Funds” model of banking, Bernanke also confirmed that he accepted it when he described it as compatible with the model in (Bernanke and Blinder 1988):

The theory of the bank-lending channel holds that monetary policy works in part by affecting the supply of loans offered by depository institutions. This concept is a cousin of the idea I proposed in my paper on the Great Depression, that the failures of banks during the 1930s destroyed “information capital” and thus reduced the effective supply of credit to borrowers. Alan Blinder and I adapted this general idea to show how, by affecting banks’ loanable funds, monetary policy could influence the supply of intermediated credit (Bernanke and Blinder, 1988).

Loanable Funds sees banks, not as issuers of debt, but as intermediaries that collect funds from savers and lend them out to borrowers. Mainstream economists do not consider that this means (a) that savers, and not banks, would be the actual owners of the debt issued, and (b) that bank deposits could not be demand deposits in this model. Instead, they simply assume that loans redistribute spending power from savers to borrowers, and that repayment of loans does the opposite, as the following quote from Bernanke illustrates in the case of the Great Depression:

The idea of debt-deflation goes back to Irving Fisher … Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. (Bernanke 2000, p. 24. Emphasis added)

The italicized text indicates that Bernanke assumes that a loan causes the spending power of savers (creditors in his language) to fall and that of borrowers (debtors) to rise, while repayment does the opposite. Therefore, in the Loanable Funds model, aggregate spending only varies with changes in the level of debt if Borrowers spend more rapidly than Savers.

Figure 5 sets this model out in Minsky: Savers lend Credit dollars per year to Borrowers (this is negative when debt is repaid); Borrowers pay Interest dollars per year to Savers; Savers pay a Fee to the banks for arranging the loans; Savers spend on Borrowers; Borrowers spend on Savers; and the Banks spend on both Savers and Borrowers.

Figure 5: A simple model of Loanable Funds–but where is the Loan itself?

Even at this point, there is an obvious problem with this model: where is the debt itself? It doesn’t appear here because, in Loanable Funds, the debt (Loans) is an asset of the Savers. To show it, we need to add another table for the Savers: one table is not enough.

Before I add that table, I want to show what the real-world situation, in which banks issue loans, looks like. In this case, Banks lend to Borrowers, Borrowers pay interest to the Banks, and there is no Fee charged on Savers. As Figure 6 shows, Loans do appear in this model, because they are Assets of the Banks: there is no need for an additional table to show them, This illustrates that the real-world practice of banking—which I call “Bank Originated Money and Debt” (BOMD)—is actually simpler than the model of Loanable Funds.

Figure 6: The real-world situation of Banks lending to Borrowers

That said, Figure 7 shows the minimum system needed to model Loanable Funds, since Loans now appear as Assets of the Savers.

Figure 7: Two Godley Tables–one for Banks, the other for Savers, are needed to model Loanable Funds

If this model described reality, then Bernanke would be right that “pure redistributions”—by which he means net lending, which I call Credit here—would “no significant macroeconomic effects” unless there were “implausibly large differences in marginal spending propensities among the groups”. In Figure 8, I build such a model, with Borrowers spending their bank balances 4 times per year, Savers spending 2 times per year, and Banks only 0.1 times per year. I then run it with varying levels of credit: initially 0% of GDP, then 5% so that debt grows, the minus 5% so that it falls, and finally back to zero percent again. There are changes in GDP, but they precisely match changes in the velocity of money.

Figure 8: Loanable Funds with large differences in spending propensities

These are however second-order effects, since there is no change in the amount of money in the economy, and therefore GDP can only grow or fall as much as the velocity of money increases or decreases. In that sense, there’s no great harm done to macroeconomics if banks, and debt, and indeed money are ignored in macroeconomic models—which is the case with Neoclassical macroeconomics.

However, what happens if we model the real-world situation that banks are not intermediaries between Savers and Borrowers, but creators of both debt and money? That is shown in Figure 9, which was created from the model in Figure 8 simply by showing Loans as an Asset of the Banks, rather than Savers, directing Interest payments to the Banks rather than Savers, and deleting the now superfluous Fee.

Figure 9: The real-world of bank originated money and debt

The result is dramatically different, because positive Credit now creates new money, which increases GDP. Similarly, negative Credit destroys money and reduces GDP.

Obviously, from the simulations above, Credit significantly affects macroeconomics in the real-world of Bank Originated Money and Debt (BOMD), but it does not in the Neoclassical fictional world of Loanable Funds.

The Logic of Credit

To understand what lies behind those simulations, I use a device that I call a “Moore Table” (in honour of the great non-mainstream economist Basil Moore) to show that, in the real-world, Credit is part of both Aggregate Demand and Aggregate Income. I abandon the frankly silly Neoclassical categories of “Savers” and “Borrowers”, and consider instead an economy consisting of Households, a Services sector, and a Manufacturing sector, where each sector spends a certain number of dollars per year on the other.

In the first Moore Table shown in Table 1, I omit lending completely, and consider just expenditure financed out of existing money. Households spend A dollars per year on Services and B dollars per year on manufacturing; Services spend C dollars per year on Households, and D dollars per year on Manufacturing; and Manufacturing spends E dollars per year on Households and F dollars per year on Services. The diagonal entries show expenditure; the off-diagonal elements show income, and in the fundamental relation in macroeconomics, aggregate income, which is the negative of the sum of the diagonal elements, is identical to aggregate expenditure, which is the positive sum of the off-diagonal elements.

Table 1: A Moore Table showing expenditure IS income for a 3-sector economy

This leads to Equation 1:

         

In Table 2, I show the Loanable Funds by imagining that the Services sector lends Credit dollars per year to the Households sector, and then Households use this borrowed money to buy more goods from Manufacturing. However, the lending by Services lending comes at the expense of the Service Sector’s spending on Manufacturing (you can’t spend money you’ve lent to someone else). So Services spends (D-Credit) dollar per year on Manufacturing, whereas Households spend (B+Credit) dollars per year on Manufacturing. Lending from the Services Sector to the Household Sector is neither Expenditure nor Income, so the transfer of money can’t be shown horizontally: it is instead shown as a transfer across the diagonal, reducing the expenditure of the lender (Services) and increasing the spending of the borrower (Households). Households pay Interest dollars per year on their outstanding debt to Services, and since this is both an expenditure and an income, it is shown horizontally.

Table 2: The Moore Table for Loanable Funds

When you add up expenditure and income in this table, Credit cancels out: for every positive entry for Credit in either Aggregate Demand (the negative of the sum of the diagonal cells) or Aggregate Income (the sum of the off-diagonal cells), there’s an offsetting negative entry that cancels it out. The only effect of lending on this model of the economy is that Interest payments turn up as part of both expenditure and income:

         

Table 3 shows the real-world situation of “Bank Originated Money and Debt”. It’s more complicated than the other tables, because we have to add the Banking Sector to the model, and we have to include the Banking Sector’s Assets—where Credit appears as an increase in the Banking Sector’s loans to the Household Sector—as well as its Liabilities and its Equity. I also add spending by the Banking sector on the other 3 sectors. Table 3 explicitly shows all spending as passing through the Liabilities (Deposit accounts) and Equity sides of the banking sector’s accounts. The Household Sector’s expenditure on Manufacturing includes Credit, as in Loanable Funds, but this credit-financed spending does not come at the expense of any other sector’s expenditure: instead, it comes from the creation of new money via the expansion of the Banking Sector’s Liabilities and Assets.

Table 3: The Moore Table for Bank Originated Money and Debt

The key outcome is that Credit does not cancel out, as it does in Loanable Funds: there is a single entry for Credit in Aggregate Expenditure—it finances part of the Household Sector’s purchases from the Manufacturing Sector—and a single entry in Aggregate Income—where it is part of the Manufacturing Sector’s income:

         

Consequently, in the model shown in Table 3—and in the real world—credit is a substantial source of both Aggregate Demand and Aggregate Income. This is the logical explanation of the difference in behavior between the “Loanable Funds” model shown in Figure 8 and the BOMD model shown in Figure 9. It is also the explanation for the real-world phenomena of debt-deflationary crises like the Great Recession, the Great Depression, and the Panic of 1837. Neoclassical economics, by ignoring banks, debt and money in its macroeconomic models, is ignoring the main factors that drive economic performance, and also cause economic crises.

This is apparent when, using the guidance above, we look at the role of both private debt and credit in the Great Recession.

The Empirics of Credit

Far from Credit having “no significant macroeconomic effects”, as Bernanke asserted, in the real-world Credit is overwhelmingly the factor causing economic fluctuations—and especially severe downturns like the Great Recession. This is because it is by far the most volatile component of aggregate demand—which mainstream Neoclassical economists miss because their false Loanable Funds theory tells them not to even look at data like that plotted in Figure 10.

Figure 10: Private Debt, Credit and Unemployment in the USA 1970-2012

In doing so, they are like the Ptolemaic astronomers that Galileo ridiculed in correspondence with Kelper five centuries ago, for their steadfast refusal to look through Galileo’s telescope. They therefore never saw the moons of Jupiter, whose existence demolished their Earth-centric vision of the Universe:

What is to be done? Shall we side with Democritus or Heraclitus? I think, my Kepler, we will laugh at the extraordinary stupidity of the multitude. What do you say to the leading philosophers of the faculty here, to whom I have offered a thousand times of my own accord to show my studies, but who with the lazy obstinacy of a serpent who has eaten his fill have never consented to look at planets, nor moon, nor telescope? Verily, just as serpents close their ears, so do these men close their eyes to the light of truth. (Gebler 1879, p. 26)

References

• Bernanke, Ben. 2009. “The Federal Reserve’s Balance Sheet: An Update.” In Federal Reserve Board Conference on Key Developments in Monetary Policy. Washington, DC: Board of Governors of the Federal Reserve System.
  
• Bernanke, Ben S. 2000. Essays on the Great Depression (Princeton University Press: Princeton).
  
• Bernanke, Ben S., and Alan S. Blinder. 1988. ‘Credit, Money, and Aggregate Demand’, American Economic Review, 78: 435-39.
  
• Bholat, David, and Robin Darbyshire. 2016. “Accounting in central banks.” In, edited by Bank of England. London.
  
• Carney, John. 2013. “Basics of Banking: Loans Create a Lot More Than Deposits.” In NetNet, edited by John Carney, Brilliant simple example of loan/deposit creation followed by regulatory requirements. Well worth modeling in Minsky. New York: CNBC.
  
• Committee for the Prize in Economic Sciences in Memory of Alfred Nobel, The. 2022. “Financial Intermediation and the Economy.” In. Stockholm: The Royal Swedish Academy of Sciences.
  
• Deutsche Bundesbank. 2017. ‘The role of banks, non- banks and the central bank in the money creation process’, Deutsche Bundesbank Monthly Report, April 2017: 13-33.
  
• FOMC. 2009. “Meeting of the Federal Open Market Committee on December 15–16, 2009.” In.: Federal Reserve.
  
• Gebler, Karl von. 1879. “Galileo Galilei and the Roman Curia.” In. London: C. Kegan Paul & Co.
  
• McLeay, Michael, Amar Radia, and Ryland Thomas. 2014. ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin, 2014 Q1: 14-27.
  

 

In “A Simple Solution to the Banking Crisis That No Country Will Implement” (Patreon link; Substack link—both open access), I argued that The Fed could end the current crisis simply by buying all outstanding Treasury Bonds at face value. After that, in future The Fed should either let Treasury run an overdraft on its account at The Fed, or The Fed should purchase Treasury Bonds directly from Treasury.

Neither of these practices are unprecedented: as I noted in that post, The Bank of England let the UK Treasury operate an overdraft during Covid, while The Fed routinely purchased bonds directly from Treasury before The Banking Act of 1935, and occasionally even after that—notably, during WWII.

Kenneth D. Garbade, a Vice-President of the New York Fed, explained the origin of the practice of requiring The Fed to only purchase bonds in the secondary market in “Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks” (Garbade 2014). It’s hard to read his history and not conclude that the current system—which requires Treasury to sell bonds to private banks and “primary dealers”, rather than to The Fed—was based on the rickety pillars of the self-interest of bond traders, and delusional ideas about money held by the mainstream economists who staff The Fed, and misinform our politicians.

The Abstract to Garbade’s paper highlights how Keystone Cops-like—to mix my analogies—the whole kerfuffle over direct Fed purchases of Treasury Bonds was:

1) Why did Congress prohibit direct purchases in 1935 after they had been utilized without incident for eighteen years, 2) why did Congress provide a limited exemption in 1942 instead of simply removing the prohibition, and 3) why did Congress allow the exemption to expire in 1981? (Garbade 2014, Abstract. Emphasis added)

As Garbade noted, direct Fed purchases of Treasury Bonds had not led to the sky falling—nor any other calamity—in the years before the 1935 Act. So why prohibit them then? The best reasons he could find in the literature were that this was done “to prevent excessive government expenditures”. The Federal Reserve Chair from 1934 till 1948, Marriner Eccles, put it this way in 1942:

“The restriction forbidding Federal Reserve banks to buy Government obligations except on the open market was imposed … on the theory that forcing the Government to borrow on the open market would afford a check on excessive public expenditures”. (Garbade 2014, p. 5, quoting Eccles)

Eccles followed up in 1947 with the explicit statement that this theory was erroneous:

Those who inserted this proviso were motivated by the mistaken theory that it would help to prevent deficit financing. According to the theory, Government borrowing should be subject to the “test of the market.”

[T]here was a feeling that [the absence of a prohibition] left the door wide open to the Government to borrow directly from the Federal Reserve bank all that was necessary to finance the Government deficit, and that took off any restraint toward getting a balanced budget. (Garbade 2014, p. 6, quoting Eccles)

Though Garbade queries both reasons on logical and empirical grounds, they are nonetheless the only ones he proffers—and humanity is hardly deficient in actions undertaken for illogical or empirically fallacious reasons. So arguably, and on the word of one of the most famous Chairmen of all time—for good reasons, for a change—the requirements that the Treasury should not run an overdraft, and also should not sell bonds directly to The Fed, reflect self-interest and ignorance of the monetary system, rather than logic and experience.

Technical stuff

The rest of this post is for nerds: if you’re interested in what how a monetary system would operate without government bonds, or with government bonds being purchased directly by The Fed, read on.

One clear advantage of both approaches is that it clears away the veil of unnecessary complexity created by believers in Neoclassical economics, to reveal the simplicity at the heart of fiat money creation: the government, as the fundamental creator of a nation’s money, creates money by incurring negative financial equity for itself, and generating identical positive financial equity for the non-government sectors of the economy.

No Government Bonds

Governments create “fiat money” by spending more than they get back in taxation: if the government didn’t run regular deficits, but instead ran a balanced budget, there would be no “fiat money” in existence. In fact, deficits have been the norm for the last century, as Figure 1 shows.

Figure 1: The average government deficit is more than 3 percent of GDP

If this were done by the Treasury having an overdraft at The Fed, and The Fed also paid interest on Reserve balances (more on that later), then the monetary system would look like Figure 2.

The first table in Figure 2 shows that, when the government runs a deficit, it spends more on the Private Sector than it gets back in taxes. This increases private deposit accounts, and therefore increases the net financial worth of the private sector. So, rather than borrowing money from the private sector when it runs a deficit—which is what economic textbooks claim, the government creates money for the private non-bank sector.

The second table in Figure 2 shows this from the point of view of the banks. As well as creating Deposits—which are a Liability of the banking sector—it also creates Reserves, which are an Asset of the Banking Sector. I also show the Banks receiving interest on their Reserves, since a legitimate role of bonds is to pay interest to banks to cover the social role they fulfil of maintaining the country’s payments system. If they didn’t have bonds, then there would be a legitimate case to pay them interest on Reserves. This interest income creates positive financial equity for the banking sector.

The final two tables show how these operations—the Deficit, and paying interest on Reserves—affects the two primary wings of the government, the Fed and the Treasury.

Figure 2: A fiat money system with no government bonds

The deficit doesn’t alter the net equity of the Fed, because as a Deficit reduces The Fed’s liability to the Treasury—the Treasury’s “General Account” in the USA—it increases its liability to the private banks at the same time, in the form of their Reserve accounts at the Fed.

Interest payments on Reserves does affect the equity of the Fed however: the interest payments are made by the Fed going into negative financial equity. This would be catastrophic for a private bank—negative equity for a private bank means bankruptcy, which is what happened to the Silicon Valley Bank. But The Fed isn’t a private bank, and Central Banks can operate with negative equity (Bholat and Darbyshire 2016, p. 15).

For the Treasury, a deficit reduces its financial equity, and sustained deficits would ultimately drive the Treasury’s General Account into the red as well. But this negative financial equity for the Treasury is the mirror image of the positive financial equity that the Deficit creates for the non-bank private sector.

Summarising this system in terms of financial equity, the Deficit creates positive financial equity for the non-bank private sector, while interest on Reserves creates positive financial equity for the private banking sector.

Some people might object to the government being in negative financial equity—hello, my Austrian friends!—but that’s ignorant on at least three fronts.

Firstly, financial assets are claims on someone else: your financial assets are other people’s financial liabilities. By construction therefore, the sum of all financial assets and liabilities is zero. Therefore, if the government were in positive equity, the non-government sectors would be in identical negative equity. Does that sound so attractive now?

Secondly, financial assets aren’t the only form of assets. There are also nonfinancial assets—things which are assets to their owners, but a liability to no-one. For the private sector, it’s things like houses; for the government, it’s things like roads, schools, hospitals, etc. The paranoia about the government’s negative financial equity has meant decades of deficits that are too small, and—for America in particular—not enough nonfinancial assets have been constructed because of the irrational obsession with a balanced budget.

Thirdly—and again, hello Austrians!—even if the Austrian wet dream of a purely private monetary system were enabled by a government that always ran a balanced budget, this would mean that the private non-bank sectors must be in negative financial equity. This is a corollary of the definition of bankruptcy for a bank: it is bankrupt if its Liabilities exceed its Assets, and to function properly, it has to maintain positive equity. Therefore, the private banking sector must be in positive equity, which would mean—in a pure credit economy—that the non-bank private sector would necessarily be in negative financial equity.

I think this structural dialectic is why, when governments get seduced by the siren song of running a surplus, the private sector almost always indulges in an bacchanalian private-debt financed orgy of speculation on the value of nonfinancial assets—primarily houses and stocks—which almost always ends in a financial crisis.

Direct Fed bond purchases

Figure 3 shows the situation when The Treasury issues bonds to cover both the Deficit and Interest on Reserves. The outcome doesn’t change for the non-government sectors: the Deficit creates money (and net financial assets) for the non-bank private sector, while the Interest on Reserves creates money (and net financial assets) for the banking sector.

Figure 3: The financial flows when The Fed buys Bonds directly from the Treasury

Likewise, the aggregate situation for the government sector—the Treasury plus The Fed—doesn’t alter either: it goes into negative financial equity to enable the non-government sectors to go into positive financial equity.

The differences, therefore, are more nuances than fundamental changes. With the Treasury issuing bonds to cover both the Deficit and Interest on Reserves, and The Fed buying them, the Treasury’s account at The Fed remains constant and positive. Interest payments no longer push The Fed into negative equity. Instead, all of the negative equity of the government sector is now concentrated in the Treasury.

Conclusion

There is no substantive difference between these two alternatives to the current situation, but the sale of bonds by the Treasury to the Fed in the second case has the cosmetic benefit that, as under current laws, the Treasury’s account at The Fed remains positive. This eliminates the obvious negative optic of the government appearing to be running an overdraft with the Central Bank, and spending from that overdraft indefinitely. Instead, the Treasury spends from a deposit account that is always positive, and wears its negative equity on its own books rather than on The Fed’s.

The advantage of both situations, and especially the second, is that the fiction that the government borrows from the private sector when it runs a deficit disappears. Far from borrowing money from the private sector, the government, through both its Deficit and paying interest on Reserves, creates money for the private sector.

The case of direct Fed bond purchases is also just a hair’s breadth different to the current situation: there is nothing, absolutely nothing, preventing The Fed from reproducing the essence of this model today by simply buying, on the secondary market, all the bonds the Treasury currently sells to banks on the primary market.

This enables us to kill that old and stubborn furphy of the government debt being, to quote that father of Neoclassical economic fantasists Gregory Mankiw, “an unjustifiable burden on future generations” (Mankiw 2016, p. 557). It is in fact a gift to current generations, which lets them achieve positive financial equity, while the deficit itself—if it were large enough—would enable the creation of substantial nonfinancial assets for the country.

References

Bholat, David, and Robin Darbyshire. 2016. “Accounting in central banks.” In, edited by Bank of England. London.

Garbade, Kenneth D. 2014. ‘Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks’, Federal Reserve Bank of New York Staff Reports, No. 684.

Mankiw, N. Gregory. 2016. Macroeconomics, 9th edition (Macmillan: New York).

 

Though Silicon Valley Bank contributed to its own demise, the root cause of this crisis is the fact that private banks own government bonds. If they didn’t, then SVB would still be solvent.

Its bankruptcy was the result of the price of Treasury bonds falling, because The Federal Reserve increased interest rates. As interest rates rise, the value of Treasury Bonds falls. With the resale value of its bonds plunging, the total value of SVB’s assets (which were mainly Bonds, Reserves, and Loans to households and firms) fell below the value of its Liabilities (which are mainly the deposits of households and firms), and it collapsed.

Why do banks own government bonds? Largely, because of two laws: one that prevents the Treasury from having an overdraft at The Federal Reserve; and another that prevents The Federal Reserve buying bonds directly from the Treasury. If either of these laws didn’t exist, then banks in general wouldn’t need to buy Treasury Bonds, and SVB would still be solvent.

Neither of these laws are inviolable. As Elon Musk once put it, the only inviolable laws are those of physics—everything else is a recommendation.

The UK equivalent of the former law was broken during Covid, with the Treasury and the Bank of England agreeing to extend what they call the “Ways and Means Facility” which is “the government’s pre-existing overdraft at the Bank.” The use of an overdraft sped up the UK’s fiscal response to Covid (such as it was).

The US law only came into force in 1935. Before then, The Federal Reserve regularly purchased Treasury Bonds directly from the Treasury. “The Banking Act of 1935” banned this practice—though it too was ignored during WWII, and at various times until 1981. Marriner Eccles, who was Chairman of The Federal Reserve from 1934 till 1948, asserted that this law was drafted at the behest of bond dealers, who were cut out of a lucrative market when The Fed bought Treasury Bonds directly from the Treasury, rather than on the secondary market where bond traders made their fortunes:

I think the real reasons for writing the prohibition into the [Banking Act of 1935] … can be traced to certain Government bond dealers who quite naturally had their eyes on business that might be lost to them if direct purchasing were permitted. (Garbade 2014, p. 5)

Call me callous, but, given a choice between bond traders losing a lucrative gig, or the financial system collapsing, I’d be happy to see bond traders become rather less wealthy.

So, a simple solution to the current crisis—which was caused by The Federal Reserve itself, as its “hike interest rates to fight inflation” policy trashed the value of Treasury Bonds—would be for:

• The Fed (and its equivalents) to buy all Treasury bonds held by banks, hedge funds pension funds, etc., at face value; and also,
• The Deposit guarantee to be made limitless, rather than capped at $250,000; then in future,
• The Fed should either allow the Treasury to run an overdraft, or it should buy Treasury Bonds directly from the Treasury.

If even just the first of those recommendations was acted upon, today’s crisis would be over. Banks would swap volatile Treasury Bonds at face value for stable Reserves—thus restoring the solvency they had before The Fed started to raise rates. Hedge funds, pension funds, etc., would swap Treasury Bonds for deposits at private banks—and those deposits would be backed by Reserves, rather than Bonds.

The second recommendation would mean that bank deposits—which can be huge, running into the billions of dollars for the largest companies—would be safe from any future banking crises. If they were going to be lost, it would take idiocy by the company or hedge fund bosses themselves, rather than idiocy by The Federal Reserve, or any individual bank.

The third recommendation would end the charade of pretending that the private sector lends money to the government when it runs a deficit. It would make obvious the reality that the government doesn’t borrow money, it creates money. Governments could focus on the important issue of how much money it creates, and for what purposes, rather than pretending that its spending is constrained by what it can borrow from the private sector.

So, why do I think that none of these easy solutions to the current crisis would be taken? Largely, because mainstream, “Neoclassical” economists are in control of our current system. They know nothing about the monetary system—or nothing accurate. They’ll fight against proposals like this, even though they would fix a crisis that they created themselves by not considering what interest rate hikes would do to the resilience of the financial sector that they are supposed to safeguard.

References

Garbade, Kenneth D. 2014. ‘Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks’, Federal Reserve Bank of New York Staff Reports, No. 684.

 

The collapse of Silicon Valley Bank has many parents. Twitter is alight with fingers pointing at venture capitalists for starting a run against a bank whose many wealthy customers had deposits far in excess of the maximum that is guaranteed in the event of a bank failure ($250,000). Michael Hudson blames the aftermath of the Fed’s Quantitative Easing, which boosted asset prices—including bonds—via massive bond purchases by the Fed and matching low interest rates. Alf at the Macro Compass blames the failure of the bank to hedge its risk to changes in interest rates. Frances Coppola blames the failure to carry sufficient capital to cope with a bank run.

Running through all these explanations is the impact of rising interest rates on bank solvency. In this post, I want to give a simple explanation of why this can cause systemic failure—not just to a single bank like SVB, but to the entire banking system.

When inflation returned to the economic scene after a 3-decade absence, The Fed fought it the only way it knows how—by raising interest rates on government bonds. Its mainstream economic models, which ignore banks, debt and money—weird, eh?—predicted that raising interest rates would lower the public’s expectations of inflation, and this would cause actual inflation to fall. Problem solved—in mainstream economic model world.

Meanwhile, in the real world, rising interest rates on government bonds can cause banks to go insolvent. SVB was the canary in the coal mine here, but the factor that brought it undone is shared by all financial institutions, because government bonds are a major component of their assets. When interest rates rise, bond values fall, and this can drive financial institutions into insolvency—where their Liabilities exceed their Assets.

I want to give a very simple explanation of why this can lead to systemic disaster—and, therefore, why it is vitally important that the Fed stop using economic models that ignore the banking sector.

The basic mechanism is extremely simple: bond prices move in the opposite direction to interest rates. A bond promises to pay a fixed sum every year in return for buying that bond for a fixed price. If the bond costs $1000 and the “coupon rate” is 3%, then the bond issuer—the Treasury in the case of government bonds—pays $30 each year to the bondholder.

If interest rates rise, to say 5%, then this bond cannot be sold for its $1000 face value. The most extreme case here are “Consol” bonds, which never expire: a Consol’s price is the fixed sum it pays each year, divided by the market interest rate. If that is 3%, then the $30 the bond pays every year is valued at $30/0.03, which is $1000—its face value. But if the market interest rate rises to 5%, then the sale price of the bond will be $30/0.05, which is $600. The bond’s value falls by $400.

To illustrate why this is a serious problem for the banking sector in the current policy regime of rising interest rates, I’ve built a very simple Minsky model in which all bonds are Consols, banks don’t hedge their risk, and where banks instantly write down the value of Bonds when interest rates rise.

The real world is far more complicated than this of course: almost all bonds are fixed term, so the impact of rising interest rates on their value isn’t as extreme; banks do hedge their interest rate risks (Alf’s post explains this very well) and they don’t instantly “mark to market” (Frances Coppola’s post gives a nice account of what they do instead). But the systemic factors remain. Its arguable too that, though an individual bank can hedge its risk, the banking system as a whole can’t; and while the whole system can delay a day of reckoning with falling asset values, it can’t avoid that day while interest rates remain well above those paid by the bonds they own.

The model has just 4 stocks and 4 flows. The stocks are bank Reserves, Treasury Bonds owned by the banking sector, Loans to the Private Sector, and the Deposits of the public. The initial values are such that the banking sectors Assets well exceed its Liabilities, so that it is in positive Equity—which is a requirement for every individual bank, let alone the entire banking sector.

Figure 1: The financial stocks and flows in the model before interest rates change

The flows are interest on outstanding private sector debt, interest on government bonds, spending by the banking sector on the non-bank private sector, and bond revaluation. Interest on outstanding private sector debt, and interest on government bonds, remain constant because I’ve left new bank loans out of the model, and I’ve omitted factors that alter bank bond holdings as well (primarily the selling of bonds by banks to non-banks, and purchasing of bonds by The Fed). Bank spending is proportional to Bank Equity: I’ve assumed banks spend half their (short-term) equity every year, so their spending starts at $2,250 billion per year.

Revaluation of Bonds starts at zero, because the prevailing interest rate is the same as the interest rate paid by existing government bonds, which is 3%. The Equity of the banking sector stabilizes at $4,890, because at that point its spending is identical to its interest income ($2,445 billion per year).

Once the banking sector’s equity has stabilized, I increase the prevailing interest rate from 3% to 5%. This is much faster than The Fed’s 0.25% monthly interest rate hikes, but again, the function of this simple model is to show what the systemic implications of these rises for the whole banking sector.

The banking sector goes into negative equity.

I emphasise that nothing this extreme will happen in the real world: this model is just to illustrate the key point that rising interest rates reduce the value of existing government bonds, and that this will affect the solvency of bondholders.

In the real world, banks sell much of their bond portfolio to non-banks, which reduces their exposure to effects like this—though that exposure doesn’t go away, but is instead felt by the non-banks that bought the bonds. Banks hedge their exposure to movements in fixed rates too, as Alf explains—but as we should have learnt from the Global Financial Crisis, hedging risk doesn’t mean eliminating it. Instead, somewhere else, someone else is on the end of a losing trade. The fall in the value of bonds still affects the solvency of the system.

Figure 2: A rate rise drives the banking sector into negative equity

SVB was the canary in this event—or perhaps the turkey—because it had an extraordinary level of government bonds on its books. But the financial sector as a whole is the real turkey that The Fed is inadvertently roasting as it thinks it is reducing inflationary expectations.

It’s The Fed that deserves to be roasted instead, for attempting to manage the financial system using models that ignore banks, debt, and money.

This is a post from Michael Hudson. It will be posted later today on his site https://michael-hudson.com/,  but the site admin is in Australia, and won’t be up for several hours. Since this is a fast moving story, Michael wanted his info up ASAP, hence this cross post.

I do recommend that people follow Michael in general, and especially on this topic. Other bloggers who are must reads on this are:

Frances Coppola, whose post on this topic pre-dated the actual collapse of Silicon Valley Bank by one day:

But there’s another problem. A bank can’t raise more cash than the market value of the securities it is selling, and if it is pledging securities, it will raise less. So if the market value of the securities is less than the value of the deposits they are backing, the bank may be unable to raise the money it needs to honour deposit requests. Silicon Valley Bank is is already suffering significant deposit outflows. It could be in deep trouble if this became a full-scale flood. (Though right now, the tanking share price seems to be a more immediate concern…)

Dean Baker, who is calling for Federal Reserve retail banking:

The most obvious solution would be to have the Federal Reserve Board give every person and corporation in the country a digital bank account. The idea is that this would be a largely costless way for people to carry on their normal transactions. They could have their paychecks deposited there every two weeks or month. They could have their mortgage or rent, electric bill, credit card bill, and other bills paid directly from their accounts.

and Alf Peccatiello at The Macro Compass, who explains the role of failing to hedge for interest rate risk in Banking Crisis?:

When you buy Treasuries, you lock in a fixed yield you receive and rising interest rates represent a risk.
To hedge that risk, you enter into an interest rate swap: this time, you pay away a fixed yield and receive variable payments in exchange…

The problems?

SVB had a gigantic investment portfolio as a % of total assets at 57% (average US bank: 24%) and 78% was in Mortgage-Backed Securities (Citi or JPM: around 30%) …and most importantly they DID NOT hedge interest rate risk at all!

I’m working on a Minsky model to illustrate the systemic danger of rising interest rates for banks which hold much of their assets in bonds; I hope to post that later today.

Without further ado, here is Michael Hudson’s perspective on the Silicon Valley Bank collapse:

The breakup of banks that is now occurring is the inevitable result of the way in which the Obama Administration bailed out the banks in 2008. When real estate prices collapsed, the Federal Reserve flooded the financial system with fifteen years of Quantitative Easing to re-inflate real estate prices – and with them, stock and bond prices.

What was inflated were asset prices – above all for the packaged mortgages that banks were holding, but also for stocks and bonds across the board. That is what bank credit does. It made trillions of dollars for holders of financial assets – the One Percent and a bit more. The economy polarized as stock prices recovered, the cost of home ownership soared (on low-interest mortgages) and the U.S. economy experienced the largest bond-market boom in history as interest rates fell below One Percent.

But in serving the financial sector, the Fed painted itself into a corner: What would happen when interest rates finally rose?

Rising interest rates cause bond prices to fall. And that is what has been happening under the Fed’s fight against “inflation,” by which it means rising wage levels. Prices are plunging for bonds, and also for the capitalized value of packaged mortgages and other securities in which banks hold their assets against depositors.

The result today is similar to the situation that S&Ls found themselves in the 1980s, leading to their demise. S&Ls had made long-term mortgages at affordable interest rates. But in the wake of the Volcker inflation, the overall level of interest rates rose. S&Ls could not pay higher their depositors higher rates, because their revenue from their mortgages was fixed at lower rates. So depositors withdrew their money.

To obtain the money to pay these depositors, S&Ls had to sell their mortgages. But the face value of these debts was lower, as a result of higher rates. The S&Ls (and many banks) owed money to depositors short-term, but were locked into long-term assets at falling prices.

This is what is happening to banks today. That is the corner into which the Fed has painted the economy. Recognition of this problem led the Fed to avoid it for as long as it could. But when employment began to pick up and wages began to recover, the Fed could not resist fighting the usual class war against labor. And it has turned into a war against the banking system as well.

Silverlake was the first to go. It had sought to ride the cryptocurrency wave, by serving as a bank for various brand names. After SBF’s vast fraud was exposed, there was a run on cryptocurrencies. Their managers paid by withdrawing the deposits they had at the banks – above all, Silverlake. It went under.

That was a “special case,” given its specialized deposit base. Silicon Valley Bank also was a specialized case, lending to IT startups. And New Republic was also specialized, lending to wealthy depositors in the San Francisco and northern California area. All had seen the market price of their financial securities decline as Chairman Jerome Powell raised the Fed’s interest rates. And now, their deposits were being withdrawn, forcing them to sell securities at a loss. Reuters reported on Friday that bank reserves at the Fed were plunging. That hardly is surprising, as banks are paying about 0.2 percent on deposits, while depositors can withdraw their money to buy two-year U.S. Treasury notes yielding 3.8 or almost 4 percent. No wonder well-to-do investors are running from the banks.

This is the quandary in which banks – and behind them, the Fed – find themselves.

The obvious question is why the Fed doesn’t simply bail them out. The problem is that the falling prices for long-term bank assets in the face of short-term deposit liabilities now looks like the New Normal. The Fed can lend banks for their current short-fall – but how can solvency be resolved without sharply reducing interest rates to restore the 15-year Abnormal Zero Interest-Rate Policy (ZIRP)?

Interest yields spiked on Friday, March 10. As more workers were being hired than was expected, Mr. Powell announced that the Fed might have to raise interest rates even higher than he had warned. Volatility increased.

And with it came a source of turmoil that has reached vast magnitudes beyond what caused the 2008 crash of AIG and other speculators: derivatives.

JP Morgan Chase and other New York banks have tens of dollars trillions of derivatives, that is, casino bets on which way interest rates, bond prices, stock prices and other measures will change. For every winning guess, there is a loser. When trillions of dollars are bet on, some bank trader is bound to wind up with a loss that can easily wipe out the bank’s entire net equity.

There is now a flight to “cash,” to a safe haven – something even better than cash: U.S. Treasury securities. Despite the talk of Republicans refusing to raise the debt ceiling, the Treasury can always print the money to pay its bondholders. It looks like the Treasury will become the new depository of choice for those who have the financial resources. Bank deposits will fall. And with them, bank holdings of reserves at the Fed.

So far, the stock market has resisted following the plunge in bond prices. My guess is that we will now see the Great Unwinding of the great Fictitious Capital boom of 2008-2015.

Michael Hudson

I was asked to contribute to an Italian online publication‘s tribute to John Kenneth Galbraith, by answering some questions about the relevance of his major work The New Industrial State (Galbraith and Galbraith 1967) six decades later. These were my responses.

About sixty years later, how relevant and actual is the vision of the American economy and economic system proposed by John K. Galbraith in his “The new industrial state”?

Reading The New Industrial State (Galbraith and Galbraith 1967) again, six decades after it was first published, highlighted for me just how far economic theory has retreated from reality since the 1960s.

The New Industrial State (hereinafter called TNIS) described the actual structure of a modern industrial economy. It has nothing to do with Alfred Marshall’s vision of a market economy, in which a multitude of small entrepreneurial firms sold homogenous goods directly to consumers in anonymous markets, and in which prices were set by the intersection of supply and demand. Instead, the economy is dominated by large corporations, which themselves are run by a bureaucratic “technostructure”—the term Galbraith invented—that attempts to manage everything, from input costs to final consumer demand which they manipulate via marketing. Prices are tamed by long term contracts, and the only source of instability in prices comes from wage demands on the one hand, and the vagaries of agricultural and energy production on the other.

This was the reality of the mid-1960s on which Galbraith commented. At the time he wrote, Galbraith was confident that this reality would supplant the Marshallian fantasy of supply and demand curves, which dominated economic theory.

Fat chance! Galbraith’s optimism about his profession of economics was misplaced: faced with a conflict between reality and theory, mainstream economic elevated theory over the inconvenient facts of the real world. The main real-world changes since Galbraith’s time have been the crushing of trade unions, which has largely eliminated the capacity of workers to bargain for wage rises, the development of globalization, which has created long and extremely fragile supply chains, with much production occurring offshore rather than in American factories, and the financialization of near everything. But a “technostructure” is still in charge, and the realities of production, management and marketing are the same as he observed in the mid-1960s.

None of this realism has seeped into economic theory.

Galbraith gained his knowledge of the actual nature of the management of industrial capitalism from simple observation and, crucially, being involved in the procurement and price control efforts of World War II. In the 1990s, the mainstream economist Alan Blinder gained similar knowledge via a very careful random survey of American companies with sales exceeding $10 million per year.

The answers these companies gave Blinder about their operations turned everything in mainstream economics upside-down—just as Galbraith’s book had done 30 years earlier. Firms face falling marginal costs, not the rising marginal costs assumed by economic theory. Over 70% of their output is sold to other companies, not to end consumers. Prices of industrial goods are subject to long-term contracts, and change rarely. Word for word, the survey reproduced the vision of the corporate sector that Galbraith had laid out. Blinder himself observed that “The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost”, and that “their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks” (Blinder 1998, pp. 102, 105).

The real world is “overwhelmingly bad news” for economic theory because, with falling marginal cost, the textbook supply curve does not exist: the output of firms is not constrained by rising costs, but instead, any firm that secures a larger market share also secures a higher profit. The neat equilibrium of the textbook is replaced by an evolutionary struggle for survival and dominance.

Not a word of that reality made it into economic textbooks. Even Blinder’s own undergraduate textbook (Baumol and Blinder 2015) pretends that Marshall’s model is accurate, despite his own knowledge that the results of his survey were “overwhelmingly bad news here (for economic theory)”.

Galbraith’s book therefore remains relevant as a description of economic reality, but the optimism he had that his realistic vision would replace textbook fantasies was misplaced.

Do you think that today we have passed from an industrial technostructure to a digital and high tech technostructure? Has the role, once of the industrial circuit, been taken today by big tech and corporate related to social networks?

Much of the US industrial circuit has been relocated to China and other developing economies, but if anything this has strengthened the importance of the technostructure: the coordination that Galbraith saw playing out across the continental USA is now an order of magnitude more complex.

The growth of software has also made Galbraith’s analysis even more apposite. Though the marginal costs of industrial firms are low and falling—the opposite of the textbook model—the marginal costs of software firms are closer to zero. The profit margins from market dominance are therefore even bigger. There is no second place in the word processor market (Microsoft Word) or the browser market (Google Chrome), and second place in the operating system market (Apple MacOs) is long distant from first place (Windows).

The need to control prices and manage demand are even bigger in the digital/high-tech world than they were in Galbraith’s industrial day, while the capacity for market dominance by the market leader is stronger still where products have a substantial network effect. This applies to everything from the obvious—such as social media products like Twitter and Facebook—to the mundane. Word‘s dominance of the word processor market is largely due to the fact that it was the program most users used. Minority product users—which I once was, using Lotus Word Pro in preference to Word because of its superior desktop publishing features—were forced to adopt Word for compatibility with the people with whom we had to communicate. Rivals like Word Pro withered and died in the marketplace, simply because they were not the number one product.

Textbooks treat this as an interesting—and easily ignored—exception to the assumed rule of rising marginal cost. But in fact, it is an amplification of the processes Galbraith identified in the industrial state, which make the textbook model even more irrelevant to the real world.

Is the role of the proletariat and the workforce in this new digital state today played by capital and technical means that replace the social weight of the workforce?

The decline in the political power of the working class since the publication of TNIS has been dramatic. Galbraith foresaw this possibility, as he noted the extent to which the technostructure attempted to have workers identify with the firm rather than their social class. Here Galbraith deserves praise for a great deal of prescience:

The planning system, it seems clear, is unfavorable to the union. Power passes to the technostructure, and this lessens the conflict of interest between employer and employee which gave the union much of its reason for existence. Capital and technology allow the firm to substitute white-collar workers and machines that cannot be organized for blue-collar workers who can. The regulation of aggregate demand, the resulting high level of employment together with the general increase in well-being, all, on balance, make the union less necessary or less powerful or both. The conclusion seems inevitable.

The union belongs to a particular stage in the development of the planning system. When that stage passes, so does the union in anything like its original position of power. And, as an added touch of paradox, things for which the unions fought vigorously—the regulation of aggregate demand to ensure full employment and higher real income for members—have contributed to their decline. (Galbraith and Galbraith 1967, p. 337)

Starting from the text “The economy of innocent fraud” how has the role of finance changed the link between technostructure and markets?

One factor that Galbraith did not anticipate in 1967 was the rise in the significance of the financial sector, not only in the USA, but worldwide. When TNIS was published, private debt was under 90 percent of GDP, and the industrial sector was the dominant sector of the US economy. Today, private debt is over twice as high relative to GDP, and the financial tail now wags the industrial dog—see Figure 1.

Figure 1: Private debt is dramatically higher today than it was when TNIS was first published in 1967

 

As a result, America is no longer dominated by the military-industrial complex—to use the phrase invented not by Galbraith, but his contemporary President Dwight D. Eisenhower—but by what I call the politico-financial complex. We have to look, not to Galbraith in 1967, but to Marx a century earlier, for an accurate characterisation of what this has meant for the viability of the capitalist system:

Talk about centralisation! The credit system, which has its focus in the so-called national banks and the big money-lenders and usurers surrounding them, constitutes enormous centralisation, and gives to this class of parasites the fabulous power, not only to periodically despoil industrial capitalists, but also to interfere in actual production in a most dangerous manner—and this gang knows nothing about production and has nothing to do with it. (Marx 1894, Chapter 33)

What is the major legacy of Galbraith?

Re-reading TNIS made me nostalgic for the 1960s, not because the music was better—though, of course, it was—but because the vision of the future which Galbraith had was better than the future itself has turned out to be. Galbraith’s erudite prose was underwritten by a presumption that the knowledge he had acquired—of how the American industrial sector actually functioned—would supplant the reassuring fictions of Marshallian markets that academic economists continued to peddle in their first year textbooks.

It didn’t. Economic textbooks today are even more arcane than the academic products of the 1960s, which Galbraith felt he could comfortably disparage as he outlined what he called the “revised sequence” of how goods are manufactured and marketed in an advanced capitalist economy:

In the form just presented, the revised sequence will not, I think, be challenged by many economists. There is a certain difficulty in escaping from the inescapable. There is more danger that the point will be conceded, and its significance then ignored…

The revised sequence sends to the museum of obsolete ideas the notion of an equilibrium in consumer outlays which reflects the maximum of consumer satisfaction. (Galbraith and Galbraith 1967, p. 265)

Unfortunately, his “revised sequence” was not even conceded by the discipline, let alone ignored. The museum of obsolete ideas is alive and well in the 2020s, instructing economics students today in a vision of a market economy even more arcane that the 1960s economics textbooks that Galbraith clearly—and wrongly—thought were going the way of the Dodo.

Instead, Galbraith’s own contributions largely went the way of the Dodo. Modern students of economics are unaware of his contributions, from the practical work he undertook to enable the USA to dramatically expand wartime production without causing inflation in either military or consumer goods prices, to his eloquent erudition of an alternative economics in works such as TNIS, The Affluent Society (Galbraith 2010) and The Great Crash 1929 (Galbraith 1955).

Galbraith partly contributed to his own subsequent irrelevance, by not providing a means by which his eloquence could be turned into equations. His contemporary Hyman Minsky (Minsky 1975, 1982), who was far less well-known than Galbraith at the time—even in non-orthodox economic circles—is the one whose non-orthodox vision lives on after him, largely because his vision could be put into a range of analytic forms (Keen 1995; Delli Gatti and Gallegati 1996; Dymski 1997; Wray 2010; Keen 2020). Even Neoclassicals, who remain as ignorant of Minsky’s real insights as they are of Galbraith’s, must acknowledge the existence of “Minsky Moments” (Bressler 2021). There is no Galbraithian equivalent.

6) What would be the characteristics of a “New Digital state”?

The main difference between the Industrial State that Galbraith described, and the Digital (and Financial) State in which we reside today is the importance of network effects for the Digital economy.

The goods produced by the companies Galbraith’s that treatise considered were not dependent on widespread consumer conformity. The New Industrial State led to the dominance of mega-corporations (like Ford, General Electric, and IBM), but their dominance did not mean that rival companies (like General Motors, Westinghouse and Burroughs) were unable to achieve market share. However, in today’s Digital State, it is near impossible for a rival to Facebook to achieve critical mass, because Facebook already has that critical mass. This makes the Digital State a much more all-or-nothing contest than the New Industrial State of the mid-1960s.

The effect is profound. If the market had reason to complain about the product of an industrial giant—say, for example, the Ford Edsel—it was easy to switch to a rival product from a rival manufacturer. But complain as consumers do today about Google, Facebook and Twitter, the capacity to turn those complaints into a rival product is virtually non-existent.

In this way, the dominance of the technostructure over the market that Galbraith identified in the 1960s is even greater today. But the Silicon Valley hipsters who might well use the word as they debate the Internet-Of-Things over a soy latte would never know that the word that describes them so well was invented by John Kenneth Galbraith.

Baumol, William J, and Alan S Blinder. 2015. Microeconomics: Principles and policy (Nelson Education).

Blinder, Alan S. 1998. Asking about prices: a new approach to understanding price stickiness (Russell Sage Foundation: New York).

Bressler, Paige D. 2021. ‘In a Minsky Moment, can financial statement data predict stock market crashes and recessions?’, The Journal of corporate accounting & finance, 32: 155-63.

Delli Gatti, Domenico, and Mauro Gallegati. 1996. ‘Financial Instability Hypothesis and Stabilization Policy: Hyman P. Minsky’s Contribution to Political Economy’, Economic Notes, 25: 411-24.

Dymski, Gary. 1997. ‘Deciphering Minsky’s Wall Street Paradigm’, Journal of Economic Issues, 31: 501.

Galbraith, James K. 2010. The affluent society and other writings, 1952-1967 (Penguin: New York).

Galbraith, John Kenneth, and James K. Galbraith. 1967. The new industrial state (The James Madison library in American politics) (Princeton University Press: Princeton).

Galbraith, John Kenneth. 1955. The Great Crash 1929 (Houghton Mifflin Company: Boston.).

Keen, Steve. 1995. ‘Finance and Economic Breakdown: Modeling Minsky’s ‘Financial Instability Hypothesis.”, Journal of Post Keynesian Economics, 17: 607-35.

———. 2020. ‘Emergent Macroeconomics: Deriving Minsky’s Financial Instability Hypothesis Directly from Macroeconomic Definitions’, Review of Political Economy, 32.

Marx, Karl. 1894. Capital Volume III (International Publishers: Moscow).

Minsky, Hyman P. 1975. John Maynard Keynes (Columbia University Press: New York).

———. 1982. Can “it” happen again? : essays on instability and finance (M.E. Sharpe: Armonk, N.Y.).

Wray, L. Randall. 2010. ‘Minsky, the Global Money-Manager Crisis, and the Return of Big Government.’ in Steven Kates (ed.), Macroeconomic Theory and Its Failings: Alternative Perspectives on the Global Financial Crisis (Cheltenham, U.K. and Northampton, Mass.: Elgar).