I’m writing a book for Polity Press entitled The New Economics: A Manifesto. It has a long way to go, but this is the reasonably complete first chapter.

1. Why this Manifesto?
   

Even before the Covid-19 crisis began, the global economy was not in good shape, and nor was economic theory. The biggest economic crisis since the Great Depression began late in first decade of the 21^st century. Called the “Global Financial Crisis” (GFC) in most of the world and the “Great Recession” in the USA, it saw unemployment explode from 4.6% of the US workforce in early 2007 to 10% in late 2009. Inflation turn into deflation— inflation of 5.6% in mid-2008 fell to minus 2% per year in mid-2009—and the stock market collapsed, with the S&P500 Index falling from 1500 in mid-2007 to under 750 in early 2009. The economy recovered very slowly after then, under the influence of an unprecedented range of government interventions, from the “cash for clunkers” scheme that encouraged consumers to dump old cars and buy new ones, to “Quantitative Easing”, where the Federal Reserve purchased a trillion-dollars-worth of bonds from the financial sector every year, in an attempt to stimulate the economy by making the wealthy wealthier.

This crisis surprised both the policy economists who advise governments on economic policy, and the academic who develop the theories and write the textbooks that train the vast majority of new economists. They had expected a continuation of the boom conditions that had preceded the crisis, and they in fact believed that crises could not occur. In his Presidential Address to the American Economic Association in January 2003, Nobel Prize winner Robert Lucas declared that crises like the Great Depression could never occur again because “Macroeconomics … has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades. (Lucas 2003 , p. 1 ; emphasis added). Just two months before the crisis began, the Chief Economist of the Organization for Economic Cooperation and Development (OECD), the world’s premier economic policy body, declared that “the current economic situation is in many ways better than what we have experienced in years“, and predicted that “sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.” (Cotis 2007 , p. 7; emphases added)

How could they be so wrong? Economists could be excused for this failure to see the Great Recession coming if the crisis were something like Covid-19, when a new pathogen suddenly emerged out of China. That such a plague would occur was predicted as long ago as 1995 (Garrett 1995). But predicting when the pathogen would emerge, let alone what its characteristics would be, was clearly impossible. However, the epicentre of the Great Recession was the US financial system itself: the crisis came from inside the economy, rather than from outside. Surely there were warning signs? As Queen Elizabeth herself put it when she attended a briefing at the London School of Economics in 2008, “If these things were so large, how come everyone missed them?” (Greenhill 2008).

Not all economists did: there were some who warned that a crisis was not merely likely, but imminent. The Dutch economist Dirk Bezemer identified a dozen, of whom I was one (Keen 1995; Keen 2007; Bezemer 2009; Bezemer 2009; Bezemer 2010). Though these economists came from disparate backgrounds, Bezemer noted that they had one negative characteristic in common: “no one predicted the crisis on the basis of a neo-classical framework” (Bezemer 2010, p. 678).

“Neoclassical” economics is the method of thinking about and modelling the economy that the majority of economists use today—both Lucas and the OECD Chief Economist (then and now) are Neoclassical economists. For this reason, it is often also called “mainstream economics”. But it is not the only framework. Though the Neoclassical approach has dominated the discipline since the 1870s, it has never completely replaced previous approaches to economics, and rival approaches to it have developed since the 1870s.

These rival approaches in economics are very different to divisions of thought in sciences like physics. Albert Einstein’s General Relativity and Max Planck’s Quantum Mechanics have supplanted Isaac Newton’s physics in the realms of the very large (the Universe) and very small (the atom), but in between, Newton’s equations work very well. They are fundamentally different visions of the how the Universe operates, but anyone who rejects any of these approaches in physics in their relevant realm is highly likely to be a “crank”, who could never get a position in an academic physics department.

But in economics, different schools of thought have visions of how the economy works that are fundamentally in conflict. There is no way to partition the economy into sections where Neoclassical economics applies and others where Austrian, Marxian or Post Keynesian theory applies. On the same topic—say, for example, the role of private debt in causing financial crises—these schools of thought will have answers that flatly contradict each other.

Economists who do reject the mainstream, the so-called “heterodox” economists, also make up a significant minority of academic economists—as much as 1/6^th of the discipline, going on a campaign by French academic economists in 2015 to establish a separate classification there (Lavoie 2015; Orléan 2015). So there is something fundamentally incompatible between the Neoclassical and heterodox approaches to economics, and the heterodox economists cannot be dismissed as cranks.

The common themes that Bezemer identified in the work of those who warned of the Global Financial Crisis indicate one of the key incompatibilities. Mainstream macroeconomic models ignore banks, debt, and money (Bezemer 2010, p. 678), while most heterodox economists regard banks, debt and money as crucial concepts in economics.

If you haven’t yet studied economics, or you’re in your early days of doing so at school or university, I hope this gives you pause: “Neoclassical economics doesn’t concern itself with money? But isn’t economics about money?” I, and many other heterodox economists, would respond “Yes, it is!”. But the mainstream long ago convinced itself that money doesn’t really affect the economy, and hence monetary phenomena are omitted from Neoclassical models. One Neoclassical economist put it this way on Twitter:

Most people who teach macro do it by leading people through simple models without money, so they understand exchange and production and trade, international and inter-temporal. You can even do banks without money [yes!]. And it’s better to start there. Then later, study money as it superimposes itself and complicates things, giving rise to inflation, exchange rates, business cycles.

Figure 1: Tony Yates defending moneyless macroeconomics on Twitter on October 19th 2020

This statement was made in late 2020—a dozen years after the failure of Neoclassical models to anticipate the crisis.

Why didn’t mainstream economists change their beliefs about the significance of money in economics after their failure in 2007? Here, paradoxically, economics has been like physics, in that significant change in physics does not, in general, occur because adherents of an old way of thinking become convinced by an experiment whose results contradicted their theory. Instead, these adherents continued to cling to their theory despite the experimental evidence it had failed. Humans, it appears, are more wedded to their beliefs about reality—their “paradigms”, to use Thomas Kuhn’s famous phrase (Kuhn 1970)—than reality itself. Science changed, not because these scientists changed their minds, but because they were replaced by new scientists who accepted the new way of thinking. As Max 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. 33-34)

Here, economics is different, largely because economic truths are different to scientific ones in that they are historical, whereas scientific truths are unchanging. The key scientific experiment that led to Einstein’s theory of relativity was the Michelson-Morley experiment in 1887, which attempted to measure the speed of the Earth relative to “the aether”, the medium that scientists then thought allowed light to travel through space. Michelson and Morley’s experiments found that there was no discernible relative motion—which implied that the aether did not exist. This experiment can be repeated at any time—and has been repeated, with increasingly more sophisticated methods—and the result is always the same. There is no way of getting away from it and returning to a pre-Relativity science—nor is there any desire to do so by post-Relativity physicists.

In economics, it is possible to get away from failures of theory to play out as expected in reality. An event like the GFC occurs only once in history, and it cannot be reproduced to allow old and new theories to be tested against it. As time goes on, the event itself fades from memory. History can help sustain a memory, but economic history is taught at very few universities. Economics don’t learn from history because they’re not taught it in the first place.

Economics is also a moving target, whereas physics, relatively, is a stationary one. When a clash between theoretical prediction and empirical results occurs in physics, the state of unease persists until a theoretical resolution is found. But in economics, though a crisis like the GFC can cause great soul searching at the time, the economy changes over time, and the focus of attention shifts.

Finally, unlike physicists, economists do want to return to pre-crisis economic theory. Events like the GFC upset the totem that characterises Neoclassical economics, the “supply and demand” diagram, in which the intersecting lines determining both equilibrium price and equilibrium quantity, and in which any outside intervention necessarily makes things worse by moving the market away from this equilibrium point. This image of a self-regulating market system that always returns to equilibrium after an “exogenous shock” is a powerful emotional anchor for mainstream economists.

These factors interact to make economics extremely resistant to fundamental change. In physics, anomalies like the clash between the results of the Michelson-Morley experiment and the predictions of pre-Relativity physics persist until the theory changes, because the experimental result is eternal. The anomaly doesn’t go away, but the theory that it contradicted dies with the pre-anomaly scientists, who can’t recruit followers amongst new students, because they are aware of the anomaly, and won’t accept any theory that doesn’t resolve it.

In economics, anomalies are forgotten, and new students can be recruited to preserve and extend the old beliefs to cover new phenomena. School and university economics courses become ways of reinforcing the Neoclassical paradigm, rather than fonts from which new theories spring in response to failures of the dominant paradigm.

This means that intellectual crises in physics are intense but, to some extent, short-lived. The crisis persists until a new theoretical breakthrough resolves it—regardless of whether that breakthrough persuades existing physicists (which as a rule, it doesn’t). The “anomaly”, the empirical fact that fundamentally contradicts the existing paradigm, is like the grain of sand in an oyster that ultimately gives birth to a pearl: the irritation cannot be avoided, so it must be dealt with. It is the issue that believers in the existing paradigm know they cannot resolve—though it may take time for that realisation to sink in, as various extensions of the existing paradigm are developed, each of which proves to be partially effective but inherently flawed. It is the thing young scientists are most aware of, the issue they want to be the one to resolve. As their lecturers who stick to the old paradigm age, the students take in the old ideas, but are actively looking for where they are wrong, how these contradictions might be resolved.

Once a solution is found, the protestations of the necessarily older, aged and often retired champions of the previous paradigm, mean nothing. Ultimately, all the significant positions in a university department are filled by scientists who are committed to the new paradigm.

As that is pushed further, then, as philosopher of science Thomas Kuhn (Kuhn 1970) explains, the new paradigm undergoes a period of rapid extension just like its predecessor, but ultimately this new paradigm will confronts its own critical anomaly, and the science falls into crisis once more.

This is a punctuated path of development. It starts with the development of an initial paradigm by a great thinker, around whom a community of followers develop. They extend the core insights and thus form a science, and initially enjoy a glorious period of the dance between observation and theory, where observations confirm and extend the paradigm. But finally, some prediction the theory makes is contradicted by observation. After a period of denial and dismay, the science settles into an unhappy peace: the paradigm is taught, but with less enthusiasm, the anomaly is noted, and the various withing-paradigm attempts to resolve it are discussed. Then, out of somewhere, whether from a Professor (Planck) or a patents clerk (Einstein), a resolution comes. Rinse and repeat.

Those punctuations never occur in economics, and because the punctuations don’t occur, neither does the kind of revolutionary change in the discipline that Kuhn vividly describes for physics and astronomy.

An economic crisis, when it strikes, does disturb the mainstream. Their textbook advice—if the crisis is empirical rather than theoretical—is thrown out the window by policymakers while the crisis lasts. But mainstream economists react defensively. They justify the extraordinary measures by the unexpected nature of the crisis, then treat the contradiction the crisis poses for their theory as an aberration, which can be handled by admitting some modifications to the core theory. One example is the concept of “bounded rationality” promoted by Joe Stiglitz (Stiglitz 2011; Stiglitz 2018). This can be invoked to say that, if everyone were strictly rational, then no problem would arise, but because of “bounded rationality”, the general principle doesn’t apply and, in this instance, a deviation from the theoretical canon is warranted.

Minor modifications are made to the core Neoclassical paradigm, but fundamental aspects of it remain sacrosanct.

Over time, the crisis passes—whether that was aided or hindered by the advice of economists. A handful of economists break with the majority, which is how heterodox economists are born. But the majority of students become as entranced as their teachers were by the fundamentally utopian vision of Neoclassical economics—a world without power, in which everyone receives their just rewards, and in which regulation and punishment are unnecessary, because The Market does it all. These new students replace their masters, and they continue to propagate the Neoclassical paradigm.

That fraction which breaks away—the roughly one in six academic economists who refuse to ignore the crisis, reject the mainstream, and then get attracted to a competing paradigm (like Post Keynesian, Marxian or Austrian Economics)—live on in universities, but don’t get the positions, promotions or research funds that accrue to the true believers in Neoclassical economics. Instead, they get positions in lowly ranked universities which leading Neoclassicals aren’t interested in—like the University of Western Sydney, and Kingston University London, where I was respectively a Professor and Head of School, or in Departments of Business or Management. The influence of heterodox economists is limited, but they exist at all times.

Given this failure to break the dominant Neoclassical paradigm despite numerous crises, both empirical and logical (Keen 2011), the discipline sits in a state of perpetual and understated crisis: a minority of heterodox economists vocally reject the Neoclassical mainstream, but the Neoclassical paradigm remains dominant. It evolves over time, but it is never replaced in the way that obsolete paradigms are replaced in science.

If you’re thinking “But what about the Keynesian revolution?”, that was snuffed out by John Hicks, with a paper that purported to reach a reconciliation between “Mr Keynes and the Classics” (Hicks 1937) by developing what became known as the IS-LM model. Though this model was presented and accepted by the majority of economists as “a convenient synopsis of Keynesian theory”, Hicks later admitted that it was a Neoclassical, “general equilibrium” model he had sketched out “before I wrote even the first of my papers on Keynes” (Hicks 1981, p. 140).

The gap between what this model alleged was Keynesian economics, and the actual economics of Keynes, was enormous, as can readily be seen by comparing Hicks’s “suggested interpretation” of Keynes, and Keynes’s own 24-page summary of his economics in “The General Theory of Employment” (Keynes 1937), which was published 2 months before Hicks’s paper. The key passage in Keynes’s summary is the following:

The theory can be summed up by saying that … the level of output and employment as a whole depends on the amount of investment… More comprehensively, aggregate output depends on … But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little.

This that I offer is, therefore, a theory of why output and employment are so liable to fluctuation. (Keynes 1937, p. 221. Emphasis added)

Keynes model sees the level of investment as depending primarily upon investors’ expectations of the future, which are uncertain and “unreliable”. Hicks completely ignored expectations—let alone uncertainty—and instead, modelled investment as depending upon the money supply and the rate of interest:

This brings us to what, from many points of view, is the most important thing in Mr. Keynes’ book. It is not only possible to show that a given supply of money determines a certain relation between Income and interest…; it is also possible to say something about the shape of the curve. It will probably tend to be nearly horizontal on the left, and nearly vertical on the right…

Therefore, … the special form of Mr. Keynes’ theory becomes valid. A rise in the schedule of the marginal efficiency of capital only increases employment, and does not raise the rate of interest at all. We are completely out of touch with the classical world. (Hicks 1937, p. 154)

The schism between Hicks’s Neoclassical purported model of Keynes and Keynes’s own views was so great that it gave rise to one of the key heterodox schools of thought, “Post Keynesian Economics”. So “the Keynesian revolution” didn’t happen, though Post Keynesians themselves—including myself (Keen 2020)—have developed approaches to economics that are revolutionary. But a revolution in thought, like that from Ptolemy’s earth-centric vision of the solar system to Copernicus’s sun-centric vision, has not happened.

The above paints a bleak picture of the prospects of replacing Neoclassical economics with a fundamentally different and far more realistic paradigm. But there have been changes over time that make this more feasible now than it was at Keynes’s time.

Foremost here is the development of the computer, and computer software that can easily handle large scale dynamic and even evolutionary processes. These developments have occurred outside economics, and especially in engineering, physics and meteorology. There are limitations of the applicability of these techniques to economics, largely because of the fact that economics involves human behaviour rather than the interaction of unconscious objects, but as I will argue in the following chapters, these limitations distort reality far less than the Neoclassical fantasy that economic processes occur in or near equilibrium.

The development of the Post Keynesian school of thought after the Great Depression is also important. There were strident critics of the Neoclassical mainstream before the Great Depression, such as Thorstein Veblen (Veblen 1898; Veblen 1908; Veblen 1909), but no truly revolutionary school of economic thought. The development of this heterodox school over the 8 decades between the Great Depression and the GFC meant that, when that crisis struck, there were coherent explanations of it—indeed, prescient warnings of it (Keen 1995; Godley and Wray 2000; Godley 2001; Godley and Izurieta 2002; Keen 2006; Keen 2007)—that did not exist when Keynes attempted his revolution.

Social media has also allowed student movements critical of Neoclassical economics to evolve, flourish and persist in a way that was impossible before the Internet. I led the first student revolt against Neoclassical economics at Sydney University in 1973 (Butler, Jones et al. 2009), but that was restricted to just one university in far-away Australia. French students established the “Protest Against Austistic Economics” in 2000, which had somewhat more traction, but whose main legacy was an online journal called the Real World Economic Review. The real breakthrough came with a protest by economics students at the University of Manchester in the UK in 2012, in response to the failure of their teachers to take the GFC seriously in their macroeconomics courses. As they put it, “The economics we were learning seemed separate from the economic reality that the world was facing, and devoid from the crisis that had made many of us interested in economics to begin with”. Their Post Crash Economics movement in turn spawned the international Rethinking Economics campaign, which now has groups in about 100 universities across the world.

There are therefore students eager for approaches to economics that break away from the Neoclassical mainstream, methods of analysis which can easily supplant the dated equilibrium methods used by Neoclassical economics, and rival schools of thought with an intellectual tradition spanning 70 years on which an alternative paradigm can be constructed. What we lack is a university system in which these conditions can foment change as occurs in physics.

Hence this Manifesto: I want to reach potential students of economics before they embark on a university course of study that will attempt to inculcate belief in the Neoclassical paradigm, and that will drive away those that can’t accept it.

1. Appendix
   

1. References
   

   Bezemer, D. J. (2009). “‘No one saw this coming’ – or did they?” VOX EU, from https://voxeu.org/article/no-one-saw-coming-or-did-they.

   Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen.

   Bezemer, D. J. (2010). “Understanding financial crisis through accounting models.” Accounting, Organizations and Society
   35(7): 676-688.

   Butler, G., E. Jones, et al. (2009). Political Economy Now!: The struggle for alternative economics at the University of Sydney. Sydney, Darlington Press.

   Cotis, J.-P. (2007). Editorial: Achieving Further Rebalancing. OECD Economic Outlook. OECD. Paris, OECD. 2007/1: 7-10.

   Garrett, L. (1995). The coming plague : newly emerging diseases in a world out of balance / Laurie Garrett. New York, New York : Penguin Books USA Inc.

   Godley, W. (2001). “The Developing Recession in the United States.” Banca Nazionale del Lavoro Quarterly Review
   54(219): 417-425.

   Godley, W. and A. Izurieta (2002). “The Case for a Severe Recession.” Challenge
   45(2): 27-51.

   Godley, W. and L. R. Wray (2000). “Is Goldilocks Doomed?” Journal of Economic Issues
   34(1): 201-206.

   Greenhill, S. (2008). ‘It’s awful – Why did nobody see it coming?’: The Queen gives her verdict on global credit crunch. Mail Online. London.

   Hicks, J. (1981). “IS-LM: An Explanation.” Journal of Post Keynesian Economics
   3(2): 139-154.

   Hicks, J. R. (1937). “Mr. Keynes and the “Classics”; A Suggested Interpretation.” Econometrica
   5(2): 147-159.

   Keen, S. (1995). “Finance and Economic Breakdown: Modeling Minsky’s ‘Financial Instability Hypothesis.’.” Journal of Post Keynesian Economics
   17(4): 607-635.

   Keen, S. (2006). Steve Keen’s Monthly Debt Report November 2006 “The Recession We Can’t Avoid?”. Steve Keen’s Debtwatch. Sydney. 1: 21.

   Keen, S. (2007). Deeper in Debt: Australia’s addiction to borrowed money. Occasional Papers. Sydney, Centre for Policy Development.

   Keen, S. (2011). Debunking economics: The naked emperor dethroned? London, Zed Books.

   Keen, S. (2020). “Emergent Macroeconomics: Deriving Minsky’s Financial Instability Hypothesis Directly from Macroeconomic Definitions.” Review of Political Economy
   32(3): 342-370.

   Keynes, J. M. (1937). “The General Theory of Employment.” The Quarterly Journal of Economics
   51(2): 209-223.

   Kuhn, T. (1970). The Structure of Scientific Revolutions. Chicago, University of Chicago Press.

   Lavoie, M. (2015). “Should heterodox economics be taught in economics departments, or is there any room for backwater economics?” INET Economics https://www.ineteconomics.org/uploads/papers/Lavoie.pdf.
   

   Lucas, R. E., Jr. (2003). “Macroeconomic Priorities.” American Economic Review
   93(1): 1-14.

   Orléan, A. (2015). Economists also need competition. Le monde. Paris.

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

   Stiglitz, J. E. (2011). “Rethinking Macroeconomics: What Failed, and How to Repair It.” Journal of the European Economic Association
   9(4): 591-645.

   Stiglitz, J. E. (2018). “Where modern macroeconomics went wrong.” Oxford Review of Economic Policy
   34(1-2): 70-106.

   Veblen, T. (1898). “Why is Economics not an Evolutionary Science?” THE QUARTERLY JOURNAL OF ECONOMICS
   12(4): 373-397.

   Veblen, T. (1908). “Professor Clark’s Economics.” THE QUARTERLY JOURNAL OF ECONOMICS
   22(2): 147-195.

   Veblen, T. (1909). “The Limitations of Marginal Utility.” The Journal of Political Economy
   17(9): 620-636.

 

 

There is a set of people with a special, personal perspective on Trump: those who have had, and survived, a relationship with a Narcissistic Personality Disorder… sufferer isn’t the right word, because they cause far more suffering than they ever feel.

I had a relationship with a NPD … perpetrator … in the early 2000s (the relationship began on September 11 2001, but that’s another story). There were some good things about that relationship as well as bad, but the one thing I can say emphatically in favor of it in hindsight, is that it gave me deep insights into Donald Trump.

The deepest insight that one gets about a Narcissist from knowing one intimately is that they neither lie, nor tell the truth. Instead, everything they say is a reconstruction of what has happened so that they are always in the right. “Truth” and “Lie” are concepts that require an internal frame of reference to an objective external reality. They don’t have that framework: instead, their frame of reference is themselves. Everything must start and end with them as the center of attention, and with them acting correctly throughout.

So, when reality doesn’t follow that narrative, as it inevitably does not, they reverse engineer reality until it fits that narrative.

I’ll give my favourite illustration of that from my relationship. I won’t use her real name (though anyone who’s known me personally or professionally for more than 15 years knows who I’m talking about): instead, I’ll call her Aida.

We were at a conference celebrating the life work of the great, and now sadly departed, Basil Moore, in Cape Town, South Africa. The food and wine at the restaurants in Cape Town, Stellenbosch and surrounds, was beyond excellent, and in overindulging, I developed pimples on my neck.

Aida had, as usual, made enemies of the other female attendees. In talking with two of them one morning, one quipped, in reference to the red welts on my neck, “Steve, it looks like you slept with a vampire last night”.

In an attempt to make light of that very clever snipe, I replied “Ah, but she isn’t a vampire, she’s a vamp”.

Before the other two women had a chance to react, Aida snarled at me “How dare you call me a slut in front of these women Steve!”

I replied “But Aida, vamp doesn’t mean slut!”. “Yes it does Steve, it means it in every language. I’m grossly offensed.” (English was not her first language).

Since this was easily the hundredth time she’d abused me in public, I replied “Well, be offensed then, just leave me alone!” and stormed off.

Round two.

Back at her home after the conference, I remembered her telling one of my sisters that, when she heard English, she first translated into French and then her own language before replying. Whether that was true or not, it left open the possibility that she had misinterpreted the word “vamp” as something derogatory. So, I asked her “Aida, when I said vamp, did you hear something like prostitute?”

“Yes, I did Steve!”, she replied, visibly overjoyed that I understood her.

“But that’s not what it means, Aida”.

“But that’s what I learnt that it meant. Look, I’ll show you”, and she went to her bookshelf to retrieve an ancient English dictionary.

As I say next to her so that we could both read the entry, she turned to the relevant page, and there was the definition of Vamp.

It was, and I quote, “sophisticated and irresistible woman“—precisely the meaning I meant to convey.

She went silent. No apology, no discussion.

Round three

By this time, I had already decided to leave her—the only questions were when, and how. So, when we went for dinner that night, I had just one thought on my mind: “before I leave, I’m going to get an apology out of this bitch if it kills me”. I thought I had the perfect chance with this event.

But, as I went to raise the issue, Aida snarled at me from across the table:

“Yes Steve, and the other women we were talking to weren’t attractive enough to be vamps, and I was offensed on their behalf.”

It didn’t matter that this was blatantly untrue. It didn’t matter that I was there, and knew it was untrue. All that mattered was that, in the light of new evidence (her dictionary), she now had a new narrative that put her, once more, in the right throughout.

So, everything that Trump has done, from the claim that his inauguration crowd was the biggest in history, to the claim he won the election against Biden, to—finally and rather pathetically– him consoling himself with the fact that he got more votes than any previous sitting President, made perfect sense to me. It was simply his NPD perspective on everything.

My worry now is what will he do for the next two months before, under the ludicrously complicated US political system, he finally ceases being President.

The best outcome, I think, would be that he falls into a deep depression—which is feasible, since his NPD mind won’t be able to cope with the fact that, whatever he believes, he will cease being President on January 20. That will mean inaction, rather than vengeance. He will do the odd thing to make himself feel better—like sack Fauci—but otherwise, it will be inaction and neglect.

But if he shifts to vengeance? While still in command of the most powerful nation on Earth? Then I just hope those who enabled his dysfunctional behavior for so long will finally have the courage, now that his term is limited, to invoke the 25th amendment and remove him from office.

More likely of course, he will recover from the funk and begin the “I was robbed!” narrative that will be his ultimate consolation, and the foundation of his attempt to establish his own Trump-wing TV network for his post-Presidential career.

So we’ll never be fully free of him, but at least we can breathe a sigh of relief that his days of getting his NPD centre-of-attention hit in the role of President are over. And we can relish the schadenfreude as we say to him:

Donald Trump, you’re fired!

As I write these words, Spain is suffering from its second wave of Covid-19, and it ranks 7^th in the world for Covid-19 cases, when its rank in world population is far lower. It has, and is, experiencing more than its fair share of pain from the novel coronavirus.

Spain suffered far more than its fair share of pain during the Global Financial Crisis too. There is now a terrible danger that these two crises will compound each other, because neither Spain nor the rest of the world had truly recovered from the financial crisis when Covid-19 began.

I use the USA for most of my examples in this book, but in many ways Spain is a textbook example of the economic forces that caused the Global Financial Crisis (GFC), and how conventional economic thinking—epitomized most dramatically in the European Union’s limits on government debt and government deficits—helped cause the crisis, and made its impact even worse.

The data on Spain’s crisis and its bungled aftermath are so obvious that you might wonder why the thesis I defend in this book—that economic crises are caused not by government debt, but by private debt—is not the conventional wisdom. The role of Euro in triggering the boom in private debt, and thus making a crisis more likely, is also obvious. After an exciting first eight years, the Euro and its “Growth and Stability Pact” have led to contraction and instability.

Much was made of Spain’s success in meeting the Growth and Stability Pact’s target of government debt being below 60% of GDP. Government debt was 70% of GDP when the Euro commenced in 1999, and it fell to a low of 35% of GDP by mid-2008. It was almost the only country in the Euro to meet and exceed both of the Euro’s policy targets: a government debt level of less than 60% of GDP, and a deficit of less than 3% of GDP. In fact, it exceeded the deficit target handsomely, running not a merely a small deficit, but a substantial surplus between 2004 and the crisis, peaking at 2.5% of GDP in mid-2006—see Figure 1.

If the Euro’s rules had the effect they were intended to have, this should have meant that Spain was less likely to experience a crisis, and well prepared to handle it if one did occur. This proved to be the opposite of the truth.

Figure 1

The reason is starkly evident in Figure 2: while Spain was lauded for halving its level of Government debt, across the same time span, private debt almost trebled—and throughout, it dwarfed government debt. Private debt had no trend before the introduction of the Euro: it was 67% of GDP in 1970, rose as high as 85% in 1977, but by the start of the Euro, it had risen not at all: it was also 85% of GDP in 1999.

However, from the introduction of the Euro until 2010, it rose far more rapidly than government debt fell: as government debt fell by 35% of GDP, private debt rose by 140%.

Figure 2: Spanish Debt Levels

As I explain in this book, private debt drives economic performance, because the change in private debt—which I call credit, using the terminology of accounting—is a significant, and by far the most volatile, source of aggregate demand. It is therefore the dominant determinant of whether the economy will be in a boom or in a slump. And a credit-driven boom will contain the seeds of its own destruction in a crash, as I explain in this book.

While the Spanish government sector did what conventional wisdom regards as the right thing—reducing its debt by “living within its means”—the Spanish private sector did the opposite. It spent far more than it earned, and made up the difference with credit. This caused a credit-based boom in aggregate demand, which was a major reason why the government could run a surplus of as much as 2.5% of GDP per year at the same time. The government mistakenly attributed the economy’s strong performance in 2000-2007 to its surplus, but the real source of Spain’s boom was the growth of credit, from zero in 1995, to 10% of GDP when the Euro began, to a peak of 35% of GDP in 2008—almost 15 times the size of the government’s surplus.

Figure 3

That huge credit-debt-driven stimulus to demand came at a price: a huge increase in Spain’s private debt, from 80% of GDP when the Euro commenced, to 210% when the financial crisis began—see Figure 4.

 

Figure 4

Both the household and corporate sector indulged in the debt bubble—though the impact of the Euro was more marked on bank lending to the corporate sector than to households. The household sector doubled its debt level from the start of the Euro till the crisis, while corporate borrowing almost trebled.

Figure 5

The crisis began when credit started falling—a pattern which was repeated across the world, but was extremely obvious in Spain. When credit goes up, unemployment goes down, and vice versa, as Figure 6 illustrates.

Figure 6

You might wonder, if the relationship is this strong and this obvious, the why did the government do nothing about it?

It is largely because their economic advisors, who are trained in mainstream economics, learn a model of banking in which credit plays no significant role in macroeconomics. That model, known as “Loanable Funds”, is technically false, as the Bank of England explained in 2014 (Michael McLeay et al., 2014). A false theory can play the role of blinkers on a horse, stopping you from looking at data that contradicts it, like Figure 6. That data makes it abundantly clear that the mainstream theory is wrong—but the mainstream didn’t pay any attention to that data before the GFC, and it hasn’t altered its model of banking since. Mainstream economics textbooks continue to teach the same false model of banking, even after being told, not only by the Bank of England but also by the Bundesbank (Deutsche Bundesbank, 2017), that this model is wrong.

What even mainstream thinkers can’t deny is that bank lending drove a bubble in Spanish house prices, which had been falling before the Euro, but rose dramatically under its influence, doubling between the start of the Euro and the crisis.

 

Figure 7

The link between household debt and house prices is not obvious: in Figure 7, the price index rises as the debt level rises from 1999 till the GFC, and falls as debt falls until 2014, but from then on, house prices are rising while debt is still falling. However, as I explain in this book, the real causal link is between change in household credit, and change in house prices. As Figure 8 indicates, this link holds across all of the data, from well before the Euro commenced until today.

Figure 8

Spain’s boom under the Euro prior to the GFC was caused by a private debt bubble, its crisis was caused by that bubble bursting, and the limits on government spending imposed by the rules of the Euro made its decline worse. The economy only recovered when its period of negative credit—which reduces aggregate demand—came to an end. But that period lasted almost a decade, and was far deeper than in the USA, where the maximum level of negative credit was 5.3% of GDP, versus 20% for Spain.

Private debt was still too high after the crisis, at 150% of GDP, versus roughly 80% of GDP for the 30 year. That alone was a problem without Covid-19. With it, the financial consequences of Covid-19 could be as great as its health consequences. The Covid-19 crisis has drastically exacerbated the impact of being highly levered. Laid-off workers are not able to pay their rent or mortgage without government support, landlords lose the cash flow to service their mortgages, corporations are forced into short-term debt where they have access to it to make up for diminished cash flow, and many corporations have gone and will go bankrupt, undermining the viability of the banks which lent to them. Government policies have reduced the impact to some extent, but the pressure of pre-Covid-19 financial commitments on a post-Covid-19 world are a major reason why there has been so much political opposition to the lockdown measures used to constrain the virus’s spread.

In this light, a proposal I make in the book is now needed much more. A “Modern Debt Jubilee” (see pages 117-119) would use the State’s limitless capacity to create money to reduce private debt significantly—by as much as 100% of GDP. But an essential aspect of that policy is that government has both a Treasury and a Central Bank that can together create its currency. Because of the Euro, Spain does not have that—nor does any other member of the Euro. I therefore believe that, unless there is a drastic change of not only heart but thinking at the ECB and the upper levels of European politics, the Euro in particular—and European economic policy in general—is a hindrance to managing the twin crises of private debt and Covid-19.

 

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.

McLeay, Michael; Amar Radia and Ryland Thomas. 2014. “Money Creation in the Modern Economy.” Bank of England Quarterly Bulletin, 2014 Q1, 14-27.

 

 

This post collates three previous posts on modelling the domestic financial aspects of Modern Monetary Theory. There is a PDF of this post attached on my Patreon page, to aid offline reading. The Minsky model is also attached, and Minsky (which is free and Open Source) can be downloaded from https://sourceforge.net/projects/minsky/. This model uses features that are not in the current release version (version 2.18) so if you wish to run it, and 2.18 is still the release version, please download the latest beta version instead from https://sourceforge.net/projects/minsky/files/beta%20builds/.

I confess immediately that I chose the title because its acronym is a palindrome.

This model considers only the monetary aspects of MMT: the Job Guarantee and inflation management components are not yet incorporated. International trade and financial flows are not considered. However, the assertions of MMT about domestic monetary dynamics remain in dispute in economic and political circles, so it is worth putting these into a mathematical model where their veracity can be tested.

The primary stimulus for developing the model was the publication of Stephanie Kelton’s The Deficit Myth. Stephanie has written the book for non-technical readers, and she’s done a very good job: it’s a very easy read that explains why many conventional wisdoms about government spending are wrong. But MMT is facing heavy resistance in political and economic circles, with my favourite to date being a motion before the US Congress, posted by Representative Kevin Hern, to resolve:

That the House of Representatives (1) realizes that deficits are unsustainable, irresponsible, and dangerous; and (2) recognizes— (A) that the implementation of Modern Monetary Theory would lead to higher deficits and higher inflation; and (B) the duty of the House of Representatives to condemn Modern Monetary Theory.

The objective of this series of posts is to allow the assessment of the first part of this motion—the assertion that “deficits are unsustainable, irresponsible, and dangerous”.

The models in this document are built in the Open Source system dynamics program Minsky, whose unique feature is the capacity to build models of financial flows using what are called Godley Tables (in honour of Wynne Godley, the pioneer of stock-flow-consistent-modelling). These tables enforce the “law of accounting” that (see Figure 1).

Figure 1: A blank Godley Table

Once an account is flagged as an “Asset” for one entity, Minsky knows that it has to also be shown as a “Liability” for another entity. This
makes it possible to take an integrated look at the financial system, which allows us to assess Hern’s motion from the perspective of the entire monetary system, and not just the Government’s view of it.

An Integrated View of Deficits, Surpluses, and Equity

This Minsky model is a simple but complete model of a domestic monetary system. It has six sectors which can be divided into five components:

• The Treasury, and the Central Bank, which together constitute the Government Sector;
• The Banking Sector;
• The Firm Sector, Capitalists and Workers, which constitute the “NonBank Private Sector“;
• The NonBank Private Sector and the Banking Sector, which constitute the “NonGovernment Sector“; and
• The sum of the Government and the NonBank Private Sector, which constitute the “NonBank Sector“.

For simplicity, taxes—and government spending—are levied only on the Firm Sector, and banks make loans only to firms (the aggregate outcome would be the same if the model were generalized to have taxes and spending and loans in all sectors—it would just be much harder to read the tables).

There are just thirteen financial flows:

• Treasury spends on firms (Spend);
• Treasury taxes firms (Tax);
• Treasury sells bonds to the Banking Sector to cover any deficit (Bond_B);
• Treasury pays interest on Treasury Bonds owned by the Banking Sector (Interest_Bonds);
• The Central Bank buys and sells Treasury Bonds in “Open Market Operations” (Bond_CB);
• Banks lend to firms (Lend);
• Firms pay interest to Banks (Interest);
• Firms repay some debt to banks (Repay);
• Firms hire workers (Wages);
• Firms pay dividends (Dividends);
• Workers buy goods from firms (Cons_W);
• Capitalists buy goods from firms (Cons_K); and
• Bankers buy goods from firms (Cons_B).

Minsky provides an integrated view of how these flows interact to determine the financial position of each of the six sectors in the model in interlocking double-entry bookkeeping tables. It generates differential equations from these flows that show how the stocks—the financial accounts—change over time.

The danger to which Hern alludes is immediately apparent when we look at the Treasury’s Equity—the final column in Figure 2: if Treasury spending plus interest payments on outstanding Treasury Bonds exceeds taxation revenue, then its Equity will fall.

Figure 2: The Treasury’s accounts

Mathematically, the rate of change of Treasury Equity is the sum of the flows Tax minus Spending minus Interest payments on Bonds held by the Banking Sector:

         

Given the initial conditions used in this post, in which Treasury Equity starts as zero, a deficit will immediately put the Treasury into negative equity.

This is not offset by the Central Bank, which comes out with no impacts on its equity position at all (note, this is not what I expected when I started building this model).

Figure 3: The Central Bank’s accounts

The rate of change of the Government’s Equity is therefore equal to its surplus—or the negative of its deficit, since the government has normally been in deficit for as long as records have been kept—see Figure 4. The only periods in which the Government has been in surplus for a sustained period are:

• The 1920s, between mid-1920 and mid-1931, a period of 11 years;
• The immediate post-WWII period, between early 1947 and mid-1949, a period of 2 years; and
• The late 1990s till early 2000s, between 1998 and early 2002, a period of 4 years.

Figure 4: US Government Surplus Divided by GDP. The average value is minus 2.48% of GDP

Returning to the model in this post, the impact of the Government deficit on the Government itself is entirely borne by the Treasury:

         

Summing the Treasury and Central Bank Equity equations to show the dynamics of the Government’s equity yields Equation :

         

Looked at just from the point of view of the Government sector then, running deficits is clearly “unsustainable, irresponsible, and dangerous”. If the government wants to have positive equity, then it should run a surplus. It’s an open and shut case—or so it appears, when looking just at the government’s books.

But in this model (and the real economy itself), one entity’s Asset is another’s Liability. So, to know whether a government surplus is a good idea for the system as a whole, we have to ask what the impact is of a government surplus on the rest of the economy?

The rest of the economy is the NonGovernment Sector, the sum of the Banking Sector, and the “Non-Bank Private Sector“: the three non-Government and non-Bank sectors, Firms, Capitalists, and Workers. This model has been set up so that Capitalists and Workers are not directly affected by government spending and taxation, or interest payments on bonds, so we can answer this question just by looking at the economy from the Banking Sector’s point of view (Figure 5) and the Firm Sector’s point of view (Figure 6). The government actions that affect the equity of the Banking Sector and the Firm sector are shown at the top of each table.

The first line in Figure 5 shows that what is a negative for the equity of the Government Sector—paying interest to banks for their holdings of Treasury Bonds—is a positive for the Banking Sector.

Figure 5: The Banking Sector’s accounts

Similarly, first two lines of Figure 6 show that what is a negative for the equity of the Government sector is a positive for the Firm Sector, and that what is a positive for the Government is likewise a negative for the Firm Sector: Government spending increases the equity of the Firm Sector, and taxation reduces it.

Figure 6: The Firm Sector’s accounts

The non-Government net financial position is therefore the mirror image of the Government’s:

         

The deficit defines the flow, in dollars per year. Equity is the accumulation of that flow over time, in dollars. The NonGovernment sector’s equity is, like its deficit, the negative of the Government Sector’s Equity:

         

An integrated perspective on government finances thus reveals two undeniably uncomfortable truths:

• For the Government to run a surplus, the NonGovernment sector must run a deficit; and
• For the NonGovernment sector to be in positive equity, the Government Sector must be in identical negative equity.

Like two halves of a see-saw, both cannot be up at the same time. If the government runs a surplus—if the sum of interest payments on bonds plus spending is less than taxation—then the non-government sector is forced to run an identical deficit at that point in time. If the NonGovernment Sector is in positive equity, then the Government Sector must be in identical negative equity.

These outcomes are the macroeconomic consequences of the fact that one entity’s Asset is another’s Liability. The flows in Equations and show changes in Equity at one moment in time. Because these flows are identical in magnitude, but opposite in sign, at the aggregate level, the Equity of an entire economy is zero, and the rate of change of aggregate Equity is also zero.

Therefore, if one subset of the economy has positive equity, the remainder of the economy has identical negative equity. Equally, if the rate of change of one sector’s equity is positive, then the rate of change of the equity of the remainder of the economy is identical in magnitude, and negative. This is shown by Equation , where the first instance of a flow term is shown in black and the second instance in red: there are nine terms, each repeated twice, once as a positive and once as a negative. The sum is zero.

         

The question therefore is not whether deficits—and negative equity—are good or bad, but whose deficits and negative equity are sustainable or non-sustainable.

There is one sector that cannot be in persistent negative equity in a sustainable economic system: the Banking Sector. A bank must have positive Equity: it’s Assets must exceed the value of its Liabilities, otherwise it is bankrupt. Therefore, for a sustainable economic system, the Banking sector must necessarily be in positive Equity (periods when the Banking Sector as a whole is in negative equity are periods of extreme financial crisis, like 2007 and 1929).

It follows that the NonBank Sector—which is the sum of the Government plus, in this model, Firms, Capitalists and Workers—must be in negative equity. This is unavoidable, given that the sum of all Equity is zero. The only question is which subset of the non-Bank economy—the Government, or the NonBank Private Sector—will be in negative equity? Which sector is better placed to handle being in negative equity?

 

That question and others are considered in the next section.

The dynamics of money

The previous section finished with the observation that, since the sum of all Equity is zero, and the banking sector must be in positive equity, part of the remainder of the economy—the government, or the non-bank public—must be in negative equity. So which sector is better equipped to handle that: the non-bank public, or the government?

This will raise the age-old question that is perennially thrown at those who advocate government spending: “How are you going to pay for it?”, or “Where’s the money going to come from?”. To answer both these questions, we first need to know how money is created in general.

Since money, exclusively in this model and primarily in the real world, is the sum of the Banking Sector’s Liabilities and Equity, any action which increases Bank Liabilities and Equity creates money. Since every transaction is recorded twice, operations which increase the money supply must therefore occur on both the Assets and the Liabilities/Equity sides of the banking sector’s ledger. Operations which occur exclusively on either the Assets side, or the Liabilities/Equity side, shift money between accounts and do not create money.

So the answer to the “where’s the money going to come from?” question is “from any operation which increases the Assets and Liabilities/Equity of the banking sector”. Equally, any operation that reduces Assets and Liabilities/Equity destroys money.

Only 5 of the 13 flows in this model affect both the Asset and Liabilities/Equity sides of the banking sector’s ledger: Lending (and Repayment); Government spending (and Taxation); and interest payments on Treasury Bonds. These are shown in the top 5 rows of Figure 7. All other operations are either Liability/Equity swaps, or Asset swaps, and they don’t create money.

Figure 7: The Banking Sector’s Ledger

Operations that don’t create money include the usual suspects—payment of interest on loans by firms (which transfers money from the Firm Sector to the Banking Sector), purchases of goods from the Firm Sector by workers, capitalists and bankers. But they also include two operations that figure large in conventional arguments about how to pay for government spending: sales of Treasury Bonds to the finance sector; and purchases of Treasury Bonds from the finance sector by the Central Bank in “Open Market Operations” (which are primarily used to control the rate of interest). Neither of these operations create money.

They are asset swaps: the sale of Treasury Bonds to the finance sector (the “Banking Sector” in this model) reduces Reserves and increases the Banking Sector’s stock of Treasury Bonds. The purchase of Treasury Bonds from the Banking Sector by the Central Bank reduces the Banking Sector’s stock of Treasury Bonds and increases the Banking Sector’s Reserves. Neither operation affects the amount of money in the economy—the sum of the Liabilities plus Equity of the Banking Sector.

Since it’s an asset swap for the Banking sector to buy Treasury Bonds using Reserves, the answer to “where’s the money going to come from?” is “from operations that increase the sum of Reserves and Bonds”. You can work this out by adding up the entries in the Reserves and Bonds columns of Figure 7: the Banking sector assets Reserves plus Bonds will grow if government spending plus interest payments on Treasury Bonds exceed taxation:

         

The Reserves that are used to buy the Bonds thus come from the deficit itself. The deficit—the extent to which government spending and interest payments exceeds taxation—creates money in private sector bank accounts (the Firm Sector and Bank Equity only in this model). This boosts the Liabilities and Equity of the Banking Sector. The corresponding Asset that is increased by the deficit is the Reserve accounts of the banking sector. If no interest is paid on Reserves—the “usual” situation, and sometimes made worse by charging negative interest on Reserves in the false belief that this will encourage Banks to lend more—then the Banks have a positive incentive to use these reserves to buy Treasury Bonds instead.

So the answer to the “Where’s the money going to come from?” to pay for the deficit question is that it comes from the deficit itself: the deficit creates money that can be spent in the private sector; and it creates Reserves, which are (usually) non-interest earning Assets of the Banking Sector that are liabilities of the Central Bank—see Figure 8.

Figure 8: The Central Bank’s Ledger

Reserves are Assets of the Banking Sector that earn it no income. But if the Treasury issues bonds to cover the deficit—if the total value of Treasury Bonds offered for sale is equal to the deficit itself—then the Banking Sector is offered a deal to swap a non-income-earning asset for an income-earning one.

What do you think the banks would do, when offered that deal? They take it, of course: this is why Treasury Bond Auctions have always been over-subscribed. Selling the bonds themselves is not a problem. It is, as Kelton emphasises in The Deficit Myth, a “no brainer” swap of a zero-income-asset for a positive-income-asset.

The money needed to buy the bonds has already been created, and is sitting in the Reserve account. Banks then transfer their funds from one Asset that earns no income (Reserves) to another Asset that does (Treasury Bonds). This Asset is a liability, not of the Central Bank, but of the Treasury itself—see Figure 9.

Figure 9: The Treasury’s Ledger

This table also shows that the increase in Reserves is caused by the fall in the Government’s equity: Reserves (and hence money) rise if the Government runs a deficit; Reserves and money fall if the Government runs a surplus:

         

How does the Treasury pay the interest on the bonds? The same way it pays for spending in excess of taxation: it runs up its own negative equity—see the final column in Figure 9.

This can be done in two ways, as indeed can overall deficit-financing itself: by the Treasury having a negative balance in its account at the Central Bank; or if the Treasury borrows from the Central Bank to pay Interest on the Bonds (the second last row of Figure 9). If it does so, the negative equity from paying interest on the bonds remains, but the Treasury Account at the Central Bank can be kept non-negative.

A third option is that the Central Bank buys the bonds off the Banking Sector in Open Market Operations (or QE). If it does so, the amount of interest the Treasury needs to pay falls. Also, since the Treasury is the effective owner of the Central Bank, it doesn’t need to pay interest to the Central Bank on its holdings of Treasury Bonds—or if it does, the interest payments come back to the Treasury in Central Bank profits.

So the Government can run a deficit, and pay interest on the Treasury Bonds issued to cover it (not finance it: the deficit is self-financing in that it creates money), so long as it is willing to countenance being in negative equity. As noted in the previous post, because Banks must be in positive equity, the non-Banking sectors (and that includes the Government) must be in negative equity. For the Government to achieve positive equity therefore—which seems desirable, if you take the partial view of the economy epitomised by Representative Hern’s motion that “deficits are unsustainable, irresponsible, and dangerous”—the non-Bank private sector must be pushed into even greater negative equity.

Does that sound like a good idea?

To show the consequences for the economy of the government running a deficit or a surplus, it’s necessary to go beyond the purely structural equations used so far, and to consider some simulations. In what follows, I’ve built an extremely simple model of monetary dynamics in which all expenditures depend on the amounts of money in relevant bank accounts. There are many other ways these expenditures could be modelled, but this way ensures fairly easily that crazy outcomes—like workers have negative bank balances, but still spending their wages—don’t happen in this very simple model.

For example, I relate consumption by workers to the level of workers deposit accounts at the private banks, using the engineering concept of a “time constant”. This is a number that tells you how long an action would take to run an account down to zero, if it’s removing money from the account, or to double it, if it’s adding money to an account. A time constant of 0.02 for workers consumption says that if workers consumed at a constant rate, and there were no other inflows or outflows in their accounts, then they would run their accounts down to zero in 1/50^th of a year—roughly a week. Higher values for capitalists and bankers—say 2 for capitalists and 5 for bankers—assert that it would take 2 years and 5 years respectively for them to run their accounts down to zero through consumption alone.

You divide the relevant stock (the level of bank accounts, in the case of consumption) by the time constant to get the annual flow—see Figure 10.

Figure 10: Equations for consumption

Similarly, a time constant of 9 for bank lending says that if this was the only inflow affecting the level of debt, and it went on at a constant rate, debt would double in 9 years. Repayment with the same time constant means that the level of (private) debt remains constant.

Figure 11: Modelling interest payments, lending and repayment

GDP is treated as the turnover of money in the firm sector (it can also be treated as the sums of consumption and investment—which investment is entirely debt-financed in this model—and net government spending, but that makes it possible to end up with negative sums in deposit accounts, unless a much more complicated model is constructed).

Figure 12: Modelling GDP and income distribution

Government spending and taxation are treated as simple percentages of GDP. For the moment, I have not considered how they are financed, so the flows Bonds_B, Bonds_CB and Interest_Bonds are not wired up. The equations that define the system’s flows at this point are shown in Figure 13. At this stage, sales of Treasury Bonds to the Banking Sector, Central Bank purchases of Bonds from the Banks, and Treasury borrowing from the Central Bank, are not defined.

Figure 13: All the flow equations in the model (without bond sales or interest on bonds)

With no explicit financing of a government deficit, the negative equity that this causes for the government turns up as a negative balance in the Treasury’s account at the Central Bank—see Figure 14, which shows the impact of a 2% of GDP deficit for 60 years on the Treasury. It runs accumulates negative equity of $160, and that is entirely due to its account at the Central Bank being negative to the tune of $160.

Figure 14: The Treasury’s Ledger with no bond sales: negative Treasury Account and Treasury Equity

Figure 15 shows the impact of a 2% of GDP deficit for 60 years from the Central Bank’s perspective, and the key point is that the negative equity of the Treasury is the same magnitude as the positive Reserves of the Banking Sector: the accumulated deficits of the Government are precisely equal to the accumulated Reserves of the Banking Sector.

Figure 15: The Central Bank’s Ledger with no Bond sales: negative Treasury precisely equals positive Reserves

How does the picture change if we require that the Treasury’s account at the Central Bank can’t go into overdraft? Then the Treasury has to sell Bonds equal to its Deficit, and borrow from the Central Bank to pay interest on those bonds.

Figure 16: Bond sales are equal to the deficit, no Central Bank purchases of Bonds from the Banking Sector

Running this model to the same point as the previous one, where the Treasury Equity reaches minus $160, this negative equity consists of $115 in Bonds and $45.2 in Loans from the Central Bank (see Figure 17; the Treasury account at the Central Bank remains at zero). The Bond sales represent the accumulated government deficit over time, while the Loans from the Central Bank represent the accumulated interest on those bonds.

Figure 17: Treasury books with Bond sales covering the deficit

Can the Central Bank afford to lend the money to pay the interest on Treasury Bonds to the Treasury? Yes: as Figure 18 shows, the loans to the Treasury are an Asset of the Central Bank. It has the capacity to expand its balance sheet indefinitely, and none of the operations shown in this model affect its equity at all.

Figure 18: Central Bank books with Bond sales and interest payments on Bonds

I have to note that this was a surprise to me: I had guessed that the government’s negative equity would be carried by the Central Bank, and the fact that a Central Bank—unlike a private one—can operate with negative equity (David Bholat and Robin Darbyshire, 2016) would be what enabled the government as a whole to sustain negative equity. But it turned out that my guess was wrong: the Central Bank simply acts as an enabler of and conduit for the Treasury’s negative equity.

Does the fact that the Treasury is borrowing from the Central Bank (in this model) cause any difficulty? No, because while private individuals can’t pay interest on loans by borrowing from banks—without that interest ballooning with further interest and driving us bankrupt—the Treasury can pay interest on Bonds to the Banking Sector by borrowing from the Central Bank because, technically and legally, the Treasury owns the Central Bank. It therefore doesn’t have to pay interest on any loans from the Central Bank If it did, it would get that money back in dividend payments from the Central Bank anyway.

What happens if the Central Bank buys all the Bonds from the Banks? Then the negative equity of the Treasury consists entirely of its debt to the Central Bank (see Figure 19).

Figure 19: Treasury’s books with Central Bank Open Market Operations purchasing all Treasury Bonds

Since those Bonds have been purchased off the Banking Sector, the Banking Sector has Reserves of 160 (see Figure 20). This is not as desirable a situation for the Banks as when they own the bonds, because with no Treasury Bonds they receive no interest payments from the Government. Far from the finance sector in general having “Bond Vigilantes” ready to deny the government bond sales if they’re worried about the state of government finances, the “Bond Vigilantes” are vigilantly on the lookout for sales of Treasury Bonds so that they can swap out of a non-income-earning asset and into an income-earning one.

Figure 20: Banking Sector’s books with OMOs buying 100% of Bonds

In the next section, I consider what the impact is of different fiscal regimes: the government running a deficit (as the USA has for most of the last 120 years—roughly of 2.5% of GDP); the government running a surplus; the government running a surplus and the private sector borrowing from the Banking Sector; the government running a surplus and the private sector reducing its debt to the Banking Sector; and the government running a deficit while the private sector increases its debt to the Banking Sector.

Simulating monetary dynamics

The previous section confirmed the MMT assertion the deficit creates the funds (in Bank Reserves) that are used by the finance sector to buy Treasury Bonds. Therefore, leaving aside the foreign sector and countries like those in the EU that don’t issue their own currency, there is never a problem with a government selling bonds to cover a deficit: their purchase is actually a favourable asset swap for the finance sector, exchanging non-income-earning Reserves for income-earning Bonds.

Though this is still a very simple and stylized model, it lets us do something we can’t do in the real world: separate out the economic impact of the government undertaking a policy from the private sector’s reaction to that policy. This allows us to isolate causal factors when there is more than one cause at play. That’s vitally necessary to be able to interpret historical data on whether running deficits is a good idea or not, because (leaving aside the foreign sector) there are two ways to create money: by the government running a deficit, or by the banks lending out more than they get back in repayments.

Historical Deficits & Surpluses

The US government has, on average over the last 120 years, run a deficit equivalent to 2.3% of GDP. The post-WWII average has been -2.5%—see Figure 21. The peak deficit occurred during WWII, at almost 26% of GDP.

Figure 21: US Government surplus since 1900

These deficits, and some surpluses—most notably, the decade of the 1920s, and the late Clinton to early Bush II years—have led to the Government debt to GDP ratio varying substantially over time—see Figure 22.

Figure 22: The US Government’s debt to GDP ratio since 1790

The relationship between deficits and the government debt to GDP ratio is not straightforward: there are substantial periods where the government is running a deficit and the debt ratio is falling. The clearest example of this is between 1950 and 1980, when there were only brief periods of surplus and the deficit averaged 1% of GDP; the government debt ratio fell from 87% of GDP to 34% of GDP over that time. This period includes the so-called “Golden Age of Capitalism” between the start of the 1950s and the middle of the 1970s, when GDP growth was high, and unemployment and inflation were low.

 

Figure 23: Government Debt Ratio vs Government Surplus

But there were also “Gilded Ages”—like the 1920s and the Clinton Years till 9/11—when the government ran a surplus and the economy boomed. During these periods, surpluses were lauded as a sign of true economic success.

This was President Calvin Coolidge’s position. He maintained a 1% of GDP surplus throughout his term, and in his final State of the Union speech in December 1928, he lauded his surplus as the cause of the prosperity of the 1920s:

No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time…

We have substituted for the vicious circle of increasing expenditures, increasing tax rates, and diminishing profits the charmed circle of diminishing expenditures, diminishing tax rates, and increasing profits.

Four times we have made a drastic revision of our internal revenue system, abolishing many taxes and substantially reducing almost all others. Each time the resulting stimulation to business has so increased taxable incomes and profits that a surplus has been produced. One-third of the national debt has been paid, while much of the other two-thirds has been refunded at lower rates, and these savings of interest and constant economies have enabled us to repeat the satisfying process of more tax reductions. Under this sound and healthful encouragement the national income has increased nearly 50 per cent, until it is estimated to stand well over $90,000,000,000. It has been a method which has performed the seeming miracle of leaving a much greater percentage of earnings in the hands of the taxpayers with scarcely any diminution of the Government revenue. That is constructive economy in the highest degree. It is the corner stone of prosperity. It should not fail to be continued. {Coolidge, 1928 #6057}

Looking at the data, it appears that Coolidge had a point: GDP rose from $70 billion to over $100 billion across the 1920s, as his government maintained a surplus of about $1 billion per year. Did the surplus cause the “Roaring Twenties” boom? In a classic case of “correlation is not causation”, superficially it seems that the decline into a deficit caused the Great Depression.

Figure 24: Government surplus and GDP 1920-1940

However, the decline in the growth rate, from 7% to minus 10%, preceded the change from surplus to deficit (see Figure 25), so perhaps the Great Depression caused the change from surplus to deficit. Also, after the original crash between 1920 and 1932, the rate of real economic growth was extremely high between 1933 and 1936, exceeding 10% per annum when the deficit was 5% of GDP. A return to a balanced budget (if not quite a surplus) between 1937 and 1938 coincided with a collapse in economic growth, from over 15% per annum in 1936 to almost minus 10% in 1938.

Figure 25: Surplus as % of GDP versus real GDP growth rate

This analysis ignores the factor that (following Irving Fisher and Hyman Minsky) I focus upon as the main cause of capitalism’s booms and busts: private credit. As Figure 26 shows, credit was positive during the 1920s, and negative during the 1930s—matching much more closely the pattern of GDP change. It was also much bigger than the government surplus or deficit: credit was as high as 9% of GDP in 1929, versus a surplus of 1%; and it was as low as -9% of GDP in 1933, versus a deficit of 5%.

Figure 26: Surplus, Credit, and Change in GDP

Let’s cut through this historical confusion with some simple simulations using this model in which we can separate out periods of deficit and surplus from periods of private sector leveraging and deleveraging.

Phase 1: A deficit for 100 years

The first simulation has a deficit of 2.5% of GDP—roughly equal to the average US government deficit since 1900—for 100 years. Spending is 32.5% of GDP and taxation is 30% of GDP. The Treasury sells Treasury Bonds to the Banks, and pays interest on those bonds to the Banks by borrowing from the Central Bank.

Figure 27: Deficit for 100 Years

The deficit is expansionary, and pushes the whole private sector—Firms, Capitalists and Workers as well as Banks—into positive equity, to the tune of $1,734. This positive equity is of course precisely equal in magnitude to the negative equity of the Treasury of $1,734.

At the end of this part of the simulation, the total assets of the banking sector are $1,834, backing an identical amount of money in the bank accounts of the non-bank private sector plus the banking sector’s equity. This is split between $100 in private debt (of the Firm sector), $616 in Reserves created entirely by the interest being paid on Bonds, and $1,148 in Bonds, created entirely by the government deficits.

Because there is no private sector borrowing, the private sector debt ratio also falls, from 70% of GDP at the beginning of the simulation to 6.3% by the end, as GDP rises from $140 per year to $1,588 at the end. Because the Treasury is selling Treasury Bonds to match the deficit and maintain its account at the Central Bank at a $0 balance, the ratio to GDP of Treasury Bonds owned by the Banking Sector rises from zero to 72% of GDP—at which point the “deficit hawks” are likely to intervene and insist that the government “gets its books in order” by running a surplus.

Figure 28: Banking sector’s books after 100 years of a 2.5% of GDP Deficit

 

Phase 2: A 1% of GDP surplus until Government Debt hits 10% of GDP

In this next phase, the government runs a 1% of GDP surplus by reducing spending to 29% of GDP. The immediate effect of this surplus is a slowdown in the rate of growth of GDP, from 4% p.a. to initially -2%. The growth rate bounces back for a while, but ultimately turns negative, and by the time the Government debt ratio has hit the 10% of GDP target (after 64 years), GDP has fallen from $1,588 per year to $1,418 per year.

Figure 29: A 1% of GDP surplus until government debr ratio hits 10%

The government’s debt level—the ratio to GDP of Treasury Bonds owned by the Banking sector—has fallen from 72% of GDP ($1,148/$1,1588) to 10% ($144/$1,430), as intended. However, the scale of the government’s negative equity has barely shifted, from $1,734 to $1,581. The reason is that a substantial part of the money that was created in Phase 1 was via interest payments on Bonds, which were financed by borrowing from the Central Bank. Even though Bonds owned by the Banks were declining at the rate of 1% of GDP per year, the interest on the outstanding debt remained high initially. These interest payments created money, countering the destruction of money by the surplus. The momentum of this plunged towards the end, hence the rate of decline of GDP increased.

The same effect applies with private sector equity, which reaches a peak when the additions to private sector equity from interest on Treasury Bonds is matched by the cancellation of bonds by the surplus. Then it falls as the scale of the government’s negative equity also falls. A surplus thus depresses economic activity, and reduces private sector equity.

But that’s not what Calvin Coolidge saw, and claimed: he claimed that a surplus causes the economy to boom, not slump. What was he, and this simulation, missing?

Phase 3: A surplus and Private sector borrowing

It, and Calvin Coolidge, missed the private sector borrowing. This simulation starts from the same point as Phase 2, but as well as the government running a 1% of GDP surplus, there is also net private sector borrowing as the time constant on lending falls to 5 years and that for repayment rises to 9 years. Credit is as high as 11% of GDP.

 

Figure 30: A surplus and private sector borrowing

Here the economic performance appears much better: GDP growth is sustained, and by the time the government debt ratio hits the target of 10% of GDP—after a mere 38 years in this simulation versus 64 year in the surplus-only case—GDP has risen from $1,588 per year to $3,529—a total boom.

However, because this was a boom financed by the firm sector borrowing money from the banks, by the end of it, the private debt to GDP ratio has risen from 6% to 79% of GDP. This is a bigger rise in private debt that occurred during the 1920s—and then abruptly went into reverse in 1920 (see Figure 31).

Figure 31: Private sector debt and credit (change in private debt per year) 1920-1940

Figure 32: The Banking sector’s books after 38 years of a 1% of GDP surplus and private sector borrowing.

What happens to the economy in this model if the private sector switches from borrowing to deleveraging while the government is still running a surplus?

Phase 4: Government surplus and private sector deleveraging

The answer, in so many words, is a Depression. With both the government surplus and private sector deleveraging taking money out of the economy, GDP plunges, from $3,529 when deleveraging began to $1614 just 12 years later.

Figure 33: The private sector switches from borrowing to deleveraging

What happens if, as occurred during the 1930s, the government switches from a 1% of GDP surplus to a 5% of GDP deficit, while the private sector continues to de-lever?

The result is a return to growth, as the deficit counteracts the reduction in the money supply caused by private sector deleveraging.

Figure 34: Government switches from Coolidge surplus to Roosevelt Deficit

Phase 0: What should be done?

I hope the previous simulations have clarified that some deficits are indeed “unsustainable, irresponsible, and dangerous”, as Representative Hern’s motion puts it. The question is though, “which deficits?”. The clearly dangerous deficit is the private sector’s. The government can sustain deficits and accumulate substantial negative equity because it owns its own bank. The private sector cannot sustain deficits for a substantial period of time, because it doesn’t. Since one sector’s negative equity is the rest of society’s positive equity, the safe situation is for the government to have negative equity and the private sector to have positive equity.

It is possible for this to occur with the government running a deficit and the non-bank private sector borrowing from the banks at the same time. This final simulation shows the impact of a sustained government deficit of 2.5% of GDP—roughly the average for the USA for the last 120 years—and the private sector borrowing with a 7-year time constant for lending and 11 for repayment. This results in a nominal rate of growth of 5.25% p.a., a private debt ratio of 57.5% of GDP and a government debt ratio of 47.5%. That is the combination to which we should aspire, in our current monetary regime.

Figure 35: Deficits and limited credit, the ideal situation

         

Conclusion

The obsession politicians have with running a government surplus results from a partial perspective on the monetary system. With a holistic view, the real danger is the private sector’s deficit—which is the mirror image of the government’s. The best situation for the long term is to enable the private sector to sustain a surplus, which requires that the government sustains a deficit. This is possible for the government because, with a Treasury, a Central Bank, and a fiat currency, the Treasury can sustain and finance its negative equity indefinitely (leaving aside what happens on the external account for now).

If the government instead becomes obsessed with achieving positive equity itself, then the private sector is pushed towards negative equity. The private sector response to this can be to gamble on financial assets: to borrow from banks and take levered positions in assets like property and shares. I haven’t included these factors in this simple model, but it is notable that the two periods where the US Government ran a surplus coincided with the two biggest stock market bubbles in American history, and the aftermath were its two deepest downturns (before Covid).

The scale of speculative borrowing when Coolidge was lauding his government’s surplus is staggering: margin debt rose from about 1% of GDP when he came to office to over 12% by the time of the 1929 Crash. It plunged even faster than it rose in the aftermath, to bottom at ½% of GDP in 1933. During the post-WWII period, it remained well below 1% of GDP until the Clinton administration came to power—obsessed, as Coolidge was, with achieving a government surplus.

Figure 36: When governments run surpluses, the private sector gambles

Correlation is not causation, but once again, the level of margin debt rose, from ½% of GDP in 1992 to the Triple Peaks of 2000, 2007, and … now (the data is incomplete because of changes in how it is recorded—whoever designed the latest data set at https://www.finra.org/investors/learn-to-invest/advanced-investing/margin-statistics needs to do some basic courses in data management!).

Figure 37: Margin debt over the long term

The bottom line of this set of posts is that we have to think about finances in an integrated manner, and not just focus upon one component, as “deficit hawks” like Hern do. With an integrated perspective, the sensible conclusion is the one MMT reaches: that the government should run deficits and be in negative equity, to enable the private sector to run surpluses and be in positive equity. Periods of apparent prosperity that coincided with the surpluses of the Coolidge and Clinton eras were the result of private sector levered speculation by a private sector that was experiencing (identical) deficits at the time. Rather than “saving for a rainy day”, these government surpluses helped set off speculative bubbles whose later crashes caused the greatest economic downturns in America’s pre-Covid history.

Private sector deficits are “unsustainable, irresponsible, and dangerous”. Public sector deficits are sustainable, responsible (subject to their impact on inflation and the balance of trade), and safe. It’s time for the “Deficit Hawks” to worry about private sector deficits, not the public sector deficit.

Postscript: The model

Figure 38 shows the full six Godley Tables that constitute this model, and Equations to show the equations of this model. If you’d like to explore this model yourself (it is attached to this post), download the latest beta release of Minsky from https://sourceforge.net/projects/minsky/files/beta%20builds/. The beta has features used here than are not in the current release version (Version 2.18) and it is very close to being a new release itself. If the release version is later than 2.18 by the time you read this paper, then download the release version instead (unless you feel like being adventurous with the beta).

Figure 38: Full Minsky MMT Model

         

 

             

         

         

The previous post in this series confirmed the MMT assertion the deficit creates the funds (in Bank Reserves) that are used by the finance sector to buy Treasury Bonds. Therefore, leaving aside the foreign sector and countries like those in the EU that don’t issue their own currency, there is never a problem with a government selling bonds to cover a deficit: their purchase is actually a favourable asset swap for the finance sector, exchanging non-income-earning Reserves for income-earning Bonds.

Though this is still a very simple and stylized model, it lets us do something we can’t do in the real world: separate out the economic impact of the government undertaking a policy from the private sector’s reaction to that policy. This allows us to isolate causal factors when there is more than one cause at play. That’s vitally necessary to be able to interpret historical data on whether running deficits is a good idea or not, because (leaving aside the foreign sector) there are two ways to create money: by the government running a deficit, or by the banks lending out more than they get back in repayments.

Historical Deficits & Surpluses

The US government has, on average over the last 120 years, run a deficit equivalent to 2.3% of GDP. The post-WWII average has been -2.5%—see Figure 1. The peak deficit occurred during WWII, at almost 26% of GDP.

Figure 1: US Government surplus since 1900

These deficits, and some surpluses—most notably, the decade of the 1920s, and the late Clinton to early Bush II years—have led to the Government debt to GDP ratio varying substantially over time—see Figure 2.

Figure 2: The US Government’s debt to GDP ratio since 1790

The relationship between deficits and the government debt to GDP ratio is not straightforward: there are substantial periods where the government is running a deficit and the debt ratio is falling. The clearest example of this is between 1950 and 1980, when there were only brief periods of surplus and the deficit averaged 1% of GDP; the government debt ratio fell from 87% of GDP to 34% of GDP over that time. This period includes the so-called “Golden Age of Capitalism” between the start of the 1950s and the middle of the 1970s, when GDP growth was high, and unemployment and inflation were low.

 

Figure 3: Government Debt Ratio vs Government Surplus

But there were also “Gilded Ages”—like the 1920s and the Clinton Years till 9/11—when the government ran a surplus and the economy boomed. During these periods, surpluses were lauded as a sign of true economic success.

This was President Calvin Coolidge’s position. He maintained a 1% of GDP surplus throughout his term, and in his final State of the Union speech in December 1928, he lauded his surplus as the cause of the prosperity of the 1920s:

No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time…

We have substituted for the vicious circle of increasing expenditures, increasing tax rates, and diminishing profits the charmed circle of diminishing expenditures, diminishing tax rates, and increasing profits.

Four times we have made a drastic revision of our internal revenue system, abolishing many taxes and substantially reducing almost all others. Each time the resulting stimulation to business has so increased taxable incomes and profits that a surplus has been produced. One-third of the national debt has been paid, while much of the other two-thirds has been refunded at lower rates, and these savings of interest and constant economies have enabled us to repeat the satisfying process of more tax reductions. Under this sound and healthful encouragement the national income has increased nearly 50 per cent, until it is estimated to stand well over $90,000,000,000. It has been a method which has performed the seeming miracle of leaving a much greater percentage of earnings in the hands of the taxpayers with scarcely any diminution of the Government revenue. That is constructive economy in the highest degree. It is the corner stone of prosperity. It should not fail to be continued. {Coolidge, 1928 #6057}

Looking at the data, it appears that Coolidge had a point: GDP rose from $70 billion to over $100 billion across the 1920s, as his government maintained a surplus of about $1 billion per year. Did the surplus cause the “Roaring Twenties” boom? In a classic case of “correlation is not causation”, superficially it seems that the decline into a deficit caused the Great Depression.

Figure 4: Government surplus and GDP 1920-1940

However, the decline in the growth rate, from 7% to minus 10%, preceded the change from surplus to deficit (see Figure 5), so perhaps the Great Depression caused the change from surplus to deficit. Also, after the original crash between 1920 and 1932, the rate of real economic growth was extremely high between 1933 and 1936, exceeding 10% per annum when the deficit was 5% of GDP. A return to a balanced budget (if not quite a surplus) between 1937 and 1938 coincided with a collapse in economic growth, from over 15% per annum in 1936 to almost minus 10% in 1938.

Figure 5: Surplus as % of GDP versus real GDP growth rate

This analysis ignores the factor that (following Irving Fisher and Hyman Minsky) I focus upon as the main cause of capitalism’s booms and busts: private credit. As Figure 6 shows, credit was positive during the 1920s, and negative during the 1930s—matching much more closely the pattern of GDP change. It was also much bigger than the government surplus or deficit: credit was as high as 9% of GDP in 1929, versus a surplus of 1%; and it was as low as -9% of GDP in 1933, versus a deficit of 5%.

Figure 6: Surplus, Credit, and Change in GDP

Let’s cut through this historical confusion with some simple simulations using this model in which we can separate out periods of deficit and surplus from periods of private sector leveraging and deleveraging.

Phase 1: A deficit for 100 years

The first simulation has a deficit of 2.5% of GDP—roughly equal to the average US government deficit since 1900—for 100 years. Spending is 32.5% of GDP and taxation is 30% of GDP. The Treasury sells Treasury Bonds to the Banks, and pays interest on those bonds to the Banks by borrowing from the Central Bank.

Figure 7: Deficit for 100 Years

The deficit is expansionary, and pushes the whole private sector—Firms, Capitalists and Workers as well as Banks—into positive equity, to the tune of $1,734. This positive equity is of course precisely equal in magnitude to the negative equity of the Treasury of $1,734.

At the end of this part of the simulation, the total assets of the banking sector are $1,834, backing an identical amount of money in the bank accounts of the non-bank private sector plus the banking sector’s equity. This is split between $100 in private debt (of the Firm sector), $616 in Reserves created entirely by the interest being paid on Bonds, and $1,148 in Bonds, created entirely by the government deficits.

Because there is no private sector borrowing, the private sector debt ratio also falls, from 70% of GDP at the beginning of the simulation to 6.3% by the end, as GDP rises from $140 per year to $1,588 at the end. Because the Treasury is selling Treasury Bonds to match the deficit and maintain its account at the Central Bank at a $0 balance, the ratio to GDP of Treasury Bonds owned by the Banking Sector rises from zero to 72% of GDP—at which point the “deficit hawks” are likely to intervene and insist that the government “gets its books in order” by running a surplus.

Figure 8: Banking sector’s books after 100 years of a 2.5% of GDP Deficit

 

Phase 2: A 1% of GDP surplus until Government Debt hits 10% of GDP

In this next phase, the government runs a 1% of GDP surplus by reducing spending to 29% of GDP. The immediate effect of this surplus is a slowdown in the rate of growth of GDP, from 4% p.a. to initially -2%. The growth rate bounces back for a while, but ultimately turns negative, and by the time the Government debt ratio has hit the 10% of GDP target (after 64 years), GDP has fallen from $1,588 per year to $1,418 per year.

Figure 9: A 1% of GDP surplus until government debr ratio hits 10%

The government’s debt level—the ratio to GDP of Treasury Bonds owned by the Banking sector—has fallen from 72% of GDP ($1,148/$1,1588) to 10% ($144/$1,430), as intended. However, the scale of the government’s negative equity has barely shifted, from $1,734 to $1,581. The reason is that a substantial part of the money that was created in Phase 1 was via interest payments on Bonds, which were financed by borrowing from the Central Bank. Even though Bonds owned by the Banks were declining at the rate of 1% of GDP per year, the interest on the outstanding debt remained high initially. These interest payments created money, countering the destruction of money by the surplus. The momentum of this plunged towards the end, hence the rate of decline of GDP increased.

The same effect applies with private sector equity, which reaches a peak when the additions to private sector equity from interest on Treasury Bonds is matched by the cancellation of bonds by the surplus. Then it falls as the scale of the government’s negative equity also falls. A surplus thus depresses economic activity, and reduces private sector equity.

But that’s not what Calvin Coolidge saw, and claimed: he claimed that a surplus causes the economy to boom, not slump. What was he, and this simulation, missing?

Phase 3: A surplus and Private sector borrowing

It, and Calvin Coolidge, missed the private sector borrowing. This simulation starts from the same point as Phase 2, but as well as the government running a 1% of GDP surplus, there is also net private sector borrowing as the time constant on lending falls to 5 years and that for repayment rises to 9 years. Credit is as high as 11% of GDP.

 

Figure 10: A surplus and private sector borrowing

Here the economic performance appears much better: GDP growth is sustained, and by the time the government debt ratio hits the target of 10% of GDP—after a mere 38 years in this simulation versus 64 year in the surplus-only case—GDP has risen from $1,588 per year to $3,529—a total boom.

However, because this was a boom financed by the firm sector borrowing money from the banks, by the end of it, the private debt to GDP ratio has risen from 6% to 79% of GDP. This is a bigger rise in private debt that occurred during the 1920s—and then abruptly went into reverse in 1920 (see Figure 11).

Figure 11: Private sector debt and credit (change in private debt per year) 1920-1940

Figure 12: The Banking sector’s books after 38 years of a 1% of GDP surplus and private sector borrowing.

What happens to the economy in this model if the private sector switches from borrowing to deleveraging while the government is still running a surplus?

Phase 4: Government surplus and private sector deleveraging

The answer, in so many words, is a Depression. With both the government surplus and private sector deleveraging taking money out of the economy, GDP plunges, from $3,529 when deleveraging began to $1614 just 12 years later.

Figure 13: The private sector switches from borrowing to deleveraging

What happens if, as occurred during the 1930s, the government switches from a 1% of GDP surplus to a 5% of GDP deficit, while the private sector continues to de-lever?

The result is a return to growth, as the deficit counteracts the reduction in the money supply caused by private sector deleveraging.

Figure 14: Government switches from Coolidge surplus to Roosevelt Deficit

Phase 0: What should be done?

I hope the previous simulations have clarified that deficits are indeed “unsustainable, irresponsible, and dangerous”, as Representative Hern’s motion puts it. The question is though, “which deficits?”. The clearly dangerous deficit is the private sector’s. The government can sustain deficits and accumulate substantial negative equity because it owns its own bank. The private sector cannot sustain deficits for a substantial period of time, because it doesn’t. Since one sector’s negative equity is the rest of society’s positive equity, the safe situation is for the government to have negative equity and the private sector to have positive equity.

It is possible for this to occur with the government running a deficit and the non-bank private sector borrowing from the banks at the same time. This final simulation shows the impact of a sustained government deficit of 2.5% of GDP—roughly the average for the USA for the last 120 years—and the private sector borrowing with a 7-year time constant for lending and 11 for repayment. This results in a nominal rate of growth of 5.25% p.a., a private debt ratio of 57.5% of GDP and a government debt ratio of 47.5%. That is the combination to which we should aspire, in our current monetary regime.

Figure 15: Deficits and limited credit, the ideal situation

Conclusion

The obsession politicians have with running a government surplus results from a partial perspective on the monetary system. With a holistic view, the real danger is the private sector’s deficit—which is the mirror image of the government’s. The best situation for the long term is to enable the private sector to sustain a surplus, which requires that the government sustains a deficit. This is possible for the government because, with a Treasury, a Central Bank, and a fiat currency, the Treasury can sustain and finance its negative equity indefinitely (leaving aside what happens on the external account for now).

If the government instead becomes obsessed with achieving positive equity itself, then the private sector is pushed towards negative equity. The private sector response to this can be to gamble on financial assets: to borrow from banks and take levered positions in assets like property and shares. I haven’t included these factors in this simple model, but it is notable that the two periods where the US Government ran a surplus coincided with the two biggest stock market bubbles in American history, and the aftermath were its two deepest downturns (before Covid).

The scale of speculative borrowing when Coolidge was lauding his government’s surplus is staggering: margin debt rose from about 1% of GDP when he came to office to over 12% by the time of the 1929 Crash. It plunged even faster than it rose in the aftermath, to bottom at ½% of GDP in 1933. During the post-WWII period, it remained well below 1% of GDP until the Clinton administration came to power—obsessed, as Coolidge was, with achieving a government surplus.

Figure 16: When governments run surpluses, the private sector gambles

Correlation is not causation, but once again, the level of margin debt rose, from ½% of GDP in 1992 to the Triple Peaks of 2000, 2007, and … now (the data is incomplete because of changes in how it is recorded—whoever designed the latest data set at https://www.finra.org/investors/learn-to-invest/advanced-investing/margin-statistics needs to do some basic courses in data management!).

Figure 17: Margin debt over the long term

The bottom line of this set of posts is that we have to think about finances in an integrated manner, and not just focus upon one component, as “deficit hawks” like Hern do. With an integrated perspective, the sensible conclusion is the one MMT reaches: that the government should run deficits and be in negative equity, to enable the private sector to run surpluses and be in positive equity. Periods of apparent prosperity that coincided with the surpluses of the Coolidge and Clinton eras were the result of private sector levered speculation by a private sector that was experiencing (identical) deficits at the time. Rather than “saving for a rainy day”, these government surpluses helped set off speculative bubbles whose later crashes caused the greatest economic downturns in America’s pre-Covid history.

Private sector deficits as “unsustainable, irresponsible, and dangerous”. Public sector deficits are sustainable, responsible (subject to their impact on inflation and the balance of trade), and safe. It’s time for the “Deficit Hawks” to worry about private sector deficits, not the public sector deficit.

This is not at all what I thought I’d be writing about tonight, let alone what I wanted to do. I am writing a eulogy for my friend and intellectual companion, David Graeber.

These are the tweets and DMs that I first sent in reaction to this shock:

Oh David! @davidgraeber. . They say only the good die young, but why did you have to be one of them? There’s even more bullshit in the world now that you are no longer with us. It was a pleasure to know you, and it is a tragedy to say goodbye.

I’m an agnostic and so was David @davidgraeber. But if he’s doing anything at all right now, it’s an anthropological study of Heaven. Preceded by a brief study of Hell, but just for comparative reasons. The Devil was sad to see him go.

I’m agnostic, but for the very first time, I am wishing that there is life after death, I told @stacyherbert , when she wrote “He’s actually trending in America now on Twitter! I wonder if he would be mortified by that or laughing his ass off . . . I suspect the latter?”

So yes David, this fellow agnostic wishes he’s wrong, and I hope you can read this and are laughing at what a sentimental twat I’m being. And being jealous of me getting smashed on Tequila as I write this—though I suppose Heaven has much better Tequila than we get down here on the Purgatory that is Earth in 2020.

2020.

Personally, David’s death feels as if 2020 is a mugger, who’s watched me escape relatively free from the chaos of 2020, and thought “OK boy, I’m going to get you where it hurts”.

So congratulations, 2020, I feel—at least to some tiny degree—the suffering that people are going through now, from losing a loved one to the Coronavirus.

I’d been exempt until now from 2020’s travails. I was in Amsterdam during Sydney’s fires, which threatened my family, but fortunately they weren’t affected. I jumped ship from Amsterdam to Thailand when it became apparent that Thailand was doing a much better job of containing it; now it has in fact eliminated it—though in more “2020 Sucks” news, Thailand has just reported its community transmission/unknown origin first case in over 100 days).

In a year of tragedy, I’ve generally managed to be an observer.

And now, one of my best friends, one of the people I admired and learnt from, whose company I all too infrequently enjoyed, and who happens to be one of the intrinsically nicest people I have ever known, has died.

“Take that Keen”, says 2020.

I’m still an observer though, compared to David’s wife, Nika. God knows how she must be feeling now. I was delighted to meet her with David at an Extinction Rebellion meeting in 2018, I enjoyed having dinner and chatting with them. I saw how much happier David was with her in his life, and how happy they were together. I thought they were set for a long life of happiness together. And now he is gone, and she is on her own.

They were married only recently, but they met a very long time ago: I’ve probably got parts of the story wrong, but they were neighbours in New York, and there was attraction then but Nika was married. That marriage ended and Nika contacted David. The rest is their love story, which I saw and, as one does a great relationship, I envied.

They understood and appreciated each other as very few couples do. Max and Stacy, I think you’re another such couple. Ross and Megan, you too. There are very double acts in this contrarian world I inhabit: just those three really. And now we’ve lost one of them. Or, rather we and Nika have lost David.

David was special for many, many reasons.

The first I’ll mention is what I expect is the foundation of David’s appeal to Nika: his trusting innocence. There was a boyish openness and lack of ego in David that made you trust him, because you could.

He was, at the same time, extremely intelligent and extremely funny. He had a nervy aspect, very befitting of someone raised in New York. But he was fundamentally funny, and looked on the world with a sense of bemusement, and all the while, incisive insight. He was intrinsically an anthropologist, in that he was capable of living amongst people and seeing their customs more clearly than they could themselves, while all the while celebrating those aspects, the good and the bad, because they were his people as well.

There was a selflessness to David too. There wasn’t an ounce of David’s body that was in it for David’s benefit alone. Well, he enjoyed his pleasures, but they could never be had at the expense of another person. That made him someone you could trust with your life.

On top of that, he was an excellent if sometimes rambling speaker, whose charisma attracted support which was worth giving. David, I believe, came up with the slogan “We’re the 99%”. David, I believe, developed Occupy Wall Street’s voting system, which was a very powerful form of democracy that still respected the rights of the minority. He was a true leader in large part because he didn’t want to be.

He was also an excellent historian of money and debt. If you haven’t read Debt: the first 5000 Years, buy a copy and do so. It’s such a pity that David won’t be here to chronicle the start of its next 5000 Years.

That’s the other thing: the suddenness. I knew David wasn’t feeling well—I’d exchanged a few messages with Nika where David’s health came up. Maybe it was Covid—I still don’t know. I won’t speculate.

But it is so bloody awful to lose such a brilliant, lovely, funny, warm human being. It’s the unkindest cut of all that 2020 has managed to deliver.

Now we know why we speak of 20:20 vision, and 20:20 hindsight. We thought it was an ophthalmologist’s crazy numbering system. In fact, it was a warning from a time traveller.

The previous post finished with the observation that, since the sum of all Equity is zero, and the banking sector must be in positive equity, part of the remainder of the economy—the government, or the non-bank public—must be in negative equity. So which sector is better equipped to handle that: the non-bank public, or the government?

This will raise the age-old question that is perennially thrown at those who advocate government spending: “How are you going to pay for it?”, or “Where’s the money going to come from?”. To answer both these questions, we first need to know how money is created in general.

Since money, exclusively in this model and primarily in the real world, is the sum of the Banking Sector’s Liabilities and Equity, any action which increases Bank Liabilities and Equity creates money. Since every transaction is recorded twice, operations which increase the money supply must therefore occur on both the Assets and the Liabilities/Equity sides of the banking sector’s ledger. Operations which occur exclusively on either the Assets side, or the Liabilities/Equity side, shift money between accounts and do not create money.

So the answer to the “where’s the money going to come from?” question is “from any operation which increases the Assets and Liabilities/Equity of the banking sector”. Equally, any operation that reduces Assets and Liabilities/Equity destroys money.

Only 5 of the 13 flows in this model affect both the Asset and Liabilities/Equity sides of the banking sector’s ledger: Lending (and Repayment); Government spending (and Taxation); and interest payments on Treasury Bonds. These are shown in the top 5 rows of Figure 1. All other operations are either Liability/Equity swaps, or Asset swaps, and they don’t create money.

Figure 1: The Banking Sector’s Ledger

Operations that don’t create money include the usual suspects—payment of interest on loans by firms (which transfers money from the Firm Sector to the Banking Sector), purchases of goods from the Firm Sector by workers, capitalists and bankers. But they also include two operations that figure large in conventional arguments about how to pay for government spending: sales of Treasury Bonds to the finance sector; and purchases of Treasury Bonds from the finance sector by the Central Bank in “Open Market Operations” (which are primarily used to control the rate of interest). Neither of these operations create money.

They are asset swaps: the sale of Treasury Bonds to the finance sector (the “Banking Sector” in this model) reduces Reserves and increases the Banking Sector’s stock of Treasury Bonds. The purchase of Treasury Bonds from the Banking Sector by the Central Bank reduces the Banking Sector’s stock of Treasury Bonds and increases the Banking Sector’s Reserves. Neither operation affects the amount of money in the economy—the sum of the Liabilities plus Equity of the Banking Sector.

Since it’s an asset swap for the Banking sector to buy Treasury Bonds using Reserves, the answer to “where’s the money going to come from?” is “from operations that increase the sum of Reserves and Bonds”. You can work this out by adding up the entries in the Reserves and Bonds columns of Figure 1: the Banking sector assets Reserves plus Bonds will grow if government spending plus interest payments on Treasury Bonds exceed taxation:

         

The Reserves that are used to buy the Bonds thus come from the deficit itself. The deficit—the extent to which government spending and interest payments exceeds taxation—creates money in private sector bank accounts (the Firm Sector and Bank Equity only in this model). This boosts the Liabilities and Equity of the Banking Sector. The corresponding Asset that is increased by the deficit is the Reserve accounts of the banking sector. If no interest is paid on Reserves—the “usual” situation, and sometimes made worse by charging negative interest on Reserves in the false belief that this will encourage Banks to lend more—then the Banks have a positive incentive to use these reserves to buy Treasury Bonds instead.

So the answer to the “Where’s the money going to come from?” to pay for the deficit question is that it comes from the deficit itself: the deficit creates money that can be spent in the private sector; and it creates Reserves, which are (usually) non-interest earning Assets of the Banking Sector that are liabilities of the Central Bank—see Figure 2.

Figure 2: The Central Bank’s Ledger

Reserves are Assets of the Banking Sector that earn it no income. But if the Treasury issues bonds to cover the deficit—if the total value of Treasury Bonds offered for sale is equal to the deficit itself—then the Banking Sector is offered a deal to swap a non-income-earning asset for an income-earning one.

What do you think the banks would do, when offered that deal? They take it, of course: this is why Treasury Bond Auctions have always been over-subscribed. Selling the bonds themselves is not a problem. It is, as Kelton emphasises in The Deficit Myth, a “no brainer” swap of a zero-income-asset for a positive-income-asset.

The money needed to buy the bonds has already been created, and is sitting in the Reserve account. Banks then transfer their funds from one Asset that earns no income (Reserves) to another Asset that does (Treasury Bonds). This Asset is a liability, not of the Central Bank, but of the Treasury itself—see Figure 3.

Figure 3: The Treasury’s Ledger

This table also shows that the increase in Reserves is caused by the fall in the Government’s equity: Reserves (and hence money) rise if the Government runs a deficit; Reserves and money fall if the Government runs a surplus:

         

How does the Treasury pay the interest on the bonds? The same way it pays for spending in excess of taxation: it runs up its own negative equity—see the final column in Figure 3.

This can be done in two ways, as indeed can overall deficit-financing itself: by the Treasury having a negative balance in its account at the Central Bank; or if the Treasury borrows from the Central Bank to pay Interest on the Bonds (the second last row of Figure 3). If it does so, the negative equity from paying interest on the bonds remains, but the Treasury Account at the Central Bank can be kept non-negative.

A third option is that the Central Bank buys the bonds off the Banking Sector in Open Market Operations (or QE). If it does so, the amount of interest the Treasury needs to pay falls. Also, since the Treasury is the effective owner of the Central Bank, it doesn’t need to pay interest to the Central Bank on its holdings of Treasury Bonds—or if it does, the interest payments come back to the Treasury in Central Bank profits.

So the Government can run a deficit, and pay interest on the Treasury Bonds issued to cover it (not finance it: the deficit is self-financing in that it creates money), so long as it is willing to countenance being in negative equity. As noted in the previous post, because Banks must be in positive equity, the non-Banking sectors (and that includes the Government) must be in negative equity. For the Government to achieve positive equity therefore—which seems desirable, if you take the partial view of the economy epitomised by Representative Hern’s motion that “deficits are unsustainable, irresponsible, and dangerous”—the non-Bank private sector must be pushed into even greater negative equity.

Does that sound like a good idea?

To show the consequences for the economy of the government running a deficit or a surplus, it’s necessary to go beyond the purely structural equations used so far, and enable simulations. In what follows, I’ve built an extremely simple model of monetary dynamics in which all expenditures depend on the amounts of money in relevant bank accounts. There are many other ways these expenditures could be modelled, but this way ensures fairly easily that crazy outcomes—like workers have negative bank balances, but still spending their wages—don’t happen in this very simple model.

For example, I relate consumption by workers to the level of workers deposit accounts at the private banks, using the engineering concept of a “time constant”. This is a number that tells you how long an action would take to run an account down to zero, if it’s removing money from the account, or to double it, if it’s adding money to an account. A time constant of 0.02 for workers consumption says that if workers consumed at a constant rate of there were no other inflows or outflows in their accounts, then they would run their accounts down to zero in 1/50^th of a year—roughly a week. Higher values for capitalists and bankers—say 2 for capitalists and 5 for bankers—assert that it would take 2 years and 5 years respectively for them to run their accounts down to zero through consumption alone.

You divide the relevant stock (the level of bank accounts, in the case of consumption) by the time constant to get the annual flow—see Figure 4.

Figure 4: Equations for consumption

Similarly, a time constant of 9 for bank lending says that if this was the only inflow affecting the level of debt, and it went on at a constant rate, debt would double in 9 years. Repayment with the same time constant means that the level of (private) debt remains constant.

Figure 5: Modelling interest payments, lending and repayment

GDP is treated as the turnover of money in the firm sector (it can also be treated as the sums of consumption and investment—which investment is entirely debt-financed in this model—and net government spending, but that makes it possible to end up with negative sums in deposit accounts, unless a much more complicated model is constructed).

Figure 6: Modelling GDP and income distribution

Government spending and taxation are treated as simple percentages of GDP. For the moment, I have not considered how they are financed, so the flows Bonds_B, Bonds_CB and Interest_Bonds are not wired up. The equations that define the system’s flows at this point are shown in Figure 7. At this stage, sales of Treasury Bonds to the Banking Sector, Central Bank purchases of Bonds from the Banks, and Treasury borrowing from the Central Bank, are not defined.

Figure 7: All the flow equations in the model (without bond sales or interest on bonds)

With no explicit financing of a government deficit, the negative equity that this causes for the government turns up as a negative balance in the Treasury’s account at the Central Bank—see Figure 8, which shows the impact of a 2% of GDP deficit for 60 years on the Treasury. It runs accumulates negative equity of $160, and that is entirely due to its account at the Central Bank being negative to the tune of $160.

Figure 8: The Treasury’s Ledger with no bond sales: negative Treasury Account and Treasury Equity

Figure 9 shows the impact of a 2% of GDP deficit for 60 years from the Central Bank’s perspective, and the key point is that the negative equity of the Treasury is the same magnitude as the positive Reserves of the Banking Sector: the accumulated deficits of the Government are precisely equal to the accumulated Reserves of the Banking Sector.

Figure 9: The Central Bank’s Ledger with no Bond sales: negative Treasury precisely equals positive Reserves

How does the picture change if we require that the Treasury’s account at the Central Bank can’t go into overdraft? Then the Treasury has to sell Bonds equal to its Deficit, and borrow from the Central Bank to pay interest on those bonds.

Figure 10: Bond sales are equal to the deficit, no Central Bank purchases of Bonds from the Banking Sector

Running this model to the same point as the previous one, where the Treasury Equity reaches minus $160, this negative equity consists of $115 in Bonds and $45.2 in Loans from the Central Bank (see Figure 11; the Treasury account at the Central Bank remains at zero). The Bond sales represent the accumulated government deficit over time, while the Loans from the Central Bank represent the accumulated interest on those bonds.

Figure 11: Treasury books with Bond sales covering the deficit

Can the Central Bank afford to lend the money to pay the interest on Treasury Bonds to the Treasury? Yes: as Figure 12 shows, the loans to the Treasury are an Asset of the Central Bank. It has the capacity to expand its balance sheet indefinitely, and none of the operations shown in this model affect its equity at all.

Figure 12: Central Bank books with Bond sales and interest payments on Bonds

I have to note that this was a surprise to me: I had guessed that the government’s negative equity would be carried by the Central Bank, and the fact that a Central Bank—unlike a private one—can operate with negative equity {Bholat, 2016 #6037} would be what enabled the government as a whole to sustain negative equity. But it turned out that my guess was wrong: the Central Bank simply acts as an enabler of and conduit for the Treasury’s negative equity.

Does the fact that the Treasury is borrowing from the Central Bank (in this model) cause any difficulty? No, because while private individuals can’t pay interest on loans by borrowing from banks—without that interest ballooning with further interest and driving us bankrupt—the Treasury can pay interest on Bonds to the Banking Sector by borrowing from the Central Bank because, technically and legally, the Treasury owns the Central Bank. It therefore doesn’t have to pay interest on any loans from the Central Bank If it did, it would get that money back in dividend payments from the Central Bank anyway.

What happens if the Central Bank buys all the Bonds from the Banks? Then the negative equity of the Treasury consists entirely of its debt to the Central Bank (see Figure 13).

Figure 13: Treasury’s books with Central Bank Open Market Operations purchasing all Treasury Bonds

Since those Bonds have been purchased off the Banking Sector, the Banking Sector has Reserves of 160 (see Figure 14). This is not as desirable a situation for the Banks as when they own the bonds, because with no Treasury Bonds they receive no interest payments from the Government. Far from the finance sector in general having “Bond Vigilantes” ready to deny the government bond sales if they’re worried about the state of government finances, the “Bond Vigilantes” are vigilantly on the lookout for sales of Treasury Bonds so that they can swap out of a non-income-earning asset and into an income-earning one.

Figure 14: Banking Sector’s books with OMOs buying 100% of Bonds

In the next post, I’ll consider what the impact is of different fiscal regimes: the government running a deficit (as the USA has for most of the last 120 years—roughly of 2.5% of GDP); the government running a surplus; the government running a surplus and the private sector borrowing from the Banking Sector; the government running a surplus and the private sector reducing its debt to the Banking Sector; and the government running a deficit while the private sector reduces its debt to the Banking Sector.

One Mathematical Model of Modern Monetary Operations

I confess immediately that I chose the title and subtitle for this post because their acronyms are palindromes.

The subtitle is more accurate than the title, because this model considers only the monetary aspects of MMT: the Job Guarantee and inflation management components are not yet incorporated. But the monetary assertions of MMT remain in dispute in economic and political circles, so it is worth putting these into a mathematical model where their veracity can be tested.

The primary stimulus for developing the model was the publication of Stephanie Kelton’s The Deficit Myth. Stephanie has written the book for non-technical readers, and she’s done a very good job: it’s a very easy read that explains why many conventional wisdoms about government spending are wrong. But MMT is facing heavy resistance in political and economic circles, with my favourite to date being a motion before the US Congress, posted by Representative Kevin Hern, to resolve:

That the House of Representatives (1) realizes that deficits are unsustainable, irresponsible, and dangerous; and (2) recognizes— (A) that the implementation of Modern Monetary Theory would lead to higher deficits and higher inflation; and (B) the duty of the House of Representatives to condemn Modern Monetary Theory.

The objective of this series of posts is to allow the assessment of the first part of this motion—the assertion that “deficits are unsustainable, irresponsible, and dangerous”.

The models in this post are built in the Open Source system dynamics program Minsky, whose unique feature is the capacity to build models of financial flows using what are called Godley Tables (in honour of Wynne Godley, the pioneer of stock-flow-consistent-modelling). These tables enforce the “law of accounting” that (see Figure 1).

Figure 1: A blank Godley Table

Once an account is flagged as an “Asset” for one entity, Minsky knows that it has to also be shown as a “Liability” for another entity. This
makes it possible to take an integrated look at the financial system, which allows us to assess Hern’s motion from the perspective of the entire monetary system, and not just the Government’s view of it.

An Integrated View of Deficits, Surpluses, and Equity

This Minsky model is a simple but complete model of a domestic monetary system. It has six sectors which can be divided into five components:

• The Treasury, and the Central Bank, which together constitute the Government Sector;
• The Banking Sector;
• The Firm Sector, Capitalists and Workers, which constitute the “NonBank Private Sector“;
• The NonBank Private Sector and the Banking Sector, which constitute the “NonGovernment Sector“; and
• The sum of the Government and the NonBank Private Sector, which constitute the “NonBank Sector“.

For simplicity, taxes—and government spending—are levied only on the Firm Sector, and banks make loans only to firms (the aggregate outcome would be the same if the model were generalized to have taxes and spending and loans in all sectors—it would just be much harder to read the tables).

There are just thirteen financial flows:

• Treasury spends on firms (Spend);
• Treasury taxes firms (Tax);
• Treasury sells bonds to the Banking Sector to cover any deficit (Bond_B);
• Treasury pays interest on Treasury Bonds owned by the Banking Sector (Interest_Bonds);
• The Central Bank buys and sells Treasury Bonds in “Open Market Operations” (Bond_CB);
• Banks lend to firms (Lend);
• Firms pay interest to Banks (Interest);
• Firms repay some debt to banks (Repay);
• Firms hire workers (Wages);
• Firms pay dividends (Dividends);
• Workers buy goods from firms (Cons_W);
• Capitalists buy goods from firms (Cons_K); and
• Bankers buy goods from firms (Cons_B).

Minsky provides an integrated view of how these flows interact to determine the financial position of each of the six sectors in the model in interlocking double-entry bookkeeping tables. It generates differential equations from these flows that show how the stocks—the financial accounts—change over time.

The danger to which Hern alludes is immediately apparent when we look at the Treasury’s Equity—the final column in Figure 2: if Treasury spending plus interest payments on outstanding Treasury Bonds exceeds taxation revenue, then its Equity will fall.

Figure 2: The Treasury’s accounts

Mathematically, the rate of change of Treasury Equity is the sum of the flows Tax minus Spending minus Interest payments on Bonds held by the Banking Sector:

         

Given the initial conditions used in this post, in which Treasury Equity starts as zero, a deficit will immediately put the Treasury into negative equity.

This is not offset by the Central Bank, which comes out with no impacts on its equity position at all (note, this is not what I expected when I started building this model).

Figure 3: The Central Bank’s accounts

The rate of change of the Government’s Equity is therefore equal to its surplus—or the negative of its deficit, since the government has normally been in deficit for as long as records have been kept—see Figure 4. The only periods in which the Government has been in surplus for a sustained period are:

• The 1920s, between mid-1920 and mid-1931, a period of 11 years;
• The immediate post-WWII period, between early 1947 and mid-1949, a period of 2 years; and
• The late 1990s till early 2000s, between 1998 and early 2002, a period of 4 years.

Figure 4: US Government Surplus Divided by GDP. The average value is minus 2.48% of GDP

Returning to the model in this post, the impact of the Government deficit on the Government itself is entirely borne by the Treasury:

         

Summing the Treasury and Central Bank Equity equations to show the dynamics of the Government’s equity yields Equation :

         

Looked at just from the point of view of the Government sector then, running deficits is clearly “unsustainable, irresponsible, and dangerous”. If the government wants to have positive equity, then it should run a surplus. It’s an open and shut case—or so it appears, when looking just at the government’s books.

But in this model (and the real economy itself), one entity’s Asset is another’s Liability. So, to know whether a government surplus is a good idea for the system as a whole, we have to ask what the impact is of a government surplus on the rest of the economy?

The rest of the economy is the NonGovernment Sector, the sum of the Banking Sector, and the “Non-Bank Private Sector“: the three non-Government and non-Bank sectors, Firms, Capitalists, and Workers. This model has been set up so that Capitalists and Workers are not directly affected by government spending and taxation, or interest payments on bonds, so we can answer this question just by looking at the economy from the Banking Sector’s point of view (Figure 5) and the Firm Sector’s point of view (Figure 6). The government actions that affect the equity of the Banking Sector and the Firm sector are shown at the top of each table.

The first line in Figure 5 shows that what is a negative for the equity of the Government Sector—paying interest to banks for their holdings of Treasury Bonds—is a positive for the Banking Sector.

Figure 5: The Banking Sector’s accounts

Similarly, first two lines of Figure 6 show that what is a negative for the equity of the Government sector is a positive for the Firm Sector, and that what is a positive for the Government is likewise a negative for the Firm Sector: Government spending increases the equity of the Firm Sector, and taxation reduces it.

Figure 6: The Firm Sector’s accounts

The non-Government net financial position is therefore the mirror image of the Government’s:

         

The deficit defines the flow, in dollars per year. Equity is the accumulation of that flow over time, in dollars. The NonGovernment sector’s equity is, like its deficit, the negative of the Government Sector’s Equity:

         

An integrated perspective on government finances thus reveals two undeniably uncomfortable truths:

• For the Government to run a surplus, the NonGovernment sector must run a deficit; and
• For the NonGovernment sector to be in positive equity, the Government Sector must be in identical negative equity.

Like two halves of a see-saw, both cannot be up at the same time. If the government runs a surplus—if the sum of interest payments on bonds plus spending is less than taxation—then the non-government sector is forced to run an identical deficit at that point in time. If the NonGovernment Sector is in positive equity, then the Government Sector must be in identical negative equity.

These outcomes are the macroeconomic consequences of the fact that one entity’s Asset is another’s Liability. The flows in Equations and show changes in Equity at one moment in time. Because these flows are identical in magnitude, but opposite in sign, at the aggregate level, the Equity of an entire economy is zero, and the rate of change of aggregate Equity is also zero.

Therefore, if one subset of the economy has positive equity, the remainder of the economy has identical negative equity. Equally, if the rate of change of one sector’s equity is positive, then the rate of change of the equity of the remainder of the economy is identical in magnitude, and negative. This is shown by Equation , where the first instance of a flow term is shown in black and the second instance in red: there are nine terms, each repeated twice, once as a positive and once as a negative. The sum is zero.

         

The question therefore is not whether deficits—and negative equity—are good or bad, but whose deficits and negative equity are sustainable or non-sustainable.

There is one sector that cannot be in persistent negative equity in a sustainable economic system: the Banking Sector. A bank must have positive Equity: it’s Assets must exceed the value of its Liabilities, otherwise it is bankrupt. Therefore, for a sustainable economic system, the Banking sector must necessarily be in positive Equity (periods when the Banking Sector as a whole is in negative equity are periods of extreme financial crisis, like 2007 and 1929).

It follows that the NonBank Sector—which is the sum of the Government plus, in this model, Firms, Capitalists and Workers—must be in negative equity. This is unavoidable, given that the sum of all Equity is zero. The only question is which subset of the non-Bank economy—the Government, or the NonBank Private Sector—will be in negative equity? Which sector is better placed to handle being in negative equity?

 

That question and others will be considered in a subsequent post.

Postscript

Figure 7 shows the full six Godley Tables that constitute this model, and Equation shows the differential equations generated by this model. If you’d like to explore this model yourself (it is attached to this post), download the latest beta release of Minsky from https://sourceforge.net/projects/minsky/files/beta%20builds/. The beta (currently version 2.19.0-beta.25) has features used here than are not in the current release version (Version 2.18). A subsequent post will define the flows used here to enable simulations, but the basic points of MMT are structural: they can be gleaned from the differential equations themselves, as I have done in this post.

Figure 7: Full Minsky MMT Model

         

 

Another two months has passed since my last update, and as with the last, much has changed in just two months. For those who want just a quick summary, the main news in this bulletin is that:

• We’re moving from Trang to Bangkok, now that the whole of Thailand is Covid-19 free (except for two quarantine breaches which the Thai authorities have reacted to very rapidly—see “PM urges return to ‘normality’ after scare“—there hasn’t been a locally transmitted case here for almost two months);
• I’ve finished four major research pieces (attached here), and am about to start a set of new tasks;
  • A review of Stephanie Kelton’s The Deficit Myth;
  • The third and final volume of the cartoon book on money that Miguel Guerra and I are collaborating on; and
  • A book for school students on what economics could be like, entitled Economics Matters Because…—this has been commissioned by Polity Press, who published my last book Can we avoid another financial crisis? (Patrons can access their electronic copy of this and my other books here).

Moving to Bangkok

It’s just four months since I made the decision to leave Amsterdam and move to Thailand, which was feasible because my partner is Thai. We arrived on March 19^th, one day before the Thai authorities started to prevent non-residents entering Thailand, and before quarantine or even compulsory self-isolation was introduced. Now, the country is only allowing citizens (or those on official business) to come here, and everyone must undergo strict quarantine.

Those who, like me, were here as tourists, have had their visa waivers extended till July 31^st (what happens after that date is still unknown). No local transmission case has occurred in almost two months now. So long as the authorities remain vigilant about border control, Thailand will be virus-free. I now plan to make this move to Thailand a permanent one.

Patron Neil Goddard’s Covid-19 visualisation tool makes it easy to reflect on this decision. I was in Sydney meeting with the development team for Minsky between February 18 and March 11; I arrived back in Amsterdam on March 13, and I made the decision to leave for Thailand on March 15. Across these dates, the infection data changed dramatically. Though Thailand had cases first (and was, for a time, the country with the 2^nd most cases after China), the rate of growth of cases there plunged compared to both Europe and Australia.

When we arrived, a surge in cases occurred in all 4 countries that I had to option to live in (Australia, the UK, Netherlands, and Thailand). But only Thailand crushed the curve: Australia let a few cases spread through quarantine and it’s now combating the feared “second wave”.

A plot of new cases per day per million people emphasises just how well Thailand handled this pandemic versus wealthier and supposedly more savvy countries. The peak rate of infection in Thailand was 2 cases per million people; in the UK and Netherlands it was over 80. Australia’s rate, which was falling towards zero, is now rising again after lapses in quarantine and testing allowed a new outbreak to commence (I hope it gets on top of this trend in the next two weeks and joins the smattering of countries that have eliminated the virus, but I won’t hold my breath).

Now that we know Thailand is safe, we’ve decided to move to Bangkok, mainly for my partner’s benefit: I can work and keep mentally stimulated anywhere there’s a power point and an internet connection, but she needs the stimulus of city life which Trang lacks. We’ve located a place not far from her family home, and will move there at the end of July.

Productivity despite volatility

Though my travails are nothing compared to those facing people still living in countries where the virus is rampant, moving countries and setting up house here have made this a wild few months that I expected would trash my productivity. It did trash my fitness: I haven’t worked out in five months, and I’ve gained as many kilos. But I’ve managed to get several significant pieces of research done:

• An expose of the dreadful work done by Neoclassical climate change economists;
• Deriving Macroeconomics directly from Macroeconomic definitions;
• A paper on system dynamics and why the multiplier-accelerator model is useless; and
• A first model of a production system requiring both energy and matter inputs

All four papers are attached to this post. The first three have already found refereed-publication homes: the first on Nordhaus will appear in the journal Globalisations soon; the second will appear in the Review of Political Economy next year; the third is a chapter in a Springer book on system dynamics in economics. The fourth will evolve into a paper with Matheus Grasselli and Tim Garrett, once I get time to work on it again after the move to Bangkok.

Reviewing Kelton

I’ve been working on the above tasks for so long, and so intensely, that it feels like a bit of a let-down to finish them. I could have tried to dive into the next set of tasks, but I was feeling the pressure of so much work at once that I feel bit of a lull is in order. Since I won’t have time to start any major new project between now and our move to Bangkok at the end of next week, I’ve decided to use the time to review Stephanie Kelton’s The Deficit Myth instead. I’ll try to use Minsky models to illustrate my review, and I will probably record a quick video, using Minsky, on the fundamental points of MMT as well.

Keep Safe!

That’s it for now. Thanks again to my Patrons for their support, without which very little of the research detailed here would have been possible.

This is the third in a series of posts documenting the development of a single commodity model of production with energy and matter. In the first I published what appeared to work as a model, but which had obvious scaling issues. In the second, I explained that this first model had errors that I spotted when working with Matheus and Tim: there was no formal link between the output of the energy sector and the energy consumption of all three sectors (energy mining, iron ore mining, factory turning iron ore into iron plus slag).

In this post, I can report on an error-free model. Following Matheus’s suggestion, I modelled the system as effectively vertically integrated: the output of both energy and mining was set to meet the needs of the whole economy. Energy output (E, not shown in the model below) was equal to the needs of energy in all three sectors; mining output (or iron ore) was identical, by the conservation of matter, to the matter output of the factory sector (which consists of both iron, and slag).

This made it possible to work with a composite of capital, rather than modelling capital and output in three separate sectors. It led to some complicated constants, but it worked. The product was the expected “Goodwin cycle”, but in this first model occurring in the wage rate (in kilograms of iron per year) and aggregate capital (measured in kilograms of iron).

Now that we’ve completed it, one of the research outputs of our group will be a paper linking the original Goodwin model to these two extensions. They were done both for their own sake—to replace the “ad hoc” productivity in the Goodwin model with something derived from the reality that all production is based on energy—and as a foundation for integrated modelling of economics and ecology. Waste output is easily added to this model, and related to the output of iron; CO2 is easily added and linked to the consumption of energy. Feedbacks can be added from waste generation (both slag and CO2) to the productivity of the economy—the sort of realism that is notably absent from the “Integrated Assessment Models” produced by Neoclassical eCONomists like William Nordhaus and Richard Tol.

I’ll close this Patron-only post with the observation that this project showed up a weakness of Minsky as it stands. Though I’m showing the simulation in Minsky, it was actually easier to do the logical work in Mathcad (see the two files attached to this post; the image below is an excerpt from one of those Mathcad files).

The flowchart paradigm is very useful when you are modelling a causal sequence, but there was a lot of algebraic logic needed to get this model right, and there the direct equation entry capabilities of Mathcad were far easier to use than Minsky’s flowchart.

This is one of the reasons that we plan to add the capability to enter parameter and variable definitions on new tabs within Minsky (currently labelled “parameters” and “variables”). It will take some time and programming nous (supplied by Russell Standish and Wynand Dednam rather than me), but I want to have the same capability to write equations just as you would on paper in Minsky—and then simulate them there.

It’s also much easier to read equations—sometimes—than it is to read a flowchart. The first yellow highlighted equation in the figure above is:

    

If you’re into reading math, then that’s pretty easy to get your head around. Not so the flowchart version of the same, which also takes up much more space:

Anyway, I’m posting these files for the interest of those of you who are into mathematical modelling, and as a courtesy to young students, who will often think, when they see a completed work by an academic, that they couldn’t do the same thing. In fact, a lot of research involves making mistakes which are gradually corrected over time. What you see in a journal paper is often the product of a lot of mistakes that get corrected over time. So don’t ever be discouraged by reading a refereed paper.