It's like a car crash, only worse

A small plane took off in dense fog, crashed into a day care, and took down the power in my neighborhood today. Everyone in the plane died. Thankfully the day care was empty. The lights are back on now.

This post, and the resulting discussion, is a similarly horrible crash, and although no one has died, the lights are still firmly off. Don't waste your time with this, rubbernecking is wrong.

Post Keynesianism in a nutshell

Here is a recap of the main points of post-keynesianism. I'm going to try and keep it short, so you will not find arguments, justifications, or retorts to standard questions. Just the core tenants as I see them.

1. Federal Deficit Spending Funds Private Savings

In a fiat money system, the State is a currency issuer, while all other parties (including foreign entities) are currency users. Just as in a basketball game, where each team competes hard for points which are meaningless to the score keeper, the State does not need or value money as it can create as much as it chooses at will. To a fiat currency issuing State, money is just points, to be manipulated to maximize real output.

Therefore the State does not need to tax in order to spend. In fact, when the State taxes it destroys money. Similarly, when the State spends, it creates money. When the State spends more than it taxes (runs a deficit) then it is net injecting newly created money into the private sector. When the State runs a surplus, it is draining the private sector of money. The net quantity of money that the State injects into the private sector sloshes around in there as savings, or more accurately, net financial assets. This mechanism is the only way that the private sector can enjoy positive net financial assets, as the liability exists in the Government sector.

I like to think of Federal Debt as "paid in equity" as it is the net financial assets that the State creates and transfers to the private sector for that sector to then leverage on top of.

The purpose of taxes, then, are not to fund Government spending. They are to 1) create demand for the currency in the first place and 2) regulate aggregate demand. If aggregate demand gets too high and creates inflation, the State can raise taxes, run smaller deficits, and drain the private sector of money. The private sector will then have less money available to spend on stuff, and this will tame inflation. In periods of insufficient aggregate demand (like now) the State should lower taxes to fund private sector savings, and reduce deflation.

2. Loans create deposits

Within the private sector, there are entities known as "banks" which are public private partnerships designed to extend prudent credit (make loans that get paid back). Their function has been incredibly perverted in recent years, but nevertheless this is their purpose and it is why they are given access to "reserve accounts" at the Fed.

When a bank makes a loan it does not drawn down a deposit. It simply creates the loan and credit a receivable asset. This then creates credits a deposit liability at some other bank in the system. If these two banks are the same, then nothing further happens -- the loan has created a deposit. If the two banks are different then the bank making the loan debits its reserve account, and the bank receiving the deposit credits its reserve account. The bank short reserves can either try to attract some deposits back, or it can borrow what it needs on the overnight interbank lending market, or, if the system is short reserves as a whole, it can borrow at the discount window directly from the Fed.

The Fed manages the total level of reserves in the system by issuing Treasuries. Treasuries drain reserves, and thus create a situation where some banks are short reserves, and others are long (instead of a situation where every bank has more reserves than it needs). This creates the overnight interbank lending market as firms trade to hit their reserve targets.

Note that banks are not reserve constrained in their lending in any way. Bank lending is constrained by capital requirements on the supply side, and creditworthy customers on the demand side. In essence, banks have license to "print money" and do so by expanding both sides of their balance sheet at the same time when making a loan. Private capital is in first loss position to encourage banks to only make loans that should be paid back, but a host of innovations (such as securitization) has dramatically undermined the banking sectors ability or interest in assessing credit accurately.

All bank spending, in fact, is done through balance sheet expansion, as they print money to pay salaries, buy printers, and eat lunch. I know, this is crazy, but it's true. Conversely, when loans get paid back (or are written down), money is destroyed and balance sheets contract.

Also note that Treasuries are simply a mechanism to drain excess reserves, and thus create an interbank overnight lending market, and thus set the Federal Funds rate. Treasuries are not the US Govt "borrowing" money and they could stop doing so at any time to no ill effect. In today's ZIRP environment, there wouldn't be any discernible effect at all, actually.

Lay off the Chinese

China buys a lot of US Treasuries, but China is not "funding" the US in any way. Rather, the US is funding China's desire to save US$. China makes real stuff, and gives that to the US in exchange for $. These $ live in a reserve account. When the US issues Treasuries, some of these $ move from reserve accounts to Treasury accounts. When they mature they will move back to reserve accounts. It is no big deal.

I think that's about it. All of the above is based on accounting and operational reality. It is not a "theory" -- merely a description of how things work in actuality. It decimates all of Macroeconomics and the Federal Governments policy towards debt, finance, the financial industry, and unemployment.

Excellent thread

The post is nonsense, but the comments are very good.

Why the PIGS might end the EMU

I've meant to talk further about the link between savings and investment brought up in the previous post, but have not had time.

Next week will be interesting as we see what happens with the PIGS, and the European Monetary Union. PIGS stand for Portugal, Ireland, Greece, and Spain, for Euro countries with weak economies, high unemployment, and large public deficits. European Monetary Union means that these countries cannot issue currency the way the US, or Switzerland can, and operate with real budget constraints, much like US States. But US States can at least hope for Federal largess -- there is no Federal currency issuer in the EU who can write a cheque to the PIGS and bail them out. So they have to choose between debt deflation, and Great Depression level unemployment, or exiting the EMU, reclaiming national sovereignty, and if their obligations are euro denominated, defaulting.

Interest rates have gone parabolic today, as the logic of Diamond-Dybvig pushes those countries toward their only, stable equilibrium.

You'll see columnists talk about how the EMU would be fine if there was more labor mobility etc. This is nonsense. What they need is a super-currency issuer who knows what they are doing. You will also see columnists talk about how the PIGS debt default (if it comes to that) also foreshadows risks in countries like the US and the UK. This is also nonsense, because those countries retain a sovereign currency and thus need never default.