Austrian School: Crap/Not Crap?

[TruXta]

I thought ItWillNeverWork's point was that the austrian schools notion of the free market self regulating was the fact that they don't and didn't, as shown by the fact they created massive bubbles of fictious capital, of money that had no backing.

I'd hazard a guess that most Austrians claim the markets were never free, and that regulation and state intervention is what created the crisis, not "pure" market forces.

 

[ViolentPanda]

I'd hazard a guess that most Austrians claim the markets were never free, and that regulation and state intervention is what created the crisis, not "pure" market forces.

That's the usual excuse: If only market forces had free rein, everything would be fine!

 

[ItWillNeverWork]

If you look at a balance sheet of any bank in it's financial accounts, unsurprisingly the balance sheet adds up to zero - i.e. total assets equals total liabilities - this shows that every asset a bank has is funded by an equivalent liability - i.e. you can't create an asset out of thin air, it has to be funded by something, if you don't have the funding/liability you can't extend the loan/asset

There's a lot in what you've said that I don't quite grasp yet, but on this point above, in this lecture Keen (if I am understaning him correctly - which I'm probably not) claims that the process by which credit is created is as follows:

- Capitalist has an idea and goes to bank for a loan to fund this idea.
- Bank creates two accounts. A credit account which the capitalist can draw from, and a debit account that records the capitalist debt.

So in this scenario, hasn't the credit been created with the books still balancing? He also talks about how neoclassials and some of the circuitists confuse stocks with flows, and that it's the flow of credit (circulation) that enables the expanded production (or something like that anyway). I need to watch the lecture again and do some extra reading I think.

I get the feeling also that I am maybe misunderstanding the subject due to my own fuzzy definitions of all the terms. For example, what measure of money are we talking of? How is 'credit' creation different from 'money' creation? I'm sure everything will be a bit more clear eventually; I am currently doing an open uni module in financial services, so that'll probably help.

Do you have any books you can recommend?

Thank you for being patient with me so far btw. We all have to start somewhere.

 

[sptme]

Re reserve banking, can some one explain:
Say I'm a small bank and the central bank as just deposited $100 in my bank. I want to lend this out with a 10% reserve. Do I:

A) keep $10 in the bank and lend out $90
B) keep $100 in the bank and make up $90 to lend out.

I'd been given the impression that banks did B and that's how the money supply was expanded.

Also, if I charge interest on the loan and the only money available is the original money given out from he central bank. where does the money come from to pay for the interest?

 

[ItWillNeverWork]

The answer is A. According to the money multiplier theory, what happens after that point is that the $90 will be placed by the borrower in another account (maybe at another bank, maybe not). Since the $90 shows up as a deposit, 10% of that can be kept in reserve and 90% lent out again as another loan ($81).

If you follow that process above through to its end, you get 100 + 90 + 81 + 72.9 etc. All of these added together can make a $100 initial reserve expand up to a larger amount. The amount it can expand to depends on the reserve requirement. So in short, the money multiplier works across the banking system as a whole and not in an individual bank.

 

[ItWillNeverWork]

Also, if I charge interest on the loan and the only money available is the original money given out from he central bank. where does the money come from to pay for the interest?

Funnily enough I was just reading into this. The answer is something (I think )to do with the initial loan being a stock (i.e. an amount measured at a given time), and the repayment coming from a flow of funds as the money circulates around the economy. Think about it this way; a single banknote can circulate indefinitely and be involved in settling any amount of transactions, the amount of transactions is not limited by the size of the stock but by the rate at which it circulates over time. One pound can be involved in more than one pounds worth of activity.

Imagine an economy consisting of me, you, and love detective; there is a money stock of one pound which I start with. I give you the pound, you give it to LD, LD gives it to me. In that process (a flow) there has been 3 pounds worth of transactions, but the supply of money (a stock) is still only 1 pound. Interest is able to be repaid out of this process of circulation; if the circulation stops for whatever reason (like it does in a credit crunch) then people cannot service their debts and the economy goes tits up.

Maybe love detective could clarify if I am beginning to get the right idea.

 

[sptme]

So I keep $10 in the bank and lend out $90 but i can claim that my bank is solvent to the tune of $100 because I can count the money I loaned out.

bank B gets the deposit of $90. Loans out $81 and keeps $9 in the bank but can claim its got $90 on its books...and so on.

Is that the right idea?

 

[ItWillNeverWork]

So I keep $10 in the bank and lend out $90 but i can claim that my bank is solvent to the tune of $100 because I can count the money I loaned out.

bank B gets the deposit of $90. Loans out $81 and keeps $9 in the bank but can claim its got $90 on its books...and so on.

Is that the right idea?

Yep, that's it.

 

[sptme]

Yep, that's it.

So you have multiple banks making overlapping claims on the same money.

 

[love detective]

you have multiple banks (and the respective people they lent to) recording separate assets (claims) and liabilities (obligations) that have been created through the circulation of money

IWNW - i agree with what you say about the flow/movement/circulation being more important than the actual stock of base money - i'd tried to get that point across in previous posts, but probably didn't make it clear

edit: i haven't watched that thing that you linked to by Keen, will have a look later and get back on it

 

[love detective]

There's a lot in what you've said that I don't quite grasp yet, but on this point above, in this lecture Keen (if I am understaning him correctly - which I'm probably not) claims that the process by which credit is created is as follows:

- Capitalist has an idea and goes to bank for a loan to fund this idea.
- Bank creates two accounts. A credit account which the capitalist can draw from, and a debit account that records the capitalist debt.

So in this scenario, hasn't the credit been created with the books still balancing?

Had a quick skim through that lecture, and got to say I think it's horribly/poorly explained in terms of the bit that you refer to above. He seems to be conflating the internal accounting transactions that a bank will make in relation to the loan account being formally set up (but not drawn on) with the actual flow/movement of money that happens in reality when the loan is drawn upon (which is ironic as he's always going on about the importance of the flow over the static). These are two very different things, with only the later actually relating to the flow & movement of money between two parties.

What he is referring to above (and not sure why he puts that much focus on it as it's not really the relevant part) is the 'internal' accounting transaction that happens prior to any loan physically being paid out to the borrower. He's technically right in what he says, but this doesn't actually explain the flows that happen once the loan is actually drawn upon/used.

So what he's saying is that when the loan is approved, the bank creates an internal accounting entry which creates an asset (representing the money owed to the bank by the borrower) and a liability (representing the money of the loan which has not yet been drawn on by the borrower, i.e. it's effectively on deposit at the bank by the borrower). So at this point in time, nothing has happened in terms of flows of money between the two parties, nor has their overall debtor & creditor relationship changed. All we have is an equal and opposite asset and a liability for the same amount between two parties that cancel out to zero. So the borrower's net position with the bank (and the bank's net position with the borrower) hasn't changed one bit. Previously he had a net position of zero with the bank, now he has an asset of 100 representing money the bank 'owes' to him (i.e. his deposit account) and a liability of 100 representing the money he owes to the bank. Overall representing a net zero relationship between the two parties. No money has flowed and the debtor & creditor relationship between the two parties remain exactly the same as they were prior to this accounting entry that Keen focuses on.

Once the borrower actually wants to use this money however (to buy something, pay someone etc..) - the bank has to be able to fund this and if they can't, regardless of the digits of a 100 in the deposit account of the potential borrower, the borrower can't get at the money (in reality though, the bank will have funded the loan position at the point of creating the internal accounting entry to ensure it's covered, however this funding of the loan is a completely different & separate thing to the internal accounting entry being discussed). So only at the point in time when the borrower draws on the loan does the original position of a net zero change, to then reflect a net liability on the part of the borrower to the bank of a 100 and a net asset on the part of the bank from the borrower of a 100. So it's at this stage that actually reflects a flow/movement of money - resulting in the creation of net debtor and creditor relationship between the bank and the borrower.

I've probably confused things even more now - so to strip it down a bit to more meaningful stuff:-

If you asked me to lend you a tenner on the phone and I said yes - this point in time is the equivalent of the internal accounting entry that Keen is talking about. i.e. it creates a (contingent) obligation between two parties but doesn't involve anything actually happening (in terms of flows of money). If the next day you come round my place to physically get the tenner, I need to have a tenner to give you. And regardless of whatever internal accounting entries I may have made the previous night, if I can't get my hands on a tenner to give you, then no amount of focus on the internal accounting entries in my ledger is going to magic the tenner into existence to pass on to you.

I only skipped through the lecture, so I may have missed out on something where he explains this more clearly, but that slide in and off itself is a very confusing thing to focus on. It places the focus on the wrong thing/part of the loan creation process - as it appears to focus on the formal accounting entries at one point in time, rather than the external activities required by the bank in order to honour the accounting entries previously created. It's technically correct in terms of the narrow accounting entries and one particular point in the process, but in terms of explaining the totality and capturing the actual flows that are required - I think it's pretty poor.

Also I can see how anyone taking this at face value could come away with the impression that commercial bank's can 'create money' from a few taps on their keyboard. I don't think Keen means to give this impression however as I doubt this is what he believes, but his method of exposition there is pretty poor and can result in people completely misunderstanding what he is trying to get across

 

[ItWillNeverWork]

Also I can see how anyone taking this at face value could come away with the impression that commercial bank's can 'create money' from a few taps on their keyboard. I don't think Keen means to give this impression however as I doubt this is what he believes, but his method of exposition there is pretty poor and can result in people completely misunderstanding what he is trying to get across

You are correct that the lecture is maybe not as clear as it could be. I have taken a look at the paper that this model is based on (edited to add: I just found an updated and better written version of the above paper here), and I think I have a better idea of what he is trying to say. A lengthy quote I know, but this is from the first part of the paper to give a feel for what he is trying to achieve:

1: Introduction

One issue in Heterodox economics on which there is widespread agreement is that the money supply is endogenous—in contrast to the Neoclassical convention of treating the money supply as exogenous (and somehow under the control of the Central Bank). Basil Moore’s pioneering work inaugurated this consensus, with a persuasive verbal and diagrammatic account of the method by which money is created—via the lines of credit that major corporations have negotiated with their banks(Moore 1983: 544, 546; see Rochon 2001 for a longer historical perspective). More recently, the Italian-French Circuit School provided a sound “first principles” perspective on the process of money creation in a pure credit economy (Graziani 1989, 2003).

However, while a verbal consensus exists, there is not yet any accepted mathematical model of how money is endogenously created by the financial-corporate system. Wynne Godley and Marc Lavoie have done the most sophisticated work to date (Godley 1999; Godley & Lavoie 2007), using the Social Accounting Matrix (SAM) framework that Godley pioneered, and there have been many other papers inspired by this approach. Several Circuit theorists have also attempted to model the dynamics of endogenous money, sometimes employing the SAM framework (Bellofiore et al. 2000; Fontana 2003). However, many conundrums exist in this literature—notably, Circuit theorists are perplexed by the issue of whether profits exist in the aggregate (Bellofiore et al 2000: 410; Rochon 2005: 125; Messori et al.2005).

In this paper, I argue for a related paradigm to Godley and Lavoie's, but with five substantial methodological and substantive differences. I then present a deliberately stylized model, which nonetheless captures the essential aspects of endogenous money creation, and provides unexpected answers to several endogenous money conundrums.

2: System design

My framework, which I call a Monetary Accounting Matrix (MAM), is closely related to
Godley’s SAM approach, but differs in five major ways:

1. Time is modelled continuously using differential equations, rather than discretely using
difference equations;

2. The model system states are bank accounts, with assets and liabilities modelled
separately;

3. Wage, profit and rentier incomes are not aggregated;

4. The equivalent to the “Social Accounting Matrix”, the “Monetary Accounting Matrix” (MAM), does not have the restrictions that are applied to Godley's SAM. In particular, though I apply a similar principle to “Each row and column of the flow matrix sums to zero on the principle that every flow comes from somewhere and goes somewhere” (Godley 1999: 394; see also Godley & Lavoie 2007: 9 et alia):

4.1.The columns of the MAM do not sum to zero, but instead return the differential
equations of the model; and

4.2.When endogenous money growth is introduced, the rows of the MAM sum to more
than zero.

5. There is no “nth equation rule”, as in the Godley SAM framework.

(My emphases)

Keen then goes on to demonstrate the construction of this model step by step, introducing a new element at each of those steps along the way. The introduction of the step that 'creates new money' does not appear to the very end, and the part of the video that you talk about is prior to this step – at that point he is merely talking about the internal transaction accounting as you rightly point out.

Most of the paper, then, is about showing that it is possible for a a circular flow model of the economy to be self-sustaining without the need for any new injections of money. What strikes me is that the 'creation' of money in this model feels like an arbitrary addendum to make the model have 'growth'. That growth is achieved by simply adding an amount of money to the loan/deposit accounts of the firm sector at a certain rate as the model runs.

This injection of money Keen puts down to a 'line of credit' used to finance entrepreneurial activity, but without following up by reading the references he mentions, I see no argument presented regarding previous conditions required for this money to be 'created' other than 'keyboard tapping'. Maybe this is deliberate though. He mentions in one of the lectures that the model is really just a heuristic to gain a bit of understanding, and that certain assumptions will be dropped at a later stage.

I have attempted to build the model using the steps outlined in the paper (albeit using agent-based modelling software rather than systems dynamics) and I get the same behaviours out of my model that occur in the paper. I will upload the model as an applet at some point so you can have a play (as well as gaze in amazement at my rudimentary programming skills )

 

[love detective]

Sorry but I don't really have the time to wade through all his papers & lectures at the moment

I think though that both proponents of exogenous and endogenous money theories paint an incorrect picture of the theory that they are opposing. i.e. in the summary above Keen states that exogenousists (is that a word?) claim that money supply is under the control of the central bank, which is clearly not what happens in reality and I doubt is what most of them claim in theory

In reality it's a bit of both, the central bank can influence the money supply in various ways and to various levels of success (as we are seeing at the moment) but it does not 'control' it as Keen suggests that exogenouists claim. Just as actors outside of the central bank can also influence the money supply in various ways and to various levels of success through their economic activity (as we are also seeing at the moment), but they also do not exert full control over it. Combined the actions of the state/central bank, commercial banks, and more generally labour & capital determine the money supply - each does in certain degrees and to certain levels of effectiveness at differing times. To stick to a theory which effectively scrubs out the contribution of one of these and over states the contribution of another is not going to tell us anything about what happens in real life. Their artificially controlled assumption based models may appear to suggest that it's possible in theory, but you just need to look around at what's going on around us in the world at the moment to see that their models and reality are not overly familiar with each other

One basic question I would ask though to anyone who continues to claim that commercial banks can create money purely by tapping a keyboard (i.e. the claim that this tapping is both necessary and sufficient) is why are we in a financial crisis?

If Northern Rock, RBS, Lloyds or Alliance & Lester can create money by tapping away at their keyboards why did they nearly go under in 2008 when they were unable to fund themselves in the money markets, why did they go to the state and central banks for emergency liquidity, when they were sitting upon this magical golden goose that allows them to create money at will? The answer is of course that they can't create money at will. They can play a part in the circulation of money if certain conditions external to themselves are met, however they can't magic these material conditions into existence by tapping on their idealist keyboards.

For the people who claim that commercial banks can create money at will, they have to explain why, when money was desperately needed to survive, they didn't just create it at will in the manner in which it has been suggested they can? If any answer to this question is met with a claim that, oh the conditions weren't right, or confidence had been lost or whatever, then it clearly pulls the rug form under the feet of the claim that they can create money at will, as this shows that this money creation process relies upon something else, something that is not achieved by typing on a keyboard, something that the bank can't just magic into existence.

edit: come to think of it, if people do think that commercial banks can just 'create money' at the stroke of a keyboard, why do banks bother lending money at all? Why do they go to the bother of 'creating' £100 from nothing, and lending it to someone for a year at 10% interest to get £110 back once a year has passed? Why don't they just create the £110 straight away at the beginning and skip out that whole lending part?

 

[bubmachine]

Seemed like politics masquerading as science - or like a religion.

Even though the system they wanted as never existed, and will never exist, they were so convinced that they were right that it is just plain annoying to read.

The "Road to Serfdom", although a piece of skilful rhetoric, is complete nonsense and I am not sure why people took it seriously. (The argument was that: if the economic is not a pure free-market, it will be mixed, and that is just a slippery slope to state socialism. Because it is.)

 

[nino_savatte]

Seemed like politics masquerading as science - or like a religion.

Even though the system they wanted as never existed, and will never exist, they were so convinced that they were right that it is just plain annoying to read.

The "Road to Serfdom", although a piece of skilful rhetoric, is complete nonsense and I am not sure why people took it seriously. (The argument was that: if the economic is not a pure free-market, it will be mixed, and that is just a slippery slope to state socialism. Because it is.)

Though Keynes found Road to Serfdom interesting, he noted that it was unworkable. I find Hayek's arguments (such as they are) against 'centralisation' to be absolutely barking. I also think his logic is flawed - particularly his notion that Nazism and socialism are the same thing.

 

[camouflage]

One can 'create' money by revaluing one's assets upwards, can one not? Isn't that Keen's point about the ponzi scheme that was the exploding property market?

love_detectives incisive posts aside, a plethora of money-like financial instruments are created in an increasing frenzy during the development of a bubble, and more money can be created simply through the valuation of assets (which again, start to sky-rocket as the bubble develops).

For me it basically all comes down to dreams, hopes and promises. Despite the attempts of any government or ruling party to control it, people make promises to eachother and on the back of those promises further promises are made. There's only so much energy and material to go around of course so then the whole expansionary paper-dreamland must collapse back to what's actually available. There's nothing wrong with this in my opinion, normal human behavior, plans exist in the future, inhale exhale, rhythms of life, etcetera.

Libertards in my opinion just don't like people, our tendency to live in societies, or the trust we have to have in total strangers to get by day to day. That's why they're obsessed with cold shinny yellow metal.

*ps thread bumped as I'd forgotten about it and now remembered it

 

[camouflage]

yeah, that's what I assumed ItWillNeverWork was talking about.

I mean the banks did lend way beyond their funds and instead of this being solved by them crashing and burning, instead they got bailed out by public money, as well as central banks actually having to print more money.

In that sense the commercial banks essentially increased the money supply by presenting states and central banks with a fait acompli? no?

No, typing money into the system like that simply causes inflation, nothing is gained. We're seeing in my opinion commodity price inflation now thanks to all the QE.

 

[littlebabyjesus]

No, typing money into the system like that simply causes inflation, nothing is gained. We're seeing in my opinion commodity price inflation now thanks to all the QE.

How is that due to qe? If anything, I would have thought that it is more likely to be due to effects such as Peak Oil. Peak Oil is likely to leave commodity prices permanently higher over the coming years until dependency on oil is reduced.

 

[camouflage]

i'm off out to the IWCA xmas social in a minute so will need to return to this tomorrow

briefly though IWNW made a number of points in his initial post - i agreed with most of them (i.e. the ones you repeated above about the fallacy of the market self regulating and I made agreeing comments on that in the last couple of paragraphs of this post above) but not with all of them (i.e. about money creation), so I think some of these points are being conflated and talked about as one thing when they are not

and yeah central banks have printed money, but if that doesn't circulate with appropriate vigour (which at present it's not really) it doesn't do much in terms of the overall money supply. As the key measures of money supply reflect not only how much 'base money' is in the system but how fast it circulates - and the base money part is usually only a small fraction of the total wider money supply, with the rest made up of it moving around everywhere, circulating, velocity and all that stuff. So the central bank creation of money through QE and the like is an attempt to boost up the overall money supply through injecting more base, to compensate for the fact that the crisis has resulted in a massive contraction in the velocity of circulation compared to previously

MV=PT, pump up the M as a sub for wanting a bigger V. Or something.

 

[littlebabyjesus]

ld explains well how qe doesn't necessarily cause inflation, though. I used to think that it had to, but ld's arguments have convinced me otherwise. It's what money does that counts - ie how it circulates.

This is one of the places where monetarism is fundamentally wrong. Governments don't control the size of the money supply in the way that monetarists think they do.

 

[camouflage]

How is that due to qe? If anything, I would have thought that it is more likely to be due to effects such as Peak Oil. Peak Oil is likely to leave commodity prices permanently higher over the coming years until dependency on oil is reduced.

I wouldn't bring Peak Oil into it just yet, I'd say it's far more likely that the additional trillions are the cause of commodity price inflation... interesting point though, where does one effect end and the other begin.

 

[littlebabyjesus]

I wouldn't bring Peak Oil into it just yet, I'd say it's far more likely that the additional trillions are the cause of commodity price inflation... interesting point though, where does one effect end and the other begin.

You need to show how. The last round of qe probably had an effect here in the uk on top-end house prices, providing banks with funds to lend out but in a situation where they will only lend to very low-risk borrowers. And, um, that's probably the extent of the effect. Banks are so risk-averse at the moment that they will not lend to anyone to provide for the basics except at extortionate interest rates - and qe appears to have made little difference to that. The extra money just sits there on deposit at the Bank of England in case there is another run on the banks - or it's used to go straight back out and buy more government debt.

As we have a situation at the moment where more money is being paid back than borrowed, the real risk is deflation - the reduction in the amount of money circulating due to this process. qe is a direct response to that reduction - an attempt to offset it. As such, it is a logical thing to do, although far from the best thing to do, imo - far better to give us the money than the banks, allow us all to pay down our debts in a way that doesn't cause deflation. Or just to print money to be paid directly to workers on, for instance, social housing building projects.

I think my question would be this: If the rise in the price of international commodities is due to qe, why has qe only affected the prices of those things? Why has it not caused a general across-the-board inflation?

My answer would be that the reasons for the increases in international commodity prices are probably elsewhere.

 

[camouflage]

Well alot of it is in the form of dollars, the international currency, so maybe the things that are traded in dollars mostly are inflating. I agree with what you say though, but the banks are using the money they've been given, to play the commodities market... I could be wrong though, talking about what's happening in the world of finance is far less interesting to me than talking about economic ideas so I was probably only half listening when I picked up this impression of what the banks are doing with all the money they're not lending to us.

Mind you if they aren't.. that's all bubble for the future I reckon.

 

[littlebabyjesus]

I can't see any bubble for the foreseeable future - at least certainly not in housing. The point is that bubbles need both the ability to lend and the desire to borrow. Nobody is going to borrow against a house in anticipation of its price going up at the moment, I wouldn't think.

Something dramatic would have to change to see a bubble situation again. Japan went through rounds of qe, and its house prices are still below where they were in 1989. Its inflation also remains around zero - indeed it still struggles to avoid deflation. The link between qe and inflation is far from straightforward.

 

[camouflage]

I made my last post in the bout-to-leave-work-rush, so it could stand some clarification. I figured a quick google of the words constituting my point (qe2 commodities inflation) should throw up the right sort of thing, and sure enough... this.​

​

A quick scan of which seems to be along the lines of what I've been saying since last February... and then some. Looks like an interesting article actually.​

 

[littlebabyjesus]

That's interesting. It suggests that it is specifically US qe that is causing the commodity inflation.

I wish they wouldn't misuse the word theorem, though. It is a theory, not em.

 

[ViolentPanda]

... interesting point though, where does one effect end and the other begin.

I suspect we're going wrong if we think of effects as being mostly independent of one another, with effects ending and another beginning. If we look at the complexity wrought by, for example, derivatives (and I don't mean the products themselves, but their effects), then we need to accept that effects, be they from Peak Oil, other scarcity, commodities blips or from banking chickens coming home to roost, interact with each other and sometimes synergise in terms of the number of people they effect. I think it's impossible to blame Peak Oil, QE or any other single factor.

 

[ViolentPanda]

I can't see any bubble for the foreseeable future - at least certainly not in housing. The point is that bubbles need both the ability to lend and the desire to borrow. Nobody is going to borrow against a house in anticipation of its price going up at the moment, I wouldn't think.

Something dramatic would have to change to see a bubble situation again. Japan went through rounds of qe, and its house prices are still below where they were in 1989. Its inflation also remains around zero - indeed it still struggles to avoid deflation. The link between qe and inflation is far from straightforward.

TBF, UK housing prices are still in a bubble, to all intents and purposes.

 

[littlebabyjesus]

TBF, UK housing prices are still in a bubble, to all intents and purposes.

In some ways, yes. I think the reason they haven't halved as you might have thought that they would is the ongoing housing shortage in this country - that combined with the low interest rates has just about stopped them from plummetting. I anticipate them bobbling around at much the same level for a few years yet. I'd be amazed if they started going up again in a concerted way.

 

[deke t lefel]

come autumn, purple will be considered the new black and flares will be back in fashion